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John Warrillow | Precisely Why You Need Representations and Warranties
POSTED 3.16.21 M&A Masters Podcast

Our special guest on this week’s episode of M&A Masters is John Warrillow, the Founder and President of The Value Builder System™. He is also the host of Built To Sell Radio, and the author of the bestselling books, Built to Sell: Creating a Business That Can Thrive Without You, The Automatic Customer: Creating a Subscription Business in Any Industry, and The Art of Selling Your Business: Winning Strategies & Secret Hacks for Exiting on Top

We chat about what dangers to be aware of during a sale, as well as:

  • How to strategically leverage debt
  • The natural and inevitable expansion of buyers in the market
  • How to maximize your value with multiple bidders
  • Who to involve during negotiations in order to retain companies’ employees
  • M&A is not DIY – how to keep your coveted information private
  • And more

Listen Now…

MENTIONED IN THIS EPISODE:

TRANSCRIPT:

Patrick Stroth: Hello there, I”m Patrick Stroth, President of Rubicon M&A Insurance Services. 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. We have a real treat today, I’m pleased to be joined by John Warrillow. 

John Warrillow is the Founder of the Value Builder System, a simple software for building the value of a company used by 1000s of businesses worldwide. His best selling book Built to Sell, Creating a Business that Can Thrive Without You was recognized by both Fortune and Inc as one of the best business books of 2011 and has been translated into 12 languages. John is the host of Built to Sell Radio, ranked by Forbes as one of the world’s 10 best podcasts for business owners, something we aspire to here one day. In 2015, John wrote another best selling book, The Automatic Customer, Creating a Subscription Business in Any Industry. John completes the trilogy with his latest book, The Art of Selling your Business, Winning Strategies and Secret Hacks for Exiting on Top. Well John, as a longtime listener of Built to Sell Radio, it’s a real treat for me to have you here on M&A Masters. Thanks for joining me today.

John Warrillow: Well thanks, Patrick’s it’s good to be with you.

Patrick: Now, John, before we get into the Value Builder System, and then your your latest book that came out the Art of Selling Your Business, let’s set the table for our audience and give them a little context. Tell us about yourself, what got you to this point in your career?

John: Well, I’ve started a couple of businesses that I’ve sold, I wrote about that experience in a book called Built to Sell which goes back 10 years ago. It’s funny, we put together a little questionnaire for that book called The Saleability Score, which is a little like 10 questions survey that identified whether you were ready to sell. And that questionnaire became very popular on our website for BuilttoSell.com, and it got me thinking, there’s probably a business out there for helping entrepreneurs understand what drives the value of their company. So that became the precursor to what we now know as the Value Builder System. And, and, and that’s been something I’ve been focused on for the last few years.

Patrick: Yeah, with a lot of people that are involved in M&A all the time, you know, and I admit, this was me, you know, six, seven years ago was that when you think about acquisitions, or mergers and acquisitions, it’s always Company A, buys Company B, read about the Wall Street Journal, these big, massive deals, and so forth. The reality is, M&A is a group of people choosing to partner with another group of people. And the objective is one plus one equals five or six. 

You can’t get the human element out of mergers and acquisitions, because it’s just what’s driving is people and people. And so you cover this really elegantly with the Art of Selling Your Businesses. The issues with the human element, obviously, fear and greed come into it. And if you’re not prepared, it can be a real traumatic experience. And so you kind of outline that in your book in a step by step version. So let’s start very first part. How do business owners even know when the right time to sell is?

John: Well it’s a great time right now, the M&A market is absolutely on fire. And that’s important, but you know, driven by interest rates, interest rates are very, very low. And most of the deals that I think we’re talking about today, the M&A deals are really underwritten by debt, right. So the private equity group making the acquisition or the strategic making the acquisition is is really the one that that is making the thing happen with debt. And so when debt is cheaper, almost free, which is what it is today, it makes it very, very easy for an acquirer to make money. So I think it’s a great time right now, even though we’re just coming out of hopefully, coming out of this pandemic. 

