Equity Promises, Promises, Promises

“Your ego is writing checks your body can’t cash.” – Stinger – dialogue from” Top Gun”

When I started this blog over four years ago, I promised myself I would not repeat a topic, and to prevent that, I keep a file of all my blogs. Well today, I have to break that promise. The reason is simple; I spent a great deal of time on three new clients (and prospects) recently dealing with this issue. So I thought maybe visiting it again will prevent at least a couple of early stage companies from having to confront this dilemma. So let’s just take one case.

An entrepreneur contacts me for help with a series of acquisition transactions. He and his team of three have been working on this project for a little over a year – – none are taking salary but all have a promise of “a piece of the pie” once they get a bit further along. The good news is the CEO is calling to tell me an investor believes in what they are doing and just invested $200,000 for 10% of the business. They are also close to a Letter of Intent on the first target. We proceed to spend the next 2 – 3 hours talking structure, due diligence, and deal points and start to lay out a roadmap to completing the first transaction. All good so far.

Being obsessed with equity, I ask about the other three team members. The CEO had made a de minimis investment to get started and the other three joined shortly thereafter. I asked what their “deals” were, and as usual, there was nothing in writing, but verbal agreement that they would each get 5% of the business. Of course, they would all vest and all were expecting to get in at “founders’ share” (i.e. de minimis) prices.

So I asked the first question; was the new investor aware of the “promises”, and unfortunately, he was not. So in the end, the 15% (and perhaps more) will probably have to be taken out of the CEO’s shares. The next question was what would be the mechanics of the key employees’ deal? The answer was that now that there were funds, they could afford to get legal counsel to draw up the paperwork and issue the shares. I was amazed to find that though there was a bona fide transaction for the recent investment which valued the Company at about $2 million, the CEO thought he could issue these shares at the de minimis value.

The lesson here is while there are investment vehicles that may not establish value (convertible notes – often cited as “kicking the can down the road” on this topic), pure equity deals due create economic value that have to be considered when granting equity. In all of these cases, solving this issue is going to take money and time; two rare resources for an emerging growth company. So as I have said before, nail down the equity issues first and treat it like gold because I believe that though cash is king; today equity funds the monarchy. Be very diligent (use advisors) when determining when and how much equity others get because you do not want to “write checks your body (company) can’t cash.”

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Why Acquisitions Fail

“Everything’s so green!” – line by King Louis XVI from Mel Brook’s “History of the World”

Over the years, I have worked with many clients on dozens of acquisition transactions. When I think back to the early stages of any of these deals, it conjures up this line from “History of the World.” A potential deal was like a new love; everything looked fantastic and the benefits seemed to far outweigh any issues; leading to that often-used phrase “it’s a no brainer.” For my more strategic thinking clients, this was often the case. I can still picture a mosaic one of my clients created in the early years of his company, detailing product features he thought were required to capture the market. With a solid assessment of the company’s capabilities, he conveyed a clear vision as to what the company would develop and what they would acquire. This became one of many success stories. But what about the failures?

When a client would call, and indicate they were interested in acquiring a company for reasons such as the target company was available or they could be bigger with an acquisition, my antennae would always go up. I quite honestly rarely saw what I considered non-strategic deals for the sake of growth work. By the time those deals were done, they usually started to come undone as the expected returns quickly faded. So besides being poorly conceived, what caused these deals to fail? I can think of four reasons:

  • Growth over culture. Money never trumps culture and nowhere is this truer than in the case of an acquisition. If the deal is not a good cultural fit, it will fail.
  • Poor post transaction planning. The details on how you are going to operate post-deal is a major factor in its success. Broadly addressed as Post Merger Integration, poor execution in this phase is a major cause of deal disappointment.
  • Unrealistic synergies. You can’t just eliminate bodies without contemplating the consequences. As to the market and customers, there were probably good reasons the two companies existed before the deal and thinking one can handle what the other did without a well vetted understanding is fool’s play.
  • Seller’s remorse. An independent owner gets acquired and has the chance to bring his company to the next level as part of a larger organization. Sounds good in theory, but when an entrepreneur has not reported to others in a long time and now he must, it doesn’t always work. If there is an earn out involved, this often complicates the matter.

So, consider the tough stuff in the early stages of a deal when everything seems to be great. Ask the difficult questions and complete the full due diligence including what is going to happen when the honeymoon is over. With the right work, upfront you can avoid transaction failure and everything will look green – especially your bottom line.

