42 | Where Software M&A Deals Typically Fall Apart

When does a software deal typically fall apart? What issues surface in diligence that can derail a close or lead to a retrade? In this episode, managing directors Mike Lyon and Scott Austin discuss the most common reasons deals break down, the potential surprises founders need to prepare for, and how the right groundwork can help you preserve leverage and keep a process on track from LOI to close.

Vista Point Advisors is a boutique sell-side investment bank providing unconflicted M&A and capital raising advice to founder-led software, AI, and internet businesses. We partner with entrepreneurs of growing businesses to help them understand their options in the marketplace so they can maximize business value, leverage their options, and realize their ideal outcomes. 

Securities offered through Vista Point Advisors, member FINRA/SIPC. This has been provided for informational purposes only and should not be considered as investment advice or a recommendation. It is not intended to address all circumstances that might arise. The views expressed herein may change at any time subsequent to the date of issue. Opinions contained herein should not be interpreted as a guarantee of future results. Outcomes will vary depending on individual circumstances. Any examples used in this material are generic, hypothetical and for illustration purposes only. Testimonials from past clients may not be representative of the experience of other clients and there is no guarantee of future performance or success. Clients are not compensated for their comments. 

Transcript

[00:00:19] Mike Lyon: Hello and welcome, everyone. I'm Mike Lyon, founder and managing director at Vista Point Advisors, and this is The Path to Exit. This show is dedicated to helping founders of software, AI, and internet businesses understand what it takes to raise capital or sell their business and how to do it well. My guest today is Scott Austin, managing director at Vista Point Advisors.

In this episode, we'll discuss where deals most often break down, the issues that tend to surface during diligence, and how founders can prepare so the process holds together all the way to close. Please enjoy my discussion with Scott.

Scott, welcome back to the podcast.

[00:00:50] Scott Austin: Thanks for having me back on.

[00:00:51] Mike Lyon: So this is a topic we end up talking to founders about a lot. So, start at a high level. When does a deal typically fall apart? Is it at the beginning, the middle, or the end? And when do things really go off track in a transaction most of the time?

[00:01:04] Scott Austin: It's a good question. We generally look at a process as being in four stages, right? So there is the data preparation stage up front before you are live and talking to folks. The second part of the stage is the marketing process that generally culminates in indications of interest.

After there is when we shortlist a group of parties to move forward into the next diligence stage, which culminates with getting LOIs, and then eventually out of there is when you are signing an LOI into exclusivity and trying to close a transaction. That final stage that I mentioned is where most deals fall apart, and it's also why we try to structure a process that makes sure that all exploratory diligence is done prior to exclusivity, and the exclusivity process at the end is really truncated down to just papering the transaction and getting to a closed deal as quickly as possible.

Because the longer an exclusivity period is, the more time that you open yourself up for deal risk. And you hear the proverbial phrase, "Time kills all deals." So in the end, that's ultimately the stage of the process where there's the most risk, that you want to shorten it in the smallest time period.

[00:02:05] Mike Lyon: And I think it's worth just pointing out that if you think about the trajectory of the process, in the early part of the process, the seller is providing information to the buyer. And at the very beginning of the process, the buyer's not doing a ton of diligence. They might be doing some market work.

As the deal progresses and you get into the heavy diligence phase, that's when they start, in theory, uncovering things that they either don't like or could even be a little bit different than what the seller framed the business or the data they gave. So typically, the closer you get towards the end, that's when the most diligence is being done, and that's when there's a chance for a misunderstanding, or in some cases, it's just a strategic play by a buyer if they have a seller in exclusivity to try and move the goalposts a little bit.

But typically, you don't see deals fall apart upfront. There's not really a deal upfront, right? You're in the marketing phase.

[00:02:51] Scott Austin: But there is a lot that you can do in that upfront data preparation phase to reduce potential issues later on in the process, in terms of just getting data in order, getting all of your documents in order, because once you're under the proverbial gun later on when you're in exclusivity, you want to be able to quickly respond to requests and be able to efficiently answer questions.

And a great part of doing so is doing the upfront preparation work, whether it's data related or related to legal, customer contract documentation, or any other areas there too.

