Tuesday, December 16, 2008
You started your company 20 years ago "in your garage", worked many 80 hour weeks, bootstrapped your growth, view your company with the pride of an entrepreneur, and are now considering your exit. The decision to sell is all too often a reactive one rather than a proactive one -- the primary reasons are a serious health issue, owner burnout, the death of a principal, general industry decline or the loss of a major customer. Often times very capable business people approach the sale of their business with less formality than in the sale of a home. Advance planning can ensure that you exit your business from a position of strength, not from weakness due to necessity.
1. Do not wait too long. Have you ever heard, "I sold my business to early?" Compare that with the number of times you've heard somebody say, "I should have sold my business two years ago." Unfortunately, waiting too long is probably the single biggest factor in reducing the proceeds from the sale of a privately held business. The erosion in business value typically is most pronounced in that last year before exiting. The decision to sell is often times a reactive decision rather than a proactive decision. An individual who spends 20 years running their business and controlling their outcomes often behaves differently in the exit from his business. The primary reasons for selling are events such as a serious health issue, owner burnout, the death of a principal, general industry decline, or the loss of a major customer.
Exit your business from a position of strength, not from the necessity of weakness. Don't let that next big deal delay your sale. You can reward yourself for that transaction you project to close with an intelligently written sale agreement containing contingent payments in the future if that event occurs.
2. Prepare yourself for life after business. We all create business plans both formally and informally. We all plan for vacations. We plan our parties. We need to plan for the most important financial event of our lives, the sale of our business. Typically a privately held business represents greater than 80% of the owner's net worth. Start out with your plans of how you want to enjoy the rewards of your labor. Where do you want to travel? What hobbies have you been meaning to start? What volunteer work have you meant to do? Where do you want to live? What job would you do if money were not in issue? You need to mentally establish an identity for yourself outside of your business.
3. Spruce up your business to create the maximum value in a sale. Now that you are all excited about the fun things you'll do once you exit your business, it's now time to focus on the things that you can do to maximize the value of your business upon sale. This topic is enough content for an entire article, however, we will briefly touch upon a couple of important points. First, engage a professional CPA firm to do your books. Buyers fear risk. Audited or reviewed financial statements from a reputable accounting firm reduced the perception of risk. Do not expect the buyer to give you credit for something that does not appear in your books. If you find that a large percentage of your business comes from a very few customers, embark on a program immediately to reduced customer concentration. Buyers fear that when the owner exits the major customers are at risk of leaving as well. Start to delegate management activities immediately and identify successors internally.
If you have no one that fits that description and you have enough time, seek out, hire and train that individual that would stay on for the transition and beyond. Buyers want to keep key people that can continue the momentum of the business. Analyze and identify the growth opportunities that are available to your business. What new products could I introduced to our existing customer base? What new markets could utilize our products? What strategic alliances would help grow my business? Capture that in a document and identify the resources required to pursue this plan. Buyers will have their own plans, but you'll increase their perception of the value of your business through your grasp of the growth opportunities.
4. Keep your eye on the ball. A major mistake business owners make in exiting their business is to focus their time and attention on selling the business as opposed to running the business. This occurs in large publicly traded companies with deep management teams as well as in private companies where management is largely in the hands of a single individual. Many large companies that are in the throws of being acquired are guilty of losing focus on the day-to-day operations. In case after case these businesses suffer a significant competitive downturn. If the acquisition does not materialize, their business has suffered significant erosion in value. There simply is not enough time for the owner to wear the many hats of operating his business while embarking on a full-time job of selling his business.
The owner wants the impending sale to be totally confidential until the very last minute. If the owner attempts to sell the business himself, by default he has identified that his business is for sale. Competitors would love to have this information. Bankers get nervous. Employees get nervous. Customers get nervous. Suppliers get nervous. The owner has inadvertently created risk, a potential drop in business and a corresponding drop in the sale price of his business.
5. Be sure to get multiple buyers involved in your business sale. The "typical" business sale transaction for a privately held business begins with either an unsolicited approach by a competitor or with a decision on the part of the owner to exit. If a competitor initiates the process, he typically isn't interested in over paying for your business. In fact, just the opposite is true. He is trying to buy your business at a discount. Outside of yourself there is no one in a better position to understand the value of your business more than a major competitor. He will try to keep the sales process limited to a negotiation of one. In our mergers and acquisitions practice the owner often approaches us after an unsolicited offer.
