Craig Checks In: Thoughts on FanMail Questions from Listeners

Craig Castelli (00:05):
Welcome to The Close M&A Podcast with Caber Hill Advisors. I’m your host, Craig Castelli. Today there is no guest you just get me. We started asking for questions via the FanMail feature, which you can click on in the show notes, and we had several come in, so I thought we’d be fun to do an episode where we just answer everybody’s questions. Hopefully this is timely and relevant to most listeners [00:00:30] here. So jumping right in. The first one’s very timely. The question was, how will a potential government shut down impact M&A? Well, here we are recording on October 2nd, so we’re day two of the government shutdown, and there are a few aspects where this could vary directly come into play, and then there are some potential longer term ramifications as well. So first off, SBA financing is going to be on pause while the government is shut down.
(00:59):
The small business [00:01:00] administration is closed for business, and so new loans that are going through the SBA will be delayed. It shouldn’t impact anything other than the timing of these transactions. We don’t anticipate any changes to criteria, any major changes to workforce or otherwise, what will eventually get approved, but the backlog’s going to build and it’s just going to take longer to get these deals [00:01:30] approved. SBA finance transactions, which typically hit smaller deals, we, at least in our experience, I don’t see this hitting too many of our transactions, don’t really see this hitting the broader middle market, but a lot of entrepreneur to entrepreneur sales, independent sponsors, search funds, those types of buyers frequently will use the SBA, as it can be a convenient method of financing their acquisitions. They [00:02:00] always take a little bit longer anyway just because there are additional hoops to jump through.
(02:05):
And now with the government shutdown and unable to approve their part of these loans, expect that backlog to build. I would estimate that take the length of the shutdown itself, potentially double it, and that’s the length of the delay you could be looking at beyond just the financing piece. Any businesses that are heavily reliant [00:02:30] on government contracts are going to face issues in two areas.
(02:34):
First of all, they’re not going to get paid while the shutdown is in place. They’re not likely to get paid. I’m sure there are some businesses that will still get paid, if they’re necessary enough to national security or other aspects of the country as a whole. But several businesses are going to see delays in their payments from the federal government and that could have some lasting impact on cashflow [00:03:00] growth, which can ultimately impact transaction.
(03:05):
Also, just the general uncertainty. If you’re in market with a government contracting business, it can be challenging to get a deal done until we see what the new budget looks like. And the expectations for your business on the other side.
(03:17):
As this lasts, I think the other risk is just the general uncertainty in the market. Uncertainty is not good for M&A, especially impacts entrepreneurs [00:03:30] who want to come to market and sell. They want to have absolute clarity or as much clarity as they can have that it’s going to be the right time to take their business to market, that they’re going to have the best outcome possible and a month long shutdown or longer could potentially rattle the psyche of a lot of players in the deal ecosystem, which will just create a little bit more volatility in overall M&A activity. If this is a short term shutdown, [00:04:00] couple days, couple weeks, I think that’s less.
(04:03):
If we start talking about a couple months, then we could expect some much more dramatic implications. I don’t see this impacting deals heading to 2026. Pipelines are still full at all aspects of the deal ecosystem. I can speak for us at Caber Hill. We’re as busy as we’ve ever been with everything from deals and market, to newly signed up clients, to some of the companies that we’re working with who are deciding exactly [00:04:30] when they want to go to market or getting their businesses ready to go to market in the next six to 12 months. So we still are very bullish on how this year will end and certainly how the first half of 2026 will go, but anything involving major government actions or in this case, inactions certainly can give everybody a little bit of pause.
(04:54):
Alright, enough about that. Moving on to topic number two.