And, you know, some people have had businesses that have been damaged by that process. I think that can be to some extent, counterbalanced, if you will, by the the the interest rates of where they’re at now. You know, the other way to think about the question, which is sort of a glib answer to look at when’s the best time to sell is, is, is when somebody’s buying, right? So when you get an offer, to buy your business, it is a very unique moment, because for that moment, you are in the driver’s seat, right? You’ve got negotiating leverage, they’ve come to you, and you’re in in the position of power. Whereas if you’re flogging your business, shopping it, if you will, all of a sudden, you’re less positioned for power. 

And I always remember the story of Rand Fishkin, Rand built a company called SEO Moz, which is a software company to do SEO, basically, search engine optimization. And Rand, built it up to 5 million or so in revenue, and he’d been told that his business should be worth giving it the fact it’s a SaaS company around four times revenue. And so they were at five and he had a goal of getting to 10 the next year. So in his mind, he was like next year, we’re gonna be worth 40 million bucks four times 10 million in revenue. 

He gets a call out of the blue from a guy named Brian Halligan, who was at the time the head of HubSpot, which is an all in one marketing company and they figured out that they wanted to add SEO. And Halligan said, look, you’ve done this amazing job of the SEO product. Why don’t we buy you? And Fishkin said, okay, well, what do you have in mind, and Halligan said, how about 25 million bucks of cash and HubSpot stock. Now, that’s five times revenue. That’s pretty good offer. For any business and even a SaaS business which have high valuations. It’s still a great offer. But Fishkin had this 40 number in his mind. And so, ultimately, he pushed back it says it’s 40 or nothing and Halligan said, well, we can’t do a deal. 

And Fishkin went away. And instead of selling his company, he raised venture capital money and got into a whole bunch of different product lines. Unfortunately, many of them failed, started to suck cash out of the company. And at one point, the VCs got really worried about Rand himself, he kind of fallen off into us it kind of spiraled into a point of depression. When he decided or the VCs decided that they should remove him from the board. So he became a minority shareholder in a company he didn’t control. And I asked him on the podcast I did with him. I said, Rand, what was that like? I mean, is your is your stake in the company worth anything anymore? 

And he said, probably not because the VCs invested with preferred shares, so they’ll get their preferred return before Rand gets anything. And I followed that question up with a question around what that offer would have been worth that $25 million in cash and HubSpot stock is HubSpot stock in the meantime, has gone through the roof

Patrick: Up and to the right, yeah.

John: Yeah. Up and to the right. And he said, yeah, it would be worth close to 20, 200 excuse me, $200 million. And I tell you that story, because I think the answer the question, when’s the best time to sell is in many ways when somebody like Brian Halligan is buying.

Patrick: Well, I think this environment is ideal. When you think about the number there, there’s a finite number of good companies out there to be purchased. Okay. However, the universe of buyers keeps getting bigger. And you think that it’d be the opposite. But no, because when you consider there about 4500 private equity firms out there, more than half of those, the majority are targeting companies under $50 million in transaction value. 

They’re competing with 1000s and 1000s of SPACs, or excuse me, 1000s 1000s of strategic acquirers. The newest development for larger companies are the special purpose acquisition corps, the SPACs, that’s the shiny thing out there. You also have 1000s of family offices, and then you’ve got wealthy individuals who want to be just independent and go buy a company. So there are there’s a universe of buyers out there. What do you think is you attribute as one of the biggest mistakes that owners make when they go get ready to sell?

John: Well, I think you just touched on it really well, Patrick, and that is that they, you know, there is this incredible breadth of acquires out there right now. And what I see is a lot of sellers get married to the idea of selling to a strategic, right, they’ve heard that a strategic acquire big, big, you know, fortune 500 company is is the is gonna drive the highest valuation. And so they get sort of fairly myopic, and it’s got to be a strategic you got to be a strategic. And what that does is effectively takes your universe of potential acquirers from massive all these PE groups that you describe, and so forth, down to like a handful of companies. And that may sound okay, until you realize that negotiating leverage in this punching above your weight, if you will, is all about having multiple offers. 

And I go back to a guy interviewed for the book a guy named Arik Levy. So Levy had two exits. One was a bit of a disappointment because he got myopically focused on one acquire the other he learned his lesson and created competitive tension so that the businesses were in the same industry. They’re in the locker space if you know anything about amazon.com you get you the whole foods. You got the Amazon lockers, right? Same business model. But Arik Levy did it in laundries. So laundromat would have lockers so that you can pick up your laundry after the after hours. And Levy built a great little business and laundry locker and he decided to sell it. He got one offer, did it himself. Didn’t hire a professional and got one offer. Accepted a letter of intent. 60 days went by guess what? The offer starts retrading they lowered the price by 20%. 

