November 3, 2008 by creddy.

Impact of Tight Credit Markets on Business Sale Transactions

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” - Warren Buffett 

Until about a year back, life in the mid-market M&A lane was somewhat predictable. Most companies entering the deal making process had respectable growth rates, rosy outlooks, and credit was plentiful. Private Equity Groups and lenders had access to money they could put to use on the right deal. More often than not, the sticking point in the deal was the valuation.

All that changed in the last year. As we approach the end of 2008, most businesses are finding that the environment has changed dramatically. A business owner looking to sell is typically in a situation where the trailing 12 month numbers look less than attractive, business outlook is no longer rosy, and credit is extremely tight. The view for the acquirer is not much better. Valuation is not the biggest sticking point any more. Even if the acquirers think they have negotiated an excellent bargain, financing the acquisition is highly problematic.

By some estimates, the value of business deals year to date has dropped by about 35% in spite of a large volume of unexpected distress deals. Excluding the distress sales, total transaction values appear to have plummeted by as much as 50%. In appears that one out two business sale transactions is not materializing largely due to the liquidity crisis.

Unfortunately, the end is not in sight. In spite of the intervention of the government in the recent past, credit is unlikely to be plentiful for the foreseeable future. Optimistic forecasts call for business trends and transaction dynamics to remain unfavorable until the second half of 2009. So, how can sellers and acquirers facilitate a meaningful business sale transaction in the interim?

The answer, while not the most optimal, is surprisingly simple! If lack of liquidity is the problem, then providing or facilitating liquidity is the solution. There are several ways in which sellers can provide or facilitate liquidity in a business sale transaction:

1.    Structuring the deal to reduce third party debt in the deal: This can be done by increasing the money required upfront, taking part of the transaction amount in the deal as earn-outs, retaining part of the equity post-acquisition, increasing the payout time on deferred monies, and other mechanisms that defer the payment schedules. Due to the inherent risks of this approach, extreme care should be taken in inking the terms of such a deal.

2.    Separating asset types for hybrid financing: This can be done by separating asset types (real estate, inventories, receivables, etc.) and finding an optimum way to finance each of the elements. For example, the real estate component could be done in a separate lease-buyback transaction or inventories could be financed by creative lender financing.

3.    Seller financing: While it is not possible in every instance, to the extent possible, sellers can float the required credit to the acquirer. The biggest disadvantage of this approach is that the acquirer’s failure in operating the business can result in a dramatically reduced return to the seller.

4.    Seller loan guarantees: Liquidity can also be facilitated by sellers guaranteeing third party debt in the deal. This approach could potentially reduce the seller’s liability substantially compared to the previous scenario but otherwise is similar in many ways.

With these deal structures, the seller’s vested interest in the deal, post-acquisition, increases dramatically. The biggest risk in any of these approaches is that the acquirer’s ability to make payments will depend on the future success of the business. The acquirer may mismanage the company, or the economic conditions may become more unfavorable, or some other unanticipated event could dramatically reduce the acquirer’s ability to pay down the obligations. Sellers should be cognizant of the risks in these approaches and take precautions to mitigate the risk and improve the return.

On the upside, there are some significant benefits to the sellers. Empirical data indicates that if a seller can assist in financing the deal, the deal value can improve as much as 40%! The deferred payment stream could also result in substantial tax benefits to the seller. Another major advantage of this approach is that the sellers would very likely be able to negotiate a higher rate of return on the deferred payments than the returns available to them elsewhere.

In spite of the sellers’ preferences, sellers should also be aware that, in these tough economic times, acquirers and lenders prefer these deal structures and some may even require them.

From a seller’s perspective, proceeding down this path should be done carefully with enormous attention being paid to the caliber of the acquirers, deal terms, collateral support for the payments, and possibly backup insurance facilities to further mitigate the risk.

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

June 12, 2008 by creddy.

Pitfalls To Watch For In Professional Practice Mergers & Acquisitions

Empirical evidence suggests that many small to midsized professional practices are increasingly disintegrating into solo practices or getting merged into or acquired by larger professional practices. The factors driving this trend are: retiring baby boomer practice owners, burned out owners, increased cost of regulation, pervasion of web-based services, and ever increasing infrastructure costs. 

In these uncertain times, middle market practice owners concerned about their financial security need to make some careful choices in deciding which way to go forward. This is especially true for the owners who are close to their retirement. Fortunately, most mid market practice owners have several options: sell the practice, merge with another practice, grow through acquisitions, or continue on the current path and let the chips fall where they may. The latter option is clearly not recommended for practitioners who seek financial security and have the need or desire to feather their nest egg.

If the practitioner is forced by personal issues, familial issues, or does not have the energy or drive to run the practice, a sale of the practice may be the only option. However, merging, reorganizing, or growing through M&A can be desirable paths if the practice ownership has the energy, skills, and sophistication. For the purpose of this article we will refer to the process of merging, reorganizing, or acquiring a practice as a “merger”.

For most practice owners, the biggest benefit of a merger is the size of the combined practice. Increased size can result in several advantages:

Ø  Resources: The resources of the combined organization may allow the practice ownership to attain previously unattainable personal and professional goals or attain them sooner than otherwise would be possible.

Ø  Better Lifestyle: Larger practices afford less administrative overhead for the practitioners while simultaneously providing better coverage for each other with less adverse impact on customer support and retention. A larger practice can help practitioners provide better coverage for the customer without sacrificing personal time-off.

Ø  Customer Leverage: The combined practice can increase the effectiveness of the marketing programs, improve ability to reach customers, expand the range of services that can be offered, and increase the number of touch points to the customer.

