[00:00:04] Speaker A: Hello and welcome everyone. I'm Peter Lehrman and this is Masters in Small Business M A. This show is an ongoing exploration into the vast and undercovered world of small business M A, where we interview both the proven and the emerging owners, operators, investors and advisors whose strategies and methods for transaction success have been put to the test. The show aims to us the nuanced, intricacies, the key ingredients and the important factors that can improve your decision making in your own journey in the world of small business M A. This podcast is produced by Axial, an online platform that makes it easier for business owners and their M A advisors to find, research and privately connect with a diverse mix of professional buyers of small businesses. In addition to learning more about Axial, you can find this podcast, show notes, edited transcripts and many other related resources all for
[email protected].
[00:01:02] Speaker B: Peter Laraman is the CEO of Axial. All opinions expressed by Peter and podcast guests do not reflect the views or opinions of Axial. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Podcast guests may have ongoing client relationships with Axial.
[00:01:21] Speaker C: Hey everybody, welcome back. This is Masters in Small Business. M-A-I am your host, Peter Lehrman. I am extremely excited to get Emily holdman on the line from Permanent Equity. This came together really quickly. Emily, thank you so much for making time. This is Monday and appreciate you especially making time on a Monday for us.
[00:01:39] Speaker B: Of course, happy to.
[00:01:41] Speaker C: So we're going to get right into it. Emily is Managing Director with north of a decade of experience at Permanent Equity, very well known lower middle market investment firm with an unbelievably unique long term holding period for businesses that they buy. They released a really, really deep and significant document just last week on due diligence. Emily, tell us the concept, the document, tell us a little bit about why you guys decided to reveal the way that Permanent Equity does due diligence. Often that's a pretty secretive affair in the world of investing. You don't tell people how you due diligence. Why did you guys decide to buck the trend? Tell us a little bit about what you guys have decided to do.
[00:02:21] Speaker B: I think the easiest answer is that we think an informed seller is a better seller and we think that it makes for better deals for all parties. And over the years we've had the opportunity to encounter a lot of people, everyone from advisors to peers who are investing to potential sellers and everyone talks about diligence being just an absolute chaotic period of the deal making process. And so for us we've always gone about it in a first principles way and it goes back in terms of how we think about it to what we saw true in venture capital. So Brad Feld specifically on Venture Deals, which was a book that he put out in the early two thousand and ten s and it was just radically transparent about how deals actually get done. And he was writing to young entrepreneurs who would be pursuing that opportunity for the first time and giving them the equipment, if you will, the information. To be able to actually negotiate from a point of confidence, but also appreciate what the other party is trying to do, and then to appreciate where you may win, where you're going to need to compromise and where you may want to let them win so that you can win on something else. Right. So there's a lot of reasons why when you get to the table to actually negotiate a real deal, we don't want one side to win. It needs to make sense for everybody.
And we consistently found that sellers felt ill equipped and ill prepared honestly, and were then told, this is how diligence works, right. From the buyer specifically. And we think that there's probably some tenets of diligence that shouldn't be dictated, but should be understood and appreciated as part of the process for everyone involved. And we could talk about advisors and sort of the role that they play in this as well, but we just wanted to set the table so that people understood this is why diligence is such a big deal, this is why things potentially get hairy during that process. And these are why the questions are as substantive as they are, because they are. And we readily admit we ask questions that can seem really abrasive on the front end, but they're well intended. And so we felt like we owed it to potential sellers and potential partners of our own to put it out there in a way that gave them the information in a scalable way so that they can choose whether we may be the right party for them or someone else and be ready to answer those questions and know why they're being asked.
[00:04:46] Speaker C: Great answer. I'm curious what went into producing this document? It's professionally produced, it's probably, I don't know, in the neighborhood of like 75 pages. How did you guys go about just getting this all laid out? What did you guys need to do in order to I know you guys have done a ton of deals, so obviously this was sort of in everybody's head at the business, but what did you guys need to do in order to get this laid out in such a straightforward and sort of well organized way?
[00:05:14] Speaker B: Yeah, so it was a labor to put together. This was a conversation that we had in May and we obviously had the internal checklist that we worked off of on deals and would continually update as we completed a deal. So the core information came from our internal documentation, but we wanted to translate that into something that isn't based on providing it to lawyers or providing it to advisors, but instead is useful and prepared specifically for a potential seller.
It shouldn't have been as novel as it was, but it did take some translation to make sure that everything felt approachable, well defended, well documented, right? Including so with every question as an example, it gives example documentation of what goes with that. So what does it mean to say what are the origins of your company? Right? Well, you need the origination documents, you need the formation documentation. And so where are you going to go find that? Because it's probably not something that you access every day. And we had to kind of go through all of those steps to really provide a substance guide. And so it was a combined effort of everyone on our team, to be quite honest. We do have two people on our team who are fully dedicated to our content efforts. And that's because we do think that content scales conversations and we think they're worth scaling specifically in this segment of the market. And so it is something that we actively invest in. But they're translators, right? And they're trying to produce content that is useful to people that are subject matter experts, right, and people who need to use it on a regular basis. And so with that, we have an in house attorney, Taylor, who leads our diligence efforts practically on a day to day basis. And so they were interviewing him. They were interviewing Tim, our CIO, they were interviewing me, our CFO, Nikki. It was a variety of different people that they were sitting down with and saying, okay, exactly how does this work? And when you ask this question, what does it mean? So it was really kind of a journalistic project in some ways to try and make sure that they were translating all of the information in a way that would be useful to a seller sitting on the other side or to an advisor who's trying to help a seller appreciate what they're going to encounter. Because we do see oftentimes that people get excited about offers, but they don't appreciate yet what the process is going to be to ultimately get to a close.