What we have found is generally that unsolicited buyer is not the ultimate purchaser, or if he is, the final purchase price is, on average 20% higher than the original offer. If the owner decides to exit and initiates the process, it usually begins with a communication with a trusted advisor - accountant, lawyer, banker, or financial advisor. Let's say that the owner is considering selling his business and he tells his banker. The well- meaning banker says, "One of my other customers is also in your industry. Why don't I provide you an introduction?" If the introduction results in a negotiation of one, it is unlikely that you will get the highest and best the market has to offer.
6. Hire a Mergers and Acquisitions firm to sell my business. You improve your odds of maximizing your proceeds while reducing the risk of business erosion by hiring a firm that specializes in selling businesses. A large public company would not even consider an M&A transaction without representation from a Merrill Lynch, Goldman Sachs, Solomon Brothers or other high profile investment banking firm. Why? With so much at stake, they know they will do better by paying the experts. Companies in the $3 Million to $50 Million range fall below their radar, but there are mid market M&A firms that can provide similar services and process. Generally when you sell your business, it is the one time in your life that you go through that experience. The buyer of the last company we represented for sale had previously purchased 25 companies.
The sellers were good business people, knew their stuff, but this was their first and probably last business sale. Who had the advantage in this transaction? By engaging a professional M&A firm they helped balance the M&A experience scales.
7. Engage other professionals that have experience in business sale transactions. You may have a great outside accountant that has done your books for years. If he has not been involved in multiple business sales transactions, you should consider engaging a CPA firm that has the experience to advise you on important tax and accounting issues that can literally result in swings of hundreds of thousands of dollars. What are the tax implications of a stock purchase versus an asset purchase? A lower offer on a stock purchase may be far superior to a higher offer on an asset purchase after the impact of taxes on your realized proceeds. Is the accountant that does your books qualified to advise you on that issue?
Would your accountant know the best way to allocate the purchase price on an asset sale between hard assets, good will, employment agreements and non-compete agreements? A deal attorney is very different from the attorney you engage for every day business law issues. Remember, each element of deal structure that is favorable to the seller for tax or risk purposes is generally correspondingly unfavorable to the buyer, and vice versa. Therefore the experienced team for the buyer is under instructions to make an offer with the most favorable tax and reps and warranties consequences for their client. You need a professional team that can match the buyer's team's level of experience with deal structure, legal, and tax issues.
8. Be reasonable in your expectations on sales price and terms. The days of irrational exuberance are over. Strategic buyers, private equity groups, corporate buyers, and other buyers are either very smart or do not last very long as buyers. I hate rules of thumb, but generally there is a range of sales prices for similar businesses with similar growth profiles and similar financial performance. That being said, however, there is still a range of selling prices. So, for example, let's say that the sales price for a business in the XYZ industry is a multiple of between 4 and 5.5 times EBITDA. Your objective and the objective of a good M&A advisor is to sell your business at the top end of the range under favorable terms.
In order for you to sell your business outside of that range you must have a very compelling competitive advantage, collection of intellectual property, unusual growth prospects, or significant barriers to entry that would justify a premium purchase price. If you think about the process of detailing your car before you offer it for sale, a good M&A advisor will assist you in that process for your business. Let's say, for example, that 4 to 5.5 multiple from above was the metric in your industry and you had an EBITDA for the last fiscal year of $2.5 million. Your gross transaction proceeds could range from $10 million to $13.75 million. A skilled M&A firm with a proven process can move you to the top of your industry's range. The impact of hitting the top of the sales price range vs. the bottom more than justifies the success fee you pay to your M&A professionals.
9. In the business selling process, disclose, disclose, disclose, and do it early. A seemingly insignificant minor negative revealed early in the process is an inconvenience, a hurdle, or a point to negotiate around. That same negative revealed during negotiations, or worse yet, during due diligence, becomes, at best, a catalyst for reexamining the validity of every piece of data to, at worse, a deal breaker. No contract in the world can cover every eventuality if there is not a fundamental meeting of the minds and a trust between the two parties. Unless you are lucky enough to get an all cash offer without any reps and warranties, you are going to be partnered with your buyer for some period in the future.
Buyers try to keep you on the hook with reps and warranties that last for a few years, employment contracts, or non-competes that last, escrow funds, seller notes, etc. These all serve a dual role to reduce the risk of future surprises. If future material surprises occur, buyers tend to be punitive in their resolution with the seller. Volunteer to reveal your company's warts early in the process. That will build trust and credibility and will ensure you get to keep all of the proceeds from your sale.
