Third Time’s the Charm?

NOAM WASSERMAN YAEL BRAID

KCC: Third Time’s the Charm?

For Eric Kurtzman and Jonathan Carson, the deal on the table would be equivalent to an early retirement. Having spent the last eight years tirelessly building their bankruptcy-consulting company, Kurtzman Carson Consultants (KCC), into a tech-savvy industry leader studded with accolades, the partners were staring at an acquisition offer that would handsomely compensate them for the value they had built.

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Jonathan (pictured below) and Eric had been down this road before, having danced with the idea of selling the company twice in the past. Both times, the circumstances, the terms, and the wooing acquirer ultimately had not seemed right and they had backed away from the deal. Both times, history had demonstrated that deciding against selling had been the prudent choice; both near-sells had spurred the team to make better choices that had dramatically expanded KCC’s

profitability and value.

Should this time be any different? Was now finally the right moment to sell? Were these terms the best they could get? Would this company be a partner to Jonathan and Eric, helping them achieve their visions for KCC? The two cofounders strongly wanted to continue leading KCC. Would the diehard entrepreneurs be better off holding

onto the reins of the company they had lovingly built and continuing to lead their loyal employees? The terms looked reasonable but imperfect. Should they exit now, or continue down the independent path that had taken them this far?

Big-town Meets Small-town

Jonathan Carson, a native of suburban Chicago, had always wanted to be a lawyer. He admired the attorneys in his family and found satisfaction in good debate. While in law school at Chicago-Kent College of Law, a bankruptcy course drew Jonathan’s interest and he realized bankruptcy law would give him the opportunity to “practice law in the corporate world without sacrificing the courtroom.” However, upon graduating in 1997, the dot-com boom was in full force and bankruptcy-related jobs were scarce, so Jonathan accepted a two-year clerkship with the Chief Bankruptcy Judge in Los Angeles. Two years later, he returned to Chicago to join Kirkland & Ellis (K&E) as an Associate in the firm’s Corporate Restructuring Department.

In contrast, Eric Kurtzman was an accidental lawyer. Eric grew up in the small desert town of Apple Valley, CA. Nearly 50% of Eric’s high school freshmen class did not graduate, yet Eric pursued an academic path, graduating as his high-school class valedictorian before earning a bachelor’s degree from UC Berkeley. Unlike Jonathan, Eric hadn’t been driven to become a lawyer. “I didn’t go to law school because it was the right thing, but because I knew it wasn’t the wrong thing,” he said. He

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November 15, 2017

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attended UCLA’s law school but hated it, decided he probably would not enjoy being a lawyer, and co- matriculated into UCLA’s MBA program. As graduation approached and job recruiters came to campus, Eric quickly learned that having zero work experience made him unattractive to the companies recruiting MBAs, forcing him to go into law after all: “My law degree had no value for business jobs. So I went into corporate restructuring, which was the closest thing I could find to going into business.”

Within a few years, both men found themselves frustrated as lawyers. In his job at Pachulski, Stang, Ziehl, Young & Jones (“Pachulski Stang”), a prominent boutique law firm specializing in bankruptcy, Eric watched people “destroy their businesses, yet none of them were pointing their fingers inward, never saying ‘senior management keeps doing stupid things.’” He found himself thinking, “I could do better than these guys!” Eric had always had an entrepreneurial itch – he was the kid who made 5X margins selling candy in grade school. “It was always pretty obvious to me how to make money on my own, and that was exciting to me. But billing by the hour is the opposite of that; you can’t scale that.”

Jonathan and Eric met when their respective firms assigned them to the same deal. Jonathan was the sole Associate counseling a Chicago-based medical-device manufacturer that had found itself on the verge of bankruptcy. Jonathan and the K&E team filed the bankruptcy case in Delaware, and at K&E’s urging, the company hired Pachulski Stang’s Wilmington office as “local counsel” to support the case’s day-to-day needs. The Delaware office was a new addition to Pachulski Stang and, at the time, Eric was the only Associate staffed in that office. Jonathan and Eric worked on the case together, sharing the administrative burden. As Jonathan recalls:

The partners above us on the case were distracted with larger deals, leaving Eric and me to run the case largely on our own. At the financial advisor’s recommendation, the company hired a Claims Agent to help manage the administrative tasks, and the firm was far less than helpful, leaving Eric and me to redo most of its work, which came at tremendous expense to the client.

During the six-month period collaborating on that case, they found their strengths complemented each other very well. Eric’s mathematical prowess and negotiating skills meshed well with Jonathan’s knack for networking and marketing. About Jonathan, Eric marveled, “I’ve never developed his ridiculous ability to remember people and their place in networks. After a dinner meeting, he would know what wine everyone prefers, what golf clubs they belong to, and where their spouses want to vacation. But I would never ask him to calculate the tip; that would be a disaster. It’s great to know I have a partner who can crush the ball in ways that I can’t.” About Eric, Jonathan said, “I knew he was incredibly smart and would handle much of the operational work, leaving me to roam freely where I could add the most value and that I could trust him to execute. Between the two of us, we had everything covered – I was marketing, he was numbers. I was outside, he was inside.” The two personalities also diverged. Eric was a “very colorful type, who wore leather pants, drove a Camaro,” and loved Las Vegas, but was more comfortable at IHOP than anywhere requiring shirts with sleeves. Jonathan came from a much more traditional background, with his big-city upbringing and more- formal demeanor.

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Prof. Noam Wasserman, Director of Founder Central and Professor of Clinical Entrepreneurship, and Yael Braid, Founder Central research assistant, prepared this case. The authors would like to thank the Greif Center for its support of this project. This case was developed from field research. Cases are developed solely as the basis for class discussion and are not intended to serve as endorsements, sources of primary data or illustrations of effective or ineffective management.

