10 Step Plan To Exiting A Mid-Market Distribution Business
“He who fails to plan, plans to fail” – An old proverb
You have worked hard for many years to build your distribution business. It has provided you income, satisfaction, prestige and purpose. Now is the time to do one final deal on the business and exit your business while making sure that that you get what you deserve.
A mid-market distribution business, the type of business you have, is typically characterized by strong customer relationships, good logistics and material management system, moderate amount of equipment, and sometimes a large amount of inventory. This combination of assets creates a unique set of challenges when it is time to sell.
Here is a 10-step plan to maximizing your return on the sale of your mid-market distribution business.
1. Be aware that for a distribution company with a valuation in the $3 million to $100 million range, funding from the Small Business Administration is not feasible and there are very few individual buyers capable of financing this type of deal on personal credit. The most likely acquirer is another private company, a public company, or a PEG (see “Is Private Equity The Right Option For Your Business”). These are professional buyers who have experience from multiple deals. Hire a competent M&A advisor or an investment banker to bring deal making experience to the table. Acquirers think in terms of multiples of EBITDA for comparable companies when it comes to valuation. A good M&A specialist will help increase the EBITDA, ratchet up the multiple, and expose the strategic value of the business to get you more for your business. An M&A Advisor will also be keenly familiar with the tradeoffs necessary to maximize your after tax proceeds.
2. Check if your corporate structure is the appropriate one for a business sale. Are you a C-Corp? S-Corp? LLC? Do you have multiple entities with multiple purposes? Regardless of the type of corporation(s) you have, if your distribution company has a large amount of depreciated assets, depreciation recapture may be a big issue for you. For distribution companies with a substantial amount of assets, being a C-Corp can be a major tax disadvantage as most acquirers prefer an asset sale to a stock sale. In a C-Corp asset sale you get taxed twice – once at the company level and once at the individual level! For most distribution company owners, it is worth getting your M&A advisor to fight for a stock sale.
3. Make sure your books are in order and your financial statements are compiled, reviewed or audited as may be appropriate for your business. Your current bookkeeping practices and tax structure may be designed to keep your taxes low on an operating basis but they may not be right for exiting your business (see “What Every Business Owner Needs To Know About Taxes & Valuation”). If your CPA firm does not have any deal making experience, consider working with a firm that has the experience. In mid-market transactions, good tax advice may be worth hundreds of thousands, if not millions, of dollars.
4. Retain the right attorney for the deal. An attorney with transactional experience as opposed to litigation experience is more likely to help put together a successful deal. Many deals collapse due to attorneys who are not familiar with transaction negotiations.
5. Understand how your competition is performing and how you measure up. How good are your profit margins? How about inventory turns? Is your equipment outdated? Do you have a lot of dead inventory on the books? Some of the value in the deal comes from the acquirer’s perception of how you rate in your peer group. Excellent companies get excellent valuations and mediocre companies get mediocre valuations. A competent M&A advisor can also help package your company to get the best deal out of it.
6. Reduce risk by diversifying the customer and supplier base. What percent of your business is tied to one customer? How dependent are you on one supplier? What can you do to ensure the customers and suppliers will continue to stay with the business after the business sale? Are your contracts being written so that they can stay with the business regardless of ownership changes?
7. Understand and have a documented plan for your growth. How do you plan to grow? Wider product lines? More services? Increasing geographic coverage? What part of your business is online? How good is your website? Do you do business outside of the immediate geographic area? What differentiates you in non-local markets? A good growth plan makes sales projections more credible.
8. Take steps to ensure that your distribution business transitions easily to the acquirer. What percent of your business is under contracts? Are they long term? How much of your business is recurring? Do you have any maintenance contracts? Do any of the supplier contracts provide meaningful exclusivity? Do you have a reliable sales team or do the customer relationships begin and end with you?
9. Do you have any known latent liabilities? Legal actions? Workers comp issues? ESOP issues? Do you have reasonable insurance coverage or you exposed to that one shipment or warehouse catching fire and taking you down with it? If possible address these and other similar issues before putting the business up for sale. If not, discuss these with your M&A advisor to make sure that they do not become a drag on valuation or deal killers. Addressing these issues is especially important if you are seeking a tax advantageous stock sale.
10. Be cognizant of the fact that business valuations are not written in stone and there is a huge variability in what you can get for your business (see “The Myth Of Fair Business Valuation”). The more you would like to get for your business, the more planning and work your deal making team needs to do and the longer it is likely to take. Plan early if you want to maximize your return.
Good luck with your business sale and let us know if we can help you.
Tuesday, April 29, 2008
Monday, April 28, 2008
Waiting For The Big Sales Contract To Come Through Before You Exit Your Company
When Is It The Right Time To Sell My Company?
“All good things arrive unto them that wait - and don't die in the meantime” – Mark Twain
We recently had a client who had intentions of selling his business for a long time but was unable to decide when to start. His big dilemma was that he was expecting to be rewarded a government contract and believed that his business would be worth substantially more once that happened. The seller did not want to put the business in the market until the contract came through. Sounds like the right thing to do, doesn’t it?
Our advice in this and similar situations is for the business owner to consider the trade-offs of starting the business sale immediately as opposed to waiting until the “big sale” closes.
First, let’s look at this type of contract from a potential acquirer’s perspective:
Ø If the company that is being acquired has recently landed a big contract, how desirable is it and how much life is left in the contract?
Ø If the company has not gotten the contract but is likely to get it, what could it be worth?
Ø Is this contract potentially a large percent of the company’s revenues and does the contract pose a material risk to rest of the company if something were to go wrong?
Ø What is the economic benefit of it going forward? Is this contract a sustainable one or is it more of an aberration?
Ø Can the contract be leveraged into something bigger and better?
Now, let’s look at the contract from the business owner’s perspective:
Ø What is the lead time for the contract? Is it 6 months? A year? Longer? Assuming delays or disruptions, which are common for big contracts, does the business owner have the time?
Ø What if the business owner does not get the contract or, worse yet, the process drags on? How will it affect the company’s operations? How long can the seller wait to recover?
Ø For most companies, the sales pipeline is almost always bigger than the current backlog. What are the chances that this contract will materialize or that there will be another bigger deal on the horizon after this deal? What does history say about how the company grows?
Ø The time it takes to sell a mid market business is typically about a year. If the business owner waits for the contract to put the business in the market, how much of a residual value will the contract have, post close?
Ø Between now and the anticipated close date of the business sale, is the competition getting stronger? Is there new competition? Are there deep pockets moving into the niche and threatening to make it more difficult for existing players? Does the business owner who is planning on an exit have the energy and drive to take on the new competition?
Ø How about the market? Are there any fundamental changes that are likely to happen over the next few years? Are there big investments needed to continue growing?
Ø Is there any potential upside an acquirer can bring to the deal? Is it more likely that the company will get the contract with the current management or with the acquirer?
So, what should the business owner do once the trade-offs are understood? The critical element to consider in this situation is the reason why the business owner wants to sell the business in the first place. Does the business owner not have the energy to continue driving the business aggressively? Is he/she under any time pressure for health, personal, or other reasons? Does the future look brighter now compared to what it will be after the contract? Does the owner not have the deep pockets or risk tolerance necessary to drive the business to the next level? Does he/she need the backing of a larger company or a PEG to continue to grow? Whatever else the reason may be, is it still valid? If the answer to any of these questions is “yes”, now is the time to put the business sale process in motion.
If you are in a similar scenario, the faster you attract the right acquirer, the better your chances are for a more favorable outcome. A competent M&A advisor can get the right acquirers to the table - the acquirers who are willing to pay for the future. The payout may not be upfront cash and could be an earn-out based on you winning the contract or generating the revenue growth. The measurement and payout could be any terms that are mutually acceptable. While the M&A advisor negotiates the deal for you, you can focus on making sure that contract comes through and other attractive deals in your sales pipeline materialize. If the acquirer is a name brand or a PEG with deep pockets motivated to drive the growth, your earn-out could be worth a lot more than it would be if you were running the business all by yourself.
In this particular case, the seller needed to be done with his business sale within 18 months due to his own personal reasons that had nothing to do with the business. The choice was clear!
When it comes to waiting for a big sales contract before you sell your business, consider the trade-offs before you make a decision.
“All good things arrive unto them that wait - and don't die in the meantime” – Mark Twain
We recently had a client who had intentions of selling his business for a long time but was unable to decide when to start. His big dilemma was that he was expecting to be rewarded a government contract and believed that his business would be worth substantially more once that happened. The seller did not want to put the business in the market until the contract came through. Sounds like the right thing to do, doesn’t it?
