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STREET SMARTS

The Rule of Three

Anticipating the torpedoes that can sink a deal

Norm Brodsky is a veteran entrepreneur.

My partner Sam has bought and sold more companies than I can count, and along the way he has come up with what I call the Rule of Three. In negotiating any acquisition or sale, he says, you will run into three potential dealbreakers that have to be overcome if you're going to get the deal done. Any of those obstacles can prove insurmountable. You may never reach the second or third if you don't overcome the first. Then again, you're not out of the woods if you do.

I realized my partners and I were creating the first big obstacle to the sale of our business by our majority shareholder, Allied Capital, when we insisted on receiving a larger share of the proceeds than we'd normally be entitled to. Most of our investment was in equity, after all, and in any liquidation, debt is paid off before equity. Though the sale proceeds would probably be enough to take care of the debt, there would be little, if any, left over to cover our equity stake. Fortunately for us, however, the company could not be sold without the landlord's approval, and we owned the land. So we had the leverage we needed to insist on better terms.

I felt strongly that we were justified in using that leverage. Granted, if CitiStorage were bankrupt, it would make sense for equity holders to get nothing, but the company was far from bankrupt. On the contrary, it was very healthy and still had substantial value. Otherwise, Allied Capital wouldn't be able to sell it. Under the circumstances, it didn't seem fair for the creditors to get all their money back and the equity holders to get nothing. Sam called our contacts at Allied and explained our position. They understood and indicated we'd work something out once the bids were in.

By then, the selling process was well under way. For me, it was a lesson in how business auctions have changed. Ten years ago, an investment banker representing a seller would create a deal book containing the relevant information that potential buyers could use to determine how much, if anything, they would offer for the business. Now, instead of a deal book, there's an online data room with the same information. After signing a nondisclosure agreement, interested parties receive a password allowing them to enter the room and search the data. It's convenient for the would-be acquirers and even better for the seller, which can track which parties go into the room and how much time they spend there. That's valuable information when you're trying to gauge how serious the different prospects are.

In our case, it soon became apparent that the most serious prospect was a company I'll call RecordsCo, which I understood was controlled by Goldman Sachs. Goldman had recruited a former executive of Iron Mountain, the giant of our industry, to be RecordsCo's CEO, presumably with the goal of doing more acquisitions and building a rival to his former employer. Frankly, I thought that getting acquired by RecordsCo was probably the best outcome for us. Though the CEO and I didn't know each other well, he had a terrific reputation in the industry, and as the selling process unfolded, I began to understand why. He was smart, affable, experienced, and capable, and he came across as a straight shooter. It also didn't hurt that CitiStorage was twice the size of RecordsCo and had more management depth. I figured the merger would open up opportunities for our employees that they might not have if we were acquired by someone else. So I was delighted when the bids came in and RecordsCo's was by far the strongest.

With a number now on the table, it was time to sit down with Allied Capital. Sam and I flew to its headquarters in Washington, D.C., and met with Allied Capital's CEO and a member of the board. "Listen," I said, "I don't understand why you're selling this business now. Whatever price you get will be 20 or 30 percent less than it should be, which will all but wipe out our equity and yours as well. But we aren't going to stand in your way."

Sam and I had already made clear what we wanted: $10 million of the $13 million we'd invested; continued use of the top two floors of our office building; and an understanding that we would be able to turn in our stock certificates, collect our money, and move on with no further financial commitments. The Allied people were very accommodating. We didn't get everything we asked for, but we came away with what we thought was a fair deal. At the time, we believed they were just being good partners. Only later did we realize they were being very smart business people as well.

What we didn't take in was that the troubled economy had presented Allied Capital with a golden opportunity -- one that it could use the sale proceeds to take advantage of. That opportunity grew out of the drop in the price of corporate bonds. Some of the bonds Allied Capital had issued were selling for as little as 37 cents on the dollar. It could buy them back, retire the debt, and make 63 cents on the dollar. (When a borrower retires debt for less money than it received at the time the loan was made, the difference is recorded as income.) Indeed, Allied Capital had done such a debt buyback in the second quarter of this year, as I discovered when I read its quarterly report. It mentioned that the company had recently paid $50.3 million to repurchase notes with a face value of $134.5 million.

So let's say that Allied Capital cleared $60 million on the sale of CitiStorage. Then it could turn around and use the $60 million to buy back more of its corporate bonds. If it had an opportunity like the one I'd read about -- which it probably won't, given the recent rise in the price of its bonds -- it could retire another $160.4 million in debt, registering a gain of more than $100 million. No wonder Allied Capital had wanted to sell us in the first place and had then been so willing to accommodate our request.

Having overcome obstacle No. 1 -- us -- Allied Capital was ready to move forward with the sale. A horde of accountants, attorneys, and analysts from RecordsCo and Goldman descended on our offices and began inspecting our records. To be sure, our people were used to the drill by now. They'd been through it twice before. But that didn't make it any less disruptive to our operations and morale, as people inevitably worried about what the future might hold. For the first time, my partners and I began to feel some animosity from a couple of senior staff members. I suppose they blamed us for putting them at risk.

As president of CitiStorage, Louis Weiner orchestrated our end of the process, while Sam and I left with our wives for a long-planned trip to Russia. By the time we returned, the due diligence phase was winding down. Both Louis and RecordsCo's CEO were confident the deal would go through, as was I. But Sam was waiting for obstacle No. 2.

It arrived in the form of a letter from RecordsCo listing 32 items in the lease that it wanted changed. I was flabbergasted. The lease was in the data room, and so there had been plenty of time earlier in the process for RecordsCo to raise any concerns about it. I knew that at least one of Goldman's key people had read it months ago, based on a comment he'd made at the time. Why were these points being brought up now? Why wait until the two sides had spent almost a combined $1.5 million on due diligence? Was Goldman suddenly trying to get out of the deal? And if so, why?

So there we were, up against the next potentially fatal roadblock to selling the business. We didn't know whether it was simply a negotiating stance on the part of RecordsCo/Goldman or the death knell of the deal. But we'd find out soon enough.

Norm Brodsky is a veteran entrepreneur. His co-author is editor-at-large Bo Burlingham. Their book, The Knack, was named the best book on entrepreneurship of 2008 by 800-CEO-READ.

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Last updated: Oct 1, 2009

NORM BRODSKY | Columnist

Street Smarts columnist and senior contributing editor Norm Brodsky is a veteran entrepreneur who has founded and expanded six businesses.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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