10. Be flexible and open to creative deal structure. Everything is a negotiation. You may have in mind that you want a gross purchase price of $13 million and all cash at close. Maybe the market does not support both targets. You may be able to get creative in order to reach that purchase price target by agreeing to carry a seller note. If the sale process produces multiple bids and the best one is $11.3 million cash at close. You may counter with a 7-year seller balloon note at 8% for $3 million with $10 million cash at close. If the buyer is a solid company, that may be a superior outcome than your original target because the best interest return you can currently get on your investments is 4%. Be flexible, be creative, and use your team to negotiate the hard parts and preserve your relationship with the buyer.
You may have spent your life's work building your business to provide you the income, wealth creation, and legacy that you had planned and hoped for. You prepared and were competitive and tireless in your approach. You have one final act in your business. Make that your final business success. Exit on purpose and do it from a position of strength and receive the highest and best deal the market has to offer.
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist
Sunday, December 07, 2008
Thursday, December 04, 2008
Buying a business is a risky proposition. The buyer is attempting to examine and access all of the risk factors to determine how much to pay, what deal structure to propose, and even whether or not to even make an offer. What if I lose a key customer, employee, or supplier? What if our technology is surpassed by a new, lower-cost solution? What happens if a big company decides to enter our niche? These are just a few of the concerns that make buyers less generous in their offer price and terms. If your financials are questionable, that may be the deciding factor that diminishes your selling price or even blows up the deal.
Audited financials are the best to put a buyer's mind at ease. For smaller companies, the cost of this is not warranted. The next best are reviewed financials. They show that a CPA has put your accounting process through some review and scrutiny. Compiled statements are OK, but are closer to a book keeper's role than a CPA's approach. Just remember, the buyer's accountant is going to perform due diligence on your financials at a level closer to an audited statements process. If he finds mistakes and inconsistencies, a lack of trust on all other data can develop.
Your business tax returns will be gospel to the buyer because the IRS frowns on companies not reporting a portion of their income and that is what the buyer's bank reviews to determine the financing available for the acquisition.
In the Mergers and Acquisitions business we all rely on "recast" financials to basically remove all of the expenses the owner runs through his business and make the company look more profitable to drive up the selling price. Sophisticated buyers (i.e. acquisition oriented corporations) may not directly confront you on the recasting, but they are not likely to give you full credit in their analysis. They may even develop some reservations about your character and ethics if the amounts are excessive. They may question your ability to fit in as a good corporate citizen as you transition your business to their institutional corporate structure.
If you are planning on selling your company in three years, why not start eliminating the expenses you run through the business that push the boundaries of business versus personal expenses? In the first year eliminate 33% of the country club, entertainment, business trips, conferences and non-contributing relatives on the payroll. The second year, eliminate another 33% of those and in the year preceding the sale, eliminate them completely.
Imagine the style points you would get from a sophisticated buyer when they discovered that your financials are really your financials with no recasting. Not only that, but you will likely receive a high end purchase price multiple and a greater percentage of cash at close. So, for example, if companies in your industry sell for a range of between 5 and 6.25 X EBITDA, then your company would likely sell at a multiple closer to the 6.25 high end than the 5 low end multiple.
If you had run $200,000 of owner expenses through the business and eliminated that practice you would pay approximately $80,000 in additional taxes. Your recast EBITDA would be higher than your reported EBITDA, but the sophisticated investor might only give you $100,000 credit and would adjust your multiple to the low end. Your recast EBITDA, for example, of $3.2 million would be credited by the buyer at $3.1 million with a valuation multiple of 5 X, resulting in a proposed purchase value of $15.5 million.
Compare this to using your real EBITDA of $3 million, but because it is not recast, your buyer pays a risk reduction premium in valuation multiple and moves you up to 6 X, resulting in a proposed purchase value of $18 million. This is a pretty impressive improvement in selling price for increasing your company's taxable income phased in over the three years prior to your business sale.
You may be asking yourself skeptically, how can this be? Remember, buying a business is all about minimizing the buyer's perception of risk. Now your financials are rock solid and do not require a long explanation on why they are really better than reported to the IRS. This is the most powerful risk reduction strategy available to business sellers. You will differentiate your company from every other acquisition target the buyer has reviewed. You increase your credibility on every other piece of information that you have provided during the courting and due diligence process. Their opinion on your business acumen, management ability, judgment, and ethics has been elevated. The buyer feels more confident that this will be a successful acquisition. For that they will pay a premium.
