Breakdown of a deal gone bad

Note: This is a real story, but for legal and personal reasons, I’m not saying what website I sold or to whom I sold it. This isn’t a takedown piece. If you know me or read this blog, you know that when things bother me, I like to describe the problem and share the details. The aftermath of this transaction bothered me — a lot — so I’m writing about it to help me process it and move on. This is my catharsis; talking trash about these guys and their firm would only make matters worse. So I’m not doing that.

For entrepreneurs, especially the bootstrapped variety, the moment of exit is a mix of nostalgia and jubilation. You can’t help but wonder what might have been if you’d only held on, but you also experience that wondrous relief of having a windfall of hundreds of thousands (or, more rarely, millions) of dollars suddenly hit your bank account.

Sometimes exits can be awful, but you usually know it’s coming well in advance. You’re already piloting the plane, the engines are already on fire, you’re already losing altitude fast, and the control tower (a.k.a. your board) tells you to figure it your damn self. You’ve given your passengers (a.k.a. employees) all of your parachutes and although it was uncomfortable and awkward, you pushed them off the plane before impact (a.k.a. laid them off.) Now it’s just you and your co-pilot (a.k.a. co-founder) and maybe a flight attendant or two (a.k.a. senior staff) still with you as the forest canopy starts scraping the bottom of your plane. And then you impact.

But I’m not talking about those kinds of exits. Here’s a different kind, one I didn’t even know existed.

I wasn’t planning to sell my side business, but when Xenon Partners asked me to head up MightySignal in October 2018, I couldn’t help exploring the option.

I interviewed Jonathan Siegel, Xenon’s founder, in my book, The Parallel Entrepreneur, so he knew about my penchant for side projects. He’d also offered to purchase one of mine in 2016, which was how we first met. That initial connection led to Xenon acquiring Scripted in 2017. Nearly two years later, I was back in conversations with him about MightySignal, another acquisition he was making.

Jonathan and I were in my car is San Francisco after a long day doing technical diligence on MightySignal when he offered me the CEO job. “What about my other business?” I asked. “I assume you don’t want me to keep running it.”

He confirmed my assumption and suggested that MightySignal could buy my business, and a few minutes later and we agreed to terms that we both thought were fair based on its current monthly revenue. A few days later I agreed to take the CEO job and part ways with my side business, and we immediately dove into MightySignal, transitioning the technology, sales and marketing processes, and all the HR and other logistics you deal with while taking over a live business.

Time moved quickly, and one night a few weeks later, my wife and I were talking about my compensation incentives at MightySignal and it occurred to us that it would be significantly better for me if I sold my business to a third party rather than to MightySignal. Since I’m incentivized to accumulate MightySignal’s cash, if I could avoid spending it on acquiring my side business, I’d be able to reach my incentive bonus faster. I hadn’t considered that option — again, a lot was going on — so the following day I sent a few emails around to people who had nibbled at my business previously.

Within a few days I’d opened up a diligence process with three potential acquirers. One of them was more serious and moved faster than the others. We quickly started drafting a letter of intent (LOI).

My business was not in pristine condition. There was high revenue concentration; one customer made up between 50 and 70% of revenue monthly revenue, depending on how much usage I billed for. I also discovered that my move to metered billing was a mistake: while it worked fine for me, acquirers were confused by the lower subscription fees. That was an unintended side effect of the billing change. Finally, to cap things off, revenue was flat.

This all added up to a low multiple. I was expecting to land on a valuation somewhere between 1-2X annual revenue, and since Jonathan agreed to that range, I made that same ask upfront to my acquirers. The acquirer I went with had the valuation I wanted with a few caveats:

  • Compensation would be 53% upfront and the rest would be paid out in 10 equal monthly installments so long as these conditions were met:
    • Specified major customer paid > $X, OR
    • All other customers paid > $Y

I agreed to this because I thought it was fair. If my whale customer went belly up, we’d have to rely on the other customers to compensate. This incentivized me to be on the acquirer’s team, helping them meet this revenue target because I’d get paid and they’d get a more valuable asset.

Our goals were aligned, so I was fine with it. If they win, I win. If the major customer churned (and I didn’t think they would) and I’d kept the business myself (or with MightySignal) then I’d be either screwed or in an awkward position with Xenon. I didn’t want that outcome, so the LOI terms seemed fair. The risks — and rewards — were shared.