[00:07:34] Speaker C: One of the things that's like in the first 20 pages of this deck, all about due diligence is the diligence work on behalf of the sell side as opposed to the diligence work on the buy side. And I wanted to make sure that we actually really zeroed in on this. I think a lot of times people think due diligence is just this activity that gets done by buyers. Basically, the seller has to sort of lay down and lay themselves bare. And it's a 100% sort of buyer interrogating seller process. You guys talk about a couple of things in this deck. One is the concept of the seller of a business assembling their diligence team. So I just want to unpack that a little bit. And then two, later on in the deck, you get into a set of key questions that you think every seller should ask every buyer. So I'd love to just talk about both of those things. Let's start just in chronological order. When a seller is preparing to sell their business, you guys talk about assembling a Diligence team. What are the Diligence team members that you're talking about them assembling? And how much lead time do you think they should plan to pull that team together before they're actually in the throes of an actual transaction?
[00:08:47] Speaker B: Sure. So in that, what we think about is the checklist is 181 questions of us asking something of a seller. And that obviously seems incredibly weighted in the buyer's favor. And like the buyer controls diligence, but that's more optics than anything. The seller has a tremendous amount of control within that process, and this is still the preamble to a deal. Right. And so we wanted it to feel that way in the document itself and to remind them of the power that they have and how they can make their own decisions in the process. And so with that building the Diligence team is a component of this. So it starts with the fact that a lot of people we talk to, because we do get people who reach out to us directly and say, hey, I think I'm thinking about doing something. And at that point, they've hardly involved anyone. They may not have even told the rest of their management team yet, and they may have had an investment banker call them, but they haven't hired somebody. Or maybe they have, but they haven't involved anyone else. And at that point, it's one of those things where when we start to talk about making an offer, they're excited to see the offer. But when we say, okay, what happens next? They don't have an answer for that yet. Right. They haven't actually formed a team that's going to be able to get them through the next phase, which is that Diligence phase. So we wanted to spend time talking about the decisions that you should make earlier on in the process, about who you're going to involve if and when you find a buyer that you actually want to go down that path with. And so we start by talking about the fact that a lot of people choose and try to do this themselves. And I can't tell you how many people I've talked to who say the first time I went through Diligence, which wasn't successful, I did not use a team, and I just tried to do it myself and it was awful and it did not end well. And that's because there are many components to the process, some of which are expertise driven, some of which are absolutely just time driven and administratively a burden that has to be carried through to be able to successfully close. And then other pieces are you want to have enough capacity as the deal driver, as the person, the quarterback of the deal, the person for whom it is of the utmost consequence. You want to have the time to actually develop relationships, pay attention to what's going on with the business deal during your diligence process and have capacity to make sure that your business continues to perform well. And so for all those reasons, forming that team matters. And so we spend time talking about how do you think about the roles that will be involved in the diligence process? Including who's going to pull information, who's going to transmit information and who's going to pay attention to things like tax consequences or legal drafting. And so some of those people are people who may already be on your staff in a company and others are going to be expert advisors that you're going to hire and recruit. And so we give a specific checklist for how to hire an M A attorney specifically. A lot of people try and use their general business attorney and we've never seen that be successful. And so we talk about why you want an M A attorney specifically and then how to think about how to qualify somebody for that role. And the same thing is true of an intermediary or M A advisor. And there advisors get a bad rap publicly a lot and we don't think it's fair. But you as a seller have to figure out what are you hiring someone to do? And there are multiple roles that an advisor can play and it starts by preparing the company to go to market, then making the market for the company, and then actually facilitating the diligence process and helping the deal to move along. All of those are separate and discrete skill sets. And so some advisors you can hire just to do one piece of it or you can hire somebody to take you through the full process. But most sellers don't appreciate that. They just say oh, should I hire an investment banker? And it's like, well, what are you hiring someone to do? And so we wanted to give them, again, a specific skill set and checklist that they can be looking through and really help to understand what the background of the person is that they're talking to and whether that's the right person to work with them on their deal.
[00:12:52] Speaker C: Emily, I want to go through some specific scenarios here and sort of see how you react to them just because there's a series of combinations for sort of how a business owner might find himself or herself approaching this. So let's say a seller has found their way to permanent equity and wants to work with permanent equity and you guys at least initially feel interested in pursuing the opportunity. And so there's the possibility, there's the distinct possibility that the buyer has been already identified, right, the acquirer has already been identified, but none of the diligence process has really kicked off yet in a situation like that. Would you recommend that that seller go and hire an M A advisor, like an investment banker? Do you even go so far as to refer at that stage in time?