Copyright © 2017 Lloyd Greif Center for Entrepreneurial Studies, Marshall School of Business, University of Southern California. For information about Greif Center cases, please contact us at greifcases@marshall.usc.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted or transmitted without the permission of The Lloyd Greif Center for Entrepreneurial Studies.

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KCC: Third Time’s the Charm? SCG-533

In terms of work culture, both preferred a more unconventional environment, a culture with more relaxed professional norms and a focus on togetherness and having fun while at work. Though they were both making comfortable salaries of $200,000, neither had an interest in climbing the law- career ladder or living the lifestyle of the senior partners at their firms.

Entrée into Entrepreneurship

In mid-2001 an opportunity emerged for the two men to buy a claims agency. Jonathan and Eric studied the business intensely. They pored over client and billing documents, and experienced the company’s culture, which was one that did not engender strong employee morale. The seller’s terms required the two men to finance the buyout by working for the seller for several years. After running the numbers, Jonathan and Eric decided they would be better off building a business on their own, as Eric explained: “We put together an unsophisticated model that showed that with only a few cases, we could make more than we were making as lawyers.”

The experience of analyzing the buyout possibility brought them closer together; they more deeply valued each other’s abilities. Additionally, the Delaware case on which they had collaborated had “allowed us to identify the pain points associated with working with a claims agent. We had an intimate familiarity with the existing solutions to a painful problem and the strengths, weaknesses, and voids that lie therein,” Eric reflected. Soon after, Jonathan and his wife moved from Chicago to Los Angeles to start the process of creating KCC. The senior partner at Pachulski Stang, Richard Pachulski, offered Jonathan the opportunity to work for the firm during the transition, knowing that the two were planning to leave within the year to found KCC. Eric explained: “Because he came from K&E, which was the source of something like 30% of Pachulski’s revenue, Richard appreciated Jonathan’s unique perspective as someone who knew the inner-workings of the K&E team and could help his attorneys better understand this important referral source.” Jonathan and Eric incorporated KCC, and in August of that year the duo hired a software-development firm to develop the core technology platform.

On November 30, 2001, Eric left his job at Pachulski (“My colleagues literally bet I’d be back within eight months,” he recalled). The very next day, he opened KCC’s first office and started building desks with his Uncle Fred, setting up phone lines and preparing the business for its January launch. Jonathan completed the year at Pachulski Stang, as he had promised Richard he would do, and officially joined Eric full-time on January 1, 2002. Early on, the cofounders didn’t care which one would take the CEO title, so their first business plan showed Jonathan as CEO and Eric as chief financial officer (CFO) and Chairman of the Board. Soon after, they settled on Eric as CEO and CFO and Jonathan as President and chief marketing officer (CMO).

Eric realized that “starting from scratch was a lot scarier than if we had bought that already- established business. That other business at least had some kind of structure we could throw putty on top of and paint over!” To help them get started, Eric brought over a small law client from Pachulski, and Pachulski referred another small case that was too small for Pachulski but provided decent revenue for the nascent KCC. It was enough to “keep the lights on while we got the office set up,” Eric said, but neither of these were claims-agent cases; they were cases Eric took on as a lawyer in a side business the partners created to raise any revenue they could.

For all their bold strokes in taking the entrepreneurial plunge, both admit they were fearful, as Eric explained:

I had gone to law school because it was “not the wrong thing to do,” and that’s the lawyer mentality: fear of risk. You’d rather not be wrong than be right. We were both in lucrative jobs that we’d worked years to get to. Jumping off to do an

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SCG-533 KCC: Third Time’s the Charm?

entrepreneurial venture was very scary. Lots of times I was ready to quit. Out of loyalty to Jonathan I went forward. Years later, I found out he had been experiencing similar fears: “Can I really put my wife through this? What if it fails, what would I tell my family?”

Jonathan similarly reflected, “The reactions I got were those of envy and disbelief; colleagues were surprised by my apparent lack of fear of failure, and jealous that I was ‘getting out.’ We both proceeded in the face of doubt; there’s no way we would have jumped off the bridge if not for the other’s commitment to do so.” (See Exhibit 1 for Eric’s later reflections on the barriers introduced by their backgrounds as law students and then lawyers.)

In short, KCC would take care of the voluminous paperwork generated during a bankruptcy process. Their original business plan stated that, “KC Consultants will service the chapter 11 bankruptcy industry by providing necessary administrative-support services to debtors and their professionals before, during, and after a chapter 11 bankruptcy proceeding….The industry is composed of approximately 8 firms that compete with one another both across the nation and within particular geographic regions. KC Consultants will compete with all 8 firms nationally, and only 2 firms in southern California, including the Los Angeles metropolitan area.” (See Exhibit 2 for Financial Projections section from KCC’s 2001 Business Plan.)

KCC: The Early Days

Seed funding for KCC came from the pockets of the founders and their family members. Jonathan and Eric each contributed $30,000. “That was the critical point where I said, ‘I’m in,’ it was a ton of money for each of us,” Eric recalls. “The first time we wrote a check out of that $60K – that really deepened the commitment.” Jonathan’s mother lent the business $50,000, as did Eric; six months later, the young business borrowed $25,000 each from Jonathan’s father-in-law and from Eric once again. Jonathan recalls the pressures of borrowing money from friends and family: “Now we really have to make it work; we can’t let them down … the only choice was to swim as hard as we could.” Although the notes paid 5% interest, the cofounders were grateful that they were able to keep 100% of the equity. With the seed money they hired a programming firm to build their case-management technology, rented office space, and leased a few photocopiers. By the fourth month in business, thanks to revenue from small initial cases, KCC was cash-flow positive.