Wednesday, December 03, 2008
Many business owners want to thank their loyal employees that have helped them build their businesses when they exit. It is a noble desire that often leads to the exploration of a management buyout. Who better to buy the business than the management team that is familiar with the procedures, the customers, the suppliers, the industry and the intellectual property?
From a practical standpoint, however, unless the potential management buyout team already owns a meaningful percentage of the company, it is unlikely they have the financial resources to complete the acquisition.
These managers may be great employees, but they generally do not have the risk tolerance to put their personal assets at stake in order to finance the acquisition.
They may originally think that they will be able to secure financing to make the acquisition. When they begin to peel back the layers they find that their enthusiasm begins to crack. Banks are not going to finance an acquisition based on a competitive market price for the business. They will make loans based on a percentage of the asset value of the equipment, receivables and inventory that exceed the company's debt level. This will likely result in the buyout group getting financing at 40-50% of the true value of the company.
Where does the rest come from? When the management buyout team explores the effective rate of mezzanine financing - 12% interest rate with warrants that drive the cost to 25%, they usually eliminate that option. The next option is the personal assets of the team. When the banks start asking for personal guarantees, individuals drop out pretty quickly.
This process sometimes evolves to the owner being asked to settle for a purchase price closer to the secured financing level available rather than the market value of the company. On a company with a $10 million fair market value, this could result in a discount of $5 million or more. I am sure the business owner is grateful to his loyal employees, but this is just not practical.
The problem occurs after this process unfolds and the once very excited management team realizes that their dream of ownership has been knocked off the track. If some of the key players blame the owner, they can turn from loyal to disgruntled and may even leave the company. This can result in erosion in company value in the eyes of the eventual buyer. The original noble plan has blown up in the owner's face.
Another approach would be for the owner to engage an investment banker to seek competitive bids from both strategic buyers and private equity groups. This process will establish the true market value that will be far superior to the financing value of the assets minus liabilities. The owner could grant key employees a cash award based on years of service, salary, or other criteria of his choice.
If the buyer is a Private Equity Group, the owner has another option that may be even more attractive to key employees and the Owner. PEGs encourage sellers to invest some of their equity back into the business. They get to invest leveraged equity along with the PEG.
So let's say that the selling price of the business was $10 million. The PEG would borrow $7 million and need $3 million in equity. If the seller invests $1 million of his proceeds back into the business, he would own 33% of the new entity. If the owner was planning on distributing $500,000 to employees, he could reinvest that $500,000 along with his $500,000 back into the business and he would then own 16 ½% and the employees would own 16 ½% of the new entity.
This works out for everybody because the employees will be highly motivated to stay and to perform at a high level for their eventual exit and cash out. The PEG gets to keep a performing management team in place that is highly motivated. The owner gets the maximum selling price for his business because of the soft auction business selling process. Finally, the owner gets to reward his loyal employees with a powerful investment in their future.
The second payoff for the owner and the powerful payoff for the employees comes five years later when the PEG sells the company now valued at $50 million to a strategic industry buyer. This second bite of the apple values the owner's retained 16 ½% stake at $8,250,000. The loyal employees cash out at that same level from an original $500,000 bonus. Now that's a bonus!
Sunday, November 30, 2008
When a company approaches you and broaches the subject of acquiring your company, it is very difficult to suppress those feelings of riches beyond your wildest dreams. Your thoughts start to move from the twelve hour work days, personnel issues, keeping your clients happy, and drift toward the tropical island with the grass hut, the perfect climate, the umbrella drinks, and the abundant leisure time. Snap out of it! Put that Champaign away and get back to reality.
We had been engaged by a client to sell her business recently and while we were in the planning meeting, the assistant walked in with a letter from a larger industry player expressing an interest in buying her company.
She was feeling pretty special until we uncovered that this same letter was sent out to 50 other companies. Buyers are looking to buy at a discount if possible. The way they do that is similar to the approach that many of those get rich quick real estate programs recommend. Go out to 50 sellers and make a low-ball offer and one of them may bite. These buyers are way better informed about the value of a company than 90% of the business owners they approach.
The odds of a deal closing in this unsolicited approach are pretty slim. In the real estate example, the home owner is not hurt by one of these approaches, because they have a good idea of the value of their home. The price offer comes in immediately and they recognize it as a low ball and send the buyer packing. For the business owner, however, valuations are not that simple. This is the start of the death spiral. I don't want to sound overly dramatic, but this rarely has a happy ending.
