What happens when a minority of shareholders don’t agree to the terms to acquire or merge their company? The terms could change drastically… or the deal could fall apart completely.
But, says Nate Gallon, managing partner of the Silicon Valley office of Hogan Lovells, there’s a way to avoid that fate… because the shareholders will be contractually obligated to vote “yes” on the sale. This provision is well-known in the world of Private Equity and Venture Capital but not elsewhere.
Nate talks about how to lay the legal groundwork to make this strategy work, as well as…
Mentioned in This Episode: www.hoganlovells.com
Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here, that’s a clean exit for owners, founders, and their investors.
Today I’m joined by Nate Gallon, office managing partner of the law firm Hogan Lovells, in Silicon Valley. Nate has spent his entire career here in the Valley working with the tech community, representing all flavors of entrepreneurs, from startups to the major corporations we know of every day. We hear about them every day in the media. As well as the entire ecosystem of the investor community that funds and supports these innovators. Nate, welcome to M&A Masters, and thanks for joining me today.
Nate Gallon: Thanks for having me, Patrick. It’s a pleasure to be here.
Patrick Stroth: There’s a lot of legal groundwork that needs to be laid way before owners and founders can even start thinking about an exit. And Nate, you were featured as a speaker in the latest Silicon Valley M&A forum, where you presented an informative briefing on the topic that needs to be brought to the attention of owners and founders planning an exit. And that’s drag along rights. Now, so the audience, I’ll let Nate explain this provision, which is routine in the venture capital and private equity worlds, but it may not be top of mind elsewhere. And that’s why he was highlighted recently, and why I wanted him to come on and share his knowledge with you on this. But before we drag Nate into that conversation, let’s start here with, Nate, why don’t you give everybody a little bit of context as, how did you get to this point in your career? Why did you pick tech, the law, and then tech law, and then ended up here in Silicon Valley?
Nate Gallon: Yeah. So yeah, I’ve been here in Silicon Valley my entire legal career, which is about 20 years. It’ll be 20 years this summer. Prior to my time at Hogan Lovells, I spent 15 years at another local Silicon Valley law firm. But my whole career has been focused on working with technology companies and investors, and to a lesser extent, life sciences companies and investors, because I wanted to be part of the economy that was creating new ideas, creating jobs, and was really helping to expand the economy and provide novel products and services and other items to the community at large. I didn’t want to work in traditional industries. I wanted to work with entrepreneurs and wanted to understand and be a part of the new technologies that were coming into existence.
And that hasn’t changed in my 20 years. I look back on what I’ve experienced, and it’s truly astonishing, the technologies and the platforms that we’ve seen come out of not just Silicon Valley, but the technology and life sciences community throughout the United States and in other parts of the world. So that’s really what attracted me.
And in M&A, and my focus is on both M&A, and equity transactions, and venture capital, and strategic investments, as well as representing entrepreneurs. And that really gives me a firsthand look at the companies, working with entrepreneurs, working with major corporations to buy companies from entrepreneurs, and really get your feet wet and get to understand everything that’s happening within the community, while also being able to act as a business advisor and help from a financial perspective for both buyers and sellers in M&A to achieve their goals. And in venture capital to help investors achieve their financial goals when they invest in new technologies and platforms.
Patrick Stroth: Well Nate, you and I share a common passion, and that is we have an affinity for people out there, the entrepreneurs that start with nothing and create something. And go from zero, to one, to two and help marry them with other parties that will get them from two to 10. And so it’s a great, great place to be in, and there’s no better place in the world than right here in Silicon Valley, while it is spreading elsewhere.
But let’s get to the topic here. What are drag along rights, and why are they so important?
Nate Gallon: Yeah. So drag along rights are something that’s been in the venture capital and the private equity community for certainly as long as I’ve been practicing, and I’m certain before that. A drag along provision, it’s a provision that’s usually located in stockholder’s agreements, occasionally in the bylaws, whereby the stock holders of a target company agree to vote in favor of, and not oppose or hinder a sale of the company. And to take any other action that’s reasonably required to consummate a sale transaction, including, if it’s structured as a share purchase, to sell their shares to the third party in the transaction.
So in other words, at the time that the venture investors make their investment in a company, well in advance of, sometimes years in advance of an M&A transaction or exit, the venture investors will often require that the parties to the stockholder’s agreement, essentially all the preferred stock holders, and typically most if not all the common holders sign on to an agreement. A stockholder’s agreement that says, if in the future, the board … and so either majority or super majority of the stockholders vote in favor of a sale of a company, to sell the company to a third party, then the other investors that are parties to that agreement, whether or not they agree with that sale transaction are bound, contractually, to vote in favor of the transaction, not oppose a transaction, and if required to tender their shares or take other action to ensure that the sale transaction takes place.
So it’s a way of ensuring that potential dissenters, or those who would challenge or oppose an M&A transaction will be contractually bound to vote in favor of, and go along with the transaction.
Patrick Stroth: So you can’t have the tail wagging the dog if one, lone dissenter wants to hold up … one dissenter can’t gum up the deal.
Nate Gallon: Exactly. Exactly. And that gets into kind of the priorities, and why would investors, or why would companies agree to such a transaction? And if you think … or a such a provision. If you think about it, there are reasons why the investor would want it, and there are reasons why a company founder might want it. Especially if you have a dispersed shareholder base, or you expect that you’ll have a dispersed shareholder base, there are oftentimes competing interests that look differently on a sale of the company depending on the liquidation waterfall. And by that I mean the, the capital structure, and which series and classes of shareholders get paid first versus last in a sale transaction. There may be competing interests and competing visions as to whether a particular M&A transaction is in the best interest of the shareholders.
So what this does, is it ensures that that kind of debate doesn’t happen at the time that the sale transaction’s in front of you. Essentially, it forecloses that debate, subject to the parameters that are actually negotiated in the drag along. And that’s often where the devil meets the detail.
Patrick Stroth: Yeah. So the benefits really on this are, this will make the decision a lot cleaner with the major shareholders. And you can’t have one party who may have an opposing viewpoint, or see things differently for whatever reason, they’re not going to slow this down. Are there any other benefits along with that?
Nate Gallon: Correct. Correct. So if you think about, let’s take the merger structure, which is one of several different acquisition structures we use when buyers are acquiring a company. The merger agreements will have a condition that the stockholders approve, some specific percentage of the stockholders approve the transaction as a signing condition. And as a closing condition, so in order to actually close the transaction, there will typically be a condition that no more than a small number or small percentage of stock holders have dissenters or appraisal rights under law. And those are, depending on the state, whether California, Delaware, or otherwise, dissenters or appraisal rights are creatures of state law that provide a judicial mechanism whereby shareholders who do not believe that they are getting fair value in the transaction in a merger can … if they adhere to a very specific time schedule that’s prescribed by state law, can have their shares valued in a court hearing, can have them valued as to whether or not the shares are more valuable or less, potentially, than the deal value.
And there are a number of headaches associated with that, because that is something that can happen following the closing the transaction. So buyers want to know that there are very few, usually under 5% of the shareholders of the outstanding shares, are eligible to have dissenter’s claims. If you have a drag along, it allows the sellers to much more easily, the target company, to more easily satisfy that closing condition. And that’s something that, for a founder that wants a deal done, or that venture capital investor, or strategic investor that is a preferred holder that wants a deal done, it allows those who are in favor of the deal to ensure that those small holders can’t gum up the closing by having the company fail to satisfy that minimum appraisal rights closing condition.
Patrick Stroth: You could actually …
Nate Gallon: Go on.
Patrick Stroth: I’m sorry to interrupt. You could have a situation then, if you don’t have drag along rights, where a small minority could really harm the deal post-closing, which now everybody gets harmed.
Nate Gallon: Right. Right. And what happens is if there are post-closing appraisal claims, typically a buyer will require that the company shareholders, former shareholders, the target’s former shareholders have to indemnify the buyer for any claims arising out of those dissenter’s claims. So to the extent that the buyer has to hire counsel to litigate an appraisal rights claim in Delaware court, those costs would ultimately be borne by the former target shareholders. And so through the indemnification process, and those former target shareholders will ultimately receive less deal consideration because essentially they are funding the legal fees of the buyer’s counsel in defending that appraisal rights claim.
Patrick Stroth: So that’s insult to injury. You’re the seller, you want to sell, you have a buyer that wants to buy, you’ve got these small percentage of dissenters that are going to hold this up. And if they’re successful in slowing this down and causing legal action, then you, the seller get to pay for all this, whichever way it goes. So that’s a real negative. That’s a real negative out there.
Nate Gallon: And that’s the outcome. If the buyer ultimately chooses to close in spite of there being a significant number of potential … or I should say, of shares available to press appraisal claims at the closing.
The other is, if the closing condition is not satisfied. So for instance, if the closing condition says, no more than 5% of outstanding shares of the target are eligible to bring appraisal claims at or after the closing. If that closing condition’s not satisfied, the buyer can walk away from the deal. So it’s not just if the buyer closes the deal, there’s an indemnification risk where the seller’s ultimately receive less total consideration because of indemnification claims. It actually can be a deal risk where the buyer could walk away. Hopefully that wouldn’t happen, but that is always a risk. So you have not just financial risk, but actually risk of getting the deal done if the closing condition’s not satisfied.
Patrick Stroth: Yeah, that’s Armageddon for sellers, is getting a deal … getting it signed and then not … and failing to get a close, and failing to get across the goal line. Then you have to go after all that time, energy, and passion has been used up, you’ve got to go back to the marker, back out. That’s just worst case scenario on the sales side.
Are there any limitations to drag along rights?
Nate Gallon: Yes, that’s a good question.
Patrick Stroth: Or is this is just a great magic bullet?
Nate Gallon: No, that’s a very good question. Typically the standard negotiated drag along rights usually have exceptions. So the drag along can be triggered by a vote of some majority or super majority of the stock holders, but they are usually conditions to enforcement. And the conditions vary depending on the deal you’re negotiating, but typically there are a number that you see, and I would say are generally customary in venture capital transactions. And you can actually find a lot of these … you can find all of them in the National Venture Capital Association forums, which are available online at NVCA.org. The NVCA has model venture capital investment documents for the entire suite of documents you’d use, including the … what we call a voting agreement. Which is a form of stockholder agreement that typically include the drag along.
And the types of conditions are, for instance, that the proceeds in an acquisition are allocated to the stockholders of target in accordance with the liquidation waterfall in the target certificate incorporation. That there are limitations on the scope of representations and warranties that a target shareholders must personally give in the acquisition agreement. And if the scope of the reps and warranties goes beyond that, then essentially that can frustrate or negate the ability to enforce the drag along.
There are other provisions around caps on liabilities for … on the liability of a stock holder of a target. And depending on the type of transaction, when and if at all a particular target stockholder can be liable for fraud or other claims by another stockholder. So it’s a fairly detailed set of exceptions, and you really have to look through them and navigate them closely to make sure that the exceptions do not frustrate … the exceptions, when you compare them to the deal you’re negotiating, do not invalidate the ability to enforce the drag along.
Patrick Stroth: All right. Now, in a practical sense, how do the drag along rights … how do they work, or how are they triggered? Is it just … if you have them set up, if you’ve got a competent attorney that helps you get your bylaws set up, you’ve got them in your agreement, and everybody’s aware of them, but they’re in there as you go forward on an acquisition. Who can trigger the drag along rights, or is it an automatic provision that just … they’re here, they work, move forward. How does it, in a practical sense, work?
Nate Gallon: Right. So the drag along would be in the voting agreements that I just mentioned. And you would have all of the preferred investors typically, and many, if not most, of the common investors signing on as parties to the agreement. As the company goes through successive rounds of financing, round series A, series B, you would continue to add parties to that agreement to make sure that you’re capturing the universe, so that you have 100% or close to … as close as possible, hundred percent drag along coverage.
When there’s an actual sale transaction before you, there are different ways it plays out. But usually the company has a good sense either through normal communications, regular communications or otherwise over whether stockholders have been on board with the company, whether they’re friendly, whether or not they’re not friendly. So that’s kind of just, know your stockholder base.
