Show Me the Money
"Many things are lost for want of asking."
Iconixx Corporation founder Stu Johnson had met Tony Forst-mann when Forstmann came to Johnson's offices to discuss Bell Atlantic's interactive video operation. They became friends, and Forstmann said he'd like to find a company to pursue together if Johnson ever left Bell Atlantic. When Johnson was looking at buying out the Bell Atlantic network integration business he had built, he looked up Tony and met with his brother Nick, the cofounder of the legendary buyout firm Forstmann Little & Co. At his first meeting, Nick Forstmann wanted to discuss the management deal. Johnson put him off, saying he wanted to find out whether he could put the deal together with Bell Atlantic first. He was actually just stalling. He had never done a deal of this type before and had no idea what to ask for.
"I said, let's see if we can put together a deal first," Johnson recalled. "I was just treading water because I didn't know enough about it." He learned quickly.
Thus began Johnson's education in the buyout world. Bell Atlantic ultimately decided it didn't want to go through with the deal, but Johnson learned a tremendous amount about working with buyout partners. Several years and a dozen potential equity partners later, he probably knew as much about the buyout business as most prospective investors. He and his partners had talked to a wide range of equity partners. Johnson had progressed pretty far in putting together term sheets with some of them. At this point, he knew what kind of investor he was looking for and under what kind of terms.
This chapter will provide you with a head start in your first meeting with buyout investors. It offers an overview of buyout firms and examines the kinds of deals you need to strike with them. We also explore some of the key documents needed for those deals. Finally, we look at diverse aspects of bank financing. You will still learn much more from your own direct experience than from reading about the process, but this overview can help you make better deals and hit the ground running.
What were the primary lessons about working with equity partners from Johnson's perspective? He identified several key insights:
• Experience pays. As with any skill, you get better with practice. Johnson knew a lot more about the investment business by the time he reached his tenth firm than when he started. He knew what partners wanted, what the best terms might be, and how he could most favorably position the deal. He learned this partly through conscious effort and partly through long-suffering experience. "By the time we put together the deal, we knew what they were looking for and how we were perceived by investors," he said. "If you don't talk to at least two potential partners, and ideally at least a half dozen, you are doing yourself a disservice." Buyout firms differ greatly in their goals and operations, and you will learn things about them and about the industry that you can only learn through experience. Many firms focus on specialized industry groups and most only pursue deals in a certain size range that is normally dictated by the size of the fund they manage. You should understand the quirks and special interests of each of the firms well before you approach them. You can find out a lot by getting recommendations from your own networks. Then you can ask for information from the firms or go to their Web sites to assess whether there is a good match with your deal and objectives. Some firms will say they will only work with you on an exclusive basis. Unless they are already your last resort, there are usually enough others around that you should walk away from these deals. If they were good partners, they wouldn't want to handcuff you to the furniture at the outset. As with all deals, it is critical to have several irons in the fire so you're not relying on one party.
• The more you bring to the table, the more you take away. Prospective investors are concerned about all levels of risk involved in pursuing transactions. Their time and money are extremely valuable, so they are constantly assessing your deal against the backdrop of thirty other deals they're pursuing. Can this team get it done? Does the deal yield the necessary return? Is there a real seller here? Can we finance the deal? Do we want to be in this industry? When and where can we exit? The more risk, the harder it will be to sell the deal to investors and the worse terms management will receive. And the converse is also true: If you tee up a sweetheart deal for the buyout firm and you've already got a credible, signed letter of intent (LOI) at five times EBITDA ready to go, you've just created huge value for them and should be asking for 25-35 percent rather than the customary 15 percent. When Johnson found investors were concerned about the integration risks of joining together fifteen companies, he reduced his target to just three core companies. By putting together an outstanding management team and a solid strategy, he was able to add significantly to the attractiveness of the deal. "Try to do as much of their work for them as you can," he said. "Look at the competitive landscape and tie down the strategy." On the other hand, the price of this preparation was that Johnson and his partner Bill Albright had put up more than $30,000 of their own capital for the initial research and start-up. At the point they needed to hire young managers, Johnson wanted to ensure that they could cover salaries and expenses for fifteen months to get the business going, so he needed to come up with an additional $3 million of seed capital, which he ultimately sourced from a Virginia-based venture capital firm.
• Understand the competition. Equity firms see many deals, but managers often act as if theirs is the only one. "You think you are the only deal these guys see because you live with it day and night," Johnson said. "There is another bus along every fifteen minutes. You have no appreciation for the deal flow and the work that is involved in analyzing the deal flow." The strategy for the business needs to be well reasoned and clearly presented.
• Understand your leverage. Johnson was surprised at how valuable his own experience and his team actually was. He remembered one investor who commented that he never lost money on technology or on betting on the long-term in the market. The investor only lost money betting on the wrong management. "I started to see I had more leverage than I thought I had," Johnson said. "The strength of the management team casts a larger shadow than even I thought it would."
• Understand your worth. When another equity partner told Johnson they never did a deal above 15 percent, Johnson countered: "You have never done something with a company this far along. I've done most of the work that you perceive as risk and it is ready." Johnson had a good strategy that was executable. There was no market risk, no technology risk. There was only execution risk, and they had a great team. The buyout partner settled on a term sheet at 22 percent.
• Know what you are looking for. Find an investment partner with a compatible philosophy and probe to understand the philosophy. Johnson once came close to signing with an equity firm that initially talked like a long-term strategic investor. Weeks later, they started discussing cashing out in six to nine months. "I had to hear that their philosophy was to build a strong operating company," Johnson said, "and there wasn't a gun to my head to get this company into the public markets." Johnson passed on the churn-and-burn partner in favor of a longer-term investor.