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Chapter 21 Mergers and Acquisitions (M&A)

Buy‐Side

Once a startup starts to find their product‐market fit and understand the clear drivers of revenue, acquisitions become a real possibility as a way to quickly grow the business. For a CFO, the main tactical efforts will include the financial merger model, the price, and how to pay for it, and managing due diligence. Primarily the CFO is the key partner (and sometimes voice of reason) for the CEO, who for startups, almost exclusively drives the buy‐side M&A efforts. As the company scales, you might hire someone to focus on M&A and the CFO becomes a key partner.

The Merger Model

The merger model is to help give your company a clear view of the before and after picture of the merger. The easiest way to do this is to compartmentalize the analysis. First, create a base model of the two standalone companies pre‐merger. This will include the actuals and forecasts. Then create another that merges the two, and some work that shows cost savings/synergies from the merger, and impacts on revenue, including the key drivers. Typically, that will include things like improved pricing, win rates, and client retention but could include a number of items. The key thing is to make sure the metrics that are driving the decision to make the merger are clear. At that point you can provide the CEO and Board some important financial metrics like payback period, total invested, and what certain metrics need to be for you to feel good about the decision. For example, when we looked at buying a new product (rather than building it), we thought that the two metrics that would improve were win rate and client retention. We were not going to change the price. So, by assuming a purchase price and cost synergies, we could illustrate how much those two metrics had to improve in order to justify the acquisition.

Figuring out the best way to pay for a purchase is an important means for the CFO to be an effective partner. You can use cash, stock, or even earn‐outs. Modeling the different scenarios and presenting the options to the CEO and board are critical skills. Many startup mergers are paid for by using company stock. Those are certainly the best use of cash flow, especially if the transition costs are not huge. But the more you use stock, the more you end up with a bunch of small stockholders that you don't know and have no idea how much of a hassle they will be. One way around that is, as part of buying a company, insist that the sellers create a single purpose vehicle with a managing partner that you know. That way you only have to deal with one person. If not, you may end up with 10s and maybe 100s of extra very small shareholders that will increase the amount of shareholder management you will need to do in the future.

If the acquisition results in increased free cash flow (after all of the cost synergies), you may be able to use credit financing to help minimize the amount of stock you need to put in the deal. This tactic is usually used for later stage companies that have established teams that can be leveraged in a merger.

Buy‐side acquisitions are also a time that the CFO can be a valuable partner for other parts of the company, helping build the transition plan and providing clear guidance and targets for things like new hiring, analyzing impact on new bookings and client retention, and other product, sales, and service plans.

Sell‐Side

Selling a company (or division) is usually one of the busiest times for a startup CFO. Not only do you have to be part of all of the many, many early meetings with possible buyers and bankers during the early courtship, but you are on every email, call, and planning meeting as the Board and management team decides whether or not to sell. You and your finance team are often working late trying to respond to the requests from possible buy‐side teams on historical numbers and financials. How you and your team react to an opportunity to sell the business is the culmination of your years of setting up scalable processes that lead to quick responses to diligence requests and modeling of scenarios. A prospective buyer will almost always want to see your financials and key corporate information in a different form and segmentation than you are used to. So how you can react to this surprise and still continue to operate the day‐to‐day business will be a true test of your team and your systems.

Key items before due diligence:

 Investment bankers. If you are at a very early stage, it is unlikely you will be using an investment banker to help you with the process. As you get bigger, a banker can be helpful for you as a resource for some of the modeling, a coordinator for a lot of the diligence process, and most importantly, assisting you in navigating the industry landscape and the prospective buyers. They can also provide guidance to the CEO and Board during negotiation of valuation terms and deal documents. As you choose a banker, the most important thing you can vet is their relationships and knowledge of your industry and the corporate development groups of prospective buyers. They can quickly give you a sense of valuation and strategically how you should approach your particular sale situation.

 Financial models. Almost every M&A process will require a new set of financial models. For buy‐side, it involves merger models and the impact of adding a new company or asset to your business. For sell‐side, it is usually normalizing your financial history for how your company looks today. For example, if you sold a division in the past couple of years, you will need to build pro‐forma financials (mainly the income statement and key bookings numbers) as if your company did not have that sold division. It is also building a multi‐year forecast. Typically, to run a startup you don't need to have a forecast past your current budget. To sell, you will need to re‐create some of the way you forecast your key sales and cost drivers and build a two‐ to three‐year forecast.