Arik Levy without another offer in hand says, okay, fine, I’ll take your 20% discount, then they turn around and say, well, we thought we could get the money to buy your business, but we actually can’t. So you’re gonna need to lend us some money to buy it. So then he ended up financing the deal. So lower money, so not a great exit. He then went to build another company called Luxor One they put these lockers in apartment buildings, so people who buy online can get their stuff shipped and secure and stuff. But this time, he learned his lesson, he was really flexible. He said, I don’t you know, we we want to, in fact go out to the marketplace, and even went so far as to say we don’t even necessarily just want an acquisition offer, we’ll accept an investment round. So he was very open to the structure of the deal, private equity group, strategic etc. 

Long story short, he got five offers for his company being open to all different types of buyers. Three of them were investment offers. Two of them were acquisition offers. All five of them, when they originally came in at the letter of intent stage were plus or minus 10% in terms of valuation. He then ginned one off the other playing one off the other in terms of valuation, by the end of this kind of auction process, he was able to triple the value he got for his company. Tripled the offer that he got through just playing one off the other. And we compare that exit with his first, right, and you see the difference between kind of myopically falling into the hands of one acquirer, versus playing the field, including private equity, including, you know, family offices, including strategics, as you described, there’s a huge universe of folks out there. Keep them all on your list, that’s what gives you leverage.

Patrick: Well, that’s a constant, I would say, that’s one of the core themes that you repeat over and over again, in you know, The Art Selling your Business is to go ahead and have multiple players in there, because that’s probably the best leverage that’s available for seller. Those who have leveraged tend to tend to use it. And if you forfeit yours, you’re in a lot of trouble. Now, you’ve got a lot of common sense, advice on the mechanics, you know, of dealing with negotiating terms and so forth. I want to touch on a couple of them, because these can be you know, stumpers. But when a company is going into acquire another company, they’re going to go through their due diligence process, and sometimes that’s going to involve a request to you know, speak to the target’s employees or the target’s customers. Okay. How do you handle that?

John: Yeah so first of all, I think when it comes to employees that that you want to bucket your employees into two buckets. You’ve got your rank and file employees, who shouldn’t really find out until you sell the business until the you know, the checks, so called in the mail. Or in you know, wired across. The other group is your senior management team, two or three people who have to help you sell your company, those folks are going to need to know your you’re for sale. And so when it comes to actually negotiating with an offer, I would hold back the the rank and file employees until again, the check is in your account. 

The two or three senior managers will probably have to go to the negotiation, the management team meetings with you. And and and that’s okay. The thing you want to avoid, of course, is people using the veil of an acquisition offer, really, just to scoop your employees right. This happens a lot I you know, one of the stories in the book is it is a guy who a private equity group who went and made a decision that they were going to roll up a category in industry. And so they went and used a very superficial Letter of Intent to put under contract 80 different companies. 

And when you sign a letter of intent, of course, that I know you know, this, Patrick, you give up negotiating leverage, right, you sign a no shop clause, so that company was effectively tied up. So they tie up 80 companies and they, you know, go through the, the the ceremony of meeting with the managers in an effort to do due diligence, they had no intention of buying 80 companies. In fact, they only bought two of the 80. What do they do with the other 78? Well, they recruited the managers that they met along the way. And it’s one of those horrible stories but it happens all the time where the acquirer is using the veil, the so called acquirer in air quotes is using the veil of an acquisition for no other purpose to find out your private information and your employees. 

So I think that you want to make sure that you’ve got a process in place to to really validate the people you are working with to make sure that they are closers. They do actually transact they do make acquisitions. Talk to other entrepreneurs who sold to that PE group or that strategic to find out if they are If they have a reputation for closing, because because yeah, these games happen all the time. 

Patrick: You really have to have professionals on your team. Why don’t you talk about this? Because there are two things I think I’d love your opinion on, first of all having an intermediary or investment banker. And then if you talk about their role, and then also the other one, you talked about you described as your left tackle. Having a real savvy, M&A attorney, not an attorney,  general business attorney, but an M&A attorney. So start with those two professionals and give me your thoughts.

