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- [00:02]
Podcast Host
Welcome to the Path to Exit, a podcast to help software and Internet founders understand the process to raise capital or sell their business.
- [00:19]
Mike Lyon
Hello and welcome everyone. I'm Mike Lyon, founder and managing director of VistaPoint Advisors, and this is the Path to Exit. This show is dedicated to helping founders of software and Internet businesses understand what it takes to raise capital or sell their business and how to do it well. My guest today is Jeff Koons, managing director at VistaPoint Advisors. Jeff has worked in technology M and a for over 10 years and has witnessed retrades during M and A and capital raising transactions. A retrade happens when a buyer and investor tries to renegotiate deal terms after they've been agreed to, typically by lowering the valuation or price. In this episode we'll explore the types of retrades, why they happen, and most importantly, how to guard against them. Please enjoy my conversation with Jeff. Jeff, welcome back to the show.
- [01:00]
Jeff Koons
Hey Mike, thanks so much for having me. Thrilled to be here.
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Mike Lyon
So maybe just give us a little bit more context for what a retrade is.
- [01:06]
Jeff Koons
Yeah, you'll hear it called a retrade, a price chip. There's a couple words for it, but essentially it's very simple. You have agreed on the key terms of a deal, so economic and legal. And then prior to closing the deal, the buyer changes the economic or legal terms of the deal. And it's always in a negative way,
- [01:25]
Mike Lyon
obviously bad for the seller. This is one of the main things you're trying to guard against. You'll hear it called strategic repricing, all these things, but it's basically a retrade. There are what we would call legitimate retrades, like when people find thing in diligence that they didn't know about or frankly, the seller misrepresented things either accidentally or on purpose upfront. But most of what we're gonna talk about is the buyer trying to take advantage of the seller through exclusivity. There are two types of retrades that we kind of think about. One is the strategic retrade. We're just gonna spend a few min on that. And then the other one, the bigger category is what we call diligence or process retrace. So Jeff, talk about the strategic retrade a little bit.
- [02:03]
Jeff Koons
Yeah, the strategic retrade is essentially the fixes in. It is a strategy that buyers will use where they intend to change the price or deal terms. Even when they're signing the term sheet, they will dress it up as we found, X, Y, Z. But there are times when It's a known strategy where they're going to promise something and. And then a week before or two days before the deal's supposed to close, they're going to change that and say, we're ready to go, but it's 30% less on the valuation side, or we're going to move this cash up front to earn out something like that.
- [02:38]
Mike Lyon
As Jeff said, this is something the buyer is thinking about as they're doing their first and second rounded. So this is more of a strategy of the firm. And unfortunately, if you're not dealing with all these buyers, and we're talking mainly about PE firms, you just don't know whose strategy this is. Experience tells you who these firms are. They're out there. They're pretty well known in terms of trying to figure out who they are. It's mainly reputational, which can be hard for founders. But there are some clues when you're getting a term sheet from a buyer. So if they're asking for a really long period of exclusivity and they're a lot more pushy than maybe some of the other buyers about getting them a long period of exclusivity, and for you to give it to them now, that could be a sign that's not a perfect indicator. Sometimes people are just aggressive. But I would say those are some of the signs you have being really aggressive, maybe moving their valuation way up without a lot of thought behind it, because they're just trying to get you an exclusivity. And again, if they get you in exclusivity for 60, 90 days and then beat you up on diligence, they think you're pretty likely to take some kind of retrade because you're tired. This is the risk you just do not want to take. The next set of retrades we're going to talk about are more diligence, process, retrade, and. And I wouldn't necessarily say these are the seller's fault. The seller has a lot more ability to influence when and how these happen and to really guard against them. We're just going to walk through several types of things that lead to retrade, talk about what they are, and then we'll talk about a mitigant for each one of those. So let's talk about performance and projections, the performance of the business during the process and how that plays in.
- [04:10]
Jeff Koons
Yeah, absolutely, Mike. And if I may, just before we jump into that one, I would like to set the table here to say we think the best protection against getting retracement traded is to have a limited or no exclusivity period in your deal. When you are dealing with multiple parties, if somebody wants to try to retrade, you have multiple options to go back to and say, hey, this party's saying XYZ and they want to change the deal. Do you feel the same way? If they don't, then you've really created leverage against that retrade. So for all of these we're going to get into tactical mitigants and the specific things you can do to avoid them. But the overarching one is limited or no exclusivity. So you retain the leverage throughout the process. So sorry, I just wanted to make sure we're highlighting that upfront here.
