Autopsy of a Dead Deal

September 16, 2023 | Issue #90

Big Deal Small Business: Autopsy of a Dead Deal

September 16, 2023 | Issue #90

If you are a new reader / new searcher, I recommend starting with the New Searcher Reader Guide.

Thank you to everyone who responded to my reader survey last month — super helpful insights. While it may take me a while to pull together, please keep an eye out for the following in the next few months:

• Downloadable spreadsheet templates

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As the new MBA school year kicks off, I’d also appreciate it if you could share this newsletter with folks in your network who may be joining their school’s ETA club. Thank you! Okay, let’s dive into a longer Saturday morning post.

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I’ve spoken in the past about a deal that got very close to the finish line, before suddenly dying in a jarring way.

Thankfully, I did eventually close a deal, so you know there’s a happy ending. But this post is meant to provide an idea of how a small business acquisition can go off the rails, ultimately resulting in months of wasted effort & ~$40K in lost diligence expenses.

Note that I’ve lightly fudged some details for privacy reasons, but is otherwise an accurate retelling of the story.

Note on Dealmaking

My general philosophy with business acquisition deals is that they WANT to die.

They are trains looking to jump the tracks. As the dealmaker, your job is to corral that train onto the tracks in any way possible. You may have heard the phrase “time kills deals” before — but it’s not that deals tend to die out over time, it’s that they are actively TRYING to die at any moment. If you wait too long, eventually they’ll outfox you and succeed.

This is a good example of a deal just figuring out a way to die that I didn’t foresee. This is a longer read, hence the weekend post — hope you enjoy it.

Deal Sourcing

At this stage in my search, I had reviewed 40-50 small businesses, so I know the basics of small business search and how it differed from my prior life in private equity.

I had started to build a thesis around high-end tour operators. These businesses organize excursions for high-end clientele.

Crucially, they don’t provide the actual activities — they will organize a kayak trip on day one, a hike on day two, and so on — but the actual kayak company is a vendor, the hiking guide is a vendor, etc.

As a result, high-end tour operators are high-margin, asset-light service businesses (other than owning transport buses) with great customers. These customers are both willing to pay & able to pay.

The operations are simple, which was important to me as a first-time operator. You’re coordinating logistics for your clients across a variety of small activity & lodging vendors. These operators tend to feature negative working capital given customers make deposits for future bookings and vendors generally don’t require upfront payments.

The key downsides are limited recurring or even repeat revenue unless you operate multiple locations, low barriers to entry, and the risks inherent with operating in exotic locations. I passed on a few deals that were either too small or too exotic before coming across a good pitch via a broker in Alaska.

As an Alaskan tour operator, the company had the benefit of:

1. Being exotic enough that domestic & international travelers both see the value of hiring a specialized tour operators

2. Being domestic enough to mitigate the risk associated with operating in exotic locations

3. Large negative working capital balance thanks to customer deposits, and we had forward visibility for 60% of next year’s revenue, nine months in advance.

LOI Negotiation

After a financial review, several Zoom discussions about the business, and a site visit, I signed a detailed LOI roughly two months after the initial introduction. In hindsight, that was too slow / long, though I was still working my day job at the time and needed to prioritize that.

It was a non-competitive process, so I felt like I could do a lot of negotiating upfront rather than spend the time on DD only to find out we don’t have an economic deal.

Note that in a more competitive M&A environment, this pace was highly unusual. Plenty of brokers will push you to submit an LOI prior to even meeting the seller. In my case, I had the luxury of it being a hard-to-sell asset, even though I thought it was a high quality business.

Given I had the time, I got granular in the LOI. I negotiated a large seller note that was partially forfeitable based on upcoming year performance, which is allowable under SBA rules.

I negotiated a seller transition agreement with salary, key dates, etc. I even negotiated the key elements of working capital given how important the customer deposits were to the business.

In other words, this wasn’t a glorified handshake LOI with bombs to come later, this was a comprehensive deal framework.

