Mergers and Acquisitions

In a recent study polling more than 400 business owners, founders and leaders across the U.S., Harris Williams reports that despite mixed positions on the nation’s general political climate, interest in M&A among middle market private companies continues to rise.

Puzzle pieces representing mergers & acquisitions
Copyright: bas121 / 123RF Stock Photo

Key findings included:

  • 95% of survey respondents are interested in M&A over the next three years – up from 81% in 2015
  • 65% said they were interested in acquiring other companies
  • 52% said they would consider selling
  • 36% would consider a merger

Drawing on this data, the report concludes that business leaders are optimistic about their companies and the economy, and companies appear to be primed for growth. The result is record levels of interest in M&A. Opportunities are strong, and business owners are in a position to leverage today’s M&A market to fuel expansion. The full report is available on the Harris Williams website.

This piece is slated to appear in an upcoming edition of the American Bar Association’s Business Law Today.

Quick quiz:

  • If your startup is seeking investors, will you have more success with private equity or venture capital firms?
  • How about when you’re looking to sell that company?

Businessman giving Vulcan greeting from Star TrekThe answers are (1) venture capital and (2) private equity.  If you weren’t sure, you’re not alone; the terms are often confused or used interchangeably.  However, PE and VC firms generally have very different investment strategies.  Understanding the distinctions may help save time and money and…perhaps…save face (i.e., not everyone will judge you for confusing Star Wars and Star Trek, but others will never forget).

Like most either/or categorizations, the distinctions blur in the middle, making generalization dangerous.  But in basic terms, here is what you need to know to avoid that awkward Han Sulu moment.

Characteristics of a PE investment (or, investing by Vulcan rationality)

PE firms typically invest in existing companies with a quantifiable track record (including proven cash flow), existing products or services, and potential for value creation.  PE investors may also consider businesses that complement their existing constellation of portfolio companies.  Therefore, whether or not PE firms invest in a company is a highly data-driven decision.  PE firms purchase a majority stake (often 100%) in their target investments.  This permits them to take an active role in their portfolio companies and to create value through financial engineering and restructuring.  In broad brush terms, this investment strategy focuses on value.  PE firms purchase underperforming or undervalued companies intending to guide them to optimal performance, increase their value, and sell them for a profit.  In other words, PE firms help existing companies realize their potential and boldly go where they have not gone before.  Because this strategy applies in many circumstances, PE investments are made across a wide set of industries.

Characteristics of a VC investment (or, investing by Dagobah ecosystem)

VC firms typically invest in emerging companies, which may have no or a limited operating history, but potential for light speed growth.  Therefore, whether or not VCs invest in a company is a holistic decision involving analyzing ideas and people (i.e., the business plan and the founders’ and management team’s ability to execute it).  To mitigate risk, VCs diversify their investments by making minority investments across a universe of startups.  Because they purchase smaller stakes, VCs have less control than PE firms over the day-to-day operations of their portfolio companies; however, VC’s often retain veto rights over certain major decisions.  In broad brush terms, this investment strategy focuses on growth.  VC firms invest early in the hopes of sharing in the upside upon exit or IPO.  These criteria keeps many VC investments industry-specific (e.g. technology and life sciences).  Although startups often fail, VCs can earn attractive returns if even one rebellious company blows up and disrupts an existing empire.

Of course, PE and VC investments have similarities, not the least of which is seeking above market returns.  The primary difference is how they arrive there.  From a company’s perspective, VC and PE firms serve distinct purposes and are appropriate at different stages of a company’s life cycle.  Entrepreneurs must understand the differences between VC and PE firms and their investing philosophies to ensure they’re approaching the appropriate investors at the right time.  Of course, there is much more to consider.  This is just a high level overview intended to demonstrate that there is a difference.  In a critical moment, remembering that PE firms invest like Vulcans and VCs invest like Jedis might remind you of the key distinctions.

