Steven Epstein, founder of RedCAT Systems, and his partners and management team had slowly but surely built their company in a highly specialized niche serving top clients, including those in the Fortune 500. They were ready to sell to take the company to the next level.
But this small, Colorado-based software company involved in HR and compensation solutions for clients like LinkedIn, Uber, NYSE, and many more wasn’t interested in being acquired by just anybody.
They were looking for a partner who wouldn’t accelerate growth too fast or take on too many new clients too quickly because they wanted to ensure a slow growth strategy that would keep current clients happy and give the new ones the same high level of customized service they’re known for. In their specialization of executive compensation, which has a lot of moving parts, this counts for a lot.
After a time, they found their match – a company that understood their business culture – and were recently funded by PE firm Broadtree Partners.
“We wanted to make sure that our clients were treated well. It’s a very high-level service. There’s really nothing that we would be asked that we weren’t able to fulfill on time, on budget, and pretty much the experience was exceptional. That’s why we were able to get the type of work that we do. And we wanted someone who would share that philosophy and maintain that while at the same time doing measured growth,” says Steven, of RedCAT.
As with any M&A transaction, there were some hiccups along the way… as well as one major obstacle that could’ve derailed the whole deal, and probably would have, if this transaction was being negotiated prior to 2019.
This is an in-depth examination of this real-world M&A transaction. We first got the story from the Buyer’s perspective – you can check out that article here. Now, we’re hearing from the Seller as we explore how the deal went down so that both sides were happy. Additionally, Steven was featured on my podcast, M&A Masters. You can listen to his episode here.
Once Broadtree and RedCAT had a signed a Letter of Intent, it took roughly nine months to close the deal.
One of the things that stalled the deal moving forward was due diligence. Broadtree was more used to dealing with larger companies that had more in-depth and detailed financial records that could be combed through. It took a while for RedCAT management to get all the required information together.
“As a company, if that was your plan [to be acquired], I would just keep much more meticulous track of every single document,” says Steven. “Every little bit of every single dollar that was ever spent took a lot of effort to come up with… and then thousands of pages of contracts we had already signed. Looking at and reviewing every single thing took quite a while.”
Tech due diligence – which involved making sure no code or other IP could be claimed by another party – also took some time to get through.
But what was the major sticking point?
One of RedCAT’s partners, who had been burned in business deals in the past, wanted some protection. Specifically, he wanted to use Representations and Warranty insurance so that less money (including his) would be held in escrow and there wouldn’t be any threat of clawback.
With R&W insurance, if there are any breaches in the Seller’s reps, it’s the insurance company – not the Seller – who reimburses the Buyer and pays the financial damages. Those claims do get paid, and this coverage is reasonably priced.
Often the Seller pays for the insurance because of these benefits. But there are plenty of reasons for a Buyer to get on board, too. For one, in case of a breach, they don’t have to go after their new team members (the Sellers) who’ve joined the company after the acquisition for damages – that’s very awkward. Also, there is no need for costly or time-consuming legal action. The claim gets paid, and everybody goes about their business.
“[R&W insurance] allayed our partner’s fears, basically of the deal and the liability,” says Steven. “If something did come up, I think it would be tremendously beneficial to have it. Let’s say we didn’t have R&W, and we put in $1.5, $2 million in escrow. And then some kind of obscure thing comes out, and we disagreed with it. That would cause a serious breach. Not only of, say it’s a million or two dollars, but then we probably wouldn’t want to stay on. And the effect is most likely the failure of the new business.”
Just a short time ago, this wouldn’t have been possible because insurers were only offering R&W coverage for larger deals. But recently, we’ve seen an increase in Underwriters crafting policies for transaction sizes under $20M, which opens up this insurance to a whole other section of the M&A world, including lower middle market companies like RedCAT.
For Steven, the R&W coverage offered more than financial protection.
“The peace of mind can be priceless. Just the feeling that I don’t have to worry about this. We’re covered. It’s not a thing that will A) damage the relationship and B) just consume life energy where you’re fighting about something that is likely frivolous.”
That’s a ringing endorsement for Representations and Warranty coverage. If this case study has interested you in this specialized type of insurance, tailor-made for M&A transactions, and now available for deal sizes under $20M, contact me, Patrick Stroth, at firstname.lastname@example.org.
This is Part 2 in a two-part series about a recent M&A deal in which PE firm Broadtree Partners purchased SAAS company, RedCAT Systems, which provides specialized HR services for major corporations like Uber, NYSE, and LinkedIn.
This time we’ll be covering the Buyer’s side of the transaction with Rob Joyce from Broadtree. (Be sure to check out my conversation with Steven Epstein of RedCAT here.)
Importantly, Representations and Warranty insurance was a crucial part of this deal. Broadtree wasn’t too thrilled about having this coverage in place at first, but, as Rob notes in our conversation, they did eventually come on board.
We talk about the initial reluctance to get R&W insurance… what changed their mind… and how this coverage changed the dynamics of the deal dramatically, as well as…
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, a clean exit for owners, founders and their investors.
Today is the second of a two-part series where we’re looking at a case where an m&a deal was insured by record warranty. This time from the buyer’s perspective. Broad tree partners are a financial buyer which purchased a Colorado, Colorado-based SAAS company by the name of red cap systems. In this I’ll have Rob joys of broad tree partners, discuss his perspective and you’re going to note that, at first he was not too thrilled about going after rep a warranty but to accommodate the seller, he agreed to move forward with us And he went through a transition going from being aware of record warranty as a concept to becoming a tool that he is going to use on a go-forward basis quite a bit like an experience that we have all too often here at Rubicon where a majority of our clients are first time users even though they may have heard of record warranty. They had yet to use it and their experience changed their opinion dramatically. The other issue I want to highlight here and be aware of is that this is a lower middle market company with a transaction value under 30 million that did not have audited financials, which would have made it ineligible in 2018 to get record warranty. However, now with the market, the way it is in 2019, not only was a solution available, it came in at the right price and also provided all the same benefits. That billion-dollar transaction gets to enjoy so now have a listen and enjoy Rob Joyce.
Welcome. I’m here with Rob Joyce, who’s a director over at Broadtree Partners. Rob, thanks for joining me today. Now tell us about brought three partners. And then we’ll get into the context of how you came to this point in your career, but give us a profile on Broadtree.
Rob Joyce: Yeah, so Broadtree Partners is a lower middle-market private equity fund, and maybe a good way to think about them is they are what I refer to as a search fund incubator. And what that means is as opposed to necessarily looking and acting like a search fund, they act as a private equity fund in almost all aspects with kind of one unique focus, which is at Broadtree.
Many of the executives are operating partners. And the intention is for these operating partners, to be deployed in the businesses after the acquisition and what means as broad trees focus is not only deploying dollars into new businesses make acquisitions, but also deploying people. And we view that as part of the way that that will help growth inside the acquired portfolio companies.
Patrick Stroth: I think that’s a really important differentiator from other investors out there who are blind, you know, contributing capital, and maybe a little advice here and there. But you’ve got operating partners that have seen businesses through the entire lifecycle, from established growth into the next transition and beyond. And I think that kind of knowledge and experience is sorely lacking, particularly from owners and founders who have only had one life cycle they’re dealing with, and that’s just the one they have.
So that’s a great additional feature you guys are bringing.
Rob Joyce: I think it’s something that is a real value add in the lower middle market, is I think one of the things that companies need to grow here, not just as capital, but oftentimes from a resource. constraint in terms of personnel, these companies are resource-constrained. And it is difficult and expensive to hire executives that can make a difference in your team. And for a lot of people, especially they haven’t done it, this can be something that’s a pretty scary thing to do. And I think this is a great way to make a large impact in these businesses is not only to deploy capital but to deploy resources as well and full time dedicated resources, whose objective is to grow the business.
Patrick: Give us some context on you. How did you come to Broadtree, how did you get to this point in your career?
Rob: Yeah, so a little bit of background on myself is for a number of years. I did M&A mainly focused on doing integrations with a little bit of carve out work. I did that for about eight years. And then after that, I transitioned and I, you know, went back to business school, and had some experience with private equity and venture capital. And what led me to read cat was I knew I wanted to stick in primary investing. And one of the things to me that was important was as opposed to just deploying dollars, which is, you know, what we talked about a second ago when I was really looking to do was also individually to be able to build something and to be someone who is helping to actually dictate the change and create the change and create growth as opposed to just deploying and stewarding dollars are and you know, investments. And Redcat, sorry, and Broadtree, you know, offered me that ability.
Patrick: And were you and I came in, came into the picture together was when Broadtree and you were pursuing the acquisition of RedCAT, which is a SAAS company based in Colorado. What led you to that particular investment? What was it about RedCAT that attracted you?
Rob: Yeah, so outside of any sort of investment thesis that existed in the area, specifically about RedCAT, what was so interesting was the work that the existing the management team, which consists of the two co-founders have managed to build to this company over kind of its fairly long life. And the kind of proof is in the pudding in the really impressive customer base that the company had as well as the fact that they were really filling a hole that seems to exist in the marketplace. But a lot of it was really a combination of the product as well as the people who are going to be part of the team that’s really what made the difference.
Patrick: So if you can walk me through the process just overview real quick. You meet with them their synergies, there’s a connection. You decide to move forward to design the letter of intent. How did the process Go for you from that date, how long of a time are we talking about? And then just, you know, it’s not it’s a lower middle market company, that doesn’t necessarily mean it’s going to be quick. And there’s not a lot to look at.
Rob: Yes, this process was certainly not quick, I would say this is on the length and if not on the far end of long for these processes for a lower middle market company in terms of time. So, there’s diligence, that obviously needs to be performed, you know, small businesses, in companies in the lower middle market in general. So sometimes can be more difficult to your point. You know, sometimes they’re easy because there’s not a whole lot to look at, but sometimes they can be difficult because they also don’t necessarily hold their data or information or are and ways you’re used to looking at for larger companies. And part of it is either lack of sophistication or lack of resources to do it and ultimately lack of resources can also play a real role and how long diligence takes to know if your company has hired if your target rather is hired, you know an investment banker or has an advisor who is actively pushing it into a sale or pushing into an auction process that will be more well defined.
Now, if you are a company that is not the norm if you’re looking at companies, now, the normal process this may or may not take longer and with RedCAT, one of the interesting things as you know, the founders are also busy running a business during this time. So, you know, acquisition or in their case of sale is a significant amount of effort. And they had to juggle that while also simultaneously continuing to grow their business. So so the process took a while but the kind of key points where there’s obviously for Due diligence, lower middle market companies will tend to have different quality of financials. And you know, which you might expect for a company that’s 10 times the size.
The next area is obviously tech diligence, because this is a software company, as you mentioned, Patrick, and it’s having someone kind of go through and perform technical diligence and kind of understand feedback on the development process and code base, and everything else like that. And then one of the things that it also comes down to is, you know, once you’ve gone through the kind of some of these key diligence items and spoken with customers is you still have to find a deal. One of the things that pushed us past one of our sticking points in this deal was, frankly, the use of rep and warranty insurance. It was a large concern on the part of one of the sellers that we were able to satisfy by using warranty insurance and it’s part of the reason why our dealership is cross the finish line.
Patrick: Well, the concern with that partner was out there and can happen had you use rep and warranty before I always your initial reaction to it, ultimately we went forward with it. But tell me about your reaction if this was your first time if not, give me a few your feelings on the concept of rep and warranty.
Rob: Yeah, so this is the first deal I’ve executed with rep and warranty insurance as part of process it’s, you know, it’s been brought up and I kind of gone through bidding as well as diligence with this being understood, but I’d never gone all the way across the finish line and that is, I think, a noticeably different discussion when you’re actually going through and executing rep and warrants even when you’re saying you know, roughly how much does it cost to get something that looks like this. And you know, Paul, parking is doing forth in the real world. So that was, that’s kind of my background with rep and warranty. For me, I was in an interesting place because as the buyer for this particular deal, at this particular size, I did not have the concerns that one of the sellers did. And so this was really used on my end primarily as a tool to help the seller one of the sellers become comfortable with the transaction and part of that was based on their prior experience. And not necessarily even with M&A, but with lawsuits and things from a corporate perspective is, is they saw this as a potential area of risk and this person was very concerned very, very, very concerned about this. And rep and warranty insurance pretty much quickly mitigated the issue.
And this was something that could have really, really been time intensive if we had not used this solution and I and it could have derailed the deal.
Patrick: It was more of accommodation on your part. And in part of this, and this is one of those common questions I get is OK, if there’s policy here, you the buyer, or the or the policyholder, because if you suffer the loss, the insurance carrier comes to you and pays you your loss rather than requiring you to go pursue the seller on them and then find the seller so it’s more of a direct line. And the question I get all the time is okay, well, if the buyer is the policyholder then who pays for and it varies from deal to deal and it can be one of three ways either the buyer pays for it. The seller pays for or the two sides split it and you were willing to accommodate them and move forward on this and they stepped in and funded the cost.
Rob: Yeah, I think that’s an important thing to note is, like you said, there’s a lot of options here about where, who pays for what in this process. And I think part of the different factor for this deal, in particular, is that this was not a concern that I had, as the buyer, the policy, the concerns that were brought up, were not one that I reflect that what I reflected was, from my perspective, or something I was concerned about. And so, you know, that’s, that’s part of the reason why it ended up that way. Now. Now, I know through our earlier conversations and through, you know, having spoken to some of my other past and present colleagues, is there are other cases where the answers on the opposite side of table where this is primarily a buyer concern, and that there are some real concerns and that the warranty insurance is there to really protect the buyer. Interestingly enough here, it is a buy-side policy, but it’s primarily meeting the needs. And not primarily, I mean, it really is there to meet the needs of the sellers.
So I think that’s an interesting way to look at it. And, you know, I think if we’re being transparent about to regardless of whose needs its meeting, that’s not necessarily with to who funds the policy, you know, negotiating point like everything else in a deal.
Patrick: Absolutely. So as you go through this experience, you had your first rep and warranty policy, any experiences you can share good, bad, indifferent, anything surprise you?
Rob: Yeah, one of the things that surprised me frankly was the variation in responses you get from talking with different brokers about rep and warranty insurance, everything from you’ll hear some people ballpark mentioned it’s not even possible to get rep and warranty insurance on a lot of these lower middle-market deals. which I know is something you and I extensively talked about that that’s, you know, just not the case anymore. You’ll get that response. You’ll get responses that have differing amounts of, you know, cost, as well as coverage. And you and I working together. I know you kind of already know where I’m going to go with this. But I was blown away by the coverage options that we got working, working with you because they were far above and beyond not only what I expected, but having spoken with my counsel who does an extraordinary number of these lower middle-market deals, as well as some other people who are in this market is no one expected to get this word average. We got them still.
Patrick: Yeah, that’s one of the big developments, which is why I wanted us to talk about this particular deal is that traditionally, rep and warranty was reserved for the hundred million dollar plus transactions they had in the last couple of years come from 100 million. down to $50 million as a threshold. The product now due to a number of competitors coming into the marketplace are now able to ensure deals with transaction values below $20 million. And the other item that was the big change is underwriters do not like ensuring more than 30% of the deals transaction value. Now mostly in Germany counts we’ve seen out there then between 10 and 20%. There are the outliers but it’s usually between 10 and 20% of the transaction value.
So the insurance carrier’s comfort level of 30% or less was rarely breached. But when you get these sub $20 million deals, and you’ve got parties out there that want to ensure up to the entire transaction value. That’s a real change but that is now available where we are now getting involved with transactions we’re ensuring 75 to 100% of the traders that So that is the new development that’s out there. Now, how likely we got this through successfully at there were a lot more applications for it and options that you expected? How likely are you to use it again on another deal?
Rob: I would say that the first step in that is this is immediately now part of my toolkit before it was kind of reactionary. On the only previous times prior to this deal, that revenue, I’d really looked at revenue mortgage insurance, and like you mentioned part, it’s the market I’m working in, in the deal size, you know, this was something that kind of I only looked at based on seller requirements, you know, they really should be happy to have this, you know, give a banker or someone else who basically says this is you know, you must include this, I kind of used it under those circumstances only, I would say now, this is an immediate part of my toolkit, one that can allow some risk mitigation on my side if I feel the need and too, I think it’s also a great tool to help overcome some buyer discomfort, as they’re worried about any sort of risks to the deal. things that can happen, that rapid warranty insurance can cover. This is exactly the tool to use that.
Once again, it’s everything is about the cost. So, it depends on you know, whether or not you need it, how comfortable you are. I will say for me personally, I would not hesitate to use it again, as a tool to help overcome buyer objections or to make them feel comfortable or in some cases where I do feel there’s a risk here to protect myself from the risk.
Patrick: I think it’s a great tool that can be deployed strategically just wear it particularly if you’re in the position as a buyer. You can offer terms that letter of intent with the seller where you say, here you go, we were looking at traditionally there is an escrow or there’s a withhold, and here are some of the risks we’re going to look at if you will so here’s another option where we don’t have to have as big an escrow or any escrow we can ensure the deal is about this is about the cost of it and seller, which would you prefer, you know, having the funds in escrow or unlocking the funds is just going to cost a little bit more, we’ve got a ballpark for you.
And I would think more often than not the seller is going to jump in at getting insurance. Ideally, you’ll get over once they see the cause they get a custom to the cost is the peace of mind and the lack of worry of a lot of these risks as the process goes on, particularly as they go through the whole diligence process with you.
Rob: I think you nailed the one thing that I probably didn’t highlight well enough in my response, which is, this is also a way like you mentioned to differentiate your bid because it does allow you to minimize dollars in escrow. And from my experience, at least that is something that sellers actively look at it’s not just How much money is you know when under what conditions they get it. And I do think this is a way when you are bidding with a company or structuring an LLI or whatever your process is, this is a way to differentiate yourself. And I think that is invaluable outside of the risk mitigation factor. Simply unlocking the cash for the sellers is a very important thing to note.
Patrick: I couldn’t have said it better myself.
Rob: Thank you very much.
Patrick: Now, Rob, you’ve with RedCAT, which we closed a few months ago, you’ve gone through by now your first board meeting with them, how are things going with them?
Rob: Things are going well, working with the sellers, we’ve been visiting some customers, we’ve acquired some new customers as well during this time and we are getting ready to make a big hire to continue to push growth. So things are going well and everyone is excited about working to kind of take RedCAT towards the next level.
Patrick: Well, I know you’re busy, a success brings on more and more Success for you. And I know that you’ve got a lot going on with us. But if there are some other folks out there that are in the same position as RedCAT, where you got owners and founders of the lower middle-market company, and they want somebody who’s not just going to throw money at them and put demands for growth, but somebody who really wants to partner with them, I really think they should reach out at least think about you and Broadtree.
Rob, how can our listeners find you?
Rob: Yeah, so you can find my contact information, as well as my partners is on Broadtreepartners.com. And I would encourage you to reach out to someone there if you’re looking to meet with anyone at Broadtree Partners. And we’d be happy to discuss anything with you tonight.
Patrick: Well, Rob Joyce, thank you very much. It was an absolute pleasure working with you and I look forward to working with you again very, very soon.
Rob: Thank you, Patrick. I look forward to as well.
When lower middle market PE fund Broadtree Partners expressed an interest in acquiring the small HR software solutions provider RedCAT Systems (which works with Uber, LinkedIn, and NYSE, among many other major firms), it looked like everything was going smoothly.
RedCAT’s management team and founders felt that Broadtree’s post-closing plans for the company meshed well with their core values of not growing too quickly in order to best serve existing customers, which have complex needs, especially with benefits for well-compensated workforces.
Broadtree was enthusiastic about RedCAT’s impressive customer base and how they had filled a hole in the marketplace with a unique and vital service. They felt, with their management resources and capital and the RedCAT team’s contacts and experience, that they could take the company to the next level – with smart growth.
The sticking point: one of RedCAT’s partners felt that Representations and Warranty (R&W) insurance should be part of the deal.
This specialized type of coverage, created especially for M&A deals, transfers all the risk, including the indemnity obligation, to a third party – the insurer.
It eliminates the need for money to held back in escrow and for an indemnification clause – which makes the Seller happy. This is why the partner wanted the coverage: to make sure his proceeds from the sale were safe and not held back. They had previous experience with lawsuits from a corporate perspective and saw this as a potential area of risk.
But there are benefits for the Buyer, too. If there are any breaches to the Seller’s reps, the Buyer can file a claim and is quickly compensated with no hassle by the insurer.
Deals with a transaction value as low as $15M will be considered by insurance company Underwriters for R&W policies. With a transaction value under $25M, the deal with RedCAT certainly qualified. But this is a development within the last year or so, which is one of the reasons why the Buyer was somewhat reluctant, at least at first, to make this accommodation to the Seller.
Another new development is that deals under $20M can be insured by R&W coverage for up to 75% to 100% of the transaction value. In the case of RedCAT, the parties were seeking a policy covering up to 75% of the transaction value. For larger deals, unlike this new lower middle market segment, Underwriters are only comfortable going up to 30%.
For Broadtree Director and Portfolio Company CEO Rob Joyce, this was the first time he had taken R&W insurance all the way to the finish line. So they were familiar with, but weren’t aware of, all the potential advantages for both parties.
“[Rep and Warranty] on my end was really used primarily as a tool to help one of the Sellers become comfortable with the transaction, and that was based on their prior experience,” says Rob. “This person was very, very concerned about this, and Rep and Warranty insurance pretty much mitigated the issue. This was something that could have been really, really time intensive had we not used the solution, and it could have derailed the deal.”
This is the perfect example of one of R&W insurance’s biggest benefits: it smooths negotiations, removing the contentious elements of escrow and holdback, which also speeds up the journey to a final Purchase and Sales Agreement and eventual closing.
For the Buyer, it gives reassurance that they will be paid promptly if there is a breach in one of the Seller’s reps, without the need to go after money held in escrow that would normally go to the acquired company’s management team… that could now be, as is the case with RedCAT, part of the Buyer’s organization.
As negotiations progressed and the due diligence process began, other issues began to emerge. And what happened should provide helpful tips for other lower middle market companies contemplating a sale by showing them what they can be doing now to prepare.
The issue was the financials. As a smaller company, RedCAT didn’t have the amount of financial data required, and it wasn’t in a format Broadtree was familiar with.
This often happens due to lack of resources. For example, in RedCAT’s case they didn’t have an investment banker or adviser actively pushing the deal. The founders were working on the deal, which takes significant time, as they continued to run the business.
The financials themselves were good, but the quality of the data reflecting that was different than you see in larger companies. The other issue was the technical diligence, which is vital with a software company. But soon enough, Broadtree understood the software development process, code base, and related items. Having R&W backing them up was an unexpected, but welcome benefit.
Broadtree Partners, after this positive experience with R&W insurance, now consider this coverage to be part of their strategy for acquisitions going forward.
Instead of being reactionary to a Seller’s requirements (for example, a banker who needs it on the deal) as they have in the past, this PE fund plans to introduce it early in the deal process because of the benefits it offers both Buyer and Seller.
“This is an immediate part of my toolkit, one that can allow some risk mitigation on my side if I feel the need, and, two, I think it’s also a great tool to help overcome some Buyer discomfort if they’re worried about the sort of risks to the deal that Rep and Warranty insurance can cover,” says Rob. “I would not hesitate to use it again.”
At this point, RedCAT Systems is well on its way to growing to the next level. They’ve acquired new customers and are gearing up for a big hire to push further growth. And it might not have happened, had Representations and Warranty insurance not entered the picture.
Note: This is Part 1 of a two-part series examining the Broadtree Partners acquisition of RedCAT Systems, focusing on the use of R&W insurance. Here we covered the deal from the Buyer’s perspective. Coming up next time, we’ll check out how the Seller saw things develop.
If this case study has interested you in Representations and Warranty insurance, contact me, Patrick Stroth, at email@example.com.
The first of a two-part series of a real-world M&A transaction. First up, I’m talking to Steven Epstein, the founder of RedCAT systems, a Colorado-based SAAS company involved in HR and compensation solutions for clients like LinkedIn, Uber, NYSE, and many more.
They were recently funded by PE firm Broadtree Partners.
Specifically, we’ll be looking at how Representations and Warranty (R&W) insurance played a key role in the transaction. What’s interesting is that RedCAT would not have been eligible to use R&W coverage to be reimbursed by a third-party – the insurer – if there had been any breach in the Seller’s reps.
We’ll talk about why insurers were willing to play ball now and how that could impact whether or not you can use R&W insurance on your next deal, as well as…
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 is the first of a two-part series where we’re going to provide a case study of an actual M&A transaction from both the Buyer side and the sell-side perspectives, where rep and warranty was used and played a key role. The first side is with the Buyer side, which is Mr. Steven Epstein. He’s the founder of RedCAT Systems, a SAAS company based in Colorado.
I’ll let Steven tell you his experiences in his own words and the benefits he got. What’s important here is for you to understand that prior to 2019, RedCAT Systems would not have been eligible for consideration for rep and warranty. It was a lower-middle market company with a transaction value well below $30 million. They did not have audited financials, and they were seeking insurance to a level that was well over half of the transaction value. Any of these three would have made RedCAT ineligible. But in 2019, not only was there a solution available, but it came in at the right price.
The other thing to consider for any of you that are either part of a lower-middle market company, or represent a lower-middle market company, the benefits that RedCAT both on the sell-side and the buys I’ve received are no different from benefits that are received with billion-dollar transactions. And now let’s turn it over to Steven. I’m here with Steven Epstein of RedCAT Systems. And Steven, if you could tell us real quick, tell me about RecCAT. What exactly is it and how did it start? Give us the background of the organization.
Steven Epstein: Sure. We formed a company prior to RedCAT in 1996 and started doing HR solutions. Started with recruiting. And then throughout the years, it’s worked on various projects for lots of mostly friends, and then that turned into acquaintances. And then as people moved, we grew holistically. And then in 2014, we formed RedCAT with a new partner.
And we kind of focus more on enterprise HR. Basically replacing technological solutions in the HR space, and then our specialty became compensation. So we end up doing our primary thing is high-end compensation for fortune 500 companies, the large global footprints of how they manage their compensation process, and then also in the performance management space a bit as well.
Patrick: Now the very important stuff, particularly as you get more and more people, you’ve got to keep track of who has stock options, who has shares in the company, all those types of things.
Steven: Oh yeah. And it’s difficult for large global organizations with 10s of thousands of people to manage this. If you’re in, say, 120 countries, you have a lot of currency fluctuations. You have a tremendous array of compensation decisions, from base salary to bonus, exponents, retention, performance-based stock, market conditions, performance conditions, you know, top performers retention thing. There’s a whole array of how a company would do this, but totally separate from things like payroll, actually giving an employee compensation.
So the tools that we do allow companies to manage that process efficiently, either sometimes with small teams. You know, some of the companies might have 50 people on a compensation team. 50 full-time people are actually thinking about compensation. And so the tool becomes a focal point and allows them to A, you know, look at all the data and manage the entire process efficiently. Because it’s easy for companies to forget that in most cases, for a lot of companies compensation is their business expense, by far.
It vastly outnumbers any other expense in those companies. And people take it for granted like, Oh, well, we just have to pay that. 94% of our total expenses, oh, that’s just a given. And they’re not really optimizing the fact that compensation totally affects more, you know, its morale, its retention it’s growth. It’s how employees view the company. Even though it’s sort of a fairly, you know, a basic metric, it’s sometimes not viewed the right way. And if you,
Patrick: Yeah, it’s a very intimately personal viewpoint held for every single person in and organization so that is central to their core why there with a company. That becomes a pretty daunting task when you got that many people.
Steven: Exactly. Yep. And even, sometimes even smaller companies in the financial services sector. Some of our clients may only have 1000 or 2000 employees, but especially in financial services, one of the key things is compensation. That’s why they’re at the job that they’re doing. And therefore, it’s extremely important. A lot of white-glove services, you have lots of people that are very interested in the outcome of compensation that year. So,
Patrick: Absolutely, absolutely. So as you got going in 2014, what led the decision to go out and be acquired?
Steven: So the decision to be acquired was mostly related to the fact that we have a lot of pressure to grow. And we didn’t really want to go with the venture capital route. We had various friends and acquaintances that, you know, had gone that route, the whole bit of it and we were finding it difficult to stay our current size and get the types of clients, very top tier clients, often multi-billion-dollar payout, run the cycle, it was difficult with our headcount.
We’re very small. And so we knew to be able to stay relevant and to meet the types of compliance for GDPR and complexity, technically, we needed to grow. And we had tried a little ourselves and we just knew we needed more help. And so we kind of helped to, decided to find individuals that had our same philosophy, or cultural you know, had our vision group culture and philosophy, and to help to get the help we needed to be able to grow.
Patrick: So, as you looked at culture, philosophy. How did the process look? Did you run out and solicit a bunch of contacts that you had or did the organization come to find you? How did you go out there to find a partner that you could team up with?
Steven: So we originally, I mean, we were somewhat blessed because one of our partners is very well connected in the financial services industry. And he had various friends that had, you know, connections through banks and advisors and people in the M&A space who do this, right? As that’s their full-time thing is to go and find and connect Buyers and Sellers. And so for a year or two, we hadn’t you know, there was a DAC into words and approached lots and lots of possible requiring entities about us, but I think for a little while it was we were just a little too small at that time.
And you know, there’s a, you know, there’s sort of like this unwritten say 2 million habit of rule that sort of seems to be out there, revenue, whatever it is. And finding the kind The type of client, the type of company was we work with, we had, we began negotiations with a few that were interested, but we could tell right away that they were more interested in like, massive growth Lots of money, hire lots of people and try to mass market. And that really wasn’t our, not our client base and it wasn’t our philosophy.
Patrick: So how did you settle on Broadtree?
Steven: The Broadtree was more, you know, when we first were introduced to them, they had a different idea of growth. It wasn’t like let’s hire 10 or 20 people right away and just sort of throw them in the fire and see if they can grow. It was much more measured growth, which was myself and Bonnie, our philosophy was more about that. Because of the clients, we had a fairly small number of clients. About a dozen at the time, and they were all very high-end.
They’re all you know, names that pretty much anyone in America would generally know if you just said it. And from that, we wanted to would make sure that our clients were treated very well, right? Which is very high-level service. There’s really nothing that we would be asked that we weren’t able to fulfill on time, on budget and pretty much the experience was exceptional. That’s why we were able to get the types of work that we do. And we wanted someone who would had share that philosophy and maintain that while at the same time doing measured growth.
Patrick: Okay, and so then the process begins about when did you guys start the process of Broadtree? Just give us an idea of the time scope on this so, timing.
Steven: So when did we start Broadtree? I think it was about from now about a year and two months ago. We had a process, effectively once we had assigned LY it took roughly nine months to actually close the deal. That’s something that I had read about like, oh, diligence is hard. Oh, no diligence is nutty. Nutty hard. Oh, Welcome to the diligence process, detail. We did an okay job prior to this whole process. Had I known at the time, like now what I knew then, as a company if that was your plan I would be just keep much more meticulous track of documents with every single document.
The same copy, the dated copy the stamped copy. We have like 600 pages of documents like this is part of our binder. Every contract, every single thing, we’re normally like in an email, you don’t think about it, you get back a signed PDF and you’re like, Okay, they signed the contract. And whether or not you signed it immediately filed it, stored in the right thing he date it, back that type of thing and all the minutes.