John: You’re absolutely right. I wouldn’t sell a business without an M&A professional. I think it’s crazy. I wouldn’t sell a house without a real estate agent. Of course, you can do it. But their job is to create competitive tension right? In the case of Arik Levy that I just referenced, the Luxor One versus the, the the laundry locker, the difference was in may pay in many cases, he hired an M&A professional. In the Luxor one deal he had Trip Wolfe, who’s a sell side M&A guy that ran the process for him got the five offers in the first example where it went poorly. He tried to do it himself. So look, it’s not a DIY project. 

The left tackle comes from the movie, The Blind Side, the book of course by Michael Lewis, where he described when a quarterback rolls back in the pocket, a right hand throwing quarterback, he kind of turns his back to the left side of his body. And of course, that exposes him to a 300 pound lineman coming to flatten them. And so the left tackle is the defensive player that basically protects the quarterbacks blindside. And that’s the description I used for the corporate M&A professional. The lawyer, excuse me, the legal representation that the corporate lawyer who is a specialist in M&A, and their job is to kind of pump the brakes, right? 

The M&A guy on your team is likely to kind of nudge you jet gently to accept terms and do points, right because they they get paid when a deal gets done. And your left tackle that the M&A attorney is there to kind of pump the brakes a little bit. And when it works, those two have a mutual if not always ammicable, but certainly a mutual respect for one another. Right? Because they know they each are doing their job. And I think that that that that’s an important piece of the puzzle, you know, to go back, Patrick to the earlier point you made, which is this idea of using protecting yourself from a legal perspective, I just was triggered by one of the guys I put in the book. 

This guy’s name is Aurangzeb Khan. I think I’m pronouncing him in right his name, right. But he built a business in the UK called ebookers. They are an online travel agency. And the most important the way these businesses work is they get a commission, right, they get a commission from the hotel chains and airlines when they book, you know, book revenue, kind of like Expedia, right. And there’s sort of four or five major online booking engines in the world. And the most coveted secret in this category is the commission rate. Because obviously if you as Expedia know what Travelocity is paying on in terms of a commission rate, then you’ve got leverage, right? 

Well, in the story, that in Aurangzeb’s case, when he sold ebookers, which is the Expedia of the UK market, he realized that the commission rate was his most coveted secret, but he took his business to market anyways, he got four offers, he learned later that two of the acquisition offers were not real. They were simply there to find out the commission rate. And, and and and you say, well, you can’t use that information. They sign an NDA, sure, they sign an NDA. But if you know what the commission rate is, you don’t have to all out and out say that, that you know just how far you can push the airline until they break, right. And you don’t ever have to reveal that you found that out through the M&A process. And so that’s just an example of why you need a really good M&A attorney who can can really protect you along these lines.

Patrick: And there’s a great balance that you have there where you’ve got your your investment banker that’s trying to push the deal forward, getting you over the obstacles and possible little fears out there. And then you’ve got the cautionary kind of the safety manager, the attorney push it back the other way, and they’re constantly thinking, worst case scenario, and the investment banker’s thinking best case scenario just to get you to move forward. So it’s an interesting balance.

John: The worst case and you find you get this balance wrong, is when you hire a an attorney who is a generalist, right? Like the same guy or gal who incorporated your company defended you on that, like wrongful dismissal suit or whatever, and says, oh, yeah, yeah, we can do M&A. Right. And they’ve done like one deal in the last nine years. The problem with hiring someone like that, although they may be your best friend and really, really, you know, heart’s in the right place. They don’t understand the M&A process and as a result, they tend to have their foot squarely planted on the brake right. 

They’re like, I can’t do anything that would expose my client to any risk whatsoever ever. And as a result, nothing gets done. Because the attorney doesn’t know what market terms are, what realistic rate, you know, reasonable reps and warranties are what are way outside market, right. And so you really need a really solid experienced M&A professional and an M&A attorney to do the deal for you. And it may not be that the guy or gal who incorporated your company probably isn’t.

