Why Good Deals Die; Reference Checks #104
Going into a few reasons why deals die and areas to negotiate (outside of price); the importance of doing reference checks
Why Good Deals Die
This post was inspired by a tweet by Brent Beshore.
Contrary to popular belief, deals die for reasons that have nothing to do with the price. Once a buyer/seller has agreed upon a deal in principle, it's in everyone's best interest to close the deal as soon as possible. However, without the right team and processes in place, deals can easily be set up for failure.
To put into the context of real estate, it's the equivalent of estimating a home renovation job all by yourself (or perhaps with a few friends) instead of working with professional contractors. The cosmetic work may seem doable with hard work but it's impossible to go a layer deeper and start assessing structural issues.
Here are a few thoughts on the list above (which I believe is largely accurate):
Having domain expertise is a cheat code. It sounds obvious but you only truly appreciate the value of a seasoned operator, lawyer, accountant and/or advisor when you're in the room trying to get a deal done. The best ones are able to use lessons from the past while keeping an open mind to new ideas. Past failures/mistakes can ultimately be a crutch and limit buyers from getting in their own way.
Aim to negotiate with the decision-maker. The number of intermediaries between the buyer and seller is often the biggest reason why deals take a lot longer than they should. Each intermediary has its own objective (see #8 on the list above) and everyone ultimately ends up playing a game of broken telephone.
M&A is a huge time commitment on both sides. This is an aspect that sometimes gets missed by buyers (especially novice buyers) and almost always is underestimated by the seller (who, in their defense, is looking to sell for the first and last time). The amount of processes and documentation that both sides ultimately go through is quite tiring and can create a build-up in frustrations.
Analysis and project management are equally important to get a deal done. Despite the credentials needed to get into the M&A space, the best deal-makers are often great at managing several stakeholders and clearly communicating goals, tasks, and timelines. As a buyer, many of the people you're working with have competing priorities/projects and your role largely hinges on being able to get everyone to focus on what's necessary.
I also found this list from Brent's essay (How to Acquire Your First Smaller Company) to be quite informative on all the tools available to influence the purchase process without actually changing the price. This also goes to show how the price paid for a business can be quite deceiving as you never know what the structure underneath actually looks like.
My take on the tools below is to always focus on keeping things simple.
Seller Debt: The seller helps finance a portion of the purchase price. It’s like any other debt, with a size, term, interest rate, security, and covenants. Depending on the situation, you can delay the amortization, or make it a bullet payment. If you don’t know many of these terms, start Googling.
Example: $3M seller note at 5% interest, on a six-year term. The first three years are interest-only, with it fully amortizing thereafter. The loan is recourse to the buyer’s equity interest in the company and subordinate to senior debt, including a working capital line of credit.
Earn-Out: Payments to the seller are based on performance. Pretty much whatever you can dream up can be done. But a warning: the more complicated, the less likely you’ll get the deal done, and if you do, the more likely you’ll have major conflict with the seller post-close.
Example: There will be a $2M payment after year two and a $3M payment after year five, as long as the company’s gross profit levels remaining at greater than $10M in every year after the transaction. So if in year 4, the gross profits drop below $10M, the final $3M payment isn’t earned.
Executive Compensation: Most sellers will continue working for the business post-close. You can adjust their compensation and the term of employment up/down as a deal tool.
Example: Seller will get a base salary of $200,000 and customary benefits, plus a bonus of $50,000 based on performance benchmarks. The initial employment contract will be for three years, but the company can buy out the contract at any time for 50% of the remaining salary.
Consulting: It’s not unusual for a seller to be associated with the business in an advisory capacity for a considerable period of time upon leaving their full-time role. Usually this comes with a smaller amount of compensation.
Example: After full-time employment ends, the seller will become Board Chairman and will be paid $50,000 per year.
Management Fee: If you’re buying 100% of a company, the management fee is irrelevant. Otherwise, it’s important. Determine how much and what it covers. The more specific, the better.
Example: Buyer will receive a monthly management fee equal to 3% of TTM EBITDA, which covers all oversight and travel expenses. Extraordinary work within the company will be mutually agreed upon and separately compensated.
Example: Buyer will agree to a 10-year triple-net lease at $17,000/month with a 2% per year escalator. Buyer gets an option to renew the lease for an additional 10 years at the same terms. At any point during the first lease term, the buyer may purchase the property for an 8% cap rate.
Preferred Equity: Classes of equity can be created that come with features.
