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Prevent Surprises in Financing and M&A Deals

Do yourself a big favor before opening up to third parties to complete a deal.

Picture2smallerIs this your year to raise capital or sell your business? The opportunity may be by your design or in response to an approach that you really shouldn’t refuse. Either way, the process will require looking at your business from the perspective of the investor or buyer.

Tackling the issues which come to the forefront in deal making is often deferred until serious discussions with interested parties are underway. By that time, it may be difficult to turn to other options or call things off. It is better to anticipate and deal with the obstacles in advance.

We ask clients to think like an investor and buyer when they are a borrower or seller of some or the majority ownership of their business. We encourage them to be tough-minded about the risks their business faces and to formulate a management strategy to mitigate those risks.

Without realizing it, many entrepreneurs and family owners of independent private companies are insulated (from the host of issues specific to third party investment and transferability) until they set out to do a material corporate financial transaction.

The transaction may be to sell a minority equity interest, to do some out-of-the-ordinary borrowing from a bank or investment fund, or sell the business to a strategic buyer or financial sponsor. Too often hurdles to closing the deal are not addressed until the necessary third party forces the issue.

Then in hindsight, it’s almost always clear that it would have been better to face the issue before opening up to the investor or buyer who will require a resolution as a condition to completing a deal.

Most often, the issues are not clear until after a preliminary agreement is accepted and intensive due diligence begins. At that point, the onus is on the business owner more so than the investor or buyer. The leverage shifts after you select a particular party to work with exclusively and others become aware that they will only be called back if there is a problem.

The investor or buyer doesn’t really have the flexibility business owners might think. The buy-side almost always has a fiduciary duty to uncover potential problems and walk away from a deal rather than gamble. They will usually work with the business owner to resolve the problem, but the dynamic will have been altered and be reflected in less favorable terms.

The issues often surface during the preparation of a data room, but many negotiated deals don’t involve a data room until a preliminary agreement has been reached. This is in contrast to a full auction involving access to a data room and mark-up of a purchase agreement prior to selection of the buyer.

You can address the issues before setting out on a campaign or responding to a prospective investor or buyer. Some of the items that could become issues may not be obvious to senior managers tasked with steering the transaction to a close. Those of us who have been down this path before can be very useful in preventing surprises.

We recommend a careful review to identify and examine what might trip-up a deal or result in a stalemate with the investor, lender or buyer. This should be done before setting out on a financing or an ownership transaction and most definitely be done if there is an unsolicited approach.

Areas to probe include license/title to critical intellectual property, customer contracts and trend data, compliance and regulatory developments, competitive overlap, positive and negative synergies, adjustments to earnings, carve-outs, any activities not consistent with the longer term strategic plan, and any other reason that could stall or nix your deal.

Entrepreneurs and family owners of independent private companies have more options than ever for raising capital and creating liquidity for shareholders. We can help you to know your alternatives and achieve your objectives.

We hope this is your year and we’d love to help you make it a great year.

How Buyers Decide What Price to Offer for Your Business

358-Board-shot-headlinex300Advisors 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.

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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.

calloutIt 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.

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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.

“Seems like a good offer, so let’s take a closer look.”

Cartoonized photo of PH and PaulThere is a shortage of supply of middle market businesses available for acquisition. That is why prices are high and private equity firms are selling their best portfolio companies. As an owner/operator, there are some days when you have to wonder about what price would tempt you to sell the business. Your readiness depends on your specific circumstances. You may have family shareholders or other partners to consider, and they may or may not be able to understand how you (as boss) gauge the competitive landscape, but there comes a time when cashing-in has great appeal. Once you decide to listen to that strategic partner who has asked you repeatedly or the private equity firm that assures you that they are different (special), it is essential to know what you could actually achieve and how it would work if you choose to pursue a deal. We help business owners know what is possible and how to negotiate the best deal. That begins with a focus on valuation and purchase price in the context of the proceeds to the seller. Here is how you can avoid surprises.

There are plenty of sources that quote acquisition purchase price multiples for middle market businesses and there is usually at least some meaningful intelligence on deal valuation for relevant companies. What isn’t so easy to find is what really matters for determining net proceeds to the seller. You may ask, “multiple of what, exactly?… trailing adjusted earnings or a current full year?… and what balance sheet adjustments might apply?… how are working capital and capital expenditures factored into cash flow? … what strings are attached to a buyout offer?”

The most straightforward deal is the purchase and sale of the assets and business of a company on a cash-free and debt free basis. That may seem simple enough, but somehow it usually becomes less simple before all is said and done. It is generally assumed that the seller is an S-Corp or LLC or that the 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 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.

Understanding the determination of purchase price multiple is tricky because each of the parties has different needs to rationalize the price as a good deal. Buyers tend to look at the multiple in terms of what they expect to earn and they do whatever they can to have the seller appreciate that the focus has to be on what the seller has produced, not what the buyer might earn. Few sellers actually realize that the buyer has incremental expenses as well as potential savings. Private business owners tend to look at the amount of money they receive rather than the multiple of earnings. The offer is a price and the multiple is a relative value indication in evaluating price. Lenders tend to look at the cash flow and the fixed charge coverage based on the specific capital structure of the buyer. The bottom line is always a measure of how much money the seller takes home.

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.

What really happens at the Dealmaking Table?

P3220394-CroppedKnowing what to expect helps owner/entrepreneurs produce better dealmaking results and avoid getting boxed into bad situations. Savvy buy-siders try to keep owners focused on the glory (and gloss over what could be gory) while reeling them in. Not until the hook is set and backing out would be painful do their technicians hammer on the issues that become costly adjustments.