Second is, typically you have the major investors sitting around the board table. And oftentimes they are, or some subset of them, is sufficient to trigger a drag along. So if you’ve gone through successive rounds of financing, you may have three, or two or three, or maybe even more venture capital firms or strategics on there that collectively can trigger the drag along. So what you would do is you would have the board approve a transaction. You’d have the specified or required shareholders approve the transaction that triggers the drag along. And then between signing and closing, you would go out, reach out to the other stockholders with an information statement, with disclosure of the transaction, solicit their consent to approve the transaction. And it’s through that solicitation process, is usually where … that interim period between signing and closing, is where you would really start to shake out those who are in favor versus those who are not.
And oftentimes, if it’s a deal where people are making a relatively good return on their investment, it’s not so much people opposed to it as it is logistics. You often have people who are out in a boat for a month and you can’t reach them. That can often be a problem. Where the brass tacks are is when it’s a deal where not everybody’s making money, or not everybody’s getting the return that they expect to get. And that’s where you start to have challenges. And where, between that … you want to know before you do the solicitation, how enforceable is the drag along relative to the deal that you’ve cut with the buyer? But once you go out and do the solicitation, then you really have to kind of look at your drag along and figure out against whom you need to enforce it.
And a drag along is enforced because one of the key practice points is, a drag along has to have … should have a proxy and a power of attorney whereby the proxy in the agreement will state that if a shareholder opposes a transaction but is subject to the drag along, that shareholder … if that shareholder is obligated under the drag along to vote in favor of transaction, even if he opposes it, the proxy is granted typically to the company CEO or a member of the board. The proxy holder, the CEO, can vote that reluctant shareholder’s shares in his place and in favor of the transaction. So you’d have a proxy, and it would be coupled with a power of attorney that which grants that CEO, the proxy holder, the ability to sign a consent on behalf of the reluctant shareholder to approve the transaction.
So that’s the teeth of enforcement. And if there’s no proxy or power of attorney, enforcement’s much harder because you’d have to sue the reluctant shareholder in court to enforce the drag along provisions, which is a much more cumbersome process rather than relying on a proxy and a power of attorney.
Patrick Stroth: Yeah, and it speeds it up too because if somebody just decides, well I’m just not going to vote. I won’t dissent, I just won’t vote, and I’ll try to slow you down there. They’ve got the proxies in place, and it’s been signed off on with power of attorney. So it’s well supported. Very well buttressed provision.
Is there … I mean, is there a reason not to have drag along rights? The only thing I could ever picture is if you got a sole shareholder with one investor, and they’re both equal investors or something. But is there any situation where drag along rights shouldn’t be there?
Nate Gallon: The only instance is if … the term I use is the dragger or the dragged. If you are likely to be the dragged, it obviously does not make sense for you to put a drag along in place. It’s often hard to determine, especially if it’s a later stage company, based on the capitalization table, whether you will be the dragged or the dragger. But typically the … it’s lead investors that want the drag along, and especially if you are a follow on investor, or maybe more likely a small investor as part of a larger syndicate, it’s more likely that you would be dragged rather than dragging. But it’s hard to say.
And I would say, as a general matter, and as a general practice point, having a drag along in place is a good thing to have. I’d say nine times out of 10, the scenarios I see, whether I’m representing an entrepreneur or representing a venture fund, a drag along is a good thing to have in place.
Patrick Stroth: Well, now in cases where a company … and this would happen with companies that probably haven’t had initial funding, they haven’t had a seed round, they’ve just pretty much opened up and been self-sustaining their entire duration, and maybe haven’t needed to look at their bylaws that often. They may not have the drag along rights provision in there. What can you do? They can be added on. How does that work?
Nate Gallon: Yeah, so if it’s a non-institutionally backed company, if it’s self-funded or bootstrapped, we do see those a fair amount. And a lot of times it’s friends and family, so you’ve got a lot of investors, or you have a number of investors that may or may not be well versed in venture capital investing. That can present its own challenges from just an expectations perspective. But you can always put a drag along in place later on, after you have a stockholder base in place. The challenge is, you won’t be able to get anybody to sign up to … you can’t enforce a drag along on somebody who hasn’t consented to be parties to that agreement, or to be bound by those provisions.
So if you don’t realize until after you have 30 investors that you need a drag along, well, you need to get each one of those 30 investors to sign up to an agreement that includes a drag along. You can’t force it on an investor without his or her consent.
Patrick Stroth: Well it may be easier to do that if there’s nothing on the horizon, right then. So if you notice that you don’t have it, you think you should get it, and there’s no deal on the horizon. Might be easier to get agreement, to get all those bases covered. It’s just one of those things that you really don’t want to have to start chasing down when you’re on the clock to try to stage up your company for an acquisition. So that’s why I think it’s … this is just one of those issues where, again, it’s like if you’re building a house, and now thinking about where the rain gutters go. It’s a minor thing, because everybody’s thinking about kitchens, and roofs, and windows, and garages, and stuff.
These are the types of things that, while they’re not right top of mind, they’re easy to address, I think, with a professional that can fast track you through the process, to check and see if you’ve got them. And if you don’t, get them in there. I think it just pays dividends down the road. If not in dollars, it does in time and quality of life because you’re not stressed out with one of these things that’s easy to overlook if you don’t have an expert looking at this.
Nate, if we’ve got a lot of listeners out there that want to look more into this, and maybe just to see for themselves if they’ve got it, or what it would take to get it, you’re the guy to go to. How can our listeners reach you?
Nate Gallon: Yeah, Patrick, the best way to reach me is, you can email me. And my email address is ngallon. That’s N-G-A-L-L-O-N@hoganlovells.com. And you can also contact me through phone. You have … my bio’s on the web. You can always find my bio and contact information on the web. I am the managing partner at Hogan Lovells in Silicon Valley, and you can reach me here in the office here. You can come by anytime. We’re here in Menlo Park, and we are embedded in the venture capital and the M&A communities, and would certainly love to hear from anybody that has questions or would like to discuss this further.
Patrick Stroth: Very helpful, Nate. Again, you took a real technical, legal issue and brought some life to it, which is what you did at the forum. That’s why I thought it’s great value to our audience. So thank you very much.
Nate Gallon: It was my pleasure. Thanks for talking.
When you hear the word drone, you might think of the military uses, the proposed Amazon.com delivery drones, or those jokers who shut down airports by flying drones around runways.
But drones are serious business, says Gretchen West of Hogan Lovells in Silicon Valley.
There are little-known commercial uses of drones that save time, money, and lives that will only expand in the near future… as long as government regulations can keep pace with development of new technology.
The industry is maturing quickly, as is M&A activity in this space. We talk about that, as well as…
Mentioned in This Episode: www.hoganlovells.com
Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters where I speak with the leading experts in merges and acquisitions. We’re all about one thing here. That’s a clean exit for owners, founders and their investors. Today, I’m joined by Gretchen West, senior director at the Law Firm Hogan Lovells in Silicon Valley. Years before the commercial drone industry was taking off, no pun intended, Gretchen was already at the forefront of the Unmanned Systems Industry advocating on behalf of the global community to reduce the barriers to enable operations and use. Now, Gretchen has been a key speaker and authority on all things drone for the past couple years and was recently featured at most current Silicon Valley M&A forum. Gretchen, welcome to M&A Masters and thanks for joining me today.
Gretchen West: Thanks for having me, Patrick.
Patrick Stroth: Now, the reason why I asked to come along today and talk to our audience is, when we think about drones, I want to go back and compare it to the evolution of the airline industry, which didn’t exist until 1914. That’s actually 11 years after the Wright brothers had their first flight ever. We compared it with the drone industry which didn’t really come to our public attention until 2001. That’s when we knew about military drones. It took more than 10 years later. The next time the public really heard about drones is when Jeff Bezos was featured on 60 Minutes talking about using drones for delivery. That was done in 2013. It just seems like yesterday. The reason why you were featured on the recent Silicon Valley forum and the purpose of our conversation is to highlight just how in the blue an industry we take for granted today just didn’t exist not very long ago and in a very short period of time became a wide part of everybody’s daily lives just like the airline industry.
If you’re an entrepreneur out there, how can you take advantage of a trend that you see it coming? Because there are a lot of opportunities out there for things that didn’t exist beforehand. We look at the drone situation here and that’s just our latest example of something from nothing. Before we get into talking about all things drone with Gretchen, Gretchen, why don’t you give our listeners a little bit of context and tell us how you got to this point of your career and with drones in particular?
Gretchen West: Sure. Well, I’ve been working in the drone and unmanned system space for about 15 years. Back when I first started, I was working for a non-profit, which my experience is in non-profit management, I worked for an association that focused on air, ground and maritime vehicles that were unmanned and so remotely piloted or autonomously piloted. Back then, it was really all military. Quite honestly, this technology dates back to the Vietnam war. Some would even say World War II. A lot of this technology was developed decades ago. It obviously evolved over the years into more sophisticated military equipment, but like you said, Jeff Bezos put us on the map from a commercial perspective but even a lot of the commercial applications were developing a few years before that. I really focused my work now.
You said that this is a newer industry. There’s lots of challenges. My work is really focused on helping enable this technology because I’ve seen a lot of the benefits, the commercial drone technology can bring to the public and to various industries. The work that I focused on is really reducing those barriers so that we can see more meaningful expansion of this industry because there’s mostly a lot more benefits to all these different various companies and industries.
Patrick Stroth: You mentioned barriers. I can imagine they’re the logical barriers of technology coming in, but there are other barriers out there. Why don’t you talk about those?
Gretchen West: Well, I think anyone that’s involved with technology understands that policy does not match the pace of technological development. It’s certainly the case where we’re talking about commercial drones. The FAA is the regulatory authority that manages our air space. This is a new entrance into our air space. Obviously, we’ve been flying on commercial aircraft for years and general aviation has been around for decades, but this is a new entrance. It is much smaller. In the future, they will be flown autonomously. For the FAA, to create rules around the brand new type of vehicle, it’s then very challenging. The rules that are on the books already really relate to commercial aviation. It doesn’t make sense to have the same rules for a commercial airline to be implied on a very small five-pound drone. Over the last 10 years, actually, longer than that, we’ve been trying to work with the government agencies to help them understand what this technology is.
Where we are today, we still have a lot of regulatory hurdles, but the FAA and the other government agencies have come a very long way in helping enable this technology, but there’s still a lot of challenges around public perception, there’s challenges around privacy. There’s just a lot of different challenges, but they are all things that we can achieve if we work together as an industry and these are all things that we’re working very hard to overcome. With any other technology in an industry, the policy making doesn’t match the speed of technology. We’re seeing that very, very clearly in the commercial drone space.
Patrick Stroth: I get a sense when we talk about some of the regulatory considerations and how it’s trying to keep pace. There are a lot of examples where, particularly with the FDA and other regulatory bodies that the regulators work very hard to slow down approval. That’s the opposite, at least, from what we read in periodicals when we’re talking about regulatory issues and autonomous cars. Do you get a sense, the FDA and the Feds are doing what they can to accelerate or facilitate? Are they working with the industry to try to come up with some good rules?
Gretchen West: They are and they have been for many years. I think, sometimes, the FAA gets a bad rep because they are moving slowly, but their whole mission is to protect the safety of the air space. No one wants to be flying on a commercial airplane and have an incursion with a commercial drone. I think we’ve all seen enough new stories about how drones have been flying around airports. That’s the number one priority of the FAA. I think we all agree that something we all have vested interest in. It’s not deliberately a slow process, but some of it is just the way rules are written in the government, that it takes time to go through an inner agency process with so many different agencies weighing in. That said, the FAA has said repeatedly, so has the Department of Transportation, that they are very interested in working with industry. They’ve made a lot of great stride. Their congress has passed, now, two re-authorization bills that has language around unmanned aircraft systems to enable broader commercial operations.