Debra L. Gruenstein writes:

Private equity firms have recently been deploying capital to purchase medical and dental practices.

Caduceus casting a dollar sign shadowThe typical transaction would involve the purchase of multiple practices and the establishment of a management company. The physicians would be paid a multiple of earnings and receive some rollover equity in the management company. Although many states have had a prohibition on the corporate practice of medicine for years, recent cases in multiple jurisdictions have made the structuring of these transactions more complex and subject to challenge.

In the recent case of Allstate Insurance Company vs. Northfield Medical Center, P.C., the New Jersey Supreme Court found that the control over the medical practice owned by a chiropractor violated the corporate practice of medicine doctrine, resulting in a verdict in favor of Allstate of almost $4 million. Previously, the District Court for the Eastern District of Louisiana, interpreting Pennsylvania law, found that the ability of the management company to participate in the profits of a dental practice, was akin to a partnership interest, one that would be precluded by the Pennsylvania corporate practice of medicine doctrine. Warren J. Appallon, D.M.D., P.C. vs. OCA, Inc., 592 F. Supp. 2d 906, and the similar case, OCA, Inc. v. Kellyn W. Hodges, D.M.D., M.S., 615 F. Supp. 2d 477.

Debra L. Gruenstein is a partner in the firm’s Health Law and Corporate departments, practicing in the Philadelphia and Denver offices.  This piece is slated to appear in an upcoming edition of the American Bar Association’s Business Law Today.

Barbara P. Alonso writes:

The Committee on Foreign Investment in the United States (CFIUS), an inter-agency committee led by the U.S. Treasury Department that reviews foreign direct investment transactions, is likely to be applied in a more stringent manner by the Trump Administration. Members of Congress and of the Trump administration have advocated for enhanced CFIUS reviews of transactions that involve the change of control of U.S. companies (or foreign companies with U.S. assets) to foreign interests.

Globe on financial reportsSince its creation in 1988, CFIUS reviews have remained voluntary in nature. Parties to M&A/private equity cross-border transactions, however, go through the time and expense of seeking CFIUS review because a transaction that is not reviewed may be subject to divestment or similar actions. In most cases, parties receive a “no action” determination within 30 days of filing, and in some cases, the Committee undertakes an additional 45-day review which sometimes results in the Committee proposing additional deal terms to address concerns raised during the review process.

Recently, however, CFIUS has blocked several deals. For example, in December 2016, the Obama administration blocked the purchase by a Chinese investment fund of a German semiconductor supplier which had U.S. assets.

Current options under consideration for expanding CFIUS review include enlarging the “scope” of CFIUS to include an economic test; expanding the definition of what constitutes a “national security” issue by adding such critical infrastructure assets such as telecommunication, water and energy assets; and adding a retroactivity element to potentially unwind previous “no action” positions.

In the current environment, transactions that involve the transfer of ownership to a foreign party, even when a foreign company is selling U.S. assets to another foreign company, should be weighing carefully whether a voluntary CFIUS filing would be prudent.

Barbara P. Alonso is a partner in the firm’s Corporate Department, resident in its Miami office. This piece is slated to appear in an upcoming edition of the American Bar Association’s Business Law Today.

Issuers and investors are well advised to document their deal in a term sheet.  Though generally non-binding, they add significant value.  Detailed term sheets raise issues early when there is still ample negotiating time. They also make drafting the definitive documents more efficient, saving on legal fees. However, parties must be vigilant to document the deal properly, especially when using terms of art.

Cumulative dividends
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For example, one commonly negotiated item on preferred stock is the dividend. Dividends can be cumulative (aka accruing) and either simple or compounding. The terms “cumulative” and “compounding” are sometimes (incorrectly) used interchangeably. But the differences are measurable in real dollars. 

Dividends are one feature that makes preferred stock preferable. Dividends are structured in (at least) three common ways. NVCA publishes a sample term sheet that includes these options.