(04:57):
So we’ve received a series of questions that [00:05:00] I categorize as reverse due diligence. We’re all accustomed to typical due diligence in a transaction where the buyer is heavily vetting the seller, but we’ve received a lot of questions from business owners about their ability to vet the buyer. And I’ll ask this in a couple of different ways or I’ll read off a couple of questions. We’ve got, am I allowed to do diligence on the buyer? What red flags should I watch out for? How do I know what my role of equity will be worth? This is a big one. Sellers [00:05:30] when offered rollover equity as part of a deal, how do we figure out if what the buyer is telling us is going to be true? What will the rollover equity actually be worth when the company gets sold against? Let’s tick through some of this.
(05:45):
First of all, am I allowed to due diligence on them? Yes, absolutely. They’re not likely to offer it up right out of the gates. Sometimes you have, first of all, you have to ask. Sometimes you have to push. You definitely have to know who to ask and what to ask, but you’re [00:06:00] absolutely allowed to do diligence on the buyers. First and foremost, there should be some screening on the front end to know that they’re actually a qualified buyer for your business. In our world, this typically means that they’re a committed capital private equity fund. They have the funds to invest. And that the size of your company aligns with the size of investments that they typically make. If we’re looking at larger companies, we call strategic buyers, buying you. If they’re public, we can vet them [00:06:30] just looking at their annual reports and other SEC filings.
(06:36):
If they’re privately held, then we have to ask for some financial information. If it’s an individual buyer, then you need to look for proof of funds, personal financial statements, again, just determining their wherewithal to close the deal. A lot of that should happen on the front end before you’re signing the NDA before you’re sharing information. But as you actually get into the transaction itself and [00:07:00] you’re heading down the path towards signing a letter of intent with a certain buyer, first of all, ask for reference. We find it very revealing how buyers, private equity firms or others putting roll-ups together respond to reference requests. We’ll have some show up to a meeting with one of our clients, with a list of all of the sellers that they have partnered with over the years in their various investments with their email addresses and their cell phone numbers [00:07:30] telling us that we can email or call anybody we want on that list.
(07:35):
We’ll have others who we have to ask three to five times just to get a single reference. So right there it is very telling on the transparency of the other party to the transaction as well as how likely you are to receive positive endorsements from the business owners that they’ve done business with in the past. So getting those references, evaluating [00:08:00] the quality of them and then ultimately checking them is paramount. If you’re going to be rolling over equity, you should ask for financial statements. You should ask for board reports, strategic plans, anything you can to determine the validity of investment. At the end of the day, you’re taking a risk just like when you buy a stock in a public company, that public company could go bankrupt. When you roll over equity into a private equity scenario, there’s no guarantee that it’s going to [00:08:30] grow. The risk of loss does exist.
(08:32):
More often than not, these investments perform and they perform well, but they don’t all perform and they don’t all perform well. And so you have to analyze the company, the leadership team, the performance of the private equity firm behind the investment. If you find that you are selling into a scenario where the PE fund has performed in the top decile for every fund that it’s raised and all or virtually all [00:09:00] of its portfolio companies have performed at or above par for their sector, then you can feel pretty confident that that’s replicable with the deal that you’re about to enter into. It’s not guaranteed. Past performance is never a guarantee of future results, but you can feel much better about that scenario than rolling into a group that’s batting 50/50, I guess I should say batting .500 to keep with the analogy here.
(09:30):
[00:09:30] How do I know what my rollover equity is going to be worth?
(09:33):
So you will find oftentimes that the business development folks at portfolio companies, the deal teams at private equity firms will paint a very rosy picture of the value of your rollover equity. And there absolutely are scenarios out there where home runs have been hit. I guess I’m sticking with baseball today since we’re early in the playoffs. We’ve heard stories of seven times cash on cash returns, 11 [00:10:00] times cash on cash returns 33 times cash on cash returns. Cash on cash means for every dollar you invest, that’s what you get back. The general expectation with rollover equity is that over a five-year period of time, you should be able to triple your investment. And if you want to handicap that for the amount of time your capital’s tied up, you should be looking at an IRR (rate of return) of roughly 20 to 22%. If you are in the [00:10:30] even upper teens to low twenties on that rate of return, you’ve gotten a great return on your investment.