Now, it’s just a matter of getting the rules in place to really enable that. It takes time, but I think we all know that we’ve all seen some of the benefits of commercial drones as has the FAA. I think they all know enforcement is the very difficult challenge. Rules have to come at a place because people aren’t going to stop flying drones. They understand the value of them. The rules need to be in place. The FAA, I think, is moving as quickly as they can as an under-resourced agency, in my opinion.
Patrick Stroth: Well, it is peril, I would say, with the autonomous driving because I had never seen regulators more excited than the concept of getting drivers off the road and so forth and doing everything they can on that. It’s encouraging to see that government is actually working with that. When we look at the public perception of this and a lot of people have what limited views they’ve seen on using drones for taking pictures or if they’ve seen them on TV shows being used in brighter ways. There’s a perception out there. I would also think with commercial airlines, it took a lot of bravery in the early days for somebody to actually think to get on an airplane and fly across the country. Now, there’s got to be some courage and some knowledge of uses for the drone beyond what people can think right off the top of their mind. You had just referenced the commercial benefits of drone usage. Give us a couple of examples on how they’re being deployed and what benefits they’re bringing to companies or to the public at large.
Gretchen West: Sure. There are so many benefits. We could spend several hours on this call, on this podcast just talking about the various benefits, but just to highlight a few. There’s the benefit of saving money. For example, in the oil and gas industry, when a human have to inspect a flares deck, that flares deck has to be shut down, which can cost a company up to a million dollars a day. If you’re able to use a drone, you don’t have to shut down the flares deck. You can use a drone with various sensors to monitor and inspect that flares deck. That’s just one example. There’s other examples of how, for example, saving lives and improving safety.
The cell tower industry, you have climbers that carry about 80 pounds of gear and they can climb up to or higher than 1,000 feet in the air. You don’t know what changes in weather there will be. There are climbers that die every year from climbing these towers. It’s a very dangerous job. Why not use a done? You could get it up to inspect the tower in about 20 minutes. If there’s a problem with the tower, then you send the climber up to repair whatever needs to be repaired, but otherwise, you just potentially saved some time and saved lives by doing that. There’s so many other industries that are using this technology. For example, in the construction world, they have to measure stockpiles. The way you do that is, you have a human walking around the pile of whatever it is measuring manually.
Well, there’s technology out there now, a sensor that you can put on a drone and it can map that stockpile and give you those measurements in real-time. It’s a time-saving. It’s a cost-saving. It’s not replacing the human worker because there are other jobs that have to be done within all of these industries. The drone is more of a … it’s a tool to help. You mentioned Jeff Bezos in delivery and I think a lot of people nicker a little bit when they hear about delivery, but I think one of the most important aspects of drone delivery is in the humanitarian area. Lots of companies are developing technology where you can deliver blood from blood banks to hospitals or organs from hospital to hospital for organ transplant. There is this testing and there are actual trials going on overseas, outside the United States, where the regulatory environment might be a little bit easier where aid is being brought to people in need. There’s countries, third world countries, where drones have flown after natural disaster, delivering water or medicine or whatever it might be.
I think some of those use cases really open up the door for delivery whether it’s consumer delivery, business to business delivery or humanitarian. I think being able to get something to you quickly especially after a natural disaster is incredibly important. I could go on and on about all the different benefits and all these different industries. You’ve got news gathering and mining and inspecting railroads, inspecting bridges, any kind of infrastructure, farmers using drones in their field to instead of walking a field to look for damage after a hailstorm or looking for areas of irrigation, maybe, or they can put a drone up in the air and have NDVI sensory imagery, all sorts of different types of mapping where they can immediately see what’s going on in their field.
Public safety has been using this technology for a long time. They’re good for traffic monitoring from a security perspective, using a drone to monitor a facility such as a prison or pharmaceutical plant or a nuclear facility. There’s so many different great use cases where drones … Really, they’re a tool that can create efficiencies and they can reduce cost, and they can save money and save lives.
Patrick Stroth: It’s whatever the limits of the imagination are. This isn’t just some funky little happy gadget. This is a real flexible, viable tool that’s going to be sustainable, I can imagine. Again, I keep going in the parallel to when they would think about the first airplanes where they were used. Before they’re carrying passengers, they’re carrying letters. They’re probably limited to about 30 or 40 pounds worth of letters that they could carry at a time. Now, you think about what FedEx delivers in a single day. I think that this is just amazing. Now, there’s going to need to be a couple of breakthroughs both on a regulatory and a developmental stage to really get this a little bit more mainstream. There were a couple areas that they may not be on the cusp of that, but what are the things that we should look out for that if these things changed or these thing gets solved regulatory or otherwise, then we’re going to see things open up wide.
Gretchen West: Yeah. There’s a handful of really near-term pending things that are going to help. There’s obviously some other longer term challenges that we need to overcome, but last year, the FAA re-authorization bill was passed. I don’t remember how many pages, but there were pages of provisions for the FAA around integrating and enabling UAF technology, drone technology. DFA has now have their handful with all these task that they need to complete, but the first and probably most important thing that the industry needs to see now is remote identification. A couple years ago, the security agencies, DOJ, DHS and others were very concerned about the clueless, the careless and the criminal actors of flying, and how do you identify the difference between the three?
You’re talking about a sports stadium where somebody is flying near a sports stadium or an airport where somebody is flying near an airport to Gatwick, for example. We’ve all read those new stories about drone flying around Gatwick and the millions of dollars that were lost because the airport had to shut down. Was that the person that was flying, which is just a kid that’s out flying with his dad just for fun as a hobbyist. Maybe, maybe not. Is it something that’s clueless that’s out there that doesn’t understand the rules or somebody that’s criminal? As of today, there’s not really a good way to identify any of the drones that are in the sky. Yes, there are some apps and some things that are baked into some of these drones, but it’s not a formal process.
To be able to move forward with any of the other expanded operations that our industry needs to see, those remote ID, whatever remote ID is going to look like, whatever the rule is that the FAA comes up with, that has to happen first. That is a critical piece to satisfy the US security agencies and the FAA. That is the number one thing that we’re waiting for. Secondary to that is, I’ve mentioned expanded operations a few times. The law, now, permits commercial operations of drones, but it’s very limited. You cannot fly beyond visual line of sight of the drones. You have to have your eyes on the drone at all times. You can’t fly over people. You can’t fly at night. Now, some of these, you can get a special permission from the FAA to do, but it’s much harder. For a lot of the operations, the industries that I just mentioned, if you’re a real estate agent and you’re just flying over a house, you can stay within visual line of sight, not fly over people and not fly at night. You’re probably fine.
If you want to monitor a big pipeline or a railroad, then you need to fly beyond visual line of sight. We’re waiting on some rules now to enable those expanded operations. One was just opened for comment which closed this past Monday and would be operating over people and operating over people in a moving vehicle. The way that the rule is crafted by the FAA, it’s going to hamper the commercial drone industry if it passes as it is. Not being able to operate a drone over a person and a moving vehicle is a non-starter for this industry and operate the restrictions around operating over people is, there needs to be more research and testing that’s done because it’s still very restrictive. Those are some rules that we’re waiting to see how they change in order to enable this community.
I mentioned a security concern, that’s a big issue for the federal government, but it’s not just about remote identification. It’s also about this new industry that sprouted up. It’s called, Counter-drone Technology or Counter-UAS Technology. Think about a baseball stadium or a football stadium. They like to use drones to film practices and eventually, maybe even film games, but they don’t want drones flying into their stadium when there’s a map gathering, when there’s a game going on. A drone was just flown into Fenway Park the other day. This counter-drone technology, potentially, could help curve some of the careless, clueless criminal, but the authorities are very, very limited in the industry to use that technology. That’s something we really need to see develop with the FAA and with congress to figure out, how do we let more than just a few federal agencies utilize this technology, how do we allow private companies to be able to use it.
I think, remote idea is the most important, but the fourth one is called, The UTM, the Unmanned Aircraft Traffic Management system. It’s basically virtual highways in the skies for drones to fly. It’s like air traffic control for commercial aircraft but at low altitude and it’s all automated. Now, the FAA have been developing this for years with a couple hundred industry partners. I think we’re getting closer to see some implementation of the UTM, but this is what is going to help our industry have all this operation. It’s going to enable delivery. It’s going to enable beyond visual line of sight and operations over people. It will be this automated system that will help all of this. It’s meant to be designed in a way that if you’re flying from point A to point B, you get your coordinates. If a medevac flies into your route at some point in time, you’re automatically diverted. It’s meant to be this automated system that’s very safe. It’s really going to enable the technology and this industry to grow. We’re still waiting for that to be implemented.
Patrick Stroth: Yeah. Not only do you not have pilots in the vehicle, but then it sounds like you’re not going to help people in the air traffic control system or the automated, which you’d have to do with the volume of vehicles out there under this UTM.
Gretchen West: Exactly. The current air traffic control system that the FAA uses is one of the safest in the world for man deviation, but think about adding millions of aircraft to that system. It will be impossible for the FAA to be able to monitor all of that in addition to man deviation.
Patrick Stroth: That’s amazing. The ID of all the different uses for the drone brings up the idea because for an M&A conversation we’re having today, drone is a very interesting topic and people might be thinking … Yeah, but how does that apply to us in M&A because we’re not necessarily in the aerospace industry or the flying industry? How is this going to be applicable? I just think that there are a variety of different technologies that drones are using right now. They open up opportunities for all kinds of innovators. You’re talking about the UTM and the counter-drone technology. You could probably flush that a little bit, but what are the types of technologies that are necessary for this industry to grow?
Gretchen West: Well, I think when a lot of people think of drones, they just think of this little, small toy aircraft that’s flying around in the sky. Really, that’s the shell of it. There’s plenty of companies that are developing the hardware, but it’s really the brains in the drone that’s the most important thing. You’ve got the sensors. There’s a variety of different sensors depending on what your application is, whether it’s agriculture, construction, mining, whatever it might be. There’s mapping technology that’s being developed. Communications, infrastructure technology. The software that comes a navigation software to be able to automate how you get drones from point A to point B. I mentioned remote ID. There’s lots of different companies that are developing technologies to satisfy what remote ID might look like.
Obviously talking about UTM, I mentioned there’s about 200 partners that are working with NASA and the FAA to develop this. A lot of it is software. It is multiple layers of software that are going into what this UTM structure will look like. We’re at step one through a program, now that several companies have developed an app where you can get notifications and authorizations to find certain air spaces, but that’s step one. There’s all these layers of software and technology that need to go into a UTM system. Insurance companies are automating drone insurance for how operators are able to obtain insurance. Again, counter-drone technology which is similar but different but a lot of different technologies that are being built into how counter-drone technology is going to work. Basically, it’s air space security is what counter-drone technology really is.
There’s so many different areas within this commercial drone space where innovators can develop different software layers to fit into whatever these different applications are. They’re all very different. There’s so much opportunity. We see startups that are developing these types of technologies every day. There’s a lot of opportunity to get into this space and start helping craft what the feature of commercial drone integration is going to look like.
Patrick Stroth: Well, I think, also, if there’s the creation, again, from nothing comes something, lots and lots of new applications and new developers on that. We got to figure down the road and again, that focus on us is looking how it applies to M&A is that there are going to be a lot of M&A opportunities. Give us, from your perspective, what you’re seeing on the M&A front within the drone sector.
Gretchen West: Sure. I think we’re going to continue to see increased activity in M&A including in this year. Back 15 years ago or even 10 years ago when these commercial companies were just starting to get into the space, there weren’t that many companies and they were mostly startups. Now, you’re seeing big named companies like Amazon, Intel, IBM, Goggle, Cisco, AT&T, Verizon, Ford, Mercedes Benz and all these companies that you wouldn’t think of as being in the drone space. All of them are starting to develop something around commercial drone. Intel, for example, has acquired a couple companies to help with what their drone solution is going to be. Goggle has done the same. Verizon has done the same. They’ve acquired a company called, Skyward, which is going to help them be a player in the UTM space.