To build KCC’s team, the founders drew on their contacts and the local universities. Three hires were particularly impactful. Their first employee, Robert Klamser, was a senior from Loyola Marymount University who turned out to be a surprise gem. “Robert was huge on morale with a head for business.” KCC hired him as a part-time worker, and paid him $8 an hour. For his work, KCC was able to bill Robert at $40-$45 an hour. After a month, they realized he was bringing in a lot of value and proactively bumped him to $9 – a move that boosted Robert’s work ethic while being profitable to KCC because KCC began billing him out at $50 an hour.

Robert was a great counterweight to another prize hire, Tony Kay, who, Jonathan recounts, “had less business savvy but was ingenious ‘in the weeds’ and had a particular knack for the intersection of technology and bankruptcy.” Tony was a “super-paralegal” who had done temp work for Eric in 1999 while Eric was opening Pachulski’s Delaware office. Eric had worked closely with Tony and had been his neighbor in a Wilmington hotel for four months. Eric knew firsthand that he was “incredibly bright, knew the industry well, knew how the players operated, and was great at technology. A jack of all trades.” A self-starter and leader, Tony initially came on board as a consultant, but in short order “effectively became our chief operating officer (COO).” Tony set up the database and the office files, and functioned as the interpreter between the founders and the technology people. Tony’s disposition fit right in with the culture Eric and Jonathan sought to establish, as Jonathan observed: “Our level of

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KCC: Third Time’s the Charm? SCG-533

anti-establishment was nothing compared to Tony’s. He’d start the day with a triple espresso, smoked hand-rolled cigarettes all day long, and we had to have Guinness in the fridge at all times for him.” (See Exhibit 3 for a picture of Jonathan, Eric, and Tony.)

The third early employee was Chris Schepper, who had left a long career as a Pachulski paralegal hoping for a meaningful career as a teacher. However, while awaiting his teaching certification, he found himself with lots of free time and little income. He joined KCC and “found both meaning and money.” Chris led the project teams and would get everyone to rally around the flag. A naturally charismatic leader whom the young team loved to work with, he also had knowledge of bankruptcy administration “beyond almost anyone else in the industry.” Chris became “the most important substantive asset” to the growing company:

He was the go-to guy for the staff, whether they had a problem in a case or were worried about asking “the boss” for something. Although we had an open-door policy and the staff felt very comfortable talking to us, Chris in many ways played a parallel role to Tony, but Chris spoke “executive” to the founders and spoke “staff” to the team.

Chris also helped bring aboard a friend of his as KCC’s office manager, who later brought her husband aboard as KCC’s chief technology officer (CTO) at a crucial time in the company’s technology-maturation process.

By the end of 2002, the team grew to 20 people and was managing 10 cases, bringing in $1 million in revenue for the year. The money funded generous bonuses to the staff, paid off the friends-and- family debt, and sent each of the partners home with $100,000 in income for the year. KCC also moved to a larger space. Each employee grew into a larger role as the company grew. The culture continued to be both anti-establishment and generous to the employees, providing morale-boosting perks like a fully stocked kitchen, game room, and nap room. Eric reflected on the roots of KCC’s approach to treating its employees:

At Pachulski, founder Richard Pachulski was a strong patriarch who always made me feel important, as if he was watching me with great interest. If he had an extra ticket to a basketball game, he’d give it to me, or he would invite me to his weekly poker night. I learned from that. I also came from a very supportive family that helped with plotting my successes and helped pick me up when I fell. That brought out the best in me, and here I had the opportunity to do that for a lot of other people.

2003’s Acquisition Dance

In early 2003, Eric and Jonathan were approached by a large public company with an acquisition offer. The company had purchased “the biggest horse in the claims-agent industry – 40% market share – and then realized it didn’t have a jockey to ride the horse to continued greatness. They looked to us to fill the hole,” Jonathan recalled, continuing:

Senior management hosted us in the boardroom of a fancy Beverly Hills hotel and offered us an all-cash deal for $12M, which fell far short of a reasonable offer, and we refused. They countered with a multi-year deal involving cash and stock with a valuation that exceeded $40M – a very aggressive valuation for a young company of our size – which was intriguing. We proposed that they provide bonuses to our employees in consideration of their incredible effort to date, but they rejected the idea. We realized that we had different priorities, that alignment could be difficult down the road.

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SCG-533 KCC: Third Time’s the Charm?

During the months of due diligence, Jonathan and Eric concluded that the fit wasn’t right. “We were too anti-establishment; they were too establishment. We didn’t want to put our baby in their hands, and didn’t feel right asking our team to work for them.” The cofounders called off the deal. Eric reflected:

I was relieved to be walking away. The idea of working for someone else, and committing to work for them for four or five years, was frightening. The fact that they were big made it even more frightening. It was exciting – it was unimaginable to have someone write us an eight-figure check. But I was making five times as much money as I’d ever made, and everything was looking upward. I didn’t feel like I was walking away from a once in a lifetime opportunity to cash in.

The experience of dancing with an acquirer made the founders realize that they wanted to accomplish more with KCC. Jonathan said, “If we sold now, we would make a lot for the parent, not for us. We hadn’t formed what we wanted to make on the pottery wheel. We walked away and focused on continued growth, with a bit of spite for our major competitor thrown in.”