(10:36):
You’re looking at doubling the performance of the S&P, if not more, and that’s the reward you should receive for the lack of liquidity because when you roll over equity, you generally don’t have the ability to choose when you sell your shares. It’s an investment that’s being held for a much longer period of time, and you’re investing into a privately held business, which inherently carries [00:11:00] more risk than a public company. So for all those factors, you should be rewarded with a greater return than you get if you just put this in index fund and forgot about it. So looking at that 18 to 22% IRR that three times cash on cash return over a period of five years is important. Set your expectations there and then get back into that type of diligence that we were just describing where you’re evaluating the company. The other thing [00:11:30] to think about is if you are an add-on acquisition, so it’s an existing company, it’s buying you, they’re backed by private equity, they’re acquiring you as part of their growth strategy.
(11:40):
Perhaps they’re putting a roll up together in your sector like we see in the case of places like roofing and janitorial or dental and dermatology. You may be coming in in the middle of that firm’s investment period, and the business may have grown considerably since they [00:12:00] first invested. Well, the business has probably increased in value and they may have raised the share price. So you may not be rolling your equity in at the same share price as the original seller, and that can be perfectly fine, especially if your shares are going to be tied up for a shorter period of time. These are some of the questions that you need to ask to really understand how to value those shares, and we will find that some of the business development folks will [00:12:30] promise these big returns. They’ll make claims that you’re rolling at the same price, but as you really start to do your diligence and unpack this, you may find out that actually they’re marking their business to market every quarter.
(12:42):
They raise the share price every year, however they go about doing it. And so it is not the same as founders equity. Again, can be okay if you hit those rates of return. You just have a right to know this before you agree to make the rollover investment.
(12:57):
Getting back to the red flags here, [00:13:00] when I see an email from a potential buyer that is paragraphs upon paragraphs justifying the potential performance of the rollover equity, that generally gives me a little bit of pause for concern because I’ve seen this oftentimes in cases where they’re trying to pay less for the business overall and convince the seller that they’re going to make it up on the backend. [00:13:30] And we actually had a question, this didn’t come in through the podcast, but is from a business owner that we’ve just been having some conversations with, they received two offers for the business.
(13:42):
One’s a lot lower than the other. The buyer with a low offer is trying to convince us it will be even in the end. How do we know if that’s true? Well, part of the buyer is trying to convince the seller that everything will be even in the end, is contingent upon a significant reinvestment, significant amount of [00:14:00] rollover equity and that rollover equity performing at or above market average expectations for that type of investment. Is it possible? Yes. Is it guaranteed? No. How do you know how to make this decision? Well, in some ways it’s personal to you on your own tolerance for taking risk. I think in this situation, there’s a really good chance that the higher offer paid a lot more cash at close, but offered less upside over the course of that three to five years [00:14:30] post sale. The other deal had less cash upfront, more potential upside at least on paper based on the performance of this rollover equity.
(14:40):
So really understanding who you’re partnering with, how they’re structuring the deal, how they’re structuring the shares, what an exit looks like, that next exit, that liquidity event, how are they modeling the distribution of the funds? How do your shares compare to [00:15:00] everybody else’s shares? How do your rights to sell compared to everybody else’s rights to sell? So there’s a lengthy list of questions that need to be asked. You absolutely need to be doing this. Ideally, and this is not even a self-serving plug, but ideally you’ve hired an investment banker who knows what they’re doing, isn’t afraid to ask these questions, understands who this buyer is long before you’ve met them so that some of this pre diligence has already been conducted and they can vouch for them to a certain [00:15:30] extent, but that doesn’t replace rolling up your sleeves and actually doing this work.
(15:37):
Alright, next question here. This is a common one that we hear, and I think we got two or three of these in some way, shape or form coming through the podcast line as well. Do I need to do a sell-side quality of earnings?