I think we’ll continue to see more companies interested in commercial drone technology. Some that you may not even think of today that will be interested in developing some drone program. Instead of going out and building your own hardware and software, which hardware is hard in a software, there’s a lot of companies out there that have been very, very successful in what they have been able to develop. I think we’ll see a lot of strategic M&A coming. Unfortunately, we’ve seen some companies that have failed in this space. I think we’ll continue to see that. I mentioned counter-drone technology. That’s a newer part of this industry. Two years ago, there were probably a dozen counter-drone technology companies. Now, there’s over 200. There’s over 200 systems that have been developed around counter-drone technology.
It’s just not sustainable to have 200 types of technology out there in the counter-drone space. I think we’ll see a lot of consolidation in that space as well and probably, eventually, see more consolidation in UTM as we get closer to private industry being a supplier of this technology with the federal government and with the users of that air traffic management system. I think we’ll see more consolidation there to just build in all those layers under one company. I think that industry is very right for just an increase, a large increase in M&A activity. It’s been one of those industries for so long where it’s just … People are developing. There wasn’t a good roadmap from a regulatory perspective. Some people were developing technologies that may not fit.
Now, we have a pretty clear roadmap. Even though it’s moving slowly and that has its own challenges, I think we are at a stage where the industry is becoming more mature and so we will be seeing a lot more M&A activity.
Patrick Stroth: It’s early mature and it will continue to go. I think the biggest beneficiaries throughout all of this is going to be the public, the consumers, because we’ll get finer working finished products here that are both safe and reliable and less and less expensive to operate as time goes on. That’s why American business does as well as it does. Do you have any predictions for just what’s around the corner for the industry or any trends that you see coming that we should keep an eye out for?
Gretchen West: Well, I think the counter-drone space is really interesting. Like I said before, there’s limited authority. A couple agencies within the federal government are allowed to actually use the technology, but there are things in play to create some new rules to allow for private companies to hopefully get approval to become a user of that technology. I think that’s very important. I mentioned before from a security standpoint using counter-drone technology around … anywhere there’s a map gathering or an amusement park or some critical infrastructure. I think counter-drone technology is an area that we’re going to see a lot more development and something to watch. I think the commercial drone industry as a whole and all these different amazing use cases that we can find benefit and save money, save lives, create efficiencies, I think … The industry is moving slowly because of the regulatory environment. I know sometimes that is a concern to investors. This is not an industry with quick returns at this stage, but we know that it’s coming. We’ve seen the value that this technology provides.
I think if people just hold on a few more years, we will see more commercial operations and those returns will come back in. There will be a lot more M&A. A lot of startups, I know, were developing technologies simply to be acquired by a customer or strategic partner or something like that. I think this is coming. Even though there’s a lot of challenges, our team and the work we do are … We’re in Washington, D.C. all the time talking to the regulators and the federal government to help reduce these barriers. We’re going to get there. We are going to get there. I think it’s really important to keep an eye on this space from commercial operations of drones, to counter-drone technology. Even urban air mobility, the air taxi industry which is similar but different to commercial operations of drone, but all of these areas, I think, are fascinating areas and they are coming. It’s going to be a place where I think investors, investment thinkers really need to pay attention to.
Patrick Stroth: Well, as you mentioned, we’re just scratching the surface of this topic. We didn’t even get in to talking about the types of investor’s funds, fund managers, opportunities and things like that. I think we’re going to leave that to our listeners that if they’ve got a particular question like that, I think they can direct that to you directly. Gretchen, how can people find you?
Gretchen West: Well, they can find me via email at email@example.com. That’s H-O-G-A-N-L-O-V-E-L-L-S.com.
Patrick Stroth: Thank you very much, Gretchen. Again, it’s a catchy topic, but it’s also right on point with what we want to do. Thank you, again, for joining us and have a good afternoon.
Gretchen West: Thank you. You too.
It’s a tight talent market out there in the technology industry. And that’s especially for all C-suite positions right now, says Stephen Kuhn, partner at Advantary. Yet companies, especially startups, are facing pressure from their boards to hire senior executives.
And that means they’re sometimes rushed into bad hiring decisions.
Stephen talks about a short-term solution to this issue that can have long-term positive impact on companies facing these challenges, as well as…
Mentioned in This Episode: www.advantary.com
Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisitions. We’re all about one thing here. That’s a clean exit for owners, founders, and their investors. Today I’m joined by Stephen Kuhn, partner of Advantary. Advantary provides interim CXO services across the entire C-suite, including CEO, COO, CTO, CMO, CSO, and wait for it, CPO. That’s a lot of Cs. Advantary augments a company’s management team long-term or short-term, full-time or part-time. Stephen, thanks for joining me. Welcome to M&A Masters.
Stephen Kuhn: Patrick, thanks very much for having me.
Patrick Stroth: Now before we get into all things Advantary and C-Suite, tell us what led you to this point in your career?
Stephen Kuhn: I’ve been in the technology industry in Silicon Valley for the last 40 years. I was born and raised in San Francisco. Started programming professionally when I was 16 in 1978, and got the entrepreneurial bug. Sold my first company while I was at UC Berkeley. Went onto study Managerial Finance at Harvard, and have in total started nine companies. I’ve been CEO at seven. Seven companies were pure tech. One was a boutique tech M&A Investment Bank, and I subsequently ran M&A Core Public Software Company. And the last company, the ninth company was a PE firm focused on the wine industry, so decidedly not tech.
Patrick Stroth: Well I’ve got to ask you, and this isn’t something that you and I prepared for, but coming from one native San Franciscan to another native San Franciscan, we’ve got quite a few in our audience. There’s a question we always ask each other is where’d you go to high school?
Stephen Kuhn: I went to San Francisco University High School.
Patrick Stroth: How about that? Okay, congratulations for you. I went to SI. That’s for our listeners who probably don’t care about that. Tell me about Advantary.
Stephen Kuhn: Advantary is a partnership of 11 and counting. We’re adding new partners. Highly experienced entrepreneurs who have started dozens of companies, raised hundreds of millions in debt and equity capital, and had many exits. We provide interim CXO services across the entire C-suite with the exception of CFO. We engage full-time or fractional, long-term or short-term, but it is an interim engagement. We’re not a placement agency. We help companies prepare for and go through transitions, including capital raises, the loss or hiring of key executives, technology issues, stagnation, accelerated growth, and international expansion, which is a major focus of our group this year.
We relieve pressure on companies as they look for CXO’s in this very tight talent market. We serve the small to mid-sized technology market, including SASS, Syntax, AR, AI, IOT, Blockchain, Cyber Security, Digital Health, and with the addition of our newest partner, Consumer Package Goods and Supply Chain Management. There’s a lot going on on the technology side of that these days.
In terms of size, there’s no company that’s too small. It’s frankly only an issue of budget. And there’s no company too large. We have a billion dollar plus revenue public client. But our sweet spot is clients with revenues between 5 and 75 million. But we go lower including pre-revenue companies of course, and obviously higher revenues as well.
Patrick Stroth: Well that’s one thing that is striking is that when we were kids dreaming about going into business or being successful, the idea of success was build a company, sell it, and then at a young age in your 30s and then go buy an island somewhere. And one thing that’s just more and more common in Silicon Valley, it’s not just here, it’s just concentrated, is people like you who are extremely successful, could have bought several islands out there. But instead of shopping for hammocks and boats and stuff, you’re going out and finding more challenges, more companies to help. It’s striking how this is what you live for and just being able to provide great services and add value to other startups. Back when you were starting up you’d get them moving on, it’s really a fantastic resource that’s out there.
What’s the type of value that Advantary brings because I can tell you right now, finding talent, if that’s tough, finding management is even more so. What do you bring to bear for owners and founders that is not otherwise out there?
Stephen Kuhn: Unlike a traditional consulting firm, think of McKinsey or Bain or PWC, we actually provide hands on operational services. It’s the highest, best value we can provide to our clients, given the length of experience, the breath of our experience in the technology market.
So you mentioned talent at such a premium, it’s hard to come by, that’s absolutely right. And a lot of companies are forced into a high pressure situation where they need to find, locate, recruit, and retain senior management. And in this market, it’s extremely difficult. And making a bad hire is sometimes existentially costly. I’ve certainly seen examples of firms that have made bad hires in C-suite, and I can think of some in particular in the chief revenue officer role that have been unqualified, culturally not a fit, and culture is a really important aspect here as well. You need people who can really fit in.
And so if a company is compelled under pressure from the board, pressure from their performance in the KPI’s on their business plan, to get someone in, just anybody who’s breathing, to find a CXO who can fill the role, that can be very challenging. And so we can step in on an interim basis, provide some real support. During the time that they’re out recruiting, the company can make forward process. It can achieve its milestones while taking the time, having the breathing space to actually find the right person for that role.
Patrick Stroth: One of the things I was thinking of, is you’re bringing somebody in to a CXO position while your client company is out doing the longer term search for the longer term solution. Largely what you’re doing is shorter term. You can do the long-term, but I get the sense that more of your stuff is targeted, your service is targeted towards short-term, is that right? Because if it is, I think it removes a lot of conflict because you can get somebody who can plug and play and they’re not worried about preserving their job or their role. They’re into add value with the knowledge that this is not going to be forever, so you’re not playing defense. You’re just working forward, and you don’t have to worry about legacies or things to kind of build in as you take a position. I think that’s a nice, un-conflicted approach.
Stephen Kuhn: Yeah. That’s absolutely true. And we work with firms, I think our shortest engagement has been probably six weeks or a couple of months and we’ve had, have a client for well over a year now. But we typically work from a quarter to a few quarters in length of the engagement.
So sure, we can come in and solve a particular problem, work with the company through a challenge or a transition and stay on for a bit longer to see through the onboarding of our replacement frankly.
The value we can bring is yes, the experience, yes, the understanding, we’ve made lots of mistakes ourselves. We can load balance as well. A lot of firms don’t need a full-time CXO. A classic example that most people are familiar with is a CFO. A lot of early stage companies don’t need a CFO. Similarly, they may not need a full-time Chief Product Officer, Chief Technology Officer. You’ve got a small firm that’s got a founder who’s a great engineer, who perhaps hasn’t been an entrepreneur before. Hasn’t run a team of engineers, doesn’t mean they’re not smart, they’re usually brilliant. But they just lack some experience and we can provide that mentorship, that guidance, and actual hands on architecture, scaling issues, security issues, so on and so forth, on the technology side, experience on the product side, the marketing side or revenue or business development.
So coming in on an interim basis to provide support when support is needed, to step back when it’s not. It actually, and because we’re consultants we’re not employees so there isn’t the tax issue there as well, we can be very cost effective for our clients.
Patrick Stroth: What does it look like to work with Advantary? I mean, describe types of engagements that you have available.
Stephen Kuhn: So we, in addition to the interim CXO positions that we’ve talked about, we actually have five package services if you will, that we provide and they are briefly, pre-transaction preparation and execution, getting ready for a debt or equity transaction, whether that’s a capital raise or M&A event. A lot of companies aren’t properly prepared, and so deals don’t get done, they get done more slowly, or on sub-optimal terms. And here’s the situation with the old adage, an ounce of prevention is worth lots of pounds of cure here. They can really drive a lot of value out of Pre-Transaction Preparation, proper preparation.
Second is around growth, strategy, marketing, sales, business development and cross border expansion. Cross border is a particular process as I mentioned earlier, for us because those firms outside the U.S. looking to enter the U.S. Market, are effectively doing a startup within a startup. It’s very risky, it’s very time consuming. It’s a real distraction from the core business.
As a team of entrepreneurs who’ve started lots of companies here in the states, we can provide a tremendous amount of value there.
Third practice is around technology and patent management, best practices, and implementation.
Fourth is around designed thinking. Designed thinking methodology is a terrific problem solving framework. And we help solve companies strategic issues leading them through a design thinking process. It’s extremely powerful. And the fourth is really focused at investors or buyers. So perhaps some of your clients for example, or your audience on the M&A side, we work with investment banks, but also the principles, PD firms, family offices, and corporate buyers on their pre-transaction diligence. So we can go in and look at a company’s team, the technology and their pipeline, their product market bid, their strategy and so on, to help the buyer if that fits with their objectives.