[00:03:23] Mike Lyon: Absolutely. Let's maybe talk a little bit about some of the common areas where we actually see a deal break or the price change be so much that a deal can't get done. We're just going to talk you through some of these common areas and what tends to happen.

Let's start with accounting. What typically happens in accounting?

[00:03:39] Scott Austin: So I would say maybe in a third to a half of our transactions, we do what's called a sell-side quality of earnings upfront, which is essentially a mini audit in terms of accountant-reviewed numbers to make sure that the numbers are the numbers and that we can move that risk away for it to later be discovered in diligence that we are doing, whether it's Rev rec wrong or other areas of our accounting diligence incorrectly, which obviously can open you up for reprice discovery in a later stage.

So that is a large area, and the key parts there that you want to make sure that you are doing is that you indeed have GAAP financials, ideally back for a few years. And you want to make sure that you have a really clean monthly revenue by customer file. And you want to make sure that you're able to update those throughout the process, because a lot of times what you will be graded against, obviously, is you'll be compiling projections for your end of year and future years at the beginning of a process.

And throughout the process, you'll be judged against those projections and how you're performing against those. So making sure that you have your accounting documents and your numbers really buttoned up heading into a process is key, because the second that people start noticing either softness in your numbers or not a general understanding of how your business is performing, that's when it will open up questions and diligence can become a little shakier.

[00:04:58] Mike Lyon: And I think where this one's really confusing for founders is a lot of founders are obviously focused on more like cash basis accounting or other metrics they care about to track the business, not necessarily like the GAAP numbers. However, public buyers and investors are, I wouldn't say solely focused on those, but that is a really important metric for them.

And so this is an area where if you don't have a good handle on your accounting and you communicate the numbers are X, and then they're going to hire accountants, no doubt, whose whole job is to look for these inconsistencies. I'd say that's the most common area where you set yourself up for a retrade, and it's solely just not being prepared upfront.

And so that's an area you want to get smart on, understand what you need to do.

[00:05:39] Scott Austin: And just for preparation there on that, in case people are curious, as I mentioned, about a third to half the time we will have our clients do, or they'll ultimately decide to do, a sell-side quality of earnings to get that accountant stamp on their numbers. Generally, if you have concerns about your numbers, those are things that cost somewhere in the like 40 to 100K range prior to launching a process.

[00:06:00] Mike Lyon: And I would say a good banker can look at your numbers and help you decide if you need to get one, just based on, obviously, bankers have seen a lot of these and understand the risks involved.

Separate but related one is the projections. And the thing I would just say here is a lot of folks are under the impression you just project as high as you can. That doesn't really play out in PE and strategic deals the way it does in like a traditional VC hockey stick pitch.

So Scott, talk a little bit about what happens with projections and how that can be a risk.

[00:06:28] Scott Austin: Yeah. And obviously it depends on kind of where you're launching a process within the calendar year. But our advice to clients is always, even if there's very lofty goals there, it's that you want to be presenting at least 97, 98% confidence that you're going to hit your numbers by the end of the year.

The worst thing that you can do is if you start trailing behind your projections by missing numbers for consecutive months. Not only will you lose interest, but eventually within the exclusivity period, you open yourself up to potential price re-discussions once people find out that you are no longer going to hit their numbers that you've guided them towards in terms of their expectations.

So the best thing that you can actually do in a process is improve your projections throughout the process based on your monthly performance. So it's a lot better to be conservative on your projection levels than it is to shoot for the moon and come up short, because it will also just start the relationship off in a poor way where they don't know where trust levels are either.

[00:07:23] Mike Lyon: Absolutely. Couple other areas here.

Maybe talk a little bit about tech diligence and market diligence. Like, how does that play out in a process, and is that more of a retrade item or a total deal falling through item?

[00:07:36] Scott Austin: Generally, you might hear the term tech debt, which is something that you should consider going into a process in terms of how modern is your tech stack, where there are potential vulnerabilities. Where I've seen any of this work happen before is, if there are any data breaches, they'll work with a business like CYMA or someone like that to do like an open scan or soft code base check. And if there are any recent vulnerabilities that are cited, that's when you can open yourself up to not just tech debt conversations, but also where there could be potential security issues that could kill a deal altogether.