[00:13:47] Speaker B: Yes. It totally depends on the scale of the operation, where the owner is specifically, are they actively involved in operations? Are they not? How well documented is the company? What type of deal are you trying to get done? I mean, everything is conditional, right? Especially in deal making. And that's as true of what kind of advisor to hire as well as should you hire one or not. But in most cases, having somebody who can help you, if you're going through this for the first time, to, again, go through those discrete components, prepare for a sale, make a market, and then get through diligence. Those are all defensible reasons for going and hiring somebody. And what we tend to find is, to your point, making a market. A market can be of varying sizes. We work with some advisors who rarely show their clients more than five to ten buyers because they spend a lot of time trying to figure out what their seller is looking for in a potential partner, and they aren't looking to auction it off to 200 firms. Right. And that is still making a market, but it's a credible market. And then the focus is on making sure that the deal is right. And that can be a tremendous value for the seller to have somebody who does deals regularly and helps to guide them through that process. And the same thing is true if you already know exactly. I mean, you and I would use it's like the shotgun wedding analogy, right? If you already know who you want to sell to, that's great. There's still a lot of work to be done. And one of the things that we find is that a lot of times people walk into the diligence process and they're like, we'll get through it 30, 60 days. How could this possibly take any longer? And then they answer the first round of questions in like two to three weeks. But none of the questions are actually substantive enough to qualify as actual answers, right? Successful answers. And so what ends up happening is you go through another round and another round, and it ends up taking so much longer. So there can be an efficiency reason that you're hiring somebody who does this regularly. And there can also be a reason of just wanting to make sure that you have enough capacity. Again, we talk to people all the time who say, my business suffered when I added a second job of going through diligence. And so, again, an advisor can be very helpful in trying to do that. So we have lots of reasons that we refer people over to advisors. There are rare instances where somebody is well versed in M A. They know who they want to sell to, and they have enough resources internally to really staff their diligence team with internal resources and execute on a deal in a way that we may say, okay, yeah, you should work on your own. But that's not the common answer. That's the rare answer.
[00:16:37] Speaker C: I want to talk about the M A attorney a little bit, too. I think that the M A advisor as a profession is a clear and distinct service for an owner of a business who's exploring the sale. I think it's maybe many sellers may still resist hiring them, but I think it's a clear value proposition that's very distinct from what the business owner does day to day, et cetera, with the attorney. I think there is a lot of confusion around why you can't just work with your counsel of ten or 15 years, who's general business counsel to you and knows you well and you trust him and he or she trusts you, et cetera. What is the distinguishing characteristic of an M and A attorney in your experience?
Why do you recommend that, in addition to the other elements of the deal team, what makes an M A attorney appropriate and necessary separate from a general business attorney?
[00:17:33] Speaker B: Yeah, so the long answer is the checklist that we provide, which helps to walk through types of deals that they've worked on, types of outcomes, how they staff a deal, all of those things. The crass answer is how many purchase agreements have you drafted and successfully closed, right. Or been a part of drafting or redlining and closed? And the reason why is that, unlike Taylor, actually makes a great analogy for this, which is if you have a specific ailment, you don't just go to a doctor. You go to the specific doctor that deals with that specific issue. Right. That's why we have ear, nose, and throat doctors. That's why we have neurologists. That's why we have cardiologists. The practice of law is not dissimilar. There are people who do specific things and they do them very well. And when it comes to M A language specific to purchase agreements and operating agreements, there are definitions in those documents that most attorneys do not deal with every day. And even general, well practiced general business attorneys who deal in contract law very regularly are still not going to have the same base of knowledge to appreciate why things are phrased the way that they are. And so by using a general business attorney instead of using an M A attorney specifically, you're starting from several steps backward in making sure that you're going to get to a common understanding on definitions. And that is half the battle in drafting purchase agreements and operating agreements specifically. It's just making sure that you have common definitions of what each thing actually means because it is all encompassing of a business's operations and history when it comes to how those definitions end up servicing the deal itself. So for those reasons, we say you need an M A attorney. You need somebody who knows what market terminology looks like right. And then can appreciate from a risk bearing standpoint and specifics of the operations of that company, how are we going to design a purchase agreement collaboratively with the buyer? Because you have the same goal, right. A lot of people think about lawyers on the seller's side being adversarial with the buyer's side. It isn't actually functionally supposed to work that way. They both want the same outcome. We all want to close a deal, but the deal has to make sense to everyone, right? And if we have somebody at the table who is supposed to be providing the language as the specialized expert who doesn't come from an M A background, it gets more difficult and more expensive and more time intensive to actually get a deal done. And so for all those reasons, we say you need to go find an M A attorney. And oftentimes your general business attorney may be able to refer you to someone that they work with regularly on these things. But if not, there are ways to go about searching for that person or that team. And we try to provide a pretty comprehensive checklist of how you can sort of assess their record right. On M A deals specifically, and make sure that they also appreciate what you're trying to accomplish in the deal.
