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Business Sale: An Event Or A Process?

Monday, October 19th, 2009

How to get the most out of a business transition

You were born to win, but to be a winner, you must plan to win, prepare to win, and expect to win. Zig Zigler

Most of the business owners we talk with have a fundamental misconception about the business sale or the business transition they see exiting their businesses as an event instead of a process. From our experience, viewing the business transition as an event instead of a process can lead business owners to make decisions that lead to unwanted outcomes. Without a proper mindset, business owners who go through the transition process typically do not end up optimizing either their business or their personal outcomes.

For many mid market privately held business owners, a majority of their wealth is tied up in their business. Consequently, lack of proper perspective and planning for the business transition can lead to significant financial distress for the business owner.

A mid-market business owner typically plays two roles: The first role is that of an executive who runs a well oiled machine with obligations to employees, suppliers, customers and the community. The other role is that of a shareholder who is trying to maximize the return on investment for the benefit of self or family or an estate. Depending on individual perspective and situation, the transition being sought could be to get out of one or both of these roles.

We view business transition as a multi step process that should be started several years in advance of the planned exit date. The first step in business transition planning is establishing the motives for seeking the transition and identifying the desired outcomes of the process. Depending on the individual situation this could be a very simple or complex matter.

The next step in the process is to establish a proper transition channel that can produce the desired outcomes. The transition channel could be internal or external. An internal channel could be a business transition to heirs, employees, co-owners, etc. An external channel could be an acquisition by another company, PEG, individual buyer, or going public, etc.

Once the proper transition channel is established, the next step is to check the feasibility of making the transaction work with the desired target within the chosen channel and the methods that can be applied to make the transition occur. The methods used should be picked after careful tax and estate considerations. In cases where the owner is relying on the cash flow from the business to retire, special consideration needs to be given to ensure the seller gets a cash flow that is commiserate with his or her expectations. Care also should be taken to protect the cash flow and ensure a comfortable retirement. For internal transitions, ensuring the company has a good capital position and access to needed capital helps to make sure the transfer is successful.

Once the motivations, goals and outcomes are well established and refined, the business owner needs to establish a timeline for the process. A properly planned transition will allow the business owner to position the company in a desirable light during the exit process. Positioning the company makes the value of the company visible to the acquirers. Attention needs to be paid to topics such as:

– Has the business been built for a transition?

– How will the transition occur?

– Is there a logical evolution path for the business? What is the potential?

– What level of investment is necessary to sustain the business or grow it to the next level?

– Who would be the ideal person or what would be the ideal entity to be the next owner?

– Is there a legacy that the owner wants to leave behind?

– Is the business environment expected to face a head wind or tail wind in the coming years?

These questions and others need to be answered in the context of the mindset of the likely acquirer. For example, a typical acquirer for a mid market company is likely to be a PEG, a consolidator or a large company. The business owner needs to be keenly aware that these acquirers have considerable experience making acquisitions and among other things they are going to be looking carefully at how the company performed in the past and how it will perform during the exit process.

A business is ready for the market only after the business is prepared for the anticipated inquisition. The subsequent steps including the transaction itself and satisfaction of the post transaction obligations are complex matters that require a tremendous amount of creativity, negotiation skills, understanding of the tax laws, attention to details, and other deal making skills.

In summary, business transition can be a complex process and needs to be tended to with care. Lack of understanding of the process means that the business could wither away without a transition ever occurring or the business owner could get much less out of the business than what is possible. The business owner needs a disciplined process that can achieve the necessary outcomes. Having a proper mindset about business exits is imperative to protect ones nest egg and the family estate.

A competent mergers and acquisition advisor who can walk the business owner through these steps can help the business owner to establish and achieve the desired outcomes.