So tech is a large portion, and I think a lot of founders, they'll be surprised that tech diligence a lot of times, especially with private equity firms, maybe less so than the larger strategic buyers, tech diligence is held off to the very end of the process, and the first few stages are mainly around customer data, financial data, accounting data, and more company-organization-specific data.

But tech at the end can ultimately be a deal breaker. In terms of market work, this is where we oftentimes do put strategic deals on a pedestal compared to standalone private equity deals where they haven't done work in specific market sectors, because that is an area of diligence work that all parties do.

If you are looking at a strategic deal, whether you are a private equity add-on or a larger strategic business that already operates in your sector, they've effectively already done the market work and believe in the market and the tailwinds there. If it's a firm that doesn't have much industry experience within your certain sub-sector, the market work done at the end of the transaction can be a big dictator around just whether they want to do a transaction or not, if they learn certain things about various headwinds in the industry or budgetary constraints or any other concerns that might crop up.

[00:09:24] Mike Lyon: And I would just say that this is one, as the seller, it's almost malpractice if a deal falls apart over that. With a private equity firm, you have to know that market work is really important, and that work should be done well before you entertain exclusivity. A buyer needs to know they like the market.

Now, as Scott said, with a strategic, it's usually not a risk. The only place it could be a risk is if you're selling it to a much larger strategic that doesn't really have a solution anywhere adjacent, and they don't really know the market that well, and they're going to do some diligence there. But usually the market work can be something where the deal just blows up because it's a TAM issue, if they don't think the market's big enough.

[00:10:00] Scott Austin: And oftentimes as part of the market work, they'll do customer calls or, like, customer surveys where they're trying to get feedback around your specific product capabilities compared to other businesses that you compete against, and then also just other trends within the sub-sector in the industry.

And that's an area that can open up diligence risk as well, as oftentimes, especially in, like, today's market, in terms of whether there's any AI-native incumbent or cheaper AI solutions that can displace your product. But it can also uncover potential customer churn issues as well.

Generally, in a private equity deal or a strategic deal at the end, they'll try to do five to 10 customer calls the final week or two of the deal. And if it becomes apparent that maybe one or two of those customers are at risk of churning, that can present a lot of other risk as well that you might not have perceived, and can then lead to either escrow conversations around the renewal of those customers or just deal risk in general. But that generally comes up in that market and customer work.

[00:11:03] Mike Lyon: And then the last couple of things I would say that come up every once in a while are founder background checks. So we've worked on deals where you kind of ask the founder, "Is there anything we should know or prep the buyer for?" And then this stuff comes out later because they run really deep background checks towards the end of the process.

This is one where you just want to get ahead of it and make sure you're communicating with the buyer anything that could have come up in your past, so, A, you can control the narrative, and B, not let them be surprised by it. Because if they're surprised, it really drops their level of trust. And so you may not disclose something like that to all the buyers, but it's something you're going to want to talk to them about and control the narrative, because they are going to find those kinds of things.

And we've actually had deals blow up over that at the very end, particularly with a big, large strategic who just couldn't get comfortable. The last one would just be any legal issues that would come up. And again, there's a time and a place to disclose these, but this is something you just want to know where the issues are.

Most of the legal diligence is pretty standard, and there's not a lot there, but if there are some lawsuits or potential lawsuits, you want to make sure you bring those up at the right time and not let those be discovered by the buyer in diligence. Because those are the things that aren't really like a retrade or a price chip. That might speak more to whether they want to do a deal at all, just because they'd get spooked by some of those things.

[00:12:18] Scott Austin: Yeah. And the last one there is just a combination of tech and legal, which is just around IP ownership and needing to be able to confirm that the IP is owned by the company.

[00:12:27] Mike Lyon: Yep. Absolutely.

One of the things that founders underestimate the most is just how risky exclusivity is. You have a term sheet in front of you, and you're talking about the exciting stuff: valuation, structure, rollover. A lot of times founders just take the exclusivity for granted, but it's actually closely tied to how likely a deal is to close.

So Scott, maybe talk about exclusivity, what it means, and how we think about managing that and how it can create an issue around deal closing for founders.

[00:12:55] Scott Austin: Yeah. A key part about our process is that we ultimately want to hold off exclusivity as long as possible and shorten that period as much as possible. Obviously, the reason is not to not get a deal done. It's that ultimately we want to make sure that all exploratory diligence has already been done before entering exclusivity, so that it's ultimately just papering a transaction and confirmatory diligence with third-party vendors at that point.

