Do We Really Need an Investment Banker?

This material came originally from John O. Huston, Chairman Emeritus of both the Angel Capital Association and Ohio Tech Angel Funds.

His original audience was Angel Investors and the Boards of Early Stage companies. We added Early Stage CEOs to the target audience, and expanded the perspective.

Cutting to the Chase – Our experience is you need an investment banker – unless you want to get a below-market price for your company. We are serious. There are many reasons why companies want or need to sell below-market, usually because they are out of cash and need to sell to the nearest checkbook. In this situation, you may find that your “friend of a friend” is the best way to go or that someone on your Board can act as your “banker.”

But if you want to get the highest price for a business that is in a position to have more than one buyer, hire a banker. We have heard – and experienced – all the stories you hear about bankers not really doing anything to help the process, being slow or inattentive, failing to find buyers, etc. But a good banker knows how to do something you cannot do for yourself: Conduct an auction. What you want working for you is not a firm or a team, but someone who can play one bidder off against the other, typically at the very last moment. You can’t do this for yourself. You are too close to the process, too emotionally involved and, frankly, under-skilled for the work.

A word about fees. Don’t worry about them. If the banker you hire can’t earn a price premium which pays for their fees, you have the wrong banker. Think of it this way. You will be delighted to wire their 2-5% fee to them at closing if they have identified the highest and best buyer, at a price 10-20% above your target.

There are dozens of other services bankers provide, including writing the Confidential Information Material (CIM), otherwise known as your sales brochure. Again, they are better at writing this than you are; even if you have to do most of the work. They are not thinking about your company from your perspective; they are thinking about what will interest buyers. You may think you know all of this better than they do. (Sure you do.) But what you’re looking for is honest, third-party feedback on how to position your business in just the right way for buyers you may not have thought about.

But … What If I Know the Best Buyer? – Why hire a banker to go pitch someone you already know? Simply this. Buy and sell arrangements are driven by only two emotions: Fear and Greed. If your “best buyer” knows there is no one else out there bidding against them, greed will drive them to what they think is the lowest acceptable price. But it’s a different situation if fear kicks in, in the form of another buyer who might steal your company out from under them, making them look stupid. And when that happens, the price goes up. Ideally, this will be in a real auction, where there are 5-7 genuine bidders. But even if there is only one bidder, there is great fear in the unknown. If the ideal buyer thinks someone else might be out there, fear steps up.

The Tale of a Sale – Here’s how hiring the right banker produced a terrific outcome for one of Lateral Capital’s invested companies, the CEO and his employees.

The most likely bidder approached Acme Software in late 2016 with a bid to buy their business for $20-25MM. After many sleepless nights, the CEO rejected this, even though it would have brought him and his investors a very attractive return. His business continued to grow and in mid-2017, he interviewed three different investment banks, choosing a mid-sized firm from the East Coast who had significant experience in marketing the software they had developed. The bank sent out “teasers,” (2-page overviews of the business with only topline numbers) to a hundred different companies. Of these, 41 signed Non-Disclosure Agreements (NDAs or CDAs) to receive the Confidential Information Memorandum (CIM) and 35 came in for management meetings. From these, 6 decided to do deep-dive due diligence, including both Private Equity and strategic buyers. The range of the bids was $35-$40MM – significantly higher than 1 year earlier.

Negotiation began with the three top bidders. The final price agreed was about $45MM. As you have guessed by now, it came from the company which had approached Acme a year earlier, for about 40% less! The investment bankers clearly earned their fee.

Here’s the perspective of John O. Huston on how Angels, entrepreneurs and their Boards should think about the process of hiring an investment banker.

Engaging with Investment Bankers

It is quite wise for Angels who are not Board of Directors (BOD) members to keep the pressure on their portfolio companies to make progress toward a lucrative exit. Regardless of whether the BOD decides that engaging an investment banker is essential to fulfilling their fiduciary responsibility to shareholders, they should at least engage with a few on a regular basis to assess market conditions. And, what if suddenly such a lucrative “bear hug bid” comes in over the transom; an offer that Directors feel is so good that a superior offer is unlikely to be found? Will they want to engage a banker for a fast fairness opinion to lower the likelihood that a shareholder will allege the BOD did not seek the highest price possible? This is an easier decision if they have already established banker relationships. I’ve personally never left an investment banker conversation without some new insights about what acquirers are looking for. Therefore, I suggest establishing relationships with a few as early as possible.

Experienced Directors typically have long-standing relationships with several investment bankers, but they do not know the vetting questions they should be asking once the BOD decides to interview several bankers, on the way and to hiring one. Investors not on the Board should suggest that a Director other than the CEO lead this process. Finalists should be presented to the full BOD, but the initial contacts can be handled by a non-management Director so as to keep the CEO focused on the business. After visiting the banking firm’s website, that Director can choose the most relevant questions from the list below to generate a template for comparing the finalists.