Onward and Upward

Shortly after the acquisition talks ended, Jonathan and Eric implemented several changes that sparked major growth. First, Jonathan said, “The sale process had been distracting for the business, requiring Eric and me both to manage the suitor as well as the business; we couldn’t do it all, but instead needed our key people’s support to maintain KCC’s positive momentum.” The founders decided to establish a Steering Committee. The Steering Committee was comprised of the informal leads of each of the key groups, who now took on more-formal roles. It met every Monday and enabled the group leads to be more informed and, in turn, to keep their employees more informed. It also promoted integration and communication across the groups, which in turn increased morale company-wide. The average age of the Steering Committee was approximately 27 and the average professional tenure was less than two years.

Jonathan and Eric also made additional hires. Some of those hires brought new tensions to KCC. As the result of a referral from a partner at K&E, at the end of 2003 KCC brought on Howard Blaustein. He served as KCC’s first employee focused exclusively on business development, and he came at a significant expense. As Jonathan recalls, “Howard was expensive, but was worth every penny. He helped bring KCC to the New York market (the largest in the corporate-restructuring industry), which fueled incredible growth.” But his hiring also brought internal tension, as some coworkers resented his high compensation, the perception that “he was out wining and dining new clients and not ‘working’ in the same manner as the consultants,” and his high performance expectations when it came to servicing business he generated.

To help establish KCC’s marketing department, Jonathan also hired Kristal Bogle, who had been groomed by a well-known branding agency and then successfully built the marketing department at another LA-based startup.

She took a 2-week reading period to learn everything about us, and then presented her findings to the Steering Committee, articulating her observation of KCC’s core traits as captured by iconic figures from mainstream society. Richard Branson captured KCC’s anti-establishment entrepreneurial mission to conquer the world. “The West Wing” represented KCC’s collaborative culture. Dumbledore from the Harry Potter books represented KCC’s “subject-matter expertise” and its authoritative aura.

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KCC: Third Time’s the Charm? SCG-533

Kristal impressed Jonathan with her ability to articulate her observations to the team, positioning her to have Jonathan’s ear as growth continued. With the continued growth came not only more structure, but also new office space, providing the founders and their team with more physical room to grow.

A major setback accompanied these hiring successes. In late 2003, Tony asked Eric and Jonathan to give him an equity stake in recognition for the value he’d contributed to date. The partners offered to sell him 10% of the firm for $100,000. Eric recalled, “He said, ‘I’ve already earned this – I shouldn’t have to pay for it now!’ It was a very principled stand: even when getting an amazing gift, he rejected it. I respected the conviction he had, but we both took a principled approach, and because of that, we didn’t agree.”

Tony decided to leave KCC. His departure made the founders anxious and nervous. Jonathan recalled: “Until then, every time we had a big problem, Tony jumped in to fix it. We had doubts as to whether we could continue to grow without him.” However, they soon realized that Tony had done an exceptional job of systematizing the procedures he had implemented, making the transition rather seamless. Without Tony, who had functioned as the “training wheels” for the young startup, the team was forced to rely on themselves more, forcing growth across the ranks with the expansion of responsibilities. Tony left a legacy of creating systems, and with his voice echoing “consistency, consistency, consistency” in their minds, Eric and Jonathan continued to preach the importance of creating systems wherever possible.

Thanks in large part to Jonathan’s business-development strategy and Howard’s ability to execute the strategy, KCC’s market share took off, with the firm winning a greater share of the larger cases because of the market’s perception of quality and reliability. The market-share growth put incredible stress on KCC’s operations, as Eric noted when asked the difference between the partners’ jobs: “My job is to make sure that everything Jonathan brings in is done perfectly and leaves a happy client who will come back. Jonathan’s job is to make my job as difficult as possible.” While working on a case, KCC’s operations team would proactively find new service lines to offer existing clients, which increased client satisfaction as well as KCC’s revenue.

Industry observers noticed KCC’s momentum, earning the company accolades such as being named The Los Angeles Business Journal’s “Fastest Growing Private Company in Los Angeles” and a #42 ranking in Inc. magazine’s “Inc. 500” list. While the recognition helped fuel growth, the founders learned the hard way that self-promotion wasn’t well-received by KCC’s audience. As a result, Jonathan shifted KCC’s public relations strategy from one of self-promotion to one of expert positioning. As part of this strategic shift, Jonathan hired a PR director to help guide KCC’s market visibility.

By mid-2005, KCC’s “story only went up and to the right” as they rode a booming market. Between 2003 and 2005, their market share of “mega” cases (Chapter 11 cases with over $500 million in pre-petition assets) rose from 5% to 30%, making KCC the number one player in that market. In October 2004, KCC opened its second office, in New York City. (See Exhibit 4 for financial performance during this period.)

Exit, Take Two

The fall of 2005 brought an uptick in the corporate-restructuring market, leading Eric and Jonathan to prepare for significant expansion. The founders decided to explore opportunities to diversify the revenue base and hired an investment banker to advise them in the process. While typically a company’s Board of Directors plays an active role in considering such strategic options, KCC’s founders never established a board, instead relying on each other and a handful of industry

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colleagues to help guide them. Jonathan explained: “We relied heavily on ourselves and our close friends. We never seriously considered creating a formal board. We had been aligned every step of the way thus far; there was no reason to change the structure at the top. Plus, we had the benefit of never raising real outside capital, which meant that KCC was born with no built-in accountability at the top. Why fix what wasn’t broken?” Similarly, Eric appreciated the fluidity of decision-making sans a board:

If I wanted to do something, I’d email Jonathan and then go do it. Our ability to react with extra speed made us superior to our opponents. Between Jonathan and me, we covered almost everything – when one of us was only okay at something, the other was really good at it. One leads and goes to the other to bounce it off of him. We became each other’s board. Then, when we expanded the executive committee, we almost treated them as a board – we had them tell us when they thought we were wrong.

