Paul Giannamore: How do we create value by doing a deal? Fundamentally, it all boils down to two things, one is decreasing risk, and two is increasing cashflow.
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Paul Giannamore: Alright, Fat Pat.
Patrick Baldwin: It's football season, Paul, but the sacrifices we make for The Buzz.
Paul Giannamore: Indeed. Are you going to football?
Patrick Baldwin: I'm going to the living room where we put the football on TV. It's too hot. It’s September 2023.
Paul Giannamore: What are you watching, Fat Pat?
Patrick Baldwin: The Aggies are playing at Miami. There are some good games, Texas, and Alabama. It's one of those games you wish both teams would lose or whatever. You're headed out to New York.
Paul Giannamore: I got to get up there. I've got meetings. Back on the road again. PestWorld is right around the corner. I understand there's a new development in PestWorld planning, Fat Pat.
Patrick Baldwin: Before I go to PestWorld, I'm going to Syracuse, Indiana.
Paul Giannamore: That's right.
Patrick Baldwin: I've got a wildlife conference put on by AAC. That'll be awesome. Tony Seery and Jack Searles, I see a lot of great wildlife people. They can be rowdy but I'll hold my own.
Paul Giannamore: Good.
Patrick Baldwin: Did you mention PestWorld?
Paul Giannamore: Yes.
Patrick Baldwin: What did you say?
Paul Giannamore: You're heading there this time.
Patrick Baldwin: I am?
Paul Giannamore: You weren't going to and now it seems like you are. Are you going to be there?
Patrick Baldwin: I've succumbed to the peer pressure of Uncle Paul and Cousin Seth.
Paul Giannamore: Good. I'm glad you'll be making a showing.
Patrick Baldwin: I'm excited to go. We're going to have a fun time. Here comes Hawaii, hopefully, we don't wreck it. I'm only worried about one person ending up in jail because you're not coming along.
Paul Giannamore: We are bringing the Mex this time. I would encourage anyone who wants to meet the Mexican in person. He will certainly be up there with sunglasses and harassing everyone. The Mexican covers acquirers for Potomac, he's the one that covers the PE firms and the strategic buyers, he's the one that deals with them constantly, and I do not. Lee Thompson, whom you know, we used to be over at Pruitt, right?
Patrick Baldwin: Correct.
Paul Giannamore: He has now joined Certus as VP of M&A. Lee, I got the opportunity to meet him at Seth's shindig at PestWorld, a super nice guy. He reached out to me on LinkedIn and wanted to chit chat Of course, I pushed him off to the Mexican because the Mexican deals with acquirers and I do not.
Patrick Baldwin: I can't wait.
Paul Giannamore: He sent an email over which is fantastic. He writes, “Hi, Franco. Hope all is well. I wanted to reach out and introduce myself. We followed each other on LinkedIn for a while and I believe I met you at Seth Garber's event in Boston last year. I just took over M&A at Certus, primarily on the East Coast. If you have any time next week or even today, I'd love to tell you about some of the things we're doing and the plans we have. I look forward to catching up.” Lee is a sweetheart of a guy and I wish him the absolute best in his new role.
Of course, him emailing the Mexican, here was the Mexican's response, “Seth Garber sucks. My experience with Certus is that you guys think you'll buy a premium business for cents on the dollar and that's no path with our clients but happy to jump on a call to discuss if that has changed.” He then provides his phone number. Lee, that is a standard response. If anyone is out there in the private equity industry reading, that is a standard response from the Mexican. That's how we roll. The Mexican will be at PestWorld harassing people. If you want the opportunity to be harassed yourself, you can feel free to track him down.
Patrick Baldwin: You've been warned.
Paul Giannamore: Yes, you've been warned.
Patrick Baldwin: Why did you say something about his sunglasses? Is he going to be chasing people with the sunglasses?
Paul Giannamore: He rolls through indoors. He shows up at meetings with CEOs, he's got his sunglasses on, and he sits there and tells them how much they suck at life and how cheap they are. The Mexican is a painful individual to deal with. Quite frankly, there's no one better when it comes to battling it out there for dollars. If you want to see him, he'll be there.
Patrick Baldwin: I want the Mexican on my side, for what it's worth.