Post-LOI Diligence

I conducted due diligence over the following two months, which included:

• Quality of Earnings

• GL & monthly P&L review by me (a ton of time was spent matching up revenue and costs given the dynamic of clients booking their tour 6-12 months in advance of the tour date)

• Analysis of prior year booking pacing, active bookings & capacity models

• Review of vendors

• Review of industry metrics, growth bottlenecks, local & national competitors, etc.

The QoE took longer than expected due to the Seller being financially unsophisticated and her internal bookkeeper having recently left for a new job. We ultimately managed to tie out EBITDA to the marketed numbers even though it required me digging through the general ledger line by line to find some inaccurately-categorized expenses.

Financing

While diligence was ongoing, we put together a great equity investor group for the equity. This part was the most enjoyable part of the whole deal process. I’m happy to make referrals for other self-funded searchers to some excellent small business investors when you have a deal ready to go. Many of the prospective investors in this deal ended up being investors in the eventual deal that actually closed.

I wish the lending side had been as smooth as the equity side.

Given the deal’s location and tourism-bent (and recall that COVID was a more recent memory), it didn’t fit the box for the well-known lenders in the SBA space.

As a result, I focused in on regional SBA lenders in Alaska & Washington State. After going out to ~8-10 banks, I ultimately got three term sheets, of which two felt thoughtful & serious.

I picked the Alaska-based lender and plowed forward into their underwriting process. We moved relatively quickly, jumping through their hoops in quick order.

They were finally going to their credit committee to discuss the deal, and the closer gave me general reassurance that this should be a perfunctory meeting.

I received a call from her later that day while I was driving — I have a vivid memory of seeing her number pop up on my phone. I was expecting an email with a commitment letter, so receiving a phone call made me pull the car over.

She explained that their credit committee had decided they want to put the loan through the SBA GP process, which is “General Partner”, which would introduce a 4-6+ week delay.

The SBA’s loans are issued via lending partner banks. They have two types of lending partners — Preferred Lender Partner (PLP) or General Partner (GP).

The key distinction is that PLPs can make SBA-guaranteed loans WITHOUT prior approval from the SBA. GPs must get explicit SBA approval before issuing such loans.

The lender I had selected was a PLP, which was on purpose — I know about this distinction.

What I didn’t know was that apparently this specific bank had experienced some credit losses in the prior few years in which the SBA told them their underwriting was faulty and refused to provide the guarantee (yes, even for PLPs, the SBA can rescind their guarantee to the bank if they find the original underwriting to have been shoddy).

So, the bank had since replaced their whole underwriting team, and even though they had PLP status, they were now gun-shy to rely on it. For larger loan requests like mine, they wanted to go through the GP process to make sure they were bulletproof on the guarantee.

Today, I have heard that the GP process is smoother, but at that time I was told that it could run anywhere from 4-6 weeks…maybe. The deal was too far along to wait that long, especially given the seasonality of the business.

With the start of the tourist season approaching rapidly, we needed to close the deal and do the transition work well ahead of operations going into full swing.

So, I reached out to the other lender who had provided a strong term sheet. Thankfully, I had left things on good terms with them even though I hadn’t selected them initially.

I explained the situation, including the fact that we already had a business appraisal completed — all the SBA forms were done, we just had to update them.

They assured us they could get to the finish line within two weeks, so we barreled forward, a train just barely on the tracks.

Final Negotiations

We were now four months into the deal (two months post-LOI), and I was sufficiently satisfied with the diligence to turn on the legal dollars.

This primarily meant putting together a purchase agreement. I delivered the draft agreement to the Seller about two weeks later…and then the wait began.

The business was now in its busiest preseason sale period and the Seller had never seen a purchase agreement before. Although there were no material changes from the LOI, it took the Seller an entire month to review with her attorney and provide comments. And yes, I was following up throughout that period in formal and informal ways.

The Seller’s attorney finally sent us their first markup of the document a month later. I was ecstatic to see it had only 5 open issues. And, the very next day, I got the bank commitment letter for the SBA 7(a) loan. It was all coming together.