To navigate the search for an acquirer, Jonathan and Eric hired L.A.-based investment bank Houlihan Lokey to run the process, with legal advice from the prominent law firm Skadden Arps. They also hired an additional advisor, Eric’s former fraternity big brother Craig Enenstein. Craig had worked on dozens of private-equity and venture-capital investments across a wide range of industries and the two partners were confident he would “be for each of us a personal back-stop, who knows you as a person and guides you through these decisions.” KCC received more than 20 “indications of interest” from private-equity firms looking to invest in the company. The interest forced Jonathan and Eric to create financial projections for the first time.” (See Exhibits 5-7 for excerpts from their 2006 pitch deck: “Management Team,” “Strong Performance in Difficult Markets,” and “Projection Assumptions” and “Projected Performance.”)

Jonathan and Eric narrowed the field of suitors to a growth-oriented private equity firm inside of Bear Stearns called Bear Growth Partners. For several months, Eric and KCC’s advisors negotiated the letter of intent with Bear Growth. Jonathan and Eric had decided to have Eric focus on the buyout dealings while Jonathan continued leading the company’s operations. Eric said: “I was the one talking with everyone every day, and then would talk with Jonathan and filter it for him so he could give me his thoughts and advice and we could decide together on next steps.”

For Eric especially, the potential financial payout was critical:

I was once at a CEO leadership-training meeting and the speaker told us to “think of the amount of money you’d need to be offered to sell your company.” I decided $60M; after the split with Jonathan, and paying taxes, that would give me $50K a month to live on for the rest of my life, which was more than I could ever use. “Now think about what you could sell your business for?” I decided: $50M. The lecturer continued, “I guarantee you that you’re short 20% of what you want.” It was amazing; he nailed it. He said, “It’s true for every entrepreneur: whatever you can get, you want 20% more. That will keep happening; your number will just keep getting higher. Instead, plant your flag in the ground, decide on your number, and sell if you get it.”

Despite having hired top-notch advisors, Eric worked tirelessly to drill down into the details. He soon found his advisors to be a hindrance: “With 10 lawyers on the phone, and with matters like tax issues, nothing gets done, because everyone operates from a position of fear, fear of being wrong. So instead, I decided to work directly with Mike, Bear Growth’s point person. I told them, ‘Mike and I will figure this out. We’ll battle it out and come to a resolution.’”

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KCC: Third Time’s the Charm? SCG-533

Bear’s initial offer was to buy 40% of the company at a valuation of $60M. In the midst of the negotiations, Eric and Jonathan realized that KCC wasn’t going to hit its projections. The uptick in the corporate-bankruptcy market that had been predicted hadn’t yet materialized. Bear reduced its proposed valuation to $56M with a possibility of returning to $60M if KCC hit its projections. Eric countered that he wanted the deal to have some upside – that downside protection for Bear made sense, but if KCC “hits it out of the park,” then the offer should rise to $64M. But Mike refused, saying he could not go back to his board for more money.

Jonathan and Eric returned to their advisors to decide what to do. Craig suggested that “Eric is past being able to play CFO.” He recommended that Eric back away and hire a CFO to help manage cash flow and prepare the business for sale once the market finally turned. He said, “Go learn how to spell EBITDA and get ready to bring the company back to the market once the uptick arrives.” Eric admitted, “We didn’t have a full grasp of our cash flow and it exposed a vulnerability. For example, we were treating expenses to fund extensive improvements on our new building the same way as we were treating true operating expenses, like salaries. This lack of financial/accounting sophistication caused inappropriate downward pressure on EBITDA.” Eric agreed that he no longer was the right CFO for the growing business. (In retrospect, both felt that their investment bank should have done a better job at helping them understand why margins had been falling although revenues were stable or increasing.)

At the same time, they recognized that Craig’s advice to walk away from the process was counter to the success-fee nature of his engagement, which made his advice even more meaningful. Houlihan (which also had a success-fee engagement) and Skadden also advised the duo to wait until KCC returned to being “a hockey stick” in its growth trajectory once the market turned.

Eric and Jonathan decided to end talks with Bear Growth. They had gotten tantalizingly close. “Had Bear not reduced the price to $56M, we would have closed, and even with the reduced price, had Craig said to close, we probably would have closed,” Jonathan explained.

Eric was ambivalent about walking away:

I was not really relieved this time. The first time we would have been getting into bed with total jerks. This time would have been getting in with people I really enjoyed. The valuation was double what it was last time. Our EBITDA was $5- 7M with no interest payments or depreciation so it was just about cash flow. I’m taking home $3M a year, which was $1.8M after taxes. I had put away over a million each year for a couple of years. With Bear, if we had sold 40%, it would be after-taxes almost $10M for each of us. Even if things would go sideways, I’d be okay for the rest of my life. We would be “taking chips off the table.” Now, by walking away, it would be a continuance of my ongoing worry that I have only a few million in the bank.

The cost of the process also frustrated Eric and Jonathan. “Between Houlihan, Skadden, and Craig, we probably spent $500K. Not the best use of cash flow for a growing business that needed continually to spend on infrastructure and technology to maintain its market leadership.” Lastly, the entire exercise had been draining and time consuming. Eric said, “We were maximizing today, not accelerating tomorrow,” and while doing so, “you lose some of your gas.”

Round Two’s Aftermath

KCC lacked proper financial leadership. Hitting projections amid construction of a new building was difficult, and they lacked insight into why that was the case. As a result, Eric hired a new CFO who “renegotiated the contracts I had long-ago negotiated, when we had little leverage compared to

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SCG-533 KCC: Third Time’s the Charm?

what we had in 2005. This process saved us half a million dollars a year. He forced us to re-examine decisions that had been right four years before, but weren’t now. It was simply time to hang a question mark next to things we had long taken as given facts.”