Paul Giannamore: Yes, you do. As long as Immigration Services is not in Honolulu, he should be there all week.
Patrick Baldwin: Love it. Peej.
Paul Giannamore: Yes, sir.
Patrick Baldwin: Underneath Potomac, I see mergers and acquisitions. We did that event for FRAXN, the Moneyball event. You joined us and had a couple of questions coming through that. I thought, “Let's talk about mergers because we're always talking about acquisitions but rarely about mergers.” When I think about what's happened in the industry, we saw the Ardent Alta merger, and that's the only one that comes to mind for me. You know that space a lot more than I do.
Let me read this and we'll hop in here. A question came in from Moneyball, “We are strongly looking at merging our three businesses together. We're not too far from each other. In fact, our service areas overlap. We're each coming in with our own set of financials, customers, employees, assets, etc. We get along, we're like-minded, and each wants to step back and put one CEO in place to run it. In regards to evaluation, can Potomac provide any guidance here or maybe even represent any of us?”
Paul Giannamore: Patrick, I remember that question coming in while we were doing the presentation. Of course, I didn't get a chance to address it when we were doing that Moneyball webinar. I have talked to at least one of those individuals since the event. To give a little bit of context, that's three separate companies of various sizes. All of them, at some point here in the relative future, want to sell their businesses.
The theory was if we take three businesses and combine them, we'll have much more scale, and we'll be a much larger business. Theoretically, we should be more attractive to an acquirer. That's not always true. In this particular case, their thesis is probably correct given the size of their businesses and the location. It would make it the largest regional player in that area. There are some compelling reasons to merge these three businesses together.
When you talk about a merger versus an acquisition, in my mind, everything's an acquisition. Mergers are typically public company situations for the most part. Back in the day, when I first got into investment banking, back in the late ‘90s, we were doing a lot of “traditional mergers”, which were effectively pooling of interest transactions.
Pooling of interest is governed under FASB or the Financial Accounting Standards Board. I remember back in 2001, after the great financial crisis, they got rid of the ability of companies to use the pooling of interest method. We're not going to go into detail as to what that is. For the most part, any merger is an acquisition. You could argue that Rentokil and Terminix merged.
Patrick Baldwin: I don't know. You can get that perception that it was a merger.
Paul Giannamore: At the end of the day, in the public company realm, a public company is using either its cash or its stock to acquire. The currency is either cash or equity and sometimes it's all equity or sometimes it's a combination of cash and equity, which is what Rentokil did. Rentokil used cash and stock to purchase Terminix. At the end of the day, it's a merger, but I always view these things as an acquisition.
Even with a privately held business, you put three different companies together, effectively, one of them is buying the other because it could use cash as a currency or it could use equity. There are a lot of laws surrounding, particularly when you get into tax, what's a tax-free transaction versus a taxable transaction. One of the participants in that particular question called me and asked me, “How do we do this?”
Clearly, you don't want to be in a situation where you're doing a taxable transaction when you're attempting to merge. Let's say you have three $5 million businesses and all three of those are to combine into one $15 million business. The last thing that you want to do is create a taxable transaction when there's not a lot of consideration being passed across the table because now you've got a tax event and you've got a liability and you don't have money.
There are different reorganizations that can be done in order to create a tax-efficient tax-free merger is a very legal transaction that these guys will attempt to do. Their thesis is correct, that business becomes more interesting because. Separately, those companies are not particularly exciting for anyone to acquire but if they merge the three together, they'll be effectively the only game in town in a pretty decent geography, which now makes them far more interesting.
Patrick Baldwin: Rentokil Terminix, I know the optics make the merger sound nice. Thinking about what happened going into it and coming out of it. Rentokil acquired Terminix. I don't know if I would think about that one as a merger.
Paul Giannamore: What would make you think of something as a merger?
Patrick Baldwin: Reading through Ardent Alta as a merger. It’s like, “We decided our two companies belong. We're better together.” At the end of the day, it's Alta branded. I don't know as far as what either party brought in and what they walked away with but they're still involved.
Paul Giannamore: You have the construct of a merger of equals. In practice, 9 times out of 10, there's going to be a controlling party in any deal. If you have a $10 million business and a $5 million business and they merge, even if there's no cash consideration. I've got a $10 million business and I use my stock as currency to buy your $5 million business. What has to happen? Prior to that taking place, we need to understand the value of my $10 million in revenue business and your $5 million in revenue business. We need to determine what each of those businesses is valued at in absolute terms.
