What Every Business Owner Needs To Know About Taxes & Valuation
Inevitably, one day the time will come for a business owner to move on. The reason for the exit may be anything from retirement, health problems, burnout, or just taking some chips off the table.
Planning this exit can have a significant impact on how much the business owner takes home from the event. Maximizing the take home requires the business owner to present the business, especially the financial aspect, in the best possible light. Here is where paying attention to accounting details makes a difference.
Businesses typically spend an inordinate amount of time setting up and using accounting practices that reduce the owner’s tax liabilities. CPAs use various business ownership structures and techniques to defer/reduce the revenues or accelerate/inflate the expenses to help business reduce its tax burden. The unforeseen side effect of this exercise is that, to a potential acquirer, the profitability of the business may appear much smaller than what it really is. There may also be other after-sale tax consequences attributable to corporate structure and to depreciation. Business intermediaries “add-back” non-business, non-cash expenses and “recast” the financial statements to get a better picture of the finances, but in most cases this is more of a band-aid than a real solution.
Since most businesses trade in multiples of the business’s cash flow, the practices utilized to save the business a lot of money may result in an artificially low valuation when the business sells. Does this mean that business owners have to give up all of their tax benefits? Not really!
When it comes to taxes and valuation, there may be ways in which business owners can have their cake and eat it too. With advanced planning, a competent M&A advisor can help mitigate potential adverse affects at sale time. Some aspects of accounting that need to be revisited in preparation for an exit include:
- Business ownership structure
- Aggressive revenue deferrals or expense accelerations
- Burdening the business with personal, family and other unrelated expenses
- Commingling revenues/expenses of related businesses
- Wasteful spending
- Inaccurate inventory statements & inventory write downs
- CapEx budgets
- Off-the-record transactions
- Accrued assets and liabilities
- Nonperforming or underperforming assets on the balance sheet
- Appreciated, overstated or understated assets on the balance sheet
- Deciding on Compiled, Reviewed or Audited financial statements
Ideally a business owner planning his/her exit three to five years prior to the actual sale has the best opportunity to do the proper financial planning and make the financial records accurate and presentable. However, it is never too late to plan for a sale and even a year’s worth of planning is better than no planning at all. Be aware that generally the more time the owner works the problem, the better the results will be.
Monday, January 28, 2008
Thursday, January 17, 2008
2008: Exit Planning For The Year Ahead
2007 is over! That is a welcome relief for many business owners. After several years of solid growth, 2007 has been a harsh year for business executives. Empirical evidence suggests that a vast majority of businesses have seen their revenues stagnate or decline in 2007.
For Business owners who were planning to retire or cash out of their business for other reasons, 2007 was tough. Business was soft, long term interest rates were near 5 year highs, credit was hard to come by, and liquidity levels were low. All of these translated into a very negative environment for deal making especially in the housing, construction and retail industries. Business owners who had their businesses on the market saw less than stellar business valuations and, in several cases, found that their deals did not close as planned. Several other business owners who were planning on exiting held back - unwilling to face a reduced valuation and hoping things would be a bit better in the not so distant future.
As we look into 2008, it appears that we have not seen the bottom in the economy. Does this mean business owners should delay their exit/recapitalization decisions until late 2008 or 2009? Not necessarily!
When evaluating the consequences of environmental trends on the business sale/recapitalization process, it is useful to keep in mind that the business sale/recapitalization process for a mid market business can take about 12 months. Most acquirers/investors look carefully at business performance as they navigate through the deal process and positive trends along the way can be helpful in closing a deal and in getting the terms sought by the shareholders.
Here are some key factors business owners need to take into account while planning exit/recapitalization strategies this year:
* Economy: While we have not seen the bottom in the economy, some segments of the market are starting to pick up. Most construction related businesses continue to be in the doldrums, but the prognosis for several other business categories is getting positive. Based on the commentary we are hearing from industry sources, it seems likely that most businesses will end 2008 with more positive trends than what they are seeing now. These positive trends can be beneficial to companies and shareholders with near term plans to exit or to recapitalize their businesses.
* Interest Rates and Liquidity: Long term interest rates are inching downwards and credit is expected to get better as the year progresses. Twenty out of twenty top economists in a recent national poll forecasted interest rates to go down in the near term. Lower interest rates not only improve liquidity, but also have an effect of making valuations higher. Acquirers are likely to find a higher valuation more acceptable in a lower interest rate regime when they can finance the deal and still meet the cash flow metrics needed. Lower interest rates, coupled with improved liquidity, make the chances of putting together winning deals a lot more likely.
* Taxes: Unfortunately, selling a business with a gain means that a business owner has to pay capital gains tax or ordinary income tax on the gain. Since capital gains are taxed at a lower rate than ordinary income, a competent business M&A specialist attempts to structure much of the gains from the sale of the business as capital gains. In the last few years, business owners have been beneficiaries of a historically low 15% Federal Capital Gains Tax Rate. With an impending new administration in the White House in 2009, most tax experts believe that the low 15% Capital Gains Tax rate is unlikely to stay at that level and there is a substantial risk of the rate being changed to something higher. The prospect of increased Capital Gains Tax should be carefully thought through in the context of the business exit/recapitalization process.
* Deal Making Opportunities: Acquirers are a lot more likely to buy a business in a flat to upwards trending market than in a downward trending market. Deal making opportunities should become more abundant as the economic trends reverse through the year. Deal making opportunities are also likely to be aplenty if the business is in a growth oriented segment, or if the business is of a type that can be desirable to foreign companies. With the US Dollar being extremely weak, foreign entities are actively looking to make synergistic acquisitions. It is unclear how long the weak dollar will last but the prognosis is for the dollar to continue to be weak for the near term.
All things considered, early 2008 would be an excellent time for business owners to review their exit or recapitalization strategies and determine how to approach the business sale/capitalization process for optimum financial return.
