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Seller Beware

From the fall 2012 issue of OPEN, the McCombs School of Business alumni magazine.

Once upon a time there was a company that wanted to purchase another company. But soon the buyer became ensnared in mistrust and turned to deception, poisoning the would-be deal without the seller’s even realizing it. Only this is no fairy tale. It’s a real-life drama that unfolds all too often, according to research from McCombs. But there is hope for both sides to have a happy ending.


A cautionary tale for sellers in mergers and acquisitions

By Rob Heidrick

Illustration by Zohar Lazar

When Robert Reeves and Daniel Nelson decided to sell their business in 2009, they knew they had their work cut out for them. The software industry was riding out the toughest economic recession in decades, and many companies were cutting their losses as software sales winnowed off to nothing.

“It was terrible. Companies were laying off employees and had just stopped purchasing completely,” says Reeves, MSTC ’12. 

Their company, Phurnace Software—founded in 2006 while Nelson was wrapping up his time in the Texas Evening MBA Program—had gotten off to a strong start under the guidance of Rob Adams, a McCombs lecturer and director of the Jon Brumley Texas Venture Labs (TVL). Phurnace won that year’s Texas Moot Corp competition (now called the Texas Venture Labs Investment Competition). 

Their products made it easier for large companies to install enterprise software—applications that businesses use to keep track of their internal operations. For example, Walmart used Phurnace software to create a portal to manage human resources data for thousands of employees. Previously, it took a lot of manpower to deploy a program on that scale, but Phurnace automated that deployment process so it took much less time and was simple enough for lower-level employees to handle. 

“You didn’t need a rocket scientist to do it anymore,” Reeves says.

In a way, the economic downturn presented an opportunity for Phurnace. Even as its customers laid off many of their high-level people, those companies managed to keep doing business using Phurnace’s technology because it helped simplify operations.

“They were able to keep things humming along, even though they let all those contractors and consultants go,” Reeves says. “It saved them a ton of money, and they got to meet all their numbers because of us.”

It wasn’t long before larger companies approached Phurnace to discuss acquisition. Given the tumultuous economy, many entrepreneurs were tempted to accept any offers they could get just to avoid going under. Reeves admits that despite Phurnace’s strong performance, he and Nelson had mostly followed the lead of potential buyers and trusted the information they provided.

But then something changed: Reeves read a Forbes article about research being done by associate professor Melissa Graebner that made the entrepreneurs rethink their sale strategy. 

Less Lamb, More Lion

In the study, Graebner examined entrepreneurs’ expectations when selling their companies, particularly with regard to the dynamic of trust between sellers and buyers. The biggest takeaway from her research: Sellers often put too much faith in buyers, leaving them vulnerable to exploitation.

“Acquisitions are high-stakes, competitive situations that will bring out behavior that people don't exhibit in other kinds of settings,” Graebner says.

Reeves says selling the company was part of the plan all along, and it was simply a matter of time before the marketplace heated up. “We were always looking for an acquisition,” he says. “But we’re not chumps, and we weren’t going to take the first offer that came up.”

By 2009, Reeves and Nelson had taken several meetings with BMC Software, one of the “Big Four” IT assistance management companies. BMC was expressing interest in a potential deal but hadn’t made an official offer. The entrepreneurs had no reason to suspect they were just spinning their wheels—but they probably should have.

“At the time, BMC was attempting to replicate our technology,” Reeves says. “We knew they were dabbling around in it, but we had no idea they had a whole development team in Israel working on it.”

After a post on the McCombs Today website directed him to the Forbes article about Graebner’s work, Reeves pored through her entire study. He took particular interest in an anecdote about a young entrepreneur who was courted by a competing company over the course of several meetings, only to discover that the competitor was stringing him along to discourage him from seeking venture funding. By delaying the entrepreneur’s plans to secure venture capital money, the competition improved its own bargaining position.

“We said, ‘If Dr. Graebner’s research is telling us that we’re trusting the acquirer more than they’re trusting us, let’s flip that on its head,’” Reeves recalls. “Let’s start trusting them less. And then let’s start rattling their cage.”

So Reeves and Nelson cancelled their next meeting with BMC and scheduled one with Hewlett-Packard in Cupertino, Calif. (also the home of Apple). They knew BMC would be curious about the meeting and whether they were discussing a deal with one of those two companies.

“We told them that maybe if we had some kind of relationship, we could disclose more information, but until then, sorry,” Reeves says. “I credit Dr. Graebner for pushing us in that direction—to be more lion-like and less lamb-like when we went into the negotiations.”

Trust But Verify

Entrepreneurs have a lot at stake when selling their companies, including the fate of their technology, the well-being of the employees they handpicked to join their team, the future of their firm’s culture and strategy, and even the role that the top management team may have in the combined firm.

However, buyers have good reason for caution as well. In addition to putting up the money, they also have to rely on the seller’s performance projections, which may or may not be realistic. They also must contend with the reality that any deal they make is bound to be a gamble—studies have estimated that more than 70 percent of mergers and acquisitions end in failure.