Posted in Business Sucession Planning, Exit Planning, Finance, M&A, Marketing, Tax Related, Valuation | 2 Comments »

Know What You Are Getting With An Earnout

Friday, July 3rd, 2009

A Guide To Structuring An Earnout

Experience is what you get when you don’t get what you want. – Dan Stanford

Before one digs deep into the structure of the earnout it is important to understand the motivation of the parties in structuring the earnout. Is the purpose of the earnout to bridge a valuation gap based on legitimate differences of opinion about the amount of future earning streams? Does the earnout have to do more with potential business transferability issues? Is the earnout primarily about creating incentive for delivering high performance?

Historically, earnouts have been used by M&A advisors to bridge a valuation gap between the seller and the buyer. Sellers typically tend to value their business much higher than a buyer and an earnout can be great way to satisfy both parties. Astute acquirers have also used earnouts to incentivize and motivate sellers to deliver on a performance promise post close.

The above thinking has changed significantly in the recent past. The recession and credit crisis have put the acquirers in the catbird seat and acquirers are demanding earnouts primarily as a negotiating lever – sometimes in situations where none would be warranted by historical precedents.

The structuring and negotiating of the earnouts should be based on a clear understanding of the motives. Regardless of the motives, all earnouts have several key components:

Duration of the earnout: Most earnouts last between one and three years. Anything shorter than a year is typically meaningless to the acquirer. In most cases, duration longer than three years significantly increases the chance of unforeseen events impacting the business and makes projections used for earnout unrealistic. To the extent used, longer term earnouts need to be written to decrease the uncertainty and reduce the inherent risks.

Identification of milestones: Milestones for earnouts can be financial or non-financial. For financial earnouts, sellers typically prefer revenue based milestones because they are easier to achieve and monitor. On the other hand, acquirers prefer net income based milestones because revenue based incentives may motivate the sellers to drive revenue at the expense of profitability. An EBIT or EBITDA based milestone can often provide a good compromise between a buyers and sellers needs. To reach a comprehensive agreement, acquirers and sellers should clearly understand the factors effecting EBIT/EBITDA, including the pre and post close accounting methods used to compute the milestones.

Operation of the business during earnout period: The goals of the acquirer and the operation of the business post-acquisition could be substantially different from the sellers goals and the pre-acquisition operational model. For the earnouts to be meaningful, the acquired business should be operated in a predictable way that, among other things, reduces mismanagement and malfeasance on the part of both the acquirer and the seller. Employment agreements should also be put in place to ensure the seller has a say over relevant control issues. The earnout may also be adversely impacted by how the acquiring company allocates operational overhead and other expenses in the earnout calculations. A merger or acquisition of the acquiring company or the acquiring division, or a divestiture of the division or a product line, could also create situations where the earnout metrics become meaningless. It is imperative that the earnout document contain clauses detailing operational, accounting, and employment specifics and identifying conditions under which the earnout may have to be modified or accelerated.

Establishing if/when milestones are achieved: Typically it is the acquirers responsibility to identify when an earnout milestone is achieved and provide the calculations pertinent to the earnout. A prudent seller should ensure that he has access to audited/auditable books that relate to the earnout calculations should a dispute arise. The parties also need to establish mechanisms to deal with any challenges to the earnout calculations.

Method of payment: An earnout may be paid in cash, stocks, bonds or other securities. If the payment is made in forms other than cash, the seller needs to be cognizant of the potential variability in the payment stream. The acquirer may offer 10,000 shares of the companys publicly traded stock at a stock price of $50 at the time of the deal and unanticipated events could result in the stock price being $5 on the day of the earnout payment – effectively driving the value of the earnout to 1/10^th of the anticipated value. Earnouts paid in private company securities could be even more of a challenge as they are illiquid and are more easily subject to manipulation.

Tax impact: The earnout language should be drafted meticulously to ensure proper tax treatment of the earnout. Depending on how the earnout is written, the payments could be capital gains, payroll income or independent contractor income all with very different tax implications. It is imperative that the language be carefully addressed to avoid conflict and to reduce the tax bite.

