By George Thresh – Transaction Services & Financial Due Diligence – Buzzacott
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Overview
Once a searcher has identified a target company and had an offer verbally accepted it is time to execute the transaction. In this article we outline each of the key steps in the process.
Search Fund transactions can be relatively complex given the various moving parts and interaction of search capital, acquisition capital, debt financing and seller loan notes. Because of this it is important that as a searcher you do everything in your control to make the process run smoothly. To assist with this we have also included our top tips at each step to make it as efficient as possible.
Step 1: Letter of Intent – ensure a signed letter is in place before work commences
It is vital that a signed Letter of Intent is put in place which includes an exclusivity period (typically 3 months) before work commences. This is vital to protect a searcher from incurring unnecessary costs on a deal that may not progress. Without this, even if the offer has been verbally agreed and accepted there is nothing legally preventing the seller from entertaining other offers until they have signed. Certainly over the years I have seen a fair few deals undone by sellers not honouring verbal agreements.
Aside from the exclusivity point, the LOI represents a chance to clearly outline the basis of your offer (particularly how you would like to treat potentially debatable areas). We believe there is a sweet spot in striking the right balance with the level of detail to be included here. On the one hand, anything agreed at this stage should make any negotiation further down the line more straightforward (e.g. treatment of specific items as debt or working capital). However, going into too much detail at this stage can put off potential sellers and delay progressing into exclusivity. We would suggest that if a deal has been sourced off-market via proprietary outreach then you have more scope to go into detail on various items. However if the deal has come through a broker then the seller will likely have multiple LOIs to review meaning there is a risk that this extra detail will make your offer less appealing when compared to others.
Additionally, it may also be useful to include a mechanism in the LOI showing how the headline Enterprise Value has been calculated. If the headline value is based upon a multiple of EBITDA then including this mechanism gives some scope to reduce the Enterprise Value accordingly if, after diligence, the EBITDA is found to be lower than initially expected. This is useful for getting the deal over the line as it represents you working within the original parameters set out in the LOI rather than having to renegotiate what was previously agreed.
Step 2: Red Flag review – carry this out to get comfortable or fail fast
Many searchers find it useful to carry out an initial red flag review, immediately after getting the LOI in place. This can normally be performed quickly with the objective of obtaining a high-level understanding of key risk areas. It is more targeted than full financial diligence, instead looking to address 5 key questions which could be immediate “deal killing” problems. Typical areas that we find ourselves targeting in red flag reviews include:
- revenue recognition;
- reasonableness of the adjustments made to get to the normalised EBITDA;
- customer concentration & churn;
- movements in gross profit & EBITDA margin; and
- the working capital cycle of the business.
If a fundamental issue is found in any of these key areas then it can lead to the deal being aborted or at the very least re-negotiated from your initial offer. Indeed we have seen numerous occasions where issues have been found at red flag stage but they have not been insurmountable and have actually resulted in a valuable reduction in the Enterprise/Equity value. If the deal is to fall over then it is better for this to happen as early as possible to avoid unnecessary costs accumulating.
Even if no issues are found, performing this review provides the searcher with an output to show to investors and lenders at an early stage to get them onboard with the process.
Step 3: Full Financial & Tax Due Diligence – ensure momentum is kept up through this process
Once the red flag review has been completed the full financial and tax due diligence stage can commence. This sees your chosen provider take a deep dive into the company financials to try and unearth any risks or major issues that will lead to the deal aborting. The only thing worse for a searcher than doing no deal is doing a bad deal, therefore this stage is vital in giving as much comfort as possible that there aren’t going to be any unwelcome surprises post deal. At Buzzacott we see diligence as far more than a simple compliance/comfort exercise, but more an opportunity to identify potential negotiation points which can be used as ammunition to get the best deal possible when it comes to negotiating the EV Bridge (see step 7).
When carrying out financial due diligence It is important that momentum is maintained to ensure the deal is completed before the end of the exclusivity period. To do this effectively it is often helpful to:
- Ensure a virtual dataroom has been set up in advance and can be easily populated;
- Consolidate request lists into one easily viewable document;
- Send request lists out in good time – the list should be sent out as soon as possible from when you decide to progress from Red Flag stage;
- Encourage sellers to provide information as soon as it is available (some have a tendency to want to complete to complete the whole list before opening the dataroom which can cause delays);
- Hold regular scheduled all parties catch ups so that issues can be prioritised and everyone is kept up to date with what is needed.
Taking these simple steps helps to keep momentum up and also make the process as painless as possible for the seller. The last thing you want is for a process to drag to the extent that seller time is compromised and the underlying trading of the business is impacted.
Step 4: Connect with lenders – as early as possible to ensure there is interest
The vast majority of search deals will make use of debt funding. Usually this will be in the form of a cashflow/term loan (calculated based on EBITDA), however we have seen instances where asset-based lending has proved a better fit (based on debtor book, inventory and fixed assets of the target).