These supposed buyers will not give you a price offer. They drain your time, resources, your focus on running your business and, your company's performance. They want to buy your business as the only bidder and get a big discount. They will kick your tires, kick your tires, and kick your tires some more.
If they finally get to an offer after months of this resource drain, it is woefully short of expectations, to the surprise or chagrin of the owner. The owner became intoxicated with their vision of riches and took their eye off the ball of running their business.
How should you handle this situation so you do not have this outcome? We suggest that you do not let an outside force determine your selling timeframe. However, we recognize that everything is for sale at the right price. That is the right starting point. Get the buyer to sign a confidentiality agreement. Provide income statement, balance sheet and your yearly budget and forecast. Determine what is that number that you would accept as your purchase price and present that to the buyer. You may put it like this, " We really were not considering selling our company, but if you want us to consider going through the due diligence process, we will need an offer of $6.5 million. If you are not prepared to give us a LOI at that level, we are not going to entertain further discussions."
A second approach would be to ask for that number and if they were willing to agree, then you would agree to begin the due diligence process. If they were not, then you were going to engage your merger and acquisition advisor and they would be welcome to participate in the process with the other buyers that were brought into the process.
A major mistake business owners make in this situation is to focus their time and attention on selling the business as opposed to running the business. This occurs in large publicly traded companies with deep management teams as well as in private companies where management is largely in the hands of a single individual. Many large companies that are in the throws of being acquired are guilty of losing focus on the day-to-day operations. In case after case these businesses suffer a significant competitive downturn. If the acquisition does not materialize, their business has suffered significant erosion in value.
For a privately held business the impact is even more acute. There simply is not enough time for the owner to wear the many hats of operating his business while embarking on a full-time job of selling his business. Going through an extended process with a buyer who only wanted to buy at a bargain can damage the small company. If you are not for sale, you must control the process. Why would you go through the incredible resource drain before you knew if the offer would be acceptable? Get a qualified letter of intent on the front end or send this buyer packing.
Wednesday, November 26, 2008
If this recent market meltdown has taught us anything it is to make sure you are diversified over several investments and asset classes. Would you recommend that a client put 80% or more of their assets into a single investment? Of course not, but a large percentage of your clients actually have that level of concentration. Your clients that are business owners likely have 80% or more of their family's net worth tied up in their business. On top of that, privately held businesses are illiquid assets often requiring one to two years to sell. So for your baby boomer business owner clients, it is time to have some tough discussions. It is time to move your financial advisory practice beyond the scope of a provider of financial products to an advisor on family wealth maximization solutions.
Business owners are typically not proactive when it comes to exit planning or succession planning in their business because it forces them to embrace their own mortality. Well, they just need to get over it. If an owner has a sudden debilitating health issue or unexpectedly dies, instead of getting full value for the company, his estate can sell it out of bankruptcy two years later for ten cents on the dollar. This is a punishing financial result for the lack of appropriate planning.
Statistics on Business Exits
· According to Federal Reserve's Survey of Consumer Finances, in 2001, 50,000 businesses changed hands. That number rose to 350,000 in 2005 and is projected to increase to 750,000 by 2009.
· 42% within 5 years. 51% of those plan on selling to another company while 18% plan on a transition to family members and another 14% plan on a management buyout.
· Only 22% have done a great deal of succession planning and another 26% have done some. But 24% have done little, and 19%, virtually none. 9% did not report.
· Only 39% percent of CEO's have a likely successor in mind, but less than two-thirds of them say that person is ready to take control today.
But among those planning to sell their business, far fewer have explored the following opportunities:
· Only 36% have planned how to increase after-tax proceeds;
· Only 35% have developed an investment strategy to protect and manage their monetized wealth
Questions You Should Be Asking of Your Business Owner Clients
In your role of providing a holistic approach to maximizing your client's wealth, you should be asking these questions:
· What are your plans for your business when you retire?
· Do you have children that you want to take over the business?
· Have you determined how you are going to transfer the ownership?
· Do you know how much your company is worth?
· What % of your family's net worth is in your business?
· In your business life, what keeps you up at night?
· If you were hit by a bus tomorrow, God forbid, what would happen to
In your role of trusted advisor, you simply must ask these difficult questions and guide your client in exploring options and planning for his eventual exit. Before he just assumes that the torch will be carried by the next generation, make sure that the next generation even wants to run the business. Imagine the loss in value that would have occurred if the real estate billionaire from the western suburbs of Chicago had turned his empire over to his son who simply wanted to produce plays.