Summary:

Earnouts, no matter how well crafted, can contain pitfalls for both sellers and acquirers. Parities to an earnout agreement must understand each others motives and craft an operationally workable win-win agreement that reduces scope for potential conflict and litigation. It is imperative that both parties know what they are getting themselves into with an earnout agreement.

Posted in Deal Structure, Exit Planning, M&A, Tax Related, Valuation | 1 Comment »

Focus On The Balance Sheet

Thursday, May 7th, 2009

Navigate This Recession With a Successful Financial Model

Learn from the mistakes of others. You can’t live long enough to make them all yourself – Unknown

When it comes to mid market M&A, both business sellers and business buyers have traditionally focused in on the top line and the EBITDA. Sell-side M&A advisors have counseled their clients to focus on the P&L and do whatever they can to improve the revenues or EBITDA to get the most out of their business at exit. Similarly buy-side advisors have tended to counsel acquirers to look at the growth prospects of a target company instead of mundane things such as assets and liabilities.

The current recession and associated liquidity crisis are making business owners and advisors rethink the P&L focus. With deal flow down more than 50% in most sectors, liquidity being at a premium, multiples down across the board, and deals taking a long time to close, it is becoming increasingly clear that the P&L focus is no longer a proper approach for most businesses – especially for growth companies.

Assets and liabilities may not sound as exciting as revenues and earnings but now is the time for business owners to increase their focus on the balance sheet. Balance sheet focus can provide an early warning system and help the business owners identify the companys shortcomings and improve the companys health and help the company survive or thrive as we exit out of this recession. Without the focus on the balance sheet, it is easy for a company to find itself in a position where the company is under-using or misusing its assets or, worse yet, in an over leveraged position. Once a company finds itself in these situations, balance sheet repair can be a time consuming process. If a liquidity crisis develops for the company with a weak balance sheet, there may not always be sufficient time to pull itself out of an impending crisis.

To analyze the balance sheet for liquidity and performance issues, one needs to focus on four key areas: current assets, non-current assets, current liabilities and long term liabilities.

Current assets

Current assets are the assets that are likely to be used up or converted into cash within one business cycle. Typically these include: cash, liquid investments, inventories and accounts receivables. The main aim of analyzing current assets should be to find ways to strengthen the cash position and bring down the level of inventories and accounts receivable to a sensible level.

Even in relatively well run companies, it is common for a company to have stale inventory or have inventory that is significantly overstated or understated. A thorough evaluation of inventory should include ensuring accuracy of inventory, converting stale inventory into cash, and putting in place a process to keep the inventory levels current and lean. A company needs to ensure that its inventory turnover (cost of goods sold divided by average inventory) is high and the company is quickly moving product through the company at a rate better than its competitors. The analysis of inventory should also take into consideration how the inventory levels have been changing historically compared to its sales. Barring special circumstances, it is a sign of poor inventory management if the inventory is growing faster than sales.

Analyze the accounts receivables to understand how quickly the company is collecting on the customer accounts to ensure that its collection methods are not unduly lax and are competitive with the rest of the industry. If a company’s collection period is higher than industry norms then the company may be accumulating subpar customers and/or leaving money on the table by letting customers stretch their credit beyond what would be considered a good business practice. Either of these conditions, even if intentional, may be unsuitable for the current economic climate.

Non-current assets

Non-current assets are all assets the company possesses that are not current assets. The balance sheet is typically deficient in accurately reflecting the value of non-current assets. Most assets that fall into this category have speculative values and may be of little use if there is a liquidity crunch. The analysis needs to identify ways of monetizing these assets if it makes economic sense or if it becomes necessary.

The analysis should include a spotlight on off balance sheet assets and hard-to-measure intangible assets and intellectual property items such as patents, trademarks, and copyrights. Special attention should be paid to non core brands and other items of goodwill that can fetch value if necessary.

Analysis of non-current assets should also be focused on ensuring that these assets are realistically valued. In addition to other benefits, valuing assets periodically may help the company write down asset values and reduce the tax bite and thus improve the companys cash flow.

