Today, I wanted to talk through common reasons why deals can die post-LOI. I've seen a number of deals die - both my own and those of others - so I have a fair amount of experience on the topic.
Key topics:
If you are short on time, I have highlighted key points to read.
First, I'd like to explain the difference between funded search and other investment styles to provide some context, which may help explain why some deals can die under one method but could work under another. I will go more into this later on in a more detailed post. Overall, however, the bar to get a funded search deal done is significantly higher than for self-funded deals, and also involves convincing ~15+ investors, which also explains why these deals sometimes do not pass the diligence phase.
This is all to say that the reasons why a deal dies may be different under each acquisition model, and that getting a funded search deal done is often very challenging. Funded search has much higher IRR target expectations, higher growth requirements, stronger metrics requirements, and many more stakeholders to please (i.e., investors) than in other models, and is often more challenging to get a deal done.
Therefore, for funded search, which is where I will focus, there are many reasons why a deal may die which may not be issues under another acquisition model.
1: EBITDA or revenue has been over-stated and deal no longer makes sense: Sometimes, the EBITDA or revenue presented prior to the LOI turns out to be over-stated or not accurate after further diligence. In these cases, the valuation may no longer make sense, and either valuation needs to be re-aligned, or the deal may need to be closed out if it doesn't make sense even with a lower valuation.
2: Growth is too slow to make sense: This is a particularly important point for funded search. To hit 35%+ IRR targets, a deal needs to be growing ~20%+ (if there is debt), or even more if there is no debt. In some cases, historical growth looked stronger than it is now, or there were non-recurring events that drove historical growth (e.g., historical one-time customer acquisitions, competitors shutting down, etc). If the growth thesis doesn't hold up, this will be a challenge.
3: Revenue is not as recurring as expected: Sometimes the % of recurring revenue is overstated, or revenue can be mis-categorized. If the % of recurring revenue turns out to be lower than expected, it means that there is a higher amount of new sale revenue that needs to be achieved each year, and that increases the risk of the deal.
4: Churn is higher than expected: Within funded search, retention targets for software companies are 95%+ NRR, 90%+ GRR, and 90%+ GLR at a minimum. If the churn is higher than expected (meaning retention is lower), then that also adds more risk to the deal or cause it to no longer make sense.
5: Lack of a clear exit opportunity: We need to believe that there is a clear potential exit path, either by a strategic or financial acquisition. If there is no way to exit, that will be a challenge.
6: Market challenges uncovered in diligence (e.g., market is too saturated, headwinds are too high, regulations are upcoming, industry is not as high-growth as expected, lack of acquisition targets, etc): This can be an underlying driver for all of the reasons listed above. If the market is declining or over-saturated, growth can be challenging. If there are very large competitors that are taking all of the market share, that also makes growth challenging. If there are potential upcoming regulations that could impact the product or service being offered, that is also a major risk. The market challenges often underlie many of the other growth and retention challenges listed above.
7: Price re-negotiation goes sideways after lower-than-expected financial results: Sometimes a price has been based off of expected year-end or quarter-end results, and the financials come out much lower than expected. As a buyer, you would either need to re-negotiate the price, or accept a higher multiple (challenging for investors and lenders to accept). If the seller won't work with you to reach a fair valuation in light of the new results, the deal can sometimes die.
8: Challenges with other seller negotiations later on: There are sometimes other challenges that come up during the deal process. For example, challenges when negotiating working capital, deferred revenue, non-competes, the purchase agreement, or other areas. Usually the deal is far along at this point, so both parties try to make it work, but there can be negotiation challenges that could derail the deal until the very end.
9: Seller changes their mind about selling and walks away: Sometimes a seller has signed an LOI, but is inherently uncertain about selling, and as the deal progresses, these thoughts may come to the forefront. They may have second thoughts about selling or retiring, their family may talk them out of it, or an unexpected life event may come up that causes them to want to hold off on a sale. All of these things can happen, which can cause a seller to walk away.
10: Tech DD or Quality of Earnings (QofE) comes back unfavorable: As the deal progresses, you will need to hire a third-party due diligence providers - tech and QofE. Sometimes these providers may uncover challenges that a) may be manageable but require a price or structure re-negotiation, or b) may be so big that they cannot be moved beyond. For example, if you are buying a software company and discover that the code base needs to be entirely re-written, the costs of which will be more than your purchase price and may take several years, this could be an issue big enough to cause you to walk away. The findings in these diligence steps are nuanced and will require you to make difficult decisions on whether you think this is a workable challenge or not.
11: Difficult to get investor buy-in: This is one of the most common challenges within funded search, and it often comes back to some of the points mentioned above. Often, investors are not supportive if some of the previously stated challenges are present that make it difficult to achieve a good outcome (e.g., growth is not as high as expected, EBITDA is too small, market is challenging, valuation is too high, there are major technical challenges, etc).
As a searcher, you may often agree with these points, but may weight them differently - e.g., if certain investors view an area as a high risk, but you believe it is manageable, then that is where the discrepancy may come from. If you truly believe that the deal has a path forward despite the challenges, then you can try to raise from investors outside of your cap table. However, you do want to make sure that you have some support on the deal before spending too much on diligence, so make sure to set stage-gates, or minimum commitments, before progressing too far. The conversations with investors may also give you valuable feedback that the valuation may be too high in light of certain challenges, and may lead you to have a valuation / structure discussion with the seller to try to make the deal more attractive.
One point to make: Investors are not as close to the deal as you and often have many deals under LOI simultaneously, and as a result, can be slow to make a decision. As a searcher, you can manage this timeline by communicating with investors prior to an LOI signature, sending out regular materials and updates about the deal, and giving decision deadlines to investors, so that you know where they stand.
12: An unexpected event happens (e.g., large customer drops off, company receives a lawsuit, etc): Sometimes, a large customer can drop off, a lawsuit can come up, or other unexpected events can happen. Depending on the magnitude of the issue, these can unfortunately cause a deal to die. If a large customer drops, much of the company's profitability may disappear and make the deal unattractive. A lawsuit with an unclear outcome can cloud the prospects of the company and also make it challenging to come in as the new owner. These things are not always predictable, but one should be ready for unexpected things to come up until the end, and be ready to make difficult decisions if needed.
13: Another buyer comes in with higher a offer, and seller pursues the deal after your exclusivity ends: Sometimes, a seller may receive another, higher offer that they like more than your offer (technically they are not supposed to be speaking with other buyers during exclusivity, but it can happen). They may drag the diligence on until your exclusivity ends, and then jump at the higher offer.
14: Searcher gets cold feet about moving to the location, or has other personal changes: A searcher can also face challenges. As they learn more about a company, they may realize that they don't actually see themselves running this type of company for ~5+ years, or may not see themselves moving to that particular location, and this may cause them to walk away as well. As one's search progresses, it is important to be aware of these personal preferences, and ideally identify these points before signing an LOI, as it will make the search more efficient to not sign LOIs with companies that there isn't interest in running.
Ultimately, there are many reasons why a deal may die. With proactive communication and a strong seller relationship, some of these can be overcome, but it is important to be aware of potential challenges and the multitude of things that can happen before your deal closes, and try to address potential deal-killers as early as possible.