Our advice in this and similar situations is for the business owner to consider the trade-offs of starting the business sale immediately as opposed to waiting until the “big sale” closes.
First, let’s look at this type of contract from a potential acquirer’s perspective:
Ø If the company that is being acquired has recently landed a big contract, how desirable is it and how much life is left in the contract?
Ø If the company has not gotten the contract but is likely to get it, what could it be worth?
Ø Is this contract potentially a large percent of the company’s revenues and does the contract pose a material risk to rest of the company if something were to go wrong?
Ø What is the economic benefit of it going forward? Is this contract a sustainable one or is it more of an aberration?
Ø Can the contract be leveraged into something bigger and better?
Now, let’s look at the contract from the business owner’s perspective:
Ø What is the lead time for the contract? Is it 6 months? A year? Longer? Assuming delays or disruptions, which are common for big contracts, does the business owner have the time?
Ø What if the business owner does not get the contract or, worse yet, the process drags on? How will it affect the company’s operations? How long can the seller wait to recover?
Ø For most companies, the sales pipeline is almost always bigger than the current backlog. What are the chances that this contract will materialize or that there will be another bigger deal on the horizon after this deal? What does history say about how the company grows?
Ø The time it takes to sell a mid market business is typically about a year. If the business owner waits for the contract to put the business in the market, how much of a residual value will the contract have, post close?
Ø Between now and the anticipated close date of the business sale, is the competition getting stronger? Is there new competition? Are there deep pockets moving into the niche and threatening to make it more difficult for existing players? Does the business owner who is planning on an exit have the energy and drive to take on the new competition?
Ø How about the market? Are there any fundamental changes that are likely to happen over the next few years? Are there big investments needed to continue growing?
Ø Is there any potential upside an acquirer can bring to the deal? Is it more likely that the company will get the contract with the current management or with the acquirer?
So, what should the business owner do once the trade-offs are understood? The critical element to consider in this situation is the reason why the business owner wants to sell the business in the first place. Does the business owner not have the energy to continue driving the business aggressively? Is he/she under any time pressure for health, personal, or other reasons? Does the future look brighter now compared to what it will be after the contract? Does the owner not have the deep pockets or risk tolerance necessary to drive the business to the next level? Does he/she need the backing of a larger company or a PEG to continue to grow? Whatever else the reason may be, is it still valid? If the answer to any of these questions is “yes”, now is the time to put the business sale process in motion.
If you are in a similar scenario, the faster you attract the right acquirer, the better your chances are for a more favorable outcome. A competent M&A advisor can get the right acquirers to the table - the acquirers who are willing to pay for the future. The payout may not be upfront cash and could be an earn-out based on you winning the contract or generating the revenue growth. The measurement and payout could be any terms that are mutually acceptable. While the M&A advisor negotiates the deal for you, you can focus on making sure that contract comes through and other attractive deals in your sales pipeline materialize. If the acquirer is a name brand or a PEG with deep pockets motivated to drive the growth, your earn-out could be worth a lot more than it would be if you were running the business all by yourself.
In this particular case, the seller needed to be done with his business sale within 18 months due to his own personal reasons that had nothing to do with the business. The choice was clear!
When it comes to waiting for a big sales contract before you sell your business, consider the trade-offs before you make a decision.
Thursday, March 27, 2008
What Professional Business Valuations Don’t Tell You
The Myth Of Fair Business Valuation
“In business, you don’t get what you deserve, you get what you negotiate”. – Chester L. Karrass
So, how can Bear Stearns be worth about $20 billion dollars in January 2007 and be worth only $238M in 16th March 2008 – just 14 months later? And how can it be worth about $1B on within days after JP Morgan announced the $238M deal? What is the fair valuation?
The answer is simple and holds a message that every business owner should be keenly aware of: There is NO fair value for illiquid assets.
While the 100:1 valuation swing that Bear Stearns saw within a span of about an year is uncommon for public sector companies, it is not at all uncommon for mid-market businesses. We routinely see business owners who have suffered enormously from dramatic valuation compression due to poor planning and/or picking wrong advisory teams. Let’s look at what “fair valuation” of illiquid assets means in the context of mid-market business owners and shareholders who are getting ready to sell or recapitalize their businesses.
Some business intermediaries and financial advisors insist that the seller get a professional valuation before placing the business in the market. Some intermediaries even insist that the business must be marketed at its “fair value” or “appraised value”. Professional valuation specialists charge thousands or tens of thousands of dollars to come up with a fancy report that narrows the value of the business to a precise number or a narrow range of values. This type of report is typically tens of pages long and addresses valuation factors such as financials, industry sector, strength of management team, value of the assets, the purpose of the sale, etc. A typical report also uses various valuation methodologies to arrive at a weighted average number that is given out as value of the business.
So, what does it mean to have a “professional valuation report” or a “fair value report”? Does this mean that the seller will know the exact selling price of the business? Not really!
Professional valuations and fair value opinions aim to provide a “fair business valuation” but they are all contingent on multiple assumptions. The valuations are as good as the assumptions upon which they are based. Two of the key factors in valuations – future growth rate and operational synergies – are highly subjective and no two views on these topics are likely to be identical. Unfortunately for business owners, the exact conditions laid out by valuation professionals never occur in real life!
On top of variability in key valuation factors, sale terms such as the type of sale, the payment schedule, consulting clauses, earn-outs, and the reps and warranties can easily cause a 20-40% swing in what the seller gets to take home. Setting aside sale terms, which are typically not covered by a valuation report, the seller will be lucky if the real sales price comes within 10% to 20% of the professional valuation. In several of our most recent deals, the initial valuation report was off at least 30% from the final sales price.
The reality of business sales process is that the value of a business is determined by the acquirer much more than any other factor. The same business could be viewed completely differently by two different acquirers depending on their strategic needs and their perceptions of future cash flows.
The business sale process also plays a big role. Acquirers tend to pay much more for a deal that they believe is competitive. While negotiating in a recent deal, one buyer, after realizing the seller needed to sell for medical reasons and thinking that there was no competition on the deal, said: “I know I got a price reduction but if I wait long enough wouldn’t the seller have to pretty much give the business away?” Fortunately for the seller, we ran a soft auction and there was another acquirer at the table who ended up consummating the deal per seller’s terms.
From our experience, the type of buyer and the type of sale skew the valuation to such an extent that it is unwise for a business owner to be not familiar with these variables and their impact before the beginning of the sales process. Business owners should be aware that these two factors play a disproportionately large role (see chart) and consequently any “professional valuation” has only limited applicability in the business sale process.
From a deal making perspective, running a competitive bid process and finding the right acquirer for the deal involves broad based search, discipline, substantial amount of negotiating, creative deal making, and people management skills. The competitive bid process tends to be longer and will require more cooperation from the seller but the upside is substantial.
The Bear Stearns deal on March 16th, 2008 was clearly based on “Fire Sale Value”. To avoid a fire sale, and to stay in the green zone of valuations, mid-market business owners should plan early, hire a competent M&A advisor who can help plan and orchestrate the sales process, and take every precaution possible to plan their exits. The key messages for business owners looking to sell or recapitalize their businesses are:
- There is no fair value for illiquid assets. It all boils down to what a willing buyer can pay and what the business owner is willing to accept.
- To maximize valuation, working with the right acquirer is extremely important. Picking an M&A advisory team that can sell the value of the business to the right buyer can go a long way in feathering the next egg.
- Be prepared for a drawn out sale process. Competitive bid process, an important tool used by M&A specialists to maximize exit valuation, can take time. Plan early and never sell in desperation.
“In business, you don’t get what you deserve, you get what you negotiate”. – Chester L. Karrass
So, how can Bear Stearns be worth about $20 billion dollars in January 2007 and be worth only $238M in 16th March 2008 – just 14 months later? And how can it be worth about $1B on within days after JP Morgan announced the $238M deal? What is the fair valuation?
The answer is simple and holds a message that every business owner should be keenly aware of: There is NO fair value for illiquid assets.
While the 100:1 valuation swing that Bear Stearns saw within a span of about an year is uncommon for public sector companies, it is not at all uncommon for mid-market businesses. We routinely see business owners who have suffered enormously from dramatic valuation compression due to poor planning and/or picking wrong advisory teams. Let’s look at what “fair valuation” of illiquid assets means in the context of mid-market business owners and shareholders who are getting ready to sell or recapitalize their businesses.
