What a transaction adviser is paid for. Buyer contacts are the cheapest part of the service

The owner who called me eighteen months ago had chosen a cheaper adviser’s offer. What it bought him was access to investors. Nobody prepared the company, and no investment thesis or materials were produced that could have defended the valuation. There was also no one to sit across from the buyer’s analyst and defend three challenged assumptions at once. The buyers looked at the company and withdrew. The company still belongs to the owner, and the market remembers that it was up for sale and nobody bought it. The owner thought he was buying the same service for less. He bought a different service.

I have changed the details so that neither the company nor the parties can be identified.

An owner sells a company once in a lifetime. An institutional buyer, meaning a private equity fund or a large industry group, acquires companies regularly, even several times a year. What an adviser is paid for follows from this difference.

The seller starts the process without any routine. In the buyer’s examination of the company, known as due diligence, he finds it hard to tell standard questions from attempts to cut the price. On the other side of the table sit investors and their advisers who have been through the same process 30 times and know at which points the price starts to fall. The adviser evens out this difference in experience.

Six stages of work that build the price

The price is built by six stages of the adviser’s work.

The first stage is preparing the company. The adviser calculates normalized EBITDA, that is earnings cleaned of one-off events and costs unrelated to the business, and checks which adjustments will hold up against the buyer’s analyst. Before the other side does so, the adviser also determines the minimum cash the company needs on hand and the normal level of working capital, meaning inventory and receivables less amounts owed to suppliers. Together with the owner, he separates out assets that do not serve the business and puts in order the contracts, the rights to real estate and trademarks, and the ownership structure.

This work takes place before the first confidentiality agreement with a buyer is signed. It determines how much of the starting price survives until closing. In Capital One Advisers projects we start with this stage, before any document for investors is produced.

The second stage is the investment thesis. A company has as many values as there are buyers with different motivations. A financial investor buys cash flows and the prospect of a later sale. A strategic investor buys the benefits of combining the two businesses, meaning synergies, access to customers or skills it cannot quickly acquire on its own. The investment thesis answers the question why this particular buyer should pay more than others. The adviser formulates it separately for each group of investors.

The third is the materials. The information memorandum, the main document describing the company for buyers, shows where its value comes from. It explains the business model in language an outsider to the industry can understand and answers half the questions before they are asked. The second document is the financial model. It shows how the valuation responds to a change in margin or costs and makes it possible to prepare answers to scenarios the buyer has not yet calculated.

The fourth is the selection of investors, and this is where misunderstandings arise most often. A longlist, the preliminary list of potential buyers, is useful only if it is built through selection. It keeps the parties that have capital, are looking for companies in the given industry and of a similar size, and are able to complete a deal. It drops those that are only gathering market information or looking for a bargain below value. A buyer who submits an indicative offer, examines the company and withdraws before signing costs the seller several months and weakens the company’s reputation in the market. I wrote about building a longlist in May.

The fifth is negotiating the terms of the agreement. The price in the letter of intent is a declaration. The amount that reaches the seller’s account follows from the definitions in the agreement. In it the parties settle which liabilities, besides loans, will reduce the price as net debt and how working capital is calculated on the closing date. They also negotiate the limits of the seller’s liability for representations and warranties, his statements about the condition of the company for which he remains liable after the sale. Just as important is the earn-out, an additional payment on the price that depends on the company’s future profits. The agreement must specify who controls costs after the sale and how those profits are calculated.

An owner who negotiated a good price and gave ground on the definitions has obtained less than he thinks.

The sixth is managing due diligence and closing the deal. The adviser makes sure that the answers to several hundred questions are consistent and that the due diligence findings do not become a pretext for renegotiating the price. Together with the lawyers, he works to make the agreement reflect what the parties really agreed.

Outside these stages there is access to buyers itself. It is the only component of the service that can be bought separately, and it costs the least.

Why access to buyers is cheap

A list of private equity funds active in Poland is easy to compile from public sources. A competent analyst can prepare a preliminary list of strategic investors in most sectors from databases in two weeks. A fund will take a call from anyone who can say in three sentences what the company is, what its EBITDA is and what the seller is looking for.