Yet buyers can sometimes be overly cautious, leading them to distrust sellers when there is no cause to do so, Graebner says. 

“Buyers feel justified in playing hardball if they think that the sellers aren’t being honest with them,” she says. “They need to protect their own interests.” 

In some cases, this imbalance of trust can cause the acquirer to take advantage of the acquiree.

“Buyers are most deceptive in a specific set of circumstances: When they don't trust the seller, but they believe that the seller trusts them,” Graebner says. “Believing that the seller trusts them creates temptation.”

TVL’s Rob Adams sees the same symptom and points to poor communication as a common problem.

“It’s more that people don’t communicate clearly, and there’s a difference of expectations,” he says. “The seller thinks they’re getting an apple and ends up getting an orange.”

So it’s important for both parties to be cautious.

“There needs to be an atmosphere of trust, but both sides have to verify each other,” Adams says. “It’s kind of a balance: The company that’s selling itself is going to make things sound better than they really are, and the company that’s buying is going to make things sound better than they really are, typically. And that’s just human nature. That’s not an ethics question.

“It’s like what Reagan said about negotiating with the Russians: ‘Trust but verify,’” he says.

Get it in Writing

The best strategy for both sides to ensure a smooth acquisition is to set simple terms with measurable targets, Adams says.

“You have to be clear about communicating, you’ve got to be clear about what the expectations are, and whatever the major drivers of the deal are, you have to have objective measurements going forward so there are no shades of gray,” he says.

Graebner believes that both deception and simple misunderstanding can create problems. A good way to avoid bad outcomes, she says, is to make decisions based only on what you can get in writing, as anything else might just be wishful thinking.

“Anything that is not in writing cannot be considered a firm commitment, regardless of how well the seller likes the people they are negotiating with,” she says.

Reeves says he took that wisdom to heart during the Phurnace negotiations. When BMC assured him and Nelson that their employees would be taken care of during the transition, the entrepreneurs insisted on written agreements about performance bonuses and other considerations.

“We put pen to paper for all of our employees,” Reeves says. “We were able to get commitments from them in writing about how they were going to compensate our employees even if there was a future layoff.”

But there are limits to how much buyers are willing to put in writing. Adams says that while acquirers sometimes offer performance bonuses for talented employees they want to retain, they rarely commit to specifics about how they will operate the acquired company in the future.

“No company is going to acquire you and guarantee what the organization is going to be post-transaction,” Adams says. “That’s just an unrealistic expectation.”

Graebner concurs: “There are certain terms that buyers will never agree to in writing because it would constrain their future strategic flexibility too much. So sellers should just take those out of their decision equation.” 

A Happy Ending

Following the sale of Phurnace, Reeves and Nelson continued to work at BMC for 15 months, fulfilling their employment contracts. Reeves entered McCombs’ Master of Science in Technology Commercialization program in 2011, giving him an opportunity to work with Graebner, the researcher who originally inspired him to think twice before going all in.

“Her research put money right into our pockets,” he says.

Within a few months of leaving BMC, Nelson longed for the rush associated with launching another company, a process he describes as both fun and terrifying. 

“It had to be the right company, the right opportunity, the right pain point,” he says. 

In April 2012, Nelson and Reeves launched Datical, which creates database schema automation software for the $22 billion IT systems management market. 

Datical has close ties to The University of Texas at Austin: It was a Texas Venture Labs company in spring 2012 and is currently an Austin Technology Incubator member company (see sidebar). Datical is a much larger company than Phurnace, offering its founders both new rewards and challenges. 

So far, the founders have talked to 60 companies about their needs, part of an ongoing process of data collection and market validation. “You ask companies what they want, build it, and go sell it to them” Nelson says.

Before coming to McCombs, Nelson never considered launching companies as a viable career choice. 

Now, it’s his passion. Being an entrepreneur is the “first thing I ever did that engaged all parts of my mind,” intellectually and emotionally, he says. 

Does this mean Reeves and Nelson are already thinking of what lies beyond Datical? Not necessarily—they have too much to deal with in the present.

“You start a company with the goal of being an ongoing, successful business, and then things happen like an acquisition or going public. Everything positive flows from that hard work,” Nelson says.

But, should the time eventually come to return to the negotiating table, Reeves says he’ll follow the same advice Adams gave them three years ago: Create a market by saying no. Don’t accept the first offer. Trust but verify. It’s the same spirit that guided them through the sale of Phurnace, empowering them to hold their ground until the right opportunity came along.

“So we said no a lot, until we couldn’t say no,” he says. “You keep saying no until you get to the point when you’re like, ‘Oh man, my wife is gonna kill me if I pass this up!’” 

--Additional reporting by Jeremy Simon


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#1 I strongly believe that the

I strongly believe that the lies and deceit of a dishonest person always catches up with him in the end. The only way to obtain long-term success is by putting all of one's cards on the table from the beginning.

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