In retrospect, this turned out to be big learning #1: Always keep your business in a great position to sell.

Lesson 1: Be ready to sell your business at any time

Here I can can accept some responsibility. My business was not in a great position to sell. Revenue was flat leading up to this negotiation. It also had high revenue concentration. This was known, upfront, by all parties. They knew this as well as I did; they had full access to all payment histories and this revenue concentration issue was discussed at great length, to the point where the deal almost fell apart. However, we eventually found common ground and executed the LOI and Asset Purchase Agreement (APA). It was a done deal. Or so I thought.

Acquirers of business-to-business (B2B) software-as-a-service (SaaS) businesses have certain expectations. Generally speaking, these are:

  • The business has high (> 80%) gross margins (net profit divided by revenue). This was true for my business. Like a typical online software product, my server and data costs were less than 20% of revenues.
  • The business is growing every month (> 2% month-over-month growth). At this point in its revenue trajectory ($15-20K/mo), my business’s new revenue acquisition (new subscriptions) was entirely offset by its churn (cancellations). When the new revenue ($1-2K per month) equals the churn ($1-2K per month) then growth stalls. Sometimes it might drop if a big customer leaves. Unfortunately, this was the case with my business at the time of sale.
  • The business has a lot of customers which distribute the revenue impact of any single churn. As stated, at the time of sale, I had one customer that made up a majority of revenue. This is not a healthy situation, and if I had more time to prepare to sell, I would have worked harder to get at least one more major customer like the one we ended up calling out in the deal terms.
  • Average sale price (ASP) is increasing over time. Increasing ASP indicates that value is being added to the product. If new customers are paying more than older customers, then there’s good product-market fit, positive market conditions, or both. In my case, ASP was also flat. I wasn’t able to find a way to get new customers to pay more, either by raising prices or by adding new paid features.

But, like I said, these were known, fully transparent faults. It’s why the valuation was what it was, just slightly over its trailing 12 month revenue. If everything about the business was attractive, the market valuation would have been a multiple (usually 2-4X) of trailing 12 month revenue. Better metrics would have provided hundreds of thousands of dollars of more value to me. But they weren’t there, so I didn’t get that valuation.

The business issues were also why I couldn’t get full payment upfront. There was risk to the acquirer, and I was forced to share it by agreeing to the lower upfront payment and contingent future payments. If my business were healthy then the buyers would not have required these conditions.

Nonetheless, we closed the deal. We signed the APA on November 25, 2018. I handed over the keys to my little kingdom: full access to my Heroku app, Stripe keys, and domain. I joined a Slack channel to help their developers take over the (minimal) day-to-day maintenance of the app. I wrote a bunch of documentation and answered all of their questions. Since our incentives were aligned, I was as helpful as I could possibly be. I thought I had a good relationship with their developers and the principals I worked with. I responded to every email and Slack message within 24 hours. I was the ideal acquiree.

Looking back, I don’t see how I could have done any better. When they migrated the entire app off of Heroku and onto Elastic Beanstalk, a competitive service by Amazon Web Services, a critical service silently went down. I noticed and told them, even though at this point, per our APA, my job was done. They told me they appreciated the heads up. I was happy to do it, again, because our incentives were aligned.

I was surprised, therefore, when I received an email from them less than two months after our deal closed and the 53% lump sum was paid. They wanted to talk on the phone, and when we got on the phone, they asked to change the payment terms. At first I was understanding, even supportive, trying to accommodate their requests, because (if you haven’t figured out this pattern), our incentives were aligned.

But I let their ask sit for a day, and it soured on me. They asked me to accept a change that would peg all of my future payouts on my one big customer. I asked a few of my trusted advisors and they verified what my gut was telling me: this was bad behavior on their part and I had no reason to make myself worse off at this point. We had a signed deal. They needed to work within the confines of the deal we agreed to. They could ask me to change terms, sure, but I didn’t need to accept.

Indeed, this is not supposed to happen. Payment terms are not supposed to be up for negotiation after a deal is signed. It’s bad form, shows poor etiquette, bad faith, and in the community of B2B buyers and sellers, it’s just straight up unethical. You don’t put a business partner in that position, and if that partner pushes back, you don’t keep pressing. Or so I thought.