When you're merging, you're more concerned about relative value. Your business is relative to mine and so on and so forth. If our two businesses “merge”, at the end of the day, I am handing you stock, I'm using stock as a currency, or we're creating a Newco perhaps. Maybe we're doing some sort of reorganization where we're both being sucked into Newco. I'm going to use simple terms that are not grounded in reality here. Let's just call it $10 million. That's probably not the case but let's just say my business is worth $10 million and your business is worth $5 million, we merge those two, even if we call it a merger, and it says, “Tax-free reorganization.” What ends up happening?
Patrick Baldwin: Two-thirds and one-third.
Paul Giannamore: The shareholders of my business, yes. Ultimately, I own a controlling stake in Newco. If you take a $10 million business and a $5 million business, I effectively would own 2/3 of Newco so I would want 2/3 of the board representation. Rentokil used a good deal of cash in order to affect this transaction to change the calculus. At the end of the day, they now have a controlling stake in Newco, which is Rentokil Terminix. You could argue that almost all mergers are effectively acquisitions because it's not often you see traditional mergers of equals.
Patrick Baldwin: Is that the defining factor of controlling interest after the transaction? If it's 50/50, then that's the only way it could be a merger.
Paul Giannamore: I tend to define mergers under FASB, which is accounting, pooling of interest type things, which don't exist anymore, but you could also argue from a practical perspective that what you said is the case, which is extremely rare. Two companies are rarely ever valued exactly the same. If you're effectively doing a stock swap, one company is probably valued more and the shareholders of that particular business would likely own more than the shareholders of the other business even if you call on a merger.
Patrick Baldwin: Can you get involved on behalf of any of the parties or all three of the parties or how do they look at valuing the business? Balance sheet and free cashflow, “Here's our capabilities.” There are a lot of variables there. How could Potomac or do you give guidance in a situation like this?
Paul Giannamore: The only thing that we would do in a particular case like that is give independent valuations of each particular entity. It would be complicated for us to advise one party in that situation so we tend to shy away from that. Your other question is, yes, there's a lot that goes into it. You're attempting to value each business on a standalone basis. We've talked about valuation before, you've got various different standards of value.
The same standard would need to be applied to all firms. When I talk about the standard of values, fair market value would be one standard, which the US Department of the Treasury uses for tax purposes. When you're valuing a business for gift and state tax purposes or courts often use fair market value and divorce litigation, there's a variety of standards. We have investment value. The extreme majority of the valuations that we do are under the investment value standard otherwise known as strategic value, which is what would a business sell for in a competitive process where a strategic acquirer is buying that business.
The standard of value becomes important in this particular merger situation only where tax liability might arise. If it's a merger and no one's writing a check and they're attempting to do a tax-free reorg, the relative value, if there's no tax liability, it doesn't matter what the value is, it only matters what's the relative value to determine who would ultimately control the board. What is the board makeup? What will the shareholders own in Newco or whatever that post-merger entity looks like? By the way, this is not tax or legal advice whatsoever. I'm going to be careful to not go into any details or nuances here because I'm not.
Patrick Baldwin: There goes my next question.
Paul Giannamore: I'm not telling people how to do this or how they should think about it. This is a high-level overview. You, 100%, need to get very competent legal advice and tax advice. There are a lot of landmines here because if you combine 3 separate businesses or 2 separate businesses, you've got to determine what governance looks like.
Of course, you need a shareholder agreement. You need to start to answer the questions like, “In the future, who ultimately can force a sale?” Can you be dragged along? Do you have the ability to tag along? There are a lot of different rights that go into a shareholder agreement. Any equity participation agreement or shareholder agreement that you would do going forward that specifies these various consent rights is going to be extremely important.
A transaction like this has a variety of different aspects and one is operations. How do we pull operations? How different is your business on the field versus mine? How are we pulling these operations? How are we dealing with the back office? How are we dealing with routing, scheduling, technicians, and harmonizing plans? There's a lot that goes into that. You've got the operational side.
