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 »

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?

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January 17, 2008 by creddy.

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

January 17, 2008 by creddy.

Picking The Right Intermediary For The

You are ready to sell your business. You ask around and find that some businesses are sold by Business Brokers, some by Mid-market M&A Advisors, and some others by investment bankers. The difference in intermediaries can make difference of 20% to 40% or more in what you can take away in many situations. So, picking the right intermediary can have a major impact on your nest egg. Which one of these is right intermediary for selling your business? Who should you use?

The following table shows the applicability of these intermediaries based on various metrics.

The deciding factor in selecting the right intermediary is type of business you have. For small companies with revenues under $1 million and for large companies with revenues over $100 million, the choices are obvious.

If your business is a small retail or service business and there is no strategic value in the business, any competent business broker may be able to get the job done. However, since there is a substantial  negotiating component in deals this size, your interests are likely to better served if you choose an intermediary to represent you exclusively (i.e. not a dual agent).

An M&A Advisor is the right choice if your business is larger, complex or has a high component of product or service specialization. A competent M&A Advisor can unlock the value in your business, represent you exclusively, and get your business the higher value it deserves. This is extremely important if your business has untapped strategic value or has intellectual property subject to a broad interpretation of value in the marketplace.

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