"Investment Banking is 10% Financial Analysis and 90% Psycho-analysis" – André Meyer  This blog is about the "other 90%"…

HumptyOne of the main jobs of an Investment Banker is to fight knee-jerk reactions. No, I don’t mean binding the legs of the buyer and seller to their chairs… or arranging negotiations in deep sand.  It’s all about managing expectations on both sides to avoid destructive over-reactions that can, in the heat of the moment, kill a long nurtured M&A transaction.

Let me give you an example.

Not too long ago, we represented the seller of a slot machine operator.  The owner, whom we might call Bill, was a serial entrepreneur, looking after a couple other businesses too.  He realized that his slot machine business was mature, offering limited growth potential to him as a financial owner, but producing strong cash flow.

At the same time the laws governing casino operators has changed and a number of players lost their licenses. Some casino owners were looking to enter other, less regulated businesses, such as slot machines, where they could employ their casino staff and know-how.

One of the former casino owners (Tom) was interested to look at the business and decided to make a bid.  The opportunity was totally synergistic for him and he identified a number of low-hanging-fruit profit-improvement opportunities, in cash control and staff management and others. However, Tom did not take our (very reasonable) price indications seriously and after doing some ‘unauthorized due diligence’ decided that Bill had no alternatives and was likely under time pressure to sell. Consequently, Tom gave a low ball ‘opening offer’ hoping to negotiate a bargain price in the middle.

What he failed to anticipate was Bill’s emotional profile.  He was a proud man, not to be toyed with.  Tom’s offer ‘burnt his fuse’ and he rejected any further contact with him.  It was a Humpty Dumpty accident:  All the Kings Sellers and All the Kings Advisors couldn’t put the deal together again.

(Post Mortem:  We could have avoided the low ball offer by educating the buyer and his advisors more before letting them bid quickly. We got carried away by the reasonable price expectations and the strong fit between the 2 businesses, instead of preparing for a possibly greedy bid.)

PhantomMy daughter has been a Harry Potter fan for years, having read the books and seen the movies several times.  During the holidays, somehow her younger siblings got hold of these scary DVDs and watched while we were out for dinner.  Upon our return our young boys educated us about the “dementors” who suck the souls out of people who then turn into the living dead.  This scary-tale turned our youngsters into spirits wondering over to our bed to escape the dementors, for a few nights afterwards.

At least this episode got me thinking about why these dementors are so feared.  It may be because kids can’t yet make the difference between what just looks real and what actually is.  To their overpowering imaginations fictitious dementors are as frightening as the real thing.

Something similar happens to a first time company seller, upon reading the representations and warranties in the draft Sales and Purchase Agreement presented to him by a prospective buyer.  The so called Rep’s and Warr’s are a detailed list of statements the seller must sign, essentially guaranteeing the buyer that everything is ok with the company, or at least no worse than had been presented in the information memorandum and the data room.

The problem usually arises with those warranties that cover areas that neither the seller, nor the buyer has a deep or detailed knowledge of, or one or neither of them has a clue as to what could go wrong with them.

For example, the seller may not know for sure that there are no proceedings in force against the company as initiated by authorities or plaintiffs.  But what if there are – they may wonder – only the announcement got lost in the mail or been thrown out by an estranged employee?

Similarly, the buyer is also likely to be afraid of such hidden faults of the company it cannot specifically envisage. The imaginable risks and weaknesses can be investigated by accountants and lawyers, but no scope description exists for unknown risks.  Therefore, buyers try to word such warranties broadly to catch any unthinkable problems that may arise too.  That unnerves the seller, who then suspects hidden motives and an intent by the buyer to trick him into warrantying losses that would be caused by the buyer himself or – at a minimum – are outside the influence of the seller.

In many such cases both buyer and seller turn out to be chasing phantoms. In most situations, the company’s assets exist and are fairly valued; it has no hidden liabilities, and customers and business partners are in reasonable terms with it, with no intention to sue, etc.  But, the ‘dementor is in the detail’.  In such uncertain situations it is worth for the advisor to sit down with the seller and discuss  line-by-line what could possibly be wrong and to disclose any doubtful situations before signing, to avoid surprising claims from the buyer later, at the expense of the bank guarantee or escrow account funded by the seller.

CrosshairsSeveral years ago, I represented the owner of a construction company who wanted to exit and retire.  His major motivation was his deteriorating health, which he felt prevented him from carrying on.  He was overweight and had high blood pressure and felt in danger in the stressful job as CEO of a $20 million general contractor.

My team found a strategic buyer for his company, who wanted to take over the business over 3 years.  They were going to buy 51% on closing, followed by two call-put options for further 23% and 26%, 18 months and 36 months out, respectively.