The valuation side is quite simple, you value those businesses each on a standalone basis, probably under a fair market value standard, and push that aside. You then have to think about the legal ramifications of this, who's going to be running it? Who controls it? Who makes capital expenditure decisions? In this particular case, we talked about one company, which is larger, owning effectively 50%. This is hypothetical. No valuation has been done. One company owns 50%, the other company owns 25%, and the other company owns 25%. There's your 100% equity.
Again, this is all hypothetical. Now you find yourself in a position where company A has two board seats, company B has one, and company C has one. Now you've got a board of four people. Even number boards do not work, you need to have a tiebreaker in there. Who is the fifth board member? Is it an outside CEO who comes in? Sometimes that's a great idea and sometimes it's not.
You go out and you got to get somebody else on there to make these decisions. If you're going to do something like this, corporate governance becomes extremely important. It's the same situation that a public company would deal with because now you don't own 100% percent of your business, you're partnered up effectively with 1, 2, 3, or 4 others.
Patrick Baldwin: Knowing that there are landmines, at the end of the day, these three businesses coming together benefit each of them greatly.
Paul Giannamore: Why?
Patrick Baldwin: As far as where they are in their business cycle, where they are in terms of life, and their end goals. Knowing where they are, I don't know if any of them are individually marketable to an acquirer. Individually, they're too small for private equity. Knowing who the strategics are, I don't think they could maximize what they could do.
If they were to sell today, individually, I don't think it could work or even attract the right buyers. Together, it changes the game for them and puts them on a whole nother level. From an operational perspective, if you're paying 1 CEO salary instead of 3 “CEO owner-operator salaries”, there's some gain there. There are some things they can do together. They could build route density because they overlap service areas.
A big thing for them would be to figure out their frequency of service. When I think about residential services, are they quarterly? Yes. If not, get them quarterly being in their geography if that's the normal thing to do. Make their service protocol look the same. We're going to get into branding and Newco and all that in a second because there was a follow-up question. Did I miss something?
Paul Giannamore: A simple lens is whenever you think about a business combination if you start with the fundamentals and say, “How do we create value by doing a deal?” Fundamentally, it all boils down to two things, one is decreasing risk, and two, increasing cashflow. As you start to think about a business combination, you're going to say, “All transactions have inherent risks. There is execution risk and integration risk. There's a lot of risk in doing a deal.”
First and foremost, you're saying, “How do I mitigate risk? How does ultimately this combined business become less risky than my own business was on a standalone basis?” Of course, you mentioned a lot of things that increase cashflow. What cost savings and revenue enhancements can we get by combining these businesses? You're right, we don't need three CEOs now, we just need one. We probably don't need the same level of back office. We can probably skinny down some costs there.
In theory, once the service organization is harmonized, we should definitely be able to get some route density out of it, which increases our gross margin and it ultimately flows to the bottom line. In this particular example, we have now taken three separate businesses that are not particularly excited to an acquirer on a standalone basis. We've combined them into one and now we've raised our profile.
Now we're a much larger business and we've also potentially put ourselves in a position where we're going to be able to increase cashflow. I don't know any of the details of any of these companies. I have no idea what the cashflow of each business is but let's assume one business does $500,000 in cashflow, another one does $500,000, and another one does $1 million. Combined, that's $2 million in EBITDA.
In theory, if this is done correctly, adding those P&Ls together and effectively integrating this and getting revenue enhancements and cost savings, we should end up in a situation where we don't have $2 million in cashflow. We have $2.5 million or we have $3 million. By combining these businesses, we've created millions of dollars in enterprise value through this combination. That's how this should work. That's how it works in theory and it's how it should work in practice. Obviously, there are a lot of obstacles to get through.
Patrick Baldwin: Having a valuation discussion and what the relative value is to each other, is there one key factor? You mentioned cashflow, is that the number one thing as opposed to the balance sheet or, “I've got this much percentage of recurring customers or this much in top-line revenue.” Is it, “This is our cashflow and that's the number one thing.”
Paul Giannamore: That's the distinction between fair market value and strategic value. If you're looking at these businesses on a standalone basis, using fair market value, in a hypothetical situation where there's no buyer and seller effectively, you're dealing with almost a financial buyer situation where there are no synergies. All of those things come into play. How durable the business is? You're looking at pricing and recurring revenue because you're trying to understand risk.