It’s every little bit of every single dollar was ever spent took a lot of effort to come up with. And then all the contracts for you know, thousands of pages of contracts that we had already signed, but then looking and reviewing every single thing took quite a while.
Like when we started in September, we’re like, oh, we’ll be done by the end of the year. Like wow, that’s great. That’s already a couple of months. And just things seem to take longer than they should. Even when we are near like after all the months and diligence, even near the end, when we’re getting closer to actually doing the deal. It still kept slipping.
Like oh, it’ll be next week. Oh, no. Oh, we don’t have the certificate from California because you know, it’s only good for 10 days and then it expires and you have to get a new one. And oh, we have seven of those in all these different states. Oh, and this state only accepts mailed copies, things like that. Like constantly there was always some extra-long extra thing that made it difficult to close but in the end, we did.
Patrick: You make one, that’s one real danger out there is that you get so busy getting everything set up for being acquired and going through the diligence process that it becomes a separate full- time job, you still have to keep your eye on the ball and keep, you know, operating and doing your client work.
Steven: Absolutely, that’s actually something that a few of the delays are just because of that exactly. Like I don’t really have time to respond in an efficient manner, because we’re in the thick of doing a project, for example. But really that in our case, it was more like I just sort of worked too hard for me for the nine months, rather than pushing it too much.
But it’s something that that like you read about, but you probably don’t fully understand the depth. At least in our industry, like in tech, of the level of diligence. And every bit of open source code, even when it was like 20 lines of code that was copied from something that was then felt like had no relevance whatsoever. Well, technically, it’s still an open-source piece of code that prints a little warning message. Oh, okay. Well, we have to disclose that.
Patrick: Gotcha that, Gotcha. There’s a lot to that. Now one of your partners was insistent on having a deal insured with rep and warranty insurance. What was the background on that? And how did you actually, how did that lead you to us?
Steven: Yes, good question. So the background is that one of our partners is part of a high net worth individual and he was more concerned about liability, about being personally sued or doing this big deal and then like what if some crazy thing happened, you know, in personally fantastical scenarios but conceivably possible given the type of, you know, our size is a very small company, versus you know, the giants and Oracle. If Oracle decided to sue us for no reason, just because we technically compete with them in an area that they would likely win, simply because they can outspend any possible sense.
In that vein, he wanted to have the ability need to have coverage effectively, to be able to help shield that liability. And so at the time, and when we first looked at this, the expectation for everyone we’ve spoken with was that rep and warranty wasn’t really available to a company of our size. Because it seemed to be in the 50 million hundred million, you know, big, big deals. And I, of course, did a quick Google. Google’s great, and, you know, spent 20 minutes actually reading various things, and they came across some, an article that you had written actually.
And that really resonated. I was like, Oh, that sounds like something, you know, an opportunity to have a solution here rather than just like we can’t do it. Like we’re going to put in a max cap that’s too low because I knew that the Buyers wouldn’t go for that. They’d be like, Well wait, if we’re spending all this money, we want to be able to have a higher limitation of our expense rather than say, a couple of million dollars.
So that seemed like there was actually an opportunity. And then the next thing that came out was cost. We’re like, oh, Well, you can get this revenue warranty insurance as a smaller entity, but is the cost prohibitive? Is it completely, if it’s like, oh, it’s 10% of the deal price, most likely that would make it completely prohibitive. But it, you know, obviously, as you know, the rates have been dropping, and it became something that was in the realm of possibility.
Patrick: When you presented this to the bar, what was the Buyer’s response?
Steven: Well, at first, the Buyer’s response was, Oh, that’s great. We don’t think we need it. Because the liability from us was very small because of the relatively limited number of possible infractions. We didn’t have that many contracts. There wasn’t that many, there wasn’t that much code that actually could possibly be infringing. But still, I think in the end, they were appreciative. It allayed our partners’ fears, basically of the deal as well as the liability.
It eliminated, from our perspective, because we stayed on, right? We’re staying on as very integral to the continued success. And if something did come up, I think it would be tremendously valuable to have in that. And why? Because if something came up, and it was like, oh, well we’re going to put something back on the Sellers originally. Like, let’s, you know, let’s say we had, we didn’t in the end because we haven’t RW. But let’s say, we did put the same, you know, million five or $2 million in escrow.
And then some kind of obscure thing came out, right? And we disagreed with it. We’re like, well, we don’t really feel that this is a valid thing. The defense wasn’t done right. That would cause a serious breach. Not only of you know, say it’s a million or two dollars, but then we probably wouldn’t want to stay on. And the effect is that most likely would be the failure of the business, the new business.
Patrick: That dilemma is something we see quite a bit where you have technology Buyer and post-closing they bring on the target company and they bring on a bulk of the personnel, the management team and so forth. They bring them on in, and that new group are just rock stars and they’re getting along great. And then all of a sudden there will be great to happen. And now the, you know, the dilemma, well do we take away their escrow that we’ve been holding? Or do we just eat it because we don’t want to have a drop in morale?
And we don’t want these guys mentally checking out on us. And so they end up a lot of times having to eat a loss that otherwise would have been insured. And so yeah, that’s a real great point. And I think that the Buyer, I agree, I think the Buyer was at first, you know, a bit ambivalent, but as the process went on, they really started to embrace it, largely because, you know, it put your partner at a lot more comfort and I think that really helped the process move forward a lot smoother.
Steven: Oh, absolutely. I completely agree. Yes. So in the end, I think I mean, obviously it still is. You know, the numbers still feel big. You’re like, wow, that’s expensive. That’s a lot but the peace of mind can be priceless, right? Just that feeling like well okay, well, I don’t have to worry about this. If some frivolous thing happened then we’re covered. It’s not a thing that will A, damage the relationship and B, you know, just consume life energy where you’re fighting about something that is likely frivolous.
Patrick: Well said. I could not have said that better myself. A lot of times with the rep and warranty policies, they’re dealt with between the Buyer and the insurance people. I don’t know how much involvement you had. Did you have any involvement in doing anything other than getting us connected with your Buyer team?
Steven: A little bit. Sure. We looked at, you know, obviously the actual policy itself and then you push back on like the wording of a couple things like, Oh, we won’t cover this little obscure thing and you say, oh, why not? And then we discuss it a little bit and we tweak those and but nothing truly material. It was all fairly small and benign.
Patrick: It didn’t slow down your process of the deal or anything like that. It wasn’t too much extra work being dumped on you?
Steven: No, not really no. The insurance bit was relatively benign timewise. We didn’t spend I mean, you have to read it. You know, we read a lot, you know, still 20 pages of reading, but that it wasn’t like we spent a lot of time and effort on it. And as far as you know, the actual timeline of the deal, it was fine. Had we closed, like right away, it still seemed like that was, it was something that we could have if we were extremely expeditious, we would have been able to still meet our deadline. As it turned out, we had extra time. So it was fine.
Patrick: So aside from now having the knowledge of watching all your documents very closely and making sure you pay attention to every dollar that’s spent and why and all the code having that accounted for, any other lessons from this experience, or is there you know, anything that really surprised you other than the minutia on the documents and details?
Steven: Document details was big. I would say, you know, obviously, you work very closely, in our case, with the Buyer spending a lot of time going through a lot of diligence, a lot of discussions. And so making sure that probably and that’s something that would evolve over time, but I would think that would be very important to ensure that the people that you’re working with your Buyer for your company like us, that you liked them. That they’re good people. Luckily we worked out. Our Buyer is great. I talked to him right before this call. He’s great. We love, I think it’s a good working relationship.
Other surprises that came up, not tremendous. I think that we, it’s easy to focus on some things that in retrospect, we spent too much time focusing on. Some of the numbers and so forth that it’s easy to imagine scenarios that are completely unrealistic to focus on like outcomes or future cases. I know that they can happen, which is why, obviously, like rep and insurance rep and warranty insurance, why it exists. But I think that probably could be streamlined. That’s something I’d like to see actually, like from you, Patrick, would be like a cheat sheet.
Hey, just in a lot of deals, these are the things that probably that you should be focusing on rather than this generic like oh, what if? What if that? What if this? And then coming up with language to address cases that are probably discovered for good like, reward too. Like, we did a lot of that before we had the rep and warranty. Like, oh, what about this case? What about that case? What’s the limit of this liability? How many months for this? And really all that was a waste of time because we knew that once we knew we were going to get several warranties.
Patrick: Yeah, then there were fewer contingencies to worry about.
Steven: Exactly. And some of the, and a lot of the contingencies, we spent too much time talking about that. We’re very far-fetched from my perspective. Things like oh, some unknown company in Russia is going to sue you for code that, like you’ve never really like, things like that.
Patrick: Yeah, gotcha. Well, now you’ve already gone through your first board meeting with your new partners and everything. How are things going? You mentioned that you liked them, which is always a really, really positive thing. But how’s it going?
Steven: It’s going well, yeah. I mean, you know, as I may have mentioned, our primary problem is capacity. Capacity strain, meaning that we’re small, and to really handle like larger volumes of the types of clients we work with, we need, you know, highly-skilled people that are really good. And that is a difficult challenge to find. But we’re doing our best, you know, we have fairly, you know, we’ve had recruiters, we’ve had thousands of applicants.
And then we have, you know, various tools that we’re using internally to try to ascertain, you know, is this person a good fit? And assuming that goes well, and hopefully it will, it should be good. Yeah I mean, then it’s just more of a How much do we want to scale? How long do we want to play this game? I mean, while it’s still fun, and that’s a big thing, make sure it’s fun. Like you have to enjoy what you’re doing or otherwise you probably shouldn’t be doing it.
Patrick: Absolutely, absolutely. Well as you’re having fun, there may be some other people that could have some questions for you. How can people reach you?
Steven: I think LinkedIn is a great way. Just reach out on my LinkedIn and ask a question. That’s easy.
Patrick: Sure. Okay. So it was on LinkedIn. Steven with a V, and then Epstein, EPSTEIN?
Steven: Yep. On RedCAT Systems.
Patrick: Great. RedCAT Systems. Well Steven, thank you very much. This has been real helpful and I’m glad that this all worked out. I mean, our objective on this whole venture that we have at Rubicon is we want to help people who created something from nothing be able to move on and exit one platform and move on to another where whether that you know, being acquired by a strategic or just going riding off into the sunset with a clean exit for a great retirement.
You’ve added tremendous value. RedCAT Systems is very successful. And your company are a list of the who’s who of Fortune 100 firms and you’re definitely adding value with what you’re doing. And I really sincerely wish you the very best of luck. And hopefully we’ll be with you when the next, you know, nine or 10 figure deal comes up for you.
Steven: That sounds great. Yeah, I mean like this was another interesting thing you could add of course is that once you’ve done this once you think oh, wow what about this idea? That would be fun. So there’s lots of ideas out there. I think it’s just finding the passion. And one extra thing that I’ll give you a little bit that you can throw on if you’re editing something together is when I first found Rubicon from the article, which I liked, and give me, you know, basis, of course, there’s everyone else had someone like did you talk to Marsh? Did you talk to this person? Did you talk to that person? And it was fine.
I tried to stay out of spending a lot of time on it. In the end, I think that everything you did was fine. It was great. The pricing was all similar normalish. It wasn’t a lot of like, wow, I need to shop around a whole lot. And it was very convenient that you were like, had worked with enough companies that you could quickly give us like an overview that you’re able to shop to the various insurance companies. So we didn’t have to spend lots of time shopping. Meaning like I felt confident that that was approximately what we would expect, and was great. It saved more time.
Patrick: I appreciate that. Yeah. That’s the other thing that is new out there is there when you and I spoke our first conversation was in fact, there were probably about 11 or 12 insurance companies active in rep and warranty. There are now as, just in a few months now we’re up to 20 companies.
And they are going all over the map from one stage focuses just on sub $50 million transactions and then others that won’t go below 100 million because they want that segment of the market. So it’s definitely maturing and something to go forward with. But I just wish you all the best of luck and we’re going to do what we can to stay in touch with you, Steven, and keep track of RedCAT Systems.
The Letter of Intent (LOI) – sometimes called a term sheet – is a vital first step in many M&A transactions. With an LOI, Buyers show that they’re serious about acquiring a business. And it allows the Buyer and Seller to have conversations to discover whether the vision each has for the deal lines up with the other… before they spend time and money on negotiations and due diligence.
It’s like the marriage proposal before the wedding, which is when the deal closes and the purchase sale agreement – which often contains very similar terms to the LOI – is signed.
An LOI is non-binding. But it shows commitment, outlines the basic structure of the deal, lays out a path forward, and contains an agreement to not talk to any other potential Buyers.
LOIs typically vary in length from about two to 10 pages, depending on a number of factors. Some argue a shorter LOI can help speed up the negotiating process as it centers the conversation around the most important elements of the deal. If there’s not agreement there, the logic goes, there’s no need to discuss other factors.
But in general, it pays – literally – to be very detailed in your LOI, especially for Sellers. What’s dangerous about a simple, two-page LOI is if there are any questions or disputes about terms, the Buyer has all the advantage and leverage. So you want to have as much spelled out as early as possible. This makes terms much easier to agree to later – and you can always pull out a term. But it’s a lot harder to add language to the LOI after it’s signed.
During the LOI stage, Buyer and Seller should talk indemnity. This, of course, is when the Seller is liable to the Buyer financially if the Seller’s reps and warranties weren’t accurate and not uncovered in the due diligence process. There’s a remedy that makes this discussion virtually non-confrontational.
It’s at this point that the Seller should build in an option for Representations and Warranty (R&W) insurance. Any escrows or withholds (which will be substantially reduced) will be based on the amount of R&W insurance in place. And if there is a breach, a third party – the insurer – will pay the damage, so the Buyer is protected, and the Seller is off the hook.
At the LOI stage, you don’t need to determine how much coverage is needed, or the cost. As a Seller, you just want that option there. But you should reach out to a broker. With the proposed purchase price, details on how much indemnity the Buyer is expecting- say 10% or 20% of purchase price, and what, if any escrow or withhold the Buyer is seeking, the broker can come back with a quote and a proposed policy. Having knowledge of the R&W cost in advance provides leverage when negotiating who pays (equal shares is very common).
With that info, the Seller can say, “We agree to the escrow and indemnity cap if we can have R&W insurance to cover it”. That puts some power back in their hands. This usually also accelerates the Seller’s acceptance of the LOI, shows good faith, and removes fear on the Seller’s part.
The other components of an effective LOI include:
Is the transaction a stock or asset purchase? What are the forms of payment? This can include cash, stock, seller notes, earn-outs, rollover equity and contingent pricing.
When the parties agree not to shop around. The Seller can’t talk to any other potential Buyers. This is typically a binding clause requested by the Buyer, who wants to ensure that Sellers are negotiating in good faith. It’s typical for Buyers to request an exclusivity period from 30 to 120 days, while Sellers will typically want as short a period as possible.
Because the Seller has taken themselves off market, if the Buyer drags their feet, the target can go back out to market. It happens often enough. On this note, Sellers have to be very careful when Buyers offer big topline numbers subject to lots of terms that are left nebulous.
Sensitive information shared during talks will not be shared. The Buyer can’t share the secret sauce recipe. Both parties have likely already signed an NDA earlier in the process, but this clause further ensures that all discussions regarding the proposed transaction remain confidential.
An agreement for the signing and closing to be at a specific target date. It’s always subject to change. But if the Seller sets this deadline, it incentivizes the Buyer to take action.
What are the tasks, approvals, and consents that need to be obtained before or on the closing date? For example, the amount of cash that should be in the business at closing, what happens to employees – what percentage remain, and debts or obligations that must be resolved/paid. The company must also be operating at the same level as it did as negotiations began.
NOTE: Closing conditions are viewed by courts as literal. If the condition was for $400K in operating costs to be left in the business, and at closing you only have $375K, it’s a serious violation of the terms. The Buyer will deduct the shortfall from the purchase price, or the Buyer can literally walk away from the deal with no liability.
In short, Buyers don’t want to acquire a company to find they defaulted on lease payments or loans or has other issues.
Compensation if either party stalls or delays. This clause is also typically binding, though breakup fees are less common in the lower middle market. In larger deals (>$500MM), breakup fees of approximately 3% are typical.
Which members of the senior management will stay on? Who will be provided equity plans? This aspect of the deal may be vague at the LOI stage before due diligence has been conducted.
Does the Buyer or Seller need any approvals (e.g., from a board of directors, regulatory agencies, customers) to complete the transaction?
How will due diligence will be conducted? This includes the nature of information (financial, technical, etc.) that will be disclosed and the manner in which it will be disclosed. A sample term would be the need to speak with three of the Seller’s largest clients. Or a requirement to interview certain people in management.
Includes size of escrow or holdback. This is the IDEAL place to include wording referring to Indemnity to be paid by R&W insurance. This will not appear fully until the purchase agreement, but sometimes the Buyer will include summary terms of their expected escrow terms for holding back some percentage of the purchase price to cover future payments for past liabilities, and this is where the Seller can counter (reduce) the Buyer’s amounts using R&W.
This also may not be finalized until the purchase agreement, but if there are contentious or non-standard terms, the Buyer may include them in the LOI.
The Letter of Intent (LOI) is an important step in most M&A transactions. It serves in some ways as a preview or summary of the deal terms that would be expected to appear in the purchase agreement down the line.
It’s not unheard of for Buyer and Seller to skip over the LOI and go straight to the purchase agreement. However, an LOI can be useful for a number of reasons.
It helps ensure that Buyer and Seller have similar (or at least similar enough) expectations around deal structure, scheduling, and other big concerns. It also means that any potential deal-breakers come up earlier in the process, so that the parties can either a) stop the transaction process before significant resources are spent on due diligence and drafting deal documents or b) figure out a resolution sooner.
The LOI is also a nice way to ensure that Seller and Buyer are on the same page about how due diligence will be conducted. In addition, the LOI’s terms serve as important protection for all parties in a deal (e.g., exclusivity periods protect Buyers, while breakup fees protect Sellers).
Representations and Warranty insurance can be a key part of your next M&A deal, and timing is critical. It’s vital that this coverage and its impact on the indemnity cap and amount of withhold be included in the LOI.
As a broker, I’d be happy to discuss this specialized coverage with you at your convenience. Please contact me, Patrick Stroth, to set up a call at firstname.lastname@example.org.
In the world of M&A, many companies, on both the buy-side and sell-side, have realized the tremendous benefits provided by Representations and Warranty insurance.
The Buyer is able to recover any losses from a breach of the Seller reps without doing so at the expense of the Seller. The Buyer simply makes a claim with the insurer. Plus, the policy cost is either discounted significantly or is free because the Seller will gladly cover the premium.
Sellers love it because they take home more at closing and the indemnification risk is transferred to a third party – the insurance company. A clean exit, and they have zero fear of future potential clawback if there is a breach.
That being said, not everyone is willing to entertain using this insurance.
This is especially true in the case of a corporate, strategic Buyer, in which one company buys another because of synergy of products… to expand to a new customer base or geographic region… or to acquire products they want.
The thing is that strategic Buyers are often much larger than the acquisition target – often hundreds of times larger. In these cases, there is no incentive for the Buyer to get R&W insurance; the protection it provides them is negligible. This is the case even if the Seller is willing to cover the cost. The other issue: the Seller has no leverage here.
So what’s a Seller to do?
As a small Seller, you don’t have to enter into an M&A deal with no protection. There are alternatives if your Buyer isn’t interested in full R&W insurance.
For tech companies, the most sensitive reps are those dealing with technology, of course. If those reps are breached, it could be very expensive as they are critical to the value of the company.
The target tech company could be confident that their IP is not infringing on anybody, but the Buyer no doubt still has a bit of worry.
If the Buyer is not willing to consider full R&W insurance, a Seller could get a limited policy that just covers IP reps. These types of policies do rely on the Buyer’s due diligence. So the Underwriters still have to engage the Buyer to get their diligence on IP. But it’s not the full report, so it’s a relatively easy ask. And the cost is still on the low end, with a premium cost at 2% – 2.5% of policy limit (subject to $100K minimum premium), with 1% transaction value retention.
The same sort of arrangement could be made for tax reps, as well.
Although the vast, vast majority of R&W insurance is on the buy-side, it is possible for Sellers to get their own policy. This could be handy if the Buyer refuses to disclose any of their due diligence and the Seller is nervous about not having any protection from risk.
To be frank, sell-side policies can be more challenging than those of the Buyer’s side. It essentially protects the Seller in the case of a third-party (which includes the Buyer) bringing action against them for a breach of their reps.
For example, McDonald’s recently bought a small AI company – the technology will be used to speed up the drive-through ordering process. A huge company buying a small one.
Hypothetically, let’s say the AI company had unknowingly breached another company’s IP. That other company will sue McDonald’s and the AI company. McDonald’s is fine – they have their own protection and legal team. But the founders of the AI company need protection because they no longer have insurance after the acquisition. A sell-side R&W policy can be a perfect option.
Owners and founders can also rely on a Directors and Officers liability policy to protect them in case of allegations of misrepresentation, unfair dealing, or fraud. At the very least, the D&O policy can pay lawyer costs to protect the policyholder.
In the vast majority of purchase and sale agreements there is a requirement that the target company have a D&O policy in place. Privately owned companies with a small number of shareholders/owners might think they don’t need this coverage because they don’t have outside shareholders. But this protection is key.
Once the Buyer acquires a company, the board is their responsibility. They don’t want to take a risk on things done before they acquired the company. It’s best to have some other source of recovery like this on their end as well.
A D&O liability policy will run you a tiny fraction of what R&W costs.
For those companies that never carried D&O insurance in the past, there’s a solution. Companies can purchase a D&O Tail policy that will provide virtually the same protection as a traditional D&O policy that has a Tail Endorsement.
In the event there is a claim against any of the directors and officers, they will be protected from legal action for up to six years post-closing if there is a D&O “tail” policy.
Even if they didn’t have insurance previously, on the acquisition date the tail kicks in and covers any lawsuits brought against the directors and officers at the target company. This covers any allegations they committed a wrongful act prior to the acquisition, all the way back to the incorporation date.
Let me wrap things up with a quick case study of a company that wanted R&W coverage in place… and a Buyer who wasn’t willing to deal… and what they did next.
A small AI company was bought by one of its clients – one 1,000 times its size, roughly, and worth $20B. The total transaction value was $17M.
The Buyer had no interest in R&W insurance, even when we offered a policy that covered the full $17M.
The Seller was really concerned because the IP reps went from general reps to fundamental reps with a longer survival period. That’s a lot of risk out there for them for years down the road if another company claims IP infringement.
We offered to insure just those IP reps, with a premium from $100K to $300K, which the Seller was ready to pay.
All that was needed to write the policy was the Buyer’s due diligence report. But they didn’t want to disclose any confidential information.
The last alternative we were able to offer the Seller was a D&O Liability Insurance policy. We got the thumbs up and did a $5M limit D&O policy for $50K.
The company was acquired on July 1, 2019. Until July 1, 2025, any lawsuit filed against the company’s board of directors for allegations prior to the acquisition date will be covered.
Of course, R&W insurance would have been preferable for the Seller. But this was the best option and does offer substantial protection.
If you’re interested in exploring your options for protecting yourself post-closing with Representations and Warranty insurance or some other type of coverage, get in touch with me, Patrick Stroth, at email@example.com.
After an M&A deal closes – and there are breaches of any of the Representations and Warranties from the Seller – the Indemnification provision protects the Buyer from the resulting damages. In most cases, a portion (10% of the transaction value) is held back from the Seller to pay for these financial losses.
Indemnification provisions, which are enshrined in the Purchase and Sale Agreement, are an ideal way for a Buyer to mitigate risk. But at the same time, Sellers aren’t too pleased with having a significant amount of cash they expected from the sale of their business held in escrow in case of a breach.
In short, Buyers want very “broad” Indemnification provisions, covering any potential loss, while Sellers strive to narrow the scope of what breaches are covered, the amount to be potentially paid out in case of a breach, and how long Indemnification provisions can be enforced – the survival period.
As you might expect, Indemnification – and all the elements that go into it – is one of the most hotly contested deal points when an M&A deal is being negotiated.
As an advisor in an M&A deal or an owner/founder who is selling their company, it’s important to understand just how important Indemnification is – it’s definitely not an afterthought but rather a critical part of negotiations with the Buyer. It could have a tremendous impact on the amount of money you take home after a deal closes and have ramifications for years down the road if any liabilities pop up that the Buyer blames you for.
Here’s a quick analogy to break this down into simple terms:
You want to buy a Tesla. You ordered it, gave the dealer your specs, and put down a down payment. You don’t want to show up at the dealership and be given a Nissan Leaf. If that happens, you want your money back. That’s the mindset of the Buyer.
But, from the Seller’s point of view… they sold you a car. Once you drive off the lot (the deal closes), it’s not their problem anymore. They want no liability for what happens after. They expect the Buyer, after having done their due diligence, to assume all the risk.
Reps can be divided into fundamental and non-fundamental, with fundamental being core reps covering the basic operations of the business, like stock ownership, authority to sell the company, or tax issues. Of course, this isn’t set in stone. Buyers want to move as many reps into the fundamental category as possible (such as intellectual property), with Sellers resisting that effort. For good reason…
In general, survival periods can run from six months to two years on non-fundamental reps. However, when considering so-called fundamental reps, the survival period is longer.
Of course, that’s where negotiation comes into play again. Buyers and Sellers will often disagree on what constitutes a fundamental rep. For example, environmental liabilities can be very expensive and time consuming to clean up… and often these issues don’t come up until long after closing. Buyers would prefer these to be fundamental reps.
Some items are subject to survival periods negotiated separately. For example, say the target company is the subject of a government investigation – that may or may not go to the courts. Buyers will advocate for a survival period for “special” Indemnification provisions for any related reps and warranties that is indefinite – because the legal process could be very slow.
Not only do Sellers want to limit the time Indemnification provisions are in force and which types of claims can be brought, they also want to “cap” how much they might have to pay out in case of a post-closing breach.
The indemnity cap is typically a percentage of purchase price. A portion of that cap is held in escrow for at least a year or until the survival period ends. That’s money that the Seller doesn’t get to take home or distribute to shareholders at closing. The feeling is that the money might never come home because Buyers will find any reason to retain it.
Indemnification is such a contentious topic that it can slow down or even shut down deals entirely. There is a way to sidestep all of this.
Representations and Warranty (R&W) insurance is a specialized coverage that transfers all the indemnity risk to a third-party – the insurer. If there are any breaches of reps and warranties post-closing, the Buyer simply files a claim and the insurer covers the Buyer’s damages. And unlike other types of insurance, this coverage is affordable (costing less than ½ of 1% of the transaction value) and more widespread than ever, with about 20 insurers now offering this coverage, even for deals under $20 million.
Savvy PE and VC firms, as well as corporate strategic buyers, are recognizing its benefits to smooth out deals and mitigate risk and increasingly making it a must-have in their M&A deals.
With IP becoming a standard fundamental rep, R&W insurance is ideal for small technology companies, at $20M or less, being sought after by larger firms. And if the Buyer is not interested in R&W coverage, which can often be the case for big companies, it is possible to insure only the IP reps in the deal. The premiums are just $125,000, with $30,000 in underwriting fees. A small price to pay for the Seller’s peace of mind.
If Indemnification has your M&A deal hung up, or if you’re a Seller concerned about this issue because you’re about to put your business on the market, I’d invite you to speak with me about Representations and Warranty and other types of M&A focused insurance that could protect you.
You can reach me, Patrick Stroth, at firstname.lastname@example.org or (415) 806-2356.
In the world of tech, a lot of companies, especially the smaller ones and startups, their financials are quite opaque. You never know on the surface if one is about to go under or go unicorn.
Austin Leo, VP of USI Insurance Services, highlights a specialized type of insurance, once reserved for large manufacturers, that can help larger companies identify who to do business with… especially those with the least risk of going under before they pay their bills.
And that’s just one benefit.
It’s a great example of insurance coverage that adds tangible monetary value… even when you don’t have a claim. Austin walks us through the many ways these policies help and how they work in real-world terms.
Tune in to find out…
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.
For most people, insurance is something that you pay for, but you hope you’ll never use. Even when it works, people are still not happy because something bad has had to happen in order for you to put your policy to use. Now there are insurance products out there that provide tangible monetary value without the policyholder ever having to suffer a loss. Rep-and-warranty insurance for M&A transactions provides this very value-added capability, and that’s what inspired me to pivot our program here at Rubicon M&A insurance to focus on insuring M&A transactions.
Today, I’ve asked Austin Leo of USI Insurance Services to join me to discuss another product out there called trade credit insurance. Like rep and warranty, trade credit provides significant financial benefits without ever having to incur a loss. That’s probably why private equity firms are now warming up to this and using it on more and more of their portfolio companies. But, I’ll let Austin tell you how. Austin, thanks for joining me today. Welcome to the program.
Austin Leo: Hey, Patrick, thanks for having me. appreciate you having me on. Glad to be here.
Patrick Stroth: Well, let’s give everybody listening here some context. How did you get to this point in your career, where you’re a specialist in this very technical area of insurance?
Austin: Sure, so good question. Sometimes I asked myself that myself. So, you know, I started off my career actually working in PR, and then ended up at a company, they were a French company, that specialized in company information in the B2B sector and advertising your products in that sector to specialized clients. Ended up you know, you know, really like that part of the business, especially the information side of that. And, I ended up at an insurance firm by the name of Coface. Now, Coface is a French insurer (second-largest trade credit insurer in the world), and I started off there as an underwriter and soon found that insurance was fascinating to me. Especially the trade credit side of things, whereas you mentioned, you know, you don’t really need to find the value when a claim happens— you can do that much earlier. And we can talk about that. But anyway, ended up you know as an underwriter, a Coface. Then went to manage our global clients, and then went on to the broker sodas business with my own firm. And then, eventually joining USI.
Patrick: Well, as with a real diverse industry like insurance, there are products that can cover any number of different exposures. Why don’t we help the audience out here— what is exactly trade credit, and then who uses it, or who’s the traditional user of a trade credit insurance policy?
Austin: Sure. So trade credit insurance helps companies identify their risks, it provides companies with information on their customers, the insurance side of it really covers a company who is selling on open account terms— open account credit terms to another company— it helps them mitigate that risk against non payment, slow payment, or bankruptcies and insolvency.
So you’re selling to another company, for whatever reason, they don’t pay you or cannot pay you. That’s when credit insurance would kick in, and pay a claim on the non-payment side of it.
Patrick: So they step in and pay your outstanding accounts receivables because the client disappears or is somehow unable to pay?
Austin: That’s exactly right.
Patrick: And the traditional policy was— I can think of these where you’ve got big ARs out there were large industrial manufacturers, textiles, commodity type things. That could be the typical client of this. But nowadays, are there other clients, particularly in the tech sector, where this could be used?
Austin: Yeah, absolutely. And you’re right, Patrick. You know, a lot of companies that have used trade credit insurance are, you know, manufacturers, distributors, the commodity traders, but, you know, manufacturer or distributor of components. And that was kind of the traditional side of a user of trade, credit insurance. Use it for multiple things, you know, both for mitigation and enhancements, financing, and sales. But now we’re finding that in the tech sector, you know, a couple of things are happening, right? Tech companies tend to be a bit focused on sales, especially to companies they might not have a ton of information on, or are new to the industry.