We managed to come to terms on the Sale and Purchase Agreement except for one item.  The buyer was also concerned for the health of the seller and felt that it was an operational risk that the founder-CEO might fell ill or be incapacitated during the 3 year transition period.  They sought to eliminate this risk by requiring the seller to take out key man insurance and assign its proceeds to the buyer.  The buyer’s negotiator was pretty proud of this proposal, the cost of which would have been born by the company, with little apparent pain to the seller.

Unfortunately, this ‘neat idea’ totally backfired.  The seller was deeply offended by what he saw as an intrusion in his private affairs by the buyer.  He also felt, that such insurance could potentially motivate the buyer to seek his demise, should the company fail to perform during the transition, and an insurance payout could help mitigate the buyer’s investment loss.

He called it “Crosshairs Life Insurance” and cancelled negotiations in disgust on the eve of the signing.

FamilyPossibly the biggest challenge for family businesses is to keep the descendant to continue running the business.  They say that the founder is in “Wonder” that he had managed to build a money machine; the second generation can be “thunder”, and make a big success having the benefit of getting groomed in the entrepreneurial culture, but without yet the trappings of wealth; their children however, are likely brought up comfortable and often make a “Blunder” of the business.

If the business is unsuccessful, than it makes sense for the next generation to follow a different path and be unfaithful to the family firm. Let father fiddle with it, if he has no better idea for wasting his life.

This blog note is about the hurdled faced by the sons and daughters of those parents owning and running successful companies.

The first hurdle is ability.  Entrepreneurs come from all walks of life, but they typically share some basic success characteristics, such as independence, persistence and critical thinking. These traits are not universal and the chances of at least 2 of the 3 to be present in the next generation are medium at best.

Next question is whether the entrepreneurial drive is present in any of the potential successors.  The hunger to succeed often triggered by the sizable gap a person perceives between their initial circumstances and their goals. The bigger the gap the greater the gravitational force pulling the person towards the goal.  For the second and later generation, that havebeen brought up in a life of comparable comfort this gap is likely much smaller, than for the founder who started with nothing.

Third is identification.  The family business is the founder’s baby, who will naturally identify with it completely and will have an emotional motivation on top, to make it work.  This is likely not the case for the son or daughter, whose job will be to become a devoted foster parent.  Strong identification with family tradition can help here create the necessary bond.  A sense of duty may also help give a different,  but possibly equally potent motivation for the person sensitive to such sentiments.

Another challenge is to train the successor to run a big company. Again the founder is at an apparent advantage here, having gone through the process of creating and building the business from scratch, which process rendered him ample chance to train himself through his trials and tribulations.  The daughter will have to step in at a high level and make it still bigger, which can be a tall order for most.

On the other hand, she can be groomed for the higher job from the outset.  There will likely be money to educate her at the best schools and universities including a Harvard or similar MBA, plus she’ll get experience by interning through high school and college years at the family firm.  Another plus is the entrepreneur’s culture that she would be exposed to all through her childhood.  Entrepreneurs’ kids are widely considered to be much more likely to be independent, self-starters with a strong work ethic than their peers with corporate or public sector employee parents.

In any event, the successful next generation must be mentally prepared and willing to choose a life of challenge and responsibility, instead of a life of leisure or low commitment.  It helps the parents if they have plenty of descendants to choose from.

True FalseLying is rampant in every walk of life and especially in investment banking.  The truth in business is seen as such a valuable commodity that it should not be given away.  It is seen as gold that has to be mined with hard labor, extracted from the other party with cunning or force, or purchased for cash.  In most discussions with prospects, investors and even clients what they say is secondary to what they try to avoid saying or are quiet about.  What they say is interesting mainly as a peeping glass into their motives as to what they wanted you to believe and why by saying it.

The commonness of lying, however, does not make it a good policy.  On the contrary.  When someone is caught telling a lie, he loses credibility and the power to persuade the one he lied to.  Lying also raises suspicion and triggers deep digging by the other party, which inevitably will uncover more dirt than should have been presented if the truth was told in the first place. Therefore, lying should be avoided at all cost.  In awkward situations – such as when a company being sold is not making its numbers, or is faced by an unexpected adverse situation such as a write-off, or a litigation – the best policy is usually to tell the truth.  I have brainstormed numerous occasions with clients about how best to communicate a negative and with rare exceptions the “best lie” turns out to be the truth.

The truth is realistic, believable, is unavoidable and has to be faced up to sooner or later.  Lying about it just adds to the problem by undermining the negotiating position of its reporter.

On the other hand, facing the truth gives an opportunity to all parties to handle it in the least damaging way.  The buyer can give a modified offer, which the seller may or may not accept.  The seller retains the moral high ground to say no to a subsequent price cut, which he could not, if caught lying. Truthfulness also saves time and energy, which then can be channeled into finding creative ways to doctor the problems created by the negative event that has to be handled lye or not.

Most importantly, truthfulness builds trust and trust brings down the mental barriers to brainstorming alternative solutions expectable by both sides in the negotiations.