For Business owners who were planning to retire or cash out of their business for other reasons, 2007 was tough. Business was soft, long term interest rates were near 5 year highs, credit was hard to come by, and liquidity levels were low. All of these translated into a very negative environment for deal making especially in the housing, construction and retail industries. Business owners who had their businesses on the market saw less than stellar business valuations and, in several cases, found that their deals did not close as planned. Several other business owners who were planning on exiting held back - unwilling to face a reduced valuation and hoping things would be a bit better in the not so distant future.
As we look into 2008, it appears that we have not seen the bottom in the economy. Does this mean business owners should delay their exit/recapitalization decisions until late 2008 or 2009? Not necessarily!
When evaluating the consequences of environmental trends on the business sale/recapitalization process, it is useful to keep in mind that the business sale/recapitalization process for a mid market business can take about 12 months. Most acquirers/investors look carefully at business performance as they navigate through the deal process and positive trends along the way can be helpful in closing a deal and in getting the terms sought by the shareholders.
Here are some key factors business owners need to take into account while planning exit/recapitalization strategies this year:
* Economy: While we have not seen the bottom in the economy, some segments of the market are starting to pick up. Most construction related businesses continue to be in the doldrums, but the prognosis for several other business categories is getting positive. Based on the commentary we are hearing from industry sources, it seems likely that most businesses will end 2008 with more positive trends than what they are seeing now. These positive trends can be beneficial to companies and shareholders with near term plans to exit or to recapitalize their businesses.
* Interest Rates and Liquidity: Long term interest rates are inching downwards and credit is expected to get better as the year progresses. Twenty out of twenty top economists in a recent national poll forecasted interest rates to go down in the near term. Lower interest rates not only improve liquidity, but also have an effect of making valuations higher. Acquirers are likely to find a higher valuation more acceptable in a lower interest rate regime when they can finance the deal and still meet the cash flow metrics needed. Lower interest rates, coupled with improved liquidity, make the chances of putting together winning deals a lot more likely.
* Taxes: Unfortunately, selling a business with a gain means that a business owner has to pay capital gains tax or ordinary income tax on the gain. Since capital gains are taxed at a lower rate than ordinary income, a competent business M&A specialist attempts to structure much of the gains from the sale of the business as capital gains. In the last few years, business owners have been beneficiaries of a historically low 15% Federal Capital Gains Tax Rate. With an impending new administration in the White House in 2009, most tax experts believe that the low 15% Capital Gains Tax rate is unlikely to stay at that level and there is a substantial risk of the rate being changed to something higher. The prospect of increased Capital Gains Tax should be carefully thought through in the context of the business exit/recapitalization process.
* Deal Making Opportunities: Acquirers are a lot more likely to buy a business in a flat to upwards trending market than in a downward trending market. Deal making opportunities should become more abundant as the economic trends reverse through the year. Deal making opportunities are also likely to be aplenty if the business is in a growth oriented segment, or if the business is of a type that can be desirable to foreign companies. With the US Dollar being extremely weak, foreign entities are actively looking to make synergistic acquisitions. It is unclear how long the weak dollar will last but the prognosis is for the dollar to continue to be weak for the near term.
All things considered, early 2008 would be an excellent time for business owners to review their exit or recapitalization strategies and determine how to approach the business sale/capitalization process for optimum financial return.
How To Maximize The Value Of Your Business
Looking At Your Business From An Acquirer’s Viewpoint
You are contemplating on selling your business and want to understand how best to maximize the value of your business. You might have heard from your industry contacts that some businesses similar to yours sold for 3 times EBITDA and some others sold for 6 times EBITDA. This variation could mean a difference of several million dollars in take-home! What makes this variation possible? How can you get the best value for your business?
The purpose of this article is to help you look at your business as an acquirer might in valuing your company. The more attractive you can make your business to the acquirer, the better chance that you will get a higher value for your business. Your M&A advisor will also play a big role in the valuation and we will cover this in a different article.
Here is a list of key vectors acquirers use in evaluating business:
1. Strategic Fit: Strategic fit occurs when some aspects of your business (products, services, distribution channels, location, etc.) are worth a lot more to another player in the industry than it is to you. When a strategic fit is established, the acquirer sees your business on a post acquisition basis and may be willing to offer much more than the going market multiples. Give careful consideration to who the strategic acquirers may be. This is one area where a knowledgeable M&A advisor can be of great help to you.
2. Cash Flow: After strategic fit, cash flow is the single largest value driver for most businesses. Think of ways to improve your EBITDA on a sustainable basis. Acquirers are suspicious of short term jumps in cash flow. So, be careful not to delay hiring or equipment purchases beyond what you believe is reasonable. Once an acquirer starts doubting your credibility, the due diligence increases and the acquirer will make changes to valuation to adjust for the risk.
3. Management Depth: Keep in mind that acquirers buy a business that they hope will be functional and growing after the sale. It is tough for the acquirer to place high value on your business if you are the sole decision maker in the company and the business depends largely on your skill set. Developing your staff so that they can run the business when you are gone can pay big dividends when it is time to sell. If you are concerned about your employees leaving once you are gone, it may be good idea to consider employment contracts, stock grants and other incentives that give them a reason to stay long term. If possible, start work on staff related issues at least a year before you plan on starting the sales process.
4. Customer Diversity: Acquirers are nervous about businesses where a high percentage of business comes from a handful of customers. Ideally, no single customer should contribute to more than 10% of your revenues or profits. The best solution for this problem is to diversify the customer base. If that is not feasible, be prepared to accept part of the transaction price paid as earn-outs or plan on supporting the acquirer in an advisory role to ensure customer continuity.
5. Recurring Revenue Stream: Acquirers love predictable and low risk revenue streams. Any long term contracts, annual service/licensing fees, and other recurring revenue streams make business more desirable and fetch a higher price in the marketplace. In service oriented business, converting predictable customer support calls into recurring revenue stream can turn a business liability into an asset.
6. Desirable Products & Services That Are Difficult To Copy: Acquirers place higher value on a business with unique products, services, or distribution systems than a business whose offerings are considered generic. What is unique about your business? Think of ways in which your product/service is unique and why it should be valuable to an acquirer. Having an edge and having the ability to communicate the edge can do wonders to your business’s valuation.