So that leaves you, you know, at risk to non-payment, or lack of information on your companies. And as I always say, you know, a sale isn’t a sale until it’s paid or collected, right? So, it’s great that you’re sales focused and offering open account turns to other companies, but until it’s paid, it’s not a sale. So, that’s where we find tech companies benefiting from the trade credit side of things, you know, the heavy AR stack on the book, the last thing you want is for multiple companies not paying you, customers not paying you.
And then I mentioned on the information side, you know. Newer companies, prospective clients… it’s tough to pull information. I mean, of course, you know, you can, you know, Dun & Bradstreet, CreditSafe is a provider of B2B company information. The insurance companies also have big databases filled with information, and they do their due diligence. I mean the last thing they want to do is, you know, pay a claim, right? They want to be profitable. So, the information that we find from the insurers tends to be better than some of the stuff we find from, you know, like the DMV. So, yeah, I think the benefit in the tech side is, you know, data information on your prospects, clients. And then, of course, you know, mitigating the risk of non-payment or insolvency from those clients.
The other thing that we find is the financial benefit.
Patrick: Before we get into the financial benefit, I just want to go back just on a really nice use case scenario. So you have… what the service that you can provide as your insurance product can provide background checks for prospective customers. So if you’re a tech firm, you’re about to sign a major contract with a potential customer, they could turn to their trade credit insurance and say, we want to sign up this company in South Korea as a client, they’re going to pay us X dollars… and we don’t have as much information. But, the insurance company with their resources, can find out whether or not that potential client in South Korea is a good or bad credit risk. Is that is that how that works?
Austin: Yeah, that’s correct. So yes, you know, we want to sell to company A in China, you know, notoriously, it’s kind of known in China, that it’s tough to get financials. The insurers are able to do that along with banks. So yeah, you know, we expect to have, you know, 2 million open, you know, AR exposure at any given time… high AR exposure at any given time. What do you guys think? And then the trade credit insurance will come back and say, “well, you know, you know, either yes, will approve the 2 million and, and here’s why. Or we’ll do a partial approval of that.” And give you information on why, you know, maybe they’re late to pay other suppliers, and that’s in their database, maybe their financial conditions have worsened Or, you know, the last answer you want here is, is “no,” but it’s relevant, you know, information, right.
The last thing you want to do is try to turn bad credit into good credit. Never works out. We’ve seen it time after time. So, yes, the credit insurance information… or I’m sorry, the credit insurance companies are all members of the Berne Union, and they share information with one another.
So you’re seeing the information that you know, the bank’s get…. the insurance gets, but you might necessarily not.
Patrick: Wow, so then, not only are you protecting your client from from a perspective loss, but you’re just giving them that that background information so that they can make a better decision that’s got to improve, you know, they’re not necessarily I think, guaranteeing this AR is out there. But, they are really protecting those.
That’s got to make a company’s lenders really happy. I mean, you had just referenced me there is a financial benefit, I can imagine, you know, with their, with their lenders, companies, lenders would love if the company had this kind of protection.
Austin: Yeah, and you bring up a good point, Patrick. So, yeah, the lenders, they love trade credit insurance. Especially when there is ABL: an asset-based lending facility in place. You know, companies… everybody thinks about their assets, right? You know, you have the people, you have your property, you have your inventory, all of those are insured, right?
A lot of times companies don’t think about your receivables as an asset. And they are, and in some cases, they’re the largest asset a company has. So the lenders love it when the foreign receivables are insured with trade credit insurance because it allows them to include those into the borrowing base of an ABL. It also allows them and their credit folks in the bank to feel comfortable raising advance rates, which is really key. You know, you could have a company that has a facility that’s getting, you know, an 80% advanced rate on their assets. With trade credit insurance, the bank can bump that up to 85%-90%.
We’ve seen companies that have gotten, you know, 1 million-2 million, just an increase in working capital, just from having a trade credit insurance policy.
Patrick: Wow. And so, in addition to mitigating risk on the one side, you’re now improving their accessibility to more cash. And that’s got to be just a great benefit that offsets any costs. And this can also be used in a couple of other things, not just for increasing your cash flow, but does it impact on other operational things like your sales?
Austin: Yes, yes, it does. So, you know, you could have you can have a group of customers, right? Where your credit folks internally, within the organization say, “we’ve looked at the financials based on the information that we have, you know, credit report financials, we’re comfortable granting $2 million dollar limit for them in credit.”
Whereas you there could be a credit insurer saying, “you know, that’s great. You know, we have information, we can justify a $4 million limit, and would be willing to include that in a credit insurance policy and underwrite that and ensure that.”
So, I mean, in essence, you know, you can go above and beyond what you might be comfortable doing internally, from a credit standpoint. And you’re just having a partnership with the credit insurance company, letting them take on that risk and really risk transferring that which in turn, you know, you can sell more to a customer… you’re obviously going to increase your sales, depending on how many times a year you do that, and what the open account terms are. So yeah, we’ve seen companies, I mean, in general— we have statistics on this, based on what the insurers provide— companies can increase their sales by 20%, just by using the trade credit piece.
Patrick: Okay, so that’s benefit three. Benefit one was protecting yourself with the information on prospective customers that you can get from the trade credit insurance company. Number two is improving terms from your lender, so they can get more cash flow probably improve their lending rate, and then you can increase sales. So all those are tangible, testable, you can do with evidence and so forth.
So that really is something. Do you have any case studies or just use examples in the technology sector? I know, you’ve been writing some tech company lately, you share with us some examples of that?
Austin: Sure. So, you know, we had a tech company that we’re working with, that had a private equity company go in, and partner with them, right. One of the things that were not making them look, so financially sound was the bad debt reserve that they had on their balance sheet.
So, you know, tech company, as I mentioned, you know, tech companies can be so much focused on sales. So they, were, but to the wrong companies, right? So, piled on a ton of AR, which turned into bad debt, which, you know, when you have bad debt, you have to keep a bad debt reserve on your balance sheet, which negative negatively impacts working capital.
So, what we did for them, is, we were able to use credit insurance as a way to take out that bad debt reserve, right? You can completely remove that from your balance sheet, transfer that risk to the insurer. In addition to that, they had, you know, two or three clients that were a concentration risk. So the three clients made up about 70% of their business. So what we did, and what the lender liked and in the private equity company, they liked that removing that risk of concentration, right? Because God forbid something happens to you know, one or two of those three big clients completely would put them out of business. So we’re able to transfer that risk.
And then from a financial standpoint, they were able to get additional working capital, from some of the foreign receivables and increase to their advanced rate on their ABL facility. So the working capital paid for the credit insurance policy times ten. And the main thing that, you know, we’re sitting down, we’re talking with the CFO, and he goes, you know, what I don’t want is to detract from sales, right? We’re a sales-focused organization, that is where we want to stay focused, we need to grow. So the tool that they really liked was, you know, using one of the large insurers for their database, and even before selling to a company, a new customer— they were able to go into the online portal of the insurer, putting the company’s name, where they’re located, and the credit limit needed, they would know before they even made the sale, if that would be eligible for trade credit insurance. Which gives them a competitive advantage, right? So you know, the information, the lending, and then removing the bad debt reserve off their balance sheet, completely changed this company. It was actually amazing to see what we’re able to do for them.
Patrick: Yeah, the one thing is private equity firms are notorious when it comes to insurance, they really do not like spending any dollars on premiums unless there is some real value coming in. So, it’s a real validation for you to have private equities firms now becoming more active and really warming up to that. Have you seen a growing trend of that with private equity?
Austin: Yeah, absolutely. I mean, you know, when private equities go in, and they invest in a company, they want to make sure that they’re getting the best return on their investment. Right. And they don’t want to spend any more money than needed. That’s for sure. So yeah, yep.
You know, we’ve seen I mean, yeah, there’s a way for us to do a financial benefit review. Right? So, before you even get the trade credit insurance policy, there’s a questionnaire that we have, there are things that we like to review, to see if it would be, you know, cost-effective or cost-prohibitive to the, to both the company and then the PE firm.
So yeah, we’re seeing private equity use tree credit insurance a lot more. You know, over in Europe, the trade credit insurance market is like 60% to 70% of companies use trade credit. Here in the US, it’s about 12% to 15%. So I think it’s just, you know, a lack of knowledge… a lack of people out there in the marketplace really educating people on trade credit. And we’re starting to see that come around. So, yeah, private equity firms are getting very keen on it. And understanding the benefits and utilizing the trade credit, you know, from the financial benefit, and from a risk mitigation benefit. For sure.
Patrick: Well, it’s all it’s also nice, because even before they have to commit to securing a policy (there is an application process) but they can find out dollar-for-dollar, how much more they can make before the even have to get a policy, I think that’s a really nice element. We see the same thing and do it proposing terms of rep warranty where you can go ahead and get the terms of a deal set up and we can already kind of model “well, here are ways that you’re going to be able to exit the transaction with more cash than you would if there were no insurance.” I mean, and usually, the financial benefit is a multiple of whatever the cost is.
So it’s as a lot of people say, once they learn about trade credit a little bit more just as with rep and warranty, the same to word description they just say it’s a no brainer. And that’s why I really think the more people that learn about this, and see how it’s being deployed is a real benefit. What’s the application process? What is there a minimum eligibility requirement? What’s the process? So if someone were to reach out to you, how would they get started?
Austin: Sure. So no, there’s no minimum requirement for trade credit. There used to be. But as we’ve seen, you know, I was talking to a client of mine 10 years ago, there’s about, you know, maybe 10. In insurance companies who’d be willing twice, right trade credit. Now, there’s about 25, or 26, we can go to, which kind of, you know, change the market and added a ton of additional capacity into the marketplace and softened the market as well, which is good for prospective buyers.
So no, listen, not a very labour-intensive application process. Basically, they want to understand, you know, who is your company? What do you guys do? Have you had losses in the past? Who are your customers? You know, one of the benefits from going through the application process is, as I mentioned, you have lots of markets to go to, you have lots of insurers who have big databases full of information. Basically, you get a free review of your top 20 customers, by multiple sources. So you could have five or six trade credit insurance companies saying, here’s what we think about all of your top 20 customers, here’s how we would risk rate them. And if we see any problems, here’s what we see. So it’s a nice kind of due diligence process, as well, as you know, looking into the product itself. So no, essentially, you know, you can reach out to me, we have our own application that all the insurers accept, and we’d be happy to guide you through the process and see if it’s something that’s right for the company.
Patrick: How long does the process take?
Austin: Generally, applications, you know, sitting down working on it, I’ve had clients fill it out within, you know, 20-30 minutes. I’ve had clients take months to get back to me, but I think it’s due to other priorities. But listen, you know, I think, you know, sitting down, it should take no longer than 20 minutes to maybe an hour if you have all the information necessary.
Patrick: Well, the other issue is just how long does it take for the insurance carriers to processing? Assuming full submission, complete submissions out there to you go to the 20 markets for them? How long is it approximately… weeks? Days?
Austin: No, it’s… you know, Patrick, it’s relatively quick. If we have a filled-in application, and we submitted to the market, we expect to have responses back from the insurers within a week to 12 days. So, you know, two weeks if you’ll all of the markets have quoted, and will sit down with people and talk about the pros and cons to each.
Patrick: Well, that’s that is it, there is no reason for someone not to reach out because just having the information will… even if it’s a no-go, that that information, I think, is a tremendous use to business owners out there and management firms and so forth.
Austin, these products are tailor-made for each and every particular client, there’s not a lot of heavy lifting, the cost is a fraction of what the benefits are. So there’s no reason why you shouldn’t be flooded with people reaching out. How can our audience get ahold of you so that they can see if this is a fit for them?
Austin: Sure, so you can feel free to contact me via LinkedIn, which is Austin Leo. You can reach out to me at Austin.Leo@USI.com or there’s always the phone which is 908-240-5145.
Patrick: Excellent, Austin. Thank you very much for helping me bring in another value add that doesn’t require somebody suffering pain in order to get benefits. So thanks again.
Austin: Patrick, thanks for having me on. I appreciate it, it was a pleasure.
It’s a landmark moment in the world of M&A. Marsh JLT, the world’s largest insurance brokerage, has announced they successfully placed the first Transactional Liability policy at a $1 Billion Dollar Limit, the largest such policy ever written. As impressive as this may seem, it’s only a matter of time before a larger policy Limit is placed on an even bigger transaction. This is just one of the many data points outlined in the Marsh JLT 2019 M&A Trends report.
The biggest takeaway is that if you have a billion-dollar deal – you need look no further than Marsh JLT. They have the resources and experience to handle these very opportunities. I’ve always believed the world needs the Mega Brokers like Marsh JLT because “someone” has to insure Disneyland!
This is just one indication of how the benefits of transactional insurance, especially R&W insurance, is being recognized by Buyers and Sellers and made an essential part of a growing number of transactions, even for transactions going as low as under $20M.
According to Marsh JLT’s June 2019 Transactional Risk Insurance Report, which looked back at trends in this space in 2018, there are 25 firms offering this specialized type of insurance. That’s a sizeable increase from the handful offering this coverage just a few years ago.
More policies are being written as well, with Marsh JLT alone experiencing a 40% increase in policy count, from 359 in 2017 to 504 in 2018. The median transaction value for those insured deals was $135M. The size of the average R&W policy placed is about 10% of the transaction value.
Industry-wide, the number of M&A insurance policies rose for the fifth straight year, according to the Marsh JLT report, driven by strategic acquirers who are gaining confidence with this product. The number of R&W transactions conducted in this sector increased by 21% from 2017 to 2018. PE and other financial acquirers are already comfortable with this insurance, with PE being the majority users.
Of the policies written, 99%, were Buy-Side R&W, leaving only 1% as Sell-Side R&W. Buy-Side policies continue to represent the vast majority because they provide broader protection (i.e. covering Seller fraud) and because they best facilitate a “clean exit” for Sellers, with no indemnity obligation and less, if any, money held in escrow.
This allows the Seller to have most of the sales price in hand when the deal closes so they can move on to new investments or distribute funds to shareholders and investors. That’s the reason why Sellers, in many cases, are more than happy to pay for this coverage.
Looking at trends and what the future holds, it’s clear that the increase in usage of R&W is the direct result of three factors that aren’t changing anytime soon:
It’s also important to note that Underwriters have more experience than ever in writing R&W and other transactional risk policies. This allows this component, including due diligence, to become a seamless part of an M&A deal.
All this is taking place with a very healthy M&A environment as the background. The Marsh report notes that global M&A activity jumped 11.5% from 2017 to 2018 to $3.5T, even as the total number of deals actually fell. That’s the fifth year in a row that deal values have topped $3T. PE firm buyout activity, meanwhile, was valued at $557B, which is the highest level in 10 years.
Expect to see increased use of R&W and other transactional risk insurance in the rest of 2019 and beyond.
The great news for specialty firms, such as Rubicon M&A, is that Marsh’s growth into the billion-dollar deal level opens a wider gap of underserved deals as there are far more sub-$135M deals out there with the exact same needs for protection and service. We’re thrilled to have Marsh JLT out there to serve the mega-deals. We’ll handle the rest!
To discuss how Representations and Warranty insurance can impact your next M&A deal, contact me, Patrick Stroth, at email@example.com or 415-806-2356.
After culling through a decades-worth of data on IT services companies, Colin Campbell, Associate Director at Livingstone Partners, sees the potential for a market downturn on the horizon.
He shares what trends he sees that point to this potential slowdown, as well as how Buyers and Sellers approach M&A deals to account for it.
Colin says that Strategic Buyers are being quite selective in companies they target and tend to go after the company aggressively once they “fall in love,” wanting to move quickly and are willing to pay a premium.
This is in contrast to Financial Buyers (like private equity PE firms) who may have a wider appetite for acquisition targets, but factor into their analysis the possibility that values may level-off or decline due to an economic slowdown or other factors – they are mindful of the potential downside when pricing a target.
In our conversation, we take a deep dive into the above concepts, as well as…
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 Colin Campbell, Associate Director at Livingstone Partners. Livingstone Partners is an independent M&A advisory firm with a proven track record of delivering exceptional outcomes for private and public businesses and financial sponsors. Colin recently published a piece titled “Does An Old Bull Need To Learn New Tricks?” which outlines possible changes in the M&A sector for tech. Which is counterintuitive to the current thinking of late of the unending robust market for M&A in general, and tech in particular. And if slow down is in the cards, well… what middle-market companies do about it?
Colin, thanks for joining me, and welcome to the program!
Colin Campbell: Thank you, Patrick. I appreciate it.
Patrick Stroth: Before we get into this report that focuses largely on the IT services companies… tell me about you, give our audience a context for you. How did you get to this point in your career?
Colin Campbell: Sure. So, I’m a multi-time entrepreneur. I’ve started a couple of businesses over the years, I’ve been an operator, I was in private wealth management for many years, focused on estate planning, asset management. And, I think at some point, I had experience from a private wealth management standpoint, guiding my clients through mergers and acquisitions, and decided that that was really an interesting part of the business. And, I think an aspect that really sort of captured my attention.
And so, at some point, I pivoted towards an M&A role coming out of USC, so I did USC undergrad at Marshall School of Business, and then graduate school, also at USC Marshall School of Business. And now, in my spare time, when I’m not advising middle-market businesses on sell-side transactions, I’m also an adjunct professor at the Marshall School of Business.
Patrick: Well, you’ve kept yourself pretty busy there! Now, with this report you recently published, “Does An Old Bull Need To Learn New Tricks?” (which we’ll link to at our show notes here at RubiconINS.com)… what led you to focus on the report? Where did this come from, and give us an overall genesis of what led up to this report?
Colin: Yeah, so, we spend a lot of our time talking to business owners that are contemplating a transaction in the next 36 months. And, at the same time, by virtue of the processes that we run, and then staying current on the market, we’re talking to a lot of buyers. And, what we find is that there are some interesting trends going on right now, not only from evaluation perspective but also from the overall economic timing, the catalyst as to what’s driving some of these transactions, and felt like in many instances, there’s a bit of a disconnect between sellers and buyers and the thought processes. So, we thought it made sense to do a little deeper dive, look at it from a historical context. And so, we pulled all the transaction data for the last 10 years in the IT services space and tried to start drilling down into what sort of conclusions can we start to extrapolate from the data?
And I think what we found is that, you know, there’s a longer-term trend— not only in deal size (and by that I should say multiple), and also deal count— where there are the beginning impressions that while we’ve been in a very, very long bull market, that there are indications that things are starting to slow down and potentially turn. And from our perspective, our clients are generally operators that are looking for a sell-side transaction. You know, there are important considerations to take account for when you’re thinking about what could happen to the economy, and specifically, what could happen to your particular sector in the next 12 to 24 months.
So, the idea behind the article was: let’s start to suss some of that out, let’s start to talk about what some of those trends are. And, obviously, the actual implications are going to be very specific company to company, operator to operator. But, it’s important to start thinking now for many of these business owners, how does that actually impact their specific business, given their specific situation, and their businesses nuances?
Patrick: Well, where you’re targeting this with technology when people talk about technology is as diverse as somebody talking about retail. You can have everything from widgets to items over at Tiffany’s, in the scope of the wide variety of things. And what I liked about what you add here is you are trying to broaden your research for all things, to all people in tech. You focused on a real finite specific group with the service providers. Tell us about that… is it just because those were the most numerous classes out there? Or is there a preference there? You know, most describe the categories of tech that you looked at in the service provider side, and then why those projects?
Colin: Yeah. And, Patrick, you make a great point, right? I mean, as you look across all of the various industries, even some of the most traditional ones, you’re seeing more and more technology being infused in these businesses. And, that’s ultimately impacting those valuations and those transactions. I think the reason why I tried to focus is that you can’t look at all of it in one fell swoop. It has to be distilled down more than that. And so, where I spend most of my time, is within the broader landscape of business services. We’ve drilled down into IT services, and that’s really what this is focused on.
Beyond that, I spend even more time really thinking about IT consulting and other services businesses, which is one of the three legs to the stool, if you will, in this IT services landscape. That tends to be where we spend a lot of time talking to business owners that are operating on one of the cloud platforms that are: providing consulting services, that are leveraging technology to impact other businesses, that are managed services providers, that are actively shifting their business towards a slightly different mix (from maybe an older, more traditional consulting business). And so, that’s seemed particularly relevant to my experience, and where we were spending a lot of our time these days.
So when we take this broader IT services space, and we drill down into data processing and outsource services being one tranche, internet services and infrastructure being the second tranche, and then IT consulting and services being the third… What we find is that there’s each one has their own DNA, their own trends. And, it’s important to think about, even though they do overlap, overlap in some instances, where specifically a business would lie, and then that’s going to significantly drive, how they ultimately become viewed and valued in the market.
Patrick: Why don’t you give us a quick synopsis of each. What is data processing? And then, what the predictions are based on the report from what you observed. Segregate that from internet services, and then segregate that from IT consulting.
Colin: Sure. So, data processing and outsourcing services businesses are what we might think of as your traditional data, big data business, right? They’re dealing in a lot of numbers, are dealing and a lot of data points. They’re trying to draw out really unique insights from vast quantities of data. And I think what we see here, in some of the analysis is that the number of transactions in this space is somewhat limited. And I think there’s a number of reasons for that. I think you have to look at deal volume, in concert with deal value. And what you find is that, for many of the historical years, the deal value has been very volatile. So, multiples in this particular space have been very high and very low. And, I think that’s a function of the limited number of transactions that you see in a space. And so, it’s a common interaction right between supply and demand that when there’s an imbalance in the market, it’s going to drive values either very high or very low.
Recently, we’re seeing a downtick in multiples in the data processing space. And I think there’s an argument to be made that as data is becoming ever more prevalent. And, I think there’s plenty of sources out there that say, we’re generating more data today on a daily basis than we were generating monthly, or annually, not that long ago. And, the rate of data creation is becoming such that to just be able to analyze the data is not becoming as unique, and it’s becoming almost maybe more— dare I say— commoditized to take data points, compress them together and try and pull out some insights. It’s becoming much, much more difficult to find something that is truly unique and insightful, versus something that’s become almost a little bit more regular way. So, I think that’s driving down some of the values in that space. But there are so few transactions in that sector, that I think there is room for someone to come out if they truly have something unique, whether it be unique insights or a very differentiated data set that is truly proprietary to their business, that I think that drives meaningful value in that particular sector.
Patrick: I hate to interrupt… On one thing, though, with the data processing, and just a quick question for some of us less tech-savvy folks. With the data processing, you’re processing… you’re handling raw data and organizing or analyzing that, does that then lead toward artificial intelligence? Or is AI a factor… a part of data processing?
Colin: It’s a factor of it, I think it depends on how you. And that’s where part of the complexity with trying to distil down a large data set that it tends to get a little bit murky around some of the edges. And so, there are companies that are, are effectively both a consulting and advisory practice, but leverage AI and have data processing capabilities. So, if we think about it more in its pure form— I think the data processing itself tends to be more data collection, data aggregation, and data analysis, and less the true cutting edge AI. Now, the more technology-infused and the more cutting edge of the more advanced you are, certainly, that pushes you towards a higher value because now you’re talking about something that is truly unique. It’s truly differentiated, and typically has some kind of moat around it. In terms of it’s difficult to replicate, it’s one of a kind, right, it’s something that is not readily available across the market.
Internet services and infrastructure. This is really going to be when you think of e-Commerce when you think of online, and what I would consider information services businesses. So, this is going to be oftentimes a B2C model, and it’s really online-based, I think these businesses, again, from a volume standpoint, there are fewer trades that go on year in and year out. And, the range of size of the business is very, very broad. And so, that also creates a fair amount of volatility in terms of the valuation of those businesses.
So right now historically, call it the last three years, these businesses have been trading high single digits, and year to date, we’ve seen actually a limited number of transactions to validate any sort of thesis around where they’re currently trading. They really tend to be predicated upon, what is the type of traffic the businesses generating? What is the type of service that they’re providing? What is the information in the case of online information commerce that they’re providing? And here, again, it blurs the line a little bit, where are they getting the data from? How are they aggregating it? how unique is it? Are there more proprietary insights that they’re able to pull out and then deliver to the consumer from their data set? So it’s, it’s a tends to be a bit more volatile space, just because there are fewer trades.
Patrick: And then we have IT consulting?
Colin: Correct. So IT Consulting… this is going to be the bulk of the market. And I think one reason being is that it tends to be more of a traditional consulting model. You have a high headcount, oftentimes there’s a little less technology development, there’s a little less proprietary technology. In this category, you might see companies that are considered the value-added resellers. These are called bars, or IT consulting businesses, that are truly doing what’s considered the lift and shift. So: helping businesses that are in more traditional industries integrate into the cloud. These are also managed service providers, which tend to be outsourced IT services providers. So if a company, maybe an industrial business, that is very tried and true, very traditional and its operations, but is now moving its back-office and ERP systems into the cloud and is looking to create a mobile application to empower its workforce out in the field, this would probably be an IT services or IT consulting business that is helping them to do the integration, and then build out that application and empower that workforce.
Patrick: And even though, unlike the other two categories, you have a lot more people involved. In terms when you said the headcount which was striking to me. You are saving… an IT consulting firm is saving a business by doing the work of hundreds of people with only two or three, but you still have two or three, that’s two or three more people than a data processing company may have to engage. Is IT consulting as a business… is the value and also the cost-driven by the depth and scope of the headcount? Is it a lot more tangible with people, then technology?
Colin: It is, right, technology tends to lend itself to being highly scalable. You tend to see that in growth rates, you tend to see that in margins. And so, in the IT consulting business, there’s maybe a bit more stability… certainly in the valuations of the companies there tends to be more stable. Partly, because there are more deals to be done. There are, you know, there’s the argument to be made that there is a lower barrier to entry into the IT consulting space because practically anybody can hang up their shingle and say that they’re an IT consultant. What I would argue is that there’s a greater barrier to excellence, where there are a limited number of folks that have truly been able to differentiate themselves, and build that requisite skill set that sets them apart from everyone else when it comes to cloud integration, app development, managed services, and really providing something that is value add to the end consumer. So in this case, it’s a B2B model, where data processing or technology as a whole is going to be highly, highly leverageable in terms that it’s very scalable, you get a lot of operating leverage. The more you can build-in from a sales standpoint, typically the much more profitable, the business becomes. In IT consulting, because there is typically a larger headcount, that it’s oftentimes about billable hours. It’s oftentimes a story of a project versus recurring revenue. And, that has a huge impact on value as businesses are looking to go to market.
Patrick: This is a little bit off-topic from your report, so I do apologize for this. But, in your analysis, I’m just curious… who was doing the acquiring of each of these categories? If you if you’re a data processing company, was it being bought by a larger data processing company? Or from others, some strategic buyer that says we need that capability, so we’re going to bring you in, we’re going to take you away from the market, and we’re going to bring you in the house? What percentage of the deals roughly involved that scenario where a strategic would go and take one of these three categories and bring it in the house thus removing them from the rest of the market?
Colin: It’s really been a mixed bag. And, I think as you go year by year, it changes. Whether it’s more of a financial buyer, like a private equity group, or whether it’s going to be a strategic buyer, like other operating businesses looking to bolt-on new capabilities. And I think what we’re seeing in some spaces, is you’ve got very large, very large operators that are creating platforms, right. Microsoft is one that comes to mind. And they’re creating an Azure platform. And, what they’re doing in many instances, is they’re out there buying businesses that have created unique technology or have captured large swathes of viewers, of users. And, they’re able to quickly onboard, either the capabilities, the technology, or the traffic, into their platform. And, that carries significant value for them. They’re not necessarily in the market of saying “we want to be a consultancy.” They have plenty of businesses out there that are able to do that on their behalf. And that’s where I think you see folks in the IT consulting space, where there are a large number of businesses that are operating with very good capabilities in the space: whether it be AWS, whether it be Microsoft Azure, whether it be one of the other cloud platforms. They’re able to cater to clients and operate on those different platforms. Whereas, you know, in data processing, in internet services… it’s less about whether or not you’re able to provide support services to a larger platform, it’s really more about your capabilities.
And I think when you see the economy has been very strong for a number of years, you’ve got strategic buyers that have built up a lot of capital. And much of that capital exists not only just on the balance sheet in terms of cash, but in many instances can be equity. And that’s where as a seller, you need to be cognizant of what the consideration during the course of a transaction is going to be and how you’re going to be compensated. Because, in many instances, we’re seeing strategic buyers, and this is across all three buckets. They can be very acquisitive, and very aggressive. But, oftentimes, they’re using their own equity. Which may, or may not, be considered overvalued at the time. They may look at that equity and say “that’s actually less expensive to me today, then maybe cash would be”
Patrick: Very interesting. So now with this report, what were the major takeaways you’d mentioned early on about a disconnect? What’s the biggest takeaway from this report?
Colin: Yeah, so from the buyer’s perspective, we’re seeing there are strategic buyers that are very, very specific right now in where they’re looking to allocate funds and spend money. And so they’re typically coming out with very targeted investment theses. That is, they’re looking for a particular type of asset or many instances, a particular asset, one type of business, one business in particular, that will augment their existing operations. When they get excited about a business, they’re willing to move rather quickly, and they’re willing to pay up for it. Remember, strategic companies are typically going to realize some kind of synergy, some kind of benefit from making an acquisition that a private equity company may not necessarily if they don’t already own a business in the space.
So strategic companies are able to be very aggressive, and typically pay a premium for a business that they love. But they’re going to be much, much more selective. Private equity companies right now are… they’re cautious. I think they’re looking at where we stand today in the economic cycle, and I think most if not all of them, when we start talking about projections and estimates, they’re looking at it from— I would even argue, a fairly realistic perspective— that is, there’s going to be a correction at some point down the road. Nothing goes up forever, right. Real estate didn’t, the stock market does not. So, they’re starting to bake in downside cases into a lot of their projections. What that’s doing is that’s changing their model that’s changing their financial return profile, to say that they maybe aren’t willing to get as aggressive. And so you’re seeing that private equity companies are struggling a little bit to compete in those cases where there’s a strategic company that’s getting very, very excited about a particular asset.
Now, there are still plenty of private equity companies out there with capital that has raised funds in the last couple years, that are looking to deploy that cash. And so, they’re being more thematic about their investment style. And I think that’s where — again, in particular, I focus on the IT consulting space— private equity companies are spending a lot of time thinking about particular platforms, whether that be Microsoft, would that be Amazon. They’re spending a lot of time thinking about what is the difference between project-based businesses and recurring revenue types of businesses? Like a managed services provider, where there’s a contractual agreement, that they’re going to get a certain amount of revenue every month from their end client, right. That carries a lot more value to the operating entity, and therefore, to the private equity company, when they can project out that revenue. They know it’s coming every month, it’s much more secure. And it gives them a lot more visibility into their long term revenue, that has a significant impact on their valuations today. And that’s where we’re seeing transactions start to occur. I think more often, and I think with higher values, is when you can substantiate there’s a high degree of recurring revenue.
Patrick: Well, I think another consideration out there is it really depends on the management or the owner/founder of the businesses that are considering themselves for an exit, to sell their company, would it be a strategic, or private equity. One of those things I recently learned about was that if you want to have an exit, you’re a founder, you want to ride off into the sunset… sometimes going to a strategic may make more sense, because a lot of times the strategic will bring you in, and they may be making some big significant changes in the short term with management. Whereas, if you come on board with private equity, they want to keep the existing management in place to help them as they add value and other areas. So that’s another consideration out there.