Quick Test: Should I Form a Startup?

“You can do it!” – line made famous by Rob Schneider in “The Waterboy.”

Being a big fan of the entrepreneurial space, I love to encourage people to get involved in new ventures. Forming something new or making what is there bigger and better can have a profound change on the world, and being a part of that is both exciting and daunting. I talk to owners every day and for those just starting out with an idea, I have a little test that I use to see if they should be encouraged or just continue to dream. Keep in mind a true entrepreneur knows the difference between an idea and an opportunity – thank you, Jeff Timmons – and you have to determine early on which of the two describes your journey.

So here is the quick, five-step test:

  1. Do you have a viable, unique idea? A baseball mitt for ambidextrous players may be unique, but viability may be a question. You should also be able to create a logical one page summary of your idea. It is amazing what happens when you have to put something down in writing. If you doubt this, try this little exercise – write down what you would like written on your tombstone.
  2. Do you have some money? Regardless of what you want to do, it will cost money. You may be able to minimize the cost, but you need to have some available money to get started. When I went into my own consulting business, I knew the most frugal way to incorporate, register, get a website and business cards, etc. but it still took a few bucks.
  3. Would you like to do this for the rest of your life? Next to sleeping, we spend most of our time working. If this is going to be your “job,” do you really like it? And please make sure you are not running from something, like a job you hate, but to a life you will enjoy more.
  4. Can you take the heat? Being the boss is the good news and bad news. Every new hire is another family you are responsible for so you have to be ready for that role. The road is full of stories about the team and sharing responsibility, but in the end, the buck will stop at your door and some people are not built that way.
  5. Can you make money doing it? Having your own business is great, but you need profits to pay salaries and make it worthwhile. This can involve difficult decisions on resource allocations. Be ready for that eventuality.

So there it is. If you have answered yes to these questions – and I think they all have to be yes answers – then you are ready to seriously commit to forming your new venture. Harness your passion and enthusiasm and get started. Just keep in mind that “you can do it.”

Buy Out Values – Hail the Willing Buyer

“How the hell did he come up with that number?” – quote from a new client reacting to his partner’s price to be bought out.

Almost every week, I get the chance to see a number of potential transactions among partners — mostly negotiating buying each other’s shares or debating what value to use in a buy-sell agreement. All different types of markets with the operative words being “fair value.” So I have been in the middle of this before and I have a solution that I have used, but it involves some education and “faith” by both parties if it is going to work. Let me explain.

Fair market value is used in a somewhat cavalier fashion in these type of deals but there is little focus on the key aspects of the definition of this term which is a value based on what a knowledgeable, willing and unpressured buyer would probably pay to a knowledgeable, willing and unpressured seller. Valuation experts use common tools to arrive at a number or range, but in the end, most importantly, you need a “willing buyer.” So what is the problem?

When you go to sell your business, the willing buyer may be a financial sponsor of some type (hedge fund, private equity, venture capital, etc.) or even your competitor or someone who wants to get into that market (often called a strategic buyer). Most of these willing buyers have another way to measure the results of their transaction. For example, I had a client sell a significant division of his company to a strategic for about 15 times earnings. This was a great deal for him, but the purchaser was public, selling at 25 times earnings; and my client’s ongoing $10 million in earnings increased the buyer’s market value by $250 million. Not bad. However, this does not translate into the private company market of “willing buyers.”

Using this example, if my client wanted to sell to his partner who wanted to continue to run this business for a long time and not sell, that partner would have to fork over all earnings (at current levels) for 15 years before he would see a plug nickel. What willing buyer is going to do that? Yet, it is a problem I confront quite often. So in this case, the “willing buyer” will only offer something a bit more reasonable from a pure cash-on-cash recovery basis – say 3 to 5 years. Many buy / sells I see have a price of 3 to 5 times EBITDA which gets you to the same place.

So I often suggest that the offer be based on projected cash flow for a 3 to 5 year period. I also suggest that a provision be added such that if the company is sold in say a 5 year period, there is some form of “claw back” – that the previous owners are paid in part as if they still owned some shares (all negotiated). The alternative is to wait for that outside purchaser to come along and prolong an important exit event. So while fair market value is a sacred term, please remember when in comes to partners, it is governed by the provisions of the “willing buyer.”