It's oftentimes, too, why, when we're talking to private equity firms or strategic buyers, if they're willing to engage third-party, whether it's tech diligence, market diligence, accounting diligence prior to the LOI date note of exclusivity, that ensures that when we do go into exclusivity at the end of the deal, they have full knowledge and full understanding of the business and potential risks. So that when we sign into exclusivity, it's really just focused on only the purchase agreement at that point and getting the deal done.

Once you are in exclusivity, you lose all of your leverage. The best thing that can happen is that you're closing the deal that you previously agreed upon. No buyer is ever going to say, "Oh, we just found out this about your company. We want to pay you more." So ultimately what you're trying to do during that exclusivity period is minimize any potential negative news that could come out.

So if it's a 10-day period versus if it's a 45 or 60-day period, that obviously is a much shorter time zone for a large customer to churn, for any sort of security issues to occur. And so by pushing that part of the process. Confirm against audio.] and doing more confirmatory diligence upfront before the final exclusivity stage, that just limits any potential bad news that can come out, and that's our goal at the end of the deal. When we do go into exclusivity, it's to sign an LOI and to close on those agreed-upon terms in the quickest period after.

[00:14:41] Mike Lyon: Great points.

Let's maybe flip over to preparation. So what can a founder do upfront and during the process to make sure they minimize the chances that there's a broken deal or busted deal at the end of the process?

[00:14:53] Scott Austin: Yeah. And we touched on this a little bit, obviously, when we discussed the quality of earnings. I mean, that's one particular way, with accounting diligence upfront, if there are particular concerns there. But having really clean financials, whether it's past audited numbers, whether you have a confident, truly certified accountant that's doing the books, you can populate a larger data room.

And it doesn't need to be through one of the formal VDR providers, but whether it's an internal Dropbox or Google Drive with all of the upfront legal diligence, financial diligence, customer-level contracts, various market work, or resources that you've done. And that's what your banker and what Vista Point would help you prep upfront, so that when we are going through the process and getting a lot of requests, we've already pre-done the work.

And not only doing the work upfront, but you can also start to understand where there are potential risks upfront, and we can work to mitigate those versus saving them as surprises later in the process.

[00:15:51] Mike Lyon: And then once you're live, maybe just talk about what separates founders who get through the diligence cleanly from maybe those who struggle, and that doesn't necessarily mean you don't get a deal closed, it just takes a lot longer, it's more arduous. What can a founder do during the process just to make sure they're on the getting-through-the-process-cleanly side?

[00:16:09] Scott Austin: Yeah. And again, time kills all deals, so it's much better to be performing a really streamlined, three-and-a-half, four-month process than a six, seven, eight-month process where it takes a lot of time to get data responses back to parties. So what we want to do once we've hit that marketing phase is be delivering the stages on monthly timelines.

So the key is that we are providing monthly updates as we're going through the process on financial customer-level information. If it takes us a week or two for a particular diligence request to get those answered, we are already kind of behind the ball, and you create risk and you lose momentum with certain buyers and investors in the process.

So what you ultimately want to make sure that you're doing is being able to answer things in a fastitious timeline. A key way to do that is by bringing other folks on your team into the process with you. A lot of founders that we talk to, obviously, it's a sensitive topic of selling your company. A lot of times they might want to do it with only themselves or their co-founders. But a lot of times expanding some of the data collection to, whether it's one person in the finance department, one person in the tech department or in HR, that can help dictate what specific diligence items need to get responded to at certain times and who's managing those internally.

So we oftentimes view internal deal teams in the three-to-five employee count perspective as being the sweet spot for who's clued in on the transaction.

[00:17:36] Mike Lyon: Yeah, just being expedient with the data and accurate. Anytime you give inaccurate data to anyone, they just start asking more questions. That's just human nature. That's how it works.

In today's episode, we explored where deals tend to break down and why, the most common issues that surface during diligence, and how good preparation can help position founders to move through the process with fewer surprises and more leverage, and hopefully avoid a broken deal or a retrade.

Scott, thanks for joining us on the podcast.

[00:18:04] Scott Austin: Thanks for having me. Look forward to the next one.