With this, this view of, you know, the possibility of what particularly with the financial buyers looking at building in possible downsides down the road and so forth. What steps should owners and founders take? I mean, this is a perspective that is out there, you can’t guarantee outcomes across the board, but you need to plan for contingencies. What’s your guide to them on what they should start thinking about?
Colin: So I think the first step that we always take, anytime we’re talking to a new business owner, is really to understand what is it they want to accomplish? What is their desired outcome? And you talked about a business owner whether or not you should sell to a strategic and sponsor based on his outcome… That’s exactly right. And so, is his goal to stay on and run the business for another five years? And does he want to transact in the next six months, or 36 months? And I think that’s an important consideration. When you think about what are the next steps.
I think, first and foremost, I would— and maybe I’m biased— but, I would argue that maybe the right place to start is you start with someone like me, or Livingstone, or whomever that can offer you advice as to what’s currently driving the market, what’s creating value? And what are those things that you need to be thinking about?
Because we’ve seen businesses to try to run quickly for a transaction thinking that the timing is right, something’s happened in their lives, and they want to go now. But the problem is, is that if their house is not in order, running that fast they end up stubbing their toe, they trip, and it creates bigger issues for them during the course of the transaction. Versus taking a step back, taking three months, six months, and making sure they’ve got their house in order.
Now, Patrick, you and I both know that a time that time kills all deals, right? So it’s a trade-off between? Do you want to wait six months? 12 months? And do the work necessary to make sure that your finances are clean, you understand what all the data is? And that’s probably one of the biggest issues is that a lot of companies that we see, certainly that are privately owned, haven’t really thought about… What are buyers going to look for when they come in and due diligence? And do I have all of the data compiled? Reconciled? Do I have all of my KPIs in place? And, having a conversation like that with someone like Livingstone upfront, I think can go a long way to making sure that you have a smoother process, which shortens the overall timeline to actually getting a deal done, and ultimately improves the probability that not only you get a deal, but that you get the value you’re looking for.
Patrick: I think one of the things is is that a mindset that sellers really should have is you should begin with the end in mind, what is the outcome you want? How are you going to get there? And, I think probably what really is a big killer, or time killer for deals in my experience has been, when you’re a seller, you’re disorganized, you don’t have the right answers, you’re not prepared for a serious buyer to come in. Even an unsolicited buyer comes in. If you are not serious and aren’t equipped to respond to them proactively, things can drag on and what the the biggest thing that happens with the time is those multiples, that valuation, just starts shrinking. And the longer it takes because you’re not prepared— and you and you may have the right answers — but that’s not formatted in a way that the buyer is prepared to receive them. It just kills everything. And I think that’s the great value you add, it’s almost like staging a house for an open house. You’re going to you’re going to incur some expenses to paint and furnish the house and get it all souped up and be cluttered and everything. And for every dollar that you pay an expert in doing that you probably reap $25 to $30 in return.
Colin: I think that’s very fair. I think that’s very fair. And if you use that same analogy, you probably aren’t going to, accept the first offer that comes in off the street, unsolicited. You’re going to want to run an auction. And I think that’s again, a value add that folks like Livingstone, folks like my team and I can provide, which is we make sure that that not only is your house in order, but that it’s being presented correctly, in order to maximize value and help guide you through that process in that transaction.
Patrick: One other thing I was thinking about, and this is because we’re based here in California, and I’m a Silicon Valley, and you’re down in Southern California. But the M&A community, particularly in tech, is not that huge. And so I think another value you probably add is not only do you know the market out there, but you know buyers, and which buyers are serious and which buyers are kind of grinders and wheel spinners. And that can be particularly helpful.
Colin: Correct. So we maintain… Livingstone has been around for more than 20 years. And all of us have been at prior firms prior to Livingstone. And so, we’ve got a very good sense as to who’s serious versus who’s just tire kickers. We know how people behave in the course of a process. And, I think that goes a long way to lending value, when you’re in the throes of a deal and you’re trying to compare different types of bids. You know which one has more teeth to it, has more meat to it. And you have a sense as to how people are going to behave during the course of the process. I think that’s that’s your point, right? That’s the value of having a more seasoned team behind you guiding you through the process.
Patrick: Well, what’s what’s the ideal profile for an ideal client for you, and for Livingstone in general, but for you and your practice in California? I know you’re not limited just to stay in the Golden State, but give us a quick profile.
Colin: Yeah, so Livingstone has offices across the US, Chicago and LA. And then we have offices throughout Europe. And so, a fair amount of our deals are in fact cross-border. I spend most most of my time working on sell side transactions. So, typically business owners that are looking to exit their business or bring in capital, whether it be private equity, or whether it be debt financing. And so, generally they’re they’re located in North America, I tend to look at businesses that have EBITDA between call it $5 and $25 million. That typically translates to enterprise value. We have a strong restructuring practice out of our Chicago office for companies that maybe need a little bit more help, have a little bit more of a story to them. Those businesses are probably in the $20 to $25 million enterprise range. And then, once we get healthier sell-side, you know, we’re typically looking at businesses that are $50 million upwards to $500 million in enterprise value.
From a sector standpoint, I’ll add, I think where I spend most of my time, is, as I said, the IT consulting and services business. And so, that tends to be anything in the IOT space, managed services providers or MSP space, anything that is cloud-related, those tend to be where I spent a lot of time thinking about, talking to buyers, talking to sellers, and tend to have a pretty good grasp of what’s going on in the day-to-day. We’ve got a number of transactions that we’ve completed here recently that have been in that space, that have gone a long way to helping inform, I think what it says in the article, but just again, our sort of industrial knowledge of of the space.
Patrick: I also think just your initial background, being in wealth management and estate planning, you definitely convey a perspective of looking for the welfare of the owner/founder or investor in this transaction and helping them transition either to short term or long term. So, I think you have an experience of beginning with the end in mind, which is very helpful. Colin, how can our listeners find you?
Colin: Yeah, Patrick, so you can email me at Campbell, spelled like the soup, @LivingstonePartners.com, or you can reach me in my office 424-282-3709.
Patrick: Thanks very much. This has been a great insightful look into the possible outcome with a slowing tech space, but just how diverse it is. And, there are ups and downs throughout. And the best way to do this is navigate with a professional who cares about your outcome. Colin, thank you very much for joining us today and we’ll talk again
Colin: Thank you, Patrick.
Going into an M&A deal there is always a “courtship” period where the Buyer is wining and dining the target company. If things go well, this leads to a Letter of Intent, which essentially states that the Buyer wants to buy the company, and the Seller agrees.
This is where things get more complicated. The courtship – and romance – is over.
Considering that a typical M&A deal is about as hard to complete as a Hollywood blockbuster, it’s a miracle these deals ever go through. There are so many elements that could derail them at any stage until the purchase and sale agreement is signed and the closing takes place.
So what happens?
If you’re a target company, you need to be aware of the mindset the Buyer takes on when approaching a deal.
It helps you manage expectations when you sit across the table. As the target, you must realize that as desirable as you may be, you might not have as much leverage after the Letter of Intent.
The Buyer’s attitude is that if they’re paying full price, then the target company has to perform to expectations or better once they assume control, even if there are unknown factors that come into play through no fault of the Seller. The Buyer believes the shareholders of the target company should take on all risks of the unknown, despite the due diligence they have done.
That’s why in these types of deals, a significant portion of the sales price (8% to 10%, generally) is held in escrow for a period of a year or more, with the Buyer basically free to take funds if there have been any breaches with the representations and warranties in the sales contract to pay for the financial losses. They can even clawback more money beyond that amount.
Understandably, Sellers aren’t eager to take that risk… or take home significantly less funds at closing… money which owners and shareholders are eager to use to retire or invest in new projects.
But, as we’ll see in a moment, there is a remedy that allows Sellers to protect themselves and not be required to leave any funds in escrow. In fact, they no longer have an indemnity obligation at all.
On the other side, the Seller maintains they can only give assurances for issues they know about and outline in the representations and warranties in the contract. The target thinks the Buyer should take on all the risk after those issues are outlined.
Clearly, the two sides are at odds. And this can make for difficult negotiations.
But there is an insurance product that can make both sides happy, remove the need for money to be held back in escrow and fulfil any indemnity obligations in the event of a breach of the Seller reps. Deals as low as $15 million will be considered by insurance company Underwriters.
Representations and Warranty insurance does this by transferring the indemnity obligation from the target to a third party – an insurance company.
For example, say a chain of restaurants is purchased. But post-closing, the Buyer discovers that there are $1M of gift cards out there yet to be redeemed. Without R&W insurance, the Buyer would have to go after the Seller to cover their financial losses. But with this coverage, they simply file a claim with the insurer.
Another big bonus: with this coverage in place, a deal is EIGHT TIMES more likely to close. Because the indemnity obligation has been removed from the Seller’s shoulders, that’s one less thing to negotiate. The process becomes that much smoother.
The vast majority of policies are “Buyer side,” where the Buyer is the Insured Party, although often the Seller is the one to pay for it, and happy to do so, considering all the benefits.
Securing this coverage is easy, and its cost is low. To secure a policy takes a couple of weeks at most, as the Underwriters review the due diligence performed by the Buyer. The rate is 2%-3% of the Policy Limit, including Underwriting fees and taxes. The price of R&W insurance has dropped considerably in the last several years, while the number of insurers offering this coverage has increased.
Timing is critical. If you want R&W insurance to cover your next M&A deal, there should be a provision made at the Letter of Intent stage. If it’s put in place at that time, it can always be removed.
If you’re interested in making Representations and Warranty insurance part of your next deal, contact me, Patrick Stroth, at firstname.lastname@example.org.
In recent years, as more insurers have entered the Representations and Warranty insurance market (according to a study from Harvard Law School, there are now more than 20 insurance companies writing these policies), there have been more opportunities for ever smaller M&A transactions to secure coverage, with deals as low as $15M deemed eligible.
The insurers that offer these policies understand that given the smaller transaction size, they will be asked to cover most, if not all, of the transaction value (TV) of the deal.
Insurance companies are providing flexibility for Buyers and Sellers by offering policies that provide coverage up to the purchase price, while also insuring the Non-Fundamental reps to a specified Limit – more on this below.
Sellers of small TV targets have less leverage than their counterparts, so having the ability to transfer ALL the indemnity risk can provide a productive tool for both sides.
Naturally, Underwriters in this space require the same levels of Buyer diligence as the larger deals, so eligibility for R&W should be checked before proceeding.
Here’s why this matters: most R&W policies don’t cover the entire cost of the transaction. They only have to provide Limits up to the Indemnity Cap (Cap) as outlined in the Purchase Agreement.
A Seller’s maximum exposure is equal to that Cap and no more. Therefore, there’s no need to provide more protection above that Cap. In many cases, the Cap runs 20% to 30% of the TV.
Typical R&W insurers that cover $100M+ M&A deals are reluctant to insure more than 30% of the TV. So, the maximum an insurer would be willing to cover on that $100M deal is $30M, even though that same insurer has the capacity to provide a $50M or $75M Limit. The reasoning is that Underwriters are not comfortable insuring a majority of the TV.
This position is not the case with deals in the lower middle market (sub-$30M TV space). Unlike the larger deals, it’s easier for Caps to exceed that 30% threshold. Consider a $5M Cap is 33% on a $15M deal. Buyers have significantly more leverage over targets in this sub-$30 TV space, and therefore routinely require higher Caps, particularly with regard to Fundamental reps.
Within the Purchase and Sale Agreement, there are specific categories of reps: Fundamental and Non-Fundamental.
Fundamental reps often include:
Any rep not identified as Fundamental is considered a Non-Fundamental rep.
Buyers scrutinize the Fundamental reps more closely than any of the other Seller reps, as breaches of Fundamental reps lead to larger, more serious financial damages.
Breaches of Fundamental reps are rare because they have been so closely watched, but according to the recent AIG claims report, they do happen.
R&W insurance is priced based on the amount of Policy Limits provided. Since smaller transactions traditionally don’t need higher Limits, Underwriters haven’t been able to set a price for small deals that justifies the risk.
For that reason, Underwriters developed the approach of offering to insure the entire transaction by covering the Fundamental reps at a maximum Limit, while including coverage for the smaller, Non-Fundamental reps Cap.
The per Limit rate for these purchase price policies is discounted due to the lower risk of the Fundamental reps, while enabling Underwriters to collect sufficient premium to insure the smaller deals.
Take the case of a PE firm seeking to purchase a chain of car washes for $22M.
Within the Agreement, the Buyer seeks a $4.4M (20%) Cap on Non-Fundamental reps, but no Cap on Fundamental reps.
Prior to the entry of the new R&W policies, the maximum limit of coverage for Fundamental and Non-Fundamental reps would be $6M to $7M and the parties would have to bear any risk above that Limit.
Today, policies are readily available to offer a package that provides $22M in Limits for Fundamental reps, with a Sub-Limit of $5M for Non-Fundamental reps.
Consider the pricing benefit as well.
A $22M Limit R&W policy runs $400K to $600K. However, a policy with a $22M Limit on Fundamentals and a $5M Sub-Limit for Non-Fundamentals can be as low as $220K.
It’s clear that the use of R&W insurance will continue to grow as more Buyers and Sellers come to understand its benefits and insurers are willing to cover a wider range M&A deals.
If you are considering a M&A deal on the small side but didn’t realize you could secure R&W insurance to protect yourself, let’s talk about this recent trend of insurers covering full transaction value.
You can reach me, Patrick Stroth, at email@example.com or 415-806-2356.
As a company is scaling up, especially a startup, it wants to stay nimble and always moving forward to maintain momentum. At the same time, the systems they used in their startup phase – like QuickBooks – just might not be robust enough to manage their new incarnation.
There are too many financial reports, people, and processes to keep track of with simple accounting software or spreadsheets. Not evolving and finding an efficient way to keep track of it all, and meet the needs of your growing company, will cause growth to stall.
There is an ideal solution to help you put the systems you need in place to properly scale up your business. It’s a comprehensive software solution that can boost productivity and efficiency while decreasing costs by integrating:
… in one system. It gives you a 360-degree view of your business, 24/7, from anywhere in the world.
An Enterprise Resource Planning (ERP) software solution can improve productivity, increase efficiencies, decrease costs, and streamline processes, and much, much more by automating front and back office processes like…
For any startup ready to take their business to the next level and grow, as well as make itself an attractive acquisition target, a solution like this is necessary.
Cloud-based software NetSuite is the ERP system of choice. Forty thousand organizations across 160 countries use NetSuite to run their businesses. Seventy percent of all startups are transitioning from other legacy systems to NetSuite ERP.
An ERP can be used by low level staff, as well as top managers, because the level of access can be customized to each user. NetSuite is ideal for companies scaling 1 to 10 to 100 people and expanding to multiple locations and is perfect for a workforce that is spread across multiple locations, has a large percentage of employees who work from home, or has a team that is regularly on the road or in the field, like salespeople.
Because it’s cloud-based, it can be accessed by any computer around the world. And it also features an API that is easy to integrate with other systems.
NetSuite features different “modules” that are added on to its core suite, including modules like financial management, payroll, order management, fixed assets, ecommerce, and more. It can be fully customized to meet a company’s needs.
You can add or switch out modules as you need them – perfect for a rapidly growing business that needs to adapt quickly to the needs of the market.
NetSuite grows as you grow, allowing you to add features and functionality as your business grows.
This ERP gives real time visibility through dashboards and reporting throughout your organization. It’s a single platform that handles multiple services for your organization.
Dashboards allow you to analyze and track system data on a variety of levels, including tracking KPIs like account balances and outstanding bills. But they can also organize deadlines, meetings, calls, and more.
The order and billing management module integrates sales, finance, and fulfillment operations to be more efficient, improve quote accuracy, and reduce billing mistakes. It also automates your approval, invoicing, and payment management responsibilities.
Fulfillment errors can be reduced with a module that centralizes customer, order, invoice, and shipping information, while integrating with shippers like UPS and FedEx.
You can monitor your supply chain from end to end, procurement to payment. And it improves collaboration and communication between vendors and customers.
But NetSuite doesn’t only tell what happened in the past or what’s currently happening in your business.
Importantly, with NetSuite dashboards, you can conduct the financial planning that helps you achieve your company’s goals. You can conduct “what-if” financial modeling to help budgeting and forecasting, which allows you to plan your next move more effectively.
The impact on your business is felt in several other ways.
Employees can be more productive because you can reduce spreadsheet-based processes by up to 70%. With NetSuite, you’ll have one backoffice system that handles financials, fulfillment, inventory, and sales. Using real-time dashboards, scorecards, and KPIs you can constantly and accurately monitor the daily cash balance.
You also enjoy reduced IT costs; it’s estimated that companies can save up to 93% in IT costs because they don’t have to maintain, integrate, and upgrade different applications that NetSuite does in one place.
If you’re ready to move out of the startup phase, it’s clear you need an ERP to help manage your business. But it’s not a matter of a simple download.
In order to truly optimize this powerful tool, it’s best to engage an Authorized NetSuite Provider (ANSP) who can walk you through the process from concept to integration (including training) to ongoing servicing.
An ANSP will ensure that companies realize their full “NetSuite potential.” Particularly, for companies that currently use NetSuite, engagement with an ANSP can be of tremendous value.
Looking for an ANSP? Drop me an e-mail at firstname.lastname@example.org, and I’ll send you the contact details for the leading ANSP in Silicon Valley.
Acquisition can be the ideal way to experience fast growth as a company. But there’s no need to stay within your home country when looking at potential target companies.
Jacob Whitish is the San Francisco-based vice consul for financial services for the U.K.’s Department for International Trade. And he doesn’t just work with U.K. companies looking into the U.S. but also American companies looking to expand in the other direction.
We chat about the unique challenges – and benefits – of these sorts of cross border acquisitions, including…
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 Jacob Whitish from the United Kingdom’s Department for International Trade. Jacob serves as vice council for financial, professional, and business services.
The Department for International Trade helps UK businesses export and grow into global markets. They also help overseas companies locate and grow in the United Kingdom. Now, when I think about business growth, business expansion, I see two ways to get there. Either slowly through organic growth, or instantly through acquisition. And since we focus on M&A here, we’re a bit more biased in favor of the instant growth approach to doing things.
That’s why I asked Jacob to speak with me this afternoon to talk about opportunities for M&A. Not just with UK companies coming here, but also for US companies seeking targets in the United Kingdom. Good afternoon Jacob, welcome to M&A Masters.
Jacob Whitish: Thank you so much, Patrick. Great to be here and thanks for having me on.
Patrick Stroth: And I promise today, Jacob, this will be a Brexit-free zone. And before we get into all the fun stuff for the Department for International Trade, let’s get a little context for our listeners here. Tell us what brought you to this point in your career.
Jacob Whitish: Sure. It’s been a little bit of a winding route, but in all of the kind of weird different paths that I’ve taken, it all somehow added up perfectly to get me exactly where I needed to be. After college I worked in the state of Washington for the state level government, so got used to what it was like to be in these massive behemoth bureaucracies that is national politics and state level politics.
And from there I saw a lot of friends that were jumping into the tech sector. They were having a great time with different startups. A lot of fun. And I was looking a little envious, decided that I wanted to go over and figure out what was going on on that side of the fence, so to speak. And so taught myself some different tech skills. Ended up as a kind of country lead for a Canadian startup that was trying to get into the US market.
So ran all of the US operations, did all of our marketing campaign, and effectively was kind of the in-country CEO. From there went to another small FinTech startup as the very first employee after the founder, handling everything on the business side. And then after a little time there, went out on my own. Started my own company doing marketing strategy and advertising. Ran that for a while. Ton of fun. Ran it entirely distributed online. I was able to travel around the world with my then girlfriend at the time, now fiancé.
And that was a lot of fun, but eventually was starting to get a little bit burned out on the just kind of endless cycle of finding more and more clients, doing everything myself, and wanted to find something little bit different, something more interesting. And just kind of stumbled upon this job with the Department for International Trade. And it was the right weird mix of background of government service, startups, self-employed, to be able to do my job here very well.
I work for a government, but at the end of the day I’m out there interacting with companies, founders, executives, all day long. So it’s kind of an interesting mix of both public and private sector.
Patrick Stroth: Well, when we think about international activity, cross-border M&A and so forth, we always initially think about it as it being instigated by a company A, usually a multinational or what could it be a multinational targeting company B. And it all stems from there.
It was interesting and refreshing to see that you’ve got a government controlled entity that is doing what they can to accelerate the process or assist there in domestic companies in that kind of expansion. That’s a great set of services that are available. Tell me about the mission for the Department for International Trade for the UK.
Jacob Whitish: Sure, absolutely. At the end of the day, my role is really to I guess primarily add economic value to the UK taxpayer. We’re entirely funded by taxpayers. We are a part of the actual government, so at the end of the day we have to be able to draw some line back to having provided value to the UK. Now, how we do that is a little bit more reform in terms of we can help companies expand internationally from the US to the UK, and thereby adding jobs into the UK. We can help UK companies grow into the US, and then therefore hopefully helping add more tax revenue back to the UK entity.
A lot of kind of playing matchmaker, introducing different people, doing some kind of upfront market research to help companies even understand if this is the right decision for them. One of the biggest things that I don’t ever want to see is a company that’s gung-ho on coming out here, spend all of the overall CAPEX and operational expenses and time, and just all of this energy to try and get into a new market, only to find out that it wasn’t the right market for them.
So hopefully upfront we can do a lot of things like helping out these companies just to figure out if this is even the right decision for them. And then if they decide it is, hopefully make that process a little bit easier through our networks, our connections, our just experience of watching companies do it over and over again.
Patrick Stroth: Almost like being a liaison. It’s an extension of the ambassadorship where they’re coming into an unfamiliar territory, you’ve got a presence here, and you can guide them and mentor them through the process that are unique to that geographic location.
Jacob Whitish: Yeah, absolutely. Absolutely. I mean, you could think of the ambassador as being the political side of what we do on the commercial side. And in fact the Department of International Trade operates out of several different consulates and offices all around the US under the purview of the ambassador. But then our kind of specific remit is the commercial side, whereas the actual consul’s general and the ambassador are a lot more about the political and policy side.
Patrick Stroth: And it’s interesting too because you’ve got a much more favorable or positive view of overseas expansion, where in America we keep thinking about it as expansion means, oh, we’re outsourcing jobs, we’re outsourcing activities that we should be keeping here. Conversely, you’re looking at, well, if we can expand internationally then our UK domicile businesses can grow, and that’s how it will benefit the home country or the headquartered company there in the UK, is through growth in revenues.
Jacob Whitish: Yeah, absolutely. We don’t see it as a win or lose scenario. There’s absolutely win-wins here. We can provide jobs for the home country, we can provide jobs in the new country that they’re expanding to. At the end of the day, we don’t care that much as to exactly what this line looks like from point A to point B, as long as somewhere along the way we can say, “Hey, we’ve helped out the UK taxpayers.”
Patrick Stroth: So then when you’re describing what you do with providing information and mentoring services and informational resource, so what specific services do you provide to UK companies looking to come here? They’re coming on over here, they look to you for assistance. Specifically, what can you do for them?
Jacob Whitish: Sure. I think I can also kind of give it a little bit bigger picture of an approach at the same time. So probing a little bit more context in my specific role, which is I specialize in all things financial services. So anything from a traditional bank asset manager, insurance, all the way up to these brand new cutting edge FinTech, InsureTech, RegTech, you name it. If it touches money or the compliance of money in some way, shape, or form that’s kind of my industry.
Geographically I represent the entire Western US, so the 11 Western states. And then I have several colleagues across the US who cover different geographic regions. Now within all of those different regions, each of us kind of have our own specialties of things that we’re particularly just good at as individuals. The kind of standard sort of things would be like providing access to reports on the cost of real estate, or the cost of talents, or even the availability of talent and how it might be distributed throughout a particular region.
So that would fall under that heading of helping companies figure out if it’s the right decision for them and where they should go. So a lot of times companies will come out, I’m located in San Francisco. Everybody wants to come out to San Francisco just because it’s the tech capital and people want to be out here and see the VC money and hopefully magic will happen.
But it’s not always the right decision for everyone. For some companies Denver, or Seattle, or Phoenix, or LA might be better choices, just depending on where they are as a company, what industry they’re in, and really the resources that they have available. It’s pretty darn expensive living out here. So not always is it the right decision for a company to come here. So that’s kind of the advice and sort of research portion.
In terms of just kind of like more softer sort of resources, I have my own personal network out here that I’ve built up. I’ve got different organizations that we’ve worked with to build out this community that we can help introduce these different founders and companies into to try and help make their transition a little bit softer. And then of course just a very extensive network of different service providers and experts that we’re able to connect people with for whatever their particular situation may be.
Maybe it’s immigration attorneys, maybe it’s someone helps them set up their US entity, or insurance, or and M&A specialist, private equity, VC. You name it, we probably have somebody in our network somewhere that will be a good fit for connecting up those people and hopefully making all that happen.
Patrick Stroth: So you’re not just providing services to startups or super huge company. You’re available for a variety of companies through whatever stage in their life cycle they’re in.
Jacob Whitish: Yes, absolutely. It goes the whole gamut, and those different services change a fair bit as you go across that different spectrum. So we’ve got people from maybe 5 or 10 just random folks in a small little one-room office. They’ve got one round of funding under their belts and they’re eager to get into the market, all the way up to some of the biggest household brand multinational names that anybody would have heard of.
At that earlier business stage, so the smaller companies all the way up to kind of the middle-sized companies or so, a lot of that tends to be more around that advice, resources, networks, things like that. That’s where it’s providing a lot more value to those companies. As companies get larger they have the financial resources, they have their own in-house specialists and experts. They don’t necessarily need us to tell them what the cost of a new developer is going to be in San Francisco versus Seattle.
At that stage what tends to be a lot more valuable is having a voice in policy discussions. So it’s not to say that we go and stick these people right in the room with the ministers back in London, though it has happened. But a lot of times we’ll bring experts out here or we’ll bring different members of the government out here to do kind of a tour of different businesses.
And they want to hear usually what are the current concerns, what are companies seeing, what are they liking, what are they not liking, what do they wish was different. And from having those different kind of open channels of communication, then they’re able to go back to the policy makers and the government officials. They’re able to then go back to London, and as they’re working on new policies or reviewing old policies, they’ve got these different connections to the larger institutions and have those kind of in-market points of view to pull from as they’re trying to determine what kinds of things are or aren’t important or what directions.
So right now actually is a great example where we have just in about two weeks’ time a senior trade policy official coming out from the East Coast to do a tour of the West Coast, just talk with different institutions and see what kinds of things would be important to them in a future US UK financial services trade agreement. Now, of course they’re not going to be making this agreement in the room. They’re not going to be pulling these people in and saying, “We promise that we’re going to do this thing for you.”
But they want those voices, and the companies like having their voice at that table also because these are massive decisions that are going to affect them pretty drastically. So having that opportunity is a really great resource that we’re able to provide a lot of these larger companies.
Patrick Stroth: That’s absolutely a channel that can’t be found elsewhere. So that’s one huge benefit. As I think about, you mentioned with the expensive of San Francisco particularly, but the Bay Area in general, I keep wondering why companies overseas would look to come to the US, just because it’s prohibitively expensive. Less of a concern with regard to culture or language. But just the cost of doing business here, I can imagine the regulatory is pretty steep compared to other places. But what drives the demand or drives UK companies to look to the United States for expansion?
Jacob Whitish: You kind of nailed part of it all already in the question. Just in terms of language and ease of doing business to a certain extent are translatable from, especially in this case, from the UK. But really from a lot of different countries around the world. If you don’t have to change the language that you’re working in, that’s already a big benefit.
On top of that, the US is a massive market. Most companies will eventually find their way to either doing business with someone in the US or full-on opening a new office or trying to get access into this market. It’s just such a great opportunity. And then likewise for US companies looking at the UK, business laws are very friendly, corporate tax rate is pretty darn low and falling. It’s one of the largest economies in total investments behind the US and China. So there’s just tons of great opportunities around the markets themselves.
But then on top of that, when you’re looking at especially UK company coming back to the US, access to capital is a massive driver. Most tech startups, I think, at least the ones that are going to be larger names eventually, always find their way to Silicon Valley or New York, or for some other sectors. Like life sciences going up to Boston, or the payments industry out to Atlanta. These companies will make their way out to the US to just try and get that growth capital to really fuel their overall growth as a company.
I think one of the kind of gaps in the market for the UK that’s also a great opportunity is that there is a pretty good amount of early stage capital around, but not as much later stage capital. In terms of like the CDE plus rounds, these massive rounds that take a lot more kind of institutional capital and knowledge to really be able to drive those sorts of deals.
There’s also a really good component, it ties into that in terms of talent. Tons and tons and tons of talent that have been through the entire life cycle of a company out here. They’ve gone from two folks in a room all the way up through IPO, exited, and started over again. The UK has a great tech scene and still growing. But they don’t have just as much of that sort of multigenerational founder and institutional knowledge of how do you go from this small company in one room all the way up to something like an IPO.
They have a great amount of talent that is kind of going up through mid-stage, and then going through different mergers, acquisitions, or other sorts of liquidity events or exit. Not as many that have taken it from that sort of mid cap to massive company. So, yeah, a lot of companies.
Patrick Stroth: The pool of … Yeah, I think the pool of serial entrepreneurs every year it gets deeper and deeper. And one thing that’s unique about being out here in Silicon Valley is that I keep seeing these people become enormously successful, enormously wealthy, and think to myself, “Well, they’re going to get their clean exit, which we try to do with the insuring their M&A transaction, and think they would ride off into the sunset. Buy an island, go shopping for yachts, and all that fun stuff.”
And what do they do? They get bored. They turn right around and open up another firm and start participating in that. And that’s been going on now for the past 20 plus years. And so, yeah, there is definitely that talent pool has gotten much, much deeper.
Jacob Whitish: Definitely. Definitely. So you get a lot of people that will bring their companies out here just to try and tap into those kinds of networks and resources that come along with all of that. They’re getting better. They’re starting to very slowly move in that direction. I’m seeing a lot more founders in the UK network go back and start to do that next generation of businesses. Not as mature as say West Coast US, but it’s getting there.
In the meantime, you’re still going to see a ton of these companies coming out here to the US for either that access to capital, access to talent, or just access to market overall.
Patrick Stroth: What about the talent on the entry level, and I’m thinking about this just from your opinion, slightly off topic. But if a US company were looking to expand into the UK, and there would be a need for entry level tech talent there, I’d imagine that talent pool in the UK is broadening and deepening as well.
Jacob Whitish: Oh, absolutely. It’s actually some of the best minds in their industries are coming out of the UK. Things like DeepMind and some of these great artificial intelligence and deep learning companies, they’re coming straight out of that Oxford, Cambridge areas, right out of the universities. Overall, the UK definitely has pretty much anything that you’re going to be looking for. If you want the financial talent, London has it, as well as just kind of a nice mix of a little bit of everything.