Jonathan and Eric also realized how entangled their names and personas had become with KCC’s reputation. Bear Growth and other interested parties had repeatedly questioned KCC’s viability without its founders, suggesting the business was purely a services firm reliant upon the two names on the door. To give future suitors the confidence that KCC was a sustainable business regardless of Eric and Jonathan’s involvement, the partners decided to distance themselves. Eric observed: “We stopped calling ourselves ‘Kurtzman Carson Consultants’ and started using ‘KCC.’ We expanded our executive board and gave them more power. We hired people to assume my roles of CFO and General Counsel, and to assume Jonathan’s role of Vice President of Business Development.”

The partners had seen how blasé their employees had been when meeting with potential acquirers, as the process “was a burden on them since they didn’t have skin in the game.” For the employees, an exit would have no upside but lots of risks: having a new boss, facing a new culture and set of procedures imposed by the parent company, even potentially losing their jobs. At the same time, certain key employees were asking about upside opportunities. They decided to establish a profit interest plan (PIP) to “empower our executive team and to distance ourselves from being the ‘Jonathan and Eric black box.’ It was all done with our exit in mind.” Eric explained: “We wanted to create a platform to give our employees a reason to push the company forward. We wanted to have people visibly invested.” “We wanted them to be excited about an exit,” Jonathan added.

Through the PIP, Jonathan and Eric set aside 10% of the upside value of the company for 18 senior executives; collectively, they would receive 10% of what KCC would sell for over $60 million (the company’s initial valuation from Bear Growth). The PIP was a complicated plan that allowed the founders to place golden handcuffs on their executives while increasing or decreasing shares each year based on performance of the executives and of KCC. The PIP design drew great accolades from Skadden Arps, whom the partners tapped to document the PIP. Ultimately the PIP was expanded to 22 people.

Finally, at this time Eric was traveling to Las Vegas several times each month to work with clients and to explore launching a mailing operation there. He was already contemplating moving there, and the projected 10% or higher California tax he would pay in the event of a sale was enough to move him from “thought” to “action” (Nevada had no state income tax). Eric approached Jonathan and said, “I’d like to move to Las Vegas and run our shop there once it’s up. Unfortunately, it’s going to be a lot harder for you, without having me here to help run the business.” With Jonathan’s blessing, Eric flipped his time, living in Vegas and commuting when needed to L.A. “I wouldn’t have gone if Jonathan had pushed back. But he was fine with it,” Eric explained.

Activities in Las Vegas also introduced challenges when KCC’s financials were scrutinized by prospective acquirers as part of the Houlihan process. Like many founders, Jonathan and Eric had used KCC as a source of funding for a variety of expenses that could be perceived as personal in nature. Regardless of the merit of those suggestions, perception oftentimes is reality, and Jonathan and Eric realized that they would have to instill more professional governance if they wanted to be an attractive acquisition target when they returned to exploring exit options.

To help captain the ship amidst Eric’s increased absence and Jonathan’s busy travel schedule, the partners appointed an Executive Committee (“EC”), a slimmed-down version of the Steering Committee, to co-lead KCC. One of the executives on the EC “was a man of the people.” Another “was more about execution, numbers and efficiency.” Their skill sets were complementary, giving both

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KCC: Third Time’s the Charm? SCG-533

leaders their own domains of focus. Jonathan and Eric hoped that the executives would develop interpersonal chemistry similar to that between the founders.

However, due to a lack of mutual respect for each other’s skills, the two executives regularly failed to support each other in decision-making, leaving employees “to approach whomever they thought would give them what they wanted. Jonathan and I had to retake considerable control over management,” as Eric recalled:

It’s very difficult for a two-headed company to operate. We failed to recognize that, to recognize that our relationship was unusual, to assume that others would be able to replicate the teamwork that came to Jonathan and me as easily as breathing. We should have established one of them as the leader and the other as the second in command, but unfortunately we needed both their skill sets, intermeshed, to achieve the leader we were looking for.

The following year was a stressful one for KCC. Although the industry had expected a big wave of bankruptcies, money was cheap and in reality “very few covenants were being tripped, meaning fewer corporate bankruptcy filings.” Given the lull in casework, the industry saw consolidation and price compression. KCC persisted, maintaining but not extending its 40% market share.

The founders’ frustrations grew when they handed out the annual PIP certificates to their executives. The founders had expected the PIP to materially increase participants’ sense of ownership of KCC and their engagement in its growth and ultimate sale. However, Eric confided, their employees “didn’t get it. It was too hypothetical and complicated to them. They couldn’t calculate how much money they’d have waiting for them, so they ignored it.” Jonathan observed, “We were giving up something significant, but the recipients didn’t appreciate the gesture.”

2008 Exit Round: Third Time’s the Charm?

In 2007, the calm came to a crashing halt. New Century Mortgage, the second-biggest subprime mortgage lender in the country, went bankrupt. Sensing a market tsunami was about to come ashore, Jonathan and Eric decided it was time once again to strategically explore market opportunities, as the business would need to diversify its revenue base if it expected to thrive in the uptick and then stabilize during the following recovery. Plus, returning to the market during a surge in bankruptcies would position KCC “to sell the growth story,” which hopefully would translate into a larger pool of potential acquirers and a higher valuation. In addition, the expansion of KCC’s senior management team had widened KCC’s “operational footprint,” facilitating its ability to scale during the market uptick.

