Advisors in deal making like to talk in multiples and turns of EBITDA. That is the price for a debt-free cash-free asset purchase with adequate working capital. The price may be all cash or include a subordinated note or a contingent earn out portion.
Entrepreneurs like to talk in dollar value and after-tax proceeds. That is how much money there is after the obligations are paid and what gain is taxable. Anything other than all cash requires some judgment about the likelihood of future payments.
Buyers usually have to decide what to offer in a bidding process unless the seller provides guidance. Our purpose here is to provide insight to owners of independent private companies on how buyers decide what they will pay to buy a business.
The first questions a buyer faces are whether there is a competitive process and what types of buyers are vying to win the deal. The days of uninformed sellers and bargain purchases are over or at least rare. That means most sellers have a good idea what a buyer in a competitive process will offer.
Seems pretty straight forward. It is not. Sellers are often surprised when prospects they consider logical buyers opt not to bid at all or to make a proposal well below the expected price. Why that happens is not so easy to answer.
Let’s begin with who the prospective buyers are and how the seller fits into their puzzle. Buyers are generally strategic corporate or private equity funds. Many larger companies in the industry are active and frequent participants with a standard approach to evaluating potential deals. Others are not organized to process and pursue opportunities the way you might expect. Private equity groups do organize themselves to buy businesses and often have the industry expertise to motivate them to aggressively pursue a particular deal. If they lack the industry experience, the learning curve can be frustrating.
Everyone reports to someone. Buyers have to justify what they are willing to bid to purchase your business. Some have more flexibility than others, but it is helpful to understand the factors that have to be considered. The first is always tough to understand because it is where the opportunity ranks in the context of other priorities the prospective buyer has and how important your situation is within the framework of things you might never know about.
Performance problems within a non-transparent business unit of a large company may make it unlikely that even a deal with obvious merit may be shot down by senior management. They may apply a discount for parts of your business that may be discontinued because they are not consistent with the strategic direction of the prospective buyer. Risks you view as reasonable may discourage a less entrepreneurial organization.
It usually surprises entrepreneurial owners to learn that it will cost the buyer more to run the business than under former owner. Conforming to the standards of new ownership almost certainly requires enhancements to management systems and human resource costs. Most sellers highlight add backs to increase earnings without acknowledging that the buyer will have added costs.
Disciplined buyers have specific return expectations or hurdle rates for operating profit as a percent of purchase price, regardless of whether they are paying a 3% borrowing cost as a corporate buyer or a mixed 12-14% as a private equity firm (5-8% senior debt and 20% equity; 50% debt/50% equity). More likely than not, $1.0 million of operating profit is worth no more than $5.0-8.0 million in enterprise value, so $5.0 million of operating profit translates to $25-40 million in enterprise value. Not all businesses are valued as a multiple of operating profit (adjusted EBITDA). Some have tangible or intangible assets that justify a net asset value in excess of an earnings multiple approach, but those are unusual and their characteristics normally restrict the type of prospective buyer.
The “quality” of EBITDA won’t be talked about much until due diligence, but it would be wise to be realistic about how disciplined the company has been at booking items such as inventory, warranties, sales credits and expense accruals in an effort to avoid concerns later that the earnings are not so straightforward. Consistency and trends also matter to the prospective buyer deciding on a bid price. A good understanding of “quality of earnings” will help you to avoid surprises. The chart earlier in this article illustrates the range in value for a company based on which items drive a premium multiple of 8.0x to be applied to the adjusted EBITDA or cause the multiple to be throttled back to 4.0x by items that limit the appeal of the company.
It is generally assumed that the seller is an S-Corp or LLC and that the seller of a C-Corp will elect 338(h)(10) constructive liquidation so that the seller is essentially a pass-through entity for tax purposes. Delivering a debt-free business in an asset sale structure leaves the seller responsible for repayment of all interest-bearing debt-free business debt and allows the buyer to record acquired assets at fair value (including intangibles and goodwill) for tax benefits to cushion the purchase price. We think any analysis of price should be in the context of what balance sheet reference point accompanies the price and what price adjustment mechanism will apply.
The usual focus for what a purchase price multiple is applied to is normalized EBITDA (that is trailing 12 month pretax earnings with depreciation and amortization expense added back plus other expenses such as owner’s compensation in excess of market cost and one-time items not necessary going forward). Adjustments to “normalize” earnings range from the fairly obvious to the quite creative. Sellers seek to maximize the EBITDA (the cash flow proxy) and maximize the multiple of EBITDA (purchase price multiple) so that the whole company valuation is as high as possible. The high end of a range is the reward for consistency, growth potential, the depth of continuing management and critical mass which also translates into market position and size. Bigger is always better when it comes to multiples in M&A. The reason is that the relatively bigger middle market company attracts a broader range of suitors and debt financing options.
Deal problems usually arise in the purchase price adjustments which become the focus of negotiations during the definitive agreement stage. That is why the evaluation of bids in auctions includes consideration of the mark-up to the seller-drafted asset purchase agreement. The two most unpopular culprits are balance sheet liabilities not accepted by the buyer and adjustments which always seem to reduce price. It is fairly easy to accept that the buyer will not become responsible for any funded debt (bank debt, capital leases, shareholder loans). Those liabilities must be repaid by the seller from the proceeds paid to the seller by the buyer. It is the contingent liabilities and other exposure such as third-party claims of intellectual property infringement which can eat into the sale proceeds post-closing that can be particularly troubling.
Balance sheet adjustments (price reductions) resulting from working capital requirements and previously unbooked liabilities identified by the buyer during due diligence after exclusivity has been granted (reserves for product warranty, litigation, pension obligations) are usually more straight forward (but not less painful) than likely indemnification claims over one to two years post-closing. The former type of balance sheet adjustments occur at closing or soon after. Holdbacks vary up to 15% of the purchase price and can be stepped down based on specific terms. Responsibility post-closing for excluded items such as discontinued business units and employee obligations can further reduce the value of a transaction to the seller. What matters most are the net proceeds to the seller after all deductions from the purchase price. That’s not always as straightforward as conversations early in the process might suggest and it may be quite sometime after closing before you really know.
Purchase price frequently involves deferred components such as seller notes, continuing ownership and/or earn-out based on post-closing performance. These further complicate matters. Subtleties such as the capital structure of the buyer are very important in determining the financial risk of deferred payout and equity upside. The second bite at the apple can be sweet as long as the terms are well understood. Owners/operators are increasingly asked to roll-over a portion of the purchase price into a continuing equity stake in the company with its new owners. That can usually be accomplished with pretax proceeds. What sometimes makes it hard to evaluate the potential upside is the capital structure which may include junior debt capital and preferred equity which have priority claims on the future value.
None of these items should discourage owner/operators from entertaining offers to buy their business. Midmarket is here to help you evaluate alternatives and make the most of what can be achieved. We have the expertise to arm you with the relevant knowledge, to anticipate issues specific to your company and to avoid surprises. We bring what you need to be comfortable that you are fully informed and able to make the best deal possible. We further distinguish ourselves by being easier to do business with than our competitors. Our terms and the cost for our services are based on an independent consulting model with flexibility not available elsewhere. Call us to learn more about how we can serve you.