Some business intermediaries and financial advisors insist that the seller get a professional valuation before placing the business in the market. Some intermediaries even insist that the business must be marketed at its “fair value” or “appraised value”. Professional valuation specialists charge thousands or tens of thousands of dollars to come up with a fancy report that narrows the value of the business to a precise number or a narrow range of values. This type of report is typically tens of pages long and addresses valuation factors such as financials, industry sector, strength of management team, value of the assets, the purpose of the sale, etc. A typical report also uses various valuation methodologies to arrive at a weighted average number that is given out as value of the business.
So, what does it mean to have a “professional valuation report” or a “fair value report”? Does this mean that the seller will know the exact selling price of the business? Not really!
Professional valuations and fair value opinions aim to provide a “fair business valuation” but they are all contingent on multiple assumptions. The valuations are as good as the assumptions upon which they are based. Two of the key factors in valuations – future growth rate and operational synergies – are highly subjective and no two views on these topics are likely to be identical. Unfortunately for business owners, the exact conditions laid out by valuation professionals never occur in real life!
On top of variability in key valuation factors, sale terms such as the type of sale, the payment schedule, consulting clauses, earn-outs, and the reps and warranties can easily cause a 20-40% swing in what the seller gets to take home. Setting aside sale terms, which are typically not covered by a valuation report, the seller will be lucky if the real sales price comes within 10% to 20% of the professional valuation. In several of our most recent deals, the initial valuation report was off at least 30% from the final sales price.
The reality of business sales process is that the value of a business is determined by the acquirer much more than any other factor. The same business could be viewed completely differently by two different acquirers depending on their strategic needs and their perceptions of future cash flows.
The business sale process also plays a big role. Acquirers tend to pay much more for a deal that they believe is competitive. While negotiating in a recent deal, one buyer, after realizing the seller needed to sell for medical reasons and thinking that there was no competition on the deal, said: “I know I got a price reduction but if I wait long enough wouldn’t the seller have to pretty much give the business away?” Fortunately for the seller, we ran a soft auction and there was another acquirer at the table who ended up consummating the deal per seller’s terms.
From our experience, the type of buyer and the type of sale skew the valuation to such an extent that it is unwise for a business owner to be not familiar with these variables and their impact before the beginning of the sales process. Business owners should be aware that these two factors play a disproportionately large role (see chart) and consequently any “professional valuation” has only limited applicability in the business sale process.
From a deal making perspective, running a competitive bid process and finding the right acquirer for the deal involves broad based search, discipline, substantial amount of negotiating, creative deal making, and people management skills. The competitive bid process tends to be longer and will require more cooperation from the seller but the upside is substantial.
The Bear Stearns deal on March 16th, 2008 was clearly based on “Fire Sale Value”. To avoid a fire sale, and to stay in the green zone of valuations, mid-market business owners should plan early, hire a competent M&A advisor who can help plan and orchestrate the sales process, and take every precaution possible to plan their exits. The key messages for business owners looking to sell or recapitalize their businesses are:
- There is no fair value for illiquid assets. It all boils down to what a willing buyer can pay and what the business owner is willing to accept.
- To maximize valuation, working with the right acquirer is extremely important. Picking an M&A advisory team that can sell the value of the business to the right buyer can go a long way in feathering the next egg.
- Be prepared for a drawn out sale process. Competitive bid process, an important tool used by M&A specialists to maximize exit valuation, can take time. Plan early and never sell in desperation.
Tuesday, March 11, 2008
Beware Of The Private Equity Buyer
What Business Owners Need To Watch Out For When Dealing With PEGs
One of the biggest obstacles to deal making for mid market companies is the lack of financing. With SBA guaranteed funding being capped at $2M, doing deals north of $3M with individual buyers becomes a challenge. Some businesses can find synergistic corporate acquirers but that is not a likely outcome for many businesses. Depending on their situation, business owners need to determine if Private Equity is the right option for the company. Here is where the business owners may find out that the Private Equity Groups (PEGs) can be saviors. For many mid-market companies, acquisition by a PEG is the most realistic exit.
While PEGs can be saviors for business owners, sellers have to be very careful in dealing with PEGs. Once the business owner determines that a PEG is the right option for liquidity, he/she has to be keenly aware that PEGs are in the business of buying and selling companies. A lot of what PEGs do is financial engineering and PEGs are extremely sophisticated and savvy in making deals that are beneficial to them. Many PEGs, in spite of being private “equity”, resort to debt extensively to facilitate transactions. Debt in the deal could mean financial conditions in the acquisition which increases the uncertainty in the deal.
Deals with PEGs are generally far more complex than those done with individual acquirers or synergistic strategic acquirers. Given the intricacies of the deal, and to combat the experience of the PEG, business owners need to have a deal making team of their own to ensure that the PEG does not take advantage of the business owner. From our experience, here are some common things that business owners need to prepare for when dealing with a PEG:
Preparations
Clean up the books and have the financial statements recast and proper pro-forma financials developed. Make sure that forecasts are not overly aggressive and especially avoid underperforming the plan during the course of the deal.
Be prepared for due diligence and review all material issues to catch any problem areas early in the process. Late surprises can have a dramatic negative impact on deal value and in some cases kill the deal. Even a minor due diligence item is likely to be used to aggressively drive down the deal value or introduce conditions that are onerous to the owner.
Remember that due diligence can go both ways! Check the PEG’s reputation and how they have transacted prior deals. Is the PEG a good match for the seller? If the deal requires the seller to stay on post-close, the seller should contact the owners of the businesses previously acquired by the PEG to understand their perspective on working with the PEG. If the PEG is not a match, it may make sense to walk away early before expending too much time interacting with the PEG.
Without a competitive environment, a PEG, or anyone else for that matter, is unlikely to pay top dollar for the company. To strengthen the negotiating position, make sure the M&A advisor is pursuing all possible angles to cast the widest possible net.
LOI
A PEG could easily lock up an inexperienced seller with a basic LOI and drain the seller with a drawn out negotiating process. A comprehensive LOI reduces back end negotiating and is to the seller’s advantage.
Negotiate key terms of the deal in the LOI. This is where the seller has the maximum leverage. Depending on how well the M&A advisor orchestrates the deal, this is when the acquirers perceive competition and do the best they can to get what they want. Once the LOI is signed, the leverage starts shifting and the longer the deal takes to close, the more leverage the PEG is likely to gain.
If the deal is a competitive deal, try to resolve as many key terms as possible before choosing which LOI to accept.
While LOIs in general are non-binding, there could be specific elements that are binding. Watch out!
Deal Terms
If at all possible, get a stock deal. The advantages are many and in most cases are well worth taking a lower valuation to compensate for the tax disadvantages of the buyer.
Whether a stock or asset sale, ensure that the M&A advisor and accountant work closely to make the deal as tax beneficial as possible. Tax issues could have a dramatic impact on what the seller gets to take home. So, leave no stone unturned!
For a stock deal, make sure there is a “basket” clause in the LOI to avoid being nickel and dimed on non-material post-close liabilities.
In a stock sale, get agreement to cap the potential post-close liability to a reasonable percent of the transaction value. This clause must be in the LOI because it can be much tougher to get it in the acquisition agreement once an LOI lacking it has been signed.
Watch out for financing conditions in the LOI. In today's tight credit environment, financing conditions introduce a potentially risky and sometimes unacceptable delay to closure.
Be very cognizant of the debt, equity tradeoffs. Keep in mind that the seller is selling an equity share and not taking out a loan.
If possible, get a “non-reliance” clause to prevent the buyer from suing seller post-close based on oral statements and other things that are not part of the written acquisition agreement.
If possible, get the PEG to sign off on a termination or “break-up” fee if the deal falls through for any reason other than seller’s non-performance.
Negotiations
PEGs are extremely disciplined about the process. Sellers get emotional at their own risk! Emotions can be easily exploited so it is better to let the deal makers interface regarding deal points without exposing the seller’s emotions.
Without competition (or the perception of it), a PEG will seize the opportunity to exploit deal issues for monetary gain. As the deal draws out the PEG knows that the seller has already spent a considerable amount of time and money on the process and without competition for the deal the PEG has an upper hand.
If the deal is getting bogged down, brainstorm with the negotiating team and look for creative ways to get the desired outcome. It may be difficult to salvage a deal if the positions are too entrenched and/or emotions take hold. Creativity and objectivity are key ingredients to good deal making.
A PEG will have multiple members of their team working on the deal. Watch out for the good-cop, bad-cop routine. Without sufficient care, it is easy to end up making multiple concessions during the process without getting much back in return. Having the deal terms handled by an M&A advisor is an easy way to avoid this problem.