Example: Preferred A shares receive an 8% coupon that is received yearly as a payment-in-kind and get a 2X liquidation preference.
Senior Debt: The senior most position on a company’s cap table, usually occupied by a bank. If you’re not buying 100% of the company, this can be a discount mechanism because the company is assuming the debt.
Example: Buyer’s offer for 70% equity interest includes $6M of senior debt provided by Regional Bank.
Subordinate Debt: Debt that sits below the senior debt. Also called mezzanine financing.
Example: In addition to the $6M of senior debt, buyer will employ $5M of mezz debt.
When it comes to hiring, there's a lot of unfair emphasis on the interview itself. Candidates are pressured to show the best version of themselves and interviewers are required to get an accurate assessment of an individual in a 30-60 minute time frame.
This essay by Graham Duncan - What's Going On Here? - is a great read on the importance of hiring well, how to be in the right mindset as the interviewer/hiring manager and how to do reference checks well. The last point is probably the most tactical for hiring managers and quite honestly, an area that is grossly neglected.
Reference checks are often considered to be not too useful because the person giving the reference is likely an advocate for the candidate. However, Graham points out that the questions asked often puts the reference provider in a position to defend the candidate. A more appropriate framework would be discuss what the ideal role for the candidate looks like and why. Instead of looking to defend whether the candidate should be hired at all, you'll have a more fruitful discussion around what the candidate is good at.
Here's a 'reference guide' by Graham Duncan that serves as an excellent resource:
There are two kinds of information: public information and private information. Our personal assessments of our peers and former employees are firmly in the bucket of private information. That’s both what makes references valuable, and what makes them hard to get.
Your mission is to collect as many private assessments on your candidate as possible.
Remind yourself that your base case is that you will not proceed with the candidate despite the fact you’re at the stage of doing references. You want to create a default mindset that listening to the references is going to actively make you change your mind to make the hire. “Let the references speak” is our mantra.
For each candidate there is often one reference that is the motherlode, the Yoda reference—the unbiased, calibrated, no bullshit, clear-eyed reference, someone with “acerbic good taste” who has experienced your candidate with limited ego baggage of their own and is willing to transfer that private information to you. Sometimes you get them on the first call, sometimes it’s on the 20th call. Have you found that reference giver yet? If not and the context permits, do not proceed with the hire, allow yourself to hold the uncertainty.
Assess whether the reference giver is calibrated—what’s their sample size and do they actually know what excellence in this role is? (Assume 80% of people are not calibrated on the Michael Jordan of this thing.)
Assess whether you find the reference givers themselves credible. Identify any biases. Would you hire the reference givers or want to work for them? If not, make sure you weight the content of the reference slightly lower.
Try to mess with the expected “script” of a reference conversation, where the reference giver reads a LinkedIn testimonial and you read from a check-list of questions. Skim the questions below in advance in order to have them in mind, but try not to read from the list because it creates a different dynamic, more interrogation and less creative exploration and appreciation of someone’s idiosyncrasies.
The dog that doesn’t bark is the hardest thing to assess and requires calibration / a big sample size —what could they say on the positive side but are not saying?
Do references in person if you can, Zoom is second best, phone is third best.
Start with an opener that makes it safe to convey private information: “Thanks for taking the time. I’m trying to find the right seat for Jane and I’m investing the time in speaking to people who know her. Everything you say will be off the record, and I don’t plan on conveying any of it back to Jane.”
Questions to Ask
How would you describe Jane to someone who doesn’t know her?
What’s your sample size of people in the role in which you knew Jane?
Who was the best person at this role that you’ve ever seen?
If we call that person a “100”, the gold standard, where’s Jane right now on a 1-100?
Does she remind you of anyone else you know?
If Jane’s number comes up on your caller ID, what does your brain anticipate she’s going to be calling about? What’s the feeling?
Three attributes I like to keep in mind are someone’s hunger, their humility, and how smart they are about people. If you were to force rank those for Jane from what she exhibits the most to least, how would you rank them?
What motivates Jane at this stage of her life?
If you were coaching Jane, how would you help her take her game up?
If you were going to hire someone to complement Jane doing the same activity (NOT a different role), what would they be good at to offset Jane’s strengths and weaknesses?
How strong is your endorsement of Jane on a 1-10? (If they answer 7, say actually sorry 7s are not allowed, 6 or 8? If the answer is an 8, “What is in that two points?”)