(15:49):
So let me just set the table for those who may not be as familiar. Quality earnings is a service performed by accounting firms in conjunction [00:16:00] with transactions. So it’s part of the transaction advisory team as the larger accounting firms, and they’re coming in to evaluate a company and validate the financials. A lot of this involves confirming revenue that revenue is recognized properly, that revenue is allocated to the proper periods, calculating EBITDA so that there’s a very clear understanding of the profitability of the business. A big component of the smaller end of the [00:16:30] market too is converting the financials from cash-based financials to accrual based financials.
(16:37):
In the public company world, in the private equity world, even in larger privately held businesses that have heavy outside financing, it’s required that the companies provide financial statements that are in accordance with gap, generally accepted accounting principles, otherwise known as accrual based [00:17:00] accounting. Many small businesses rely on cash based accounting. It’s easier, it’s more tax friendly. Depending on the company, there could be pretty significant differences in any individual 12 month period between what the cash looks like and what the accrual books look like. And so it’s important for a buyer to understand, if I need to start accounting for this on a gap basis post-close, what do the numbers actually look like? I’m underwriting that number, not the number that you put on your tax [00:17:30] return. So a buyer will almost always conduct a quality of earnings. They’ll hire a third party accounting firm to do a Q of E in the last several years.
(17:42):
It’s become increasingly common for sellers before they go to market to hire their own CPA firm to do what’s called a sell-side quality earnings. It’s essentially the same analysis and report only done on behalf of the seller. They’re going to market as opposed to on behalf of the buyer. [00:18:00] We’re frequently asked, is this required? Is this necessary? And it’s really two common reasons business owners want to know this besides the fact that they’ve just heard about it and learned the term. Number one, it’s time consuming. Number two, it can be expensive. We’ve seen companies with as little as $5 million of EBITDA have to spend between $50 and $120,000 [00:18:30] on a sell-side quality earnings. So not a small investment, but it’s an investment that can pay dividends. There are certainly less expensive service providers out there, and I don’t want to get in the business of telling you what this should cost because a lot of it’s going to come down to the size and complexity of your business.
(18:49):
How many legal entities do you have? Do you have intercompany transactions? Are you on cash or accrual books? What does your revenue cycle look like in your revenue recognition [00:19:00] policies look like? How many entities is payroll running out of, et cetera, et cetera, et cetera.
(19:06):
So a single legal entity already in compliance with gap, with very little inconsistencies from year to year, very cash heavy type payments, whether there’s not a lot of outstanding AR that’s going to be a much simpler and less expensive quality of earnings than a cash-based [00:19:30] healthcare business that’s receiving a lot of Medicare payments and has 13 legal entities. So regardless of that part of it, first of all, we always recommend a sell-side quality earnings. There’s never a scenario in which it’s a bad idea. The necessity of it is relative. It is relative to a lot of the factors I just mentioned.
(19:56):
It’s also relative to your industry, your deal size [00:20:00] and the target buyer for your business. If you know that you’re going to sell into a private equity scenario, you know that the buyer is going to conduct a buy-side quality earnings, you can get out front of that by conducting your own sell side Q of E. What is that sell side Q of E going to do for you? First of all, you have a third party who is supposed to be disinterested in the outcome of the transaction [00:20:30] conducting this analysis for you. So it is much more objective and certainly gives the air of objectivity. I am not objective. The Caber Hill team is not objective. We represent you. We are here to get the best outcome for your business, which means any calculation we’re making, any decision we’re making in the presentation materials, we’re going to break any ties in your favor.