The Manchester Midlands area has some great kind of back-end, back-office talent. Scotland has the financial and asset management experience. Northern Ireland is starting to become this really interesting tech sort of little paradise. In fact, they’ve got some really great programs out there where they’ll … Actually, the government will go out to … Or I guess lack of government, sorry. Will go out to universities to work with them and create custom programs to train individuals specifically for companies, if a company is willing to put a large enough investment into their local economy.
And so there’s some really interesting little sub sectors. And you look at it, Wales, or you get this awesome hardware talent in the semiconductor space. And so there’s a little bit of everything all over. And you can find pretty much whatever talent you want somewhere within the UK.
Patrick Stroth: Well, on the US side we’ve got this huge market. It’s not only large, it’s wealthy. And it’s deeply wealthy, which attracts a lot of suitors here. But it can’t be all great. What are some of the challenges that companies face coming here? And don’t just list the challenges for me, but support that with what can you do to help companies overcome these challenges?
Jacob Whitish: Sure. I mean, I can kind of actually play a little bit off of that last question even and say that talent is a double-edged sword. Out here you have a ton of great talent, but it’s also really expensive and in very high demand. So for a smaller company coming in, especially if they’ve maybe only got a couple rounds of funding under their belts and not terribly deep pockets, might be shocked at what the total comp packages are for, especially like really hardcore development talent.
But really anybody out here in the Bay Area is going to be a lot more expensive than somewhere else. Which is kind of also then why a lot of times I’ll be working with these companies and kind of pushing back a little bit to say, “Is this the right place for you? Maybe you should look at Phoenix and go check out Arizona’s new FinTech sandbox and see what you can do with that. Or go up to Seattle and-
Patrick Stroth: Idaho-
Jacob Whitish: … find out what’s going on up there.”
Idaho. Yeah, there’s tons of great kind of second-tier cities that have lots of opportunities, lots of great talent. Maybe not quite Bay Area level talent, but still great talent. And even that’s changing. People are getting sick of living here in the Bay Area and they’re moving out. So those people are still looking for jobs, and they’re still great talent. So that’s definitely one of the bigger challenges.
Within the financial services sector specifically, I would say one of the biggest things is just the regulatory environment. It is absolutely insane for companies coming out here that are used to having one overarching regulatory regime for the entire country, and then they get out here to the US and see that there’s 50 different states, which are basically 50 different countries, even though it’s all one massive country.
And all of a sudden they just kind of get paralyzed and don’t know what to do. How do you handle 50 different regulatory regimes? And not to mention just the paperwork involved in all of those sort of applications and compliance measures that are required for all of that. So that’s definitely the number one thing that I hear from anyone within the financial industry, is just trying to figure out that sort of environment.
Now, on that side of things there’s all kinds of different opportunities like working with private equity groups to find things like reverse merger opportunities, or even just straight-out purchase opportunities to basically find a company in the US that is maybe not doing so hot financially but already has those licenses in place. So that’s a great opportunity for companies coming into the US to be able to, I won’t say circumvents the rules, because it’s not circumventing it. It’s all perfectly legal. But sort of accelerate the process of getting into market quickly.
There’s also different strategies like just saying target New York and California, go after the biggest economies, or find local partners that you can just partner up with on deals. All of these are different things that we would bring in a lot of the experts from our network to help identify these opportunities, or to just try and figure out what opportunities are available for a particular situation.
Patrick Stroth: Great. So you’ve got not only the network of service providers that you probably, just in addition to the service providers you’ve got the law firms, you’ve got other advisors. And then you’ve got relations with private equity firms and other organizations such as that.
Jacob Whitish: Absolutely, absolutely. If you are a service provider out there or any sort of firm that works with other companies, frankly, we want to have you in our network. We want to know who you are, what you’re doing, where you’re at, and what kinds of companies are you looking for. And we may or may not have a lot of referrals for you, but maybe we will.
That’s just kind of part of our game is knowing who’s out there, who’s doing what, how we can be of help, so that when a company approaches us or gets referred into us and they say, :Hey, I have a problem with X,” hopefully we’re going to know someone who can fix X. So that’s at the end of the day the biggest value that we can provide.
Patrick Stroth: Yeah. I mean, the analogy I have with that and the importance of having a good network like that and the value you add there, it’s no simpler analogy than if you were to leave your home or your work and move across the state or to another country. You just want to find somebody who says, “Well, where’s a good pizza place? Where do I go shopping, and where can I get my hair done?
Jacob Whitish: Yeah. Exactly
Patrick Stroth: And they’re really mundane things, but everybody needs them. So I think that’s a great source. And you’re a trusted advisor in this because your objective is to help out the taxpayers and add value for the UK companies. And so you’re a real credible resource because you’re looking out for their best interests.
The idea on the reverse mergers is real interesting, just because it’s nothing more than a workaround. But it’s also, if you’ve got owners and founders or investors that have a company that is maybe not doing well financially, they can leverage an asset that they didn’t realize they had, which are their licenses, that maybe they did not have as great value in them. Now suddenly there’s some great added value in the licenses and so forth to facilitate a reverse merger.
So with that in mind, who’s an ideal candidate for UK companies to partner with? On the reverse merger in that scope?
Jacob Whitish: You know, it really depends a lot on the company that is … So like the UK side company that’s coming in and what sort of services that they’re doing. It wouldn’t make a whole lot of sense for an insurance company to try and partner up with a bank because they’re not going to have the same licenses. So a lot of times it’s going to be kind of the smaller to midsize regional institutions. Perhaps they’ve been around for a while and maybe it’s a generational shift sort of thing.
There’s this great opportunity right now where there’s this massive shift from one generation to the next of assets and businesses. And sometimes the younger generations don’t necessarily want to step into the family business. So you have this older generation of maybe the founder who they want some liquidity to be able to go off and fund their retirement, and they just don’t really want to operate it anymore as the day-to-day person.
So maybe this is a great opportunity for a company to come in and partner with them, reverse merger with them. All kinds of different creative arrangements that you could find. But in the end of the day, then you have this UK company coming in being able to relatively easily get access to these licenses. Perhaps even to built-in clients. And then for the merging company, then they have a liquidity event. They have the ability to, maybe if it’s this kind of generational issue, walk away to a nicely funded retirement and not have to worry about it anymore.
Or there’s a lot of kind of fun, creative ways that companies can approach this and find different partners that maybe they wouldn’t have even expected. Maybe it’s a card issuer looking to partner up with a small regional bank and be able to cross promote each other’s products into each other’s clients. The opportunities are really just very wide open.
Patrick Stroth: I was thinking just that the small regional banks as being one of those ideas or candidates out there, because there are fewer and fewer of those out here. But they don’t want to get rolled up by the major banks. They’d prefer to have something else happen. But what’s usually the situation is one regional bank is acquiring another regional bank.
So I think that would be an ideal opportunity for a UK-based financial institution who wants to get a foothold where they don’t have to be in New York, where they can be in a couple of other regions. I think that would be an ideal place, particularly in the South, and in some parts of California.
The other idea I was just saying off the top of my head, accounting firms.
Jacob Whitish: Accounting firms, wealth management, anything that has some sort of licensure or governmental oversight, great opportunities.
Patrick Stroth: Okay. I can see that both in the insurance agency and brokerage business and in the accounting space you have a lot of independent small regional organizations. They are going through this very specific generational change, and you’re not having the next generation coming in, stepping in in the shoes of the predecessor. So those opportunities are going to be around for the next several years. What trends do you see in UK expansion to the US going forward?
Jacob Whitish: You know, kind of overall, I’ve seen companies coming out a lot earlier in their life cycle. Used to be waiting a little bit longer, getting a little bit more mature in their home market. More and more it’s been a lot of companies coming out earlier and earlier wanting to not quite necessarily shun their own market, but they want a piece of the US pie earlier and earlier in their life cycles.
So a lot of times they’ll be coming out, maybe even too early at times. And I’ve had that conversation with companies before of saying, “Do you really think that right now is the right opportunity for you to come out?” Of course earlier and earlier for funding, as the overall funding climate is changing. And I know we said we weren’t going to go there, but I think this fall the political situation in the UK is going to probably decide a lot of what the future direction of those different trends are going to be looking like.
Patrick Stroth: Is there also just a byproduct, not to pump you guys up too much with you guys, but I mean is there a growing awareness of the services that you’re providing in the Department for International Trade, where your resources are clearly providing some benefits. And there’s got to be more awareness. So if you’ve got somebody who’s going to help you out, I mean that could probably speed up the decision process too.
Jacob Whitish: I mean, that would definitely be … I wish I could say that. I’m not sure what the kind of overall volumes are. But based on just kind of our own internal metrics, there’s definitely been a growth in the number of companies that have started to figure out that we’re out here and we exist. I know we’ve, as the Department for International Trade specifically, only been around for a few years. There have been some other incarnations in the past. But as far a name recognition goes, it’s definitely a growing trend. But I think we’re on the right track.
We’ve got some really great leadership in place that’s not tied to politics, so they’re going to be around for a little while. And it’s definitely a great resource. I wish that more companies knew that we were out here. Almost everything that we do is absolutely free. And we are all sworn to secrecy. We take actual, have to get our actual security clearances and everything to be here, and everything that we do is considered commercially confidential.
So unless the company tells us that we can talk about them publicly, or they have said something publicly themselves, we keep tight-lipped on it, everybody’s plans.
Patrick Stroth: Well, I’m new to the knowing about what the Department for International Trade does, and it’s a shame that you are one of the best kept secrets out there in the UK government. And the more we can advocate for you, and the more people learn about the services you have, both here and abroad, I think the better it’s going to be for a lot of organizations and a lot of people. Because one of the thing is just really unique and the reason why Silicon Valley is the epicenter for all this great tech innovation and growth and so forth, is unlike generations past where in order to succeed you had to literally do it yourself. If you couldn’t steal it from somebody else, you did it yourself, and you grew bigger and bigger and you did it on your own for yourself. And you wouldn’t because of competitive reasons or envy or fear, you wouldn’t share the secret sauce with anybody else.
That’s how what happens here. This is probably one of the most a collaborative environments out here where there are always people looking to provide some kind of support, some kind of assistance, mentorship, whatever. Sometimes for obvious profit motives, others for altruistic because they have the vision that you know the rising tide lifts all boats.
So from accelerators, to incubators, to mentors, to angels, sources of funding and everything. There are so many resources out here getting founders from zero to one, and then from one to two, and then from two to Google. You know, this is just another great resource out there, and it’s been an absolute pleasure learning about this. And Jacob, if there are people out here that would like to just benefit from all the things you have, how can they get ahold of you?
Jacob Whitish: Sure. I am on LinkedIn is probably the easiest place to find me under my name, Jacob Whitish. W-H-I-T-I-S-H. Likewise anybody can feel free to email me directly at email@example.com. You can probably put that in the show notes or something.
Patrick Stroth: We’ll make sure we have that whole mouthful in the show notes and so forth. And I would also say, unlike me from time to time, I may not be on my LinkedIn on a daily basis. Jacob is on it hourly. So if you put a connect request out there you’re going to get a response almost in real time. So I can personally vouch for that. Jacob, thank you. It’s been a pleasure speaking with you and we will speak again.
Jacob Whitish: Absolutely. Thank you so much, Patrick.
As more players in the world of M&A come to realize its tremendous value, there have been several big changes in the use of Representations and Warranty (R&W) insurance to protect Buyers and Sellers post-transaction. (Any financial loss resulting from a breach of the Seller’s representations in the purchase-sale agreement are paid by the insurer because they take on the indemnity obligation from the Seller.)
I’ve mentioned previously that the number of insurance companies offering this specialized type of coverage is more than 20 today, compared to just four in 2014.
There are also more policies being written than ever before. A part of that is the fact that just a few years ago insurers only felt comfortable insuring deals of $100M or more, and then only with audited financials.
Now, they are offering coverage for deals under $20M… in fact, they’ll now go as low as $15M… without requiring a strict financial audit during the due diligence process.
The reason? The R&W market has matured, so to speak. Insurance companies are more comfortable with it as they’ve had successful experiences with larger deals. Underwriters are familiar with the product and the claims process. (Only about 20% of deals result in claims.)
Now, insurers are looking to increase their bandwidth and increase the number of clients they cover. And that means they have to look at smaller clients.
The risks are smaller and can’t be mitigated as much as with larger clients. But by bringing down the rates enough, they can cover the small deals. And because the amounts involved are so low, there isn’t much financial risk.
Still, sub-$20M deals are different in a few key ways:
There are many more M&A deals on the smaller side that don’t get the press of the big-name transactions. And I think the use of R&W insurance to cover transactions at any level can only go up as it becomes more well-known, especially among PE firms and VC funds.
I’m an optimist by nature. But if there is a slowdown in the economy, you will see a lot of owners and founders running to the door to close out business – that’ll cause a spike in sub-$100M transactions.
And in order to capitalize on their return and secure more cash at closing in uncertain economic times, they’ll want an R&W policy covering the deal.
If you’re involved in an M&A deal under $20M and are interested in the protection that comes with Representations and Warranty insurance, I’d invite you call me, Patrick Stroth, at 415-806-2356 or send an email to firstname.lastname@example.org. I’m experienced in deals of all sizes and I have the contacts at the insurers to secure the coverage you need.
When we usually see cross-border deals, it’s a U.S. company acquiring a foreign business. But increasingly the reverse is happening, says Craig Lilly, corporate partner at the Palo Alto office of Baker McKenzie, and there are three primary drivers for that trend.
But cross-border deals with foreign buyers aren’t without their pitfalls, especially with newly enacted regulatory and anti-trust and merger controls – at that’s just the start. Just look at what is happening with Chinese telecom giant Huawei.
Cross-border M&A is far from a done deal. Foreign companies are still acquiring U.S. companies, says Craig, but just engaging experts like his company to shepherd the transaction.
We talk about where cross-border M&A is headed in 2019 and beyond, as well as…
Mentioned in This Episode: www.bakermckenzie.com and Winning Strategies in Cross Border Deals Tips for Success Presentation
Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters where I speak to 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 Craig Lilly, M&A and corporate partner at the law firm Baker McKenzie in their Palo Alto office. Craig’s practice focuses on acquisitions, divestitures, joint ventures, and strategic investments.
But it’s in complex cross border deals where he’s really developed great expertise and he’s now thought of as an industry leader. Craig’s been a regular contributor on Bloomberg, the Wall Street Journal, and other M&A specific publications. Craig, welcome to the program and thanks for joining me today.
Craig Lilly: Thank you, Patrick. I’m glad to be on the program.
Patrick Stroth: Well, Craig, now that we’re getting past the first quarter here in 2019 rather than just focusing on cross border deals which we’re going to get into in depth. Tell me what your perspective is as an expert on what the state of M&A is here in 2019.
Craig Lilly: Well, I think MNA is very strong and still in 2019, the values is increasing even though the volume may be slightly lower. 79% of executives say that the M&A will increase in or remain the same in 2019. We’re seeing record amounts of a private equity raise as well as venture raise which is really good for the ecosystem in mergers and acquisitions. In the last 12 months alone, we’ve seen over 3.6 trillion in deal value over 19,000 deals in US and Europe. So that’s a very strong technology M&A is up 20%.
Also, we’re seeing M&A more institutionalized. 20% of all targets, Pat, are backed by either private equity venture firms or professional investors. Also, there’s record levels of what we’d call dry powder or money to make acquisitions. The PE dry powder is estimated to be over 1.7 trillion and also, the top five tech companies alone have over 340 billion in dry powder. And that includes Apple, Google, Microsoft, Facebook, and Amazon. So the key M&A drivers that we’re seeing are really for strategics are customer expansion and diversification. And so those are all I think big drivers for M&A and which will continue in 2019.
Patrick Stroth: Well, we’ve got just a confluence of changes that have been happening over the world where you’ve got either the world getting flatter or a lot of capital looking for places to be put and maybe people aren’t looking at their backyards anymore. They’re looking overseas. They’re looking cross border. And which is why I wanted to come speak with you about this. But before we get into the technical issues on cross border and the ins and outs of it. Give us a little bit of context for you. What brought you into becoming an M&A attorney first and then to specialize in cross border acquisitions?
Craig Lilly: Well, I had a background in financing and accounting so I was always interested in M&A and investments which really drew me into it. I originally worked in private equity back in the cottage days of private equity when it was a very early industry. And then I started working in technology over the last 16 years or so. And one of the things to that really interests me about the technology and in M&A is that companies at earlier and earlier stages are expanding internationally which is a big driver of cross border M&A. So those are the things that really interest me is the international aspects, the complexity, and also getting to learn new industries and verticals.
Patrick Stroth: So what makes a deal a cross border transaction? Is it as simple as we think just anything outside the US borders?
Craig Lilly: Well, really it’s really any deal with foreign aspects. It could be the buyer or the seller or material assets or it could be a US company acquiring another US company that has material foreign assets as subsidiaries. So typically almost every kind of major US corporation has some type of foreign aspects. So all those acquisitions even though it may be a domestic acquisition really is a cross border because of the foreign aspects or subsidiaries that a US company may have.
And we’re seeing this in an earlier stages of the companies. A lot of early companies are young companies are expanding overseas whether to develop technology, develop manufacturing or to acquire customers through diversification.
Patrick Stroth: A lot of times we’re thinking of US going outside and looking to foreign markets for acquisition targets. But it’s also on the flip side, according to what you just told us where you’ve got foreign-owned companies coming to the US which intuitively we think that the US is too expensive a market for targets. But that’s not necessarily the case. There are things that must be driving these foreign-owned companies to come and invest in the US. What drives the demand from their side to come here?
Craig Lilly: I think it’s three primary drivers for foreign companies to want to make acquisitions in the US. The first one obviously is technology. We’re seeing the fourth industrial revolution happen here in United States where technology is embedded in almost every different vertical or industry whether it’s automotive or manufacturing or artificial intelligence within industrial manufacturing. And so that’s spurring a lot of the investments and acquisitions by foreign acquirers here in the US.
The second is just customer acquisition. Companies are looking to acquire customers and essentially diversify their base. And a third driver really is not only the diversification within a customer base but diversifying their own different revenue streams where they could be diversifying in a new analogous business that maybe is very synergistic with your existing line of businesses.
Patrick Stroth: I agree. One of the things that changed my perspective when we talked about this a while ago was that the focus always on customer basis and so forth. People immediately think China or India where they’re billions of potential customers out there completely overlooking the fact that while we may not have the largest population. We probably have one of the richest. So if you can make a stand here in America with a very friendly consumer base, you’ll do very, very well. And that was one of the things that really came up when you and I were talking about the US being such a great target for them. This can’t all be that easy. What are the challenges that are germane to cross border deals versus ups or domestic deal?
Craig Lilly: Well, there’s definitely changes or challenges in regulatory, whether they are antitrust or merger controls. Obviously, CFIUS which we’ll get into later is a major challenge for companies investing in the US and CFIUS is the Committee on Foreign Investments in the United States. And also, structure and tax issues. Furthermore, key issues when a foreign company comes here is complying with employment laws. It could be unions or the WARN Act. When you want to terminate employees. Intellectual property, data privacy, and security are a major concern as well.
You’re seeing often more and more companies are having inadvertent data breaches. So that’s a key issue for any company in any type of transaction particularly for cross border where you could have cultural issues and other different challenges in data privacy. Also, anti-corruption is always a big challenge for companies and having internal compliance programs implemented to correctly deal with those types of issues. And obviously, in any type of transaction diligence, culture, deal execution, and also, post-closing integration is a major issue. And in post-closing integration, something doesn’t start after closing. It really starts very early in the acquisition process.
Patrick Stroth: Can I ask you this is a little off topic but with all of those challenges that are there that’s probably a role that you and your firm will give guidance to if you can’t have absolute on the ground consulting recommendations you have resources or can provide resources to companies to address those various areas of concern?
Craig Lilly: All right. We have great breadth in over 45 countries around the world and have over 70 offices. So we have experts in all these areas. And really that’s what you need is a specialist or cross border specialist teams because of the numerous landlines involved in foreign deals and some of the really kind of two big areas that companies are very concerned a bit right now obviously is data privacy. But also the anti-corruption issues that are involved and because of the stiff penalties can be imposed and that’s really you outbound or inbound.
And so we see companies take a very in-depth look at that. One of the things we also look at every transaction, we try to very early on the process is sit down with a client and discuss what are the really high-risk areas, where is really the concerns for the company, where’s the value? It could be in the intellectual property and so we’re going to really take a deep dive in intellectual property to potentially a freedom operate analysis to make sure that they’re protected. And if they do buy the company that they have the freedom to use it the way that they intended to have synergies with their existing businesses.
Patrick Stroth: Talk about CFIUS a little bit. Should every company now be aware of it, not just the ones that are the traditional chemicals and military applications number one? And then number two, CFIUS is US. Explain what happens if other countries have something similar.
Craig Lilly: Well, the Committee on Foreign Investments in the US or CFIUS is where a foreign company proposes to acquire a target a US business that generally either produces designs, test, manufactures, fabricates or develops one or more critical technologies. And because of the recent changes in the law, even a 1% investment in a company with critical technologies could trigger a CFIUS filing. So its critical technologies has been expanded for CFIUS and includes such things as defense articles, and defense services, commodity software, and technologies on commerce control list or controlled for reasons relating to the national security, chemical or biological weapons, missile technologies or for reasons relating to regional stability or surreptitious listening.
It also can include energy and things subject to Department of Energy regulations such as nuclear equipment, software, and technologies, and also includes emerging and foundational technologies which is not to be defined which is very broad. There’s actually currently 27 pilot program industries identified by NAICS code which will require mandatory filings. Also, CFIUS applies if the target owns, operates or manufacturers or supplies critical infrastructure or real estate.
And critical infrastructure is broadly defined. It can include systems and assets so vital to the United States that the incapacity or destruction would have a debilitating impact on national security. For example, the purchase or lease or incession of a foreign person to a foreign person or any of real estate is located in the United States and is located within an airport or a maritime port or close in proximity to a US military installation that is sensitive for national security reasons.
And why should an acquirer be concerned about CFIUS? Well, US Treasury which oversees this can unwind the transaction or impose very harsh equitable remedies and fine. Also, each party can pay up to the amount of the purchase price for the fine. And yes, other countries do have similar laws. The EU also has a similar law. Seven transactions last year were blocked by the EU and we had over 14 deals either blocked or abandoned during the last few years. Over 240 deals were actually formally reviewed by the US in last year. And so CFIUS has very wide overreaching kind of application.
Previously before the recent changes, a company that was making an acquisition in the US could make an investment of 9.9% or less without being subject to CFIUS. But now it applies even to a 1% investment in critical technologies and that’s a mandatory filing. So it’s a very broad expansive type of law and it’s not just only in the US. EU also has these laws as well and a lot of people also are also concerned about China. And why is China’s such a huge presence in cross border here over the last decade? Well, in 2008, China inbound was 1 billion. However, eight years later, by 2016 inbound was 48 billion.
So that alone has led to a lot of the concern over CFIUS. Also, there are a lot of changes in capital markets and venture capital. Previously DARPA was very heavily involved if there was some type of sensitive technology being developed. But because of the expansion in private markets and venture capital, there’s all types of new technologies that are being developed where DARPA is not involved at all anymore. It used to be decades ago, DARPA would be almost involved in any type of development of critical technologies because it was usually done by larger companies. Because of the expansive venture capital over the last 20 or more years. Now we’re seeing critical technologies being developed even with very small companies.
Patrick Stroth: At what stage are you filing for CFIUS? Is this where you pass a letter of intent and you’re beginning to get things structured up there or is it something where it can be preemptively checked before advancing too far into an M&A transaction?
Craig Lilly: Well, generally, we will recommend clients to do a CFIUS assessment of the risk very early on prior to the letter of intent stage. Typically, companies will be even talking with the Treasury even during this letter of intent stage. And that’s generally what we recommend so that we can basically get some initial advice from the Treasury as to whether this is a very high-risk type of assessment which would require a filing. And in most cases, it can be a mandatory filing.
But typically, you will file this generally right around or medially before the execution of the contract. And that’s just to sign a contract where you may later do the acquisition usually in a two-step type transaction.
Patrick Stroth: The other question for you. Its something we didn’t talk about. But you triggered my thought process here. Compared to a US deal, I know every deal is different depending in industry and size and everything but are cross border deals routinely larger? And if so, how much larger than a domestic deal for technology or pick a case study?
Craig Lilly: Well, historically, we saw a lot of large investments but now we’re seeing even the very small investments. There has been just a rush of investments over the last decade of all types of foreign and Asian investors in the US it was particularly with technology companies and so that’s helped a big surge in venture capital investment as well. But we’re seeing across the board obviously, some of the investments by some of the Asian investors has decreased over the last year just because of some of the CFIUS concerns in the regulatory landscape. But there’s no particular size for cross border or a foreign investment we’re seeing across the board all different shapes and sizes just like you would see with a domestic acquisition.
Patrick Stroth: And assuming that CFIUS gets taken care of. There are the other kinds of risks out there that are germane to M&A. A lot of those risks can be mitigated or controlled or completely eliminated with ensuring a deal through rep and warranty insurance and it’s been used at an increasing rate in domestic deals. How has rep and warranty impacted cross border M&A?
Craig Lilly: Well, representation and warranty insurance actually was more expensive in the EU and in Europe before it really came to the US. And so it’s very prevalent in Europe and generally, there’s lower price premiums as well. As you know, representation and warranty insurance essentially allows sellers to walk away with more cash at closing while giving buyer’s interest protected in the form of an insurance policy against loss.
So typically whether it’s in domestic buyers in Europe or otherwise, there’s been the landscape for representation and warranty insurance and in Europe, particularly is fairly widely accepted. And because it’s a less litigious type environment to typically the prices and premiums and risk retention’s are much lower for a Europe-type acquisition.
Patrick Stroth: Craig, you mentioned China before and how they ramped up very extensively of going from a billion dollars in deals and then a very short term, they come up to $48 billion in transactions. What do you see aside from the slow down right now which could be temporary but what do you see going forward both in Asia and cross border M&A overall? What trends do you see there?
Craig Lilly: Well, it definitely a cross border M&A has slowed down because of CFIUS and you’ve seen with the recent trade restrictions that were imposed on the Huawei by the US that that’s a definitely an impact on perception at least for Asian investors here in the US. I definitely think it’ll probably be very slow for a lot of the Asian investments in the US. I do think you’ll see more and more US buyers throughout the world whether it’s in Asia or in Europe. I think some of the big drivers for that though is just because there’s a lot of dry powder available for not only private equity funds but also a lot of the large institutional and strategics.
As I mentioned before, the top five tech companies are 340 billion in dry powder. But also you’re seeing a lot of kind of old-line companies that are really trying to expand whether it’s through technology whether it’s a FinTech or an agricultural tech or some other kind of emerging tech or they’re trying to diversify their customer base or their revenue streams. And also you’re seeing obviously you see continued outsourcing whether it’s through manufacturing or assembling happen and that’s throughout Asia. And also we’re even seeing a lot more in Mexico and Latin America because of the close proximity and probably the more respect or for the cultural aspects of the United States including protection of IP.
So I think we’ll see kind of more and more US companies do a lot more cross border. The acquisition of tech is obviously a very driving aspect but obviously, the customers diversification, aqua hires, and other things too. And I think you’re seeing this across all different types of verticals whether its artificial intelligence or robotics, FinTech. Of course, auto tech’s been a very big area servicing a lot more of different transportation companies that are trying to expand and drilling through multiple verticals here. It’s a whole… Electric car, autonomous vehicles. The communication slash smart car and also ride sharing too as well. Those are all things that are kind of driving the transportation industry and I think we’ll continue to see that.
Patrick Stroth: So we’ll be doing a lot more US buying outside our borders as opposed to the last couple of years where we’ve had predominantly Asians coming and buying into the US. That trend looks supportive because it seems that there are more and more service providers out there and advisors such as Baker McKenzie that can make things easier for US buyers to go abroad where they probably were reluctant to do that because of a lot of the bear traps out there that they didn’t know what they didn’t know. And they’ve got resources like yours now that they can bring to bear that will help. At the same time, CFIUS is making it harder for the foreign-owned companies to come in and maybe easier for us to go out. So it may have not the same sustainability or robust outlook as you do domestic but it’s still fairly positive. Would you agree?
Craig Lilly: No, I agree. And also we’re seeing kind of a trend that’s really developed over the last few years is that you’ll see a US slash Delaware Corporation basically as a holding company but really their operations are really abroad and even though any M&A or acquisition is of the Delaware company as a domestic acquisition, essentially the company is a foreign company. And so we’ve seen a lot more of those types of transactions and that’s obviously been spurred by the not a venture capital investment here in the United States as well. And I think we’ll see that continue.
That’s why I’m saying M&A is also becoming more institutional-wise where 20% of all targets are backed by some type of institutional investor whether its private equity or venture capital. So I think we’ll see that continue. Obviously, we’ll see a lot of I think secondary private equity sales. And what that means is one private equity funds selling a portfolio company to another private equity fund. Now those type of exits account for somewhere close to 30% now of all private equity exits. I think that trend will continue as well.
Patrick Stroth: Well, you’ve got a lot there for us to consider, particularly just not the cultural differences but a lot of the other regulatory and compliance traps and so forth and just how things are different outside. But that shouldn’t stop you from taking advantage of some great opportunities out there. And if there are organizations like you and Baker McKenzie that can be brought to help smooth that transition, that’s all the better for a lot of owners and founders out there. Craig, how can our audience reach you? Because I’m sure they’ve got a lot more questions than I can give you.
Craig Lilly: Well, I’ll have a presentation which I’ll have on Rubicon’s website after this. And then also you can reach me at our website or my email address which is just email@example.com. Also, you can reach me through my phone number 650-251-5947 plus I’ll have a cross border presentation that I’ll post on Rubicon’s website that can be accessible and will have my information as well.
Patrick Stroth: Well, that’s absolutely fantastic. Thank you very much. And you can check the show notes here under the insights tab at Rubicon, R-U-B-I-C-O-N-I-N-S as in Sam, rubiconins.com. Go to the insights tab there and you’ll have the show notes along with a link to Craig’s presentation and you can also reach out to Craig directly. Craig, very informative. You cracked open a lot of different avenues of thought there so I greatly appreciate it. My audience will appreciate it as well. Have a good day. Thanks so much for joining us today.
Craig Lilly: Thank you, Patrick, very much.
There is nothing venture capital funds like more than a clean exit in which they can take their money from sales of portfolio companies, distribute funds as necessary to investors, and then move on to new acquisitions with the money they earned from the sale.
But sometimes there’s an issue and a VC fund can be sued by a third party well after the sale of the portfolio companies… with the fund being on the hook for millions.
That’s not such a clean exit.
Here’s the scenario.
A VC fund has a portfolio of 10 tech companies. They were all promising startups. Some fared poorly. Some did okay. With such early stage companies, that’s just the cost of doing business. Nobody can tell for certain what startups will crash and burn.
But some of the portfolio companies did very well in growing quickly and seeing revenues soar, thanks to breakthrough tech products, not to mention guidance from the fund.
After a few years, the fund had plenty of potential Buyers come calling. The VC fund was happy to offload several of the portfolio companies, resulting in a tidy profit overall. The fund managers are happy. The investors are happy to see a return on their seed capital.