Patrick Stroth: That’s pretty comprehensive. You mentioned with the cross border so I don’t want to sound redundant here, but the services for Advantary are available not just California but what’s your service territory range? Entire U.S.?
Stephen Kuhn: It’s global in fact. We’ve got clients, certainly across the U.S., but also in Australia. We have a French client we acquired last month. And we are working in Mexico and Latin America as well. So really it’s global. We have a natural center of gravity if you will in the Bay Area. If you looked at a heat map of the globe, there would be a bright red spot around the Bay Area. But you’d see hotspots around the globe as well.
Patrick Stroth: Gotcha. Well now the biggest questions people have when they hear about services like this, well is it a fit for me, yes or no? And they can make that decision based on what you said.
The next thing, and this is just true of life, is timing is everything. At what point if there are people in our audience or there are questions, at what point should they start thinking about someone like an Advantary?
Stephen Kuhn: That’s a great question and it really depends on the nature of their needs. For example, if they’re thinking, even contemplating an exit in the next year or two, that’s a great time to be thinking about us to help in that pre-transaction preparation. A lot of things can be fixed relatively quickly, but there are a lot of things that take time. It takes effort to steer the big tanker in the ocean, to move in a new direction or to find the right person to fill that role. So we can be very helpful long in advance of those types of transactions, but then there are other things that are much more immediate. You need to hit your numbers this quarter, right. So you’re going to need some strategy, marketing, sales, and business development efforts.
You are looking to raise capital. And we can help prepare the company for that capital transaction. And those usually aren’t done a year or two in advance, that’s usually the next few months we need to get that done. So it really depends on the nature of the engagement.
Ranges from today, oh we need your help today. In fact I met with a client, a prospect yesterday who is launching here in the U.S., they’re a Mexican firm. And they’re looking to get launched in May. And they’ve got a tremendous amount of work to do before they can do that. So they needed immediate. So you can see it really depends on the circumstance, the context, and the nature of the services that they require.
Patrick Stroth: Yeah. Stephen, of the services and the types of engagements you talked about, the majority of them revolve around or have an aspect of the practice of M&A and we do try to focus on M&A. You’ve been around companies and helped companies that are both scaling and exiting. And so you’ve got a great perspective with regard to M&A. What do you see in the trends going forward here in 2019 going forward for M&A? Just at any level from what you have seen.
Stephen Kuhn: On the M&A side, clearly, historically, M&A has been roughly 90% of the exits. When companies exit, M&A is the exit of choice verses IPO about 90% of the time. I don’t see any change in that. If anything, despite some very large, very successful IPOs, I think the trend is definitely continuing on the M&A track.
And I pause there only because several examples came to mind of firms that are providing, think of co-location spaces, and other accelerator programs that are creating essentially a marketplace of technology and entrepreneurs. On the one had they’ve got small entrepreneurial companies with brilliant technology. And those companies are really good at innovating, creating new technology, and getting from zero to one, from nothing to something.
And on the other side of that market, you’ve got large firms, typically Fortune 500 firms, that are really good at scaling, but maybe not always so good at innovating. And so there are a number of incubators, an increasing number of incubators out there that are positioning themselves, as they say, a marketplace for large corporates to come in and get access and visibility to the startup world providing a key for them, which is innovation.
And on the other side you’ve got these young firms that are really good at innovating, and are challenged with scaling and are looking for opportunities to partner, in the short-term, partner with the larger corporates, but really looking to those corporates as their exit path. And so with the lives of these incubators, these marketplaces if you will as I tend to think of them, there is I think increasing amount of M&A activity. And as I speak to my investment banking friends around the country, both boutique and larger firms, they are absolutely saying trends up and to the right on M&A.
Patrick Stroth: This is a very good perspective to have. I appreciate that.
Stephen, how can our listeners find you to learn more about Advantary for themselves, for their own entities, or for their clients?
Stephen Kuhn: Yeah, thanks for asking. Of course there’s our website www.advantary.co. And you bring up a really important point which is that while we do work for the companies themselves, we’re often brought in and referred to those companies by, there’s other service providers. It could be one of our partners in the Fractional CFO space, it can be VC or PD or Family Offices as well. It could be an investment bank that needs help with one of their clients or prospective clients as they are going through or contemplating going through an M&A transaction.
So encourage all of your listeners if they think they have a need, or suspect they might have a need for some of our services, just go to the website. Pick up your keyboard and send an email over to me or to firstname.lastname@example.org and we’ll certainly get right back to you.
I’m also available of course on LinkedIn, easily findable there. Yeah, looking forward to hearing from your clients and seeing if we can be of help.
Patrick Stroth: Well it was a pleasure speaking with you today Stephen. Thanks very much. And if anybody needs to find out other ways to get ahold of Stephen, go take a look at our show notes at www.rubiconins.com. Hit the insights tab and you’ll find our interview there as well and you’ll have the show notes as well.
Patrick Stroth: Thanks for joining us today Stephen, and have a good day.
Stephen Kuhn: Thank you very much Patrick.
The politics of healthcare is a mess in this country, as you know.
But Matthew Hanis, executive producer and host of the Business of Healthcare, is more interested in practical measures for incrementally improving a system that is the most expensive in the world and doesn’t offer a great quality of care in exchange.
We also talk about the M&A landscape in healthcare, including the trend towards increasing vertical integration, as well as…
Mentioned in This Episode: www.bohseries.com
Patrick Stroth: Hello there, I’m Patrick Stroth. Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisition. We’re all about one thing here, that’s a clean exit for owners, founders, and their investors. Healthcare is literally a force of nature in our economy. It’s been in the news quite a bit lately and like it or not, as time goes on, everyone will be consuming more, not less of it.
Today we’ll discuss the future of healthcare from a business perspective, and how mergers and acquisitions will factor into the inevitable changes coming to healthcare. I’m pleased to be joined by Matthew Hanis, Executive Producer and host of Business of Healthcare. Now in his 13th season, BOH is an online platform where Matt interviews senior leaders in healthcare. BOH estimates that 118,000 decision-makers are responsible of 80% or more of the buy and sell sides of US healthcare. Just about 20,000 of these very decision-makers participate in BOH’s audience. That’s about one in six, which is a respectable share of any market. It is for this audience that BOH was purpose-built to identify and help propagate proven innovations, elevating mission and margin more rapidly. Wow, one in six, that’s nothing to sneeze at. Matt, thanks for joining me, and welcome to the program.
Matthew Hanis: Patrick, thank you so much for inviting me on.
Patrick Stroth: Now, we’ll get into Business of Health in a moment. First, tell us how’d you get to this point in your career?
Matthew Hanis: Well, I tried to make as many mistakes as possible, and this is the culmination. I’d spent about 25 years in healthcare, most of that time I’ve either worked on the vendor side, selling data solutions to health systems, larger payers of health plans, or working within a health system, Mercy in St. Louis, to have the experience of actually doing the work of healthcare. Ultimately, all of those experiences culminated in a passion for entrepreneurship and for finding the innovations that I felt could really transform our healthcare delivery system in the United States.
Patrick Stroth: When we see BOH’s core statement, which is mission and margin, with mission, we get that because healthcare and doing good and providing care to people, there’s a passion, the mission. It’s the margin that people start looking at real quick. Why don’t you explain what you mean by mission and margin in the Business of Healthcare.
Matthew Hanis: Healthcare makes up about a fifth of the US economy, and every sector of the economy is important, but healthcare one of our challenges though is the cost of healthcare has continued to rise at a rate faster than pretty much any other aspect of our economy. But when you look at the quality of healthcare as measured by access, patient satisfaction, survival, life expectancy, all the broad measures of healthcare, we don’t do very well in this country. We have a major portion of our economy, which is getting progressively more expensive, and on most measures of quality, it’s not very good.
I believe that this is unsustainable. Now, the laws of physics tell us that all systems come back into balance. There’s a couple of different ways that we can see the US healthcare system coming back into a healthy balance in terms of cost and quality. One of the ways though, which tends to be the primary focus right now is trying to cut payments to physicians, and try to manage healthcare by managing how consumers consume it and managing how it’s provided. Our belief is that these approaches are unsustainable and that there are at the same time, very, very sustainable ways to improve the effectiveness and efficiency of our healthcare system. That’s what we try to bring to bear.
Mission is really about all the things you and I can agree on, quality, access, patient satisfaction, physician and other provider satisfaction. Margin is recognizing that like any other part of the economy, the providers who deliver healthcare must be able to make a profit in order to make it a sustainable business. We just need to figure out how to balance that with the cost to the consumer.
Patrick Stroth: The problem that you mention out there which is making a challenge for us is that cost of healthcare continues to go up, quality continues to go down. I would think that a lot of people would think well, the more it’s intuitive almost that if you spend more you should get better quality. Are there any specific reasons why the cost goes up and yet we’re not getting the value, the benefit?
Matthew Hanis: Yes. There’s a couple of different reasons. One issue which is very microeconomics, is pricing. We know that one of the biggest drivers of the cost of healthcare is the price that’s charged for healthcare. There’s an enormous set of problems around understanding price. God forbid you should have to go to the hospital for surgery. It’s extremely difficult to understand what that’s going to cost you, and what the costs would be for you to go get that exact same procedure in other settings.
Why is it so complicated to understand price and the cost of healthcare? Well, I believe that a big part of that is we’ve got a lot of intermediaries in our delivery system. Too many intermediaries can cause such a separation between the consumer of healthcare, the provider of healthcare and the payer of healthcare, that we create a whole myriad of complexity. I think a big aspect that we can look at is, why do we have so many intermediaries, so many people that handle healthcare transactions multiple times? Why is it so hard to get that data to be meaningful to the consumer?
I think another cause that we face in our system is regulatory constraints. I’m not suggesting that healthcare should become an unregulated industry. I think we can all agree that just about any industry in the US, we want to have good regulation over healthcare to protect the consumer and protect the providers of healthcare. The problem that we face today though is that the regulatory environment that healthcare providers face is so confusing and so complex that it’s almost impossible to comply. I’ll give you a concrete example. A typical health system reports somewhere in the order of 4,000 different quality metrics each year. Most of those quality metrics, most of those 4,000 are actually redundant metrics that are being reported to different organizations in slightly different ways.
Another issue in the regulatory side are the constraints of the Stark Laws. The Stark Laws were created to prevent or to discourage physicians from referring patients to treatment from which the physician would profit. The problem with that is if we ask a physician to take accountability for a patient’s total spend, and for that patient’s quality of care and their overall quality of life, which is the concept of fee-for-value, if we were to ask physicians to do that, unlock their ability to make those decisions and to be able to refer patients to the providers that they most want to work with and potentially refer them to themselves, for things like imaging, and other services that are adjacent or ancillary to the primary purpose of care, these issues of so many intermediaries and the regulatory constraints that are so confusing, create an enormous part of the enormous waste of our delivery system. Today we spend about a third of our healthcare dollar on waste, things that do not provide value. A decent chunk of that waste is directly related to too many intermediaries and enormous regulatory constraints.
Patrick Stroth: Wow. I think when people look at healthcare, the only way you address this is, either you have the universal care, care for all, unlimited, which a lot of people would say, well that means care for nobody because the system would be overrun. Or, the other extreme is fear there would be extreme rationing out there, where some arbitrary person will dole out allocation healthcare by some abstract basis. You’ve got fear on both sides, but it’s really a false choice. It’s not all of one, all this or nothing. There are models that are being set up and there are ways that are being tried to go forward. Why don’t you talk about those types of models.