7. Barriers To Entry: With so much competition all around you, why is your business difficult to copy? Why will the acquirer have as much success with the business as you have had? Is it because of intellectual property (patents, copyrights), regulation (permits, zoning), difficult to get contracts (you are one of the two or three qualified vendors at each of your major accounts), or something else? Having good answers to these questions indicates that there are barriers to entering your business. These barriers make your businesses more valuable than your competitor’s with similar cash flow.
8. Pending Upsides: You believe you are about to come up with a compelling new product or make major inroads into a premier customer. You expect these developments will double your business next year and do not want your company to be undervalued based on current financials. Delaying the sale has other consequences that make it unattractive for you to wait. So, what do you do? A good forecast backed up by management presentations with examples on why the company would achieve the forecasts is extremely powerful. However, keep in mind that any forecasts that do not materialize as planned during the sales process can have substantial negative impact on the sales price. Having a good understanding of your product/sales pipeline and having the ability to communicate it with your M&A advisor can help structure a deal where part of the sales price can be paid in earn-out to capture some of the upside.
9. Industry Exposure: Perceived industry leadership is an intangible that can enhance your company valuation. Keep a record of newspaper stories, articles in trade magazines, mentions on local TV or any other mention of your company in print or any other media. Your business is more valuable, if your company is perceived as being a leader in the industry and sought after for its expertise. Asking your employees to write articles and keeping in touch with local and industry reporters not only enhances your valuation in the long term but also helps drive your business and image in the community.
10. Strategic Plan: A written strategic growth plan that clearly documents the areas the company can grow can be an asset to acquirer. Length of the document is not as important as the content. A well written 2 or 3 page growth plan is sufficient. Acquirers will also find useful prior year plans that show the history of your ventures – along with their failures and successes.
11. Record Keeping: To many acquirers, high quality book keeping reduces risk and also says a lot about how the business was run. Having a set of clean, easily auditable books inspires confidence and helps during the due diligence and negotiation process.
12. Accentuate The Positive: Every business has its chinks and it is very important for the seller to identify these negatives and proactively offer solutions for turning the negatives into positives. It is important sellers take steps to put out any bad news on the table early and dealing with issues upfront. Unidentified negatives can haunt you during the negotiating process.
The most important takeaway from this article should be that while EBITDA matters, EBITDA is not everything. Improvement along the key vectors mentioned above will give you and your M&A advisor a considerable upper hand during the negotiation process. If the EBITDA of your business is $1 million, a difference in a multiple of 3 and 6 would mean a difference of $3M in pre-tax earnings. Not bad for doing a little bit of homework!
You are contemplating on selling your business and want to understand how best to maximize the value of your business. You might have heard from your industry contacts that some businesses similar to yours sold for 3 times EBITDA and some others sold for 6 times EBITDA. This variation could mean a difference of several million dollars in take-home! What makes this variation possible? How can you get the best value for your business?
The purpose of this article is to help you look at your business as an acquirer might in valuing your company. The more attractive you can make your business to the acquirer, the better chance that you will get a higher value for your business. Your M&A advisor will also play a big role in the valuation and we will cover this in a different article.
Here is a list of key vectors acquirers use in evaluating business:
1. Strategic Fit: Strategic fit occurs when some aspects of your business (products, services, distribution channels, location, etc.) are worth a lot more to another player in the industry than it is to you. When a strategic fit is established, the acquirer sees your business on a post acquisition basis and may be willing to offer much more than the going market multiples. Give careful consideration to who the strategic acquirers may be. This is one area where a knowledgeable M&A advisor can be of great help to you.
2. Cash Flow: After strategic fit, cash flow is the single largest value driver for most businesses. Think of ways to improve your EBITDA on a sustainable basis. Acquirers are suspicious of short term jumps in cash flow. So, be careful not to delay hiring or equipment purchases beyond what you believe is reasonable. Once an acquirer starts doubting your credibility, the due diligence increases and the acquirer will make changes to valuation to adjust for the risk.
3. Management Depth: Keep in mind that acquirers buy a business that they hope will be functional and growing after the sale. It is tough for the acquirer to place high value on your business if you are the sole decision maker in the company and the business depends largely on your skill set. Developing your staff so that they can run the business when you are gone can pay big dividends when it is time to sell. If you are concerned about your employees leaving once you are gone, it may be good idea to consider employment contracts, stock grants and other incentives that give them a reason to stay long term. If possible, start work on staff related issues at least a year before you plan on starting the sales process.
4. Customer Diversity: Acquirers are nervous about businesses where a high percentage of business comes from a handful of customers. Ideally, no single customer should contribute to more than 10% of your revenues or profits. The best solution for this problem is to diversify the customer base. If that is not feasible, be prepared to accept part of the transaction price paid as earn-outs or plan on supporting the acquirer in an advisory role to ensure customer continuity.
5. Recurring Revenue Stream: Acquirers love predictable and low risk revenue streams. Any long term contracts, annual service/licensing fees, and other recurring revenue streams make business more desirable and fetch a higher price in the marketplace. In service oriented business, converting predictable customer support calls into recurring revenue stream can turn a business liability into an asset.
6. Desirable Products & Services That Are Difficult To Copy: Acquirers place higher value on a business with unique products, services, or distribution systems than a business whose offerings are considered generic. What is unique about your business? Think of ways in which your product/service is unique and why it should be valuable to an acquirer. Having an edge and having the ability to communicate the edge can do wonders to your business’s valuation.
7. Barriers To Entry: With so much competition all around you, why is your business difficult to copy? Why will the acquirer have as much success with the business as you have had? Is it because of intellectual property (patents, copyrights), regulation (permits, zoning), difficult to get contracts (you are one of the two or three qualified vendors at each of your major accounts), or something else? Having good answers to these questions indicates that there are barriers to entering your business. These barriers make your businesses more valuable than your competitor’s with similar cash flow.