- [04:57]
Mike Lyon
As Jeff said, this is going to apply to all these as a general mitigant. And remember, exclusivity is kind of bad for the seller, good for the buyer. And so you only want to give that at the right period and ideally give, as Jeff said, little to none of it. Let's talk about maybe the performance and projections. How's that one play out?
- [05:13]
Jeff Koons
Yes. So this one is simply you are a founder, you're going to give these forward looking projections and then during your conversations with the buyer or investor, you have to deliver on. And so let's say you're saying, hey, we're going to do 12 million in ARR this year and at this point in the year we should have been at 9 million. Well, actually we're at 7 million. You are very likely going to get your deal repriced because the buyer is going to say we thought you were bigger and growing faster. That's what our valuation was based off of. This is now not true.
- [05:44]
Mike Lyon
And this is one that you have a lot of control over. I think there's a strategic view here about where you treat projections. So for example, not giving them the monthly projections right away, sticking with annual projections because it's less clear if you're going to miss those in the middle of a process. The other issue to think about here is the marketing value of your projections. So for example, if you think you're going to grow at 45% this year, it doesn't really do you that much good to put a projection out of 45 versus 40. From a marketing perspective, you're going to get the same level of interest in the early part of your process. And if the business performs well, you can take those projections up later and still kind of monetize, if you will, the 45% growth. However, if you Thought you were going to grow at 20% a year and you brought the projections down to 11%. That could be a big difference in terms of how buyers would view the business early. So basically, you just don't want to take asymmetric risks. If you think you're going to grow at the 45, but you could easily grow at 42, you put the 40 number in there to not take that risk. There's a tremendous amount of downside in terms of missing your projection. And so you just want to be smart about what you're putting out there. Always meet or exceed those numbers. But you also have to think about the marketing element of how you market the business up front. I think those are some good tips in terms of thinking about the growth rate of the business. And if you're over 100% growth, it doesn't really do you that much good to show 110 versus 100. It just doesn't really matter that much in terms of the upfront interest, especially
- [07:12]
Jeff Koons
on the revenue side with SaaS businesses because of the way ARR and revenue is recognized. If you were planning on being at a certain level of ARR in Q1 and then you miss that, you're missing a lot of months of revenue recognition along the way. So for SaaS companies, this is particularly acute. If those bookings ultimately get delayed, it gets harder and harder to catch up. And so again, as Mike said, you just really want to be judicious. The way you present them should be annual or quarterly, not monthly, and ensure that you are really able to defend these with the buyers. It's not like the VC community where you can just say, yeah, we're going to be at 300 million three years from now. And it's more about tech and product. If you're getting a big liquidity deal done with a strategic or PE firm, they are going to hold you to your numbers.
- [07:58]
Mike Lyon
Absolutely. Let's talk about the accounting issue. So this is accounting diligence. Know that every buyer is going to go hire a fairly large firm to come in and do accounting diligence. And they're hired to look for stuff, right, that they can kind of use as ammunition. They have two roles. Understand what the numbers actually are and do they match what we told them, and then also try and find things that could be helpful to the buyer. Talk about how the accounting retrade plays out. Jeff.