When dealing with multiple PEGs, keep in mind that each deal is different - different players, different negotiating leverage, different risks, and different timing. Strategize a plan specific to each PEG with the advisory team. Be keenly aware of the seller’s personal limitations, deal-breakers, and wish-list, and the amount of time and money that is being consumed in the deal making process.
Summary
While PEGs can be a boon for mid-market sellers, it is imperative that the sellers understand that they are dealing with a professional buyer. A good advisory team, careful preparation and negotiating skills are necessary to maximize the benefit. Sellers beware: One line in the contract can make the difference between a good deal and a bad deal.
One of the biggest obstacles to deal making for mid market companies is the lack of financing. With SBA guaranteed funding being capped at $2M, doing deals north of $3M with individual buyers becomes a challenge. Some businesses can find synergistic corporate acquirers but that is not a likely outcome for many businesses. Depending on their situation, business owners need to determine if Private Equity is the right option for the company. Here is where the business owners may find out that the Private Equity Groups (PEGs) can be saviors. For many mid-market companies, acquisition by a PEG is the most realistic exit.
While PEGs can be saviors for business owners, sellers have to be very careful in dealing with PEGs. Once the business owner determines that a PEG is the right option for liquidity, he/she has to be keenly aware that PEGs are in the business of buying and selling companies. A lot of what PEGs do is financial engineering and PEGs are extremely sophisticated and savvy in making deals that are beneficial to them. Many PEGs, in spite of being private “equity”, resort to debt extensively to facilitate transactions. Debt in the deal could mean financial conditions in the acquisition which increases the uncertainty in the deal.
Deals with PEGs are generally far more complex than those done with individual acquirers or synergistic strategic acquirers. Given the intricacies of the deal, and to combat the experience of the PEG, business owners need to have a deal making team of their own to ensure that the PEG does not take advantage of the business owner. From our experience, here are some common things that business owners need to prepare for when dealing with a PEG:
Preparations
Clean up the books and have the financial statements recast and proper pro-forma financials developed. Make sure that forecasts are not overly aggressive and especially avoid underperforming the plan during the course of the deal.
Be prepared for due diligence and review all material issues to catch any problem areas early in the process. Late surprises can have a dramatic negative impact on deal value and in some cases kill the deal. Even a minor due diligence item is likely to be used to aggressively drive down the deal value or introduce conditions that are onerous to the owner.
Remember that due diligence can go both ways! Check the PEG’s reputation and how they have transacted prior deals. Is the PEG a good match for the seller? If the deal requires the seller to stay on post-close, the seller should contact the owners of the businesses previously acquired by the PEG to understand their perspective on working with the PEG. If the PEG is not a match, it may make sense to walk away early before expending too much time interacting with the PEG.
Without a competitive environment, a PEG, or anyone else for that matter, is unlikely to pay top dollar for the company. To strengthen the negotiating position, make sure the M&A advisor is pursuing all possible angles to cast the widest possible net.
LOI
A PEG could easily lock up an inexperienced seller with a basic LOI and drain the seller with a drawn out negotiating process. A comprehensive LOI reduces back end negotiating and is to the seller’s advantage.
Negotiate key terms of the deal in the LOI. This is where the seller has the maximum leverage. Depending on how well the M&A advisor orchestrates the deal, this is when the acquirers perceive competition and do the best they can to get what they want. Once the LOI is signed, the leverage starts shifting and the longer the deal takes to close, the more leverage the PEG is likely to gain.
If the deal is a competitive deal, try to resolve as many key terms as possible before choosing which LOI to accept.
While LOIs in general are non-binding, there could be specific elements that are binding. Watch out!
Deal Terms
If at all possible, get a stock deal. The advantages are many and in most cases are well worth taking a lower valuation to compensate for the tax disadvantages of the buyer.
Whether a stock or asset sale, ensure that the M&A advisor and accountant work closely to make the deal as tax beneficial as possible. Tax issues could have a dramatic impact on what the seller gets to take home. So, leave no stone unturned!
For a stock deal, make sure there is a “basket” clause in the LOI to avoid being nickel and dimed on non-material post-close liabilities.
In a stock sale, get agreement to cap the potential post-close liability to a reasonable percent of the transaction value. This clause must be in the LOI because it can be much tougher to get it in the acquisition agreement once an LOI lacking it has been signed.
Watch out for financing conditions in the LOI. In today's tight credit environment, financing conditions introduce a potentially risky and sometimes unacceptable delay to closure.
Be very cognizant of the debt, equity tradeoffs. Keep in mind that the seller is selling an equity share and not taking out a loan.
If possible, get a “non-reliance” clause to prevent the buyer from suing seller post-close based on oral statements and other things that are not part of the written acquisition agreement.
If possible, get the PEG to sign off on a termination or “break-up” fee if the deal falls through for any reason other than seller’s non-performance.
Negotiations
PEGs are extremely disciplined about the process. Sellers get emotional at their own risk! Emotions can be easily exploited so it is better to let the deal makers interface regarding deal points without exposing the seller’s emotions.
Without competition (or the perception of it), a PEG will seize the opportunity to exploit deal issues for monetary gain. As the deal draws out the PEG knows that the seller has already spent a considerable amount of time and money on the process and without competition for the deal the PEG has an upper hand.
If the deal is getting bogged down, brainstorm with the negotiating team and look for creative ways to get the desired outcome. It may be difficult to salvage a deal if the positions are too entrenched and/or emotions take hold. Creativity and objectivity are key ingredients to good deal making.
A PEG will have multiple members of their team working on the deal. Watch out for the good-cop, bad-cop routine. Without sufficient care, it is easy to end up making multiple concessions during the process without getting much back in return. Having the deal terms handled by an M&A advisor is an easy way to avoid this problem.
When dealing with multiple PEGs, keep in mind that each deal is different - different players, different negotiating leverage, different risks, and different timing. Strategize a plan specific to each PEG with the advisory team. Be keenly aware of the seller’s personal limitations, deal-breakers, and wish-list, and the amount of time and money that is being consumed in the deal making process.
Summary
While PEGs can be a boon for mid-market sellers, it is imperative that the sellers understand that they are dealing with a professional buyer. A good advisory team, careful preparation and negotiating skills are necessary to maximize the benefit. Sellers beware: One line in the contract can make the difference between a good deal and a bad deal.
Is Private Equity The Right Option For Your Business?
What Private Equity Investors Look For In A Company
To understand what Private Equity Groups (PEGs) look for in a company, one needs to understand the meaning of Private Equity. So, what is Private Equity?
Private Equity is long-term, committed capital provided in the form of equity to help private companies grow and succeed. If your growing mid-market company is looking to expand, Private Equity could help. Private Equity could also help if you are trying to recapitalize the company, exit the company, or transition the company to new management.
Unlike debt financiers who require capital repayment plus interest on a set schedule, irrespective of your cash flow situation, Private Equity is invested in exchange for a stake in your company. After the equity infusion, you will have a smaller piece of the pie. However, within a few years, your piece of the pie could be worth considerably more than what you had before.
Private Equity investors’ returns are dependent on the growth and profitability of your business. If you succeed, they succeed. If you fail, they fail. PEG’s capital infusion and involvement have proven beneficial to companies and many companies have gone much further with Private Equity than they otherwise would have. PEGs will seek to increase a company’s value, without having to take day-to-day management control. In some cases, PEGs bring in their own management team and facilitate a management transition. Given the high amount of risk these investors incur, and the duration of their investment, PEGs invest in the business on the strength of the manager’s business plans, knowledge, trust and negotiations with him.
Generally speaking, unless a business can offer the prospect of significant growth within five years, it is unlikely to be of interest to a PEG. For some high growth companies and companies with limited “hard” assets, Private Equity may be the only option for capital.
However, Private Equity is not for every business. Private Equity may not be suitable for companies with limited capital needs, for companies with stable cash flow, or for companies with substantial hard assets. For these types of companies, debt financing may be a better alternative. Many small companies whose main purpose is to provide a good standard of living for their owners are also not suitable for Private Equity investment, as they are unlikely to provide the necessary financial returns to this type of investor.
Assuming the company is suitable for Private Equity investment, investors look at several criteria before providing the equity for your business.
Strong Management team
Unless the intended purpose of the equity transaction is management transition, the quality of the management team is by far the most important criterion for many Private Equity investors. Most investors do not invest in a company unless they are satisfied with the management team.
Growing Market Segment
The value added by Private Equity in many cases is their ability to grow the “pie” and in that context the growth potential in the target market segment is a very critical factor. PEGs also want to ensure that the company is well positioned to grow within the target market segment.