[00:20:35] Speaker C: I think part of the reason why an owner of a business gets anxious about hiring a diligence team is because very often they start the process of making these hiring choices very proximate to when they actually want to get a deal done. And so now they want to get a deal done this year as opposed to, like, in the future. And so then they have to make an M A attorney selection. They have to hire an M A advisor. They have to make all these huge know, bring new faces and new people into their life, bring them into the innermost sanctum of their business. And they have to do it in a really fast way, if they haven't done it already. And yeah, I think it's just hard for people to be like, sure, I'll talk to a few M A advisors and then, you know, pick one when they only started meeting them like, a week ago or a month. So I realize that sometimes timing is the most important thing and you got to make quick decisions. But in an ideal world, what would you say if your brother were selling his business? When would you tell him to start evaluating, referrals to M A attorneys or M A investment bankers? How far in advance of an active sale process would you recommend he or she start meeting with people and begin developing those relationships just so that it's not so quick and so sort of so compressed?
[00:21:57] Speaker B: Absolutely. I mean, I would never tell somebody to try and get everything done within a year. I think most people are best served by thinking about this two to three years in advance. And that gives you the time to actually develop relationships and not to make decisions about hiring someone in a week, right? Because to your point, these are incredibly trust based decisions. If you're going to make them in a way that you can be confident about the outcome, it's not just objective in identifying what somebody's record is as an M, a attorney or as an advisor. These are people that you want to get to know, like how do they treat people around them? How do they interact with you? How do they interact with your team? Do they follow through on deadlines? Do they do what they say they're going to do? And for all those reasons, we think that your relationship building for the purposes of doing a deal at some point in the future. Honestly, it's rarely too early, right? So we have people who contact us who say, hey, I think I might want to do something in two to five years, but I just want to understand what matters to you and how a process would work with you. And we will happily entertain those conversations because we do think that for most people, rushing a deal ultimately is going to lead to sellers remorse. And so what we would rather see happen is everything should take as long as it should. And so that's as true when it comes to diligence. That's as true as forming your team. It's bizarre to me, but people will hire a CEO or a COO and then turn around and go to market two months later and it's like, do you trust them yet you hired them. Hopefully there was an appropriate hiring process, but oftentimes then they'll say, we're going to exclude them for a while. We don't want them to be worried about their job. But we went ahead and hired them so that you could see that we had a full management team. And it's like, no, you've got to make these steps kind of make sense and be able to have everybody involved in a trusting capacity so that when you're sitting at the table, you're confident on all sides. And so we have seen it play out in a variety of different ways. And certainly if there's a health crisis or something has to be done quickly for a specific reason, you can be transparent about that and people will come to the table to try and make something happen for you. But if you are not a forced actor, don't force yourself to make decisions, right? Make them relationally over time and give yourself the luxury of making sure that you can build trust over time.
[00:24:19] Speaker C: Let's talk a little bit about maybe the buy side of all of this. I'm curious to hear a couple of things in terms of buy side diligence. So with respect to buy side diligence. I'm curious to have you maybe take us through sort of how you guys do buy side diligence and what you see in the market are other ways that buyside diligence gets done. You mentioned before we pushed record, for example, that you guys don't hire like an external Q of E firm to do quality of earnings. Could you take us through sort of the nuts and bolts of the permanent equity diligence process? Why you guys have chosen to insource everything and just what you consider to be sort of like the different approaches that a seller is going to see depending upon who they're working with on the buy side of the table. What can they expect in terms of different approaches and in source team versus third party and how to think about the differences there?
[00:25:13] Speaker B: Yeah, sellers will encounter a wide variety of things and it kind of depends on how a buyer's team is organized. We have 20 people on our team and that's intentional. And most of those resources are dedicated to supporting our companies post close. But that involvement starts in diligence. And so philosophically, we really think about diligence as the engagement period of a marriage. So this is the period where you're relationally saying we're making a commitment to each other, but if something doesn't go right here, then maybe marriage is not the direction we should be going in. Right. And so it is the time that we want to introduce people that they will be working with on the operating side for years to come and make sure that relationally it works, that they can start to build trust. But also that the people on our team who are going to be working on the business start to develop an education about the business. And so for those reasons, to your point, we do not use outside parties for our core diligence checklist. So when it comes to the financial pieces of a company, our internal finance team works with the company's financial team to rebuild the financials, goes through the general ledger, reroutes the bank statements and makes sure everything ties up. And that's what we call our internal quality of earnings report. So we don't need to use a buy side Q of E team because our financial team needs to know how the financials are prepared, what the processes are internally and it's an opportunity for us to start developing a relationship with them. So we do that in every area of the diligence checklist. So operations and team questions are all handled by our operations and HR team. And the intent again, is that we understand how people are compensated, how they've been incentivized historically, how they think about who's going to lead the team post close and who's going to be involved in the quote unquote, management team. All of those are things that we want to know internally. And so for those reasons, our diligence team is internally. Organized. It's led by Taylor Hall, who is our in house general counsel. And so prior to working here, he was a full time M A attorney and worked on thousands of deals over his career. So he's well versed in what it takes in terms of drafting, in terms of business quality and documentation to actually get a business deal across the finish line from a legal standpoint, and also make sure to involve all the different parties who are going to be able to best