I was reading an article this morning by Hunter Walk over on his blog titled “I Wanted to Do the Deal But Couldn’t Convince My Partners:” A Handy Explainer.” And I thought to myself, based on about a bazillion business valuations and M&A deals that I’ve worked on… “Aha! I know exactly where this is going!”
It didn’t go there.
Hunter actually DOES explain some great reasons that deals don’t get done. But his perspective is that of a VC. I ofcourse immediately thought of all the failed deals because the shareholders in the operating company couldn’t agree.
This happens all the time. In main street and the lower middle market (for arguements sake let’s say companies under $50 million revenue), there often aren’t a ton of shareholders. In many cases there may be only 2 or 3. And that’s where things get sticky.
Why “Partner Deals” Fall Apart
Not Enough Value to Exit. This happens when you have a few partners, and the income of each approaches their pro rata share of deal proceeds. Example: WidgetCo has 3 working shareholders, each earning about $500k per year. They don’t leave much in the way of profit in the business. The company is valued at, say, $2 million. Shareholder A looks are B and C and says “Gosh, if I just work for 18 months I’ll be in the same position.”
What’s really happening here is that the WidgetCo fellas are likely taking an above market salary- meaning that a big portion of their salary is a dividend in disguise. No matter, Shareholder A doesn’t want to hear that. Deal = stalled.
No Consensus. Let’s stick with WidgetCo. What happens when B and C say “I get it – and I just want to retire and catch fish” – but A holds out. A doesn’t want to do the deal. So he / she drags their heels, annoys the buyer, and is generally a stick in the mud. Deal = stalled.
Too Much Value in Shareholders. Another one we see all the time – A,B, and C are all on the same sheet of music (hooray!) and want to exit and catch fish and play golf. Unfortunately, A runs Ops, B runs Sales, and C runs the whole show. From a buyer’s perspective exiting all operating shareholders at once presents a lot of risk as the new owner. Result: Deal = stalled.
How to Fix?
Getting past all of these sorts of issues can be tricky. But the clearest path is proactive planning and getting all shareholders in agreement well in advance of any potential exit. Some thoughts:
- Adjust Shareholder Comp to market. There’s no need to take a $500k salary. Pay each shareholder exactly what an outside hire would earn, and divy the rest up as a dividend.
- Develop Concensus. Agree in advance on the general nature of a deal, the likely business valuation, and the potential structure. Everyone is eventually going to exit – even if by dying in your desk chair – so if the goal is to exit, understand and agree in principle on the potential terms.
- Work Your Way Out of a Job. If you are working on any sort of exit planning you will understand this concept well: you create organizational value by diminshing your personal value. Reduce risk for a buyer by developing middle management / second in command.
- Shareholder Agreement. Have shareholders? You should have a shareholder agreement. Work with your attorney to document buy-sell provisions and restrictions so that no one is surprised.
- Board of Directors. This is really the secret weapon, and it’s really what separates main street from “real” companies. A Board is responsible for the direction and actions of the company. But as companies grow and become more formal, they also gather more stakeholders. Those includes banks, equity partners, operating parthers, limited partners, etc. By establishing a formal Board of Directors companies 1) often establish additional market trust based on outside oversight of the company and 2) Mitigate strife with smaller shareholders.
As I said at the outset- I’ve seen what seems like a gazillion deals blow up because of partners issues. Valuation is occassionally the central reason – but often valuation is just masking deeper issues amongst shareholders. Work these out in advance in order to increase your likelihood of a strong exit!