8. Pending Upsides: You believe you are about to come up with a compelling new product or make major inroads into a premier customer. You expect these developments will double your business next year and do not want your company to be undervalued based on current financials. Delaying the sale has other consequences that make it unattractive for you to wait. So, what do you do? A good forecast backed up by management presentations with examples on why the company would achieve the forecasts is extremely powerful. However, keep in mind that any forecasts that do not materialize as planned during the sales process can have substantial negative impact on the sales price. Having a good understanding of your product/sales pipeline and having the ability to communicate it with your M&A advisor can help structure a deal where part of the sales price can be paid in earn-out to capture some of the upside.
9. Industry Exposure: Perceived industry leadership is an intangible that can enhance your company valuation. Keep a record of newspaper stories, articles in trade magazines, mentions on local TV or any other mention of your company in print or any other media. Your business is more valuable, if your company is perceived as being a leader in the industry and sought after for its expertise. Asking your employees to write articles and keeping in touch with local and industry reporters not only enhances your valuation in the long term but also helps drive your business and image in the community.
10. Strategic Plan: A written strategic growth plan that clearly documents the areas the company can grow can be an asset to acquirer. Length of the document is not as important as the content. A well written 2 or 3 page growth plan is sufficient. Acquirers will also find useful prior year plans that show the history of your ventures – along with their failures and successes.
11. Record Keeping: To many acquirers, high quality book keeping reduces risk and also says a lot about how the business was run. Having a set of clean, easily auditable books inspires confidence and helps during the due diligence and negotiation process.
12. Accentuate The Positive: Every business has its chinks and it is very important for the seller to identify these negatives and proactively offer solutions for turning the negatives into positives. It is important sellers take steps to put out any bad news on the table early and dealing with issues upfront. Unidentified negatives can haunt you during the negotiating process.
The most important takeaway from this article should be that while EBITDA matters, EBITDA is not everything. Improvement along the key vectors mentioned above will give you and your M&A advisor a considerable upper hand during the negotiation process. If the EBITDA of your business is $1 million, a difference in a multiple of 3 and 6 would mean a difference of $3M in pre-tax earnings. Not bad for doing a little bit of homework!
The Experience Factor
The folly of going with a single buyer
“When a man with experience meets a man with money, the man with experience walks away with some money and man with the money walks away with some experience” - Anonymous
Recently an insurance company executive approached us about selling her company. She had an offer from a national insurance company, let’s call it “XYZ Company”, and wanted to see if we could bring in a buyer to pay more for her company. We have seen many instances where a buyer, typically someone in the same industry, makes an offer on a local company and ends up paying a substantially lower value for the company than what a proper business sale would enable. The best advice we could give her was to retain our company to represent her and conduct a confidential M&A Process to maximize her take home.
This buyer, a sharp lady, is a great insurance executive but, as is the case with most business owners, has no experience selling companies. The national insurance company on the other hand, has done many acquisitions in the past and has a seasoned team working on this transaction. Without representation from a competent M&A specialist, here is what this business owner will likely go through:
* XYZ starts the process off with a basic, generic, non-binding LOI with an offer well below or at the low end of the business’s value
* Seller may ask for more money and the XYZ Company may accede depending on their acquisition strategy and how tough its negotiators are.
* Once the seller thinks she has got fair value for her company, XYZ embarks on an exhaustive due diligence process. XYZ company’s attorneys, accountants, acquisition experts start their inquisition into the seller’s company affairs.
* The owner gets busy with collecting tons of paperwork, preparing many diligence reports, answering questions and starts losing focus on the business
* XYZ starts finding several small and big things that are wrong with the company’s financials, sales pipeline, future projections, leases, etc.
* XYZ puts out an updated LOI which is lower than the initial offer because of all the things that they uncovered in the due diligence process.
* The terms in the updated LOI are complex, payments delayed, tied to future performance, and generally structured in a way that is not advantageous to the seller
* By this point in time, the seller has spent countless hours of precious personal time and has also spent several tens of thousands of dollars in attorney fees reviewing the contracts and other legal documents.
* The process also takes its toll on the business. With the seller’s eye off the ball, the business starts to suffer. Employees get nervous and productivity drops. In some cases, key employees or key customers may leave. XYZ Company’s continued due diligence finds signs of deteriorating business and asks for further accommodations from the seller.
* If the seller realizes she has been had or if she becomes emotional about the process, she will pull the plug, cut her losses, and go back to rebuilding the company for a sale later. But more often than not, the seller is tired, anxious, stressed out, under time pressure to make the transaction, and eager to move on. Faced with the compelling arguments from XYZ Company’s experts, the seller decides to take the lowball deal and moves on.
The seller could avoid this with one simple step - Start M&A process with a competent set of advisors and let them work with multiple buyers. The M&A process will enable all potential buyers, including the one that started off the process, to compete for the business. The buyer who sees the most value in the business will likely win and provide the seller with the best value as well as favorable terms. A win-win deal for all parties involved.
At our firm, we have routinely done deals where the final take away was 20% to 40% higher than what the seller would have netted had he/she gone with the first offer.
“When a man with experience meets a man with money, the man with experience walks away with some money and man with the money walks away with some experience” - Anonymous
Recently an insurance company executive approached us about selling her company. She had an offer from a national insurance company, let’s call it “XYZ Company”, and wanted to see if we could bring in a buyer to pay more for her company. We have seen many instances where a buyer, typically someone in the same industry, makes an offer on a local company and ends up paying a substantially lower value for the company than what a proper business sale would enable. The best advice we could give her was to retain our company to represent her and conduct a confidential M&A Process to maximize her take home.
This buyer, a sharp lady, is a great insurance executive but, as is the case with most business owners, has no experience selling companies. The national insurance company on the other hand, has done many acquisitions in the past and has a seasoned team working on this transaction. Without representation from a competent M&A specialist, here is what this business owner will likely go through:
* XYZ starts the process off with a basic, generic, non-binding LOI with an offer well below or at the low end of the business’s value
* Seller may ask for more money and the XYZ Company may accede depending on their acquisition strategy and how tough its negotiators are.