Realistic Growth/Expense Plan
Unrealistic planning will create a doubt in investors’ minds about the management’s business skills. Similarly, under budgeting for material, labor and equipment costs will reflect poorly on the management team.
Exit Route
The PEGs are in the deal for the long term but they need a workable exit to get their money back. The exit could be business sale, management buyout, IPO or something else. PEGs need to have the confidence that there is a clear, planned path to their exit.
Security
Unlike debt, equity investment does not come with any overt security collateral. To mitigate risk, PEGs typically require a seat on the company’s board and a codified management plan to protect the PEG’s interest.
Contingency Planning
No business grows without hiccups. Understanding what could go wrong and putting contingency plans in place to deal with specific situations can go a long way in gaining a PEG’s trust.
Reputation
PEGs check the business credit rating, the management team’s reputation, and enthusiasm and determination of the team before they invest. The best business ideas are not worth much without good people and PEG’s want to make sure that they are getting a strong, positive team with good marketplace reputation.
Good Rate of Return
When everything else checks out, it comes to terms. PEGs look for a good return for the capital they are risking on your venture. The return a PEG is willing to accept is a direct function of how desirable your deal is and how much competition exists for your deal.
In summary, PEG investors must be assured that the capital being deployed by them will yield the returns they are seeking. If the investment is considered worthwhile then there will be competition to do your deal. Competition often means you get a higher valuation, better deal terms for your company and more cash proceeds for you.
To understand what Private Equity Groups (PEGs) look for in a company, one needs to understand the meaning of Private Equity. So, what is Private Equity?
Private Equity is long-term, committed capital provided in the form of equity to help private companies grow and succeed. If your growing mid-market company is looking to expand, Private Equity could help. Private Equity could also help if you are trying to recapitalize the company, exit the company, or transition the company to new management.
Unlike debt financiers who require capital repayment plus interest on a set schedule, irrespective of your cash flow situation, Private Equity is invested in exchange for a stake in your company. After the equity infusion, you will have a smaller piece of the pie. However, within a few years, your piece of the pie could be worth considerably more than what you had before.
Private Equity investors’ returns are dependent on the growth and profitability of your business. If you succeed, they succeed. If you fail, they fail. PEG’s capital infusion and involvement have proven beneficial to companies and many companies have gone much further with Private Equity than they otherwise would have. PEGs will seek to increase a company’s value, without having to take day-to-day management control. In some cases, PEGs bring in their own management team and facilitate a management transition. Given the high amount of risk these investors incur, and the duration of their investment, PEGs invest in the business on the strength of the manager’s business plans, knowledge, trust and negotiations with him.
Generally speaking, unless a business can offer the prospect of significant growth within five years, it is unlikely to be of interest to a PEG. For some high growth companies and companies with limited “hard” assets, Private Equity may be the only option for capital.
However, Private Equity is not for every business. Private Equity may not be suitable for companies with limited capital needs, for companies with stable cash flow, or for companies with substantial hard assets. For these types of companies, debt financing may be a better alternative. Many small companies whose main purpose is to provide a good standard of living for their owners are also not suitable for Private Equity investment, as they are unlikely to provide the necessary financial returns to this type of investor.
Assuming the company is suitable for Private Equity investment, investors look at several criteria before providing the equity for your business.
Strong Management team
Unless the intended purpose of the equity transaction is management transition, the quality of the management team is by far the most important criterion for many Private Equity investors. Most investors do not invest in a company unless they are satisfied with the management team.
Growing Market Segment
The value added by Private Equity in many cases is their ability to grow the “pie” and in that context the growth potential in the target market segment is a very critical factor. PEGs also want to ensure that the company is well positioned to grow within the target market segment.
Realistic Growth/Expense Plan
Unrealistic planning will create a doubt in investors’ minds about the management’s business skills. Similarly, under budgeting for material, labor and equipment costs will reflect poorly on the management team.
Exit Route
The PEGs are in the deal for the long term but they need a workable exit to get their money back. The exit could be business sale, management buyout, IPO or something else. PEGs need to have the confidence that there is a clear, planned path to their exit.
Security
Unlike debt, equity investment does not come with any overt security collateral. To mitigate risk, PEGs typically require a seat on the company’s board and a codified management plan to protect the PEG’s interest.
Contingency Planning
No business grows without hiccups. Understanding what could go wrong and putting contingency plans in place to deal with specific situations can go a long way in gaining a PEG’s trust.
Reputation
PEGs check the business credit rating, the management team’s reputation, and enthusiasm and determination of the team before they invest. The best business ideas are not worth much without good people and PEG’s want to make sure that they are getting a strong, positive team with good marketplace reputation.
Good Rate of Return
When everything else checks out, it comes to terms. PEGs look for a good return for the capital they are risking on your venture. The return a PEG is willing to accept is a direct function of how desirable your deal is and how much competition exists for your deal.
In summary, PEG investors must be assured that the capital being deployed by them will yield the returns they are seeking. If the investment is considered worthwhile then there will be competition to do your deal. Competition often means you get a higher valuation, better deal terms for your company and more cash proceeds for you.
Monday, March 10, 2008
Financing Options For Mid Market Companies
Debt Capital, Equity Capital & Convertible Debt
There are three basic types of funding options for mid market companies: debt, equity and convertible debt. In this article, we will discuss the trade offs of each of these funding options in the context of a mid-market company.
Debt Capital
Debt capital is money raised for a company that must be repaid over a period of time with interest. Debt financing can be either short-term or long-term. Unsecured debt is rare and lenders typically secure debt with assets of the company. This also means that service, technology, and other asset-lite companies have a hard time raising debt capital.
Common debt financers include banks, credit unions, finance companies, and credit card companies.
Advantages of debt capital
* Raising debt capital, for profitable asset intensive companies, can be faster than raising equity capital.
* Debt capital is typically cheaper than equity capital because the financing companies pick only the lowest credit risk companies and further secure their loan with assets.
* The lender does not gain an ownership interest in the business and this allows the business owner to remain in the driver’s seat of the company without being answerable to investors.
Disadvantages of debt capital
* The loan amount and the interest payments can saddle the balance sheet and income statement of the company.
* Any downturn in the business or unexpected capital needs can make it difficult to make the interest payments and send the company into a debt induced downward spiral.
* For some debt instruments, the terms can be complex and may onerously burden the business.
* If the debt is personally guaranteed, liability will extend to non-business assets.
* If the company gets into trouble, the debt financier could become adversarial.
Equity Capital
Equity capital is money raised by a business in exchange for a share of ownership in the company. Equity financing allows a business to obtain funds without incurring debt and without having the burden of associated interest/principal payments. For a growing company with cash needs and for companies with an erratic earnings stream, it can be a big advantage to not have to repay a specific amount of money at a particular time.
Equity capital can be public or private. Public equity capital is only available for large companies (revenues over a hundred million dollars). Two key sources of private equity capital for mid market businesses are Private Equity Groups (PEGs) and corporate investors. Other forms of private capital such as angel capital and venture capital, are typically not available to mid-market companies. Angel investors and venture capitalists provide funding to young, nascent private companies.
Equity investors can be passive or active. Passive investors are willing to give you capital but will play little or no part in running the company, while active investors expect to be heavily involved in the company’s operations. Investing in a company’s equity over a long term without any security collateral is inherently high risk. As a result of that, this form of capital typically comes with an active participation from the investors.
Passive or active, equity investors are typically patient, long term investors. These investors seek to add value in an effort to help the company grow and achieve a greater return on the investment. In return for their risk and participation, private equity investors usually look for a 25% or more return on investment, and put a number of checks and balances on the company’s operations to achieve their goals.
Advantage of Equity Capital
* Lack of recurring principle/interest payments makes the business more able to cope with the ebb and flow of the business and increases the margin of safety
* Corporation’s risk is shared with investors
* Right investors can add significant value
* Smooth transition option for business owners looking to ease out of the business
* May be the only possible type of capital for rapidly growing and asset-lite companies
* Equity investor is committed to the company until exit. If the company gets into trouble, the equity investor is likely to help with the turnaround
Disadvantages of Equity Capital
* Owner answerable to investors and some loss of control
* Can be more expensive than debt capital (albeit at a lower risk)
* It typically takes longer to raise equity capital than debt capital
* Deal terms can be complex. Without good deal making support, the company may unknowingly allow the investor to undervalue the company and take a disproportionately higher percentage of the company compared to the value of the investment made.