Patrick: Absolutely not, because they’re they’re going to be looking at disclosures in the reps and warranties. And what you have to understand is that the seller individually, personally, they can’t hide behind the corporate veil. They are personally liable to the buyer, if they make a representation or disclosure in that schedule to the buyer. Buyer performs diligence, but you may not know everything that’s there, you may have forgotten something. And then post closing, if the buyer suffers a financial loss within the contract, they can come out after you and collect dollar for dollar and claw it back. 

And so it’s a real big area of fear. What what I appreciate, and it hasn’t been widely publicized on lower middle market sub $50 million transaction deals, there’s actually an insurance policy that takes away that risk, where the insurance industry will go ahead and look at what the disclosures are, they look at what kind of diligence the buyer performed. And then they say, great, well, we’ve looked at everything for a couple bucks. If anything happens, we’re going to transfer that indemnity obligation away from the seller, and we’re going to take it over to the insurance company and we’ll absorb it. The buyer suffers a loss, the insurance company will pay the buyer so the seller gets a clean exit. 

So if something does blow up that they had no idea about it, you know, it gets taken care of. It also helps because it off sets any escrows or withholds because no need for an escrow or withhold if an insurance policy is collectible and out there. And is a great development that’s been out there. I know when we’ve we’ve heard your your guests talking about issues on the diligence and the reps as a real big area of fear.

John: Yeah, absolutely. Because, look, I mean, you’re selling your business, for freedom, right and and the last thing you want is to have an incomplete or as you say, not a clean exit, right having that. I mean, you might as well keep control your company, if you’re not going to be fully out. Why sell it right? If you’re if you’re not going to have that sense of freedom. When I when I talk to entrepreneurs about why they sell their company, I think it comes down to this core need that I think all of us share in common, which is the desire for freedom. And they want a clean exit. 

And you know, I go back to a guy named Joey Redner. Joey, is another guy a feature in the book, he built a company called Cigar City Brewing. Brew pub in the beginning, and a brew brand, I should say a specialty beer. And he built it up, he borrowed about 800 grand from his dad the very beginning to build a brew brewing facility. And a lot of money, very capital intensive business, but got it off the ground and it became really successful. And Tampa Bay, people were buying the beer like crazy and it was a hit. So much so that he ran out of brewing capacity. He goes to the SBA and gets him to guarantee a massive loan to build out his brewing capacity even further. 

So he’d have you know, 10s of 1000s of cases a month or whatever he was selling. Things are going well for a year or two more. And guess what he runs out of capacity again, now he’s in hock to his dad, he’s got a massive bank loan. And the banks come in and say Joey will lend you the money, just sign here, Right. All your personal guarantee in place to expand the production facility again. And Joey throws up his hands and goes enough. You know, like, I feel like the gambler at the poker table who’s just being asked, like, I just won five hands in a row and you’re just asking me to put all my chips in the middle of the table again. Like it’s crazy, I won. 

And and he said, I just wanted that sense of freedom to be out. To be out from under all this debt and all these obligations. And, and I’ve always remembered that story, because I think that is the essence of what you get when you sell your company, right. Is you get that your first foot on the rung of Maslow’s hierarchy of needs, right? Like when you get a clean exit and you sell. Like, no one can take that away from you, right? You you you have, you don’t have to worry about money anymore. And I mean, that doesn’t mean you’re not going to work most like Joey was 40 when he sold his company, right? 

He’s gonna have lots of other things that he does in his life, but he’ll never be able to slip his foot off that first rung of Maslow’s hierarchy of needs. And I think that’s what we you know, as entrepreneurs, that’s what we all crave. And when you sell and the in the owner can claw back half the value, you know, because you forgot to disclose something. I mean, it’s, it’s tragic. So I think it’s a I think it’s a really important issue you raised.

Patrick: Well, we talked about before how you can maximize your value getting multiple bidders, and some of the issues out there and improving your leverage and so forth. Let’s just give one quick little reference to some of the things to be fearful, or just be aware of. And it’s really helpful because if you can spot these spot these things coming, you’re prepared for and you’re going to have the right response. Let’s talk about, you know, what are some tricks that an experienced buyer could try to apply against an inexperienced seller? What do you have to look out for. Just mention one of them. 