 Due diligence. You will (unfortunately) typically have to respond to due diligence requests even before you get a term sheet or letter of intent (LOI). These are usually high level regarding corporate documents, organization charts, financials, forecasts, and key business metrics like bookings and client base. Most of this is hopefully on hand and can be handled entirely by the finance team. Once an LOI is signed, the due diligence expands to include many others in the organization. As CFO, you will need to quarterback the diligence process for your company. To prepare for this, the best thing you can do, well before the sale process, is to review a typical due diligence request and assess your readiness. Once it starts, the major areas can include the following critical requests:Legal: All material agreements, client agreements, NDAs, IP items like patents and trademarks, data licensing, partnership agreements, key vendor agreements, real estate leases as just a start. Much of this can usually be negotiated from a sense of materiality or importance. Typically, the buyer/buyer's lawyers will press on certain items they consider important.Human Resources: Employment agreements, stock compensation agreements, employee termination agreements, signed sales commission agreements, and payroll.Corporate areas: All historical corporate documents such as shareholder rights agreement, stock purchase agreements, and Charter. They will typically push for every version of these and the required signatures.Finance areas: All recent tax returns, audit information, state filings, DBA filings, and definitely Good Standing certificates in any state you are registered in.Data security: Buyers may hire third‐party firms to test your company's data security process, test your systems, and audit your information storage policies and procedures.Accounting: Even if you get annual audits from a global account firm, buyers may want to hire a firm to do a “quality of earnings” analysis which will include not only analysis of things like your accounts receivable, accounts payable, fixed assets, really any and all accounting, but also the trends of your sales bookings and the likelihood of them continuing in the future.Product, client and service: Buyers will also spend a lot of time analyzing your client base, including client concentration, segments, and retention, but also want to know about your roadmap and development process.

The CFO will need to coordinate a lot of this work with the different groups in the company that will respond to the requests. The use of secure data rooms (your lawyer or banker will help you set that up if needed) will be your friend in helping you have one place to manage the multiple possible buyers and keeping it easy to follow which buyer saw what data. The CFO will also need to negotiate with the buyer which diligence is really necessary vs. what's on the checklist. Buyers and their lawyers will look for any opportunity to get more and more information so you will need to work with your side to keep it reasonable.

Other sell‐side items that are typically more for later stage companies:

 Flow of funds analysis: The flow of funds is exactly what it sounds like, detailed instructions of where every dollar goes with wire instructions. This will include paying for bankers and lawyers so you will want to be aligned with your outside counsel on their fees. This will need to be approved by all parties involved so it is a good idea to set the structure up as soon as is reasonable.

 Working capital adjustment: Because you will be operating your business during the sale process, your working capital could be higher or lower than usual. Especially if you have a seasonal business or stopped paying invoices during the process. So typically, you will agree with the buyer on a reasonable working capital number that is usually based on some average balance over the last twelve months. Then the final purchase price will be adjusted based on whatever the working capital number is at the close versus this agreed to number. Additionally, there is often a 90‐day working capital escrow that can cover any expenses that come up that weren't, and should have been, included in the closing balance.

 Fairness opinion: Consider doing this to protect against shareholder lawsuits.

 Shareholder communication: Required mailings, waiting period, compliance filings, compensation for insiders.

 Seller representations and indemnification: Work with your bankers and lawyers to understand which types of representations are seen in the market and how you can use rep and warranty insurance to simplify this part of the deal.

 Shareholder representation and M&A platforms: Once a deal is closed, there may still be a lot of communication, including tax form preparation, with seller shareholders to go and guidance needed on any liability and working capital escrow issues. By hiring a shareholder rep and using an M&A platform, you outsource a bunch of that work. This becomes valuable if you have a lot of small unknown shareholders. If you are a small group with a couple of investors, this will not be necessary. But if you have 400 shareholders of all sizes and sophistication, it is very helpful to hire a shareholder rep.