Current Liabilities

Current liabilities are obligations a company must pay within a business cycle. Typical items include payroll liabilities, payments to suppliers, and current portion of long term debt. Inability to pay current liabilities is the primary reason why many companies go bankrupt.

Analysis of current liabilities should include a thorough evaluation of how the company pays its suppliers, employees, and the government. It is necessary to clearly identify the companys total short term obligations (including upcoming maintenance, capital purchases, current portion of long term debt, and any special or one-time payments to vendors, customers or government). Many a company has found itself in a cash crunch situation by failing to account for a liability that could have been easily forecasted with proper planning. Historical context is essential for predicting future liabilities. Having a historic context on how individual line items have varied over time with sales can also show if the company is overburdened with liabilities it does not need.

Analysis should also include an evaluation to determine if the proper form of financing is being utilized by the company for asset purchases. For example, is the company using short term debt to finance capital budget items?

Long term liabilities

Long term liabilities are non-current liabilities i.e. the liabilities that the company owes in a year or more time. Long term liabilities typically consist of bank or bondholder debt. Sometimes off-balance sheet debt may have been used to finance capital expenditures while keeping the apparent debt levels low. Business owners must realize that carrying undisclosed debts can be dangerous in the current environment especially if the resulting short term liabilities are not properly accounted for in cash flow calculations.

Summary:

In the midst of a recession and an unheard of credit crisis, even a moderately leveraged company may have difficulties raising capital. If the debt level is high by traditional standards, the company may be headed towards bankruptcy.

For a growth company looking to grow either organically or through acquisitions, being highly leveraged may mean that it may not find sources willing to provide debt financing. In this case, a company may find itself in a situation where it may have to issue stock on unfavorable terms. Worse yet, the company may find itself with a strong P&L but growing itself out of cash and into a bankruptcy.

Management should review its appetite for risk, the level of debt it wants to carry and whether it is using a proper mix of short term and long term financing and the overall degree to which a company is leveraged. A company that finances its assets with a high level of debt is risking bankruptcy. This may happen if the economy does not recover as expected or if the business does not perform as well as expected for other unrelated reasons. Business owners must comprehend worst case economic scenarios and ensure that they have sufficient resources to make debt payments.

A thorough focus on the balance sheet and a somewhat reduced focus on the P&L will help the company survive and thrive in the current environment.

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

Grow Your Business During This Recession

Monday, February 9th, 2009

Success Strategies For Business Executives In Recessions

When Times Get Tough, the Tough Get Going – Anonymous

As the pundits debate if we are in a recession or in a depression, companies are looking forward to see what they can do to get back in to growth mode. We looked back at the learnings from the past recessions, and have come up with a list of things that have worked well in the past and are likely to work well again in the current environment.

1. Improve cash flow. This is by far the most important thing to do for companies looking to survive and prosper in recessions. As simple as this may sound, increasing sales is not the only way to improve cash flow. We are constantly amazed by how lax businessmen and organizations become in good times and how much room there is for improvement. Some simple and effective ways to improve cash flow include:

Ø ensure accurate book keeping and audit for abuse and theft

Ø collect accounts receivable early and delay accounts payable without incurring penalties

Ø clear out underperforming or unused assets and slow moving or stale inventory

Ø delay capital purchases and look to coincide purchases with vendor sales

Ø review payroll and other large expenses and look for cutbacks as appropriate

Ø negotiate favorable rates and payment terms from suppliers or switch suppliers (easy targets include rent, insurance, workers comp, and telephone system)

Ø purchase essential items in bulk to save shipping costs and get price breaks

Ø charge customers upfront fees/payments where possible

2. Maintain a good cash position. Since no one really knows when a recession ends and the next growth cycle starts, it is imperative that companies maintain a good cash position through the down cycle. Cash cushion is critical for a company and also puts the company in a strong position vis-à-vis suppliers and bankers.