Whether the deal is for the sale of a business, the purchase of another, raising debt or equity, buying out a partner or striking a strategic alliance, the process always becomes more complicated than originally envisioned. While there is no shortage of capital for independent private companies and family owned businesses, actually completing fair deals and keeping everybody happy is the hard part. Here are some insights on what to expect and how to protect your interests.

Timing is rarely convenient for owners who haven’t been actively planning for a deal. The trigger for action is often an incoming call which is either flattering or frightening. A respected industry leader wants to talk about doing something together or a major revenue source begins to stumble. A new product line takes off and draws attention or a partner wants out when cash flow can’t support more borrowing or the hit to equity.

The discipline of tidying-up before a turn at the dealmaking table will minimize surprises, reduce anxiety and may be the only way to be able to close the deal. If you can’t do that, at least recognize it and begin to deal with issues on your own terms so that you don’t hand control of them to someone else unless you want that to happen.

In many instances, the historical financial results and some measure of management’s plans have been shared under a confidentiality agreement before the principals sit down together. In an auction sale process, the buy-side will have been required to provide a valuation range in order to be invited to talk. For an investment or credit facility, review of background information is common for determining level of interest in meeting with management.

Financial fundamentals always matter. Since the earnings proxy so commonly has adjustments or a story attached, the focus of conversation about earnings should be on their make-up and quality so that approached to valuation can be validated. While relative value is a multiple of EBITDA, price is a dollar value and structure determines how price translates into after tax proceeds. The difference between 6.0x and 8.0x and 10.0x is a function of market position and quality of management within a framework of opportunity size and deal competition. Size of company is a major factor in valuation.

The buy-side will determine what they will pay for an acquisition (price amount, not multiple) or how to backstop an investment (liquidation preference to cover downside and supercharge upside). Lenders will focus on the measure of availability and cap with the protection of fixed charges coverage and selective veto power.

This all gets a little trickier if the recent fundamentals (most importantly earnings) don’t support the sell-side or issuer valuation expectations or the credit request. If these problems can be overcome, they may require compromise and creative structuring.

Most published accounts of deals are biased because people like to talk about their successes rather than the tough issues that kept other deals from getting to the finish line. Taking an objective view to anticipate and resolve the trapdoor issues before or at the outset of negotiations pays great dividends before the power-leverage shifts away from the business owner. Signing a general letter of intent or term sheet and hoping for the best inevitably leads to disappointment. Avoid getting backed into a corner by clarifying dealbreakers early.

Tell-tale signs of an owner’s mindset often limit value or discourage interest without their even knowing it. This is generally less damaging in a change of control deal, but can sink an equity investment or strategic alliance when the other party recognizes the danger of reliance on an entrepreneur who isn’t ready or capable of the psychological adjustment to serve the best interests of all the owners. More deals die because the money loses faith in the owner than for any other reason.

Chances are that the other party is a more frequent participant in the type of transaction on the table. If they are a public company or private equity firm or bank, they usually have less flexibility in what they can live with than independent business owners can readily appreciate. The rigidity is evidenced more by terms than by pricing. Entrepreneurs are cocktail-napkin-May-blog2more comfortable living with risk than investors and lenders governed by an independent board or approval committee with fiduciary responsibility.

A corporate financial advisor with a track record of success in helping business owners address all of these concerns can be worth their weight in gold. When you decide to go to the dealmaking table, give us a chance to help you make it as rewarding as possible.

Open Season for Corporate Hunger Games

Graphic for blog April 2012 JPEG croppedCorporate buyers committed to growth through acquisition are stepping up their game to win the favor of owners of successful middle market companies. Although business owners strive to be meaningful players on the competitive scorecard, they often don’t actively prepare for the time when bigger players approach them. Most acquisition deals for entrepreneurs and family businesses are ignited by an incoming call from a senior executive at a larger company you know and respect. You may not be actively planning to sell, but you might consider the option when the buy-side is most eager to make an offer you may not want to refuse.

If you own a good business, you are not impressed by the idea that your company is an attractive target for a strategic buyer or a private equity fund with an agenda that you fit nicely into. What you may not know is exactly how real the alternatives are for grabbing the brass ring and having a shot at sweetening the profit in a deal. That is where MidMarket can add value for you to maximize those opportunities.

A common mistake by owners is assuming that the buy-side interest will be there whenever they decide to go to market. The fact is that a variety of factors outside of your control have an impact on the attractiveness of your company. You should be cautious about assuming that the market will be interested whenever it suits you. We suggest striking while the iron is hot.

What the majority of entrepreneurs and family businesses so often fail to appreciate is that people who own businesses for a living (corporate buyers and private equity firms) are fundamentally different from people who happen to own and work at the business they own. Professional ownership is motivated by the opportunities to grow and monetize the business, so different standards for measuring success apply. Unless you have actually participated in an ownership group involving a corporate owner or private equity owner, you most likely don’t really know their game. We can provide that input for your benefit so that you manage the interaction with prospective buyers or investors.

What is not surprising it that your competitors are plotting to succeed at your expense. They may not be as nimble as you or as capable, but they are very real and you must be ready to anticipate and respond to their actions. Strategic deals often trigger further activity and can also limit options. All the more reason to be out in front of your competitors on these matters.BeReady-blog

MidMarket can help you to take advantage of this surge in corporate acquisitions and ownership transactions. Just call us if you are interested in how we can be helpful. Contact us for a no-strings attached assessment of your situation.