Seasoned dealmakers talk M&A with KeyBanc Capital Markets
From negotiating valuations, to retaining talent, to details related to net working capital and representations, dealmaking is a complex process — learn from these experts before your next transaction.
M&A activity in the tech sector remains robust, despite macroeconomic headwinds of inflation and an economic downturn. Deal value for the first half of 2022 exceeded $270 billion according to PwC1, and tech transactions are driving much of the current momentum.
David Lipkin, a partner in the M&A practice at McDermott Will & Emery, moderated a panel of dealmaking experts at the 2022 KeyBanc Capital Markets Technology Leadership Forum in Vail, Colorado. Panelists Steve Mitzenmacher, SVP of Corporate Development at Rackspace, Jeremy Segal, EVP of Corporate Development at Progress Software, Yair Cassuto, Partner at Pitango, and Brad Feld, Managing Director at Foundry Group participated.
They talked shop about current M&A trends and shared hands-on strategies and perspectives they bring to the table when they sit down to make a deal.
Valuation: balancing three target constituencies
Determining a company’s valuation is a complex undertaking, but also one of the first steps a buyer must complete to set a deal in motion. Mitzenmacher describes his approach to balance the priorities of three key constituencies within the target company – investors, management and the employee population – all of whom hold varying degrees of influence and power in the negotiation process. In particular, he emphasizes the importance of taking employees’ interests into consideration: “We talk about the IP, but at the end of the day it’s the people who built that IP who have the ability to walk out the door.”
To encourage key talent to remain with the company and keep the business functioning smoothly, buyers can offer incentives as part of the transaction. For Segal, it often means layering employee incentives on top of the purchase price. “It’s hard if you were working for a startup, and then all of a sudden, you’re working for a big 2,000-person public company. It’s a different type of environment and we know we’re going to lose people,” he acknowledges.
Mitzenmacher prefers to avoid retention payments, noting that they can incentivize recipients to depart once they’ve collected. Rather, he focuses on structuring deal terms to motivate cooperation between investors, management and employees. “I need to be comfortable that all three constituencies are happy, not just the investors. If you’re an investor, you have to help me solve my other problems to get your deal.”
Buy side and sell side panelists agree that when parties on both sides of a deal are experienced and sophisticated in their approach, negotiations tend go more smoothly. But when there’s a gap in sophistication between buyer and seller, mismatched expectations create friction. “We’ve dealt with some unsophisticated sellers, and it’s painful,” says Segal.
Feld notes that the key to negotiating effectively is understanding the perspective on the other side of the table before settling on a price. “I always try to get to know the other side of the equation and their level of sophistication, especially having been on the buy side.” Lipkin adds that as an attorney, part of his role is drawing from his own experiences to educate clients who may not be as familiar with the process. “When I’m hired as sell-side M&A counsel, I sit down with whoever it is — board members, CEO, CFO — and say, ‘let me understand where you come from and make you smarter.’”
The pros and cons of earnouts
The panelists talked about when it makes sense to include earnout provisions in the deal. On the buy side, Cassuto describes three possible scenarios: (1) buyers who avoid earnouts altogether and are willing to walk away if the seller won’t agree to their desired purchase price; (2) buyers who are genuinely trying to compromise and use earnouts to bridge valuation gaps; and, (3) buyers who will agree to an earnout to make the transaction happen, even when the likelihood of getting to the earnout milestones is low. From a buyer’s perspective, Cassuto indicates that avoiding earnouts tends to be the most successful of these strategies. “If things don’t pan out, earnouts create a lot of frustration on both sides.”
These considerations depend on the circumstances of the target company. For example, as Livkin points out, earnouts are more common in the life sciences world, where milestones related to regulatory approval for new drugs and other therapies are critical to the future of the business. Feld is willing to entertain earnouts on a case-by-case basis. “For a private-to-private deal, I will have the conversation if it’s well-defined—and no longer than 12 months. Longer than that, and it creates so much disincentive on both sides.”
When to go cash-free, debt-free
Whether to structure a cash-free, debt-free deal or make net working capital adjustments is another area of debate in the M&A space. While a cash-free, debt-free structure is less complicated for both parties, the panelists point out that there are circumstances where it makes sense to adjust for net working capital—specifically, when a business has excess cash on the balance sheet. And while the negotiation process is likely to go more smoothly when parties agree to the deal structure prior to signing an LOI, the buyer may not uncover all the relevant details until after the LOI is signed and the due diligence process is underway.
Mitzenmacher explains that in a cash-free debt-free deal, where the target company’s investors have just injected a large amount of cash into the business, the buyer pays the agreed-upon price for the business, but that surplus cash goes to the seller. “As the buyer, I feel a little screwed.”
“I think the overfunded business problem will be a real issue for the next couple of years because of all the financings that were done in the last 24 months,” remarks Feld.
A “brave new world” of representations and warranties insurance
In a public deal, “caveat emptor” rules — there is typically no way for a buyer to recoup money from public company shareholders after closing if the seller misrepresented details or other issues arise. But most private transactions include a post-closing recompense system for the buyer. “From the seller’s perspective, the most important thing is ‘what am I getting?’” notes Mitzenmacher. “Whereas from the buyer’s perspective, the most important thing is 'what’s my protection?’”
Standard procedures are now changing. Traditionally, parties would agree on an escrow of somewhere between 10% and 20% of the purchase price, set aside for a predetermined period after closing, and buyers and sellers could spend significant time and resources negotiating terms. Recently, panelists note, more deals are investing in representation warranty and insurance policies, against which the buyer can make a claim after the deal closes in the event of a breach by the seller. Segal observes that in competitive deals, representation and warranty insurance as the sole recourse is becoming the norm, but that his team still tends to use escrow as the primary method of recompense for deals they’ve sourced.
From Feld’s perspective, the main difference between escrow and insurance is time and cost of capital to negotiate the details. He also emphasizes that the extreme cases of fraud and bad actors are rare in the tech M&A world: “You only get one shot at being bad in this industry, because everyone knows each other, and they all talk.”
The tech sector remains one of the most dynamic and consequential drivers of M&A activity in today’s public and private markets. From negotiating valuations, to retaining key talent, to hammering out details related to net working capital and representations and warranties insurance, dealmaking is a complex process — but when the parties on both sides collaborate in good faith to get a deal done, the rewards are well worth the effort.
To discuss the future plans of your company, and learn more about M&A strategy, contact your KeyBanc Capital Markets investment banker.
About the 2022 Technology Leadership Forum
The 2022 Technology Leadership Forum attendees included 170 institutional investors, 124 private equity/venture capital and corporate development investors, 72 public companies and 82 private companies. The agenda included 56 Fireside Chats/Presentations, 11 thematic panels, 8 industry specific spotlight sessions, 3 banking workshops/industry deep-dives and 5 Keynotes.
This article is for general information purposes only and does not consider the specific investment objectives, financial situation, and particular needs of any individual person or entity.
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