I declined. I told them that since I was no longer running the business, it was not fair of them to ask me to take on a new level of risk. They could accidentally take the site down, or intentionally raise prices or introduce some other change that could drive this customer away. I would have no say in the matter, and that change could strip me of nearly $100K in future payouts. A rationale actor would not take this deal. If the tables were turned, they wouldn’t take this deal. That’s what I told them, and that’s when things began to really turn south.

I learned a valuable lesson here: everything is up for (re)-negotiation.

Lesson 2: Nothing is final until the money’s in the bank.

Even signed contracts are fungible. Even legit private equity firms can be amateur. Even grown-ass men can be emotional wrecks (I can’t count how many times their lawyer told me the principals were “feeling very emotional right now.”)

Nothing is final until the money’s in the bank.

I thought a signed Asset Purchase Agreement, with all of its legalese, references to courthouses, and carefully negotiated commitments, was cast in stone. I thought once you sign a big multi-page business agreement, you’re stuck with it. Apparently not, because these guys kept trying to get me to change it.

When I said no a second time, they respond with the nuclear option: they “terminated” our agreement and referred me to their lawyer.

What. The. Fuck. This is when I got pissed. Fuck these guys and their stupid fucking lawyer. I cursed, I threw rocks against the bucket down at the creek in my backyard. I told my wife, tail tucked between my legs, that the guys I trusted my business to, to whom I was introduced by one of the best entrepreneurs I know, turned out to be rat-ass bastards. Then she was pissed too.

I still remember the day I got that email from the main partner at this private equity firm. It was written formally, as if drafted by a lawyer, and he followed up by sending a written version via certified postal mail a few days later. Except there was a problem. A glaring one that these dumbshits never corrected. Even after we settled, they never acknowledged this error even though we brought it up to them many times, on the phone and in writing.

In their termination notice, they claimed that “Purchaser has breached material obligations…” Here’s the full letter.

Do you see the problem here? “Purchaser” is them. “Seller” is me. They referenced the wrong fucking clause in their own fucking termination agreement. I mentioned this in my first communication (sans-profanity, obviously) to the lawyer they requested I contact. She turned out to be nice, even apologetic, but served her clients well. It became clear after a few weeks that unless I hired my own lawyer, they were going to keep calling my bluff and strong-arming me into submission, reckless legal error or not.

The best offer I was able to negotiate with her was about 15% of the remainder they owed me. I turned it down and asked her if they wanted me to hire a lawyer and sue them. She didn’t reply. So, despite my best efforts to avoid it, I hired a lawyer.

I met JP Schnapper-Casteras at the Harvard Kennedy School sometime in late 2006. He was a bright young Stanford guy and I liked him right away. He was in the group of friends I went to Puerto Rico with during our graduate school spring break in 2007, successfully re-living our college years at a beachside rental in Rincón. All of my friends at Harvard were smart, but JP had a special wit and warmth about him that I always admired.

We stayed in touch over the decade between then and now. I was happy for him when he told me he started his own law firm after clerking and joining a big fancy private firm. When I was negotiating the Asset Purchase Agreement for this acquisition, I asked him to take a look. And when I needed a lawyer to protect myself from these jackals, JP was the first person I called. He took the case.

Oddly enough, I’ve always liked lawyers. I enjoyed talking to them over the years at Scripted, working through the process of incorporating the business, raising money, and hiring and firing employees. The lawyers I knew were smart, articulate, and most of all, disciplined. They were on time, on point, prepared. It must be a state of mind in the lawyer community, because I’ve never known a lawyer to not be on it. I always appreciated that.

So working with JP was, dare I say it, fun. We brainstormed strategy, talked business and family, and managed to thread that needle between old friends and new business associates. I told him what I cared about in this dispute, what I ultimately wanted, and why it was important to me. He took the lead in communicating with their lawyer and for a while ran into the same walls that I did. It wasn’t until we drafted a complete, official complaint and threatened to file it that these jokers finally came around.

The content of the complaint was nothing new. These were all points that we’d made on the phone and in writing previously. They just needed me to spend the time and money to write it up before they’d take my position seriously. It was, in short, a dick move. If they’d offered the amount we ultimately settled on from the beginning, which ultimately was 30% lower than the floor I’d originally gave them, I would have taken it. I shouldn’t have needed to hire a lawyer, but this was their game, their tactic, and they forced me to do it. To this day I still don’t understand why.