Unfortunately, that fund, a legal vehicle for having equity in those portfolio companies, is still liable for lawsuits from third parties. And the fund also retained an obligation to indemnify the Buyer for contingent liabilities they were unwilling to assume.
And because a good portion of the capital from the sale of the portfolio companies is still held in reserve for contingent and/or tax liabilities that might come up, that capital is at risk and they are unable to make a final distribution.
It’s like if you had a bank account for several vacation rental properties you owned. You’ve already sold the properties. But because you still have that bank account with the sale proceeds, you are still linked legally to the properties.
If this lawsuit from an outside party is successful, the proceeds will come – be “clawed back” – from your reserves held in escrow against potential liabilities.
But there is a way to speed-up the liquidation of the fund so that all the proceeds can be distributed to investors instead of being held in case of potential clawbacks.
Fund managers can make a final distribution to the fund’s partners or interest holders without fear.
With this “fund liquidation insurance” in place, VC funds are able to close the “liquidity gap” after the sale of their portfolio companies and get a clean exit while still meeting the reserve requirement, which is what they’re after, of course, and maximize their returns.
This coverage can also be expanded to cover heirs, assigns, estates, spouses, and domestic partners of fund managers. With this insurance in place, policyholders are covered for identified and unidentified contingent obligations that fund managers would otherwise prepare for with reserves or holdbacks.
Fund liquidation insurance unlocks the millions (in some cases tens of millions) of dollars VCs are forced to keep in escrow/reserve to cover the cost of these potential liabilities.
Some Private Equity and similar investment funds are also using fund liquidation insurance rather than holdbacks during windups to cover back-end risks and to enable the efficient distribution of a fund’s proceeds to investors.
Divestments, which can be multi-year liabilities, can be insured, with the risk of clawback transferred completely to an insurance company. This is not Representations and Warranty Insurance (R&W), although the two types of policies can work in tandem.
This policy will be set up during the final stages of the liquidation process.
Potential liabilities, which can include sell indemnity caps, escrows, and excesses, are added up to form the policy limit. Premiums for this insurance are 1.3% to 3% of that limit, with an additional premium of 3% to 5% for unknown risks. It’s a low cost, considering all the benefits.
Another benefit: this specialized type of insurance could also be a deductible expense. Consult with your tax professional.
For more information on fund liquidation insurance, contact me, Patrick Stroth, at firstname.lastname@example.org or 415-806-2356.
It’s a good time to be alive for Buyers and Sellers in the M&A world.
The use of Representations and Warranty (R&W) insurance, is more widespread than ever, with deals as low as $15M considered insurable. That’s down from a minimal deal size of $100M just a couple of years ago.
What makes R&W coverage so attractive?
It protects both Buyer and Seller if there is a financial loss resulting from a breach of the Seller’s representations that were outlined in a purchase-sale agreement.
The insurer covers the losses in case of a breach because they take on the indemnity obligation from the Seller.
Plus, the number of insurance companies offering this coverage has jumped from 4 in 2014 to more than 20 today.
The news comes from the latest report from one the largest insurance companies in the R&W and broader M&A insurance space, AIG. The report, their fourth in the Claims Intelligence Series report, is called Taxing Times for M&A Insurance.
When this report is released, those involved in the M&A industry and Private Equity pay close attention to the trends it highlights.
The bottom line is that more R&W policies are being written than ever before as both Buyers and Sellers come to understand the benefits such a policy will bring to their deal, such as…
Both sides of the table have a better understanding of how R&W works, not just for their negotiations, but when the time comes for actually “using” their policy.
That calls to mind another trend of note: more claims are being reported in this space. It’s not surprising as there are more insured deals out there. But never fear, insurance companies do pay claims in this space readily, unlike with some other forms of insurance. And, as of now, the trend of claims isn’t outpacing the premiums generated by R&W, so pricing and retentions will remain steady.
Plus, it’s clear that policyholders (the Buyers) are better prepared to work with the insurer to get their claims paid. The more policyholders purchase R&W, the more comfortable they’re getting as R&W impacts their negotiations as well as when a claim does happen, they are better prepared to:
A) Report a loss at a more favorable time (after the Retention level has dropped down 12 months after closing), and
B) When they do report a claim, they bring extensive supporting documents to help the insurer process the loss more efficiently and quickly. This comes from R&W claims representatives who work with policyholders directly on claims.
Note that 74% of breaches are reported to R&W Insurers within the first 18 months of closing. It’s more evidence that policyholders are more sophisticated in the use of R&W, with half of those breaches reported after 12 months when the Retention drop-down provision has been triggered.
Overall, this is a good sign that R&W insurance is steadily maturing and provides a sustainable tool for M&A.
Here are some of the raw numbers:
Buyers and Sellers interested in one of these R&W policies need a broker who specializes in R&W, works on these deals routinely, and is experienced in M&A.
I’d welcome the opportunity to speak with you further about how R&W insurance could benefit your next M&A deal. You can call me, Patrick Stroth, at 415-806-2356 or send an email to email@example.com, to set up a time to chat.
With any merger or acquisition, tax liability is a major concern because when you buy a company you assume its tax obligations. And you can bet the IRS is keeping close tabs on every transaction for taxable events, not to mention state tax authorities.
Not paying attention to tax treatments that apply to acquisitions could cost a Buyer significantly, and perhaps negate any advantage they had in the deal at all. For example, say a Buyer purchases because they think it has favorable tax deals, but the taxing authority disagrees. Then they’re on the hook for the tax bill.
But for a low premium, tax insurance, with policy terms generally set at six years, would protect against that disastrous event. Think of tax insurance as an “add-on” to Representations and Warranty insurance, kind of like you add earthquake or hurricane coverage to your homeowner’s policy.
That might be putting it too lightly, actually. Tax insurance protects a taxpayer (in this case, the acquiring company) if there is a failure of tax position arising from an M&A transaction, as well as reorganizations, accounting treatments, or investments.
A few examples of where tax liability insurance would be applicable (thanks to RT ProExec Transactional Risk’s recent white paper for this info and other helpful tips in this post):
Checking tax status is, of course, part of any Buyer’s due diligence. An outstanding tax bill is easy to find. But certain tax treatments the Seller insists are correct and up to standard, may not be. The Buyer, relying on its tax attorney’s specialized tax expertise, can insist those issues be taken care of pre-sale because they are exposures.
In the past, Sellers could go to the IRS and ask, “Is this an exposure?” and get a Private Letter Ruling okaying the request. But with the IRS swamped these days, they’re not really issued anymore.
When there are tax issues that come up for debate during due diligence for an M&A transaction, both sides bring in tax attorneys and each side makes the best determination in their opinion if this is a taxable transaction or not. They could take a light touch or be very conservative.
The Buyer will likely insist that a portion of any tax liability goes to the Seller, whose expert says they don’t agree with that determination. If there is a disagreement – get tax insurance.
Underwriters will get letters from tax attorneys from both sides outlining their arguments, along with supporting documents. It’s quite simple underwriting.
Underwriters want to see:
It generally takes the Underwriters about three to four days to deliver a preliminary response.
In some cases, M&A transactions can become tax-free transactions or tax-free exchanges. Of course, the IRS can always disagree and insist on back taxes and fines.
Some things to keep in mind:
When Underwriters aren’t confident about a specific tax position, they may set retention at where they think the tax authority would settle. When they are more confident, they will be okay with minimal retention by the insured or none at all.
If a tax memo convinces them that the IRS agrees that it is not a taxable event – good. If not, the IRS triggers an inspection.
The insurance will pay the legal costs to fight the IRS, as well as taxes, penalties, and fines if they lose. And, get this. If your insurance win was, let’s say, $5 million and the IRS says, “You just made $5 million in income,” the insurance will pay tax on that as well. That is known as a “gross-up.”
Tax liability insurance is more expensive than R&W (it generally costs between 3% to 6% of the limit), but it makes sense as the stakes are higher. So it should be an important part of any M&A transaction.
If you’d like to discuss how to protect yourself with tax liability insurance and how it coordinates with R&W coverage (because R&W does not include a Seller’s identified or disclosed tax risks), please call me, Patrick Stroth, at (415) 806-2356 or email me at firstname.lastname@example.org, to further discuss this vital insurance protection.
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.
Most companies are built for acquisition, and they can either go M&A, which is the usual route, or go through an IPO. But M&A isn’t right for every company, and there are certain cases where a company should consider an IPO instead.
To set some context. There were 190 IPOs in 2018, compared to 11,208 M&A transactions. For many companies, an acquisition just makes for a cleaner exit.
The big-name IPOs get a lot of attention in the press. But generally, they’re not good for investors because the majority of growth for those unicorns is already done. And you can’t expect much return.
For example, rideshare app Lyft got big fanfare for its IPO, but its stock price soon dropped. And now investors are suing Lyft for allegedly making misleading statements ahead of the public offering that inflated the share price. Shares are down 4% over the last month.
If your company has particular capital needs for expansion, an IPO can be a good way to secure that money. This is particularly the case where private money is hard to come by.
Why would a smaller company reject an IPO? The owner/founder is concerned about giving up control; if they go public, they’ll have to answer to the board. Keep in mind that if the owner still holds a majority of the shares, the board acts as a sounding board and can give advice, but he or she can essentially do what they want.
Just think of Jeff Bezos and Mark Zuckerberg.
When you have a board, you may not be as autonomous as you want to be, but it’s good to have oversight. Look at Elon Musk and how his social media comments, public behavior, and business decisions have been causing trouble for his companies.
The idea of having a big personality like Musk out there isn’t always the best for a company. It might be good for startup getting to $2 to $3 million. But after that you need adults in the room. A good board can rein in a founder while still letting their creativity flourish.
Owners are also concerned that if they go public, all their dreams and plans for their business go out the window. They feel they are giving long-term flexibility for short-term goals… that the focus will be on looking good on quarterly reports.
But a good leader will be able to integrate the long-term vision and still meet quarterly goals. Example: Jeff Bezos.
There’s never been a better time to go public for companies with those needs.
It’s a more business friendly environment now. Compliance reporting requirements are more routine and not as cumbersome as they once were. After several years into Sarbanes-Oxley, the process has been streamlined.
IPO is not the killer it was seven or eight years ago.
And even simply starting the IPO process can have an unexpected benefit. The first step if you’re considering an IPO is the S1 Filing. It’s the first set of disclosures to the SEC. The minute you submit it, that report, full of financial information about your company, becomes public record.
Strategic buyers will get a copy and know how much your company is worth… and consider buying it in an M&A deal. The valuation comes back at $100M, and they offer $200M.
It’s a good idea to put up a for sale sign.
Whether a company pursues an IPO or an exit through M&A depends on several factors specific to that business. But both can be viable options to be examined.
We focus a lot on M&A and IPOs in the tech space. And it can be helpful to examine the trends impacting Silicon Valley.
Download this free report for what’s on the horizon in this sector:
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.
The typical insurance broker wants to serve all their clients’ needs, especially if it’s a large client that requires various types of insurance to cover its operations.
The motivation is to be there for the client, who you know well. And the extra commission doesn’t hurt either.
But although a broker may have the best intentions, if the insurance required is out of the broker’s area of expertise (and no broker is master of all), this practice is actually not good for clients. They’re just not going to get the best value out of their policy.
When it comes to Representations and Warranty (R&W) insurance, a highly specialized variety that covers M&A deals, this is definitely the case.
R&W insurance protects both Buyer and Seller if there is a financial loss resulting from a breach of the Seller’s representations that were outlined in a purchase-sale agreement.
If there is a breach, the insurer covers the losses because the coverage transfers the indemnity obligation from the Seller.
Buyers and Sellers entering into deals who are interested in one of these policies need a broker who specializes in R&W insurance and does it routinely. Not to mention that the broker must understand how M&A works.
In R&W insurance, it’s not what you know, it’s what you don’t know that will come back to bite you.
Here’s why: On the surface, the coverages from one R&W policy to another are very similar. It’s rare when R&W insurance policy verbiage diverges greatly and have material coverage missing, which often happens with other types of business insurance. Within various business insurance programs, many coverages considered “essential” by some are deemed “optional” by others and therefore omitted to save costs (i.e. Uninsured/Underinsured Motorists coverage).
The scope of coverage for an R&W policy is determined by two elements: The Seller’s reps and the degree to which the Buyer performed diligence on those reps.
The key difference between R&W policies comes from decisions Underwriters make as to what degree they’re willing to cover all or most of the Seller’s warranties. This decision is based on two elements: The Underwriters’ appetite for risk in a certain business sector and the amount of diligence performed by the Buyer. It’s essential for the insurance broker to determine to what extent each insurer is willing to cover the majority of warranties, and where there may be flexibility.
Unlike other instances when business insurance is considered, R&W is brought to bear in M&A transactions where 100’s of millions are at stake. That’s both exhilarating and terrifying for the parties. Often times, Buyers and Sellers haven’t used R&W before, so they have no idea what to expect from the process. They need a “steady hand” to guide them, manage their expectations and inform them as to what they can expect.
Brokers who lack experience in placing R&W will struggle to navigate the underwriting process. Ultimately, this can put their clients through unnecessary stress due to delays and “surprises” that an experienced player can anticipate and prepare for.
An example would be to prepare Buyers for the time and access Underwriters will need with the Buyer’s team to review the diligence performed and which outside parties participated. Brokers unfamiliar with R&W might fail to prepare their clients for this, which can result in a huge burden on the Buyer.
A broker’s relationships with Underwriters at different insurance companies is essential. Different insurers have different appetites for risk. A qualified broker, who are also experienced with M&A, knows who does what.
Some insurers are comfortable with healthcare deals and the added regulatory scrutiny they bring.
Some insurers are comfortable in the up-and-coming cannabis market. (Actually, there’s only one insurer in this market so far, but more will ultimately follow.)
Some insurers will cover certain deals but only with so many strings attached that the client won’t actually qualify, or the cost will be too high.
Insurance companies’ appetite for certain risks can change over time, and a savvy broker will keep track of these trends.
R&W policies cover complex business deals – and the Underwriters typically don’t know every industry well. That’s where the broker comes in to match the right Underwriter with experience – and interest – in a certain space for the deal.
A good broker/Underwriter relationship has other benefits.
First, a good broker sends information the Underwriters need without waiting for them to ask. That means coverage is obtained that much more quickly.
Just like anything in life, when you know someone, things just go smoother. This is particularly true on smaller deals, in which Underwriters have to deal with less due diligence provided by the Buyer.
Some insurers will penalize the Buyer for having less comprehensive due diligence. But a good broker can be a go-between and mediate in that case.
For example, say the financial statements were reviewed but not officially audited. The broker can explain why that was the case and why it’s okay. A trusted relationship makes it possible.
Typically, both Buyers and Sellers have their own brokers handling their respective insurance programs. When those brokers see the premium sizes (and the resulting commission) from R&W policies for big deals they say, “Sign me up.” They’re not qualified, but they’re certainly not leaving that money on the table and are willing to dabble if given the chance. This creates unnecessary friction between the parties as they argue on behalf of their “guy” or “gal”.
The best approach is to select an independent specialist who will only handle the R&W placement. There would be “zero conflict” with the incumbent brokers as R&W is a one-time deal that doesn’t touch any other policy.
That neutral broker will have a fiduciary responsibility to the Buyer (R&W policyholder) to provide the broadest level of protection, while committed to delivering a variety of options that are budget appropriate in the interests of the Seller (who often shares in the cost of R&W).
That’s why a neutral broker who knows R&W best practices and has the clients’ best interest at heart will get the ideal outcome for both sides.
There’s no shortcut for a broker who has experience and has had working relationships with Underwriters for years. With that comes mutual respect. If there are disagreements or contentious points, they are easier to work through.
In an M&A deal, Buyers and Sellers should not rely on a broker who does their other insurance to secure their R&W policy. Get a specialist.
A number of Underwriters have already “trained” me. I know the inside track. They know I’ll run the process the way they need to provide the best policy in a timely manner.
I’d be happy to discuss with you how Representations and Warranty insurance could benefit your next M&A deal, as well as the costs. Please contact me, Patrick Stroth, at firstname.lastname@example.org or 415-806-2356.
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 email@example.com 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 pool of Buyers of technology companies is getting wider. Tech companies, as well as Private Equity firms, are now facing significant competition for quality acquisition targets from an unlikely source – non-tech strategics.
In fact, traditionally non-tech companies have become the most active acquirers of tech companies.
The most recent example is the $300M purchase of Dynamic Yield, an artificial intelligence (AI) company, by McDonald’s. It’s the fast food giant’s largest acquisition in 20 years. They plan to use Dynamic’s tech in order to improve drive-thru ordering, as well as digital products like self-serve kiosks and a mobile app.
“With this acquisition, we’re expanding both our ability to increase the role technology and data will play in our future and the speed with which we’ll be able to implement our vision of creating more personalized experiences for our customers,” says McDonald’s president and CEO, Steve Easterbrook in a statement.
But this practice isn’t new. Newspaper company Gannett purchased the remaining shares of online site Cars.com for $1.8B in 2014.
Brick-and-mortar businesses have good reasons to go on a tech buying spree. There are several drivers that explain this trend.
In the case of Gannett, the acquisition of Cars.com filled Gannett’s shrinking advertising revenue it and other traditional media outlets were losing to online advertising. Cars.com is a leading site for online research and shopping for new and used cars, which, before the internet, was the bread and butter of newspapers. It’s the perfect fit.
Other drivers for the acquisition of tech companies by non-tech strategic corporate acquirers include:
I believe the most important driver is the concept that today, every company is a technology company, no matter what the industry. Technology saturates the day-to-day operations of every business.
Quoting from Wired magazine, “The essence of the value of technology companies is – people. It isn’t just the intellectual property that a technology company creates, owns, and sells; it is the people who create that intellectual property and who bring fresh thinking and fresh ideas about how to solve problems, particularly problems that relate to the customer. Ultimately, every industry will become a technology industry and every company will have to become a technology company.”
This bodes well for owners and investors of emerging tech companies.
More Buyers increases competition for desirable targets. Add to that, non-tech strategics are willing to spend more than Financial Buyers such as Private Equity.
According to 451 Research, Strategic Buyers have paid 20% more for target companies than Financial Buyers. To avoid losing opportunities, look for Buyers from all sides to provide more aggressive terms to preempt auctions.
One way savvy Buyers compete is to deploy Representations and Warranty Insurance (R&W) to enhance their offers.
R&W coverage insures Buyers and Sellers from financial loss resulting from a breach of the Seller’s representations and warranties outlined in the purchase agreement.
R&W transfers the indemnity obligation away from the Seller over to an insurance company. With the indemnity risk removed, Sellers can reduce or eliminate escrow or hold-back provisions and collect more cash as closing.
Buyers benefit by enjoying the protection from a post-closing loss that can result in both a financial hit as well as the fallout from having to claw-back money from the newly added tech company principals.
In most cases, the Sellers are willing, if not eager, to cover the cost of the insurance in exchange for securing a clean exit from the deal, so Buyers benefit even further.
R&W coverage has been used routinely by Private Equity. However, Strategic Buyers are slow to engage in this useful tool.
If you’re working with a Strategic Buyer, there’s an above average chance they’ve never used R&W, so introducing the concept of transferring risk out of a deal at a modest cost would add tremendous value.
A great guide to promote an understanding of the benefits is a free report I’ve put together about how you apply for R&W coverage, the costs involved, when the topic of R&W should first be discussed, and more.
You can download it here: 8 Things You Need to Know About Representations and Warranty Insurance
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.
The NFL Draft takes place this year from April 25 – 27. It’s an exciting time for fans, with millions watching the telecast as players in suits are selected and hold up their new team’s jersey for the cameras… smiling from ear to ear.
The ceremony is a culmination of months, even years, of speculation by fans and commentators. And the picks could impact a franchise’s prospects for a playoff spot, even the Super Bowl, for years to come.
There are many factors that go into what player a team selects. Their performance at the college level, their stats, their physical fitness, their commitment to a team, salary requirements… but there are some other elements that don’t make it into the mainstream coverage.
Picking up a star player (or one with potential to be a star player) is a huge investment, money wise and in terms of opportunity cost. So that’s why NFL teams conduct thorough due diligence of every potential pick. They actually hire private investigators to do background checks to check for legal issues, drug problems, or whatever else could be a liability.
It’s comparable to the due diligence a Buyer does when considering acquiring a company in the M&A world. As part of that process, the financials are gone over backwards and forwards, and often Buyers will even conduct background checks on top executives to make sure they are on the level.
There is a lot on the line. A bad decision in a draft pick, and the General Manager or even the Head Coach can get fired. Make the wrong acquisition, and the CEO of the purchasing company could be fired.
Think back about 20 years ago. Tennessee starring quarterback Peyton Manning was the number one draft pick in the 1998 draft. Heisman Trophy finalist from Washington State, Ryan Leaf, was the second overall pick. There were high hopes for both. Manning, as you know had an illustrious career. Leaf… well, had a brief, lackluster career followed by drug abuse and jail time.
You can bet the teams that picked Leaf and Manning had both done extensive diligence on these players. But that research can’t uncover everything or predict every potential issue.
It’s the same during due diligence in the run up to an M&A deal. With the complexity of today’s transactions, it’s harder than ever to conduct effective and thorough due diligence… it’s easy to miss issues that could turn into a breach of representations that could result in financial damages.
Buyers in today’s competitive, fast-moving market are looking at, on average, three to four acquisitions in the coming year and are using due diligence to determine the highest “draft picks.” But, as we’ve seen, even the high picks on paper don’t always pan out.
In professional sports, the team has to eat the cost of a lackluster player and are often contractually obligated to keep paying them even with lack of performance.
Fortunately, in M&A, there is a tool Buyers can use to insulate themselves from issues that pop up post-closing. Damages resulting from a breach in a representation in the purchase sale agreement can actually be paid without hassle by a third party.
All that needs to be done is for a Representations and Warranty insurance policy to be put in place. Both Buyers and Sellers like R&W coverage because it smooths out negotiations, the Seller takes home more money at closing, and, again, the insurer will pay the Buyer if there are breaches post-closing.
This coverage is affordable and easy to get. Premium insurers will charge 2% – 4% of the policy limit. The Underwriting fee, which is $25k – $50K (depending on the size of the deal) and policy taxes are based the Buyer’s state of domicile, ranging from 3% – 7% of the premium.
It’s a small price to pay for the peace of mind. And you can bet NFL teams would love to have similar coverage in place to insure themselves against a bad pick.
I don’t know who’s going to be the top pick in this year’s NFL Draft. But I do know that as we get into the heart of 2019 and M&A activity is on track for another record year, the protection offered by R&W insurance is essential.
I’ve put together a special report outlining all the advantages of R&W insurance, as well as the process for securing this coverage. If you’re looking at acquisitions in 2019, it’s worth a close look.
You can download this report here: 8 Things You Need to Know About Representations and Warranty Insurance.
When we talk about M&A, it’s tempting to focus on the deals involving PE and VC firms because this sector has had record activity in the last several years.
But let’s not forget another facet of M&A: corporate acquisition, by which a company buys another company or portion of that company (usually smaller than the Buyer) to expand their business. Technically, the Buyer has to purchase all or most of the shares of the target company.
The conditions are right for increased activity here:
Private equity gets all the attention… its share of M&A transactions is growing year after year. It’s “sexy.” But corporate acquisition still represents the majority of deals each year.
According to Pitchbook’s Annual M&A Report for 2018, here’s how many corporate acquisition deals there were in the U.S. and Europe for the last few years, along with the percentage of total deals they represented:
As you can see, Private Equity is closing in somewhat. But the corporate acquisition is holding strong.
We can see that corporate acquisition is a widespread practice. But why would a company decide to grow through acquisition rather than “organically?” It can be an ideal tool for growth. But it’s not taken lightly.
Corporations have whole departments dedicated to strategic acquisition strategy. There are several objectives but three main ones:
The idea is for the purchasing company to grow stronger, of course.
But the corporate acquisition isn’t without risks. That is why corporate acquirers should take a page from PE firms when it comes to protecting their deals with a specialized type of coverage: Representations and Warranty (R&W) insurance. Savvy PE acquirers are increasingly using this type of coverage because deals today are so complex and fast-paced… and that means issues can be missed in the due diligence to the tune of millions, even billions, of dollars.
When this insurance is in place, if there is a breach of Seller Representations post-closing, a third-party, the insurer, pays the damages directly to the Buyer.
In addition, (R&W) insurance is low cost, makes for less contentious negotiations, and the Seller takes home more money at closing because less cash is held in escrow. And, unlike what you might have experienced with other types of insurance, R&W claims are paid in the vast majority of cases.
For more information on how R&W insurance can transform your next corporate acquisition, you can check out this special report that showcases all its benefits, the costs, and how to secure it.
This episode was originally published on May 23, 2018.
M&A activity has been heating up in the last few years… and 2019 is no exception. At the same time there has been a lot of movement in the healthcare sector, but due to its unique nature, special care has to be taken when dealing with acquisitions in this industry.
Patrick Krause, a director at investment bank MHT Partners focused on healthcare, has shepherded a lot of deals in this sector. He shares how he helps turn M&A transactions into win-win-win deals, where both Buyers and Sellers are happy – and patients benefit, too.
Tune in to find out…
Mentioned in This Episode: mhtpartners.com
Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters, where I speak with the top experts in mergers and acquisitions, and we’re all about one thing here, that’s a clean exit for owners and founders. This week, I’m joined by Patrick Krause. Patrick is a director of MHT Partners and also the co-head of their healthcare services. MHT Partners is an investment banking firm with offices in San Francisco, Dallas, and Boston. Patrick has advised on numerous transactions during his career, including sell-side and buy-side advisory work, as well as various strategic advisory assignments. Again, this is all exclusively within the healthcare sector. Patrick, welcome aboard today.
Patrick Krause: Well, thank you, Patrick. It’s a pleasure to sit down and chat with you a little bit here today. Hopefully, we can make it fun and informative for our listeners.
Patrick Stroth: I don’t think that’s going to be a problem. Tell me now, how did you get started in investment banking in general, but then also specifically where you focused on one sector as an expertise, which is healthcare? Walk us through how you got there.
Patrick Krause: Happy to. So, I’ve spent the bulk of my career working at the confluence of healthcare, finance, and technology. Upon graduating from the University of Michigan, which seems like a million years ago, I came out to the Bay Area and really cut my teeth as a consultant working for Deloitte. I worked across a number of their different groups, but almost exclusively serving their large global healthcare clients, ranging from integrated models like Kaiser to large biotech companies like Gentech, Roche, and really everywhere in between on the healthcare value chain, hospitals, provider groups. It really gave me an opportunity to deepen my skillset there. The range of my assignments varied from technology implementations, to the development of financial controls, to audit work, so between the operational exposure and the ability to build a deep skillset, and then move to investment banking was a straight forward one.
I worked at a number of post-merger acquisition deals, diligence deals for private equity businesses, all related to healthcare, knew that I’d been bitten by the deal bug. At the time there was not an opportunity to do more transaction oriented work at Deloitte, so I went back to business school and got my MBA with the intent of getting more hands-on deal experience, either at a bank or as a corporate development officer at a business, and have been fortunate to have the opportunity to do both. Prior to joining MHT Partners, I had a quick stop at Novartis’ Molecular Diagnostics Group doing some business development, corporate development work. Then, linked up with the founders of MHT Partners, as they were leaving their respective prior firms, to come onboard and help build-out our healthcare practice, which is what I do today. I lead our practice, and again, focus on serving founders, owners, entrepreneurs, private equity groups, as they seek to craft and execute healthcare strategies designed to maximize outcomes for the party.
Patrick Stroth: Well, I like how you went and characterized it, you got bit by the deal bug. I think that’s something that’s kind of common in this industry right now. As an investment banker, now your expertise is, not on the diagnostic side, but it’s helping owners and founders sell their businesses faster, and for a greater return, and making it overall smoother. Now, healthcare is very, very different from other sectors like tech or consumer products, okay? Both based on their ownership structure and then also operationally, there’s a lot less outsourcing that can be in done in healthcare. Why don’t you describe the differences between the healthcare sector versus pretty much any other sector out there?
Patrick Krause: Yeah. It’s certainly an interesting place to play as a banker. I think the realization that folks need to come to is, first and foremost it is, it’s a people driven business, whether they’re relying on providers to deliver great care or taking great care of your patients, it’s really driven by the interactions between different folks. Being able to speak the language of medicine and business helps bridge the gap. It helps to be more effective when you’re crafting the deal. Investing and healthcare is obviously a process which requires some thoughtfulness, just to ensure that you’re compliant with the rules and regulations that are in place in our country, generally speaking, with good reason. That is such that business concerns don’t necessarily drive medical decisions or outcomes.
We talked a little about this in prior conversations, to buy a healthcare company that actually is responsible for delivering care, a couple extra steps are involved. It’s not like, you know, a sales force going out and acquiring Realsoft, which just happened, or you negotiate a deal and you’re done, you can directly buy the company. Physicians and physician practices in this country are required to be owned by physicians, to be compliant with corporate practice of medicine. I’m not a lawyer, I’ll say that. I just play one on TV. A good transaction attorney can help you through all this, as well. But, in order for someone to directly invest in a private practice, there’s typically an interim step, whereby, we create a management service organization, or anther legal entity that that private equity group can invest in, that group does the administrative work and kind of back office work that physicians tend to loath, while the physician retains ownership of their business, and then signs an agreement to share revenue with the MSO, enabling the private equity group or other non-physician to invest in the brackets.
It’s a little more convoluted than a traditional sale. But, we found over the years, that it’s an effective way to get these deals done, appropriately align incentives, and really capitalize on the value proposition that we all believe in on these deals, which is, you free doctors up to focus on the delivery of high quality patient care, you hand-off some of the administrative tasks, and as you become a bigger organization, not only can you see more patients, make healthcare more accessible, hopefully, you make it more efficient and more cost effective for folks.
Patrick Stroth: Yeah. That’s something that, you know, you can only outsource so much of the admin work and the file keeping, and so forth. It’s the actually delivery of care, it’s impossible to outsource, but as you get larger groups, if groups come together, and organizations get bigger, there’s a lot more sharing, and it improves, like you said, the accessibility. That’s a real key point that is a big differentiator. The other thing we could get into a little later on, that you mentioned, is the regulatory burden is unavoidable in this sector. Now, my experience in the healthcare sector in the last 20 years is largely on the insurance side, doing the directors and the officers, and the regulatory, and cyber coverage, things like that. When I first got into the sector, I thought of two things. There were doctors and there were hospitals. That’s what every person sees on the street and everything. I didn’t realize that there’s this entire universe of other businesses like the MSOs that are established just to support, and facilitate, and supply the delivery of care.
Now, when we’ve spoken before, you have a real neat, clean way of dissecting that huge diverse universe into really simple to understand, I would say, buckets, for lack of a better word. Tell me about these buckets. What’s the differentiation between each, and then how are they exposed or not exposed or what are their big concerns facing an M&A transaction?
Patrick Krause: Yeah. I don’t think there’s a lot of original thought in this. This is how we at MHT have elected to kind of segment the healthcare universe.
Patrick Stroth: Oh, no. You take credit for it. You made a very user friendly way. So, go ahead and take credit for it.