assess the specific pieces of information we'll receive. So in that way, our CFO leads the financial piece and then brings in team members who will work on the company ongoingly. Same thing is true on the operations team. Mark, who is our COO, brings in the operations team and brings in people that will work ongoingly. And it's also an opportunity for the management team to tell us what do we hope to do as we start working together. So in Diligence, we're building a list of things that they're saying, these are our priorities, this is what we want to work on. So the documentation may say, this is how we currently do things, but we may all readily identify this is not how we want to do them going forward, right? So it's an opportunity too, to do kind of a health check on what's important to the management team as we get started on our partnership together. And so all of that creates our Diligence team. So there's typically two to three people coming from the operations side, two people coming from the finance side. Taylor leading as quarterback because he also liaisons with our outside legal counsel. So we use an outside drafting team to help him in documentation efforts. And then from there, that creates the team by which we get all the way to the finish line. So if something comes up when we're procuring documentation in the checklist, that may affect how something can be drafted later. Taylor, by being quarterback, can flag it very early and hopefully then it's not as much of an issue. So that's how we approach Diligence and we've learned to do that over time. It's why Taylor came in house, and we've really seen it work well in being able to develop relationships in what can otherwise be called a fairly choppy piece of getting a deal done. From a peer standpoint, we have known and seen a lot of different approaches, right? Some people are one to two people, and they are therefore going to have to rely on some third party elements to get through all the pieces of Diligence and to make sure that they have the appropriate things checked, especially if they're using bank debt and those types of things. There are some reasons why if a bank is providing a loan on a deal, they may want third party validation on something. So there are a lot of pieces that can be handled in a variety of different ways. The point, if I were talking to a seller, is that you just want to understand how they're going to execute on diligence, who's going to be reviewing the information and what they're reviewing it for. Because some people are reviewing information in order to validate that what they knew to be the case is true. Some people are looking for problems to be able to highlight, to say, we would now like to retrade, or we now see an issue and therefore we've provided our value to the buyer. If they're a third party or there are people that go about it and just say, look, I just need all the information to exist somewhere. But we'll figure it out, we'll get the deal done, and then I'll figure out what we're working with. Right. People have different approaches for us. We think it is an opportunity for both buyer and seller to substantively work on building a relationship and build the deal along the way, taking into account all the key pieces of the company's heritage and history and its active operations in a way that when the deal closes, everyone already knows what we're working. Everybody already knows how we can march forward. And there are relationships between the parties on both sides.
[00:31:14] Speaker C: What's your point of view on how much diligence should be done both by the buy side and the sell side prior to going under exclusivity with one another? Does permanent equity typically go under exclusivity on a business in order to perform some amount of due diligence? Do you guys?
[00:31:34] Speaker B: Absolutely, yes. So we look at it as especially given that we do the work internally. We want exclusivity in order to dedicate the internal resources because the exclusivity is tied to commitment. So if a seller is not willing to make a commitment to us to dedicate those resources on their side and commit at that level to say, I think this might be the one, then we probably shouldn't be over investing and bringing a lot of people on our team into the fold to continue to work on that. So, yes, we very much work under an exclusivity basis. What I would say is I think that most sellers who work with good advisors are working to find the right partner rather than running a perfect process. And so what I mean by that is we are very averse to being involved in processes that may have a perfect process but don't allow for us to get to know a seller or keep everything to be fairly objective. Right. So IoIs are just tell us what your number is and loi is your term is this their term? Is this let's negotiate and we'll tell you if you're the one who's selected, this is a relationship based deal and we think therefore, knowing your counterparty and knowing rather than a counterparty, really your potential partner is vital to making a good decision. And so when we see processes we will be involved in will may not be process perfect, but they are intended for people to get to know each other in such a way that when the seller decides to go under exclusivity they feel good about that. So we will absolutely tolerate a seller asking for multiple calls or we'll go visit them and sit down and spend two days with them answering all of their questions to make sure that we've provided enough information for them to feel comfortable with that decision. It's why we publish as much content as we do as well. We want them to be able to get to know us in a passive way and to be able to sort of reconcile what we say with what we've said publicly, with what our record of achievement has been. And so if all of those things tie up, we think that it is a good basis for establishing trust in a potential relationship with us specifically. But I think a seller in any scenario, again should feel empowered that the person sitting across the table from them doesn't get to tell them that now you're going under exclusivity. It is your decision as a seller to go under exclusivity and you can absolutely ask for whatever you want. But you do have to appreciate from a buyer's standpoint they do have limited resources to dedicate to pursuing any deal and so they want to make sure that there is a mutual intent of commitment, right, if they're going to dedicate those resources. And as long as you have that understanding, however, you best form that relationship and form that trust is the way it should be done and it should take as long as it takes.
[00:34:33] Speaker C: Do you think that it's fair to say that the relationship and the conviction in the relationship between the seller and the acquirer is the thing to most be convicted about as a seller prior to going exclusivity? And the sort of hardcore diligence is reasonable to have wait until you're under exclusivity. Like if you were to draw a line for a seller and say hey seller, these are the things that you must feel good about as a seller before you go under exclusivity. Do you think that those largely refer to chemistry, general structure of offer, quality of the rapport and the relationship or do you think that there's other elements of diligence, soft diligence that should happen prior to an exclusivity agreement?