It led me to the next lesson of this blog post: you can’t know what’s going on in anybody’s head; anybody can be irrational.

Lesson 3: Don’t assume that your counterparts are rational.

While all this crap was happening, I was gearing up for my (hopefully) final thyroid cancer treatment. Unless they were regular readers of this blog, they couldn’t have known that, and I don’t mention this for pity points. It’s just a fact.

Conversely, I don’t know what was going on with them. Maybe they also had cancer. Maybe a loved one was sick or their marriages were falling apart. Maybe something else was causing financial distress. I don’t know. I can’t know. And that’s my point. You can’t assume that your opposition has it all together, that everything’s fine, and they’ll make decisions as if they’re in a perfect world kind of scenario. Chances are that’s not the case.

Going into and throughout this negotiation, I assumed they were rational. I assumed that they wouldn’t want to take on the reputation risk. Although I’m not outing their firm in this post, they have to assume that close friends and advisors of mine, many of whom are influential, will know the full details. It’s within my legal rights to share these details with lawyers and financial advisors, and word gets around. The private equity community, especially for small SaaS businesses, is small. Bad actors get outed fast.

Private equity influencers like the partners at Xenon (it should be obvious by now, but Xenon is not the firm in the dispute I’ve described here) told me they can’t believe the firm in question here would put their reputation at risk over a sum less than $100K. They told me this is completely irrational. If word of my experience keeps them out of just one deal, it’s not worth it for them. The rational thing for them to do would have been to shrug off their buyer’s remorse, pay me out, and move on.

I agree, of course, but that doesn’t matter. They didn’t act rationally and I couldn’t will them to do so.

We ultimately settled for just over 30% of what they owed me based on the word of the contract. It sounds like I was overly generous, but I have a play. A rational actor wouldn’t care about my next move, but now I know better than to assume they’re rational. So I’m not going to lay it out here but it’s valuable enough to me that I can sleep fine at night.

All told, I received over 70% of the valuation we agreed to. I’ll get that remaining 30% back in other ways. Those gears are already in motion. Which leads to me the fourth and final lesson I learned: always keep a plan B.

Lesson 4: Keep your options open.

There’s an important corollary here too: keep a cool head. You need a cool head to see the cracks in your opponent’s plan. Use their hot-headedness against them. Let them make a mistake or two.

In fact, these guys made plenty of mistakes along the way. I had more information than they knew I did. I knew the monthly revenue and the size of the payments from the whale customer. All I had to do was ask them; I’m still friends with those guys, and they remain happy (albeit smaller) customers of my old business. I also had good reason to believe that the revenue from other customers was below the payment trigger threshold.

Thus, per the letter of the contract, they didn’t owe me anything. The business, due to some technicalities in the agreement (using only subscription revenue instead of total billings), didn’t trigger the payout criteria and wouldn’t get me there any time soon.

They could have just ridden it out, but they didn’t. A rational actor would have said cool, the agreement is doing its job, protecting us from downside risk. We don’t need to pay Ryan right now because the payout triggers aren’t met. Sucks for Ryan. Poor guy! Oh well, he’ll survive.

No, instead they sent that stupid letter, made me hire a lawyer, and settled for much more than I’m due right now.

That’s ultimately why I took the deal.

So I’m not bitter about where this whole thing landed. I’ll never sell a business this way again, but this entrepreneurship thing a is a living, learning process. I hope this blog post is useful for those who want to sell and those who want to buy small businesses. There are tons of lessons here for both sides of the deal.

If I’d had the opportunity to read a post like this earlier, I might not have signed the deal. That’s why I published this.

As for the principals at the private equity firm I sold my business to, I hope they learned some valuable lessons too.

(I also hope they drive to the beach and realize they forgot their sunscreen. I hope they get pulled over for a broken tail light. I hope they sit in front of a crying baby on a red eye to Timbuktu. I hope they have to sleep outside with a bunch of mosquitos.)

Outside of that, I don’t harbor any real ill will. It’s just business. I get it. They tried to do what’s best for their fledgling private equity firm. They made mistakes. They’re paying for those mistakes, even now. I am too. But we’re both learning.

What else is there, really?

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