The COVID-19 pandemic has created a lot of challenges in the dealmaking space. Deal activity all but halted in March, creating disruption and a great deal of uncertainty that’s challenged dealmakers. Difficulties in diligence, continued limitations on face-to-face interactions and seller hesitancy are all contributing to a slower deal pace.
Funding — the lifeblood of the startup world — has tended toward those with established relationships. While early stage companies that have already landed a few rounds may benefit from cautious investors placing their money on safer bets, that has left some entrepreneurs unable to connect with their first funders. Much like dealmaking in established companies, relationships and networking are critical aspects of growth in the startup world. And those aspects have been limited, as people aren’t gathering as readily as they had been previously.
Still, dealmakers are on the lookout for opportunities — whatever their stage or position — and with patience and perseverance, connections are being made. We talked with dealmakers, established strategic buyers, startups and more to understand where the M&A market is today, and what strategies its participants see as effective, even amid unprecedented market disruption.
Difficult to predict
There was a pause, generally, in new deal activity beginning in March, when the government-mandated shutdowns began, says Brett Motherwell, managing partner of Kassel Equity Group. While that pause disrupted deal activity, he expects it will create pent-up demand that will lead to upticks in deals through the last quarter of 2020 and the first quarter of 2021.
Some of that, he says, will come from business owners eager for an exit.
“I think a lot of folks — more so those in generational-oriented businesses that have gone through the dot-com cycle and then the 2008-2010 mortgage crisis — are seeing this and saying, ‘Hey, you know what? I’ve been able to make some money and I don’t want to experience this ever again, so I’m just going to sell and be done,” Motherwell says.
There may be more willingness to sell on the part of some owners as the year progresses, but a diligence process complicated by uncertainty has made transacting more of a challenge.
Girish Gowda, managing director of SteepGraph Corp., says that when he does acquisitions, the focus is typically on anticipated projections — what is the target’s likely revenue for the next three to five years. But that’s difficult to forecast now.
“That traditional measure that we used to use has been turned upside down because it’s very difficult to predict right now,” Gowda says.
He says a target company may look attractive, with a nice portfolio or a technical competency that could be complementary, “but the problem today is their revenue — they can’t predict it because the founders or the owners of the company feel that, ‘Oh, this is not the time for me. I can’t give a right prediction. So, I may not get the right price.’”
A business that is struggling may be doing so not because of some flaw in its approach but rather because the industry it’s in has been negatively affected by the virus. There may be no structural issue with the company, it’s just not, for example, getting the orders it once had. Gowda says on one hand, there’s the expectation that an industry will bounce back once the virus isn’t a factor, but how long should a company wait to make an acquisition? And what’s the risk of letting a good acquisition go and missing out on the opportunity to onboard a valuable asset?
“This is the problem that we are in,” Gowda says. “The uncertainty has thrown all of the traditional equations into the wind right now.”
Shift in priorities
Carlton D. Dean III, president of Demarrt Building Services – ServiceMaster by Demarrt, says prior to the pandemic, he hadn’t been looking to acquire companies that were heavily automated, preferring physical assets instead. He recalls looking at a potential acquisition about a year ago that had employees who were located across the country and all worked from home.
“At the time, we didn’t like the acquisition because we felt we couldn’t have control,” Dean says. “You had people that we couldn’t physically see them, people that are in Atlanta, Virginia, Texas, all over the place. The company made sense. It had been around long enough, making good EBITDA, but the fact that we tangibly couldn’t see the people, talk to the people, build a relationship with the individuals, we decided to shy away from that deal. Looking back now, that kind of deal would be a sweetheart deal for us right now.”
The pandemic, then, has encouraged Dean to look at acquisitions where more processes are automated, where the underlying IT infrastructure is good, and people are set up to work remotely with laptops and access to enterprise software.
“Now we’re looking at, not necessarily the business itself, but the infrastructure of the business,” Dean says. “Those are the questions that we’re really asking now.”
The terms and conditions of deals are also expected to be impacted by the pandemic. Motherwell says there have been some changes from pricing to more structure being put into deals in the form of earn outs, carried equity or additional seller financing. Another consideration he expects to continue in the near term is, if a company received PPP money, how does that affect its existing bank covenants? If one was tripped, that could cause problems for both buyer and seller later.
So now, when exploring the purchase of a company, there’s a tendency to be more thorough, to look at its 13-week cash flow rather than — or perhaps in addition to — its monthly or quarterly cash flow. Also, Motherwell says it’s helpful to look at billings and collections, and the state of potential jobs, looking for work that might have been put on hold by customers.
“It’s really taking a very micro look at what happened throughout this 100-some-odd day look back, then what does it look like going forward,” he says. “What indicators seem to be standard and steady, and what indicators are fluctuating. Looking through all of that, you should be able to develop an idea of where things are going to go.”
Startups in this environment are also feeling the effects of the pandemic. Mike McCann, SVP and corporate partner at Rev1 Ventures, says it’s a challenging funding environment for startups, but he continues to see companies raise capital.
He says there were fewer deals in the first half of 2020 than he saw in the first half of 2019, but deals continue to get done. Toward the end of the second quarter, he saw numbers that looked a little bit closer to what they were in 2019. However, the characteristics of funding have changed somewhat.
“Funds tend, in times like this, to spend a little bit more time in follow-on investments versus new investments. There’s a little bit of rebalancing of the portfolio, so to speak,” McCann says.
That tendency of funders to concentrate on current investments is reflected in Prescribe FIT’s situation. Brock Leonti, the company’s CEO, says he’s planning to talk to his seed round and strategic round investors, but will also look to add investors, whether they’re VCs, family offices or strategics. He says the company’s funding strategy heading into 2020 is still intact — it will be opening the round in the next couple of months — but the amount of funds they’re looking for has increased.
“Just not knowing where the economy is going to go and where things are going to land, we’re going to fundraise for a little bit longer, so, maybe looking from 12 months to 18 months,” Leonti says. “That’s just to make sure that, a year and a half down the road, we know that we’re protected, as far as funds are concerned, for us to get what I would deem as through the growth phase and into that next phase of our company.”
Despite a market challenged by COVID, there are bright spots, ways dealmakers have found to navigate the uncertainty to complete deals or capture the funding necessary to allow the green shoots to continue to grow. And, according to Michael Jordan, managing partner at Ice Miller LLP, there’s reason to believe there’s confidence that the M&A market will bounce back and be as strong as ever.
He says alternative investments from institutional investors in funds with private equity are strong and have been strong, and there are no conversations that he’s having so far that suggest that there’s any doubt about the continued strength of that investment. As longer-term investors, he said his company would need to see a much longer stretch of poorer-than-expected performance before conversations about putting dollars elsewhere would begin.
“The investor side serves as a bit of a preview of what’s to come because these investment managers are not going to take hundreds of millions, if not billions of dollars, of institutional investor capital and deploy it if they didn’t think they were going to be able to deploy it within the three-year or five-year commitment horizon,” says Jordan. “So, I think that bodes well. As long as the money is going in on the front end, from an M&A perspective, there’s a higher level of confidence it’s going to get put to work and invested in an M&A transaction.”