- [08:20]
Jeff Koons
So you'll be providing a set of financials and you'll say, here's our revenue, our cost of goods, sold, expenses, net income, ultimately and then the buyer will, as Mike said, hire KPMG or Deloitte, one of those parties, and they might come back and say, hey, the revenue checked out, but you assumed your gross profit was 88%, but you didn't have your customer success wages in there. And so it's actually 77%. And so we thought we were buying this high 80s, really nice margin business. And it's actually kind of mid lane. And so our view on price has changed because you're not as profitable at the gross profit level. So that's how it actually plays out. The accountants find out that your accounting is inaccurate in terms of the Mitigan here. This one in our mind is totally in control of the seller. And so there's really two ways to approach it. One, you have either audited financials or you have a internal quality of earnings done. So again, it's not a buyer doing it, it's you hiring Moss Adams or KPMG or whoever who then reviews your books, they give you the output and then at that point this risk is off the table. Right. You have a high reputation account and you say, no, we've looked at this, this is correct. So that's one way to mitigate it. A lot of our clients actually don't need to do this because the accounting is somewhat simple. These are not massive businesses. And so one of the good ways to stress test, hey, are we going to hold up in diligence? Is actually when you take some of the operating KPIs or the SaaS metrics. So like your revenue by customer by month report that you're going to use to determine your retention. And then you compare that to the financials. So let's say your rev by customer by month is coming from Salesforce or HubSpot, because that's where your contracts live when you export those. And then you're saying, okay, my revenue by customer by month says, in may I was at 1 million in revenue. But your P and L says you were at 1.4 billion in revenue. That is a big enough gap where you probably want to hire an accountant to go make sure you know something's not right here. And you need to figure out which one it is, is. But let's use that same example and say, hey, our rent by customer said we're at a million and our P and L said we're at 1.1 million and that 100k is from professional services, which wouldn't show up on the MRR report. Then you're probably in pretty good shape. On the revenue side, and then you do some other checks on the profitability side compared to the cash flow or the balance sheet. And that's the way that you can get comfortable and then not incur the cost of the sell side quality of earnings. But again, this one, in our mind, you just got to be buttoned up and prepped up front, and then this one is totally in control of the seller.
- [10:47]
Mike Lyon
Absolutely. I would say no excuses on this one. And the problem here is the way founders tend to think about accounting. They tend to think about things like cash flow, not GAAP revenue.
- [10:56]
Jeff Koons
Yeah. Paying the employees. Right.
- [10:58]
Mike Lyon
Yeah. So you just don't really think of it that way. But the buyers uniformly will all think about it from a gap perspective. The easy answer is, go get a Q of E. We don't think that's always the right answer. As Jeff said, you go through this analysis till you see it, and an audit can be nice if you already have it. But there's just extra cost and expense from going from a quality of earnings to an audit that frankly doesn't help you that much.
- [11:20]
Jeff Koons
Yeah.
- [11:20]
Mike Lyon
What you want to do is survive diligence and not have the buyers thinking they can push you around on your accounting. So that's really the core principle here. Are we going to survive diligence? Well, and is that going to create any issues? But I think this is a huge blind spot for founders. Whenever we hear from someone, we're super buttoned up. It's like an 80% correlation, small to major disaster on this area. So a lot of people think they're buttoned up and they're not. You just need to talk to people who understand SaaS accounting. And what we typically do is look at that analysis, Jeff said, and then make a recommendation about, do we need to do a qab? There's always a lot of cleanup. I'd say we only really recommend the QAB 30 to 40% of the time, maybe less, depending on the company. Let's talk about another one. We're calling it the framing retrade. Jeff, talk about the framing retrade, what that is and how it plays out.
- [12:06]
Jeff Koons
Yes. So the framing retrade is essentially when you're gilding the lily on how you're presenting the business. So you might present the retention of the business in this very optimistic or rosy way that upon diligence kind of falls apart. Or the total data set tells a different story than the cherry pick data set you use to create some analysis or marketing point in your materials. And so then again, the buyer gets the full data set and then they say, well you said this, but when I have all the data, it's actually closer to this. And as a result of that, this is different than I thought it was. I'm changing the price or the terms.
- [12:43]
Mike Lyon
This one comes up a lot. And unlike the projection one, where basically we were advocating just being pretty conservative, this one we feel a little bit differently. So obviously on these retention rates, that's really a core crux of the valuation. So you want to be as aggressive as you can, but again also survive diligence. But you don't have to survive diligence with everyone. So I would say our typical deal where we're dealing with a bunch of PE firms, maybe 70 to 80% of folks get comfortable with the way we viewed retention. And so not everyone does, but that still leads to a better outcome than maybe going so conservative that everyone would agree with the view. And this is just experience based. There are many different ways to calculate retention. We all talk about net, gross and logo. That's true, those are the three main types. But the way you could calculate those is infinite almost. And so you just have to have a lot of experience with basically what you can get away with upfront and still survive diligence. And that one's just really critical. Jeff also mentioned some other things around gross margin. I'd say that one is a little bit more solid in terms of this is the way you do it. We still see a lot of misunderstanding Amongst founder led SaaS businesses about what's in cogs and what's not. So I would say only about 10% of the time do we see that and it's perfect. Usually it's close, but that's also another big one. Let's talk about the one that I think frustrates bankers the most, which is the market retrade. Jeff, so what is that one?