(20:54):
The accounting firm’s going to be much more objective. Number two, the fact that you were willing [00:21:00] to go through this process shows a higher level of sophistication, a higher level of commitment to the transaction, and just an overall higher level presentation of your financial. So the credibility of you as a business owner and the credibility of your financial statements, the numbers we’re presenting increases tremendously when you have a sell-side Q of E that you can present to buyers compared to when you don’t. Third, the Q of E teams [00:21:30] typically make themselves available to the buyer’s Q of E teams to answer questions. So you can have accountants talking to accountants about accounting matters and helping to strengthen your position and negotiate certain aspects on your, when we get into cash versus accrual, and we get into working capital calculations and true ups, which I don’t even want to go too deep on in this pod, perhaps that’s a topic for a podcast in [00:22:00] the future and any other fluctuations or recognition issues, we can also run into timing of payroll and how payroll matches up to revenue, especially for commission-based employees.
(22:13):
So anyway, there are these clear scenarios in which it is useful. If you’re selling to a strategic buyer and you have relative confidence that that strategic buyer is light on the diligence that they’re doing and [00:22:30] their diligence is really around industry specific metrics or they just don’t do a Q of E, you know they’re just not going to do the Q of E, well then perhaps the necessity is less. We’ve had some scenarios in which the buyer is a supplier to the business. Take the audiology sector as an example where they, the hearing aid manufacturers are buying the practices. They know enough just by looking at the volume of hearing [00:23:00] aid sales, the pricing of hearing aids at both the wholesale and the retail level, that that drives value more than anything else. Yes, the EBITDA can be important, but it’s of secondary importance. When you think about the fact that these companies now control from the manufacturer of the product all the way through to the sale to the consumer, the distribution to the patient — they control that entire value chain.
(23:25):
So value to them is created differently than a pure financial buyer who [00:23:30] can only create value by growing the bottom line of the company.
(23:34):
We’ve seen it in industrial businesses where strategic buyers need to expand their footprint, they need a facility, they need a customer base for them. EBITDA is important, but it’s somewhat secondary, and whether it was off by five or 10% is not as material. They’re comfortable with their internal team doing the numbers. And so again, in a case like that, perhaps [00:24:00] it’s not as necessary. The private equity firms, because of how they raise money, how they invest, how they borrow money, they pretty much always have to do a Q of E on every single deal. And so that’s really the scenario when we think it’s most beneficial. You will find that some investment bankers, some brokers will tell you that, yeah, you don’t need to do it.
(24:20):
You don’t need to bother with it. Just let the buyer pay for it. You may find some of your advisory firms say, Hey, we do enough financial analysis [00:24:30] that makes up for it. You don’t need to do it. I generally find that those are folks who are afraid of having a tougher conversation with you, afraid of pushing you into doing something that may feel a little bit annoying, a little bit uncomfortable. Don’t let that mindset talk you out of something that you know is good for you. We have a very advanced and sophisticated financial team here at Caber Hill. We have several resources, [00:25:00] several people who are going through your numbers, digging as deep as the general ledger detail going, transaction by transaction, analyzing your business, talking to your accountants, talking to your CFO and others on your finance team. If we’re giving access to really truly understand the numbers and present things both accurately but favorably as best as possible, it still doesn’t substitute for a quality of earnings. We’re not a CPA firm. We are not disinterested in the [00:25:30] outcome of the transaction, and we just are not able to deliver this in the way that the Q of E provider can deliver it. So am I going to force you to do one as a contingency of signing you on as a client? Maybe most of the time, no. Every once in a while, yes. But do I think it’s a good idea? Absolutely, all the time. There’s never a scenario in which it’s not.
(25:57):
Well, I think we’re going to cut it there for today. [00:26:00] We had several more questions come in that we can save for a future episode, but I think you’ve heard me rambling here all alone by myself for long enough. Keep the questions coming. We really enjoy them. I look forward to doing this again. Hopefully the feedback is positive. So if you like this, leave a review, shoot me a note. I don’t hide very well. You can reach me at Craig@caberhill.com and find me on LinkedIn and on our website. But I look forward to doing this again. And as always, thank you for joining [00:26:30] us on The Close.