Patrick Krause: Well, we have a fairly broad mandate in terms of where we like to play. That translates into four industries, sub-vertical. I’ll start with the first. It’s really been the cornerstone of our healthcare practice, and that’s specialty physician groups, whether it’s hospital-based specialties like anesthesiology, radiology, cardiology, or it’s more consumer-facing medical fields like dermatology, ophthalmology, dental, and physical therapy. We’ve seen a lot of activity in the space. I’ve done a number of deals in this space.
Key challenges there are, obviously, making sure that all the partners incentives are appropriately aligned, risk and compliance is appropriately addressed, and then making sure that you’re delivering high quality care. At the end of the day, as a physician, you’re only product is a satisfied customer, meaning, is a well patient or is a better patient, and really having that high touch, and focusing on people is important, and that drives the culture and the business. Making sure you get a group of physicians aligned with the same mindset is a big part of the battle.
But, certainly, an important part of healthcare system in this country, it’s the folks that are on the battle lines every day, taking good care of people. Gosh, it’s been a pretty exciting place to be an investor the last five or six years. I cannot think of a more active period of investment in that space in a long time.
The second industry vertical that we spend a lot of time on is post-acute care. It’s kind of a catchall for us. But what that means is, the treatment of folks outside of a hospital or clinical setting. It could be home health, it could be hospice, it could be behavioral health.
Patrick Stroth: Physical therapy too?
Patrick Krause: That’s more reliant on providers.
Patrick Stroth: Okay.
Patrick Krause: We tend to keep that in the first group, but point well taken. I suppose it could be in that bucket, as well. But, the element here, the interesting thing for investors has been a lot of the dynamic that we see in our country. For better or worse, we are a graying nation. Folks are getting older. Folks are needing to consume more healthcare services. A hospital is not always the best setting for that. It’s not your home. It’s expensive. It could be a risk of infection, just by being around people that are sick. Taking care of people in their home is a compassionate, cost effective way to deliver care. We see that as a pretty exciting area of growth in the coming years. It’s not without its challenges, as well. Reimbursements have stabilized over the past several years. But, a business that has yet to find a model where you can scale over larger regions, just because it’s so focused on the provision of care by a local population and skilled nurses, or physicians assistants to take care of people.
As you’re thinking about how to allocate risk, whether on a deal or after a deal has been identified, and you’re thinking about how to translate that allocation of risk into your purchase agreement, you need to make sure you’ve got a good handle on providers, credentialing, their past record, make sure that incentives are appropriately aligned, so that those providers stick around. Turn can be kind of a scary component in this industry.
Again, it all comes down to taking good care of the patients. I think culture is an important thing to look at when you’re evaluating any opportunity to doing a deal in this space, as well, it’s a good thing to take a look at. And, throwing a bone to Patrick, it’s one where insurance is your friend, and you have to make sure you have the right product in place, and risk appropriately identified, allocated, mitigated.
Patrick Stroth: Gotcha.
Patrick Krause: Last big bucket for us is technology driven products and services. That could be true healthcare IT point solutions or products geared towards serving commercial payers like revenue cycle management, billing, coding, scribing, things like that. Or, you could have a different risk profile. It’s more product driven and technology driven, so you want to make sure that there’s no infringement of IP, there’s kind of a uniqueness or a dependability to that technology. And, you want to make sure that you’ve got an exciting, addressable market to go after.
Last bucket, a smaller one, but one that’s important to us, as well, is other healthcare services. You’re familiar working in that space too. That could be pharma services, like CROs. It could be the delivery of goods and products to a hospital or a clinic, it could be some of those products themselves. It’s another area that we like. Again, just different risk profile in that it is not driven by people or providers per se, but by products and services. There a more traditional business risk profile exists around customer concentration, products, cost of acquiring or creating products, cost of selling products, all those good things.
But, it’s a broad mandate for us. It’s a great big world out there from a healthcare perspective. It continues to be an exciting place to play from and M&A perspective, from a strategy perspective. Gosh, we have a ways to go, but if we can take some of the other business principles from other industries and apply them to healthcare, hopefully, we can get better outcomes, make it more affordable, more accessible for everybody.
Patrick Stroth: Well, I think great item that you pointed out there, that a lot of people overlook, it’s more of a millennium-type of term is called culture. And, particularly in a post-acute care, where we’ve got nursing homes or assisted living facilities, and everybody can recall those terrible news stories about elder abuse and everything, and these disconnections within the system that doesn’t bring the care that should have been brought, a lot of that is cultural, and it’s just having that culture of wanting to deliver the best care, the best services, and stand behind it. You see the physicians are pressing that because it’s literally their name on the door or their name on the practice. As you get to these other things, I can’t tell you how you can possibly understate the importance in culture with the post-acute care because that’s where you’ve got behavioral health, you’ve got a lot of these other things that are the softer-type, longer term issues that you’ve got to keep that great sense of excellence. That’s great that you pointed that out with these.
As you look, because you’re dealing with the founders and owners, many of them are physicians, some of them aren’t, they’re in the medical tech area, what’s the difference, where some founders, they succeed in getting what they want out of their deal? They get it set up, they get what they want, and then their peers will struggle. Maybe you can differentiate it between a physician owned practices or physician owned companies and non-physician owned companies, but where’s the drop-off, where some struggle and others seem to get right to go, right to where they need to be?
Patrick Krause: Well, being ready, it’s kind of the biggest thing that you can do to be success in a transaction. I mean that in multiple ways. One, obviously, it’s important to have your house in order, to make sure that you’ve got processes documented, that you’ve got your financials cleaned up and on an accrual basis, if possible. But, I also mean, you need to be ready emotionally. In some instances, seek control of a business that you’ve built for 30 years. Be able to bring on a partner that is going to have thoughts on how you run your business, and be ready to let go on something that you’ve spent a career building. Some folks are ready to do that, others are less so. But, being able to really understand why you want to do a transaction, why it’s the right time, and being able to let go, so to speak, can help a lot.
A good advisor will be able to talk you through that. At the risk of seeming shamelessly self-serving, it’s very important to pick the right advisors to guide you through this process, accounting, financial, deal related. They’ll be a sounding board. They can help depersonalize a lot of the issues that come up on a transaction. Just like a good lawyer would not choose to represent themselves in a deal, a good advisor can kind of take you out of some of the more contentious conversations.
Patrick Stroth: I don’t want to interrupt you too much there, but I do want to really highlight this because I think it’s a real big point, of having somebody as a third party, intermediary there that can be diplomatic, can listen to the various players, and give honest feedback without being emotionally tied or defensive with the other sides, I think that’s a great role that experts like you play in this. This is a very emotional time, you may have different objectives on the seller’s side, and being able to negotiate within that selling team before going off to the buyer, I think is critical with what you do.
Patrick Krause: I couldn’t agree more. Just depersonalizing it, and knowing that somebody there’s to be your arms and legs will make all the difference in a transaction. There’s no secret to it. It’s hard work. Maybe that is the secret. It’s just like anything else, stay organized, be fair in your puts and your takes, and you’ll get through it. A lot of folks, it ends up being a great experience. It’s a chance for folks to realize some liquidity. It’s a chance for folks to effect a generational shift in their business, such that it survives beyond the first generation of the founders, or to find a partner to help grow and achieve the growth that you see for the business.
Patrick Stroth: I think another real big benefit of having someone like you involved is, for a lot of these, especially physicians, but a lot of these owner and founders, with some exceptions, this is their one deal. This is their one time. You’ve been involved in hundreds of these deals. I think, not only have you seen these processes work, you know who the real good buyers are, as opposed to the other buyers that may not have the best intentions in the world, and may make a perspective seller spin their wheels only to grind them down, where you’ve got others that they may not offer the best price outright, but they’re going to be a lot easier to deal with, and you know their buying habits.
Patrick Krause: That’s right. You make a great point there, Patrick. A good advisor, particularly one that focused on an industry, will have been down the road a few times with a few of the buyers that you’d be reaching out to in that process, give you insights into how to negotiate, what’s important to them. That in turn allows you to position a seller’s business to get the most of what’s important to you, the seller. A good banker or advisor will be able to help you do just that.
Another key consideration is whether you want to sell all of it, all your business, so to speak, or if you want to find a partner and continue to work with them to grow it. That can certainly influence your buyer choice, as well, whether you sell out entirely or you identify a partner to move forward with, can give you unique opportunities, different in several regards. But, I think the key point is a process, well-designed, will create options for you, such that you can evaluate buyers, you can match price points to roles going forward, such that you can get most of what you want. It might not be everything, but if you have a couple options to pick from, you can usually get what’s more important to you.
Patrick Stroth: Is there a particular size practice or metric for people that are listening that want to get ahold of you? What size practice or maybe value is an area that you fall in with your clients?
Patrick Krause: That’s a good question. I think there’s a degree or flexibility on our end in terms of the mandates that we take on, but I think if you were looking at averages for MHT Partners as a firm, we typically represent companies with around five million dollars in EBT, earnings before income, tax, and depreciation. That’s not to say that we wouldn’t work with bigger companies or smaller companies, just on average that’s where we tend to shake out. That’s more of a function of the lifecycle that the companies that we represent are in, right? They tend to be a little bit older and more established. The owners might be looking for an exit or a liquidity event and it just happens to be where they are. But, no hard and fast rules. The only real criteria for us is to work with great companies, niche market leaders in their states, and usually uniquely differentiated from their peers.
Patrick Stroth: The best way then for listeners then to decide whether MHT would be a fit for them is, they need to reach out to you directly. How can our listeners find you?
Patrick Krause: They can certainly find us on the internet, mhtpartners.com. You could always reach out to me directly. I’d welcome the conversation. You can call me in the office, that’s 415-446-9511 or email me at firstname.lastname@example.org. Would love to be helpful however I can be.
Patrick Stroth: Well, fantastic. Well, this is diverse, very technical, very specific type of area to get into. I’m sure a lot of people listening are going to have further questions for you. And so, I encourage everybody to reach out the Patrick. He’s going to be absolutely responsive and maybe there’s a fit, maybe not, but the thing is having a conversation with these experts, really enhances your chance of having a clean exit. I want to thank Patrick for helping us and sharing his knowledge with a very, very highly regulated technical industry that is enormous. We wish you all the best of luck, Patrick. Thanks again for joining us.
Patrick Krause: My pleasure.
In recent years, the number of companies with “institutional backing,” i.e. they are assets of Private Equity or Venture Capital firms, has grown dramatically. And that means that the number of companies backed PE and VC firms that are being acquired is increasing, too.
In fact, according to Pitchbook’s 2018 Annual M&A Report, there were a record number of those types of acquisitions in 2017 and the trend continued in 2018 with another record at 20%.
The simple fact that there are more of these types of companies, means more will be acquired.
But also consider that the target companies are more sophisticated than a typical founder-owned firm, making them more attractive to Buyers, who would rather deal with professional investors. This, of course, means savvy, experienced parties on either side of the table, leading to, as the Pitchbook report put it: “…increased price discipline, possibly leading to more aggressive price negotiation from Sellers and fewer cheap deals.”
But because these types of companies are enjoying increased valuation, Sellers are more likely to sell companies in their portfolio. Over half of PE-backed exits in 2018 involved sales to other PE firms, which is called a secondary buyout.
Of course, this means that the share of founder-owned businesses being acquired is shrinking. And although the percentage of publicly traded companies being acquired was actually increasing until 2018, this amount is expected to drop steadily as the number of publicly traded companies overall continues to decrease and economic uncertainty makes Buyers hesitant to make these sorts of deals.
But why are the numbers of PE and VC backed companies growing? In the case of VC especially, that funding source has become very popular among startups that are ready to scale up to either go public or be acquired (which is usually what happens).
Expect to see the acquisition of companies with institutional backing to continue in 2019. We’ll see if we have another record year.
One thing both Buyers and Sellers should consider in these types of deals where portfolio companies are changing hands is Representations and Warranty insurance.
With this coverage, if there is a breach of the Seller’s Representations, the insurer pays the financial damages suffered by the Buyer as a result of the breach.
In today’s complex deals, R&W insurance is a must in my mind for any M&A transaction. But it’s especially necessary when portfolio companies are being acquired. With a full portfolio, the Seller won’t know each individual business well… and might not recognize potential issues.
There’s been one case I’ve been keeping an eye on that’s a perfect illustration of this.
Back in 2013, Citadel Plastics Holdings, a portfolio company of PE firm, HGGC (formerly known as Huntsman Gay Capital Partners), acquired Lucent Polymers. Then in 2015, A Schulman Inc. bought Citadel. But the next year, A Schulman discovered that Lucent had falsified test results to show its products were Underwriters Laboratory certified. Next step, a lawsuit seeking $272 million in damages from Citadel Plastics that has yet to be resolved.
In this case, the PE firm didn’t know what its portfolio company was up to and paid the price. But, if there had been R&W coverage in place, there would be no legal issues because the insurance company would have paid the damages.
As a PE or VC firm looking at acquisitions in 2019, it’s clear that R&W insurance is the protection you need, especially when acquiring portfolio companies.
I’m happy to chat with you about what’s covered, the price, and the process for securing a policy – which is much cheaper and easier than you might think.
You can call me at 415-806-2356 or send an email to email@example.com, and we can set up a time to chat.
We’re living in a Golden Age of Mergers and Acquisitions. The numbers are in and… there were $2.2 trillion in M&A transactions in 2018 in the United States alone, compared to just over $2 trillion in 2017. That marks the fourth year where the level has breached $2 trillion.
Some other signs of this very healthy M&A environment:
Although there was a slight dip in 2018 in the number of deals done (11,208 compared to 12,647 in 2017), I expect this trend of increasing M&A activity to continue. Here’s why:
The consensus is that going forward in 2019 and beyond, we’re going to see more deals, and bigger deals. This is despite ongoing global economic uncertainty, rising interest rates, anti-trust issues, the impact of tariffs, capital market volatility, and some concern that the economic conditions that have driven the rising trend could turn.
A recent survey of 1,000 PE firms and M&A corporate executives conducted by Deloitte bears this out.
The main reason for this rising trend: the PE firms at the forefront have larger funds, and they’re not sitting on that money. They’re leading the charge. In fact, in that Deloitte survey, an impressive 94% of PE executives at funds over $5 billion expect more deals in 2019.
This is confirmed when you look at what’s happened over the last few years. According to PitchBook’s annual report, PE firms accounted for 34.2% of M&A deals in 2018; that share of the market has risen steadily since it was at 25.4% in 2015.
(Not to be discounted as an element of this trend, is the growing corporate M&A strategy of acquiring companies to expand their customer base and/or diversify their offerings. Corporations also have more cash on hand due to the recent tax reform. They view M&A as the best way to grow.)
Another trend we’ve seen, especially among savvy PE firms, is the increasing use of Representations and Warranty (R&W) insurance to cover deals.
According to a study from Harvard Law School, the number of R&W policies written has grown from a few hundred just five years ago to more than 1,500 in 2017. Their report also notes that more than 20 insurance companies are now writing these policies.
Essentially, this specialized coverage puts the risk of breach of Representations in the hands of a third party: the insurer. That gives peace of mind to both Buyer and Seller and speeds up negotiations because a main sticking point, indemnity, is off the table.
The Seller gets more cash at closing because less money is held in escrow (and won’t be at risk if there is a breach). The Buyer won’t have to pursue the Seller in case of a breach; the insurance company will pay claims promptly. And with 19.4% of deals subject to a claim in 2018, at least at insurer AIG, it’s clear why this protection is important.
With the complexity of today’s deals, it’s easy to miss something in the due diligence process, and R&W insurance insulates you from that risk. And, it’s much more affordable than you might think.
If you’re part of this rising trend in M&A activity, you should consider making R&W insurance part of your next deal.
I’d be happy to discuss with you what these policies cover, how you apply, and the estimated cost. I can easily put together a quote with just a few pieces of information from you.
I can be reached at 415-806-2356 or by email: firstname.lastname@example.org
Domestically, the trend for M&A is robust, with nowhere to go but up in the next year in terms of the number and size of deals. There were $2.2 trillion in M&A transactions in 2018, with six deals above $50 billion. That’s the fourth year in a row above $2 trillion. Median deal sizes are also going up, doubling in the last four years to hit $60 million in 2018.
It’s a rosy picture on the domestic front.
But when it comes to cross-border deals, in which a foreign company acquires a U.S. company, we have a seen a slowdown.
According to a recent report from PitchBook, cross-border activity decreased in 2018, hitting the lowest level in four years, continuing a trend that started in 2017. There were only 2,192 cross-border transactions worth $655.6 billion in 2018, compared to 2,983 in 2015.
There are a few factors at play here:
It’s important to note that European companies conduct the majority of M&A deals with U.S. companies. Mexico is also a major player, and continues to be, despite recent tension.
But China is the one to watch as until recently it was rapidly gaining ground, growing from just 1% of U.S. cross-border deals in 2010 to a high of 9.4% in 2016. But there is a slowdown there too, with only 5.6% of deals coming from China in 2018, no doubt the result of recent tariff disputes.
Let’s look closely at China.
Chinese companies are especially interested in anything related to technology: telecoms, aerospace, etc. And they had money to drive prices up to the point that domestic Buyers couldn’t keep up. That was the main factor in the meteoric rise up until 2016.
But now, they’re facing regulatory roadblocks, on top of trade tensions and tariff issues.
The Committee on Foreign Investment in the United States (CFIUS) is the agency tasked with examining cross-border deals closely to ensure the transaction does not threaten national security and is in the best interest of the country.
I was actually involved in a deal where CFIUS got involved – luckily it was much smoother. Startup car rental company Silvercar, a U.S. company, was being bought by Audi through its U.S. subsidiary. But because Audi itself is a German company, CFIUS had to approve the deal.
Taken more seriously are instances where a U.S. tech company designs and manufactures communications equipment for the U.S. military. Being acquired by a Chinese company, which would then have access to classified data, would be a no-go, according to CFIUS.
If this seems familiar, you might have seen Chinese telecommunications giant Huawei, which makes smartphones and other devices, in the news recently. The U.S. has accused the company of espionage and being a threat to the country’s national security because of its alleged business deals in Iran that violated sanctions against that country. This culminated in the arrest of the CEO in Canada back in December, with anticipated extradition to the U.S.
The company and the Chinese government contend they are being unfairly targeted and have filed suit in the U.S. Whatever the case may be, or how this plays out, it’s clear this tension isn’t going anywhere any time soon.
Concerns over Chinese purchases of U.S. companies isn’t limited to technology or aerospace. Technology is getting embedded into traditional industries such as transportation, industrial, manufacturing and agriculture, so involvement by CFIUS will only increase.
Whatever the causes of the general slowdown in cross-border deals (exacerbated by the U.S. government shutdown, during which there were no CFIUS reviews done), I believe that this could mean opportunity.
When deep-pocketed foreign companies are taken out of the equation, at least to some extent, that puts U.S. Buyers in a better position to land deals at better prices. I expect to see a continued growth in domestic M&A activity in the coming year.
For more analysis on why domestic M&A will continue its upward trend, be sure to download my free report: The 13 Factors Contributing to the M&A Boom
What did due diligence in M&A deals look like before virtual data rooms? Teams of lawyers and other experts combing through paper files stacked floor to ceiling in a conference room.
With the virtual data room, explains Darryl Grant of Toppan Merrill, those days are long gone.
Today, sharing a company’s financials, contracts, and other pertinent information with potential buyers is a simple matter of uploading some documents and sending an email.
We talk about how this speeds up the process and ensures transactions move more quickly through the marketplace, as well as…
Mentioned in This Episode: www.toppanmerrill.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 Darryl Grant, Senior Vice President of the newly minted Toppan Merrill. Toppan Merrill provides innovative SaaS solutions that deliver high fidelity SEC regulatory filings, XBRL solutions, and virtual data room due diligence services.
Darryl co-leads Toppan Merrill’s Bay Area capital markets team working directly with C suite execs, law firms, corporate finance, and legal departments to manage IPOs, mergers, spinoffs, along with all routine SEC filing requirements. Today, we’re focusing on Toppan Merrill’s virtual data room, or as the millennials like to say, VDR services, along with due diligence services for mergers and acquisitions. Darryl, welcome to the podcast and thanks for joining me today.
Darryl Grant: Thank you for having me.
Patrick Stroth: To give our audience a little bit of a context about you before we get into all things Toppan Merrill, tell me what led you to this point in your career.
Darryl Grant: A long journey, but we’ll try to keep it as brief as possible. I started out my career in New York City in the late ’90s back in 1999 just before the 2000 stock market bubble crash and etc. I always wanted to be in the capital markets. My college career and finance training gave me the aspiration of being an investment banker, but I ended up deciding to become a financial printer.
My first IPO was Intercontinental Exchange, who later went on to acquire the New York Stock Exchange. Once I did that first IPO, it led me to want to do more in the space and have an opportunity to do some of the most largest mergers in stock market history, including the market sharing cloud merger, the Pfizer YF merger, and most notably, the JP Morgan Chase Bank One merger. I came to climb the ladder, working for customer service, and to various management roles, including leading our XBRL efforts for a company called Bowen in New York City.
Then, five years ago, I moved here to Silicon Valley and I took a role as an internal global account manager working with capital markets accounts for companies that were going through a scale of acquisitions, spinoff, etc. Then I landed here in Merrill about two and a half years ago as senior VP, formerly managing director, and I got a taste of what it meant to really support companies because in this role I’m responsible for connecting our clients with solutions that fit their most prominent needs. And because we talk about M&A space, the Merrill virtual data room has been a market leading product for the last 15 years. It’s just been sensational to support companies going through an M&A do due diligence with their technology.
Patrick Stroth: It’s interesting you mention that you’d been working with financial printers and then moved over into this other space. Even though we’ve gone from a very paper-intensive to a “paperless” world, it’s amazing how much there’s a need for the printers and the record keepers, record makers, in the support services, isn’t it?
Darryl Grant: It really is. The world of virtual data rooms really kicked off back around the time that Enron was going through their challenges, and it was a lot of due diligence that was required, as you would think, with a transaction that size. Even in that time, the virtual data room didn’t exist. People still flew into large conference rooms reviewing banker boxes full of documents with someone guarding the door to make sure that no lawyer, investor, banker, etc., were to leave with any of those very sensitive documents.
You can imagine what that looked like over the course of the weeks, these papers getting wrangled and also searching for specific information within these large conference rooms, sometimes banker boxes to the ceiling full of documents. But Enron tapped Merrill and drew other companies, and we put together what was then one of the first virtual data rooms in the market. Fast forward to today, everything’s done digital. All of these transactions are moving quickly through the marketplace as a result of stakeholders having instant accessibility and also tracking mechanisms in place to a proprietary virtual data room like Merrill’s.
Patrick Stroth: Wow. So you could say that, while Enron may have spawned a lot of negative things, specifically I’m thinking about Sarbanes-Oxley and the big regulatory environment that followed right after, one of the good things was that technological emergence of an electronic room to replace the banker’s box. So that’s a nice byproduct from Enron.
Darryl Grant: Absolutely.
Patrick Stroth: I think that’s a great story to bring forward. I’m going to totally steal that from you. For our listeners of the podcast, at least they’ll know where I came up with that idea. What types of deals or industries are best suited for using a data room? We understand that the data room is there and it’s replacing those warehouses in law firms or whatever with the big box of information. But are there particular deals, types, sizes, or industries that are better suited, or is this one size fits all?
Darryl Grant: It’s one size fits all. The beauty of our technology is that it can fit mergers such as a LinkedIn Microsoft, which is a massive acquisition between two companies and merger. We were fortunate enough to have our technology be a part of that process. But it could scale down to a $10 million acquisition, or it can be a sell-side event. It can be if you’re a life science company, in licensing, out licensing of your drug products. It can be used for FDA approvals as a portal in that space. It’s really more if it’s in multiple communication pools. Sideline topic, it can be used for fundraising if you are going through an equity event where you’re raising capital for venture firms or others.
Any matter of due diligence where you are thinking about sharing sensitive documents that you want no one else in the world to see outside of your firewall, virtual data rooms are the perfect lock box to invite parties in and give you full visibility as to what those parties are looking at and how long they’re looking at specific pages, which gives insightful intelligence around the interest of those investing parties now allowing you as the seller of your assets to have full transparency into what people are doing, and that’ll give you some foresight into what questions they may ask you, which now facilitates the deal. So we’ve seen deal traction actually accelerate through our virtual data room technology.
Patrick Stroth: I can imagine, yeah. I would almost describe as, while it is a data room, I would almost re-characterize it as a data vault because of the security and stuff. I want to skip a little bit ahead on some of my notes with this. Our listeners can’t see what a data room is. I mean, conceptually, you get an idea that this is an electronic version of having all of your records in one spot, maybe like a Dropbox but a very secure one.
But for our listeners who can’t really see what a data room looks like, why don’t you describe just how the process works from opening an account, how documents are put in there, how security is done, how access is granted? Because I know there are different levels of security where you can have certain general files accessible to multiple parties and then keep everything else confidential, and then open up permissions and tracking who looks at. Walk me through that, as a prospective customer, how you would onboard somebody and what would it look like.
Darryl Grant: The onboarding process … Thank you, Patrick … is very straightforward in the spirit of today’s business applications, or email. Let’s say you’re the user. The first thing you would get is a link from our team, inviting you into your virtual data room after it’s been set up. You open up that link and it would immediately take you to your log-in page. From that log-in page, you would create your username and password, log in, you’ll have your Terms and Conditions that will be already pre-populated, you accept those terms and conditions.
It’s usually you can set it up as a user, as an administrator, you can set it up as a one-time click or you can make parties agree to this due diligence disclosure every time you log in. But once you’re in the room, you’re essentially looking at the entire landscape of what you would need. So left, there’s a file folder structure already laid out which tells you what the hierarchy of your respective index is for your virtual data room, and that’s something that can be set up by our team, set up by the individual user. You would simply just right click and it’s updating information through your keyboard.
Once you’re in that room, if you, say, had 5,000 to 10,000 or 20,000 pages of documents that are on your desktop or in your internal hard drive set up in a folder, you can simply drag and drop that entire folder as it stands with all of the internal folders, hierarchy, indices, labeled, and all the documents included would move right into that virtual data room as they were on your desktop, which is easy to set up.
Then, once set up, you add users. Those users are then … You can grant those users access on multiple levels. You could say, if you print or download, or even more exciting in today’s world is you can have administrative rights to revoke access from folks. With those options, you say, “Okay, these guys are just being introduced to our data room. We don’t want them to see too much. You have view only access.” Now, the deal starts to heat up and you say, “Okay, you can have view, print, and download access.” And now the deal’s really taking root and you’re excited and traction is there and you say, “Okay, I want that download access but I still would like control,” you can set your permissions to the extent that when that party downloads that document you still have control over that document remotely.
So if the deal dies, if things pivot, you can revoke access without having access to their computer. You can do it all through a desktop through our virtual data room. It is the most secure platform on the market. It has all of the certifications, including ISO 27001, SOC 2 Type 2, GDPR, and extensively there’s penetration tests done on our platform on a monthly basis to ensure that we have the highest security in the marketplace. That’s generally how it would feel as a user and some of the security components that ensure that all system documentation is kept safe.
Patrick Stroth: I can imagine just the usages come up. Can you give me a feel for the growth of usage with virtual data rooms from your experience?
Darryl Grant: Exponentially, everyone who is entering into a sell-side or a buy-side event generally would have a banker that they have advocating, help them facilitate the transaction. The banker, nine out of ten times, well, ten out of ten times these days, will say, “Hey, you need to get an enterprise-grade data room,” which would be us or one of our peers, ours being the leading product in the market today.
Now, there’s obviously other different technologies that are out there that … Well, actually, ironically, they in some ways found our niche when you talk about the consumer versions of the box, Dropbox just by name. I have nothing against those firms, but the file sharing environments really started, as I mentioned earlier, dating back to those earlier days around Enron. At Merrill, we never took it down a consumer route but for an M&A transaction that data room is now being used, our technology or our peers, for nearly 100% of the transactions out there in the marketplace, especially if it’s of the magnitude of the LinkedIn Microsoft or NetSuite Oracle, just a few that we’ve done.
Patrick Stroth: Yeah, it’s become virtually ubiquitous. It’s a check the boxes. This is one of your must-haves you have to have. Otherwise, you run the risk of, if you want to put your company off for sale, you’re going to have prospective buyers and they’re going to need information and you can’t field all those requests and then respond real-time for them. It’s better if it’s off at a secure location. You’ve got somebody else monitoring it. So it’s just a logical first step. How would you say that Toppan Merrill’s different from other virtual data rooms?
Darryl Grant: One clear differentiator that jumps off the page is the speed of our technology. It’s the result of a significant investment, a re-architecture which has taken about four years to come to market and has been in market for over a year now, that is 5X faster than our room and we’ve done speed tests on other platform of our peers and we’re close to 5X faster than any of those others. So speed is one of the key factors.
Another key factor is security. It is the most secure platform in the market as far as we can tell based on our penetration testing and also our certifications. I think the third and the biggest component, which our customers tend to lean on more than they plan to before they open up that room, is our service. Our 24/7 service operations are there to support our clients.
It’s not a paid service, so they can call and use these services as much as they need. And what does service mean? If you need to have documentation uploaded, our team can do that for you. If you need to add users, our team can do that for you. If you want to delete users, our team can do that for you. If you want to prepare an index for a specific transaction because we’ve seen thousands and thousands of these transactions we know what these indices look like and your index for what documents you should be including in your due diligence.
A lot of times we put things in front of clients and they’ll say, “Wow, I forgot to include X, Y, and Z. Thank you.” Our team can do that. And furthermore, we offer a consultation to say what the timing typically would look like in terms of setting up your room, executing your room, inviting users, and etc., and also the reporting systems which is like no other. We have dashboards that will show you down to the page level how users are behaving and interacting with your sensitive documentation.
That visibility is leading the market in very impactful ways, and our customers have intelligence to the extent that today’s being Wednesday. If you have a call scheduled on a Friday, you can go into this data room on Thursday night and see exactly what investors are looking at so when that call happens on Friday, you’re way ahead of every question that they’re asking because you can see where they’re spending their time, and that’s been very valuable.
Patrick Stroth: I can imagine that. I mean, if you’re looking at a potential M&A transaction with a competitor, let’s say, and you can see how much time is the competitor looking at your schedules and looking at your financials as opposed to looking at your client list. You can get some insights there, I think, is helpful. That, I think, also you just dovetailed into it on your due diligence services. Because you’ve seen thousands and thousands, literally, of these transactions, you know what information is critical and what information’s nice to have but it’s not as essential.
That also helps with the sophistication and how serious you are as a player in M&As. If you’re prepared, you’ll have all the documents lined up, and I think it’s helpful having used a sounding board to say, “Hey, we just checked the list of all the stuff. Why isn’t this here?” It may be material, may not. But that’s nice having that extra set of eyes looking over your materials as you get ready to essentially stage your house for sale.
Darryl Grant: Absolutely.
Patrick Stroth: Well, you kind of referenced into this because you have seen literally thousands of M&A deals, probably more in the last couple years than you have previously. Can you give us any insight on any trends you’re seeing in tech, investors in M&A in general? What have you seen in terms of either deal flow, deal size, just snapshot of a trend that would be helpful for the audience just to be aware of this, as somebody who’s seen thousands of these deals?