Convertible Debt
Convertible debt is a hybrid of debt capital and equity capital. Convertible debt typically involves favorable interest rates and other terms on the loan in return for the option to convert some or all of the debt into equity at predetermined price levels. Convertible debt instruments are complex and require a substantial amount of work on the part of the deal makers. There are many different variations of convertible debt available depending on the needed trade-off between debt and equity.
Convertible debt is more likely to be seen in distressed or high risk companies, and some investors specialize in distressed convertible debt. However, the flexibility of convertible debt makes it an attractive option in a wide variety of situations. This option gives the management maximum flexibility and is worth considering for larger mid-market companies.
There are three basic types of funding options for mid market companies: debt, equity and convertible debt. In this article, we will discuss the trade offs of each of these funding options in the context of a mid-market company.
Debt Capital
Debt capital is money raised for a company that must be repaid over a period of time with interest. Debt financing can be either short-term or long-term. Unsecured debt is rare and lenders typically secure debt with assets of the company. This also means that service, technology, and other asset-lite companies have a hard time raising debt capital.
Common debt financers include banks, credit unions, finance companies, and credit card companies.
Advantages of debt capital
* Raising debt capital, for profitable asset intensive companies, can be faster than raising equity capital.
* Debt capital is typically cheaper than equity capital because the financing companies pick only the lowest credit risk companies and further secure their loan with assets.
* The lender does not gain an ownership interest in the business and this allows the business owner to remain in the driver’s seat of the company without being answerable to investors.
Disadvantages of debt capital
* The loan amount and the interest payments can saddle the balance sheet and income statement of the company.
* Any downturn in the business or unexpected capital needs can make it difficult to make the interest payments and send the company into a debt induced downward spiral.
* For some debt instruments, the terms can be complex and may onerously burden the business.
* If the debt is personally guaranteed, liability will extend to non-business assets.
* If the company gets into trouble, the debt financier could become adversarial.
Equity Capital
Equity capital is money raised by a business in exchange for a share of ownership in the company. Equity financing allows a business to obtain funds without incurring debt and without having the burden of associated interest/principal payments. For a growing company with cash needs and for companies with an erratic earnings stream, it can be a big advantage to not have to repay a specific amount of money at a particular time.
Equity capital can be public or private. Public equity capital is only available for large companies (revenues over a hundred million dollars). Two key sources of private equity capital for mid market businesses are Private Equity Groups (PEGs) and corporate investors. Other forms of private capital such as angel capital and venture capital, are typically not available to mid-market companies. Angel investors and venture capitalists provide funding to young, nascent private companies.
Equity investors can be passive or active. Passive investors are willing to give you capital but will play little or no part in running the company, while active investors expect to be heavily involved in the company’s operations. Investing in a company’s equity over a long term without any security collateral is inherently high risk. As a result of that, this form of capital typically comes with an active participation from the investors.
Passive or active, equity investors are typically patient, long term investors. These investors seek to add value in an effort to help the company grow and achieve a greater return on the investment. In return for their risk and participation, private equity investors usually look for a 25% or more return on investment, and put a number of checks and balances on the company’s operations to achieve their goals.
Advantage of Equity Capital
* Lack of recurring principle/interest payments makes the business more able to cope with the ebb and flow of the business and increases the margin of safety
* Corporation’s risk is shared with investors
* Right investors can add significant value
* Smooth transition option for business owners looking to ease out of the business
* May be the only possible type of capital for rapidly growing and asset-lite companies
* Equity investor is committed to the company until exit. If the company gets into trouble, the equity investor is likely to help with the turnaround
Disadvantages of Equity Capital
* Owner answerable to investors and some loss of control
* Can be more expensive than debt capital (albeit at a lower risk)
* It typically takes longer to raise equity capital than debt capital
* Deal terms can be complex. Without good deal making support, the company may unknowingly allow the investor to undervalue the company and take a disproportionately higher percentage of the company compared to the value of the investment made.
Convertible Debt
Convertible debt is a hybrid of debt capital and equity capital. Convertible debt typically involves favorable interest rates and other terms on the loan in return for the option to convert some or all of the debt into equity at predetermined price levels. Convertible debt instruments are complex and require a substantial amount of work on the part of the deal makers. There are many different variations of convertible debt available depending on the needed trade-off between debt and equity.
Convertible debt is more likely to be seen in distressed or high risk companies, and some investors specialize in distressed convertible debt. However, the flexibility of convertible debt makes it an attractive option in a wide variety of situations. This option gives the management maximum flexibility and is worth considering for larger mid-market companies.
Saturday, February 23, 2008
Can You Afford To Employ A Dual Agent In A Business Sale?
The pitfalls of hiring a dual agent in a business sale transaction
Most people have heard of dual agency in the context of a real estate transaction and have some awareness of the issues surrounding dual agency. In spite of the inherent conflict of interest, many people do not mind transacting residential or commercial property using a dual agent. The reason is pretty straight forward – while there is risk of not getting good representation, the downside is typically small. Property values are driven by comps and cap rates and in most cases, the amount of money left on the table is a small percent of the transaction value. The commodity nature and relative liquidity of real estate also helps make buyers and sellers comfortable with the risk level.
But does this logic apply to business sale transactions? Businesses, compared to real estate, are illiquid and the valuations and the ultimate closing prices vary dramatically from business to business. The deal amount can also change dramatically through the duration of a deal. In Business sale transactions, not having a fiduciary agent working for you can cost you plenty.
Let us start with an explanation of “fiduciary duty”. An agent used to represent a buyer or seller in a business transaction has a fiduciary duty. A fiduciary duty is the highest standard of care imposed at either equity or law. A fiduciary is expected to be extremely loyal to the principal. Among other responsibilities, a fiduciary must not put their personal interests before the duty and a fiduciary must not profit from the fiduciary position without express knowledge and consent of the principal. A fiduciary also has a duty to be in a situation where there is no personal conflict of interest and where there is no conflict of interest with another fiduciary duty.
In light of large sums of money at stake in a business transaction and these fiduciary responsibilities, let’s look at the three key issues faced by a dual agent in a business sale.
1. Conflict of Interest
This is by far the most obvious and most damning part of being on both sides of a business sale transaction. A business intermediary is obligated to serve the best interests of his or her principal. Buyers and sellers by definition have conflicting interests. Who should the intermediary be loyal to? Is the agent looking after your best interests? Some agencies will tell customers that they will assign separate individuals to the buying side and selling side and create a Chinese wall.
In practice, the wall between the two sides in the same company, even in a large company with processes to cover this type of conflict of interest, let alone a typical small to mid market intermediary, is more akin to a sieve than Chinese wall. An agency in this situation is in violation of the standards of being a fiduciary.
2. Advocacy
Any competent agent will tell you that, when two principles’ interests are in direct conflict, the agent cannot advise, advocate, or give allegiance to either party if such counsel gives one party an advantage over the other. Not remaining neutral or showing favoritism would be illegal and can make the agent liable to potential damages. A careful dual agent would shun the risk of advocacy and will tell you that they will be extremely careful to represent both parties equally and fairly. In other words, both parties lose "advocacy" for their best interests! Is this what you pay your agent for? Wouldn’t you rather pay an agent that advocates your interests?
In practice, providing equal service to two parties is difficult and, even if the agent is highly ethical, agent’s biases and self interests may tip the scales in difficult situations.
3. Sensitive Information
A business sale can take an extended amount of time and the seller or buyer may experience one or more personal events which, while not affecting the performance of the business being transacted, may have substantial impact on the negotiations. The agent may become aware of this sensitive information which, if disclosed to the other party, could harm one party and benefit the other. If the agent has one principal, clearly the agent will develop a strategy to minimize the impact to the principal. How does a dual agent handle this type of information about a client? Would you trust your sensitive information with a dual agent?
In practice, the agent ends up playing favorites or in a worst case scenario, one or both of the parties’ interests are sacrificed in the interest of “getting the deal done”.
Summary: Business sellers and buyers need to carefully pick their agent in a business sale transaction. Providing equal service to both clients is practically impossible in most deals. In the best case scenario, neither the seller nor the buyer is getting an advocate. In the worst case scenario, one or both of the parties are being sacrificed. For this reason some states do not permit dual agency. Much can be lost by employing agents who put themselves in the position of being dual agents and thus not living up to the fiduciary standards.
For most business owners, a business sale is a once in a lifetime event with significant impact on how well the family’s nest egg is feathered. With so much at stake, can you afford to employ a dual agent?