What is rare is knowing which buyers have closed a deal this year. Some of them only look at companies. An adviser also knows which fund has capital ready to deploy and which is coming to the end of its investment period, the time set aside for new acquisitions, and is keeping its remaining money for its portfolio companies. The most valuable knowledge is how a buyer behaves in a difficult due diligence. One will sit down to solve the problem. Another will use the difficulties to cut the price by 20 percent, because he sees the seller’s weak position.

Everyone has a fund’s contact details. Only someone who has negotiated with that fund before can judge how it will behave at a difficult moment.

How the fee structure chooses the adviser for the owner

An owner who shifts the adviser’s entire fee into a bonus for closing the deal, the success fee, believes this aligns his interests with the adviser’s. The effect is often the opposite.

The fixed fee pays for work that is invisible from the outside: preparing the company, normalizing the results, building the model, the investment thesis and the selection of investors. That is months of work before the first contact with the market. An adviser who gets nothing for this phase has two options. The first is to cut the preparation to a minimum and go to market quickly with weak material. Such a document will attract interest, but it will prove useless when the valuation has to be defended. The second option is not to take the mandate at all if the chances of closing seem too low.

The effect of the second option is invisible to the owner and the most damaging. A success-fee-only model attracts advisers who take easy, quick cases and deters those who would have something to fix in the company before going to market. The owner of a company that needs preparation gets offers from advisers who have no intention of doing that preparation.

Alignment of interests also works differently here from what the owner assumes. An adviser paid only for closing earns mainly on the closing itself. With a flat percentage rate, rejecting an offer cut by 20 percent and going back to talks with other buyers means six more months of work for the adviser and the risk that the deal will not close at all. The extra commission does not offset the risk of losing his entire fee. For the owner, those 20 percent are a large part of his wealth. Some agreements soften this divergence with a higher commission rate on any amount above an agreed base price. Even then, an adviser with no fixed fee risks losing his entire fee if the deal collapses because of tough negotiating. The structure that was meant to align the parties’ interests separates them at the point that matters most to the owner.

A fixed fee also carries a risk. If it is too high, the adviser earns from simply running the process, even when the deal does not happen. The market therefore uses arrangements in which the fixed fee is credited against the final success fee. When comparing offers, what matters is which specific documents and analyses the fixed fee covers and whether it will be deducted from the success fee after closing. At Capital One Advisers the fixed part covers the cost of preparing the company, and the main fee comes from the success fee on closing.

When a success fee alone is enough

A success-fee-only model can, however, be the right one.

The first situation is a known buyer with whom talks are already under way. There is then no need to build a list of investors and search for them in the market, and the risk that the deal will not close is clearly lower. The adviser focuses on reviewing the financials from a valuation standpoint, structuring the deal and negotiating the agreement.

The second is a company that is already prepared for a transaction. It has recently undergone a review commissioned by the seller himself, known as vendor due diligence, it has clear reports on margins and costs, and its own finance team is capable of handling the buyer’s due diligence.

The third is a transaction so small that the cost of full preparation would be out of proportion to its value.

The fourth is a client who knowingly buys brokerage alone, because someone else has done the rest of the work. This is a rational choice if the client understands its consequences.

Five questions before choosing an adviser

The first question concerns failures: how many processes the adviser started in the last three years did not complete, and why. An adviser who claims they all closed has run very few or is not telling the truth.

The second concerns the team: who exactly will work on the project and how much time each person will devote to it every month. The partner wins the mandate and a junior team carries it out. That is normal. What should cause concern is the partner disappearing after the agreement is signed.

The third concerns how long the preparation will take before the company is shown to the first investor. In a company that has not previously put its finances and contracts in order with a sale in mind, an answer shorter than two months means there will be no thorough preparation.

The fourth concerns the financial model: whether one will be built and who will defend it in due diligence. A model is useful only when someone who understands it defends it at the table.

The fifth is the most important. It concerns the situation in which the adviser would advise the owner against selling. If an adviser paid only for closing cannot describe such a case, in practice he will never see one.

When the decision to sell has not yet been made

It is hardest when the company needs preparation and the owner does not yet know whether he will sell it. For him, the fixed fee for preparation is an expense incurred before a decision that has not yet been made. Some owners take the view that preparation pays for itself even without a sale, because the company then has orderly reporting and contracts. Others prefer to wait until the decision matures. If it is made suddenly, however, for example after an unexpected offer, there will be no time to put in order the contracts and financial results for the years the buyer’s due diligence will cover.

Service: M&A advisory on a company sale