  1. Dividends can be paid on the preferred when (and if) they are paid on the common. The preferred holders have no dividend preference – they are treated as common holders and paid as if converted to common.
  2. Dividends can be paid on the preferred when (and if) declared by the Board of Directors. If the Board does not declare dividends, they are forfeited.  Here, the preferred holders enjoy a preference on dividends but may not receive them.
  3. Finally, as described in detail below, dividends can be cumulative and perhaps even compounding.

Cumulative vs. Compounding

Emerging companies rarely have the ability to pay dividends to preferred holders. As a solution, companies often agree to pay dividends upon a liquidity event (e.g., sale of the company).  But how much will investors receive? This is where the terms of art (cumulative, accruing, compounding, simple) become very important.

Cumulative (aka accruing) dividends provide investors with a certain annual return, typically expressed as a percentage of the original per share price of the preferred stock (e.g., “8% of the Series A Original Issue Price”).  Thus, the term “cumulative” refers to the fact that dividends accrue over the years and will be paid upon a liquidity event.

Cumulative dividends can be calculated on a simple or compounding basis.  “Simple” means the dividend is based only on the original per share price.  “Compounding” means the dividend is based on the original per share price plus the dividends that accrue over time.  Thus, the terms cumulative and simple refer to how cumulative dividends are computed.

For example:

Cumulative and Simple (aka Non-Compounding):

Suppose an investor invests $50,000 and receives 100,000 shares of preferred stock ($0.50 per share) with an annual 8% cumulative, simple dividend. In 5 years, the company is sold. The 8% annual dividend is calculated on the original per share price. The investor has earned $4,000 in dividends each year and, upon liquidation, the company must pay the investor $20,000 in dividends.

Cumulative and Compounding:

Suppose the same facts, but dividends are now cumulative and compounding. The 8% annual dividend will be calculated on the original per share price and on the accrued and unpaid annual dividends that accumulate over the years. This is similar to a promissory note with compound interest: the original per share price is like “principal” and the 8% annual dividend is like a compounding 8% interest rate. In this scenario, the investor earns $23,466.40 in dividends.

Clearly, there is a measurable difference between simple and compound dividends. And at first glance, the $3,466.40 difference may not seem overly significant. But the proper use of term sheet terminology has a greater value. A detailed and thoughtful term sheet helps maintain deal flow and good will during negotiations, can decrease legal fees and helps avoid disputes down the road.  For issuers and investors at the outset of a long friendship, these benefits can be immeasurable.

As mentioned in the first post of this series, the goal of many entrepreneurs is to seek venture capital financing or ultimately sell their company in an “exit” merger or acquisition. Upon making representations and warranties (which are essentially, assurances) associated with any of these transactions, the seller opens itself up to risk. If these assurances turn out to be false or are breached, the seller is subject to suit for breach of contract. Often, however, the parties negotiate an additional protection mechanism called indemnification.

So why is indemnification expected?

Puzzle pieces representing mergers & acquisitions
Copyright: bas121 / 123RF Stock Photo

In a traditional acquisition, the seller affirmatively agrees to indemnify the buyer for damages or costs related to various things; most notably, breach of a representation or warranty. The seller agrees upfront to hold harmless and to reimburse the buyer for any and all expenses related to their breach. For example, if the seller represented that its equipment was in working condition and it turns out it was not, the seller must make the buyer whole. Essentially, the seller is insuring the buyer on its purchase. Just like an insurance policy, this agreement to insure lasts for a certain period and covers certain events. As this creates ongoing obligations and future potential liabilities for the indemnifying party, the indemnification provisions in transaction documents, and particularly the scope and extent thereof, are often heavily negotiated and should be approached with extreme caution.

There are many protections that can be built into indemnification provisions and transaction documents that limit the scope of the seller’s liability beyond simply excluding scenarios which are covered. For example, the seller may agree to indemnify the buyer but only:

  • when the damages or costs exceed a certain amount in the aggregate (what’s known as a “basket”);
  • when the damages or costs exceed a certain amount for a particular claim (a “mini basket”);
  • in the aggregate up to the purchase price or some other set number (a “cap”); and/or
  • for a set period of time from Closing (the “indemnification period”).