Licenses and Legal Questions

  • Is your firm a Registered Broker-Dealer? Are all your intermediaries securities licensed? Are you registered in the state where this venture is headquartered? Will you become registered in the acquirer’s state before the close of our contemplated transaction? Do you think this is important? Are you a member of SIPC, FINRA or other self-regulatory organizations? Remember if the investment banker you engage is not affiliated with a FINRA Broker-Dealer, the BOD is putting the venture and its investors at risk of rescission. This means that if disgruntled investors get the SEC involved, the government can force the entire deal to be “unwound,” going back to square one. This is in addition to significant fines.
  • Please divulge any litigation (settled or in the process) which has been brought by clients in the last five years against any member of our deal team or your firm.

Your Firm’s Focus, Capabilities, Scope and Successes

  • What portion of your firm’s revenues comes from sell-side engagements versus your capital raising services?
  • Do you specialize in sell-side engagements, or do you also represent buy-side clients? If both, what has been the relative importance of each over the last two years?
  • What is the profile of your firm’s ideal sell-side engagement for ventures of our size?
  • What do you tout as your firm’s most important defining difference which could impact the success of our engagement?
  • Does your firm have a professional research department? What proprietary databases do you use/prefer?
  • What industries do you avoid?
  • Financial and Private Equity Bidders: Does your firm focus on these bidders? Are you aware of any rollups being orchestrated in our industry segment by private equity firms?
  • International Bidders: Tell us about an engagement you have personally completed with an international purchaser. Does your firm have any affiliations with foreign investment banking firms?
  • What percentage of your engagements with young ventures being positioned today to sell to strategic bidders end up being failed engagements (i.e., no exit occurs at any price during your initial engagement period)? What has been the primary cause of these failures? How can we best work with you to avoid such a disappointing outcome for our venture?
  • What percentage of your firm’s engagements has closed above or below your estimated valuation range?
  • Discuss a successful transaction about which you are extremely proud. What made you so effective? What issues did you overcome? What strengths did you bring to bear? What aspects are applicable to our engagement?
  • Describe one of your transactions which encountered a seemingly insurmountable obstacle. How did you overcome it? Are there similarities to this engagement? How can we work together to minimize them?
  • Describe one of your failed engagements (i.e., you failed to sell the company or the price was woefully below your target range). Why did you fail? What would the venture’s CEO say about the causes and your personal efforts? Your firm’s efforts? May we call him/her?

Your Firm’s VC Experiences and Relationships

  • Which VCs have engaged you to sell one of their portfolio companies?
  • What percentage of your sell-side engagements involve VCs on the cap table?
  • Would you prefer VC-led exits or strategic buyer exits for our company?

Your Firm’s Process

  • Explain your methodology for establishing our venture’s enterprise value and the likely price range.
  • Explain your firm’s transaction methodology, process, and typical project plan.
  • Please summarize your likely work plan for our project. If we track your typical project plan, what timeline do you foresee for this engagement?
  • When in the process do you plan to contact our direct competitors? When must we provide our approval for you to do so?
  • Explain how you typically manage confidentiality. What’s your timing for requiring NDAs?
  • Does your process involve any unique way to move potential bidders from their initial “Indication of Interest” to submitting a “Letter of Intent”? In your personal experience, what has been the most frequent cause of attrition (when a bidder ceases to move forward)?

Market Intelligence Questions

  • What’s your current sense of the IT/software/SaaS M&A market (or whatever industry the target company is in) in terms of momentum/trends; recent interesting transactions?
  • What key factors today determine the price tag for an IT/software company with revenues <$10MM and insignificant EBITDA? What specific KPIs (Key Performance Indicators) do you think drive value in our industry?
  • What’s your market outlook for the next four to six quarters of M&A activity? Is this a good time to sell or will it be more of a “seller’s market” in a year or two?
  • What do you perceive to be our venture’s most valuable strategic assets and capabilities?
  • Please explain current market terms regarding personal indemnifications requested of the founder/CEO. What tactics have you found to be successful to minimize such personal exposure and potential liability?
  • Reviewing the purchase documents’ terms and conditions from recent exits, please comment on any noteworthy recent market trends for:
  • Paid how (stock or cash).
  • Type of purchase transaction (buying our venture’s assets or stock).
  • Reps and warrants and covenants.
  • Founder/CEO personal indemnification of reps and warrants.
  • Escrows and holdbacks.
  • Integration plan for people (Who is essential?).
  • Integration plan for the IT systems.
  • Employee communications plan/timeline.
  • Stay bonuses/options vesting.
  • Approvals needed (governmental bodies/regulators, major suppliers and customer communications).
  • Drop dead/breakup fees.
  • Timing to close: Exclusivity/no shop/go shop period; closing.
  • For ventures like ours, how often have the CEOs remained at the helm six months post-closing?
  • What should we expect in a deal today regarding likely escrows, holdbacks and earnouts, based on your recent deal closings? How do we avoid earnouts which are unlikely to be achieved?