- [14:04]
Jeff Koons
So in any one of these deals, a buyer or an investor is going to hire some third party diligence company to evaluate the market and what is the tam or the total addressable market, which I'm sure all the founders here have heard that term. You know, there's the old joke of a private equity partner falls asleep in a meeting. The first thing they do when they wake up is going to say what's the tam? But the reason why is because it is really important. How big is this market and how much market share do you need to build a really big business here? Because if you need 90% of a market, that's probably not going to happen. So that's why it's important the retrade happens when you say the market is 5 billion and then the market analysts come in and say, yeah, it's not 5 billion, it's 750 million. But again, this point we keep coming back to is you said this, the third party said this. And there's always a moral hazard when you're buying a company, right? What do they know that we don't? Or of course they're going to be marketing. And so when it actually comes to bear, and it says this is $750 million market, that very much so can lead to a change in the deal or honestly a pulling out of the deal. The reason why Mike said this one's so frustrating is because the market hasn't changed from the time you got the term sheet. So you agree on this term sheet. It's not like two months later the market you're in is any different. So two months ago they thought the market was fine and justified this valuation. Now all of a sudden it's not. And that is really, really frustrating because they should have known that.
- [15:31]
Mike Lyon
Absolutely. And I would say it's on the seller. So if you give a buyer exclusivity and they try to retrade or pull out over market, you did not do a good job vetting your buyers. One shortcut here is a lot of the better buyers in a space will know the space cold before talk to you, right? They've done a bunch of research, they know it say those buyers are a little bit less at risk, but there are some product specific issues like it might be a big market, but maybe they think your product in that market's dam will go well. Be particularly on the lookout for this with a buyer who's not done a lot of work in your space or done a deal in your space. They may come to a different conclusion. But frankly, we've had good buyers come to totally different conclusions in the same market. Or we had one buyer once who spent about a million dollars on a diligence report. They said the market was too small and they flushed the report and did the deal. But regardless, you just have to make sure they've done this. We press them about all these diligence at every phase of the process. Where are you at? What have you done? And obviously we are seeing which third parties they're hiring. But this is the seller's mistake. If you get a pass over this, these passes should come early in the process, top of the funnel where you're talking to a lot of buyers and weed those guys out. So again, that one is probably the most frustrating because as Jeff said, the market hasn't changed. Let's talk about something that can come a little bit later in the process, which is tech diligence.
- [16:46]
Jeff Koons
We talked about the strategic retrade and now we're talking about the diligence retrace. Tech is one that actually can kind of fit into both categories. This will be considered tech debt. And so the buyer will hire a cross lake or Palo, some third party technology consultant to diligence the tech stack of the business. And what this retrace is, the buyer comes and says hey, we've evaluated all your technology. We think we need to make a $4 million investment to get your technology stack stack up to snuff. So you're on an older version of PHP or you need to replatform from Azure to Google Cloud, or we think you need to upgrade your entire language from dot net to react, something like that. And they'll put a price tag on it and they'll say, well because we have to make this $4 million investment, we're going to lower this price by 4 million. And the reason why I say it could fit into both of these, sometimes it is just pure BS and it is just the reference of the buyer or investor or it's just a way to chip the price. But the product works. There's no security vulnerabilities and it might not be bleeding edge latest and greatest, but it's worked for five years. Our clients love it. We never have outages, our uptime's great, we've never had security vulnerabilities. And it's really hard to look at me and say I need to invest 4 million in tech for this thing to work. That's why again, sometimes it feels strategic. Retrading intentional on the more I would consider legitimate side tends to be that let's say we are leveraging a lot of open source components. That open source license actually requires us to back publish to the community. So we have to like back publish our ip. Well at that point we need to remove that open source component and replace it with something. Or maybe we have told the buyer, hey, we think that we're good for the next year in our ability to scale and handle our data load. But we actually think we might need to make some pretty heavy infrastructure investments to support 40 million in ARR for example and that one can be a little bit more legitimate. But we tend to find this come up more often Is it feels very specious. The things they want here, they feel like nice to haves, not must haves. And they're trying to get us to pay for it ultimately.
