Who Is Steve Pappas and Why Should You Care?
Steve Pappas is co-owner of Touchstone Advisors, a lower-middle market advisory firm and has 15 years of M&A experience, which means that he helps people who own businesses get top dollar when they sell. He is also the current President of the Hartford Chapter of Connecticut Exit Planning Exchange (XPX), a community of trusted advisors to privately-held businesses. Steve holds a designation as a Mergers and Acquisitions Master Intermediary. He can be contacted at spappas@touchstoneadvisors.com.
What types of businesses does Steve Work With?
Touchstone Advisors works with businesses that have revenues between $5M and $50M, with the bulk of clients in the $5-$20M range. They work with a wide range of different industries such as manufacturing, distribution, technology, healthcare and other B2B service companies. Their process with clients develops deep expertise in multiple verticals.
What is an M&A Advisor?
M&A stands for Mergers and Acquisitions and these firms are hired to help businesses acquire other business or to help business owners sell their company. If you are a business that does less than a few million a year, you probably will end up doing a private sale using a business broker, which is a bit more like a listing agent for businesses. Business brokers do help with removing friction in transactions but tend to be a volume business as compared to an M&A Advisor, who tends to work with larger clients and spends more time preparing the “deal room” and “creating a market”. Touchstone, for example, will typically spend 3 months with a client just in their first “due diligence” phase, getting to know every aspect and nuance of the client’s business.
What’s a deal room?
A deal room, also known as a data room, used to be an actual room where all documents related to the due diligence process of an acquisition or merger would be kept for both parties to access and review. These days, the deal room is virtual. Using an M&A like Touchstone allows you to make sure that the deal room has absolutely everything needed for due diligence, as well as a plan for how to present all this data in the best possible light for the acquirer.
What’s “creating a market?”
If you’ve ever seen the old Supply and Demand curve, then you’ll probably remember that if there is more demand for a thing, the price goes up to meet that increased demand. Businesses are no different than other things. If you only have one person interested in buying it, then you don’t have a lot of “pricing leverage”, but if you have a group of buyers, that can bid up the price. Steve has seen companies get 15-20% premiums because other competitors were interested in the same deal.
Let’s Ask Steve Some Questions:
Chris: Tell me about the difference between businesses in the 5-10M range and businesses north of 10M.
Steve: The lower you go on the spectrum, the crazy the business valuations and negotiations get. Frankly, for company to go from 5M to 10M is a very big leap in terms of business complexity and process. I’d also say that once a business gets to 10M, it can no longer be a lifestyle business.
We also noticed that a lot of these businesses would have benefited from speaking with us years before, so they could be “groomed for an exit” so to speak. We started letting our network know this and have been able to offer advice that increased enterprise values significantly for our clients.
All that being said, most businesses in this range tend to experience similar things that depress values.
Chris: What are the top three things that lower the value of a business at exit?
Steve: First is Key Person Risk. Second is Customer Concentration Risk. Third is the lack of a management team.
Chris: Can you tell us a bit about each of these?
Steve:
Key Person Risk:
This is where the business relies too heavily on one or a few people for the business to operate. That presents risk to a buyer. What if that person or persons leave? Increased Risk = Decreased Value For Business. The most common situation for Key Person Risk is with the Owner or a superstar sales rep. If 50% of your revenue is because you (the owner) or your key salesperson has some special sauce, that presents a problem for the acquirer. We ask every new client we engage with to take two preliminary surveys. One is called “Owner Readiness”, which evaluates the emotional and financial readiness for an exit and the second one is “Company Readiness” in which we determine how reliant the business is on the owner.
How To Solve Key Person Risk:
If there is a key person that needs to stay for the business to hold it’s value, that risk can be mitigated through earn outs or bonus comp. For example, if you have that superstar salesperson, and you need them to stick around, you can offer them a “stay-bonus agreement”. This provides a cash bonus at close, and two bonuses at the end of year 1 and year 2 with the new entity. This gives the buyer some certainty that they will stick around. If the owner is the key sales person, that’s a different problem because it’s hard to believe that an owner who just had a pay day is likely to stick around for any additional comp and it’s always difficult for founders to stick around and no longer be the leader. In these cases, we think it makes sense to bring in a sales management consultant to help build and grow a sales team that can operate independent of the owner.