* Once the seller thinks she has got fair value for her company, XYZ embarks on an exhaustive due diligence process. XYZ company’s attorneys, accountants, acquisition experts start their inquisition into the seller’s company affairs.
* The owner gets busy with collecting tons of paperwork, preparing many diligence reports, answering questions and starts losing focus on the business
* XYZ starts finding several small and big things that are wrong with the company’s financials, sales pipeline, future projections, leases, etc.
* XYZ puts out an updated LOI which is lower than the initial offer because of all the things that they uncovered in the due diligence process.
* The terms in the updated LOI are complex, payments delayed, tied to future performance, and generally structured in a way that is not advantageous to the seller
* By this point in time, the seller has spent countless hours of precious personal time and has also spent several tens of thousands of dollars in attorney fees reviewing the contracts and other legal documents.
* The process also takes its toll on the business. With the seller’s eye off the ball, the business starts to suffer. Employees get nervous and productivity drops. In some cases, key employees or key customers may leave. XYZ Company’s continued due diligence finds signs of deteriorating business and asks for further accommodations from the seller.
* If the seller realizes she has been had or if she becomes emotional about the process, she will pull the plug, cut her losses, and go back to rebuilding the company for a sale later. But more often than not, the seller is tired, anxious, stressed out, under time pressure to make the transaction, and eager to move on. Faced with the compelling arguments from XYZ Company’s experts, the seller decides to take the lowball deal and moves on.
The seller could avoid this with one simple step - Start M&A process with a competent set of advisors and let them work with multiple buyers. The M&A process will enable all potential buyers, including the one that started off the process, to compete for the business. The buyer who sees the most value in the business will likely win and provide the seller with the best value as well as favorable terms. A win-win deal for all parties involved.
At our firm, we have routinely done deals where the final take away was 20% to 40% higher than what the seller would have netted had he/she gone with the first offer.
Business Broker, Mid-market M&A Advisor Or Investment Banker?
Picking The Right Intermediary For The Sale Of Your Business
You are ready to sell your business. You ask around and find that some businesses are sold by Business Brokers, some by Mid-market M&A Advisors, and some others by investment bankers. The difference in intermediaries can make difference of 20% to 40% or more in what you can take away in many situations. So, picking the right intermediary can have a major impact on your nest egg. Which one of these is right intermediary for selling your business? Who should you use?
See http://www.elitemanda.com/resources/Business+Broker++M$26A+Advisor+Or+Investment+Banker.pdf
The deciding factor in selecting the right intermediary is type of business you have. For small companies with revenues under $1 million and for large companies with revenues over $100 million, the choices are obvious.
If your business is a small retail or service business and there is no strategic value in the business, any competent business broker may be able to get the job done. However, since there is a substantial negotiating component in deals this size, your interests are likely to better served if you choose an intermediary to represent you exclusively (i.e. not a dual agent).An M&A Advisor is the right choice if your business is larger, complex or has a high component of product or service specialization. A competent M&A Advisor can unlock the value in your business, represent you exclusively, and get your business the higher value it deserves. This is extremely important if your business has untapped strategic value or has intellectual property subject to a broad interpretation of value in the marketplace.
You are ready to sell your business. You ask around and find that some businesses are sold by Business Brokers, some by Mid-market M&A Advisors, and some others by investment bankers. The difference in intermediaries can make difference of 20% to 40% or more in what you can take away in many situations. So, picking the right intermediary can have a major impact on your nest egg. Which one of these is right intermediary for selling your business? Who should you use?
See http://www.elitemanda.com/resources/Business+Broker++M$26A+Advisor+Or+Investment+Banker.pdf
The deciding factor in selecting the right intermediary is type of business you have. For small companies with revenues under $1 million and for large companies with revenues over $100 million, the choices are obvious.
If your business is a small retail or service business and there is no strategic value in the business, any competent business broker may be able to get the job done. However, since there is a substantial negotiating component in deals this size, your interests are likely to better served if you choose an intermediary to represent you exclusively (i.e. not a dual agent).An M&A Advisor is the right choice if your business is larger, complex or has a high component of product or service specialization. A competent M&A Advisor can unlock the value in your business, represent you exclusively, and get your business the higher value it deserves. This is extremely important if your business has untapped strategic value or has intellectual property subject to a broad interpretation of value in the marketplace.
Valuing Growth Companies
The folly of industry multiples
I routinely see individual buyers coming up with low valuations for growth businesses based on simple multiple of the most recent year’s profitability and, worse yet, based on a multiple using a weighed average of the profits from the preceding 3 years. I usually offer them this simple way of looking at the problem.
Let’s take the example of 3 different businesses with identical last 12 month revenues and earnings:
* Business1 has a history of cash flow growth of 10% over many years and the target market is continuing to grow.
* Business2 has a history of a steady cash flow for a long time with relatively minor variation from year to year and the target market is a stable.
* Business3 has a history of steadily declining cash flow for the last several years and the market outlook appears to be unfavorable.
Using industry standard multiple of most recent year’s earnings, all these business are valued the same. Would you value these businesses at the same level? Of course, not!
How about using multiple based on weighed average of last 3 years profits? A quick check would show that this would lead to the conclusion that Business3 has the highest valuation and Business1 the lowest valuation! In most scenarios, this answer would be preposterous!!
So, why did industry multiples and weighed averages give wrong results for these companies? How can you value these companies? I will cover the answer to the former question in a different blog entry. For now, let’s focus on how you can better value these companies.
Setting aside the strategic or synergistic value of these companies, there are a couple of good answers to this question:
* Use Gordon Growth model to arrive at a growth adjusted value of the earning stream.
V= E / (R-G)
Where: V= Value of a company
E = Annual earning stream
R = Required rate of return
G = Projected long term growth rate of the Earning Stream
v Develop a forecast of long term earnings stream and conduct scenario analysis based on discounted cash flow. This method is more sophisticated and requires spreadsheet skills but can be useful in establishing a range of values under different scenarios.