In the transactional context, indemnification serves as the enforcement of representations and warranties. A buyer can truly rely on the seller’s representations if the seller has also agreed to hold harmless and reimburse the buyer if the representations are false or breached. The seller can effectively affirm the value of its business, but in doing so exposes itself to risk as a de facto insurer. As this is generally unavoidable in the context of a transaction, limiting the scope of this risk is key for sellers. For these reasons, indemnification provisions should be approached and drafted with extreme caution.

For investors and founders of emerging tech companies, leaving money on the table is a tragedy which can never be remedied once it occurs. An exit sale to or investment from a large strategic buyer is for many young tech companies a once-in-a-lifetime event with enormous economic consequences impacting both the company’s founders and investors. They must “get it right” with respect to the enterprise value of the emerging tech company.

For reasons explained in a 2014 article by Fox Rothschild partner Mark V. Santo, the failure by the emerging tech company to conduct ‘reverse due diligence,” and undertake a deep dive into the operations and management of the acquirer, is tantamount to leaving money on the table.

The goal of many entrepreneurs is to seek venture capital financing or ultimately sell their company in an “exit” merger or acquisition. In each case, the company’s historical operations come under onerous pressure through the representations and warranties the seller is asked to make, and the related due diligence the seller must produce. To a small business, this can be extremely uncomfortable and/or challenging. To a big business, it may be more comfortable but nonetheless more demanding.

So why are they expected?

Puzzle pieces representing mergers & acquisitions
Copyright: bas121 / 123RF Stock Photo

Representations and warranties are often a glimpse into the business and its history of performance. To a buyer, these validate value and allocate risk. If you were buying a pharmacy, for example, wouldn’t you want the seller to represent and warrant that its financials are true and correct (validating the value), and that it is and has been licensed to sell pharmaceuticals (minimizing any risk of noncompliance or violations)? If the seller represents and warrants to these items and it turns out they are false, the buyer now has recourse against the seller (which reduces upfront risk and may make them whole).

Representations and warranties also facilitate fact-finding, as the buyer can rely on the seller’s representations and warranties, caveated by disclosure. For example, if the seller represents that it has provided the buyer with all of its material contracts (which is common) except for those disclosed, the buyer can review those contracts as part of its due diligence process of evaluating value, risk, and outstanding or potential liabilities.


Representations and warranties serve a good purpose for both parties to a transaction. Few businesses are sold “as is” for, among others, the above reasons. It is important to remember, however, that reps and warranties, like everything else in the transaction, are always subject to negotiation.

Philadelphia skyline
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A group of Philadelphia-area companies and organizations just released a joint study describing the state of the information technology industry in the region. The group is composed of Ben Franklin Technology Partners of Southeastern PA, CEO Council for Growth, Select Greater Philadelphia, Ernst & Young LLP, Fairmount Partners, Comcast, and the Greater Philadelphia Alliance for Capital and Technologies (PACT) . In pointing out that the routes of the IT revolution were established in Philadelphia in 1946 with the demonstration of the ENIAC (Electronic Numerical Integrator and Computer) at the University of Pennsylvania, the report seeks (successfully) to detail investment in IT companies in the Greater Philadelphia region from 2010 through the first half of 2015.  It also describes the many resources available to members of the IT community in Philadelphia, from incubators and co-working spaces to colleges and universities, and it provides an in-depth look into IT-based occupations in the Greater Philadelphia region.