Matthew Hanis: One of the fundamental trends in healthcare is the shift from fee-for-service to fee-for-value. The basic idea is that today, when a physician bills for a service they provide, or a hospital bills for a surgery that was performed in one of their operating rooms, they essentially are billing for units of work performed. They’re not charging for a knee replacement, they’re charging for all of the components that go into a knee replacement. The concept of fee-for-value is that you charge, or pay provider for the outcome that they’re delivering. The knee was replaced, no infection occurred, the patient came out of the procedure with a responsible period of recovery. Those concepts around fee-for-value create far better aligned incentives between the providers of healthcare and the payers of healthcare.
I just want to touch on your point about, I think you touched on the Medicare for all concept. It’s important to recognize three things about our current US delivery system. First, we cost per capita somewhere between 30% more and 200% more than the rest of the delivery systems in the world, like that in Britain, Canada, Sweden or Switzerland. Before we toss those systems out as being un-American, or undesirable, consider the fact that they generally provide much better access to care. More people can get to care faster. They cost on a per capita basis, far less than our system does, and in general their consumers of healthcare report being better satisfied with the care that they received.
Now, I’m not arguing that those systems are perfect, and I’m certainly not arguing the idea that Medicare for all is a particularly good solution. But I would want to differentiate between the concept of a single payer system versus the concept of universal healthcare. A single payer system essential says, we’re all going to agree that one entity is going to pay for healthcare. Doesn’t say what the rules are about that. It’s just saying that each of us that pays money into healthcare is going to pay it to one place, and that entity is going to be the entity that pays the providers of healthcare. That’s how most of the delivery systems in the industrialized world operate.
In the United States we kind of have that, because 70% of healthcare provided in the United States is paid for by the government. Most people forget that it’s a relatively small portion of healthcare that’s paid for by the consumer and large employers. A single payer system does not necessarily mean universal healthcare. Universal healthcare takes it a step further and says, everybody gets healthcare and the government’s going to pay for it. Two really different ideas, but related.
Patrick Stroth: Well, let’s focus on M&A on the physician side of the industry, because we’ve got the large health systems, and we’ve got the large institutions and then you’ve got the pharmacy development, medical devices and everything like that. Let’s just look at the physician provider side of the industry. What do you see for the future of physicians in healthcare as we try to change into this fee-for-value emphasis?
Matthew Hanis: I think physician practices for the next 5 to 10 years are in a race for lives. What I mean by that is, if you take the concept of fee-for-value, which has generally pretty solid evidence to indicate that it produces better healthcare value for the consumer and the payer and the provider. If you agree with that premise, then that means that physicians are in a race to find ways to be in contractual arrangements where they have accountability. If I’m a primary care practice, it behooves me to try to enter into contracts where I take on the risk of a Medicaid population, a Medicare population, but I go directly to employers and contract with those employers to serve their employees and the employees families.
Those sorts of arrangements, manage care contracting if you will, are the strongest position for a physician to be in to get a market. If I as a physician practice hold contracts, either for the bundles of healthcare, like I’m a surgical practice, and the bundle for doing orthopedic surgery for a large employer, or I’m in the primary care space and I’m going to contract for the quality of care for an entire population, I’m guaranteed to be sitting at the bird’s eye view of how the money moves in healthcare. If I don’t have the contract for lives, that means that I’m going be subcontracted to somebody else.
I believe the essence of the M&A space for the physician world will be the race for lives. Those physician practices that have built the infrastructure and the capacity to take on population risk of various sorts, that can demonstrate their value in measurable ways, those organizations will continue to expand contractual relationships and exclusive network relationships with payers and ensure the flow of patients to their doors. That requires an enormous amount of work in infrastructure. Frankly, many physician practices are not spending those dollars. I think from an M&A perspective, I don’t think we’re going to see much more acquisition of physician practices by health systems. We’ve seen that market cool significantly. In fact, there’s signs of a number of physician practices unwinding their relationships with health systems.
What I do think we’ll see is acquisition and merger between physician practices, specialty groups merging into multi-specialty. I would expect that when you look at the 4,000 largest physician practices in the country, those organizations will likely consolidate. In 10 years from now I would predict that we’ll have half of those practices that occupy the largest group of physicians.
Patrick Stroth: You spoke awhile earlier about where we’ve got a big layer of intermediaries involved between provider and patient. If there was a way that if we had the physician practices moving toward this fee-for-value model than physician groups are going to be consolidating and one group will buy another, and so forth. Does that translate also to possibly them buying other facilities, imaging centers, surgery centers, physical therapy? Is there room for vertical integration and how would that look?
Matthew Hanis: Yeah. I think you’re spot-on. I feel like the trend there is a combination for the race for lives. If I’m a physician practice, I can provide a much better Population Health solution if I’ve got pretty good control over lab, pharmacy, imagining, rehab, physical therapy, those sets of services that are ancillary to the work of a physician, but are critical to achieving a particular outcome for a patient. That vertical integration trend, I think is very likely. I think that trend comes in two different flavors. One flavor is the vertical integration of healthcare service, like I just described. But the other is vertical integration in a manner to dis-intermediate many of the non-value producing participants in the healthcare ecosystem.
I’ll give you an example. If a physician practice had the ability to manage the total, all the healthcare transactions for one of their patients and they’re in a Population Health contractual arrangement, they probably are going have a much better understanding of the spend of that patient and be able to manage that spend more effectively. I can imagine, or I can see physician practices getting better at being able to do the data of Population Health and perhaps dis-intermediating stakeholders by directly contracting with employers, or contracting with employers in a manner that takes advantage of less brand name sorts of health plans, and more health plans that are designed to serve physician practice needs as much as they’re designed to serve large employer needs.
Patrick Stroth: Is there going to be need for some regulatory reform in order to do this?
Matthew Hanis: I think there is. We’ve already seen the Center for Medicare and Medicaid Services signaling that they want to soften or weaken the Stark regulations that prevent self-referral. We’re seeing several rulings that have come out of the Federal Trade Commission that solidify the ability for independent physician to contract together with health plans and other payers, without getting into anti-trust problems. I feel like from a regulatory perspective the three big things to be watch are Stark Laws, anti-trust law, and then a third area which is CON, certificate of need. Certificate of need constrains in about 20 states of the 50 states in the Union, about 20 states use CON laws to constrain the ability to create new imaging centers or add new surgery suites. Those constraints on the surface, make enormous amount of sense because they prevent the addition of unnecessary healthcare services, which often lead to an increase in utilization.
The problem with CON laws is they often get in the way of a physician practice being able to add imaging and other services to their capabilities of achieving that vertical integration. From an M&A perspective, the loosening of those laws would suggest an acceleration in the merger of physician practices and the expansion of practices to this vertical integration process.
Patrick Stroth: Could you see owners of medical facilities, I don’t know if they’re exclusively physicians as opposed to medical groups and physician practices by law, have to be owned by and run by a physician. But when you’ve got things like kidney dialysis centers, or labs, those don’t have to be owned by physicians. Could there be a situation in M&A where you could see a multi-state network of labs buying physician groups? Could that happen?
Matthew Hanis: I don’t know that I’m aware of that particular example occurring, but I’m 100% sure that there’s strange bedfellows in the outcome of these acquisitions. For example, United Healthcare acquiring DaVita, the largest dialysis business. Well, turns out United Healthcare is currently the largest employer of physicians in the United States. That’s kind of a surprising number because we all think of them as a health insurer, but in fact, they’re a provider of healthcare.
We also see retail pharmacy businesses moving aggressively into the providing of healthcare services. Being able to walk into a clinic at a Walgreens, to get your care taken care of. In those cases it’s not actually in most cases the entity, like the pharmacy is not necessarily employing the physician, but they’re contractually enabling the physician to practice care, and there’s movement of money. I would argue that, if it isn’t a merger on in fact, in many cases, it’s a merger in reality.
Patrick Stroth: The great interviews you have and they’re in HD quality videos and so forth, on Business of Healthcare. Matt, how can our listeners find you?
Matthew Hanis: Absolutely. They can find us on our website at BOHseries.com, or they can search for us on the web. Search on Business of Healthcare and our red logo, you’ll see us pop-up pretty high on the list, both our website, our podcast channels, or LinkedIn and our Twitter as well.
Patrick Stroth: Matt, thank you again for joining us, and we’ll talk again soon.
Matthew Hanis: Thanks so much Patrick. Thank you for having me.
This episode was originally published on October 3, 2018.
Many technology companies are sitting on an untapped resource that could add 5%, 10%, 20%, or more to their company’s value, says Dr. Elvir Causevic, managing director of Houlihan Lokey’s Tech and IP advisory department.
Problem is that if you wait until you have an M&A deal… all that value is lost to you – it automatically goes to the buyer.
Elvir and his colleagues have been innovating a new way to make sure companies, especially those in Silicon Valley, avoid that fate. And we go through that process, step-by-step. It’s actually pretty straightforward once you know the trick.
This episode was originally published on August 29, 2018.
In an era when few companies go IPO and there are even fewer unicorns, M&A is more popular than ever, says Mihir Jobalia, a veteran of KPMG’s Silicon Valley operation.
In fact, among VC-backed companies in the last 10 to 15 years, he estimates that more than 90% exit through M&A. And business in the last few years has been especially good.
We dive deep into what makes the current environment so appealing to M&A, who the big players are, and best practices for companies hoping to exit with this strategy.
Silicon Valley is obviously on the forefront of technology. What’s not as clear is how to keep track of trends, new companies, key players, and all the rest, especially since it’s always changing.
That’s why Bob Karr created LinkSV, a Valley-centric, comprehensive, and constantly updated social network. We talk about how to get the most out of LinkSV, whether you’re a service provider, startup looking for an angel, an investor looking for an acquisition, and beyond.
In today’s episode we shake things up and put Patrick Stroth, the regular host and founder of Silicon Valley-based Rubicon Insurance Services, in the hot seat for an exclusive interview with business consultant Steve Gordon.
Patrick is on a mission to tell investors, founders, corporate development teams, attorneys, and anyone else in the world of mergers and acquisitions about a unique insurance product that can save tens of millions of dollars in a transaction and speed deals to completion, while reducing risk for Buyer and Seller.
If this insurance is in place deals are 8 times more likely to close.
It’s been used in 1/3 of M&A deals over $25 million in value in recent years. Patrick says that once more people understand the benefits that number should jump.
We get into the details on how this insurance works, including…
Mentioned in This Episode: www.rubiconins.com
Steve Gordon: Welcome to the M & A Master’s podcast. I am your temporary host today. My name is Steve Gordon. Today we’re doing something a little bit unique on the podcast. We are putting your normal host Patrick Stroth on the hot seat today. I’m going to be interviewing him. I think you’re going to get just a tremendous amount of value out of this interview.
Patrick is an absolute expert at some fairly new and unique approaches to handling risk in mergers and acquisition. Patrick, I’m excited about this. Before we jump in I want to give you a proper introduction though.
For those of you who don’t know Patrick, he is the founder of Rubicon M & A Insurance Services. He’s a speaker on M & A topics and he’s the host of this very podcast, the M & A Master’s podcast where he interviews thought leaders and folks who’ve had real success in the M & A space. Patrick, welcome to your podcast.
Patrick Stroth: Thanks for having me today, Steve.
Steve Gordon: This is going to fun. I always like turning the tables on folks and doing these interviews. It’s going to be an absolute blast to do with you. To start us off, we’re going to talk a little bit about this insurance product called rep and warranty insurance, representations and warranty insurance. I want to start with, from your perspective, why is having this conversation important? Why would it be important for somebody who’s listening today?
Patrick Stroth: Well, thanks again for having me Steve. The reason why rep and warranty is an issue is because it’s a tool in putting a deal together that has just gained significant traction over the last four or five years to the point where this item, rep and warranty, is being used in about one-third of all M & A deals over 25 million transaction sites. That’s a huge jump from the last couple of years.
For people that are in and around an M & A transaction, whether you’re an investor, a founder, corporate development, everybody is looking to find a tool that’s going to give them an edge. It’s going to improve their deal, improve their terms. So, along comes this item that is, like I said, gaining higher profile status, it’s gaining traction because it’s become effective. The people that have used it are repeat users and they’re using it a great amount.
