Structuring for Uncertainty - Legal Trends in Middle-Market M&A - Pt. 2

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Speaker B: Hello everybody. Thanks for rejoining us for episode two of our discussion with Bruce Fenton on, um, structuring for uncertainty, legal trends and middle market M and A. Uh, look forward to continuing our discussion. Bruce, thanks again for joining us on the capital table.

Speaker C: Thanks Steve, for having me. I'm delighted to be back.

Speaker B: What are some of the other risks that you're. Obviously we're all seeing, but from your standpoint, the couple really important risks that uh, need to be accomplished or dealt with. Probably better choice of words, when you're uh, structuring for uncertainty in these times.

Speaker C: Well, the. There, there, there, there are really two aspects of that. The first aspect of that is, um, it's something that, that you do every day of, of of your professional career. Going in and uh, uh, trying to determine whether the valuation that the seller, uh, has in mind, uh, kind of intersects with the expectations of value that the buyer has. And ultimately, um, all of these techniques that we have been and will talk about, uh, come off of that. And an example I give, um, to clients, it's very simplistic, but it illustrates the point is, I'll say to a client, look, um, valuation, uh, risk is just a function of valuation. Uh, if I said you could, if I could get you this business on the buy side for a dollar, would you buy the business? Absolutely. And the second is the response. Okay, but there are all these problems we just talked about. Ah, the business has. Very few businesses are quote, clean and no business is perfect. So we've just identified all of these concerns. Yeah, but Bruce, for a dollar, Are you kidding me? I buy that every day of the week and twice on Sundays. Okay, what you're saying then is that risk is a function of price and therefore value. So it's that discrepancy in value expectation that creates, uh, speed bumps in getting deals done and creates the need for not only the opportunity for, uh, creative deal people like you, and hopefully people think me and others, um, to add value there, but actually the necessity, uh, to do that and those kinds of techniques. The principal one is an earnout. Um, but, um, there's a tried and true, uh, technique in private equity. Again, not typically used in Strategic, strategic deals, uh, something called rollover where the seller keeps a portion of their equity in the business, uh post the transaction. So not only becomes an operator for the private equity group, but is a co owner with the private equity group in order to align uh, their interests more closely. The amount of rollover is uh a technique that can be used to um, deal with a valuation um imbalance, uh as can uh a purchase price note, um from the seller, uh in order to bridge that gap. So there are a number of what we would say are um, typical uh customary techniques. But they start to pull in the same kind of a Steve relationship issues that we were just talking about. The more uncertainty you have going forward post closing in a transaction, the more opportunity there is for a buyer and a seller to disagree, particularly when there's a lot of money involved. So when you look at, you go in and you look at uh a seller, uh, you do their quality of earnings, you try to create um, a frame of reference for a buyer to determine valuation. Uh, that in and of itself is a critical risk management technique that buyers have in order to get that outside uh, assurance that outside view that their valuation, um metrics, their foundational principles are actually accurate and that they're on the right path. But once you get beyond that and you start getting into more gray area whether it's because of operational questions or potential tariff uncertainty or again ah, and it's interesting because uh, there's been a move in private equity to uh, more tariff certain businesses. So for example US Based services businesses, one could say have, have no tariff exposure except to the extent they're there. And I'm not saying private equity missed this, they're very aware of it. But it illustrates the complexity of the inquiry that you've got to. If the U S based service business is providing services to businesses that have tariff exposure, the portfolio company itself may not have tariff exposure. But if all the people who are paying you, all your AR is created by people who have tariff exposure, if that, that exposure goes sideways, your AR is not so good anymore. So yeah, there are layers upon layers of this.

Speaker B: The whole tariff issue. I mean whether it's uh, even manufacturers that feel they're shielded because you know they're not importing product, but if they're buying from a supplier in Nebraska that's importing components, they are exposed to it and certainly.

Speaker C: Exactly right.