3. Consider an active acquisition strategy. During a recession, there will be a lot of good opportunities to expend cash to invest in undervalued assets or businesses that provide strong cash flow. Retain a competent advisor to develop and implement a cohesive acquisition plan.

4. Understand how customers determine value in tough times. Tailor product offerings to more closely reflect the changed customer needs. The key is to provide more value to the customers without sacrificing margins. Look for creative product and service bundling opportunities and keep on constant lookout for ways to retain existing customers. Keep in mind that attracting new customers is several times more expensive than retaining existing customers.

5. Fine tune marketing campaigns. Recessionary time is typically not the best time to cut marketing spending but is the time to use the marketing budget more wisely to increase return and create a stronger brand. Look for competition that is unable to address client needs and go after their customers. Customer acquisition costs are much lower for you if your competitor is going out of business. Target some of the marketing dollars to go after customers of companies that are going out of business. For the stronger companies, recessions are the best time to gain market share.

6. Negotiate long term supplier deals at below market rates. Can you get an extraordinary lease on a prime property because someone else went out of business and the landlord is desperate to get a tenant? Can you negotiate a favorable long term advertising rate? Recessions are the best times to lock in long term supplier deals. Good deals are nearly impossible to get when the market is hot.

7. Build or improve your distribution/sales channels. In tough times, distributors and sales people are hungry for business. Current channels may be more receptive to your needs. Some desirable channels that were not open to your company before may open up. You may be able to negotiate more favorable terms from your existing distribution channel or get a stronger channel to replace your current channel more cost effectively.

8. Stay away from general cuts across the board. Cuts, if needed, should be in areas that do not create value or business areas that are not part of the core business. Look to divest or outsource non-core operations and invest in areas that are the future growth areas of the company.

9. Build employee loyalty. Employees will remember you for sticking with them through the tough times. Operate the business by emphasizing core values and leading by example. When tough decisions need to be made, solicit employee feedback. Use slow times to invest in employee training and developing compelling marketing and sales strategies and tactics. Communicate profusely and make sure the morale stays high.

10. Have a clear vision of where the company needs to be when the recession is over. Managing your business is a lot about allocation of resources and prioritizing where to prune and where to grow. Having a clear vision helps make tough choices that need to be made along the way.

Work out a solid plan. Implement it. Grow your business during this recession!

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

Credit Crisis: What Does It Mean To Mid Market M&A

Monday, November 3rd, 2008

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 acquirers 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 sellers liability substantially compared to the previous scenario but otherwise is similar in many ways.

With these deal structures, the sellers vested interest in the deal, post-acquisition, increases dramatically. The biggest risk in any of these approaches is that the acquirers 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 acquirers 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 sellers 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 Deal Structure, Exit Planning, Finance, M&A, Valuation | No Comments »

Practice M&A: The Devil Is In The Details

Thursday, June 12th, 2008

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 owners 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, Finance, M&A, Valuation | No Comments »

Avoiding Value Killers In A Business Sale

Saturday, May 3rd, 2008

10 Factors That Reduce The Value Of Your Business Sale DealDiligence is the mother of good fortune.- Benjamin Disraeli

If you are like most mid-market business owners, your business is your single largest asset. To get the most value for this asset it behooves you to understand what reduces the value of your business and minimize or eliminate these value killers. The purpose of this article is to help you identify the value killers in a typical business sale and help you take steps to get a higher value for your business.

Here are the key value destroyers in a typical business sale:

1. Unplanned Sale: The most expensive mistake that sellers make is not taking the time to plan a sale. If you have to sell in a hurry, the chances are pretty slim that you will get what you deserve. Planning for the sale should begin a minimum of one year and preferably three years before you need to sell. A good M&A advisor will start with a comprehensive presale plan and get an action plan in motion to maximize your return.