[00:35:24] Speaker B: It's an interesting question. I think, again, it's conditional based on who the parties are to some level. But I do think that as a seller, in addition to the relational components and knowing the core components of the deal, you also want to know how they're approaching that next step and all of that ties together, right? So example questions around this would be like what is something give me an example of something that as we enter into diligence would cause you to change your mind about your confidence in this deal or your risk tolerance for this deal or would cause you to want to move your valuation. Those are absolutely valid questions for a seller or a seller's advisor to ask of a buyer. We have people who will ask us for references both to advisors we previously worked with as well as sellers that have sold to us. We don't give those out prior to at least a spoken commitment of exclusivity, again, because we're asking time of other people on a deal. And so we want that commitment to feel real before we're going to do that. Otherwise, given the amount of deals that we talk to in any given year, we could be calling people every day asking them for a reference check. Right? So there's a reasonableness test to it. But I think that, again, as a seller and as a seller's advisor, you can absolutely ask for whatever you want to and then just appreciate what the buyer says is reasonable in their response and the counter is also true. Right. A buyer can ask you for whatever they want prior to going under exclusivity and you can choose which level to provide, which level of depth to provide. And so that's true of both sides. And I think you use that to your advantage to make sure that whatever it takes for you to feel confident that you do that. And I think behaviorally, what I see most commonly happen is people just want to spend time with people, right? So that you have an understanding of behaviorally, how they are going to communicate and how they sort of follow through on what they said they were going to do prior to getting into what can feel like a pretty rigorous process, people who instead don't really know their counterparty and get into Diligence. There are too many versions of the questions, versions of the responses, adversarial kind of movement on the advisor's part to keep the deal going that can break down the relational side pretty quickly if it hasn't been firmly established. So I do think that that is the foundation of making it through. But above and beyond that, it sort of depends on what you're optimizing for in the deal as well. If you had seven potential buyers and one of them was 50% higher than everybody else, I would very much be asking about where their source of funding is coming from, what their confidence is based on, and how sure they are about how they're going to proceed on the deal before I would make that commitment. Because while it may feel like you found the one, there's also a very good likelihood that you're not going to get across the finish line.
[00:38:23] Speaker C: I want to flip it around to the buyer side for a little bit on Diligence. If somebody was a rookie at buying businesses and they took your buyers, your list of questions, right, the Diligence questions that you put how many questions is it? 181.
[00:38:39] Speaker B: 181? Yes.
[00:38:41] Speaker C: So let's say that 181 questions. Those are the only questions that this rookie buyer can ask. And then there is a more seasoned professional buyer of businesses that's bought 2030 businesses permanent equity, other acquirers that are out in the market. What is the spectrum of skill that exists, and how does somebody get better, even if the questions are the same? What are the ways that acquirers get better at doing diligence? So you fix the questions. Those cannot be changed. How does a buyer get better at diligence or worse?
What are the ways for buyers to become better and better at due diligence over time, even if you sort of keep the questions identical over that same period of time?
[00:39:23] Speaker B: Yes. So I think there are two parts to this answer. One is, specifically, as you relate to individual responses to questions, it's the same as when you were in school. It's any qualitative response. What makes a good qualitative response? Right. If you don't know what a good response looks like, you don't really know what you're looking for. And so I think that reps matter, and I think that expertise matters. And this is why our CFO, who is a certified fraud examiner, reviews financials, and I don't review them when it comes to that phase of the process. You want somebody who actually knows what they're looking for and what they're looking at in an incredibly substantive way. And I think that you will always pursue greater excellence by that specialization, having eyes on the documentation. And by the way, that can be a very good reason why at some firms, they're going to use a third party to conduct some of the diligence. But a broader piece of it is the element of, like, what are you trying to find and what are you trying to do with the responses that you get? So this is a conversation that we have on every deal that we pursue into diligence at permanent equity, which is just around is it validating? Is it better than or worse than, and if it's better than or worse than, to what degree and to what degree does it matter? Right? And so this goes into risk tolerance, and there is no perfect company. Diligence is intentionally designed to make sure you know what you're walking into, which means it will show the flaws of the organization. And for a seller, you have to appreciate that a buyer will be a better steward of your business by knowing what those vulnerabilities and weaknesses are. But it doesn't feel great to provide the answer that shows that you had a lawsuit here or you've got this issue over here. You just have to recognize that that's a piece of for a good buyer, they don't care, right, on the surface, because we know that businesses are not perfect. But again, what are you going to do with the information you receive. I don't believe in people putting deals under exclusivity just to whittle down the valuation by getting enough documentation that things are worse than they were presented in the marketing information to be able to go back and retrade the deal right. I think that's a bad approach and I think it makes for losing trust with advisors and sellers and it's reputationally damaging and I think it's a way to really hurt yourself in the long run, vice versa. I think people who enter into diligence with an expertise driven this is what we're looking for. If you have a good quarterback of deal making, they're going to know how that affects documentation, they're going to know how that affects timing for the deal and any consequences postclosed how things should be structured. That includes regulatory approval, customers just knowing all the dominoes that can be affected by how the organization is structured and how it needs to move forward in a deal. So from that standpoint where you get volumes of information that can take up terabytes on a cloud somewhere, the ultimate thing is do you have people in the position to raise the issues that actually substantively matter in a way that keeps the deal moving and keeps everybody at the table. And so if you can achieve that, you're getting better every single time. And I think most buyers do themselves a disservice when they don't look at the primary documentation. Again, if you're using third party resources, that's fine, but make sure that you at least spot check stuff right and you at least appreciate what they prioritized in their response to you to say oh, this was an issue. Well, do you agree that's the issue number one, right? Because your risk tolerance may not be the same as theirs. They may say this is a common issue, but for you it may be consequential or not consequential and vice versa if they don't pick up on something that you can readily see and was important to you in your initial discovery of the deal. Make sure to point it out and make sure that you spend the necessary time to work through it and make sure that you understand it because it does. No one a service for someone on the buy side to be surprised either right before a deal gets done or right after. In either case, it is not going to serve the company well and it's not going to serve the buyer well. And so in that way, I think people get better by knowing what they're looking for in the responses and making sure that they're communicating internally on what responses matter and what you're going to do with that information to make sure that it's actionable in a way that actually produces the right outcome for everybody involved. And sometimes on the rare occasion that is, that the deal should not be done right, it can come out in diligence every once in a while for perfectly good reasons that the buyer is not the right steward, potentially. For the business, or that the business is not yet ready to be sold, or that organizationally there is something that makes the business specifically in need of blank before they're going to be able to proceed. And all of those are things that are just realities. They're the exception, not the rule though, to how you should approach Diligence specifically as a buyer.