Speaker B: Operations team is seeing uh, you know, a lot of activity around tariffs. And frankly, you know, for the audience a number of instances were people have been overpaying significantly by not understanding this, but not to go down the tariff uh, rabbit hole bringing us back I think to just the uncertainty. And you mentioned earnouts and other types of structures like seller notes. I guess. One comment I want to make for the audience. I know that we get involved oftentimes of doing the Q of E as you said and then you get to the agreement know again we're talking about structuring for uncertainty that the more clarity you can bring into the mechanisms that will define an earn out. And speaking from the accounting side, a lot of times those terms are in our opinion too vague that uh, allows interpretation down the road when people are not on the same side of the table. They're you know, they're on opposite sides of the table. So my comment where I'm leading to that really I think this whole discussion for our audience points to having legal advisors like Bruce and his firm that are experienced and have seen these and accounting advisors and risk management, uh, firms also that are in the M and A world because uh, things happen down the road and it's not always uh, as rosy as the day you close the deal.

Speaker C: Um, well that's exactly right Steven. And in fact I would kick it right back to you and your colleagues because ah, the whole idea of an earn out is um, we will pay for future performance. And you are 100% correct. Uh, the critical question that always comes up is uh, who's in charge of directing the portfolio company's performance post closing in order to um, either be able to drive that portfolio company towards on the one end maximizing the earn out and on the other end minimizing the earnout. And there are many uh, issues that come up in that regard. But at the same time burnouts are inherently uh, mathematical formulas. If you uh, achieve X, you will receive Y. And those formulas are either based on the work that you initially did in your Q of E and your updates or uh, even if there for whatever reason it's not an earnings um, uh issue. It's um, more of a um, milestone issue or whatever it is. Um, so there are small exceptions to that. But at the end of the day the achievement of these earnouts is going to come back to the accounting rules and the financial statements that show the result. It's like the purchase price adjustment. It's like compliance with the uh, covenants in the credit agreement. All of those are going to come back to the financial statements and, and therefore as a result of that, as critically important as it is to have the lawyers involved, all the financial terms all the math, all the formulas have to be vetted by the accountants and the tax advisor in order to make sure that we're taking apples to apples and that the client knows what the client's getting.

Speaker B: Absolutely. Yeah. And so we're certainly um, seeing that from the same perspective again, having both of us having done this while we've seen what can happen if there isn't that clarity and things uh, go sideways down the road. So uh, final thoughts, Bruce, on uh, big trends for this year or just what's been happening in the market as we deal with uncertainty?

Speaker C: It's uh, it's never boring. Uh, it's uh, uh, always interesting. Uh, there have been a couple of uh, large bulge bracket banks who have predicted that 2026 will be the largest year for M. Um and A in history, including the iconic year of 2021. Uh, but um, frankly I think a lot of that is, is um, based on upper market projections, not middle market projections. I think next year will continue to be choppy, um, as, as we get. If we get more clarity on um, Ukraine, on uh, tariffs, on political uncertainty, um, things may dramatically pick up. Uh, but even if we don't, the robustness and the um, uh, kind of grit that the middle market has the ability to be creative and flexible, uh, the ability to uh, kind of push your way through and get deals done will continue to mean, uh, I think you and I are going to be busy, uh, and uh, I think we will continue to get deals done. Uh, the question of how much these risk mitigation techniques need to be used is really a macro question. And then we'll have to be as flexible as the middle market is in answering those.

Speaker B: Absolutely agree. And certainly as we look forward into 2026, I guess from my view, I'd like to say if we're back to normal, of course I really don't know what normal means anymore, uh, in this market and the geopolitical environment we're in. But um, I think we all see that confidence. I agree there will be some choppiness to the market. It's not going to be smooth sailing, it's not going to be normal. But uh, the activity should be back. I think we all thought that a year ago and then Liberation Day happened. So dealmakers have to get deals done and capital that's out there needs to be deployed and private equity needs to exit a number of portfolio companies uh, that have been in the portfolios too long. So looking forward to working uh, on a lot of good transactions this year. So hopefully we will be there.

Speaker C: Absolutely.

Speaker B: Thanks again Bruce for your insights over these two part, uh, episodes that we discussed the legal trends in middle Market M and a great insights uh, to our audience. Thanks for joining us. This concludes our little mini series here and certainly appreciate everyone listening in and we'll catch you next time on the Capitol Table.

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