After the tremendous growth of the prior eight years, KCC had saturated its existing markets. As Eric recalls: “We reached the limits of how much we could expand within our market. We were doing 40-plus % of the cases nationwide and 70-plus % of the mega cases. We were skeptical about gaining additional market share and had already expanded the scope of services we could provide to claims- agent clients. Without revenue diversification, our finely-tuned ship would simply rise and fall with a market we did not control.” If they didn’t diversify their sources of revenue, Jonathan explained, “We’d grow tremendously and then shrink as corporate defaults and bankruptcies slowed, as happens in every cycle.”

Thanks to the changes they had made in the aftermath of 2005’s near-sale, the partners felt better positioned to navigate the acquisition market now. Hiring a CFO had proved to be “a game changer. The CFO grew the bottom line in ways we did not foresee,” Eric explained. Jonathan said, “In 2005, with $20M in revenue and approximately $7M in EBITDA, our valuation was approximately $60M. In 2008 we did $53M in revenue and $18.7M in EBITDA and commanded a $130M-plus valuation.”

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SCG-533 KCC: Third Time’s the Charm?

Furthermore, with an experienced CFO and full-time general counsel in place, the partners were far more confident that they could answer any question that could arise during the selling process.

In searching for the right acquirer, Jonathan and Eric considered two options: a strategic exit in which they sold to a corporation in a related business, or a financial one in which they sold to private equity.

Jonathan thought back to his perspective in 2005, when they had nearly sold to private-equity firm Bear Growth. At that time, the best way to diversify the revenue base had appeared to be finding a private-equity firm to help them acquire businesses in and around their core business. KCC had been smaller in 2005 and thus less interesting to larger strategic buyers. The partners had also preferred to retain post-transaction control of KCC’s growth plans and they had found that private- equity firms oftentimes defer to founders with specific industry expertise. Going with private equity also would have enabled them to get a “second bite at the apple” from a subsequent liquidity event that would result in a return on the private-equity firm’s investment.

However, the prior process of nearly selling to a private-equity shop had educated Eric and Jonathan about how private-equity firms operate. They were no longer convinced that a private- equity firm would be able to help them achieve their vision for KCC. For his part, Jonathan said, “I am reluctant to hand over control of my baby to a financial buyer who has a fraction of the knowledge and experience in the corporate-restructuring space that Eric and I have.” The stakes were high: “We have the vast majority of our personal net worth tied up in the company, and we are worried that ceding control to a private-equity firm would mean we would have less say in monetizing the value of what we had built because we’d have a minority role at the board level.”

The partners decided they wanted to sell 100% of the business to a strategic acquirer and to be integrated into a larger company that would bring new opportunities for expansion. They did not want to risk owning a piece while someone else was controlling its destiny. With a strategic partner, they hoped “to take KCC to the next level, hopefully with us still very involved in the game,” Eric added.

They needed to select an investment bank to guide them, so in mid-2008 Jonathan and Eric engaged in discussions with a few banks. They chose Lazard for two main reasons: it had one of the largest corporate client bases in the industry, broadening the possibility of finding the right strategic buyer, and it had strong expertise in the legal-services arena.

The Last Dance?

Eric and Jonathan narrowed their criteria for a best-fit strategic buyer. To protect their position as an industry leader, the partners sought a buyer that would support their core growth initiatives but also help them diversify KCC’s revenue base before the next market lull. An ideal fit would be a company that offered a related portfolio of services that KCC could sell through its channel, or an ancillary channel that could be interested in KCC’s core corporate-insolvency services. Second, Jonathan and Eric were ready to take KCC global given the nature of their market and the lack of a prominent global-services provider, and therefore sought a buyer with an international footprint.

During a pitch to an investment bank, Jonathan further described their ideal:

A partner could help us grow KCC into a diversified company. We could do it ourselves, but it would take longer and be more difficult to get there without the resources, infrastructure and access provided by the right strategic partner. The right partnership would enable us to accelerate our growth and broaden our value proposition through both organic and inorganic expansion. We are so

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KCC: Third Time’s the Charm? SCG-533

internally focused, we’d also like someone to step back and take an objective look at the business and offer new ways or perspective on the right direction to go. It’s possible someone else might see a path to make more money.

Ultimately, after targeted outreach by Lazard, some potential strategic acquirers and a few private- equity firms expressed interest. Eric and Jonathan focused on the two best strategic buyers. The first was a large public company with significant capacity and a global footprint – a financial-services business that lacked a relevant presence in the bankruptcy industry. The other was a privately held private-equity-owned business that saw KCC as a strategic hedge for its financial services platform.

Both companies were aggressive in approach, but Eric and Jonathan were particularly intrigued by opportunities to partner with the public company due to the potential for synergies and apparent “fit.” As Jonathan said, “They are a large financial-services market leader with an international footprint 11,000 employees strong, a desire to enter the bankruptcy space, and a willingness to support Eric and me on our articulated path to continued growth.”

The suitor proposed an acquisition of 100% of KCC at close, with approximately 71% of the consideration paid at close and the remaining 29% paid over the course of a three-year earn-out assuming KCC hit preset EBITDA targets. For the earn-out, the founders and their team would receive a one-third payment each year if KCC’s EBITDA exceeded targets that would start anew each January 1. The targets would be based on KCC’s annual projections and would be $21.5M, $23.5M, and $28M, respectively. Assuming KCC achieved the full earn-out, the total current value of the deal was about $137M.

The deal also included an eight-year non-competition agreement for the founders.