Regardless of the type of debt funding chosen, it is vital to gauge the appetite of lenders for the deal as quickly as possible. This can help to avoid delays in securing the necessary debt funding and also ensure you don’t get too far down the line with a deal which cannot be supported by debt funding. Lenders may be reluctant to proceed if they don’t like the sector, have concerns around the impact of the existing owners leaving or if the debt funding requirement is beyond the level they can achieve based on the normalised EBITDA.
We recommend first discussing the deal with lenders around the LOI stage. This has the added benefit of meaning that particular lender due diligence scopes and concerns can be obtained and used to fine tune the financial due diligence process to ensure that it meets the preferred lender’s requirements. Once selected the preferred lender should be kept updated as the transaction progresses, sending them the red flag, draft and final financial due diligence reports. It is highly likely that the lender will look to place reliance on the due diligence. This is achieved through a reliance letter which is put in place between the lender and your diligence provider.
Step 5: Keep Search Capital investors updated throughout the process – this is to avoid surprise cap table gaps that need to be filled
Similarly to the lenders, it is important to keep your investors updated on progress with the transaction and any findings. We would recommend sending the red flag report and the draft FDD report to them when ready, before providing the overall finalised FDD report.
The objective here is to ensure any investors that are going to pull out, do so early. It is fairly common that at least some of the search capital investors will choose not to follow on and contribute to the acquisition capital (resulting in a gap on the cap table). This could be for a whole host of reasons such as: not liking the sector, not having the funds available to follow on, being over-indexed in that particular territory etc.
If a gap is to arise then it is useful to know the extent of this as early as possible so that you can reach out to replacement investors and find others to fill in.
Step 6: Sale & Purchase Agreement (“SPA”) – this takes a lot of negotiating so kick off the process early
After the LOI, the next (and more important) major legal document is the Sale & Purchase Agreement (“SPA”). This is a lengthy (typically 100+ page) document signed by buyer and seller which establishes the terms under which the searcher is acquiring the company. Key elements of the document include the purchase price, payment terms, completion mechanism (locked box vs completion accounts), warranties & indemnities and tax covenant.
The first draft of the SPA is typically prepared by the buy-side lawyer before being reviewed and marked up by the sell-side. The buy-side and sell-side financial advisors will typically contribute financial areas (such as form of the completion accounts and accounting policies which will be applied etc). There is typically a fair amount of back and forth between them as key terms are agreed, particularly around the EV Bridge (see Step 7), the Warranties & Indemnities, the Tax Covenant and non-compete clauses etc.
To maximise efficiency this SPA negotiation can be run concurrently with the due diligence process. This helps to prevent there being a significant delay between completing the due diligence and finalising the SPA. As mentioned earlier, if your LOI is detailed enough then it can eliminate the need for some of this negotiation as it can be referred back to when drafting the SPA.
Step 7: Enterprise to Equity Bridge (“EV Bridge”) – this is vital in determining how much you pay for the business
The Enterprise to Equity Value bridge and completion account form is normally the area of the SPA that takes the most negotiation. If the transaction is on a cash free, debt free basis with a normalised level of working capital then this schedule details how you get from your headline offer (Enterprise value) to the amount the sellers will actually receive (Equity value). It is normally put together on Excel and then dropped straight into the relevant Appendix of the SPA once the form has been agreed.
The key areas to negotiate are typically around which balance sheet items are treated as “working capital” and which are treated as “net debt”. We have found that deferred income, bad debt, accruals, provisions and social security & other taxes are normally the most hotly debated areas, however this changes on a deal by deal basis.
When negotiating the EV Bridge it is useful to seize the initiative, putting your schedule to the sellers first and using it as a base to work off. We find doing this makes it more likely that you will get your desired allocation between net debt and working capital items. Therefore while performing diligence you should have your provider put this together as soon as they have performed enough work to take a view of the key items.
Step 8: Regulatory approval – if needed ensure this does not cause a major delay
Regulatory approval is a factor that is frequently overlooked and can become an annoying headache that causes a delay close the end of a transaction.
In the UK there are two key approvals that often need to be obtained when a searcher completes a transaction. The first of these is approval under the National Security & Investment Act, with the searcher required to notify and obtain approval from the UK government if the target company works in one of 17 sensitive areas of the economy. The government have 30 working days to review and make a decision. The second area in the UK is FCA change of control approval which is needed if a searcher is acquiring an FCA regulated entity. Here the FCA has 60 working days to make a decision.
Because of the timeframe that these notifications take it is vital that a searcher is organised and submits applications in good time to avoid delays. We normally find that as soon as the final cap table has been decided on it is best to start the notification process. Of course these approvals are specific to the UK. If you are acquiring a company in another territory it is vital that you speak with a lawyer to determine if there are any specific approvals that will need to be sought.
If there is likely to be a significant delay in approval then we often see searchers go for a split exchange and completion, with the SPA signed but with a condition precedent that completion will only take place once approval has been granted.
Conclusion
Search fund transactions can be relatively complex and there are multiple stages to think about. However the above top tips represent simple things you can control which should help the process to run more smoothly.