The valuation arrived by these methods gives acquirers a reasonable starting point in many small to mid-market business acquisitions. The acquirer should aware that the real value of these companies has more to do with the strategic or synergistic value of these companies and can be much higher than what these simple methods suggest. We will cover this topic in a different article.
I routinely see individual buyers coming up with low valuations for growth businesses based on simple multiple of the most recent year’s profitability and, worse yet, based on a multiple using a weighed average of the profits from the preceding 3 years. I usually offer them this simple way of looking at the problem.
Let’s take the example of 3 different businesses with identical last 12 month revenues and earnings:
* Business1 has a history of cash flow growth of 10% over many years and the target market is continuing to grow.
* Business2 has a history of a steady cash flow for a long time with relatively minor variation from year to year and the target market is a stable.
* Business3 has a history of steadily declining cash flow for the last several years and the market outlook appears to be unfavorable.
Using industry standard multiple of most recent year’s earnings, all these business are valued the same. Would you value these businesses at the same level? Of course, not!
How about using multiple based on weighed average of last 3 years profits? A quick check would show that this would lead to the conclusion that Business3 has the highest valuation and Business1 the lowest valuation! In most scenarios, this answer would be preposterous!!
So, why did industry multiples and weighed averages give wrong results for these companies? How can you value these companies? I will cover the answer to the former question in a different blog entry. For now, let’s focus on how you can better value these companies.
Setting aside the strategic or synergistic value of these companies, there are a couple of good answers to this question:
* Use Gordon Growth model to arrive at a growth adjusted value of the earning stream.
V= E / (R-G)
Where: V= Value of a company
E = Annual earning stream
R = Required rate of return
G = Projected long term growth rate of the Earning Stream
v Develop a forecast of long term earnings stream and conduct scenario analysis based on discounted cash flow. This method is more sophisticated and requires spreadsheet skills but can be useful in establishing a range of values under different scenarios.
The valuation arrived by these methods gives acquirers a reasonable starting point in many small to mid-market business acquisitions. The acquirer should aware that the real value of these companies has more to do with the strategic or synergistic value of these companies and can be much higher than what these simple methods suggest. We will cover this topic in a different article.
Valuing Companies With Erratic Earnings
What is the right metric?
A significant number of businesses that come to market do not have consistent stream of earnings. Inconsistent earnings history makes it difficult for acquirers to predict future earnings and create a valuation challenge. Using an “industry earnings multiple”, the most common metric used to value mid-market companies can be meaningless in these situations.
Which earnings number does one pick? The highest? The lowest? Most recent? The average? Weighted average?
On the surface, using weighted average may seem like an appealing answer. However, using weighted average typically leads to overvaluing or undervaluing the company by a substantial margin to the detriment of either the acquirer or the seller.
Assuming a reasonable earnings number can be picked using weighted averages, is “industry earnings multiple” a valid multiplier to arrive at a valuation? In not, how does one value these companies?
A keen appreciation of financial methods and industry knowledge are essential to answer these questions. The first step in the process is to gain a clear understanding of the reasons for the earnings variability. Some common reasons for earnings variability are:
* Economic changes in the target market
* Development phase of the company
* Large non-recurring income/expenses
* Loss/gain of large customers
* Entry/exit of major competitors
* Changes in management or key employees
* Changes in physical environment and target market
* Substantial changes in level or amount of operating equipment or people
* Changes in COGs that are out of line with changes in final product/service prices
Acquirers may see some of these reasons as problems that reduce the future earnings. They may also see some other reasons as opportunities that increase the future earnings. It is imperative that both the reasons and the impact be well understood early in the valuation process. Once the reasons are identified and their impact assessed, appropriate adjustments can be made to recast the financials to get a more meaningful picture of the company’s revenue and earnings stream. Quite often, these recasted numbers indicate a stable or predictable earnings or revenue stream.
If the earnings stream is predictable, the acquirer can use industry price/earnings multiples to arrive at a reasonable valuation.
If the earnings stream is somewhat erratic but the revenue stream is predictable, the valuation may have to rely more heavily on industry price/sales multiples.
If neither the earnings nor the revenues are predictable after recasting, the valuation process becomes highly subjective. In such a situation, the transaction price should either show a substantial discount to a market multiple or be tied to future performance of the business.
A significant number of businesses that come to market do not have consistent stream of earnings. Inconsistent earnings history makes it difficult for acquirers to predict future earnings and create a valuation challenge. Using an “industry earnings multiple”, the most common metric used to value mid-market companies can be meaningless in these situations.
Which earnings number does one pick? The highest? The lowest? Most recent? The average? Weighted average?
On the surface, using weighted average may seem like an appealing answer. However, using weighted average typically leads to overvaluing or undervaluing the company by a substantial margin to the detriment of either the acquirer or the seller.
Assuming a reasonable earnings number can be picked using weighted averages, is “industry earnings multiple” a valid multiplier to arrive at a valuation? In not, how does one value these companies?
A keen appreciation of financial methods and industry knowledge are essential to answer these questions. The first step in the process is to gain a clear understanding of the reasons for the earnings variability. Some common reasons for earnings variability are:
* Economic changes in the target market
* Development phase of the company
* Large non-recurring income/expenses
* Loss/gain of large customers
* Entry/exit of major competitors
* Changes in management or key employees
* Changes in physical environment and target market
* Substantial changes in level or amount of operating equipment or people
* Changes in COGs that are out of line with changes in final product/service prices
Acquirers may see some of these reasons as problems that reduce the future earnings. They may also see some other reasons as opportunities that increase the future earnings. It is imperative that both the reasons and the impact be well understood early in the valuation process. Once the reasons are identified and their impact assessed, appropriate adjustments can be made to recast the financials to get a more meaningful picture of the company’s revenue and earnings stream. Quite often, these recasted numbers indicate a stable or predictable earnings or revenue stream.
If the earnings stream is predictable, the acquirer can use industry price/earnings multiples to arrive at a reasonable valuation.
If the earnings stream is somewhat erratic but the revenue stream is predictable, the valuation may have to rely more heavily on industry price/sales multiples.