On a Friday, I hopped on the phone with the Seller to discuss those 5 open issues, plus 1 new one from me related to the Seller Note (which I’ll discuss below).

Of the 6 issues, I agreed to give her two, I needed her to give me two, and we met halfway on the remaining two.

She was going to take the weekend to think my proposal over and get back to me. The conversation had been constructive and I was confident we could finalize the purchase agreement in a couple days.

Instead, I woke up on Monday morning to an email from her lawyer to my lawyer saying his client had reconsidered and had decided to not proceed with a transaction.

No mention of the open legal document issues. Just not proceeding with the transaction at all.

No further explanation, no courtesy phone call, nothing.

Even the Seller’s broker found out about her decision from me.

I spent a week trying to get the Seller on the phone to no avail. Her lawyer stated he didn’t think a call was necessary and stonewalled us completely.

The deal was dead, with nothing for us to do but pay our outstanding diligence bills (and vent to friends). All told, we ended up burning roughly $40K.

So…What Happened?

I wish I could give you a clear answer. As I said at the top, deals just find a way to die over time. We never had a call to close the loop with the Seller, so these are our best guesses as to why she killed the deal.

Seller Note:

• She had always hated the Seller Note and worried about if she’d ever be able to collect on it.

• She had her attorney in her ear telling her that normally a Seller Note would be fully collateralized outside of the business. This is simply untrue given that would defeat the purpose of keep her skin in the game. But it highlights the deal risk that comes with your Seller hiring an attorney inexperienced in M&A.

• I had agreed to not make equity distributions (other than tax) while the Seller Note was outstanding. The focus for the first 2-3 years was going to be reinvesting in the business or paying down the SBA loan, not taking distributions, so this felt like an easy give to her.

• Unfortunately, the SBA lender required we remove this language from the Seller Note – they viewed it as the Seller having effective control of the business, thereby making the deal not financeable using an SBA 7(a) loan.

• This was the one new must-have change in the purchase agreement vs the LOI, which further weakened the value of the Seller Note in the Seller’s eyes.

Headline Price-to-Proceeds Surprise:

• Every Seller has this moment of realizing the delta between headline purchase price and their day one proceeds. Once you do the math of capital gains tax, broker commissions, seller note, etc…the actual proceeds to the seller can be materially different. Ideally this realization happens BEFORE launching a sale process, but it seems she learned of these issues as the deal was progressing.

• In this case, that delta was worsened by poor COVID performance, which required the Seller to put cash on the B/S for working capital as part of the deal (though we had agreed on this at LOI).

• We were buying the business real estate, which included her personal home, so she’d need to buy a new place while technically being unemployed. She had a chat with a mortgage broker who told her they’d view her as unemployed despite the massive payday at sale.

• This all made her start to recalculate, very late in the deal process, what her real “number” was to comfortably retire.

Business Recovery:

• The business recovered too rapidly from COVID. By the time we were negotiating the purchase agreement, it had become clear the business would exceed pre-COVID sales.

• Given small businesses sell for 3-5x annual profit, it is tempting for a Seller to kick the can down the road another year, make another 20-33%, and then sell.

Conclusion

In sum, I believe she felt 1) she was never going to collect on the Seller Note, 2) she wasn’t getting enough day one proceeds to retire, and 3) the business was firing on all cylinders. As a result, it made more sense to hold on for another year and keep collecting cash flow.

It was a brutal way to lose a deal — but not uncommon. If you’re considering search and budgeting for deal expenses, budget for at least one dead deal.

Thanks for sticking through a long post. For thoughts or feedback, just hit reply to this email or post/DM me on Twitter. 

Thanks,

Guesswork Investing

P.S. I run a local building maintenance contractor in Seattle, WA that focuses on single family residential & commercial properties. To the extent you know folks in the RE industry in Seattle (both homeowners & property managers), I’d always appreciate intros.