Most people have heard of dual agency in the context of a real estate transaction and have some awareness of the issues surrounding dual agency. In spite of the inherent conflict of interest, many people do not mind transacting residential or commercial property using a dual agent. The reason is pretty straight forward – while there is risk of not getting good representation, the downside is typically small. Property values are driven by comps and cap rates and in most cases, the amount of money left on the table is a small percent of the transaction value. The commodity nature and relative liquidity of real estate also helps make buyers and sellers comfortable with the risk level.
But does this logic apply to business sale transactions? Businesses, compared to real estate, are illiquid and the valuations and the ultimate closing prices vary dramatically from business to business. The deal amount can also change dramatically through the duration of a deal. In Business sale transactions, not having a fiduciary agent working for you can cost you plenty.
Let us start with an explanation of “fiduciary duty”. An agent used to represent a buyer or seller in a business transaction has a fiduciary duty. A fiduciary duty is the highest standard of care imposed at either equity or law. A fiduciary is expected to be extremely loyal to the principal. Among other responsibilities, a fiduciary must not put their personal interests before the duty and a fiduciary must not profit from the fiduciary position without express knowledge and consent of the principal. A fiduciary also has a duty to be in a situation where there is no personal conflict of interest and where there is no conflict of interest with another fiduciary duty.
In light of large sums of money at stake in a business transaction and these fiduciary responsibilities, let’s look at the three key issues faced by a dual agent in a business sale.
1. Conflict of Interest
This is by far the most obvious and most damning part of being on both sides of a business sale transaction. A business intermediary is obligated to serve the best interests of his or her principal. Buyers and sellers by definition have conflicting interests. Who should the intermediary be loyal to? Is the agent looking after your best interests? Some agencies will tell customers that they will assign separate individuals to the buying side and selling side and create a Chinese wall.
In practice, the wall between the two sides in the same company, even in a large company with processes to cover this type of conflict of interest, let alone a typical small to mid market intermediary, is more akin to a sieve than Chinese wall. An agency in this situation is in violation of the standards of being a fiduciary.
2. Advocacy
Any competent agent will tell you that, when two principles’ interests are in direct conflict, the agent cannot advise, advocate, or give allegiance to either party if such counsel gives one party an advantage over the other. Not remaining neutral or showing favoritism would be illegal and can make the agent liable to potential damages. A careful dual agent would shun the risk of advocacy and will tell you that they will be extremely careful to represent both parties equally and fairly. In other words, both parties lose "advocacy" for their best interests! Is this what you pay your agent for? Wouldn’t you rather pay an agent that advocates your interests?
In practice, providing equal service to two parties is difficult and, even if the agent is highly ethical, agent’s biases and self interests may tip the scales in difficult situations.
3. Sensitive Information
A business sale can take an extended amount of time and the seller or buyer may experience one or more personal events which, while not affecting the performance of the business being transacted, may have substantial impact on the negotiations. The agent may become aware of this sensitive information which, if disclosed to the other party, could harm one party and benefit the other. If the agent has one principal, clearly the agent will develop a strategy to minimize the impact to the principal. How does a dual agent handle this type of information about a client? Would you trust your sensitive information with a dual agent?
In practice, the agent ends up playing favorites or in a worst case scenario, one or both of the parties’ interests are sacrificed in the interest of “getting the deal done”.
Summary: Business sellers and buyers need to carefully pick their agent in a business sale transaction. Providing equal service to both clients is practically impossible in most deals. In the best case scenario, neither the seller nor the buyer is getting an advocate. In the worst case scenario, one or both of the parties are being sacrificed. For this reason some states do not permit dual agency. Much can be lost by employing agents who put themselves in the position of being dual agents and thus not living up to the fiduciary standards.
For most business owners, a business sale is a once in a lifetime event with significant impact on how well the family’s nest egg is feathered. With so much at stake, can you afford to employ a dual agent?
Wednesday, February 20, 2008
The Limitations of Using EBITDA for Mid Market Companies
Looking behind the numbers
"Does management think the tooth fairy pays for capital expenditures?" – Warren Buffett
EBITDA, follow-on to EBIT, was created by investment bankers to find out the true operating profitability of the company. EBITDA is a great tool to measure the profitability of companies with expensive assets that get depreciated over an extended period of time. Financiers look at EBITDA to measure the debt carrying capacity of the company. It is common to measure mid-market company profitability and cash flow using EBITDA and use EBITDA as the exclusive indicator of the business performance.
Each business has its own unique set of strengths, weaknesses, opportunities and threats, none of which can be captured by EBITDA or any other single metric. Intelligent business acquirers must consider the amount, the growth rate, and the variability of cash flow generated by the operations. EBITDA, when used properly, can be a helpful starting point in this regard. However, as you will see from the discussion below, EBITDA has several limitations when it is used for measuring cash flow.
To arrive at EBITDA for a business, acquirers add back Interest, Taxes, Depreciation, and Amortization to the Net Income of the company. Let’s look at each of the items in EBITDA to understand the rationale and limitation of these add backs:
* Earnings
The most common mistake seen in EBITDA calculations is the inclusion of non-operational earnings in the earnings number. To start off the process, it is imperative that all non operating profits have been factored out of the earnings. Are one time real estate or other asset sales factored into the earnings calculations? How about warranty cost reserves and bad debt allowances? The earnings data needs to be scrubbed to make sure that the earnings number used in EBITDA reflects operating earnings.
* Interest
Interest payments of a business are primarily a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the net income. While adding back interest makes sense in terms of identifying operating profitability, it does not make sense to add interest back in terms of cash flow. Interest payments are certainly a burden on the cash flow! To get a more meaningful measure of cash flow, it would be necessary to subtract from EBITDA the anticipated cost of financing under the new regime.
* Taxes
Taxes are accounting and owner dependent and a pre tax view of the profits would be a better indicator of the operating profit stream. However, like interest payments, taxes are a real expense and estimated taxes under the new financing and operational structure should be factored into calculating the expected cash flow.
* Depreciation
Depreciation is an accounting construct that provides for an indirect and backward looking measure of capital expenses. Depreciation expense can be a highly misleading indicator. The accounting treatment of depreciation for many businesses is substantially different from real world depreciation. For equipment intensive businesses, adjustments to EBITDA are almost always necessary to get a true picture of the earnings.
Since depreciation is a non cash expense, it makes sense to add the line item back for cash flow calculations. However, keep in mind that some of the depreciated items need to be replaced over time and new equipment needs to be added in. Any cash flow calculation should factor in the cost of the replacement equipment.
* Amortization
Amortization is similar to depreciation except that what is being depreciated are intangible assets such as goodwill of the business – very likely from a past acquisition or startup costs. Barring a few rare exceptions, amortization can be fully added back for profitability and cash flow calculations.
In addition to the above, there are some other limitations to EBITDA. It is important to understand that EBITDA only accounts for two non-cash items - Depreciation and Amortization. There is no provision in EBITDA to adjust for some very important non-cash items such as stock grants, stock option grants, inventory value adjustments, bad debt allowances, and gift certificate redemption credits.
EBITDA also ignores the impact of changes in working capital. Increases in working capital consume cash and a business could have great EBITDA numbers but terrible cash flow numbers and could be on the verge of going out of business. To have a meaningful picture of the cash flow, acquirers need to review working capital changes to see if there are growth related issues or other working capital changes of significance and adjust cash flows accordingly.
In summary, acquirers should not rely exclusively on EBITDA or any other single metric to measure the performance of a business. To the extent EBITDA is used, acquirers should replace the removed interest, taxes, depreciation, and amortization from their earnings calculations with their own expected operating numbers to get a better picture of anticipated profitability and cash flow and the variability to the cash flow. This can be accomplished by:
- Substituting the Interest costs with expected capital costs under the anticipated capital structure
- Substituting the Tax items with their own tax-rate calculations under the new capital structure.
- Substituting Depreciation expense with an estimate of future capital expenditures.
- Amortization can be kept at zero unless there are extraordinary items that need to be factored in.
- Reviewing working capital changes and adjusting cash flows accordingly.
"Does management think the tooth fairy pays for capital expenditures?" – Warren Buffett
EBITDA, follow-on to EBIT, was created by investment bankers to find out the true operating profitability of the company. EBITDA is a great tool to measure the profitability of companies with expensive assets that get depreciated over an extended period of time. Financiers look at EBITDA to measure the debt carrying capacity of the company. It is common to measure mid-market company profitability and cash flow using EBITDA and use EBITDA as the exclusive indicator of the business performance.
Each business has its own unique set of strengths, weaknesses, opportunities and threats, none of which can be captured by EBITDA or any other single metric. Intelligent business acquirers must consider the amount, the growth rate, and the variability of cash flow generated by the operations. EBITDA, when used properly, can be a helpful starting point in this regard. However, as you will see from the discussion below, EBITDA has several limitations when it is used for measuring cash flow.
