The current economic environment makes it a prime time for mergers and acquisitions.
Activity in M&A in recent years bears it out. Total global M&A transactions for 2017 hit $3.2 trillion, the third year in a row annual M&A crested $3 trillion.
So, if you’re considering selling your business, whether you’re an owner/founder, shareholder or investor, or in venture capital, now is the time to put the company on the market.
There are several factors at play here – and several types of players involved in the majority of this activity. One thing is for certain. For most deals, having Representations and Warranty (R&W) insurance in place to cover the transaction has definite benefits because it transfers risk away from Buyer and Seller to a third party. As you’ll discover, it’s a liquidity tool. More on that in a moment.
The Right Economic Conditions
The main factors in record-breaking M&A activity in the last three years are…
- The post-recession economy. In a good economy, sales are up, profits are up, and costs are down. Companies have cash on hand.
- Corporations have more in available cash thanks to the change in the tax code.
Cash is worth… cash. But if you invest $100 million, in say an up-and-coming tech company, that investment could grow to $500 to $700 million in a few years. So, companies are eager to deploy cash.
- Fewer companies are going public. That has shifted focus to an alternative market where private equity and venture capital are looking to put their money to work buying companies rather than into the stock market. This is especially true of tech companies and those with valuable intellectual property.
This confluence of circumstances won’t be going away for the foreseeable future. As market watchers say, there’s a lot of dry powder (cash on hand in private equity and corporations) out there. According to a recent report from alternative assets data firm Preqin, there is $600 billion in private-equity money alone.
But in many ways, this trend has stayed under the radar. Perceptions of M&A activity are skewed because most business publications won’t report on a M&A transaction unless it hits $1 billion or more.
So, Disney’s bid of $71.3 billion for Fox is all over the press. But you won’t hear about the “mom-and-pop” company that sells for $130 million, with the owners splitting the proceeds right down the middle.
Types of M&A Players Out There Today
We’ve talked about companies acquiring other companies to secure intellectual property, talent, assets, customers and market share. That’s what they need to grow. Growth through acquisition is much faster than organic growth. Think Amazon buying Whole Foods to fast-track their entry into the high-end grocery market.
Another main group involved in M&A today are individual venture capital investors. They’re looking for returns. If things go right, the objective is to invest in a company and it either goes public (and they’re in on the ground floor)… or the company grows by 30% to 40% per year.
In the best-case scenario, they invest in a “unicorn” – a company that grows to $1 billion or more. That kind of growth requires a lot of capital; $100 to $200 million. It’s like an Uber. But that’s pretty rare.
In many cases, the VCs have been very patient. The company won’t go public; it’s not a unicorn. It’s a good investment, but not great. Now they’re looking for an exit so they can have cash on hand to invest in something with the potential to be great.
Smaller investors might put in, say, $1 million in a company that grows 4% to 5% a year. It’s profitable. But after six or seven years, the shareholders are wondering where their return is. The only way to get liquidity is when the company is sold.
Both types of investors – small and VCs – want a clean exit. There is a risk when selling a company and if there is an indemnity claim, some of the proceeds of the sale will be clawed back. Also, they’d rather have all the cash from the sale rather than have a significant percentage held in escrow for a year to 18 months. The largest shareholder is on the hook if something happens.
They want to use the money for a new investment.
That’s where R&W insurance comes in.
With this coverage, you transfer the liability in the event of a breach of the Seller Representation to an insurance company (and it’s very straightforward for the Buyer to file a claim). R&W insurance takes the indemnity obligation away from the Seller.
This insurance also smooths negotiations between Buyer and Seller and ensures a good relationship is maintained post-transaction.
If a Seller is willing to pay for this coverage, it reduces resistance from the Buyer. And Sellers are all too happy to pay for these policies. For a $100 million deal, it’ll mean they walk out of closing with $99 million rather $90 million, with no risk of any of it being clawed back.
All this for a very low cost. The premiums are between 2.5% and 3.5% of the limits purchased. (Example: a $20M Limit policy runs between $500K and $700K)
In my experience, some VCs haven’t heard of R&W insurance. But once I explain the scenario above, they’re sold. And with the transactions covered ranging from $20 million to $1.5 billion, many deals can take advantage of these benefits.
The last group driving M&A transactions in recent years are large venture capital funds. Unlike standard VCs, which are individual investors, they have deep pockets… $1 billion or more to invest.
These funds, including one of the largest, Summit, have ownership stakes in dozens to hundreds of companies. They’re so busy they don’t even attend board meetings for many of the companies they invest in.
They’re not necessarily the majority shareholder; they usually own something like 30% of the company.
Again, what moves the needle for them are IPOs or a unicorn. The trend now is that these funds are starting to look at their portfolio and spinning off the assets without unicorn potential. They want to get their money out and use it elsewhere.
The Sell Side
Let’s meet a typical Seller: owners and founders. They’re ready for retirement after a long career working 12-hour days in a company that’s been their passion. They say the reason most small and medium-sized businesses sell is usually one of the four Ds: death, divorce, disability, and departing.
These owners generally have majority ownership, little to no debt, and a profitable operation. But it just won’t grow. It certainly won’t go IPO. It’s more like a job for these folks. To get their money out and be able to retire, they have to sell. That does make them very motivated Sellers.
They’re also very attracted to R&W insurance because they want to walk away completely from the business, without worrying about a significant portion of funds held in escrow.
Take one husband and wife team I encountered who owned a SaaS company. They were in their 60s, ready to enjoy life after a cancer scare. They had no debt. They owned the company 100%. So, with R&W they got the majority of their $80 million sale price right away. In fact, they were able to give key employees $1 million each as well.
More Reasons M&A Activity Will Stay Strong
With current economic conditions and what market watchers see on the horizon, the ongoing “boom” in M&A transactions won’t be slowing down anytime soon.
But individual VCs, venture capital funds, and big companies aren’t the only players in the game. And the changes in the tax code and the boost in cash on hand thanks to the growing economy aren’t the only factors driving this trend.
You can download a free checklist to explore why M&A activity has exploded here: The 13 Factors Contributing to the M&A Boom.
It could help you determine whether now is the time for you to engage in your merger or acquisition.