However, there’s two-thirds of the market out there that may have heard about it. It’s new, they haven’t used it yet, so they’re trying to find out a little bit more to just get a little bit more comfort out there.
The great thing about rep and warranty is it’s not mandatory for every deal. It may not be a fit, but where it’s a fit it saves parties tens of millions of dollars in some cases and it speeds deals to a successful completion. So, if you’re an advisor, legal, financial, compliance, whatever, it really behooves you be aware of this product on a global level, then see whether or not it’s a fit for your particular deal.
Steve Gordon: Patrick, let’s start at the beginning for people who, maybe they’ve heard of it but they don’t understand how it works. What exactly is rep and warranty insurance?
Patrick Stroth: Yeah, rep and warranty is short for representations and warranties. Reps and warranties are the disclosures that sellers make to the buyer giving them details about their company. The ownership structure, legal issues that may or may not be out there, sales, financial aspects … all the facts about a company that the seller needs to disclose to the buyer and the buyer then will perform due diligence to look at those disclosures to see how accurate they are. Based on the quality of those disclosures the buyer makes the decision whether or not they’re going to pay a certain price to go ahead and purchase a company.
Now, because these transactions happen is such a tight timeframe it’s impossible to find out every little nook and cranny detail about a company. A lot of times you’re going on faith that the disclosures that you’re being told are accurate, are truthful, and that post-deal there won’t be any surprises.
Well, in the real world there are surprises that happen, and they often happen after the fact. Now within the purchase sale agreement and contracts right now there’s what’s called an indemnification clause, wherein the seller must indemnify the buyer for any losses the buyer suffers as a result of those reps and warranties, those disclosures being inaccurate and those inaccuracies lead to the buyer suffering a financial loss.
A great example of that would be you’re buying a chain of restaurants. Unbeknownst to you, the chain of restaurants had given out over two million dollars in free entrée vouchers to beef up business and beef up sales. Well, you’ve purchased the chain of restaurants and now all of a sudden you didn’t know about two million dollars of free food you’re going to have to give out, but you’re obligated to honor that.
That would be an example of one of those types of surprises. You want to be able to have some kind of recourse to come after the seller. That’s done with this indemnification clause.
What has happened though is it gets pretty contentious because sellers want to sell their business and they want to pay their investors. They just want to move on to their next venture. They want to take their money and move on. Buyers don’t want to get stuck holding the bag if there is some surprise out there that costs some money that they just missed in diligence. They’re trying to keep the seller on the hook as long as possible. Seller wants a clean exit. So, there’s this natural tension.
The insurance industry came along and developed a product where they would insure those disclosures, those reps and warranties, by stating that they will review what those disclosures are. They look at what the buyer did in terms of due diligence making sure that they double checked the financials, they looked at the inventories, they did a cap table, they did what they could to make sure that they held the seller to task as much as possible.
If the underwriters are satisfied they simply say, “I’ll tell you what, we don’t think anything bad is going to happen. Give us a couple of dollars and we’ll insure the deal so that should there be a breach of the reps and warranties we’re going to take that indemnity obligation away from the seller and we’re going to take it. Buyer, in the event there’s a breach and you suffer financial loss, come to us with that financial loss and we will pay you up to whatever the policy amount is.”
What it’s done is rather than have this natural tension between buyer and seller, you’ve got this independent third party that looks at everything, has deeper pockets than both the buyer and seller combined that can go ahead and pay the buyer their loss. The great thing is buyer goes ahead and they’ve got certainty that if something bad happens they’re not going to be left holding the bag.
And, the seller gets a clean exit. A lot of times they end up collecting a lot more money at closing because an insurance policy, the rep and warranty policy, begins at an attachment point that’s far below what the seller normally would have to be locked up in escrow.
The difference between an uninsured deal with an escrow versus an insured deal with a deductible could be, in some cases, tens of millions of dollars. That’s the product that’s out there. It was initially used for very contentious transactions where there were big disagreements and only an insurance policy could come at.
Then, there was also a usage for the product where you had buyers or sellers that just were very, very risk adverse and wanted any way possible that they could mitigate the risk as much as possible. But, what happened is that it’s become more of a financial tool.
That’s why private equity has really embraced this product because they’re constantly buying and selling portfolio companies, usually to other private equity firms. Having this product eliminates post-closing losses in terms of financial commitments, accelerates profits and realizing proceeds at closing, and they move on to the next deal.
The private equity buyer knows that should there be a breach or some other loss, those losses are mitigated because there’s a product there. It’s been something that has actually accelerated M & A transactions rather than being some pure risk mitigation thing that a bunch of worry warts wanted to have.
Steve Gordon: Patrick, it’s pretty clear that there are benefits for a seller in this situation. It accelerates the speed with which they’re able to get their cash out of the deal. What are the benefits to a buyer, particularly a strategic buyer? Why would a buyer say, “I really want that as a part of the deal?”
Patrick Stroth: Great question, happens a lot because the buyer in many cases is in a position where they say, “Well, we don’t want to take the risk,” or, “We don’t see the risk. Why should we involve ourselves in this? Let’s keep the seller on the hook.”
The fact of the matter is right now in this environment, this is a seller’s market, so sellers are pressing the terms because they have a lot more leverage these days. What a buyer needs to do is they to make as seller-favorable a term sheet as possible. Now, how can you do that without having to do the obvious thing is well, just pay way more money than anybody else can and then we’ll buy it.
Well, this is an alternative to having to over-buy. If you can go ahead and provide something that mitigates the seller’s risk, accelerates their profitability or their returns without having to raise your offer, that’s a big help.
Another thing is that there is certainty of recovery. If there is a breach and it does impact the buyer financially, they are not worried about sellers scattering out all over the place, particularly if you’ve got situations where you’ve got multiple shareholders in a company and you’re going to exert a lot of expense and time trying to track them down to recover.
So, you’ve got one party. You will go to them and they will partner with you. The fact that using rep and warranty can accelerate the process, the timetable for getting the deal done because if a rep or warranty is insured there’s no need to negotiate it any further. You move on to the next rep and warranty, and the next one, and so forth. It saves time and money with the attorneys on having to go back and forth.
For strategics, it can remove a real uncomfortable situation. When you purchase a target company, you’re usually bringing that management team on board with you. It gets very uncomfortable in the event there’s a breach post-deal. The company now has to go to those rock star new members of their team and say, “You know what, I know it’s not your fault, but something bad happened, it cost us money. We’re going to have to claw back a significant amount of your escrow or a significant amount of money that we had promised to pay you.” This removes that.
The other issue about this is that it can provide a little bit of a backup on your due diligence. If you’re performing a bunch of diligence and you’re not insured, you’re going to be moving forward in to the great unknown hoping that diligence worked and hoping that you got that escrow or that seller on the hook if something goes wrong.
Well, if you’ve got insurance there and they’re looking at it and they say, “Yes, these reps are covered,” now you’re not as worried about your diligence issue because it’s insurable should the event happen. Then, you’re taken care of.
The bottom line, the biggest thing that’s a benefit for the buyer is … We get this information from multiple investment bankers, is that at the end of the day you want to get the deal done. Okay, deals with rep and warranty are eight times more likely to successfully close than deals that are not insured. If you’re a buyer and you’re going into this, think about it, why are you even going into this exercise unless you want to get it done? Okay, this is a way that’s going to make it much more likely for the deal to be successfully consummated. You know the great thing? You don’t have to overpay to get it.
Steve Gordon: Patrick, you’ve touched on a number of the benefits of using this tool in a deal. What do you see as the most important one or two advantages of rep and warranty compared to a standard escrow arrangement?
Patrick Stroth: Honestly, the deal is going to get done. When you go in to a venture, I mean, if it’s meant to happen it’s going to happen, but the issue is if you’re going to go forward with the expense and the time to perform diligence on a target company, and go through all the work to get it, you want this thing to happen successfully. The great thing about rep and warranty is that it removes the tension between buyer and seller.
Now, there’s this theory out there with regard to parties that really insist on having a good sized escrow there, so you have cash on hand. If both sides go ahead, they’re in good faith, they tell everything, they do all the due diligence, and everything is on the table let’s say. The fact that we’ve got a little cash on hand, off to the side, that if something does blow up, “Hey we’ve got the cash. We just go pay it.” Money on hand is going to remove any tension between the two sides. That’s just not necessarily true.
I think that when you’ve got this situation whereas you’re going forward with of the deal, particularly as you get to the reps and warranties and the disclosures and the indemnification clause … Indemnification clause, I mean, is almost like negotiating a pre-nup agreement between a loving couple before marriage. Suddenly, all these bad thoughts, bad ideas come up because the nature of it is you’re thinking worst case scenario, both sides are.
The advantage on having rep and warranty is that you’ve got a tool that brings a third party in. So, it’s not you versus the other party. Well we’re going to make sure that you’re honest, so if you have skin in the game in the presence of a big escrow amount, hey that will make you more honest.
Then, you’ve got that subliminally, the seller may be saying well, “You don’t trust me?” I mean, there are a lot of dynamics out there that you can completely bypass and transfer a lot of these things out to a third party.
The other really nice thing about this is if you can lower the temperature in the room, remove a lot of the contentiousness in the negotiations, why not look at it? Because what’s going to happen is you’re going to have a buyer that’s in a position of possibly fear that they missed something. You’re going to have a seller that’s very defensive, “Why are they asking me these questions? I told them. Why don’t they trust me?”
It’s just that element, there’s enough stress in these deals to begin with, particularly the money involved. If there’s a way that a tool can be used to lower the temperature in the room and successfully get the deal done, that’s not just win-win, that’s win-win-win for everybody.
Steve Gordon: Patrick, let’s talk about the elephant in the room for a minute. We’re now going to involve a third party insurance company. I know the thing that is probably in the back of some people’s mind is well, when it comes time to actually make a claim … If worst case scenario that something does go wrong in the deal post-close and we’ve got this insurance policy in place, is the insurance company going to pay the claim or am I now going to have to go fight them?
Patrick Stroth: Probably the most common question I field with this … This is just unfortunately the rap that people get with insurance, on any insurance product is that, “Well, that’s great. We’re going to pay all this money, but what happens when the claim happens? I’m not going to collect what I wanted to do.”
What happens with rep and warranty is unfortunately it’s called an insurance policy. It is an insurance policy. However, it is different from another other policy that’s written for a couple of reasons.
First of all, the scope of the insurance policy for rep and warranty is very narrow. It is only covering the stated reps and warranties that are in a purchase sale agreement. That’s the only scope. It’s doesn’t go beyond that, so if there are any other side agreements or whatever, those are not part of this. Anything that is known by either party prior to closing of the deal is not covered.
All that is out there are these reps and warranties where both sides are warranting that they don’t know of anything else. You’ve got a real narrow scope of the coverage that needs to be applied. Unlike other policies such as directors and officers, which are so broad that they have to respond to everything, which ends up meaning that they’re going to decline 90 percent of the claims that come in initially just because they’re so broad and they want to get a little narrow.
The second area where these policies are different is the amount of diligence that is performed on placing a rep and warranty policy is so much more thorough than any other insurance policy that’s issued. The underwriters have a very good, wide-open-eyed view on what they’re getting into. They’re essentially sitting there in the room virtually with the buyer’s diligence team.
So, when they go through the underwriting process keep in mind the underwriters for rep and warranty are all M & A attorneys, they are not actuaries, they are not insurance people, they are attorneys. So, you have attorneys that are reviewing M & A legal documents. They are attorneys that are looking at the due diligence materials, and so forth. It’s really hard for an insurance company to say, “You know what, you didn’t tell us about this when we were putting a policy together. We’re a little reluctant right now because you didn’t tell us about this.” They can’t do that. They’re tied in with this because they were in the room when the deal was done.
You’ve got the narrow specific coverage. You’ve got the fact that they’ve seen everything, so if something comes up as a surprise, like I mentioned the free dinner coupons or whatever. Hey, if they missed it, everybody missed it, it’s going to be covered, and so forth. They’ve got that which is different from all other insurance.