[00:44:31] Speaker C: That's a hugely painful outcome, minimally for the seller when all of a sudden that conclusion is reached. Right? You mentioned in the document, obviously time kills deals and that's a sort of well known cliche in the deal world. But what else other than time kills deals?
How can sellers think about and categorize in their mind sort of different kinds of things as being potentially deal killers versus things that maybe modify the deal but don't kill the deal?
I think there's just so much anxiety there at this point in the process from a seller's perspective, for sure. I think that's the challenge, obviously, with getting Diligence done and getting it done really well. What do you think really kills deals versus just sort of modifies the structure, modifies the right approach?
[00:45:27] Speaker B: So I think everything kind of comes down to behavioral elements more so than the actual answers. Right. To your point, if you market something poorly and forget to include something that substantively changes the goalposts on how the company can perform going forward and that's discovered in Diligence. It may move the valuation, right, but that was poorly marketed. You should have disclosed that earlier. And behaviorally, your approach to marketing your opportunity set caused that outcome, right, in some way. And so that's the same way I would think about it in Diligence, once you've made that commitment to somebody, the thing that actually will kill a deal most often is someone behaviorally exhibiting that they are not going to be helpful post close, right? And that can take a whole host of forms. It can be that you don't want to disclose information or you're trying to disclose the bare minimum. It makes people skeptical right on the buy side. So comprehensive answers are important, they matter to a buyer and they show that you are committed and confident in the information about your company. If you don't want to answer things, people will naturally have more questions then beyond that it's how is the business being run during this period? Right? There are plenty of examples of organizations that leading up to a sale will behaviorally demonstrably operate differently? They will accelerate sales, they will run promotions they do not normally run, they will get down to an inventory level they would never normally have in their warehouses. All of these are examples of things that can raise suspicion about is this company actually on a forward trajectory that feels sustainable? Versus is it being prepped for sale in a way that is going to time tick a very top period. And so behaviorally, I would think about it as base every decision as if you are working on the person that you would want to get married to, right? You want that person to have integrity, you want them to be trustworthy, you want them to be ethical. The same is true of us as a buyer looking at any seller. We want them to have integrity, we want them to be communicative, we want them to actually ask questions right to the point on communication. It's not just are you providing comprehensive answers, but it's do you want to know things about us? Right? And can we have dialogue and can we solve conflict between the parties? Diligence is naturally going to include conflict, especially when you get to legal drafting. And so you have to be able to talk through those issues. And if we can't do that and instead you're demonstrating not treating people well, or a combination of withholding information, providing bad information, or just being unreachable in some cases, if those are the signs that you're exhibiting, there's just a natural skepticism that's going to develop about whether the deal is viable. But even more so than the deal post close activity and it just will lead to a natural degradation of the relationship and ultimately probably will end and it not going forward in most cases.
[00:48:40] Speaker C: What about just like a clean and relatively understandable recharacterization of business profitability? To me, that's the kind of thing that is probably a manageable adjustment, right? The business indicates that it has X million of EBITDA or X million dollars of pretax cash flow or profit. It ends up having X percent less than that.
If you were not in the business of buying that company and you were just coaching that seller, how would you coach that seller on how to manage to a closed transaction? When there's something like that, that happens because a lot of times I think the business is generally more or less well understood.