The potential acquirer insisted that Eric and Jonathan designate one of the two partners as the KCC CEO who would report directly to the parent company’s North American senior-leadership team. The duo feared that doing so would disrupt the 50/50 leadership dynamic that had been a long-time asset to the business both internally and externally. Lastly, Eric and Jonathan worried about being “accountable to someone else” and having a parent company potentially prevent them from continuing their path of growth.

For Eric, accepting the earn-out was very difficult: “We are in a cyclical market and are being asked to project out three years. We have no concern about Year One, but don’t know what will happen in Year Two. Our backlog of work should carry us through 2010, but might not through 2011.”

Would a parent company that is large and publicly owned allow KCC to develop on its own accord, even if at times that meant disregarding the priorities and vision of the parent company? Could the partners successfully integrate themselves and their employees into the larger company’s apparatus, while keeping their key managers motivated to drive KCC’s success? (Please see Exhibit 8 for their 2008 organization chart.) Was the earn-out fair and reasonable?

Jonathan and Eric had walked away from the negotiating table twice before. Should now be any different? Was it time to sell, with these terms, or would Jonathan and Eric and an already-successful KCC be better off continuing to fly solo, even if they might end up flying into a lull in the market in the years ahead?

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SCG-533 KCC: Third Time’s the Charm?

Exhibit 1: Excerpts from Eric Kurtzman’s reflections on the barriers to his becoming a founder (written around 2007)

Here’s the big question – why us? In all of my hubris I do not begin to imagine that Jonathan and I were the only two lawyers perceptive enough to see this opportunity. We were two of perhaps hundreds of legal associates who were using claims agents in 2001, and we were two of perhaps thousands of associates who had used claims agents in the past ten years; surely many of the associates of our time and before our time saw this opportunity. Why didn’t they jump on it?

Lawyers are formed from a group of people more concerned with not being wrong than they are with being right, who are subjected to three years of Murphy’s Law downside instruction [in law school], and then trained for years [while working as associates in law firms] to treat life like a mine field. Any entrepreneurial character that these “need to not be wrong” people had was destroyed in law school and in their lives as legal associates. By the time they saw the entrepreneurial opportunity, they had no capacity to seize it.

I was not invulnerable to the attacks on our entrepreneurial spirit. In 2001 as Jonathan and I formed our plans, there were many moments of unrest for me, moments of failed confidence, self- doubt, and the kind of questions that one can only ask oneself as one’s greatest critic. Somehow at each of these moments, just when my breaking point seemed to come into view, Jonathan would call me; he would call me and tell me something like, “I just calculated my hours for the month. I billed 320 hours last month. At least it was a 31-day month. Dude, I’m dying. I can’t wait to get out of here and build our own ship.” Those calls were like CPR to my entrepreneurial soul. I had made a commitment to Jonathan and he was relying on me to jump off this cliff together. I would not abandon him.

Were we the perfect entrepreneurs? Were our entrepreneurial souls invulnerable to the attacks of law school and lawyerism? Absolutely not, but something survived. Something with large enough doses of courage, frustration, loyalty, honor, perhaps a dash of grace, and of course a good share of luck, survived in each of us. And here we are. We’re not necessarily the smartest lawyers who ever worked with claims agents, we’re just the ones who had the right concoction of character to survive regular attacks on our entrepreneurial spirit and seize the opportunity we saw.

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KCC: Third Time’s the Charm? SCG-533

Exhibit 2: Financial Projections section from KCC’s 2001 business plan

Based on industry standards, the claims and noticing agent can expect to generate gross revenues and incur expenses according to the following table:

Number of CreditorsCase SizeApproximate RevenuesApproximate ExpensesQuarterly ProfitApproximate Case Duration
<1,000Small<$60,000$25,000$7,5001 year
1,000-5,000Medium$120,000$50,000$9,0002 years
5,000-20,000Large$600,000$210,000$39,0002.5 years
>20,000Mega>$1,000,000$350,000$54,0003 years

KC Consultants expects to run seven small, five medium, and two large cases by the end of year one; seven small, eight medium, five large cases and two mega cases by the end of year two; and five small, seven medium, seven large, and three mega cases by the end of year three.

Year 1Year 2Year 3
Revenues ($000)$495$1,570$2,178
Expenses$195$592$800
Operating Profit$300$978$1,378
Fixed Expenses$412$340$400
Interest Expense (12% interest)$18$4$0
Profit-$130$634$978
Running Profit-$130$504$1,482

Source: KCC

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SCG-533 KCC: Third Time’s the Charm?

Exhibit 3: Jonathan Carson, Eric Kurtzman, and Tony Kay, Circa 2002

Exhibit 4: KCC Performance, 2002-2006

page16image2408
20022003200420052006 est.
Revenues ($M)$1.20$5.60$11.80$17.40$25.36
% Growthn/a356%109%47%46%
Case Wins11131621n/a
EBITDA (adjusted, in $M)$0.48$3.05$5.63$6.84$9.52
EBITDA margin (adjusted)38.90%54.00%47.70%39.30%37.60%
Employees432537492

Source : KCC

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KCC: Third Time’s the Charm? SCG-533

Exhibit 5: 2006 Pitch Deck: “Management Team” slide

page17image1784

Source: KCC

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SCG-533 KCC: Third Time’s the Charm?

Exhibit 6: 2006 Pitch Deck: “Strong Performance in Difficult Markets” slide

Source: KCC

page18image2184

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KCC: Third Time’s the Charm? SCG-533

Exhibit 7: 2006 Pitch Deck: “Projection Assumptions” and “Projected Performance” slides

Source: KCC

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page19image3840
page19image4008

SCG-533 KCC: Third Time’s the Charm?

Exhibit 8: 2008 Organization Chart

Source: KCC

page20image1944

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