If neither the earnings nor the revenues are predictable after recasting, the valuation process becomes highly subjective. In such a situation, the transaction price should either show a substantial discount to a market multiple or be tied to future performance of the business.
Structuring An Exit
An Overview of Tax Beneficial Strategies
There are several possible ways to structure a deal to suit the needs of a seller. This document summarizes some commonly used strategies and the associated trade offs:
Installment Sale
Installment sale is a simple strategy where a part of the sale price is deferred. The deferred amount is paid to the seller in several installments over a period of time.
Structured Sale
Structured sale is similar to an installment sale except that the payment stream is guaranteed by a third party
1031 Exchange
Allows for a seller to roll equity and debt into a new property and defer the capital gains tax until some future sale
1042 Exchange
Complex exit strategy where privately owned stock can be exchanged for publicly traded stock. If a highly appreciated asset is owned by a corporate entity, shares of that entity can be sold and exchanged for shares of a listed stock.
Charitable Trusts
This method is only applicable if the sellers have determined what they will leave to charity at death. It is possible to make a future gift to a charity in exchange for an income stream. This method allows for an income stream comparable to what is possible with direct sale of business. It is also possible to gift the income payments to charity and have the asset revert to the estate at death.
Private Annuity Trust / Deferred Sales Trust
The capital gains benefits available with a Private Annuity Trust may be discontinued. In this method: Grantor(s) establish a trust, sells the asset to the trust and the trust sells the asset to the buyer. Trust makes installment-like payments to the grantor(s) over their lifetimes. Capital gains taxes are due as installment payments are made to grantor(s). At death of grantor(s), asset passes to beneficiaries.
There are several possible ways to structure a deal to suit the needs of a seller. This document summarizes some commonly used strategies and the associated trade offs:
Installment Sale
Installment sale is a simple strategy where a part of the sale price is deferred. The deferred amount is paid to the seller in several installments over a period of time.
Structured Sale
Structured sale is similar to an installment sale except that the payment stream is guaranteed by a third party
1031 Exchange
Allows for a seller to roll equity and debt into a new property and defer the capital gains tax until some future sale
1042 Exchange
Complex exit strategy where privately owned stock can be exchanged for publicly traded stock. If a highly appreciated asset is owned by a corporate entity, shares of that entity can be sold and exchanged for shares of a listed stock.
Charitable Trusts
This method is only applicable if the sellers have determined what they will leave to charity at death. It is possible to make a future gift to a charity in exchange for an income stream. This method allows for an income stream comparable to what is possible with direct sale of business. It is also possible to gift the income payments to charity and have the asset revert to the estate at death.
Private Annuity Trust / Deferred Sales Trust
The capital gains benefits available with a Private Annuity Trust may be discontinued. In this method: Grantor(s) establish a trust, sells the asset to the trust and the trust sells the asset to the buyer. Trust makes installment-like payments to the grantor(s) over their lifetimes. Capital gains taxes are due as installment payments are made to grantor(s). At death of grantor(s), asset passes to beneficiaries.
Stock Sale vs. Asset Sale
There are two primary ways of structuring the sale of sale of mid-market companies: Stock Sale and Asset Sale. This document compared the trade offs involved with each of these approaches. Acquirers should keep in mind that regardless of the tradeoffs, asset sales may not be practical in some cases for contractual or other reasons. In such cases, stock sale is the only way to go.
See http://www.elitemanda.com/resources/Stock+Sale+Vs+Asset+Sale.pdf
See http://www.elitemanda.com/resources/Stock+Sale+Vs+Asset+Sale.pdf
Double Lehman Explained
How do M&A intermediaries get compensated?
We use a Double Lehman fee structure for helping sell our customers business. Some of our clients are familiar with the Double Lehman structure and some others have heard about Lehman formula and some have not heard of either of these fee structures.
Lehman Formula, a precursor to Double Lehman, is a compensation structure developed by Lehman Brothers many decades back for investment banking services. The basic Lehman fee structure is as follows:
* 5% of the first million dollars of transaction value
* 4% of the second million
* 3% of the third million
* 2% of the fourth million
* 1% of everything thereafter
This formula suggests that a seller would pay an M&A firm a fee of $150 thousand on the first $5 million of transaction value. The M&A firm would get an additional 1% for transaction value in excess of $5 million. A $100 million transaction, a small transaction by investment banking standards, would generate a transaction fee of $1.1 million, or 1.1% of the transaction value. Over the decades, as inflation kicked in and as the complexity of the deals grew, this fee structure has evolved. In modern investment banking transactions, this Lehman structure is augmented heavily by upfront fee, retainers, hourly fee and other fee to compensate for the expenses in the transaction.
For large deals, the Lehman Formula provides huge fees and national M&A firms such as Goldman Sachs, Merrill Lynch compete to win these deals. These deals are highly customized and the M&A firms’ compensation tend to be tailored per the objective of the deal. Typical time to consummate these deals is between one and two years and it is common for investment bankers to derive most of their income from upfront fee and monthly/hourly fee well before the deal consummates.
On the other end of the transaction size spectrum, business brokers typically charge 10-12% of the transaction proceeds. These deals tend to close in a matter of a few months and brokers derive most, if not all, of their fees at the closing of the transaction.
Mid market M&A specialists have a challenge in the sense that the work of closing mid market deals can be as difficult as or more difficult than for larger deals. The time taken to consummate the transactions is also similar to that of the larger deals. Lehman was not developed for these smaller deals and working at the compensation level implied by Lehman is untenable for M&A firms. On the other hand, charging clients 10-12% fee as business brokers charge can be detrimental to the interest of the client selling a multi-million dollar business.
Double Lehman is a compensation structure designed by M&A specialists to solve this problem. Double Lehman is a variation on the Lehman Formula to bridge the gap between the small (less than $1 million) and large (greater than $100 million) deals.