- [18:50]
Mike Lyon
And there's a ton of subjectivity on this one and it does feel a little bit price chippy. So just be on the watch out for this one. This one I don't think is super expensive on the buyer's behalf to do this tech diligence.
- [19:01]
Jeff Koons
Yeah.
- [19:02]
Mike Lyon
So we try to get them to front load that and just take that off the table. But let's talk about some of the legal diligence, which a lot of times can come later in the process. Talk about what pops up there. Jeff.
- [19:10]
Jeff Koons
The thing about legal retrading, if you will. So again you have all your price and economic terms on the term sheet, but then you also have the legal stuff. So what's the fundamental versus non fundamental rep? What's the indemnification package? Is there an escrow for this? Do the reps expire or close all this stuff? And the lawyers are expensive. And so buyers normally try to have the lawyer side of the legal due diligence happen towards the end because they're immediately in for 500amillion bucks to do the legal diligence. And so where this happens, legal retrades tend not to have price implications so much as risk sharing implications in terms of what happens if something goes bad. So an example of this would be, hey, I, the buyer have found that in all your contracts with major customers, you guys agreed to unlimited liability in the event of a data breach. We buyer are not comfortable at all with that. We said that we would have no escrow walkaway deal in the rep and warranty insurance policy. But. But we need you guys now to be on the hook for if there's any claim related to a data breach that happened before we bought the company, you guys have to pay all of that up to the purchase price. That's a very different consideration. Post deal with, hey, I walk away, nothing. I have a small escrow from my rep and warranty insurance and that's it versus now. Wow. They could come back for the entire purchase price if there was this data breach that resulted in a claim. The minigun here as we see it is, hopefully you've had good corporate counsel. If you haven't, it's not the end of the world. But prior to giving all of your contracts and all of the corporate documentation access to the buyer, hopefully you have your M and A council, which oftentimes for our clients is different from their day to day lawyers. You have them go through your data room, go through your contracts and basically reverse engineer buyer diligence. So every lawyer works on both the buy side and sell side. They know what the buyers are going to be looking for and what's going to cause them concern. And so having them go through your key customer and supplier contracts, finding any red flags with articles of incorporation, your cap table, things like that, they can then say, hey, here's the three things. Not going to matter, not great, but they're fine. But these two things really do matter. We can get ahead of this now and then it's not going to be an issue. But if it comes up two weeks before the deal closes, this is going to be a big issue.
- [21:22]
Mike Lyon
I think the best way to mitigate this, where this comes from a lot is you negotiate a loi or a term sheet, which is a three or four page document, but the final legal document, the purchase agreement or the merger agreement or whatever you're working on is 100 pages. And in that translation all these other things that can come up. So get a marked up purchase agreement before you ever give them exclusivity because A, you know what's in there and B, they're less likely to play games when it's still competitive. And then the other thing that's really helpful is if you get rep and warranty insurance in the deal and you have what's called a walk away transaction, all this stuff starts to matter a lot. So if you do a marked up purchase agreement outside of exclusivity, that has rep and warranty insurance and a walk away, you have neutralized a lot of that. Now there's still some special issues that could come up where they could say, hey, we want you to have an indemnity or escrow. And speaking of that one, let's talk about the all time obvious one that's going to come up. But the buyer always acts surprised when they see it, which is sales tax. So Jeff, tell us about why founders have a sales tax issue and dealing with that.
- [22:22]
Jeff Koons
This one just always comes up. So founders out there might be familiar with the Wayfair ruling, but essentially it is the ability for different state and local jurisdictions to collect sales tax on SaaS revenue. And so if you are selling software in Texas or Pennsylvania, Washington state or the city of Chicago, they are all going to have these tax laws. And I would say, I don't know Mike, keep me honest here, but I'd say our clients are probably like 60% good in, in compliance and 40% just not paying their sales tax to any of these states. You think that's fair?
- [22:54]
Mike Lyon
Yeah, it seems like there's always some issue, but I think that's probably about right.