The other issue, and this is a real profound issue particularly with regard to private equity, is that rep and warranty policies are very profitable. They have very few losses and they’re being used by repeat buyers, private equity firms, particularly buying these policies over and over and over again. Because the diligence is so thorough and because the risk is actually significantly low, compared to other policies, there haven’t been very many claims.
So, the absolute worst thing an insurance company can do after having a narrow scope and being in the room with everybody is to show any kind of reluctance when a claim comes in. The minute they do that their credibility with the marketplace is eliminated. Private equity and the law firms that work with them will leave them immediately.
There’s a financial pressure on the industry unlike any other product where if you don’t do your absolute best to get it right when a claim comes in … That’s their thing, they don’t just want to pay claims. They want to get it right. That’s over and over what the insurance attorneys tell me when they are helping to settle claims on these.
They pay a lot of these claims, even though again, the losses are small compared to the amount of business they are writing. There is this obligation that they are going to show up and they’re going to do what they say and say what they do, which is unique in the industry.
Steve Gordon: Patrick, can you share an example of how this has been applied to a deal, maybe to give folks who are listening a little bit of a specific example of how this played out?
Patrick Stroth: Oh, absolutely, yeah. Here’s a case with a strategic where you had a large top brand auto company that was purchasing a software company because they were doing on demand drive sharing programs. The auto company wanted to get involved with that and move it over.
Well, it’s easier to go buy this technology company than develop their own tech. The technology company had two major shareholders and had about 10 other investors. While the large auto company was making this purchase, it was a nine figure purchase, and the auto company could afford if there was a loss or whatever. They weren’t really worried about risk.
But, the sellers, the technology company, was afraid because you had the two major shareholders were real concerned that hey, they’re going to be the deep pockets in this deal. In the event something did blow up it wouldn’t be the other 10 investors that the auto company would go after, it would be them.
So, these two shareholders were very, very concerned. They came to us and said, “Is there a way we can insure the deal so we are protected?” We talked to the auto company and said, “Well, if you agree to put this policy in place where the auto company is the policy holder, if there’s a breach of the reps, auto company gets paid and these two major shareholders are off the hook. They don’t have to worry.”
The auto company said, “Hey, we’re all for it. We don’t see the risk. We want these people happy. Tell you what, we’ll split the cost. If they’re willing to pay a majority,” they paid most of it, “if the seller is willing to pay for it, then we’re willing to go forward. We’ll share our due diligence with the insurance company, we’ll go.”
That was a case where even though you had a large corporation, weren’t worried about the risk, but to accommodate their target they went and did this. You have investors and shareholders that are really pushing to get reduced exposure so that they can get their proceeds and move on and not worry about a claw back.
There was another situation with a telecom company where it was being purchased by a larger telecom company. The owner/founder actually beyond the threshold that his attorneys had wanted him to do, bared his soul, disclosed more than his attorneys thought he should have disclosed, but he wanted to be out there honest and did everything.
Well, the technology company said, “Fine, thanks very much. We need an indemnity cap that’s going to be about 20 percent of the transaction value.” The owner was offended. He just said, “Wait a minute. I just bared my soul. If anything is out there, I have no idea. You don’t trust me. Forget this. I can’t fathom having that kind of exposure out there when I’ve just shared with you everything.”
The telecom buyer, more of an institutional player and they said, “Look, this is the rules. This is what we do. We want a 20 percent indemnity cap and that’s just the way it is. We’re sorry. We don’t think there’s more exposure than anything else, but this is how we do it.” So, you had an impasse.
We came in and presented a rep and warranty policy at the 20 percent indemnity cap. Seller did not have to worry because now he is not on the hook for this. Buyer, they were able to check the box, got their requirement in there. Everybody was happy. Deal had been sidetracked was going to not happen solely over this blowup. A policy was plugged in and solved the deal, bridged the gap between the buyer and seller. You have all kinds of examples of things like that out there.
Steve Gordon: That’s clearly a powerful tool and can be used very strategically in a deal to keep things moving forward. Patrick, that really brings me to the next most important question, for somebody listening, how do they know if they’re working on a deal that would be a good fit? What would constitute a good fit deal for a rep and warranty policy?
Patrick Stroth: The way we look at this, first of all, we’re asked often, what sector can you write, what sector can’t you write, and so forth. The insurance industry out there is open to all sectors. I mean, from aerospace to zoology, A to Z. They will entertain and look at pretty much everything. If there are businesses that are in highly regulated fields or businesses that are in non-regulated fields, like cannabis for example, the appetite is a little bit trickier there.
However, as time goes on there’s more comfort that comes along with underwriters. The best way of saying this is the insurance underwriters are industry agnostic. Some like some things more than others, but there’s a variety of places out there. The issue is really if a deal has an indemnity cap in it of 10 million dollars or more. Now, we can do smaller deals, but transaction value, we’ll hear about that where if it’s a transaction value of 25 million and up to a billion dollars, we’d look at that.
We prefer to look at the indemnity cap. What is the buyer looking for? If you look at the 10 million dollar indemnity cap … Because that’s how big the policy is, that’s a great starting point. So, if you have a deal, whether it’s a 50 million, 30 million, whatever, if you have a 10 million dollar indemnity cap or up, rep and warranty is an ideal fit, okay?
The reason why I say 10 million, because the minimum premium for a policy right now is about 250 thousand dollars. That happens to be the rate for a ten million dollar policy. If you’ve got a smaller deal and you need a five million dollar policy, you don’t have a ten million, that’s fine. We can still do it. There are markets that are willing to write a five million dollar policy for that indemnity cap, but again, it’s going to be that minimum 250 thousand dollars. If it makes sense, great. It can be a fit. Ideally you want to look for risks where there’s an indemnity cap of ten million, all the way up from there.
Steve Gordon: That’s, I think, really helpful for folks to draw a fence around where this applies as they’re working through deals. Patrick-
Patrick Stroth: Yeah, what happens often in this … Some people may say, “Well, why ten million? Why so big? What’s going on?” It’s largely because we’ll get asked about sub-ten million dollar transactions. Wouldn’t it be great if there was a market that could handle the two million to ten million dollar deals because there are thousands and thousands of those out there.
The reason why the underwriters want the larger deals is because you’re looking at the buyer’s due diligence. The buyer’s due diligence has to be pretty thorough. You’re not having a real thorough due diligence done on the smaller transaction value deals.
Once you get over 25 million transaction value and up you’re having M & A attorneys. You’ve got to invest in bankers. You’ve got professional advisors. You’ve got audited financials, or at least reviewed financials. The elements that make a risk eligible as opposed to ineligible. So, I definitely want to put in that issue on the ‘why’ at that threshold.
Steve Gordon: I think that’s good information. Patrick, we’ve only got a few minutes left and there are a couple of questions that I think are important for folks who may be looking at trying to learn more about this. The first is, I know you do a tremendous amount of education around rep and warranty insurance and M & A in general through your podcasts and your website and all that. You guys publish articles, I think at least twice a month on these topics and on other M & A related topics that folks can get to. I know that you go and do presentations and that you do webinars. How can folks tap in to all this education that you are doing?
Patrick Stroth: The best way to find stuff, I’m pretty proud of the work that we’ve done on our website on this, is first to visit our website at Rubiconins.com. If you click on the insights tab there we’ve got a list of our articles, links to podcasts, and so forth, just to get a flavor. I would say this, as an insurance broker in the M & A sector, we have probably the easiest, most user-friendly website when it comes to finding M & A-related material.
There are videos in there with some side-by-side comparisons on an uninsured and an insured deal. There are other resources there that it’s one click and you’re in. I’m very proud of that because when I had to do my research on this years ago, you were hunting and pecking all over the place. So, I would say the first place would be to go there.
The other issue is that we do routinely is, on a regular basis, we’re providing ongoing continuing education to the corporate groups and the M & A practices for a number of law firms. We can do these either live or I have a webinar where we go point by point on how to execute this product, pricing on the product, and the comparisons. It’s really difficult when you’re listening to something when you hear numbers here and there, and comparisons, and so forth.
It’s important to have some visuals. I would argue we probably have the best visuals when it comes to an M & A webinar presentation. So, those are available just by reaching out to me and scheduling that to give you on the ground work on this.
I would say that without exception, if you attend one of my webinars on M & A for rep and warranty you will know more about rep and warranty, and how it can be executed, and how can it impact a deal than about 95 percent of the people in the insurance industry.
There are a lot of commercial insurance agents and brokers out there that are very good and they do great work … They don’t know this. It’s not just how the product works, but how you can go from dead stop to getting a policy placed and get it set. That’s a real problem when you’ve got something new.
When you’re into M & A transactions and you’re dealing with bankers and their fees, you’ve got advisors and their fees. If you want to stage your company you’re going to have some compliance issues and costs to get yourself set up, IT expenses to get your security up.
Then, you’ve got legal costs. You have all these things you’re going to incur before you’re even going out there on the road to get an offer for selling your company. There’s all these expenses out there.
To get the idea of rep and warranty in there, that’s just one more thing on the pile of other to-dos that you have. It becomes a reluctant item because you’ve got so many other things out there. What we show with both the webinar and in speaking with me is that there’s a step-by-step way of doing it. It’s a very simple process and it’s manageable. The best thing about it, it’s at zero cost. Until you’re committed to where you want to move forward on a policy you don’t spend a dime.
So, that’s a nice departure from traditionally getting other services where you’re going to incur some kind of retainer fee or expense just to get started. That’s not the case with this. The more people that know that there’s this free resource for a key tool, the better.
Steve Gordon: Excellent, Patrick. I know you do a tremendous amount of work to put all that together. So, for folks who have listened to this and now they’re thinking, “Well, maybe I have a deal that could be a fit,” what’s the best way for them to maybe get in touch with you to begin to talk some specifics, just to see if the deal is a fit? How do they go about doing that? How do they get in touch with you?
Patrick Stroth: Absolutely. The easier it is just to get a quick snapshot look, I think, the better. So, the way you do this is you either reach out to me by email, which is email@example.com. You can also find it on the website or call me, 415-806-2356. Give me a call.
Here’s what I need. This just shows you how simple we’ve made it for you, okay. If I have four data points: the transaction value that you’re thinking about, what the indemnity cap is, is there an escrow amount, for comparison purposes, what escrow if you were uninsured, what would that be, and then what is the state of domicile for the buyer? That’s important because all policies have taxes and it depends on where the buyer is domiciled, so we can get that.
If you have those four items, I don’t even need to know what type of company it is. If you give me that, we can at least give you a real back-of-the-envelope number. Then, it’s just a matter of is the due diligence eligible for the underwriters? And we would go through that later.
But, at least with those four data points, that’s all I need and you’re going to at least have pricing. If you can get that idea budgetary-wise what’s out there, as you go into the letter of intent stage, it’s a lot easier to incorporate this powerful, powerful tool without having to stop doing what you’re doing in the deal to then inject this process and then do it later. It’s much more effective if it’s baked in to the deal at the outset.
Steve Gordon: Very good, Patrick. This has been really educational. I know I’ve been taking notes as we’ve talked. You’ve shared just a ton of information. I appreciate you doing that. Folks, Patrick will be back as the official host of the M & A Master’s podcast in the very next episode, so be sure and come back for that. Patrick, thanks for giving me the opportunity to turn the tables on you today and put you in the hot seat. Thank you again, for everything that you’ve shared. It’s been great having this conversation with you.
Patrick Stroth: Thanks very much, Steve. Appreciate the help there.
Samir Shah has a unique pedigree in the M&A world. He was previously an owner whose company was successfully sold. And these days he’s with Silicon Valley-based pre-series A venture capital firm Cervin Ventures, specializing in helping founders in the enterprise technology space.
Based on his experience Samir has come up with eight “one-liners” (i.e. rules or words to live by) that should guide every startup.
The first one is a question every entrepreneur should ask before even thinking about starting a business.
You get all the details, and, along the way, find out…
Mentioned in this Episode: www.cervinventures.com