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Waiting For The Big Sales Contract To Come Through Before You Exit Your Company

Tuesday, April 29th, 2008

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 TwainWe 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, doesnt 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, lets look at this type of contract from a potential acquirers 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 companys 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, lets look at the contract from the business owners 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 companys 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.

Posted in Valuation | No Comments »

What Professional Business Valuations Dont Tell You

Thursday, March 27th, 2008

The Myth Of Fair Business Valuation

In business, you dont 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 16^th 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. Lets 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 wouldnt 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 sellers 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 16^th, 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.

Posted in Deal Structure, Finance, M&A, Marketing, Valuation | 1 Comment »

Beware Of The Private Equity Buyer

Tuesday, March 11th, 2008

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

Ø 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.

Ø 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.

Ø Remember that due diligence can go both ways! Check the PEGs 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.

Ø 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

Ø 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 sellers advantage.

Ø 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.

Ø If the deal is a competitive deal, try to resolve as many key terms as possible before choosing which LOI to accept.

Ø While LOIs in general are non-binding, there could be specific elements that are binding. Watch out!

Deal Terms

Ø 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.

Ø 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!

Ø 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.

Ø 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.

Ø 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.

Ø 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.

Ø 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.

Ø 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 sellers non-performance.

Negotiations

Ø 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 sellers emotions.

Ø 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.

Ø 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.

Ø 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.

Ø 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 sellers 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.

Posted in Deal Structure, Finance, M&A, Marketing, Valuation | No Comments »

Is Private Equity The Right Option For Your Business?

Tuesday, March 11th, 2008

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. PEGs 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 companys 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 managers 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 managements 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 companys board and a codified management plan to protect the PEGs 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 PEGs trust.

Reputation

PEGs check the business credit rating, the management teams reputation, and enthusiasm and determination of the team before they invest. The best business ideas are not worth much without good people and PEGs 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.

Posted in Deal Structure, Finance, M&A, Miscellaneous | No Comments »

Financing Options For Mid Market Companies

Monday, March 10th, 2008

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

Ø Raising debt capital, for profitable asset intensive companies, can be faster than raising equity capital.

Ø 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.

Ø The lender does not gain an ownership interest in the business and this allows the business owner to remain in the drivers seat of the company without being answerable to investors.

Disadvantages of debt capital

Ø The loan amount and the interest payments can saddle the balance sheet and income statement of the company.

Ø 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.

Ø For some debt instruments, the terms can be complex and may onerously burden the business.

Ø If the debt is personally guaranteed, liability will extend to non-business assets.

Ø 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 companys operations. Investing in a companys 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 companys operations to achieve their goals.

Advantage of Equity Capital

Ø 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

Ø Corporations risk is shared with investors

Ø Right investors can add significant value

Ø Smooth transition option for business owners looking to ease out of the business

Ø May be the only possible type of capital for rapidly growing and asset-lite companies

Ø 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

Ø Owner answerable to investors and some loss of control

Ø Can be more expensive than debt capital (albeit at a lower risk)

Ø It typically takes longer to raise equity capital than debt capital

Ø 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.

Posted in Deal Structure, Finance, Tax Related, Valuation | No Comments »

Can You Afford To Employ A Dual Agent In A Business Sale?

Saturday, February 23rd, 2008

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, lets 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? Wouldnt 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, agents 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 familys nest egg is feathered. With so much at stake, can you afford to employ a dual agent?

Posted in Finance, M&A, Marketing, Miscellaneous, Valuation | No Comments »

The Limitations of Using EBITDA for Mid Market Companies

Wednesday, February 20th, 2008

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. Lets look at each of the items in EBITDA to understand the rationale and limitation of these add backs:

v 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.

v Interest

Interest payments of a business are primarily a function of the companys 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.

v 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.

v 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.

v 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.

Posted in Finance, M&A, Miscellaneous, Tax Related, Valuation | No Comments »

Net Income, EBIT, EBITDA, SDCF

Tuesday, February 5th, 2008

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 Sellers 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.

Ø 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 companys earnings stream.

Ø 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 companys 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.

Ø 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.

Ø 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,

Ø EBIT = Net Income + Interest + Taxes

Ø EBITDA = EBIT + Depreciation + Amortization

Ø SDCF = EBITDA + Owner/Officers 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.

Posted in Finance, M&A, Valuation | No Comments »

Taxes & Valuation: Can You Have Your Cake And Eat It Too?

Monday, January 28th, 2008

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 owners 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 businesss 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 years 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.

Posted in Finance, M&A, Miscellaneous, Tax Related, Valuation | No Comments »

2008: Exit Planning For The Year Ahead

Thursday, January 17th, 2008

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:

Ø 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.

Ø 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.

Ø 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.

Ø 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.

Posted in Deal Structure, Finance, M&A, Marketing, Miscellaneous, Tax Related, Valuation | No Comments »

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