- [22:58]
Jeff Koons
And so what happens, as Mike said, is the buyer comes a week before the deal closes. They're like, we can't believe this, but you have this $600,000 sales tax liability because you haven't been filing taxes in these couple jurisdictions. And we have these penalties and the back tax amount and we might have to hire lawyers to help us with this thing called the voluntary disclosure. And so they put this big number out there, and if you haven't done the prep work to argue that number, you are in trouble because it's going to be really hard for you to combat that. You're going to have KPMG or Deloitte on one end saying, here's a sophisticated analysis and here's why you owe this. And your response is going to be, well, we don't think so. And that's just not super compelling. Obviously, the good news is there's just a good way to avoid things this. And that is one. Hopefully, on just a normal corporate hygiene, corporate housekeeping standpoint, you have a good tax accountant and they're going through the rev by customer, by state and determining are you meeting nexus and thus have to file. And so you're already ahead of it. If you're filing in all these states, then this issue goes away. But the other important thing is if you haven't been doing that, that's fine, is that you have a tax accountant who can come and say, we think the actual exposure here is $200,000 and that's for everything. And so at that point, the buyer can come with their $600,000 analysis, but that analysis is their third party trying to win for their client. So they're like 2x higher than the exposure actually is. And what they'll do is they'll try to say, hey, this is a purchase price. Right now we're going to treat this 600k as debt. And so your deal is 600k less if you're not prepared. It's really hard to argue with that. However, if you've done the work upfront, you could say, actually no, our accounts have gone through this. Here's the four states where we have exposure. These three states, we don't even meet the minim threshold, so we're exempt from it, even though they were in your sheet. And we are not going to agree to a Purchase price reduction. What we're going to do is we're going to put this smaller number in escrow. And when I prove to you that I'm right and this wasn't a $600,000 issue, this was $200,000 issue, I'm going to get any money back that was below that amount.
- [24:59]
Mike Lyon
Great point. And I think the fact that the buyer's estimate is double the seller's estimate, some of them are just trying to be conservative. Right. Because they're worried about the liability.
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Jeff Koons
Yeah, that's true.
- [25:07]
Mike Lyon
But they oftentimes will put in all the penalties and back interest. And usually if you go through this thing called the vda, which is what you do post deal, you hire a firm to help you go do this, you don't end up paying all those fees and penalties. So Jeff's point is a great one. Don't let them take it as a purchase price reduction because they might even just not go do it and just deal with it later. So you don't want it as debt because that's a dollar for dollar purchase price reduction. What you might agree on is somewhere middle of the road between those amounts as an escrow. Go solve it and then you get what's left of the escrow. Rather just agreeing to a purchase green. And it leads to another good point. When you're negotiating. Usually these deals are cash free and debt free. So that means the seller gets to keep the value of the cash on the balance sheet, but they have to pay off any debt, which makes sense. You have to pay off a loan or whatever. What buyers will try to do is play games with that definition of debt and put things like the sales tax or put deferred revenue from working capital. You want to aggressively negotiate that debt definition and make sure it's inclusive and not vague and not give them an opportunity to retrade you on that later. Because that's just them trying to change the purchase price. Really. Same thing goes for working capital. Being really aggressive to make sure we hammer that. So we've covered a lot in today's episode. We talked about these strategic retrades. So again, this is flat. Just the buyer, usually a private equity firm, strategy to retrade. We know who they are, we don't give them that long of exclusivity and are on the watch out for that. Then these more diligent and process retrades, some can be legitimate. If you're just misrepresenting the numbers accidentally, that's gonna be an issue. But most of these there are some mitigants to deal with that range from, as we always say, don't give them much exclusivity, stay out as long as you can until they complete all this diligence. So you know, there's no issue. And then there's just some smart things you can do to be prepared for these to just kind of take them off the table. Jeff, thanks so much for joining us today.
- [26:54]
Jeff Koons
Thanks so much for having me, Mike. Really enjoyed it.
- [26:57]
Podcast Host
Disappoint Advisors is a founder focused investment bank that advises software and Internet founders through M and A and capital Raise transactions. We are a fully unconflicted investment bank who owns only works for founders on the sell side, so you know that we're always representing your best interests. Security is offered through VistaPoint Advisors member Finra Sipic. This has been provided for informational purposes only. It is not intended to address all circumstances that might arise. Testimonials from past clients may not be representative of the experience of other clients and there is no guarantee of future performance or success. Clients are not compensated for their comments. If you have any questions about the process of selling your business or raising capital, reach out to a member of our team or check out the four Founders section of our site by visiting four Founders Guide.