Under Double Lehman, the M&A specialist fee is structured as follows:
* 10% of the first million dollars involved in the transaction
* 8% of the second million
* 6% of the third million
* 4% of the fourth million
* 2% of everything thereafter
The Double Lehman provides for a fee of $300,000 for a $5 million transaction (6% of transaction value). The fee on a $20 million deal would be $600,000 (3% of transaction value). Due to the complexity of the transaction and the duration of time it takes to consummate the transaction, mid market M&A professionals typically charge upfront fees and retainers in addition to the Double Lehman based fee structure.
Bottom Line: The Double Lehman is a convenient way to begin discussions regarding M&A specialist compensation for selling mid-market companies. For most mid market transactions, the fee structure is likely to be a combination of upfront fee and success fee and most deals are negotiated. The seller and the M&A specialist can work together to create win-win deals.
We use a Double Lehman fee structure for helping sell our customers business. Some of our clients are familiar with the Double Lehman structure and some others have heard about Lehman formula and some have not heard of either of these fee structures.
Lehman Formula, a precursor to Double Lehman, is a compensation structure developed by Lehman Brothers many decades back for investment banking services. The basic Lehman fee structure is as follows:
* 5% of the first million dollars of transaction value
* 4% of the second million
* 3% of the third million
* 2% of the fourth million
* 1% of everything thereafter
This formula suggests that a seller would pay an M&A firm a fee of $150 thousand on the first $5 million of transaction value. The M&A firm would get an additional 1% for transaction value in excess of $5 million. A $100 million transaction, a small transaction by investment banking standards, would generate a transaction fee of $1.1 million, or 1.1% of the transaction value. Over the decades, as inflation kicked in and as the complexity of the deals grew, this fee structure has evolved. In modern investment banking transactions, this Lehman structure is augmented heavily by upfront fee, retainers, hourly fee and other fee to compensate for the expenses in the transaction.
For large deals, the Lehman Formula provides huge fees and national M&A firms such as Goldman Sachs, Merrill Lynch compete to win these deals. These deals are highly customized and the M&A firms’ compensation tend to be tailored per the objective of the deal. Typical time to consummate these deals is between one and two years and it is common for investment bankers to derive most of their income from upfront fee and monthly/hourly fee well before the deal consummates.
On the other end of the transaction size spectrum, business brokers typically charge 10-12% of the transaction proceeds. These deals tend to close in a matter of a few months and brokers derive most, if not all, of their fees at the closing of the transaction.
Mid market M&A specialists have a challenge in the sense that the work of closing mid market deals can be as difficult as or more difficult than for larger deals. The time taken to consummate the transactions is also similar to that of the larger deals. Lehman was not developed for these smaller deals and working at the compensation level implied by Lehman is untenable for M&A firms. On the other hand, charging clients 10-12% fee as business brokers charge can be detrimental to the interest of the client selling a multi-million dollar business.
Double Lehman is a compensation structure designed by M&A specialists to solve this problem. Double Lehman is a variation on the Lehman Formula to bridge the gap between the small (less than $1 million) and large (greater than $100 million) deals.
Under Double Lehman, the M&A specialist fee is structured as follows:
* 10% of the first million dollars involved in the transaction
* 8% of the second million
* 6% of the third million
* 4% of the fourth million
* 2% of everything thereafter
The Double Lehman provides for a fee of $300,000 for a $5 million transaction (6% of transaction value). The fee on a $20 million deal would be $600,000 (3% of transaction value). Due to the complexity of the transaction and the duration of time it takes to consummate the transaction, mid market M&A professionals typically charge upfront fees and retainers in addition to the Double Lehman based fee structure.
Bottom Line: The Double Lehman is a convenient way to begin discussions regarding M&A specialist compensation for selling mid-market companies. For most mid market transactions, the fee structure is likely to be a combination of upfront fee and success fee and most deals are negotiated. The seller and the M&A specialist can work together to create win-win deals.
Buyers Approach To A Stock Sale
Steps that acquirers need to take in a stock sale
In most small to mid market situations, it is advantageous for acquirers to structure the business acquisition transaction as an Asset sale. However, in some cases there may be significant advantage to going the Stock sale route. Also, asset sales may not be practical in some cases for contractual or other reasons. In such cases, acquirers need to pay special attention to three key factors:
* Indemnification Agreement: Acquirer should get a bulletproof indemnification from the seller for any potential liabilities that may have occurred before the transaction closes but only surface after you close the deal. A stock sale without a proper indemnification agreement exposes buyers to potentially damaging legal and financial risk.
* Seller Carry: Acquirer should get a significant amount of financing from seller as part of the deal. It is best to have this spread out over a period of few years so that you will have leverage in the event a claim materializes. The seller carry can come in handy if there is a lawsuit and the seller balks at keeping his end of the bargain.
* Corporate Structure: The structure of the corporation being acquired may have significant impact on the tax status of the acquirer. If the acquirer owns one or more corporations prior to the sale, some post acquisition structural alternatives could significantly enhance the acquisition benefits. These alternatives need to be reviewed carefully before the close for maximum leverage. It is essential for acquirers to incorporate these key factors in any stock sale.
In most small to mid market situations, it is advantageous for acquirers to structure the business acquisition transaction as an Asset sale. However, in some cases there may be significant advantage to going the Stock sale route. Also, asset sales may not be practical in some cases for contractual or other reasons. In such cases, acquirers need to pay special attention to three key factors:
* Indemnification Agreement: Acquirer should get a bulletproof indemnification from the seller for any potential liabilities that may have occurred before the transaction closes but only surface after you close the deal. A stock sale without a proper indemnification agreement exposes buyers to potentially damaging legal and financial risk.
* Seller Carry: Acquirer should get a significant amount of financing from seller as part of the deal. It is best to have this spread out over a period of few years so that you will have leverage in the event a claim materializes. The seller carry can come in handy if there is a lawsuit and the seller balks at keeping his end of the bargain.
* Corporate Structure: The structure of the corporation being acquired may have significant impact on the tax status of the acquirer. If the acquirer owns one or more corporations prior to the sale, some post acquisition structural alternatives could significantly enhance the acquisition benefits. These alternatives need to be reviewed carefully before the close for maximum leverage. It is essential for acquirers to incorporate these key factors in any stock sale.
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