If you figure out what the valuation is on a fair market value basis for those three businesses, it's all done standalone. The distinction between fair market value and strategic value is that when Rentokil goes or a private equity firm goes out and looks at a transaction, they would love to be able to pay for a market value because there's usually a huge delta between FMB and strategic value but that's not the case. If the seller has more than three brain cells and is running a competitive process, they're going to be forced to pay something in the strategic value range.
On a transaction like this with the merger of these three businesses, you're basing things off fair market value because 1 of the 3 might have an interesting capability, which would provide value to a strategic acquirer. The strategic acquirer might say, “Here's a capability that we want to buy.” That's worth is something above and beyond to us but you're not dealing with that strategic acquirer. The three of you are together and you're doing this on a fair market value basis. It becomes relative value because if there's no cash changing hands, this is a merger and you're using stock as currency and you're doing this under the fair market value construct.
Patrick Baldwin: Assuming the merger goes through, one of us is a better-known brand on one end of the service area and another brand on the other end. What do we need to think through in terms of branding or rebranding if we're considering selling in the next couple of years or possibly waiting several years out?
Paul Giannamore: There's always beauty in having one cohesive brand. When I think about this particular case, if you've got company A in one market and then companies B and C are covering the same market, I don't know that there's a benefit of B and C operating under two different brands. You would probably rebrand that into a stronger brand.
If that's what the question is asking, you would take B and C and combine them and B and C would be operating under whatever the strongest brand is in that particular market. Company A might continue to operate as company A in that market. If there's an overlap between B and C and A, if company A is in one market and B and C are in another market and companies B and C are going out into A's territory, they might be now branded under A in that particular market.
Patrick Baldwin: That makes sense because then you can build route density. If they’re a few years out, in the future, “We're not going to sell anything in the near term,” then they could pull off this. All three sets of owners are still involved to help transition customers over to a new brand. “We're still here. We haven't gone anywhere.” If you have B and C in the same area picking one brand, that's good. A and the other one, pick that brand, that's great. Shuffle some customers for where they cross over the service area. What I'm hearing is do not create a company D. There should not be a new name for any customer. No need to make a Newco.
Paul Giannamore: You can do that. It's not the recommended course of action. I wouldn't do that.
Patrick Baldwin: Let's think where if it's still a long term, getting their service frequencies, service protocols, all that together, and an acquirer comes in, they decide, “A few years out, we want to sell this whole business together.” You're saying it's okay to have two different brands and then this whole transaction can go together.
Paul Giannamore: Sure, yeah.
Patrick Baldwin: We've talked about increasing cashflow and all that but are there things that operationally maybe not financially, things that they need to have in order before that happens if they're running separate brands?
Paul Giannamore: This would turn into a 40-hour episode if we went into all of that. Every one of these parties effectively needs to do buy-side DD on the other one. One company may be playing fast and loose with regulations. There might be all sorts of termite liability baked into something. You have to do legal diligence on each of the different entities. That creates complications when you want to combine these businesses.
I'll give you an example. If one business has been playing fast and loose and maybe there's some potential undisclosed liabilities and people stand back and say, “We don't want to buy the stock of this business. We need to buy the assets.” You might have to do some sort of an F-reorg, set up a new entity, and move. There's a lot that goes into this. I know one of those businesses is an LLC and it's a flow-through.
I don't know how the other businesses are organized. Depending upon whether they're corporations, whether they're flow-through entities, LLCs, and so on and so forth, that changes the legal methodologies you could use effectively to combine those businesses and still allow them to be tax-free reorganizations. There's a lot that goes into it on the legal side and on the operational side.
PB, if you think about it, almost every company out there runs its operations differently. They have different vacation days, they have different policies, they have different operating hours, they have different perks for employees, and there are different wage rates. It's not just service frequency. Do we do three services a year or four? What's included in your residential protection plan? How often are they serviced? There's a myriad of operational things that have to be sorted through.