To arrive at EBITDA for a business, acquirers add back Interest, Taxes, Depreciation, and Amortization to the Net Income of the company. Let’s look at each of the items in EBITDA to understand the rationale and limitation of these add backs:
* Earnings
The most common mistake seen in EBITDA calculations is the inclusion of non-operational earnings in the earnings number. To start off the process, it is imperative that all non operating profits have been factored out of the earnings. Are one time real estate or other asset sales factored into the earnings calculations? How about warranty cost reserves and bad debt allowances? The earnings data needs to be scrubbed to make sure that the earnings number used in EBITDA reflects operating earnings.
* Interest
Interest payments of a business are primarily a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the net income. While adding back interest makes sense in terms of identifying operating profitability, it does not make sense to add interest back in terms of cash flow. Interest payments are certainly a burden on the cash flow! To get a more meaningful measure of cash flow, it would be necessary to subtract from EBITDA the anticipated cost of financing under the new regime.
* Taxes
Taxes are accounting and owner dependent and a pre tax view of the profits would be a better indicator of the operating profit stream. However, like interest payments, taxes are a real expense and estimated taxes under the new financing and operational structure should be factored into calculating the expected cash flow.
* Depreciation
Depreciation is an accounting construct that provides for an indirect and backward looking measure of capital expenses. Depreciation expense can be a highly misleading indicator. The accounting treatment of depreciation for many businesses is substantially different from real world depreciation. For equipment intensive businesses, adjustments to EBITDA are almost always necessary to get a true picture of the earnings.
Since depreciation is a non cash expense, it makes sense to add the line item back for cash flow calculations. However, keep in mind that some of the depreciated items need to be replaced over time and new equipment needs to be added in. Any cash flow calculation should factor in the cost of the replacement equipment.
* Amortization
Amortization is similar to depreciation except that what is being depreciated are intangible assets such as goodwill of the business – very likely from a past acquisition or startup costs. Barring a few rare exceptions, amortization can be fully added back for profitability and cash flow calculations.
In addition to the above, there are some other limitations to EBITDA. It is important to understand that EBITDA only accounts for two non-cash items - Depreciation and Amortization. There is no provision in EBITDA to adjust for some very important non-cash items such as stock grants, stock option grants, inventory value adjustments, bad debt allowances, and gift certificate redemption credits.
EBITDA also ignores the impact of changes in working capital. Increases in working capital consume cash and a business could have great EBITDA numbers but terrible cash flow numbers and could be on the verge of going out of business. To have a meaningful picture of the cash flow, acquirers need to review working capital changes to see if there are growth related issues or other working capital changes of significance and adjust cash flows accordingly.
In summary, acquirers should not rely exclusively on EBITDA or any other single metric to measure the performance of a business. To the extent EBITDA is used, acquirers should replace the removed interest, taxes, depreciation, and amortization from their earnings calculations with their own expected operating numbers to get a better picture of anticipated profitability and cash flow and the variability to the cash flow. This can be accomplished by:
- Substituting the Interest costs with expected capital costs under the anticipated capital structure
- Substituting the Tax items with their own tax-rate calculations under the new capital structure.
- Substituting Depreciation expense with an estimate of future capital expenditures.
- Amortization can be kept at zero unless there are extraordinary items that need to be factored in.
- Reviewing working capital changes and adjusting cash flows accordingly.
Tuesday, February 05, 2008
Net Income, EBIT, EBITDA, SDCF
What is the right metric to use for business valuation?
The most commonly used “earnings figures” used for small to mid-market business valuation are Net income (NI), Earnings Before Interest and Taxes (EBIT), Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and Seller’s Discretionary Cash Flow (SDCF). With a variety of metrics to choose from it is natural for a business owner to ask “which is the right one to use for my business”. To answer the question, first we need a quick background on what these earnings metrics are.
* NI: NI is the net profit of the business after deducting all expenses of the business including all operational expenses, owners’ or officers’ salary, interest expense, taxes, etc. Some people consider this as the “true earnings” but for many small to mid market companies, which are on a constant quest to minimize taxes, this number can be grossly understated and is not a true reflection of the company’s earnings stream.
* EBIT: EBIT is the net profit of the business before factoring in financing and taxes. The rationale for using this metric is that tax payments are highly accounting and owner dependent and a pre tax view of the profits would be a better indicator of the profit stream. Similarly, interest payments that are a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the NI. EBIT shows an earnings number that is adjusted for these variables to reflect a truer picture of the earnings.
* EBITDA: The accounting treatment of Depreciation and Amortization for many businesses is substantially different from the real cash flow impact these elements have on the business. EBITDA allows for looking at the profitability of the business before factoring in these two items. One needs to be aware that this can be a highly misleading indicator based on the depreciation and amortization characteristics of the business and adjustments to EBITDA are almost always necessary to get a true picture of the earnings.
* SDCF: For smaller businesses, where the owner may see the business as a “job”, the true measure of profitability may be the sum of all the monies the owner derives from the business including salary, benefits and other perks.
Effectively,
* EBIT = Net Income + Interest + Taxes
* EBITDA = EBIT + Depreciation + Amortization
* SDCF = EBITDA + Owner/Officer’s Salary + Benefits + Perks
So, the answer to the question, “Which earnings is the right one for my business?” depends on the nature and size of a business and an understanding of which metric may more accurately reflect the true earnings. For many mid-market businesses the appropriate metric is likely to be EBIT or EBITDA.
Once the correct metric is identified, the business owner needs to understand the range of multiples that may be applicable to the chosen metric. For example, the earnings multiples for most small companies tend to vary between 1 to 3 times SDCF and the earnings multiple for mid-market companies are more likely to be 3 to 5 times EBIT or 3 to 7 times EBITDA.
However, businesses tend to be more unique than typical and a multiple that is good for one business may be too low or too high for another. The more exceptional the business is, the more likely it is that the multiplier will be outside of the typical range.
The most commonly used “earnings figures” used for small to mid-market business valuation are Net income (NI), Earnings Before Interest and Taxes (EBIT), Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and Seller’s Discretionary Cash Flow (SDCF). With a variety of metrics to choose from it is natural for a business owner to ask “which is the right one to use for my business”. To answer the question, first we need a quick background on what these earnings metrics are.
* NI: NI is the net profit of the business after deducting all expenses of the business including all operational expenses, owners’ or officers’ salary, interest expense, taxes, etc. Some people consider this as the “true earnings” but for many small to mid market companies, which are on a constant quest to minimize taxes, this number can be grossly understated and is not a true reflection of the company’s earnings stream.
* EBIT: EBIT is the net profit of the business before factoring in financing and taxes. The rationale for using this metric is that tax payments are highly accounting and owner dependent and a pre tax view of the profits would be a better indicator of the profit stream. Similarly, interest payments that are a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the NI. EBIT shows an earnings number that is adjusted for these variables to reflect a truer picture of the earnings.
* EBITDA: The accounting treatment of Depreciation and Amortization for many businesses is substantially different from the real cash flow impact these elements have on the business. EBITDA allows for looking at the profitability of the business before factoring in these two items. One needs to be aware that this can be a highly misleading indicator based on the depreciation and amortization characteristics of the business and adjustments to EBITDA are almost always necessary to get a true picture of the earnings.
* SDCF: For smaller businesses, where the owner may see the business as a “job”, the true measure of profitability may be the sum of all the monies the owner derives from the business including salary, benefits and other perks.
Effectively,
* EBIT = Net Income + Interest + Taxes
* EBITDA = EBIT + Depreciation + Amortization
* SDCF = EBITDA + Owner/Officer’s Salary + Benefits + Perks
So, the answer to the question, “Which earnings is the right one for my business?” depends on the nature and size of a business and an understanding of which metric may more accurately reflect the true earnings. For many mid-market businesses the appropriate metric is likely to be EBIT or EBITDA.
Once the correct metric is identified, the business owner needs to understand the range of multiples that may be applicable to the chosen metric. For example, the earnings multiples for most small companies tend to vary between 1 to 3 times SDCF and the earnings multiple for mid-market companies are more likely to be 3 to 5 times EBIT or 3 to 7 times EBITDA.
However, businesses tend to be more unique than typical and a multiple that is good for one business may be too low or too high for another. The more exceptional the business is, the more likely it is that the multiplier will be outside of the typical range.
Monday, January 28, 2008
Taxes & Valuation: Can You Have Your Cake And Eat It Too?
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.
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.
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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