M&A Monday: The Doom Scenario
And How to Avoid It
When I represent a client buying a business there is one thing that keeps me and the buyer up at night. The true nightmare scenario when after closing the business takes a steep decline below debt service coverage: This is The Doom Scenario.
All businesses have ups and downs and some amount of drop-off after closing due to transition challenges is normal and expected. There will be challenges not discovered until after closing and those will be handled by a competent buyer.
In the Dozens of transactions I have closed only a few have had real detrimental post-closing issues. In each case, there were red flags that indicated The Doom Scenario, but the buyer persisted in closing.
Examples of The Doom Scenario: (i) key customers leave after closing, (ii) key employees leave after closing (iii) product is no longer competitive in the market, (iv) financial misrepresentation or accounting error, (v) major legacy liabilities, or (vi) costs are much higher than expected.
In this M&A Monday I will review the points in a deal red flags are discovered and the single factor I found correlated with The Doom Scenario.
There are three points in a transaction, red flags are discovered. Each can lead to The Doom Scenario:
1. Seller voluntarily discloses the flags in the LOI or diligence process. This is the best case and is usually indicative of nothing more than what has been disclosed. Usually, after getting comfortable or putting in place legal protections for this issue, the buyer can feel comfortable proceeding with the deal.
2. Buyer’s lawyer, QoE provider, or banker discovers the red flags. This is better than not discovering, but worse than a voluntary disclosure. Problematically, Buyer’s diligence relies (in most part) on seller’s honesty and disclosure (that is why M&A differs from real estate). Thus, usually a red flag is not discovered until after closing (see #3). Even more problematically, there are only two reasons buyer’s team were the ones to discover the red flag and neither is good: (a) Seller actively concealed the issue or (b) Seller did not have the processes to realize there was a material issue with their business. Both reasons indicate potential issues beyond what was discovered. Buyer should proceed with extreme caution.
3. Buyer discovers the red flag after Closing. Either because of #1 or #2, the Buyer did not discover a material issue until after closing. Now, the buyer better hope that they have strong enough representations, warranties, and indemnities with enough of a promissory note or escrow to go after the seller for those losses (Here is a deep dive into representations, warranties, and indemnifications: HERE).
Before I tell you the sole factor correlated with The Doom Scenario. Here are ways to find red flags prior to closing:
1. Have good advisors. Legal, and Quality of Earnings find many issues, and even good bankers flag issues.
2. Make sure seller has skin in the game after closing. Seller must know that it is in their interest to disclose prior to closing because it will be costly if they don’t. This can be done through rollover equity, significant seller note, or indemnification escrow/holdback.
3. Pull on strings in your diligence. Ask lots of questions. If something does not seem right, follow that thread. Ask about everything and if seller is holding back, ask yourself why.
4. Follow your gut. This may be the most important factor. Every buyer in The Doom Scenario will tell you that the transaction didn’t feel right, but they pushed forward for one reason or another. Don’t. If it does not feel right and seller is not being forthcoming, it is probably not going to end well.
Finally, the factor most indicative of The Doom Scenario is seller dishonesty. This comes in many forms from withholding key information to providing inaccurate information. If you find out a seller has not been honest, run. The small fracture you see is indicative of a deep and pervasive rot. Run.
The Doom Scenario is rare, but catastrophic. Save this post and know how to avoid it.