Questions Regarding the Deal Team on our Engagement

  • Please provide the bios of our deal team members. Highlight their past engagements which are most similar to ours and the outcomes.
  • Do you have any conflicts of interest/other relationships which prohibit your bringing forth any specific bidders?
  • Please enumerate for each of our deal team members the other engagements in which they will be simultaneously involved.
  • Do you plan to approach any financial buyers? Why? Are you in contact with any Private Equity firms seeking to lead a rollup in our industry? Could our company be a keystone/anchor for such an initiative?
  • Will you approach any international bidders? If so, with which ones do you have a historic relationship from prior deals? Has anyone on your team attracted an international bidder previously for an ABC like ours?
  • Which previous bidders in your team’s past transaction might view us to be a fit? Can you get them to the table again?
  • Who will actually draft the Confidential Information Memorandum? With whom on our management team must they interact? What is the earliest date this must occur?
  • What electronic data room do you use? Who is expected to deliver our due diligence materials into it? What is the earliest date this must be accomplished?
  • Discuss the regular progress reporting you will provide us.
  • When must our CEO become deeply mired in this project? Same question for our Chief Technical Officer?. How long can you keep this off their plate so they can stay focused on growing sales?
  • What do you envision to be the most likely cause of your failing to consummate a transaction for our venture within your proposed range of values and timeline? How can we work together to avoid this outcome? What likelihood of success would you assign to our transaction being consummated within your target price band?

Compensation Questions

  • Explain your fee structure (success fees plus retainer plus expenses). Is your retainer netted against your success fees at the close? Do you have a minimum fee?
  • We prefer a “Lodestar Fee” arrangement that will reward you exceedingly well for the amount by which the transaction value exceeds our agreed upon target. What is your view of this pricing approach?
  • What is your engagement tail? Over the last two years, how many times have you divorced a client, thereby bringing the tail into potential play?
  • Do you allow the portion of success fees related to contingency/note/earnout payments to be paid as those contingency/note/earnout payments are made? We want to avoid “cash negative” payments to our banker. By this, we mean paying them fees on amounts our venture has not yet received from the acquirer. The most prevalent examples are deferred payments such as escrows, holdbacks, earnouts, milestone payments, Contingent Value Rights and royalty payments.

Miscellaneous Discussion Questions

  • We don’t want to waste your valuable time so please tell me how mature my venture must be before I should routinely keep you apprised of our momentum and progress.
  • What has been your experience regarding the banker selection/vetting process being driven by a Director from our Board, versus the CEO? Any comments and suggestions?
  • What upcoming industry conferences/conventions/symposia do you think our venture’s management team should regularly attend? Can you assist in getting them podium time?
  • Could you please share some worst practices of “Hall of Shame” stories to illustrate behavior that our venture’s CEO and Directors should avoid during our M&A sale process?

Early Stage Director Concerns

  • Our Directors are concerned about their fiduciary responsibility. If they unanimously recommend to our shareholders that a bid from a single suitor be accepted, regardless of how attractive it might appear, what is our liability, if any? In your experience, how likely are they to suffer litigation for not even attempting to get other bidders to the table? What steps should they take to diminish this possibility (e.g., enhanced “Side A” coverage in our D&O policy)? What deal factors increase their exposure (e.g., lucrative employment contracts for the CEO and C-level executives)?
  • Our Directors have invested personally in our Series A shares and have mentioned they are concerned about “insured vs. insured” lawsuits in the situation where one Director is extremely opposed to accepting an offer. However, buying additional “Side A” D&O insurance is costly. And, buying our way out of the usual “insured vs. insured” D&O exclusion is even more expensive if it can be obtained at all. Can you share any war stories or insights about litigation arising in successful exits which nonetheless caused some investors, and especially dissenting Directors, to litigate?
  • Presume that this venture suddenly receives a surprise “preemptive strike/indication of interest letter” offering an attractive all-cash purchase price with minimal holdbacks and no earnouts. Please provide your suggestions regarding these possible actions:
  • Seek a fairness opinion? If so, does your firm provide them? If not, whom do you recommend and what will they charge?
  • Rush to engage your firm to try to swiftly attract other suitors? If so, are many of your firm’s engagements of this “emergency” nature?
  • Engage your firm to merely vet and negotiate the terms and conditions? Would your firm take such an assignment? If so, please explain your typical fee structure (presuming sourcing bidders will not be involved in this case).
  • Some of the most grizzled Early Stage Directors posit that the best bankers share at least one common skill: The ability to exude the sense that an auction is underway when actually just one bidder seems interested. Do you agree that this is a highly critical and differentiating skill? If so, let’s discuss examples of where you have displayed it in previous engagements (on a fully confidential basis, obviously).
  • Reflect on your experience selling companies similar to our venture. Pretend you are the independent Director of a venture that has just engaged an investment banker to run an M&A process. What guidance, insights and wisdom would you share with your fellow Directors?