Highlights of the study include the following:

  • From 2010 to Q2 2015, more than 6,000 IT-based companies operated in the 11-county Greater Philadelphia region, employing almost 90,000 people;
  • From 2010 to Q2 2015, over 1,000 investment rounds in IT companies were closed, more than 250 M&A deals (valued at $10.2 billion) were completed, and over 400 funded deals (valued at over $1.1 billion) involving IT companies were closed;
  • The IT industry grew from $21 billion in sales in 2001 to $35.8 billion in sales in 2014, accounting for approximately $8.3% of the Greater Philadelphia region’s GDP; and
  • A layered IT ecosystem, consisting of pre-seed/seed investment partnerships, startup communities, co-working spaces,  incubation/acceleration programs, university challenges, regional initiatives, corporate partnerships, media, and even targeted community programs, was successfully developed and continues to flourish.

The study is certainly worth a read, as both the scope and volume of IT-driven growth in this region is often overlooked by those within and outside of Philadelphia.

JaffeDavidIn Part I of this series, I discussed the “ins and outs” of the decision process sellers undertake when they consider hiring an investment banking firm to effectuate a sale of the company. Part I identified three common scenarios where bankers can offer high value on the sell-side. In this post, we’ll take a deeper look at the banker interview process and explore some key questions (and the rationales behind them) that every seller should ask when considering engagement of an investment banking firm.

Not your father’s LMM

The influx of talented deal professionals into the lower middle market (“LMM”) over the last decade has radically changed this market segment. In the early going, most M&A advisory firms were generalists whose main expertise was in working on smaller transactions with privately held or small cap client companies. As the LMM has matured, it has segmented. The LMM has now evolved to the point where a banker must not only have “chops” in common LMM attributes (smaller transactions, knowledge of mezz players, closely-held companies, revenue volatility, customer concentration, thin capital, etc.), it must also have industry expertise. Moreover, as new industries rapidly emerge, evolve and undergo segmentation and sub-segmentation, clients increasingly are expecting financial advisors to have depth in sub-specialties, sectors and niches within industries. Nowadays, it is not uncommon to find many smaller, highly competent “boutique” M&A shops with these very deep and narrow sub-specialties.

With the plethora of choices available, it is possible now more than ever for sellers to find highly competent advisors to represent them in a sale process. However, in order to do so, sellers must be more diligent than ever before in their search. That process starts with knowing what questions to ask. If you are considering a sale of the company, here are some important questions you should ask bankers seeking to represent your business during the interview process:

Question 1.      What percentage (by deal volume and dollar value) of your firm’s work is in M&A? Corporate finance? Other?

Many middle market investment banking firms offer an array of different services – including merger and acquisition advice, corporate finance (e.g., capital raising), fairness opinions, valuation services, restructuring and/or turnaround advisory services. By asking this question, you will gain some general understanding of the relative importance of M&A to the firm’s overall practice and the banker’s expertise in M&A relative to other areas. Naturally, as a seller, you will want to select an advisor whose focus is M&A.

Question 2.      How many M&A engagements have you led in the past 2 years?

Recent experience is generally more relevant than dated experience and many industries tend to move in 18-24 month cycles of activity. Moreover, transactions usually take at least 90-120 days from inception to closing. So a two year “look back” should provide a good barometer of the firm’s familiarity with emerging deal trends. This question will also provide you with a sense of the banker’s deal pipeline which you will want to know in order to determine the level of attention your transaction will receive and the capacity of the firm’s top professionals. It’s one thing for a banking firm to be highly sought after. However, if there are too many deals in the shop in the same stage of the process, you risk getting lost in the shuffle or getting the “B” players assigned to your deal.

Question 3.      Of your firm’s M&A engagements, what percentage is sell-side?

Most investment banking firms that do M&A will tell you that the vast majority of their engagements are sell-side mandates. However, there are firms out there who work with a select group of buyers in a narrow range of industries. As a seller, you should ask this question of the banker if only to filter out of your process any firm that does not have recent, relevant sell-side experience. Moreover, responses to this question (in combination with responses to the next question), should enable you to determine whether the banker has institutional relationships on the buy-side to which it is beholden and that could adversely impact the sale process for your company. One common example of this is when the banker receives a large share of its engagements from an institutional investor such as a private equity firm. In such cases, there can be a natural, if subconscious, tendency to show preferential treatment to that client in engagements that the banker has undertaken for other clients.