2. Lone Acquirer: The second most expensive mistake that sellers make is that they get themselves into a single buyer auction. This typically happens when the seller got an unsolicited bid from an industry player. The other common situation is when a seller tells his banker or CPA or attorney that he is planning to sell and the well meaning counsel introduces the seller to someone who is looking to buy a business. Regardless of the reason, if there is just a single player determining the value of your business, you are very likely to get an offer that is well below the market price. Engage an M&A advisor to run a soft auction to get the best price and terms the market has to offer.

3. Surprises: Once you get the deal and terms you want make sure there are no surprises in the deal and you deliver to the acquirer what you promised. Any negative surprises can dramatically alter the deal as the acquirer starts questioning the surprise and begins wondering if there are any other issues with the deal and redoubles his/her due diligence. Negative surprises can lead to changes in price and terms of the deal and in many cases end up becoming deal killers. Anything that can be perceived negatively by the acquirer should be put on the table early and managed properly to reduce the downside risk.

4. Losing Focus: One of the most expensive mistakes that sellers make is taking their eye off the ball during the business sale process. This is especially true if the loss of focus leads to a drop off in the business performance. Loss of focus tends to be not only expensive but traumatic as the buyer renegotiates price and terms of a deal that you think is done. Here again, a competent M&A advisor would buffer you from the minutia and stress of the deal and help you stay focused on running the company.

5. Customer Concentration & Lack Of Recurring Revenue Streams: Acquirers are nervous about businesses where a high percentage of business comes from a handful of customers. Ideally, no single customer should contribute to more than 10% of your revenues or profits. The best solution for this problem is to diversify the customer base. If that is not feasible, see if you can get the customers to commit to you with long term contracts. Lack of long term contracts, annual service/licensing fees, and other recurring revenue streams make business less desirable and results in a lower EBITDA multiple.

6. Lack Of Management Depth: Acquirers buy a business that they hope will be fully functional and growing after the sale. It is tough for the acquirer to place a high value on your business if you are the sole decision maker in the company and the business depends largely on your skill set. Developing your staff so that they can run the business when you are gone can pay big dividends when it is time to sell. If possible, start working on staff related issues at least a year before you plan to start the sales process.

7. Poor Financial Records: To many acquirers, poor bookkeeping indicates increased risk and also says a lot about how the business was run. Having a set of clean, easily auditable books inspires confidence and helps during the due diligence and negotiation process.

8. Poor Legal Records & Weak Contracts: Having poor legal records and having contracts without teeth is a sign of weakness. How well is your intellectual property protected? Are all your independent contractor agreements signed and readily available? Are you locked to your landlord with 5% raises for the next 10 years? Can your suppliers stop servicing you at the drop of the hat? Can your customers drop your line at their whim and fancy?

9. Lack Of Confidentiality: Lack of confidentiality about the sale may mean that your competitors may use the uncertainty to their advantage. Customers and employees may be concerned about the uncertainty and leave you. Loss of a key employee or a key customer can be devastating to the companys value. If you are concerned about your key employees leaving you, you may want to consider employment contracts, stock grants and other incentives that give them a reason to stay long term. Beware of the cost of doing this and the impact on the bottom line.

10. Inexperienced Deal Making Team: A typical mid-market acquirer is an experienced corporate entity with professional M&A advisors, lawyers, CPAs, and industry experts on their team. Lack of a good team that can balance the experience of the acquirer can be very expensive. Can your transaction management team get a good deal on your price and terms for you? Can your team overcome the aggressive steps taken by the acquirers during due diligence to drive down the value? Can your team make sure the deal closes on time and does not drag out endlessly?

The most important take away from this article should be that while EBITDA matters, the process and approach to deal making also has considerable impact on the perceived value. Avoiding the value killers mentioned above will give you an upper hand during the negotiation process. If your businesss EBITDA is $3 million, the difference between being paid a multiple of 4 and a multiple of 6 is $6M in pre-tax earnings. Not bad for doing a little bit of homework!

Posted in Valuation | 1 Comment »

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.

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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 »

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