The reality is that doesn't all need to be harmonized on day one. When Rentokil or Orkin goes out and buys a business, they don't harmonize all these things on day one. They might have a 90-day plan for compensation plans and they might have a 180-day plan for service plans. Back office might be a full year. You have to start by saying, “What do we do similarly and what do we do differently?” You have to think about, “How do we want to operate this business going forward? What are we going to do? You do this, I do this, and he does that. What's going to be our go-forward plan? What's the actual plan to harmonize this over time?” It's not day-one stuff.
Patrick Baldwin: Do they need to harmonize before they go to market 5 or 10 years down the road?
Paul Giannamore: I would say so because otherwise, you're just lumping three distinct businesses together. Effectively, they are three separate businesses, they're just one owner now. Unless and until you do those things, you won't increase cashflow. As a matter of fact, you have to be prepared to have a lot of additional expenses in the near team. None of this stuff is cheap. It's distracting to the employees, it'll decrease efficiency, and it will decrease your cashflow in the near term. It's like a curve and ideally over time, you're able to increase cashflow.
Patrick Baldwin: In terms of buy-side DD if you will, would you go so far as to have a third party come in and survey each of the company's clients or customers? “What do you feel about company A?”
Paul Giannamore: I don't know enough about the companies to make that determination. Unless there's a lot of customer risk, and that's usually in commercial customers, if these are residential players, any one customer is not particularly risky. You lose a $500,000-a-year customer, big deal.
Patrick Baldwin: Taking a turn here. The question was posed, rebranding and reorganizing service frequency operations, and all that, compensation for, “We want to sell in five years.” What if they decide to do something together in the near term, a year or two years? Are there things that they should or shouldn't do?
Paul Giannamore: Here's the thing, when you look across any industry, software, pest control, landscape, doesn't matter, every company out there, their shareholders are going to have different goals and objectives. What do I mean by that? You and I might each own a pest control business and I might be a guy who looks at the pest control business, it's not my sole source of income, and I want to grow a capital asset. I want to focus on growing the shit out of this business.
I might not even take dividends from that company. I might not distribute any cash. I might reinvest it all in the business. Whereas you, you've got a family, you like to eat barbecue, and you got a bad Chick-fil-A habit. You need those biscuits. You need that money from that company. You're not reinvesting. My company might have a much higher growth rate. Five years from now, my company might've grown 120% and yours might've grown 30% percent over five years.
If you, me, and another company are getting together, and we're going to merge our three businesses, right off the bat, you're going to look at me and say, “Paul, you've always reinvested in that business. You don't take any cash from it. I've got a family to support. I have kids who are getting ready to go to college. I need my money. I'm going to need to distribute.” Depending upon the organization of the business, if it's S Corp, we have to distribute pro rata with each other based on ownership.
You and I are in our 40s and our third partner might be 68, so he's got different considerations than you and I do. He's got a much shorter runway and he might want to try to sell this during his natural life. That imposes some deadlines on us. When you get together and do something like this, you all have to be honest about, “What is it that we're trying to accomplish here? Are we going to sell this in a year? Are we going to attempt to sell this five years from now?”
You got to almost put some stake in the ground and say, “This is our target.” You got to sit back and say, “How much do each of us need to take out of this business?” You have to figure that out. You got to get strategic about how you're going to reinvest. What's your CapEx spend look like? How are you going to reinvest back in this business? What are the avenues for growth? A lot of that hinges upon, A, what you and I need to take out of the business, and, B, what's our timeline to an ultimate exit?
These conversations are easy to have if you understand what it is. A lot of guys go into this and don't talk about that and then they find themselves in, effectively, a bad marriage. If you understand what the issues are and you can talk about them and document them, it should be a pretty easy situation. You and I, having different shareholder goals and objectives, will need to somewhat harmonize at the shareholder level what we're trying to accomplish.
You're going to have to become more of a growth investor focused on capital appreciation and I'm going to have to become more of a dividend investor than I am. You're going to have to give up some and I'm going to have to give up some. I'm going to have to say, “I've got to take some cash out because Patrick needs cash to live.” Whereas before I didn't care about that.
Patrick Baldwin: You said I need cash to feed my Chick-fil-A habit.
Paul Giannamore: Correct.
Patrick Baldwin: I know what you're saying.
Paul Giannamore: You understand it's a real addiction. You need that bread.