Customer Concentration Risk:
Customer concentration risk is where too much of your revenue comes from one or a few sources. We generally consider 15% of revenue coming from one customer as customer concentration risk. This is almost the other side of Key Person Risk, think of it as Key Customer Risk. Again, Increased Risk = Lower Value.
How To Solve Customer Concentration Risk:
The way that you approach customer concentration risk from an exit perspective is dependent on a few factors. Does the owner have the bandwidth to stick around for a few years? If so, they can hire a marketing and sales consultant to help them build out additional customers that would lower that concentration. If they don’t have a few years, then the other major way to avoid a serious discount to your business is with earn outs and/or selling to a strategic. If a strategic buyer already has a relationship with this customer, then that can make the concentration moot. If they aren’t a strategic or don’t have a relationship, they may be willing to structure an earn out. For example, the business could offer 60% of the price upfront, and assuming the customer stays on, an additional 10% is paid out each year for 4 years. This gives the buyer enough time to solve the concentration issue with downside protection.
Lack Of A Management Team:
This is a pretty obvious dilemma for selling a company. If you don’t have a management team, that means the owner has all the processes, relationships, and operational insights inside their head.
Solving A Lack of Management:
Our role in M&A for this situation is often to recommend an HR professional that can come in, help them see the gaps in their org chart, define roles and responsibilities, and help to find the right people for those roles.
Chris: What are the other major roadblocks you see to getting a deal done?
Steve: We’ve identified that a number of people think they want to sell their business but when they get to the finish line, they have second thoughts. We much rather find out upfront if that is going to be an issue. It is important to have discussions with the owner about this topic. We find that conversations along with our owner readiness review helps us mitigate that potential situation, as we better understand if they are emotionally ready for this separation. You have to remember, many of these business owners have been in operation for 20, 30 years or more. This is their baby and their identity. Do they have plans as to what they are going to do after an exit? Do they have hobbies? Do they have another passion or project to go spend time on? We need to make sure they have something to transition to or it increases the likelihood of second thoughts. We also need to make sure that based on their current spending levels, that the exit will provide them with enough money to comfortably retire, if that is indeed their plan.
Chris: How does a pandemic affect valuations?
Steve: A lot of companies have seen a hit to revenues, often between 15-30%. Some owners are waiting to see how they rebound but others are willing to create earn outs that provides some downside protection to acquirers, sort of a COVID rider, if you will.
Chris: How do you come up with a price for a business?
Steve: We actually don’t set a price, we create a market. It’s a controlled auction process. We want to put 5-6 real contenders competing for the business. In some cases if we have too many interested parties, we’ll often do a preliminary IOI (Indication of Interest), which allows us to weed out the companies that are just bargain hunting for a deal.
What makes our LOI process so effective is that we let our bidders know that we will NEVER ask them to raise the price from the LOI they submit. They have only one chance to make their “best and highest” offer. This is told to all interested parties. Immediately prior to the LOI submission date, we let them know we are not asking them to overpay, but to pay every dollar they believe it’s worth. Most importantly we tell them not to reserve any money for negotiations. We will not be asking them to raise their price. If another bidder gets the deal, they would feel very foolish if they were willing to pay a higher price… “Don’t let that happen.” we tell them. To be fair with all parties, this is a “sealed bid” process, we never work one buyer against another.
Chris: What’s your distilled advice to business owners who hope to be in your office one day negotiating an exit?
Steve: Don’t be afraid to hire quality people in your management team. Even if you’re good at sales, hire a VP of sales. We had one client who approached us to sell his company. We performed a valuation and estimated the value at $5-6M. The company was in manufacturing, had great technologies and was growing. We told him it wasn’t the time to sell. He hired a CEO coach, and 3.5 years later, we sold it for many times our initial valuation. He followed the things that no one does. We told him to hire a great general manager. We told him to hire a great CFO. He wanted out when the company was only 5M. He couldn’t handle the stress of the company. He was being overloaded. He hired a great management team to help him carry that stress, and it worked out wonderfully.