John: Yeah, I mean, look, private equity companies will ask you to roll equity, right. So when a private equity company buys a business, they generally don’t have management in place, their financial engineers, they’re not managers of companies. So they’ll say, look, we love your company, you’ve done an amazing job, we’re gonna, we’re gonna buy your business. But we want you to hold on to 30% of your equity, we want you to roll that into a new entity, now we’re gonna grow that new entity with lots of debt, and maybe we’ll buy some more companies, and then we’ll go on to sell that in the future. And we’ll make a truckload of money. 

They call it the second bite at the apple. And it’s a very overused expression, which I can’t stand. But in any event, that’s what they say. So you might get that pitch. And in theory, when it works, and I’ve seen it work, it can be spectacular for both the private equity group as well as the entrepreneur who kept a rolled equity. The challenge, however, is that it doesn’t always work. I’m reminded of a guy named Ryan Moran, who I just interviewed on my podcast, where he built a company. And it was a supplements company to my recollection, and it was about $20 million of revenue. And he sold it, I think it was 18 or 19 million bucks. 

So like a big number of big, big successful exit, that was the valuation but he got 60% of his money up front, and was asked to roll 40%, into a new entity. And he thought, that sounds great. And they had all sorts of great plans for his company. And, you know, but they wanted to bring in a new manager. So they brought in a new CEO to run the company after Ryan stepped down. Well, the CEO had no idea of how to run the company. He taught the private equity company piled on a truckload of debt in order to try to grow the business and bring on and pay the salary of this fancy CEO. 

And long story short, the company wasn’t able to pay back the bank debt. The company ultimately defaulted, went bankrupt. Now, the PE company lost its money on that deal. But so did Ryan, the 40% of his equity that he rolled into the entity went to zero. And he was out of control because he was a minority shareholder in a company he no longer controled. And so that’s the downside, that’s a rolling equity rolling a lot of equity is is really, you know, it’s a gamble in the sense that you are, you are not the majority stakeholder anymore. Yet, you’ve got a significant portion of your net worth in a company, you don’t really control. the dirtiest one I’ve ever heard is, and I’ve only ever heard this once. And so I don’t think it’s a common practice. 

But I did hear at once that the acquirer the private equity group, asked the seller, to guarantee personally the debt, the private equity company was taking on to grow the business after they sold it, like so here, I’d like you to buy my house. And and, and you’re basically that when the seller is saying, or the buyer is asking the seller to basically guarantee their mortgage, it’s like the craziest thing I’ve ever heard. But again, there’s all sorts of shenanigans that happens in that space. And just be mindful of the the equity carry, and, and, and, and, and for sure, there’s some great upside it happens. But there’s also some significant downside.

Patrick: And these are the types of nuggets that are really helpful for owners getting out there considering this as they go through this life changing transaction. And I will say that the book is not full of, you know, checklists and to do and step by step programs is a number of these real common sense advice points. And you go through the whole process from beginning the transaction all the way through to the end, including the exit, which is a great guideposts for them. And so define your ideal profile for your ideal client.

John: Yeah, look, I mean, it’s really someone who has a business worth somewhere between one and $50 million. So they’re not startups. They’re not dreamers. They are not. What’s that?

Patrick: Hobbyists.

John: Yeah, they’re not hobbyists. They are, they’re running real companies, with employees, they have put everything on the line in their life to to build this company. They know it Joey Redner’s case everything there is to know about brewing beer, but probably not as much about the M&A process. And so we try to really help owners do what they do really well, in the case of Joey’s you know, selling beer. And so we can help them with the the actual kind of punching above their weight, some of the negotiation theory around effectively selling.

Patrick: Now, as everybody’s been listening to you’re making reference after reference of all the people that you’ve spoken to in your podcast, I would sincerely invite people to go check out John’s podcast. Built to Sell Radio is on iTunes, and pretty much where all podcasts can be found. And it’s a great entertainment set of stories about all of these things. And you get to see these real life experiences and is nicer probably hearing other people’s experiences before you fall into some of the columns yourself. John, in addition to the Art of Selling Your Business, how can our audience find you?

John: The best place to go is builttosell.com. And there’s a little button in the top right corner. I think it says free gifts. You can download a bunch of free stuff, white papers and videos on what drives the value of your company. So just click on free gifts, and all roads all roads lead to builttosell.com

Patrick: John Warrillow again, absolute pleasure having you. Thanks for joining us today.

John: Thanks, Patrick.