Patrick Baldwin: If we get together as shareholders, let’s say two years, let's see the most we could do in the next two years. Is it more beneficial for them to come to you today and say, “The three of us want to sell in two years.” As three separate businesses come to you, I'm holding this up like 1 part here, 1 part here, and 2 parts here. We can sell these as our own standalone brands and you're able to take those three businesses simultaneously to market as three companies. Are they better off working through this exercise “merging” their companies together, getting their operation in line, and then coming back to you in “two years” to sell it as maybe two brands?
Paul Giannamore: The kernel of that question comes down to having combined those businesses. Two years from now, will it be valued more on a combined basis or a standalone basis?
Patrick Baldwin: Assuming the external market doesn't change.
Paul Giannamore: If we cast everything aside and we say, “What is the fundamental lever that answers that question?” It is cashflow. If they are able as a combined entity to increase cashflow without increasing risk, the answer is simple, it is more valuable. If they're not able to do that, the juice isn't worth the squeeze in Texas lingo. You can boil a lot of these things down to simple fundamental questions. Two years from now, will it have higher cashflow and no greater risk? If the answer to that is yes, then it's potentially a good decision to do that.
Patrick Baldwin: Since our Moneyball event, then 1 of these 3 companies has signed up for FRAXN. I'm thinking about how far back to take each of these three companies. If they want to get an apples-to-apples comparison, how far back should they be looking?
Paul Giannamore: When we do revenue ruling 59/60 valuations, we'll go back five years, that's traditional. In this particular case though, you have to think about the fact that there's valuation and then there's operation. You could go back five years easily and look at cashflow. Cashflow is a result and the chart of accounts, for example, doesn't have to be the same. If you're thinking about it from an operational perspective, we're in 2023 right now, let's just that these guys decided to do something at the end of this year as an example. You would want all of 2023 and you would want 2022.
I wouldn't worry too much before 2022. Now, from an evaluation perspective, I would want to go back before 2022. The question you're asking me is when you said apples to apples, you're trying to compare the operations of the business as expressed in the P&L on a line-by-line basis to help us make determinations as to cost savings. What does the insurance look like? What's management? What's the back office? In a perfect world, you would have the current year, a trailing twelve-month basis, and then you would have the full prior year. That would give you enough information because it's the last eighteen months or so is the most relevant to the combination discussion.
It's important to make the distinction between operations and combining the financials versus what I need to understand from an evaluation perspective. From an evaluation perspective, understanding risk trends, and so on and so forth, I'd go back five years, but I don't care what they were spending on insurance per se in 2018. I'm more concerned about what the gross margins look like and what their EBITDA or adjusted EBITDA looks like five years ago.
Patrick Baldwin: That makes sense. I’m thinking if they were to get on the same chart of accounts, then they can go line by line and say, “Here's where we can save money.” They can begin to build up their synergy.
Paul Giannamore: I would strongly recommend that they set up their financial systems the same. When companies merge or when one company acquires another company, they're not on the same financial systems. They typically don't have the same chart of accounts and so on and so forth. You have a transaction services group come in.
At Potomac, we have a transaction services team. There are four people on the team that do that stuff. I wouldn't recommend doing it that way. I would recommend, if there's some runway, while the businesses are each independently owned, get yourself set up on the same reporting structure so that it becomes easy.
You could sit down at a table and you're all in the same chart of accounts and you've identified, “How are we collectively measuring gross margin?” It's all done the same. Now it's crystal clear and I can look at 2023 and I can look at 2022 and I can say, “Your gross margin is 63% percent and yours is 52%.” I then ask a question, “What's going on here?” We then start to peel back the layers of the onion. That's my opinion on that.
Patrick Baldwin: I love it. Paul, I know we've talked about landmines in terms of, “These are some things you need to talk through in terms of shareholder objectives, finances, and operations.” Are there other questions that they might just be overlooking and they're not asking?
Paul Giannamore: When you do a ton of transactions and you see what works and what doesn't, you start to learn the types of things you should ask. These folks will learn quickly and hopefully, they learn it before they do a deal that you have to run through a lot of scenarios and get into a shareholder agreement. For example, the combined entity, let's say you've got a new CEO there and he wants to do some capital expenditures, what requires a board vote? We then talk about consent rights.
