Owners of entrepreneurial and family businesses should be careful about the banter of deal professionals about high relative value multiples and aggressive financing structures. They do not apply widely on a uniform basis, but there are ways to make them apply for you.
The often-referred barometer for conditions in the acquisitions market is a combination of EBITDA multiples and leverage multiples. Helpful as they can be for a discussion on valuation and borrowing capacity, these benchmarks rarely reflect the accrual sale proceeds and eligible advances on credit facilities.
There is wide consensus that a) there is a shortage of supply of independent non-sponsored middle market private companies for sale, and b) banks are once again eager to make loans. Strategic and private equity buyers are paying top dollar for strong companies and lenders are looking for new business for both expansion and funding shareholder liquidity transactions. This is a very good time for business owners to evaluate their options for financing and liquidity for shareholders. Doing that properly requires realism and a thorough understanding of all the moving and interrelated parts of the analysis.
While most business owners are not in the market to sell their business, it is almost certain that their companies have borrowing needs and may have further opportunities to invest in growth initiatives or even to make a strategic acquisition. It is worth knowing how both valuation and financing capacity apply for your company so that you can put the market references into a practical framework to rely upon as you plot strategies.
The M&A market is more transparent than ever, but also fickle and uneven so that sellers cannot take for granted that they will garner high multiples and loose terms. The willingness of the buyers to conform to a tightly managed sale process depends on the size and attractiveness of the target and access to vital due diligence material.
A large segment of the entrepreneurial and family-owned middle market is not comfortable loading a data room with information buyers need to flag issues that could lead to reduction of offer price or derail financing. As a result, most sellers are not able to require buyers to mark-up a purchase agreement as part of an offer.
Multiples can be misleading because when talking about them, sellers tend to exaggerate and buyers tend to be conservative to control expectations. The realm of add-backs and synergies is a creative place where persuasion and rationalization are finely tuned. Rude awakenings can also lurk if the buyer has the freedom to reshape what is being sold by way of carve-out marginal of business or create reserves that reduce price.
It often comes as a surprise to entrepreneurs and family-owned businesses that private equity firms on-balance are granted higher relative prices for businesses they sell and more aggressive financing terms for what they buy. It is really only logical that a party active as both a buyer and seller would be more attuned to the competitive dynamics of any market. It also only makes sense that an owner who follows the recipe for success…rigorous financial discipline, meaningful long term planning and top talent…will be rewarded when their business is offered for sale or seeking capital.
The value of a business that applies for a particular transaction is in many ways tied to the type and structure of the transaction. Raising growth equity is clearly very different from the sale of majority control, more as a result of structure and terms rather than price.
The balance sheet and actual free cash flow for the business have to be included for any value estimation to withstand the inevitable scrutiny of buyers and lenders. To rely on a multiple of EBITDA minus funded debt for estimated proceeds is unwise. Working capital and net asset adjustments can sink deals that may initially seem acceptable.
Lenders know that CFOs cut-and-paste the best features offered up by competitors vying to be selected for the financing. Senior debt multiples of EBITDA need to allow for working capital in addition to what does not remain in the company. Cash flow acquisition loans are virtually unavailable for businesses with less than $10 million in EBITDA and any kind of unsecured term loan is tough to snare.
Actual advance rates on fixed assets usually shock and disappoint borrowers as they become increasingly nauseous in reading through orderly liquidation appraisal reports. Even with working capital credit facilities, borrowers might not appreciate how eligibility and advance rates and excess availability requirements can squeeze actual borrowing availability.
The good news is that independent private companies are in high demand on every front. We would happy to provide our input on what you can do to take advantage of these opportunities.
We are hosting an event at MidMarket on Thursday evening, March 7th. It has to do with the ins and outs of doing business in Hong Kong and China. We will be joined by some people whose experiences and insights may be very different than you might expect. This is made possible through the auspices of our good friend Louis Ho and the Hong Kong Trade Development Council and we have asked our client Frank van Lint to share some comments about an IPO his Dutch investment group sponsored in China which debuted on the Hang Seng.
Last month marked the ninth anniversary of our entry into China. You may remember it. Marriott Conshohocken : Patrick Hurley, late in the evening in Hong Kong, interviewing group of public company executives in a live feed to a big TV screen at the Marriott, where Graeme Howard led a discussion with a panel of executives of companies here with activities there. You may also remember Jim Papada of Technitrol, a Philadelphia company, which in a few short years had most of its employees in China, saying that if you are not already there it’s over.
This was all pretty interesting and activities around the event helped to get MidMarket into China in a meaningful way.
We’ve remained active in China, an ever interesting and ever complicated place to do business and have worked for a number of companies and some very large entities. But it’s such a big and diverse country, that if you’re not careful, you can end up trying to do business in the wrong places for the wrong reasons.
MidMarket partner Telu Tsai is pretty good at spotting the tight situations and navigating clients through them. Time and again, he would say to me “You need to understand, Chinese people think differently.” I think we understand that now. We’ve learned some other things; for example, it’s not only companies with high labor content products that can lower costs there. It can work just as well for those with high material content too.
For example, we are working with a company with a product where material amounts to 75-80% of total cost – surely not a candidate for off-shoring? Wrong. It’s done its homework, knows how significant its savings could be, and knows it would be foolish not to seriously plan manufacturing in Asia. There are many other stories like this. You have to know where and how to look.
There’s been one constant through it all, and that’s Louis and HKTDC. The HKTDC is conducting an event in New York City in June, with the March event at MidMarket serving as a preview. We will be joined by Lewis and his team along with other guests with interesting experiences in China.
This will be a good opportunity to get an update, to find out what predictions made way back when at the Marriott came true, hear something about a cross-border deal involving European investors in a now public HK Exchange company actually worked, and finally to get some insights into what’s going on and where you might want to be, and how to get there.
Is 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.
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.