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.
Thursday, January 17, 2008
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.
Monday, April 24, 2006
Venture Capital firms turn to M&A more for exits
"Pressure mounts on 1999, 2000 vintage-year funds as IPO market 'calcifies'"
This article is a very telling article on Venture economics and some of the hangover still left from the glory days. A lot of the pitches from the companies on the shopping block will be very slick and convey visions of huge potential.
In reality, they are where they are for a reason. A lot of the companies that are looking for M&As tend to be zombies and would very likely disappear if not for the M&A activity. There will be a gem or two that pops up once in a while but acquiring companies need to be extremely careful so as not to get stuck with the walking dead.
This article is a very telling article on Venture economics and some of the hangover still left from the glory days. A lot of the pitches from the companies on the shopping block will be very slick and convey visions of huge potential.
In reality, they are where they are for a reason. A lot of the companies that are looking for M&As tend to be zombies and would very likely disappear if not for the M&A activity. There will be a gem or two that pops up once in a while but acquiring companies need to be extremely careful so as not to get stuck with the walking dead.
Sunday, March 12, 2006
First Post
Chakradher Reddy's Weblog
Welcome to my blog!
Blogging is a wonderful new mechanism that facilitates instantaneous sharing of opinions and ideas and help further democratize the knowledge distribution process.
Most of this blog will be about mergers & acquisitions and how the issues affect business owners and companies. Occasionally I will also be posting my thoughts on wide ranging subjects outside of the m&a field.
Welcome to my blog!
Blogging is a wonderful new mechanism that facilitates instantaneous sharing of opinions and ideas and help further democratize the knowledge distribution process.
Most of this blog will be about mergers & acquisitions and how the issues affect business owners and companies. Occasionally I will also be posting my thoughts on wide ranging subjects outside of the m&a field.
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