Ø  Supplier Leverage: Larger practices typically have more leverage with suppliers resulting in better prices and terms. A larger revenue stream may also enable the practice to attract suppliers unattainable prior to the merger.

Ø  Cost Reduction: Consolidation, with proper planning, leads to more efficient and streamlined use of staff, space, systems, and equipment resulting in lower administrative costs. These cost savings fall to the bottom line and make the practice more profitable and valuable.

Ø  Increased Market Share: Combining practices increases the market share and this by itself can become a virtuous cycle and further propel the practice to newer heights.

Ø  Built-in Exit Strategy: The terms of the combined practice can be written in such a way that there is an automatic exit strategy for an individual practitioner within the group in the event of disability, death or other agreed upon event. If planned well, the outcome for the owner or owner’s estate can be significantly better than what is possible in a smaller practice. 

Ø  Increased Valuation: Practice valuations for mid-market practices vary widely depending on the size, transferability and strategic value of the practice. Transferable, larger practices routinely command EBITDA multiples dramatically higher than smaller practices without a proper management structure.

While these benefits make the M&A path very attractive to practice owners, there are several disadvantages of taking the M&A path and several pitfalls to watch for to arrive at a successful outcome. Here are some concerns and pitfalls and the approaches that can be taken to overcome them.

Ø  Loss of Control: The biggest disadvantage to practice merger is the loss of control and autonomy, real and perceived, by the parties. While the loss of some control is a reality in most mergers, the problems arise when the perceived loss is more acute than expected or when the perceived benefits of the merger are less than expected. In order to minimize the chances of this outcome, ensure that you have a clearly defined buy-sell agreement and an agreement defining roles and responsibilities of the parties post merger. Both these agreements will be of great benefit should the merger not materialize as planned.

Ø  Owner Satisfaction: While successful practice mergers are aplenty, it is not uncommon for owners to be disenchanted with the merged practice. To increase harmony and streamline integration, the goals of the merged practice should be extremely clear and well understood by all parties. What is the purpose of the merger and what is the strategic direction? More services? Broader market? Practitioner coverage?  Going after a different customer base? Whatever the reasons are, if the expectations are clear, the satisfaction of the practitioners and the probability of success of the merged practice is enhanced.

Ø  Capital Structure and Voting Stock: One of the sore aspects of a merger involves lack of agreement on capital structure and control of the practice. A retiring practitioner may care little about control but a lot about the finances. On the other hand, the partner looking to grow may have stronger feelings about control. To avoid this, efforts should be made early on to separate the capital structure from voting rights structure. The financial and governance needs of key management members and the ownership should be addressed and codified. A good set of Bylaws along with delineation between what needs to be approved by board vs. shareholders vs. officers of the company should be well documented.

Ø  Compensation Structure: Compensation structure and division of income for the owners, and key staff members must be developed with an eye toward tax impact as well as fraud and abuse considerations.

Ø  Benefit Plans: A substantial discrepancy between the benefit plans of the merged corporations is another potential problem area in practice mergers. Benefit plans of the merging entities and key individuals must be reviewed carefully and adjusted as needed to ensure there are no post close surprises.

Ø  Compatibility between Practitioners: Practitioner incompatibility is another disadvantage of practice merger/acquisition. This problem can be especially acute if the practice includes several specialty areas and the needs of the specialists are not compatible with the needs of the organization as a whole. Consider this aspect of the merger carefully and put plans in place before the merger to head off any issues.

Ø  Offices & Personnel: Offices & Personnel is another area of friction in practice mergers. Care must be taken to ensure which of the office locations and personnel will continue with the combined practice after the merger. If resolution of this issue is expected to occur post close, bylaws and governance rules can be created to ensure the process for resolution is agreeable to both parties.

Ø  Liability, Fraud & Abuse: Liability, fraud and abuse issues should be addressed to make sure that the combined organization and the key individual needs are adequately addressed. Merging parties typically would indemnify one another from liabilities that predate the merger.

Ø  Supplier & Customer Contracts: Ensure the supplier/customer contracts are reviewed carefully and any differences between two different contracts with the same supplier or customer are reconciled to the advantage of the joint organization (costs, reimbursements, etc.).

Practice mergers can be of great benefit to mid market practice owners. However, practice owners need to be cognizant that practice M&A can be complex and the results can be adverse unless considerable amount of preparation and deal making occur prior to the finalization of the agreement. Extreme care should be taken to ensure that issues such as the ones mentioned above are carefully considered and addressed prior to close. To adequately address these and other complex issues, practice M&A can take an extended period of time. Six to eighteen months of preparation/negotiating from signing of the LOI to the close is common.

The time and money spent upfront to avoid typical merger pitfalls and achieve a common understanding of the deal can go a long way in ensuring the personal and financial goals of the M&A process are realized as planned.

Posted in Business Sucession Planning, Exit Planning, M&A, Valuation, Finance | No Comments »

April 29, 2008 by creddy.

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.

Posted in Exit Planning, M&A, Miscellaneous, Finance | No Comments »

March 27, 2008 by creddy.

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

March 11, 2008 by creddy.

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 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.

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 seller’s 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 seller’s 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 seller’s 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 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.

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

March 11, 2008 by creddy.

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.

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

March 10, 2008 by creddy.

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 driver’s 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 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

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  Corporation’s 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 Valuation, Tax Related, Deal Structure, Finance | No Comments »

February 23, 2008 by creddy.

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?

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

February 20, 2008 by creddy.

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:

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 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.

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

February 5, 2008 by creddy.

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.

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 company’s 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 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.

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/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.

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