Darryl Grant: Yeah, I think what is really compelling is, use an example, what happened with Adaptive Insights recently. They were three days away from ringing the bell in New York and they were acquired by Workday. So what we’re seeing is that once companies disclose their financials, etc., through an S-1 filing with the SEC and that public filing, then buyers tend to line up and the opportunities for a sell-side event tend to increase, especially in the life science space. But when you talk about tech companies, that is, I think, becoming more and more prominent.
But furthermore, we talk about M&A transactions and trends, they’re … I think this is tried and true that most companies will exit via sell-side compared to those who will exit via IPO. I think those trend lines are still strong and we don’t see much of a divergence from historical traction in that regard. I think something that’d be interesting for the audience to know in terms of in the day, is that the devaluations we see are equally staggering as you would anticipate with comparing them to prior rounds and equity raises. We’re starting to see a lot of companies really maximizing their value in an M&A environment as opposed to, say, an IPO.
Patrick Stroth: I mean, last year, 2018, how many IPOs were there, like 30? As opposed to maybe …
Darryl Grant: I think if we look at the global stats, it’s somewhere north of 270. I think locally in the Bay Area it was just north of 30. Last year was a strong year for IPOs, and I think 2019 has the legs to replicate a lot of what happened last year and potentially break some of those records, even with the government shutdown because we’re still very early in the year. But overall, you’ll see a lot more sell-side M&A events than you will these larger-
Patrick Stroth: Oh, I think, yeah. I forget which organization it was, Middle Markets Magazine or whatever. One of those sources quoted that it was about roughly between 1,000 and 1,200 middle market M&A transactions happening per quarter, steadily for the last couple of years. So there are exponentially more M&A transactions than there are IPOs, and that’s a great insight that once you get out there with your S-1 filing, you pretty much hard and fast set a rate, and if somebody can go north of that, that’s a great buying opportunity out there.
Darryl Grant: Absolutely. And then furthermore, we look at companies that are going through these sell-side events. It’s competitive. Your strategic partner or buyer is looking at multiple companies within your space and they’re intelligent about the space that they’ve already been shopping for a while, which typically most companies are, and their analysts are sharp. So you do want to gain an edge. However that you can gain that edge is smaller than they seem, it can move the needle. And if you’re showing up to a buyer with an unsophisticated data room that’s generally used for consumer usage, it does give you a disadvantage. So using the enterprise-grade data room, not because it’s a product of ours. It’s not why we recommend it. I truly recommend it because I know for certain that it does facilitate a better deal outcome for anyone selling their company.
Patrick Stroth: I don’t think there’s any better reason in M&A when you have a service out there to consider as the judge of whether or not the service is accurate is, does it make consummating a deal and successfully closing easier or harder? And if it’s the former, you go with it. If it’s the latter, you stay away. It’s just that simple.
Darryl Grant: Absolutely, and buyers are smart. They do due diligence all the time. So when they receive a link from, say, a Toppan Merrill data room or they see our data site one, “Okay, this company is on it. They’re sharp. What we’re potentially going to buy has been securely managed, so I feel good about this transaction already.” Versus the three other links that they may get that may not be enterprise-grade data rooms. Your company may not be on par in terms of value, but yours certainly gets a better look and a more sophisticated look when you use enterprise-grade data rooms. My mother used to always say, “Don’t be penny rich and dollar poor,” so it’s worth a spend.
Patrick Stroth: That’s absolutely correct. Another quick thing on the trends. Give me a balance between financial buyers and strategic buyers like corp dev or whatever. Are you seeing changes in the amount? Who needs who in terms of the number of transactions, corp or private equity or financial buyers?
Darryl Grant: I think the splits are … I wait for the numbers to flesh out. I think they’re pretty much on par with what we’ve seen in the past. The CDC space has grown exponentially. I think every large multinational or large corporate firm issuer has a venture arm and they look at strategic ways to grow because organic growth is somewhat easier that way sometimes instead of doing all of the development yourself. I think that those trend lines will continue to grow, and we’ve seen them grow over the last couple of years. But private equity’s still very much involved in the space. They are experts in some areas in terms of maximizing value and turning companies around, so I think we’ll continue to see that.
Sometimes it happens strategically, like Cavium recently was acquired and part of that acquisition was intentional by both parties because the private equity firm has some specialties that help them accelerate what they were planning to do with their products. I think we’ll continue to see CDCs and strategics be more engaged and involved in their buying habits, and they’re getting in a lot earlier. They’re very much engaged into Series A, Series B, Series C companies to build a rapport and relationship with founders, and they’ll be a part of introductory and support them prior to a and acquisition, whereas private equity tends to participate a little bit later sometimes. But strategically, I think over time we’ll continue to see more and more corporations buying other companies and leading that trend.
Patrick Stroth: All of that is good for us in the M&A business, so appreciate all that and some great insights here today from Darryl Grant. Darryl, how can our audience reach you to go get a demo of Toppan Merrill’s data room or the other services they have, just to kick the tires and see how it could work for them? How can they get ahold of you?
Darryl Grant: Absolutely. If you’re looking to get in touch with me, you can reach me on email at Darryl, D-A-R-R-Y-L, Grant, G-R-A-N-T, @toppanmerrill.com, T-O-P-P-A-N, M-E-R-R-I-L-L, .com. If that’s too much, just reach me on my mobile directly at 917-847-4111. I’m a native New Yorker and I can’t let my New York phone number go, so I’ve been in the Bay Area for five years. Your best bet on reaching me is there.
Patrick Stroth: Excellent. Darryl, thank you again, and we’ll be talking to you for other insights on Toppan Merrill. Have a good afternoon, Darryl.
Darryl Grant: Thank you so much.
If you’ve been keeping an eye on oil and gas markets, you know there was a significant drop in oil prices in 2014, starting in June of that year. No news there. From a 3 ½ year average of $110 per barrel, prices fell steadily, hitting a low of $29 in 2016.
This had wide-ranging repercussions, of course. But let’s focus here on how investors reacted.
For starters, Master Limited Partnerships, which had been a favored investment for more than two decades and had benefited from the Shale Revolution, were hit hard, with many going bankrupt or facing restructuring.
The fall of MLPs set the stage for opportunity. And, from 2014 onward, Private Equity filled in the gaps and has made increasing investments in this sector as the downturn continued.
What happened to MLPs, which were the structure historically used by “midstream” companies that transport and store oil and gas? Even as oil prices rise, they haven’t regained their popularity.
The most recent tax reform bill reduced some of the tax advantages they had over corporations, for one. Then rising interest rates made other investments more attractive.
Fast forward to present day and MLP’s loss is PE’s gain as the price of oil increases. Since the bust, PE firms have been investing in smaller acquisitions through portfolio companies and snapping up acreage at discounts during the oil bust. And now they’re getting ready to cash in.
There are some obstacles in the form of a slow-down in M&A in the energy sector in the last year or so.
But, inevitably, these conditions are changing. The energy market, especially oil and gas, are irrepressibly cyclical in nature. So, while M&A activity has been slow recently, there are numerous signs of an increase in the coming year:
Look for Private Equity to lead the charge in M&A in the energy space for two reasons.
1. All the dry powder. Investors don’t want to sit on the money; they want to invest and make it work for them.
2. The availability of companies for sale at bargain prices due to the downturn.
While opportunities abound, the scale of capital required compels players to use caution.
Here’s what you need before engaging in any Mergers and Acquisitions in the energy industry:
You need the right advisors. You must have an investment banker with experience in energy and an M&A lawyer experienced in doing your type of deal. Don’t be scared of high fees from these experts – it’s worth it because they know the network and the relatively small energy M&A community.
It’s unlike other industries in that, because of the hundreds of millions used in capital projects, one little “mistake” could cost millions. The energy industry has its own language and legal/regulatory requirements. It’s complicated. Savvy Buyers seek expert help when conducting due diligence on potential acquisitions and during the transaction.
But it doesn’t hurt to have some extra protection for peace of mind.
This is why Representations and Warranty (R&W) insurance is essential to cover deals in this industry and is increasingly used.
An R&W policy removes the risk from the transaction from either Buyer or Seller and shifts it to a third party – the insurance company, who pays out if there are any breaches post-closing.
When Private Equity is on the sell side, they want a clean exit and the ability to distribute the proceeds to their investors quickly. R&W coverage accomplishes that by ensuring less money is held in escrow. And M&A is a great way to reduce risk and get a clean exit with no worry about clawback. Not to mention, it makes for much smoother, less contentious negotiations.
My recent podcast interview with Jimmy Vallee, partner in the M&A and Energy practices at the Houston office of law firm Paul Hastings, was invaluable in gauging where the energy sector is today and where it’s going – and why.
You can get more details here: http://www.paulhastings.com/home.
There’s been a lot of talk lately that M&A activity will trend downward in the coming year because of…
These factors do have an impact on the economy, but I think the impact on M&A specifically has been vastly overstated. It’s not hard to see why, when you consider those issues popped up in the last 60 days of 2018. It was overwhelming bad news in a short timeframe. It made people nervous.
But, when you look at current real market factors, the same ones that made 2018 a banner year for M&A, you’ll see that the same conditions are projected for 2019.
In the first nine months of 2018 alone, there were $1.3 trillion worth of deals for American companies. If you look at the worldwide figure – it’s $3.3 trillion.
This is the most in the four decades that records of M&A transactions have been kept.
There may not be a mad frenzy of buyers, because they have so many options for acquisitions. But especially for transactions in the $50 million to $300 million range, it’s going to be a good year.
Corporate America and private equity firms have plenty of cash on hand, popularly known as dry powder, and they’re spending it to increase their market share, obtain valuable intellectual property, and more. As of June 2018, there was more than $1.8 trillion in capital waiting in the wings, which is a record.
Investors are also driving this trend, as when they give money to a PE firm, they expect them to buy something. Investing in other companies is a more efficient – and profitable – use of the money than sitting on it. That’s the attitude. And with so many attractive acquisition targets (see #4 and #5 on this list), who can blame them.
It’s true that interest rates have gone up. The Fed raised its benchmark rate to 2.5% in December 2018 and has announced plans to go to 3% in 2019. This is up from a low of 0.25% in 2008, at the kickoff of the Great Recession. It’s gradually gone up since then, starting with a hike to 0.5% in December 2015.
But, when you look to the past, you’ll see that current interest rates are actually quite low in comparison. In 2007, the rate hovered around 5%. It was at nearly 10% in 1989. And in the late 1970s, early 1980s, rates were all over place, ranging from 8% to over 20%.
Today’s interest rates are tame by comparison.
The M&A market has been very seller-friendly based on macro issues, including the use of auctions rather than negotiated sales and an increase in private buyers. But this year things are going to even out, and may even tip to a more buyer-friendly market.
It’s all that dry powder. Buyers have all this cash and are getting more favorable valuations for target companies. Something that was valued at five times earnings is, in this climate, valued at four times earnings.
Another factor here is that Boomer business owners are ready to retire and looking for an exit. They’re ready to sell now. And Buyers know it.
More than ever, companies today are being created and carefully built for acquisition, not an IPO. I’m not talking about the headline-garnering acquisitions like Disney buying Lucasfilm for $4 billion back in 2012.
The real heroes are those companies that get sold in the $50 million range. These deals just don’t get the press, even though they’re often very beneficial to investors and Sellers.
Imagine two scenarios. In the first, you’re an investor in Uber, which is planning to go public later this year. Consider your return on investment with a small piece of the Uber pie and compare it to having a 40% stake in a small tech firm that gets bought for $50 million.
In one recent case, a tech company was sold for $80 million. Husband and wife owned it 100%. They would have never gone IPO. But, by building a solid company, they were able to be acquired for a tidy sum. And with the proceeds, they were able to give $1 million to each of their 15 employees.
In the current market, more companies are simply well managed and well run, with professional and effective leadership. Management is given the resources it needs to be successful. And good ideas are supported.
The days of the Dotcom era where companies were slapped together, investor money was thrown around freely, and “management” was a dirty word are long gone.
This means there are plenty of solid companies with good financials and management teams out there, ripe for acquisition. And often management stays on in the transition.
All these factors provide a rich environment for M&A that is strong and sustainable. And there are more that I believe are contributing to an ongoing M&A boom.
To get the full list, just get this free download:
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.
There is an insurance product that almost every business in the healthcare sector and even individual providers needs, especially those that bill patients and payors (like insurance companies or the government through Medicare).
It’s just as important as malpractice insurance. And, if you’re ever thinking about selling your dental practice, doctor’s office, or other medical business, it’s critical you get this coverage right away.
It’s called Healthcare Regulatory and Billing Liability insurance.
Even if a company in healthcare isn’t directly billing patients, they could still be at risk. Anybody providing resources to care for patients should be covered, and it’s not just those who provide care for patients directly.
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.
You’ve seen the commercials on TV.
You visit a website and easily apply for insurance for your home or car, getting quotes from multiple companies at the same time. Some types of health insurance even work like this.
The advantage of these online marketplaces is you don’t have to go through the time-consuming process of calling or visiting an agent to get your policy… who might even try to upsell you on other services. It can be a real chore.
I have no problem with this so-called “insurtech” when it’s used to secure these relatively simple types of “consumer” insurance faster and easier.
When it comes to any sort of insurance product with the least bit of complexity, however, insurtech should be just a first step to give you a ballpark idea of what’s out there.
And, you need an expert helping you in person when you go beyond this Step 1 to ensure you get the coverage you need.
Take the popular online legal services website, LegalZoom. They make it super easy to set up articles of incorporation. But if you’re a startup looking to attract serious investors, doing so would lose you all credibility. And you couldn’t be certain your business was structured correctly.
With insurance, you could potentially go “DIY” and try to do your own research to figure out which option is best for you as far as type of policy and level of coverage. But if something goes wrong down the line and you discover a certain risk isn’t covered, it’s all on you.
You could sue the insurance company but… good luck there.
You need an expert who does this for a living and knows specialized types of insurance like Representations and Warranty (R&W), which covers M&A transactions, as well as Directors and Officers liability insurance, Cyber Security insurance, and more, inside and out.
If you deal with a broker, you not only have an expert to answer questions. The broker is also accountable. By law, they have a fiduciary responsibility to look after your best interests. If they make a mistake, you have someone to go after.
These brokers may not be available 24/7 like an online marketplace, but they have the specific information you need and the answers to your complicated questions, backed up by years of experience dealing with these issues every day. That peace of mind is priceless when so much money is on the line.
And, speaking of money, the difference in what you’ll pay in fees for an online marketplace versus an in-person broker is not as much as you might think. A bargain compared to the millions of dollars that change hands in a typical M&A deal.
When you use a broker, you get responsiveness and expert-level input to make sure you get the right policy.
Let’s use an example from the auto insurance world.
On-line auto policies provide Liability and coverage for physical damage to the car (Comprehensive/Collision coverage), which most buyers understand. To keep costs down, buyers only select the coverages they think they need at the lowest Limit possible to comply with the law.
The danger, is these “optional” coverages purchased at levels solely dictated by price, can leave drivers seriously unprotected.
In the case of Uninsured motorists – a driver will be left paying his medical bills and those of his passengers if his car is struck by someone with little or no insurance (think drunk driver).
Worse is when young adults (the “m-word”) living in their parents’ home purchase a tiny amount of insurance thinking they have no net worth at risk. They later find a court will likely allow attorneys to pursue their parents’ home for compensation because of their residence – so the house is “fair game”.
This is no problem when there is a savvy broker involved. They’ll ask the questions necessary to understand what’s at stake and they can provide complete explanations of coverage, so buyers can make an informed decision.
When it comes to complex insurance like Directors and Officers liability and R&W, only where the needs are very simple can I say that insurtech is the way to secure a policy.
The vast majority of situations and transactions are much too complex. In the case of R&W insurance, this coverage is intimately intertwined with an M&A deal and is a major component of the negotiations. Underwriters need quite a bit of information before they’re confident in writing your policy. That’s not something you can handle online.
In these cases, you need someone on your team who can put together a “patchwork” of different coverages and policies so there are no gaps… and no overlapping that causes you to pay too much.
The layman can’t read through the policies to figure that out on their own. This complexity is why brokers are licensed and regulated.
If you’re looking at securing a specialized type of insurance like Representations and Warranty, Directors and Officers liability, or Cyber Security, bypass the online portals and talk with an expert.
I’m happy to jump on the phone or answer your questions by email. You can reach me at (650) 931-2321 or email@example.com.
A phishing attack on UnityPoint Health, a hospital and clinic system in Illinois, Wisconsin, and Iowa in March 2018 resulted in 1.4 million patient records being compromised.
In April 2018, hackers were offering up 5 million credit and debit cards online to the highest bidder, stolen from luxury department stores Lord & Taylor and Saks Fifth Avenue.
Where is Silicon Valley headed in 2019… and beyond?
As with any forecast, you first have to look to the past and the present day to get a sense of what trends will continue, and what surprises we might find in the future.
I recently sat down with Bob Karr, founder and CEO of business-focused social network, Link SV, to get his thoughts on what he sees as the most important trends that will impact the Valley.
They run the gamut, from staffing to mergers and acquisitions.
If you run a startup, work in tech, or invest, this is a must read to get an idea of fundamental shifts that are changing the way you do business.
As Bob notes, some people these days are building companies to pass down to their kids; the classic family business. Others are trying to create major companies that they hope will grow big enough to go public…a unicorn like Uber, in other words.
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.
When it comes to M&A transactions, the relatively low cost of Representations and Warranty (R&W) insurance makes it a no-brainer for those Buyers and Sellers who want a smoother deal process, more money at closing for the Seller, and a third-party (the insurer) ready to pay out to the Buyer if there are any breaches post-closing.
Right now, the cost of R&W coverage is a narrow range. The premium insurers will charge is 2% – 4% of the policy limit. And that number doesn’t appear to be going up anytime soon.
Add to that the Underwriting fee, which is $25k – $50K (depending on the size and complexity of the deal) and policy taxes determined by the Buyer’s state of domicile, which can range from 3% – 7% of the premium.
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 firstname.lastname@example.org. 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.
I recently had the privilege of speaking with Samir Shah, operating partner with Cervin Ventures, which is a Silicon Valley based pre-Series A venture capital firm specializing in enterprise technology. Samir has a background that gives him unique insight into the world of tech startups and M&A.
Prior to joining Cervin Ventures, Samir founded the software testing firm, Zephyr, and ran it as CEO until it sold.
After seeing what makes for a successful (and attractive) company from the sell side, and what he and the team look for when investing in startups, Samir has distilled that knowledge and experience into a series of eight “one-liners” (think of them like maxims or rules) that should guide any entrepreneur as they build their business, as well as VCs looking for startups with potential to invest in.
These one-liners get into the heart of what separates successful businesses from those that crash and burn.
Every business owner has to ask this question – and sometimes face a hard truth that could impact growth and/or a future merger or acquisition.
The way you answer, is to look at what you’ve created.
Have you come up with something that’s simply a feature that improves an existing product?
Is this a product that people will actually use? Be honest with yourself about the market potential.
Once you know the answer to these questions you can figure out how to sell that feature or product to another company. At that point your journey with this business is over.
Do you actually have a company with the potential to create many profitable products… a sustainable venture that could continue to grow and could be bought down the road for a sizable amount?
It’s essential to start generating revenue as early as possible. Too many business owners fall in love with their product before they’ve even sold one unit and delay bringing it to market to perfect it.
Perfect is the enemy of good. And, the sooner you get a product out to market, the sooner you get feedback and can make adjustments, tweaks, and improvements that will make it more attractive to your customers.
Apple is a great example. Their first version of any new product, while superior to other market options, is completely inferior to the versions they release a year or two later. Apps get released with major bugs that are later ironed out. There isn’t one app that hasn’t needed some fixes down the road.
It’s essential to note that the business doesn’t need to be profitable at this point, just that there is someone out there willing to pay you for your products. Build/improve from there, and revenues will lead to profits.
3. It rains dollar bills when their hair is on fire.
Take a long hard look at the product or service you offer. Does it fit a need? Does it solve a problem?
Your goal is to find the people who have that need because they will pay anything to have that problem solved. As Samir says, “How do you get to revenue fast? Real revenue, sustainable revenue comes from use cases where the customers’ ‘hair is on fire,’” i.e. they have an intense, urgent need.
A great example of this is IT security. Hacking has been a big deal for a long time… and always will be. Products in this niche have a high demand. They’re a must-have.
“Selling is hard. Everybody is trying to sell something,” notes Samir. It’s true that people are hard-wired to feel threatened when “being sold.”
So instead of trying to persuade someone to buy, make it easy for your customers to find you and make your product or service as easy to use as possible, not to mention truly useful (see #1).
If it’s easier to buy from you than a competitor, and you’re the “path of least resistance,” you become the clear choice.
5. One good salesman is transformative.
Nothing happens until something is sold and someone has to do the “selling”. In the beginning, it’s the owner/founder, but at some point, someone else is needed in this essential role for a company to truly grow.
Probably the hardest person to hire is a top-notch salesperson. You almost never get it right the first time.
But you have to keep trying because nothing happens if you don’t sell.
To find this person, talk to mentors and colleagues, get recommendations. Sometimes your best salesperson is someone inside your firm who understands your product and believes in it.
Compensation does go up for these special people, and your search will take time. But it’s well worth it for how this one person can radically change your business.
It’s not enough to have a great idea or concept. Until customers pay you money… you don’t have a real business. Revenue is the lifeblood of any company.
And when you have money coming in, it changes how customers, your team, investors, and your competitors look at you. It also changes the perspective of potential strategic partners. Obviously, if you’re generating significant revenue, people will be more likely to want to work with you.
Think back to the Dotcom era. So many startups just burned through investors’ money without anything to show for it. They weren’t generating revenue, let alone a profit. And we all know where those companies are today.
Companies that make the leap to actually generating revenue have to be prepared for the next stage when they become flush. It’s counterintuitive, but more money can actually create more problems, as we’ll see in the next step.
You’ve worked so hard to build the business and to generate revenue. Once you accomplish that goal, it’s tempting to “take a break,” so to speak. But when management gets sloppy, things can go south quickly.
Samir suggests thinking of your business as a bucket. Customers (and revenue) are pouring in at the top. But, if you have holes in the bucket, more money could start leaking out than is coming in.
You might put off solving small problems or inefficiencies that cost more to solve later. You could be hot in pursuit of new customers… but neglect your existing core customers, which prompts them to leave. Bugs could crop up, you could have problems with pricing, or a new competitor could emerge.
The point is, you have to always watch for leaks and plug them as soon as possible.
Your greatest source of additional revenue is existing clients. And it’s much easier (and cheaper) to “sell” to them than convince new customers, who don’t know you, to come on board.
Don’t take your core customers for granted. Always consider if there is anything more they need from you. Is there more value you can deliver?
It’s tempting to think that you already have an account, so you’re free to focus on going after new accounts. But you risk losing customers. If you meet their new needs they’re less likely to go elsewhere.
Samir’s eight one-liners can help guide founders, entrepreneurs, and VCs as they build or invest in businesses. In the complex world of Silicon Valley and the tech industry, it can sometimes be easy to forget what makes for a strong, viable business.
The truth is that these rules apply to any industry. As you’ve seen, these are simple good business practices that you should follow for any business venture. If you’re involved in any sort of startup these should be rules to live by.
To help you keep Samir’s one-liners top of mind, you can download Samir’s list of one-liners and keep it posted as a reminder for you and your team.
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
The typical M&A deal can be a long, drawn-out process – and painful, too. Negotiations on the Purchase and Sale Agreement can stretch out for months – or longer – as lawyers haggle over terms and contract language. And Sellers are often dismayed by how much money is held in escrow at closing to cover indemnity.
There’s a way to make those problems go away:
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Imagine the subtle grin on your client’s face as you tell them how you’ve managed to improve the terms of their deal by a few million dollars…
You’d have a happy client, wouldn’t you?
And, if you could do that for all of your clients, I’d bet that word would get around.
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.
Many companies today are sitting on an untapped goldmine that could be worth tens of millions of dollars. Technology companies, in particular, are poised to benefit, especially those in Silicon Valley.
The gold is patents that are unused and not part of the core business. This intellectual property might not be valuable to the company that developed the technology, but the right Buyer would be willing to pay top dollar. And, you can start monetizing these assets now, as you’ll see in a moment.
Today, we discuss why cybersecurity is a necessity for companies considering an M&A transaction. If your company doesn’t use the Internet, you can skip this program.
The old school, traditional way of looking at corporate security involves physical assets such as market research, intellectual property, and other corporate secrets that can be locked away. Picture the secret formula for Coca-Cola is sitting in a safe somewhere in an undisclosed location in Atlanta.
Today, we discuss the details behind the best practices to exiting with M&A.
When an M&A Buyer acquires a company these days – especially a tech company – more often than not they compel the business’s Founders and key employees to enter into a re-vesting agreement.
Here’s a conversation regarding revesting, a staple in tech M&A designed to favor not only buyers, but owners, founders, and their investors.
News came across the wire recently about a major lawsuit targeting a well-known Private Equity firm due to a post-closing dispute in a substantial M&A deal.
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Today, I speak with Stephen Hohenrieder about M&A in a sector we ALL use EVERY DAY – food. After hearing this conversation, you won’t look at food the same way again!
From a cost perspective, there’s never been a better time to deploy Representations and Warranty (R&W) insurance in M&A deals.
In every M&A deal, the devil is in the details. Nate McKitterick explains the ins and outs of one of the biggest potential deal breaking issues – indemnification.
The current economic environment makes it a prime time for mergers and acquisitions.
Activity in M&A in recent years bears it out. Total global M&A transactions for 2017 hit $3.2 trillion, the third year in a row annual M&A crested $3 trillion.
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Representations and Warranty insurance is the ideal way to protect both Buyer and Seller in an M&A transaction. If there is a breach of a representation or warranty in the purchase and sale agreement, they are protected. Both sides come out ahead because the risk is transferred to a third party: the insurance company.
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Technology isn’t the only fast changing industry. Listen to Jimmy Vallee explain why the oil and gas business is so dynamic that the city of Houston is now considered the “Silicon Valley” of energy.
Closing an M&A deal is similar to closing escrow on a house. You sign documents, a wire transfer with the funds is processed, and you take possession.
If you’re considering your first deal, why not get the perspective from someone who has successfully completed over 500 deals in the past 30 years.
The use of Representations and Warranty insurance in M&A has been growing over the last several years. It jumped 240% from 2001 to 2015. And while in the not-too-distant past only deals of $50 million to $1.5 billion were eligible for coverage, insurers are now covering deals as low as $20 million.
In our conversation, Patrick Krause explains the unique balance healthcare companies must make between quality of care and profitability, as well how the healthcare sector is unique to any other business today.
If you’re the Buyer in a merger or acquisition, you can take one action at the start of the deal—at the offer stage—that will
In this podcast, I speak with Terry on the importance of getting your “financial house” in order BEFORE you let anyone know you’re looking to sell your company.
Would you buy a house without a home inspection or a title search?
Of course not. It would be way too risky.
That’s why Underwriters insist on thorough due diligence when they put together insurance policies covering multi-million-dollar M&A deals.
In this podcast, I speak with Shari Yocum of EY focusing on the often overlooked “human-side” of M&A.
Today I speak with Patrick Crocker, an investment banker with MHT Partners to discuss the critical role investment bankers play in helping founders/owners maximize their payout in M&A.
In our first podcast, listen as I interview the leading M&A litigator, Joe Finnerty of DLA Piper as we discuss claims in M&A.
As global insurance and risk management professional service firms, Marsh & McLennan and Aon do great work and have solid reputations in the world of M&A insurance. Along with Rubicon M&A Insurance Services, LLC, they are the only companies offering this specialized type of insurance to companies in Silicon Valley.
At the end of the day, successful mergers and acquisitions are about bringing people together… coming to an agreement and moving forward to everybody’s satisfaction.
I have a surprising truth for you. It goes against everything you’ve been taught or experienced when it comes to insurance companies.
When it comes to standard car, home, or health insurance, policyholders tend to play it close to the vest.
They won’t freely give information above what the insurance company requires, and if the insurer starts asking questions, especially about a claim, they get downright defensive.
They’re worried the company is trying to deny a claim or exclude something from their policy. A policyholder’s biggest fear is not getting paid when they actually want to use the insurance they’ve been paying premiums for. Hey, it does happen.
Up until very recently, rep and warranty insurance, which offers many advantages to buyers and sellers during mergers and acquisitions, has been available primarily with deals worth $50 million or more.
But good news for those involved in smaller deals.
A couple of years back, I witnessed a train wreck of an acquisition that could have gone much, much smoother if the parties involved had taken one extra, but very low cost, step as they put together the deal.
Let me set the scene. The owner of a telecommunications company was ready to sell… to the tune of $100+ million. He had a buyer all ready to go. That’s when the trouble started.
Representations and warranties insurance should be part of any large-scale merger or acquisition deal. Such a policy puts the risk in a business transaction away from buyer and seller and onto a third party – an insurance company.
In March 2017, luxury automaker Audi, part of the Volkswagen Group, announced they were buying Silvercar, a distinctive and disruptive rental car company known for its fleet of Audi A4s in, what else, silver.
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The scene – an unnamed company. A new CFO was appointed and installed as the 401(k) plan administrator. He replaced the 12 investment options offered before with three mutual funds. It turns out his brother managed those funds. A clear conflict of interest with regard to the 401(k) plan – enough to trigger serious legal action.
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If you’re offering health insurance to your employees, you may not know it, but there’s a “hidden” liability waiting inside your plan. It’s waiting for you, the fiduciary of the plan, to make a simple clerical mistake. When you do it will cost you $110 per day, per employee. For a 100-person firm, that’s $11,000 PER DAY!
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Rep & Warranty Insurance is a well-known tool to reduce risk and increase cash flow for the M&A industry. But what if your deal is too small (under $50M transaction value) for R&W?
There’s hope for one of the most active sectors in M&A – healthcare, where news of a lesser-known tactic for saving money is all the more important for physicians, owners of healthcare firms and their advisors.
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Imagine the subtle grin on your client’s face as you tell them how you’ve managed to improve the terms of their deal by a few million dollars…
You’d have a happy client wouldn’t you?
And, if you could do that for all of your clients, I’d bet that word will get around.
If you could do that, without adding any cost or complication to your world, you’d do it on every deal, wouldn’t you…?
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Many employers provide 401(k) plans and other retirement benefits to their employees for a variety of reasons from altruistic, to pure competitive necessity. What these
employers don’t realize is that the moment they set up a Plan, they’re no longer just an employer. They are a Plan Sponsor, and in the eyes of the Federal Government – a “fiduciary”.
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Over the last 3 years, Representation & Warranty Insurance (R&W) has been gaining interest throughout the M&A Sector. R&W is an insurance contract designed to protect buyers and sellers from financial loss that result from a breach of the seller’s representations.
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Step 1. There’s no insurance application. While not required, we prefer to schedule a 20 minute call with a member of the Buyer’s team to discuss the deal in general terms in order for us to prepare a narrative for Underwriters. In addition to the pre-submission discussion, terms can be provided upon our receipt of the following:
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The Seller’s Nightmare is Real
Time is a cruel and silent thief, with its hand deep in your pocket. The longer the process drags on, the lower the price will go (or the smaller the check will be at closing). All BAD NEWS for you.
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