Question 4.      What percentage of sell-side engagements is for Private Equity clients and what percentage is for Independent/Owner-Operated clients?

This is a very important question for a non-P/E-owned seller to ask. As I explained in the rationale for Question 3, many advisory firms have substantial, long-term relationships with private equity firms who will use the same investment banking firm (or group of firms) to sell their portfolio companies and also to identify acquisition targets for the firm and its portfolio of companies. This can present several issues for an independent owner/operator including, among others, how the transaction will be prioritized by the banker who has a significant institutional client sending it lots of deal flow? What resources and personnel will it allocate to the transaction? How much attention will senior bankers give to the deal? If questioned, the banker may tout its relationships with P/E firms as a benefit inuring to you, the seller. While this may be true if you will be considering bids from P/E firms, it may present more obstacles than benefits. Most importantly, as many LMM deal pros can attest, representing independently owned businesses that are run by families requires a unique mix of skills and experiences that is distinct from the skills required to represent institutional owners like P/E firms or large cap public companies.

Question 5.      What has been the average transaction size (deal value) of your sell-side M&A engagements over the last two years? Minimum size? Maximum size?

Over the past few years the LMM has witnessed the entrance of banking firms that previously would not have considered doing transactions at values less than mid-nine figures (and yes, I mean to the left of the decimal point). As a seller, you want to understand the importance (as measured by indicative transaction value) of your deal relative to the banker’s backlog of transactions. If it is too small, the banker might deprioritize your deal in favor of transactions that are larger and more lucrative to it. If it is too large relative to the firm’s average transaction, the firm may lack the expertise and resources to get you to a successful closing. Ideally, the sale of your company should be of sufficient size and value that the banker is eager to obtain the engagement but not so large (or small) that it takes the banker out of its zone of competency.

Question 6.      Of recent sell-side transactions (initiated in the last 2 years), what percentage have closed to date?

One of the biggest concerns a LMM seller must address is closing risk. The M&A process will take up an exhorbitant amount of management’s time and attention for several months. The opportunity cost of a failed transaction in terms of attention and resources diverted from the operation of the business is considerable, to say nothing of the reputational damage. Sometimes deals break because the market turns in the middle of the process. Other times, deals break because they are mismanaged by the banker. Understandably, investment bankers prefer not to admit defeat. They are more apt to live by the adage “Old deals never die, they just close later”…and later…and … you get the point. In the absence of external factors affecting the industry generally, if the banker is sitting on pipeline of deals that it hasn’t closed within a two year time frame, it is a major red flag that you need to know about. This question is a way to elicit information on “close rate” that might not otherwise be apparent.

Question 7.      What percentage of your closed transactions have closed at or above the initial valuation range?

When investment bankers come to pitch sellers, it is common for them to provide what is known as a pitchbook. Among other information, it contains a preliminary (or indicative) value based upon financial data provided by the selling company (usually under confidentiality agreement) and transaction data from the sale of other “comparable” companies. Bankers recognize that the pitchbook valuation has great significance because it establishes a baseline expectation in the seller’s mind of what the company is worth. For this reason, most reputable banking firms will not submit a valuation unless they are highly confident that the final transaction price will meet or exceed that value. Conversely, investment bankers recognize that if the indicative value is too low relative to seller’s expectations, they will be unlikely to win the engagement. So, reputational risk constrains them on the upside and competition constrains them on the downside. Either way, it is extremely important for a seller to be able to gauge the ability of the banker to deliver against the pitchbook valuation in the form of actual purchase price in closed transactions.

For company owners, no single event is as important as the sale of the enterprise. The transaction professionals and advisors you choose will have a very significant impact on the outcome of the transaction; none more so than the investment banker. By using these questions, you will be able to get better insight as to the best fit for your company.