[00:49:20] Speaker B: Well, behaviorally, a lot of businesses month to month can have swings, right? So if your diligence period is going to take 90 days, there's a chance that month one looks different than month two, which may in aggregate look different than what was projected for the quarter. And I think that the natural answer is what is the degree of difference and what are the easily identified attributes that are contributing to that? That's sort of the surface level. But then also when you're thinking about who your potential buyer is, you've got to think about how you're negotiating the deal in the first place. Philosophically, as an example, we don't have a prescriptive way that we do any deal, but on principle we typically when we go under loi are using hard numbers. Meaning when we say the valuation is blank, the valuation is a number, the valuation is not a formula to be determined at the closing date. And the reason that we do that is for exactly what you're talking about, because it works on both sides. If you're negotiating a deal as a seller and you tell the buyer, well, I want credit for the last month, the last 15 days before closing because my business is continuing to compound and build. And so I want that formulaic answer for valuation so I can get every last cent out of it. If your business doesn't perform and it goes the other direction, shouldn't the buyer get credit? Right? Because you've set up the deal structure that way. Our philosophy is typically that that's why you want it to be number based from the beginning because those swings are natural, businesses are living organizations. And so in that way, if something is a little bit off, it shouldn't change the deal dynamics in a super substantive way. And again, it comes down to the degree of which it is off. We had an example a couple of years ago of a business that expected to generate significant cash during the period that we were conducting diligence. And the business had not, up until that point in the year, produced any cash, but it was purely a collections issue based on some big contractors. And so it was a question of when was this going to come through? Well, behaviorally, we went through three months of diligence and there was never any cash flow. And so for us, you're sitting there and that's a contingent point on the deal. And the fact that it never came through meant that we went we all knew that from the beginning. We said, this is going to be important, that this comes through, right, so that we can behaviorally see what was the bottleneck and how did it ultimately pan out. And when it doesn't, or if it doesn't, then we're going to sit here and we're going to talk about it and figure out if we can move forward or not. Ultimately, we couldn't move forward on that deal because that cash flow never manifested, right? So from a buyer standpoint, if you engage with a buyer, if something will matter during that diligence period, especially if it's not just a swing on profitability, but something significant about generation of cash or conversion of a contract or something along those lines, those performance metrics should be laid out as part of entering into diligence. Those are things that both sides can flag and say this is meaningful. Union contract negotiations, like all of that kind of stuff, are things that should be laid out for both sides and say this is an important contingency for us to be able to move forward. And as long as you know what those are as a seller, then you just need to manage accordingly and communicate accordingly. We have had situations where people we said something was important to us, they knew it was. It didn't pan out exactly as perfectly as they had initially projected, but they were communicative about it, behaviorally exhibited that they weren't trying to hide it from us, we weren't trying to do the deal preemptively. But ultimately life happened and it was slightly different than what they had initially set out to do. And we were fine with that. Right. Because it was behaviorally what we would expect of a good partner, and ultimately the outcome wasn't consequential enough to meaningfully move the goalpost on the deal. So those are the types of things that you just have to figure out who you're working with and how much it matters to both sides. And as a seller, it's why I don't really understand in most cases why you would set yourself up for the formula, a formula evaluation, because I think in most cases, it sets people up for a lot of back and forth in the diligence period that can get contentious about what counts as performance in what time window.
[00:53:51] Speaker C: Right. Yeah. It also creates these incentives for the seller to potentially operate the business differently.
[00:53:56] Speaker B: Absolutely.
[00:53:57] Speaker C: Yeah. Emily, we could probably go on for the rest of the afternoon. I've learned a ton. It's been really fun to bounce back and forth between the sell side and the sell side's lens and viewpoint on this and also learn about how a professional buyside organization with the time horizon you guys have, how you guys think, how you guys do business. I've enjoyed the time a ton. Congratulations on making this document public and visible.
[00:54:21] Speaker B: It's obviously we definitely toasted internally when it was finally public and we couldn't edit on it anymore. Yeah, no, it was a labor of love, but it was definitely a labor for the last couple of months.
[00:54:32] Speaker C: Well, it's a great document. Congratulations on being brave enough to share your internal processes and your questions. And I know it will have some of the intended effect that you guys want it to have. So thanks for coming on the show and spending this time with me.
[00:54:45] Speaker B: Yeah, absolutely. Peter, it's always good to talk to you. Good to see you. And I would say that obviously we really value the axial community generally and to the extent that whether they're peers or advisors or operators of business who have any feedback on the content we're putting out I would love it because part of the reason for making this open source is so that we can get better as well. So we know that this is going to be iterative. Our intention is to make public updates to it ongoingly, but if somebody has pushback or an idea on a specific section, we'd love to hear it.
[00:55:15] Speaker C: Should they just send you an email in that case? Just yeah, absolutely.
[00:55:18] Speaker B: So my email is E, as in
[email protected].
[00:55:22] Speaker C: Emily, thank you so much. Great seeing you. This was terrific. Enjoyed it.
[00:55:26] Speaker B: Thanks.
[00:55:33] Speaker A: If you enjoyed this episode, check out axial.com. There you'll find every episode of.
[00:55:38] Speaker C: This podcast, as well as our recorded.
[00:55:40] Speaker A: Axial member roundtables, some downloadable tools for Dealmakers, Axial's quarterly league table, rankings of top small business acquirers and investment banks, and lots of other useful content that we've created over the course of time. If you're interested in joining Axial as either an acquirer, an owner considering an exit, or as a sellside M A advisor, you can get started for
[email protected] as well. Lastly, if you have ideas for podcast.
[00:56:05] Speaker C: Show guests, feel free to reach out.
[00:56:07] Speaker A: To me directly at
[email protected]. I promise I will respond.
[00:56:11] Speaker C: Thanks for listening.