Leadership; You Will Know It When You See It

“I always admired a subordinate who could stand up and say ‘you said it, chief.’” – quote from a long-time entrepreneurial client

We have all had experience with leaders, and I would be the first to admit that I openly copied the leadership traits of those I admired. The above quote came from a client years ago as I was asking how he instilled the “followship” that is an important part of leadership. His backhanded comment was a reminder of the fact that without some respect (admiration and even fear), the effectiveness of a leader can be somewhat diminished.

I thought about this when I recently attended a session / presentation on leadership. A panel of successful leaders responded to questions and provided some guidance on this topic to the audience. As enlightening as it was, I was somewhat taken aback by the commonality of the message on leadership. While each took their turn at eloquently explaining what they believed a leader was, none captured more than one or two elements of what I thought made a leader. It was at that point that I realized that no definition could capture the wide range of effective leaders I have known.

What I also began to realize as I reflected on my role models was that it was an event or opportunity that allowed that person to become a leader in my eyes. It was action more than executive presence that defined them for me. While I had known most of my leaders and knew what they were capable of, it was an event that brought out their best. Two situations, both related to initial public offerings (IPO) come to mind.

If you have ever been involved in an IPO process, you know it is one of the most intense processes known to man. While not quite like sending someone to the moon, it relies on very timely coordination and execution from a diverse team to come to the right point in time where everyone can “sign off” and give the go signal. At times, that window is only open a day or two at best and if you miss it, you have to revisit the process. At the time of this decision, expectations are high as are the attendant professional fees.

In two separate cases, we were at that go or no-go point and each CEO stepped up and determined the time was not right and the deal was pulled. In one case, it was an experienced professional manager who had been through the process before, but in the other case, it was a business owner with a very unsophisticated business who saw certain parties in the process being pushed to the edge of the envelope. While he was not sure what was going on (and he had the most at risk) he sensed it was not right and stopped the presses.

Crisis, personal issues, conflicts, financial distress, loss of major customer – – I have seen various owners respond to these traumatic events, but it was the true leaders who did not let the situation control them but stepped up to show they were leaders. It was obvious to all present that they saw leadership.

So, as an owner, be prepared to show you a leader. You may in fact be a good mentor and coach to your team, but when the opportunity presents itself, be prepared to step up and do the right thing. The ultimate success of your company may depend on it.

Do I Let My Company CFO Into My Family Office?

“Badges; we don’t need no stinkin’ badges.” – quote from “Blazing Saddles” by Mel Brooks. (Believe it or not, this is a “misquote” from a 1948 movie.)

There is no doubt that in any business a CFO can be a very valuable asset. The ability to translate the vast array of data into understandable, user-friendly and actionable information for both internal and external stakeholders is truly a highly-valued capability. In most cases, there is an unwavering trust in the CFO and having him or her in the Family Office just seems like an extension of their fiduciary responsibility. In addition, in many cases the CFO believes they have earned the right to take on this responsibility – that in fact they “don’t need no stinkin’ badge” to assume this role.

However, the position specification for a financial/operating leader in a Family Office is much broader than what is normally found for a CFO of an operating family business. When there is an operating entity, the focus is on the mechanics of that business – pricing, people, profitability and cash flow. This is a playing field where most CFOs are very comfortable and where they have gained the bulk of their life experience. But in the Family Office, the CFO has to deal at a much more personal level with individual family members. The CFO may be seen as the older generations’ “person” and may find themselves catering more to the needs of that older generation when the real needs may be those of the next generation. The CFO may have little patience for those with limited financial experience and may not be able to provide the guidance required to all family members. The requisite tasks also become much more “treasurer” based, investment performance, dividend yields, capital markets, etc., versus operating profits. This experience may not be in their “bailiwick,” and while they may be able to provide some guidance, they actually may be somewhat lost in that environment. The need to understand taxes; estate planning and wealth management may be foreign to them and simple tasks such as paying family members’ bills or providing appropriate financial education can become a bit of a challenge.

So, if you are going to consider allowing your company CFO into your Family Office, you or an advisor should assess the overall skillset, including the interpersonal capabilities and the trust and confidence that various family members have in that individual. It is not a standard “rite of passage” that you allow your Company CFO into your Family Office. I had the honor of working with several CFOs as the NY Managing Partner of Tatum and I can tell you not all would fit in with what I envision as the CFO in a Family Office. Make sure you consider the real DNA of your CFO before making this decision. In the end, if there is a match, he or she does not need a “stinkin’ badge” to be a valuable and integral part of your Family Office.