If the majority shareholder wants to do X and he controls the board, what do the minority shareholders have the right to consent to or otherwise veto? There's a lot of that. They issue new stock and they do capital expenditures. Can they do an acquisition? Let's say that one guy, maybe he's not going to be a majority shareholder in this situation, but he might have a plurality of the equity. He wants to do another deal because he says, “We did a merger and now there's another opportunity.”
You and I are sitting there and we're like, “We want our dividends. We don't want to reinvest this cash in it.” We need to have the ability to consent to these things. There's a sophisticated transaction attorney that deals with equity participation agreements, and shareholder agreements. All these things are going to be able to sit down and ask these folks 100 different questions as to how this should all work in practice and they have to think it through.
Patrick Baldwin: We've had Mike Stanczyk on the show. As you're talking through tax, I'm thinking about Corey Vargo. Are these two that you would recommend?
Paul Giannamore: I always recommend Mike, he's fantastic at this. Corey's great as well on the tax side. You're going to need a sophisticated attorney. In a case like this, you're probably all going to need a separate attorney. Everyone's going to need an attorney. One attorney is going to have to take control of the shareholder agreement and draft it.
If you and I were doing this, I'd have my own attorney, and the attorney would sit down and say, “Paul, what would you say if X, Y, and Z happened or what would you want to do here?” We have to go through it and negotiate that shareholder agreement. That's complicated. Of course, everyone's going to need their own tax representation because sometimes what works for me from a tax perspective does not work for you. It's unlikely that there'll be one tax advisor structuring all of this. You're probably going to need multiple.
Patrick Baldwin: As you said, each party will need their own attorney. A part of the question was, “Can Potomac provide any guidance here and maybe represent any of us?” In your case, you have to toe the same line or you can either choose to represent all 3 or 1.
Paul Giannamore: In this particular case, I wouldn't represent anyone. I would be independent. It would be different because it's from a valuation perspective. I would be providing guidance solely on the valuation of each entity on a standalone basis, which is independent. When I talk about lawyers and tax, you need advocacy. This isn't a competitive sell-side process where I would be a fiduciary to the company in question or the target. This is one of those situations where an attorney would be an advocate for one particular party.
He would be a fiduciary and represent your interest, Patrick, and pound his hand on the table and say, “That's not fair to Patrick. Fat Pat needs this, that, or the other.” They need that. From a valuation perspective, the parties could agree that these relative valuations would effectively be binding. A third party would assess the value and this is what we'll go with.
The parties could say, “We're going to use that constitutively. We'll have a third party value for each entity and we'll take that into consideration but this is going to be a negotiated transaction.” If I feel like I've got a better brand, I'm going to pound my hand on the table and say, “This should be my brand and my brand's better and this is what it's worth,” and so on and so forth. It's a negotiated transaction.
Patrick Baldwin: That’s helpful. I'm glad we spent almost an hour talking about mergers for you to tell me that there's no such thing as a merger. Thanks, Paul.
Paul Giannamore: You're welcome. I could have cut this short.
Patrick Baldwin: Paul, safe travels. I'll see you soon. I have to start working out.
Paul Giannamore: Yes, you do. Enjoy your Chick-fil-A and I'll catch up with you next episode.
Patrick Baldwin: Thanks, Paul.
Paul Giannamore: Take care.
Patrick Baldwin: See you, man.
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Dylan Seals: Thank you so much as always for supporting us at The Boardroom Buzz. We know your time is valuable and the fact that you spend 45 minutes or an hour with us means the world. All the media that we put out from Potomac is meant to honor and celebrate you, the service industry owner. As Paul would say, “Yee who toil in the pest control vineyards.”
As part of giving back, we have this podcast, but more than that, Paul and I have been working our tails off over at POTOMAC TV. We've spent a tremendous amount of time, energy, and resources to build out that platform to bring you market updates, to bring you visual breakdowns of the merger acquisition process, and to tell stories and present information in ways that, frankly, it's not possible for us to do on The Boardroom Buzz.
Adding the visual element takes it to the next level. I want to invite you to go to YouTube and find us, it's POTOMAC TV. Potomac.tv will get you there. Go there and subscribe. Check out some videos and leave some comments. Let us know what you like and let us know what you don't like. Let us know what you want to see more of and we'll see you over there.
Mike Stanczyk
Potomac.tv