Are his heirs even capable of running the business? Has he held on to the reins so tightly that the kids involved in the business have not been able to develop their decision-making or leadership skills? Do they command company respect because of their personal strength and skills or are they grudgingly granted respect because they are the child of the owner? If that is the case, the odds are not good for them taking over when he retires.
The business owner must make some difficult decisions when he or she decides it is time to retire. Why did he create this business? Was it to keep this business in the family for generations or was it to provide for his family for generations? If the desire and the capability of the children are not evident and the company is large enough, it may be the right decision to first get outside board members actively involved as step one. Step two would be to hire professional management to run the business.
Another way to ask your client to think of it is, while I am running the business, the best ROI is to keep the bulk of my net worth invested in this company. If I am no longer running the company what is the best risk reward profile for my net worth? Would my heirs be better off if the business was sold and the value converted to financial assets?
Many financial advisors feel uncomfortable having these types of discussions with their clients. Because of the business owner's reluctance to plan for his business exit, you should actively get out in front of the process with your client. This decision and how it is executed will be the single most impactful event in your client's financial future. You can take on the quarterback position in assembling a multidisciplinary team that can include:
The Financial Advisor - Coordinate all the pieces for a holistic wealth maximization plan
Attorney - Create the necessary documents, wills, trusts, family LLC's, corporate structure, etc.
Estate Planner - work with financial advisor and attorney to create the properly documented estate roadmap
CPA/Tax Advisor - review corporate structure, analyze after tax proceeds comparison of various transaction structures, create tax deferral and tax avoidance strategies
Investment Banker/Merger and Acquisition Advisor - Analyze the business, create value creation strategies, position the company for sale, and create a soft auction of multiple buyers to maximize selling price and terms.
As your business owner clients approach retirement, you need to help them with investment decisions that employ sound diversification and liquidity strategies. Their business is generally the largest, most illiquid, and most risky investment in their total wealth portfolio. Their successful business exit should be executed with the same diligence, knowledge, experience and skill that you regularly apply to their other asset class decisions.
Please contact us for a free white paper on this topic.
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist
Monday, October 13, 2008
Ask any business owner who has sold a business or attempted to sell a business, “What would you do differently?” If he or she attempted to sell it without help, chances are pretty good that the transaction did not succeed. If the transaction were actually completed, chances are that they did not get a good price, but had no idea that this occurred.
We were recently engaged to sell a medical products company. In our process we will identify 50 to 150 companies that would be likely buyers based on similar products, services or markets served. When those targets are approved by our seller client, we get on the phone and contact the buying prospect to see if we can generate some interest and get confidentiality agreements executed.
We were able to identify several interested buyers and were at the stage where they were submitting their qualified Letters of Intent. The LOI basically says that if we complete our due diligence and we find that everything is as you earlier presented it, we will pay you $XXX under these terms and conditions.
We got one offer from a perfect fit buyer and we determined that it was well short of our seller’s expectations and well below what our view of the price for similar companies in this market niche. We called this buyer to discuss his offer. When we told him our client’s range of expectations, he said that it was way too expensive. We asked him what basis he had for that conclusion, he replied that he was looking to pay 5 X Cash Flow for a business. We told him that recent transactions indicated that similar companies were selling for 2.5 times revenues and not a price based on a cash flow model.
Let’s take this a little further with some ball park calculations based on our transaction. For example, if our client had $5 million in revenue and a 20% cash flow margin, his cash flow is $1 million and according to this buyer, his company should sell for 5 X $1 million or $5 million. The market view, however, is that this company is worth $5 million X 2.5 or $12.5 million. When we dug a little deeper into our buyer’s offer we found out that he currently was in the process of buying another similar company.
When we inquired for more detail we found that this other company was a long time competitor, the owner was getting ready to retire and approached this buyer to see if he would be interested in acquiring them. We asked the buyer if the seller was represented by an investment banker, business broker or merger and acquisition advisor. He said that the seller was not. I asked him if there were any other buyers involved in the process. He said that as far as he knew, he was the only buyer. I asked him how the selling price was determined. The buyer said that he set the price based on, you guessed it, 5 X cash flow.
Let’s see what this seller’s approach is going to cost him. If we assume that he was very similar in size and cash flow to our client. A competitive market price in a formal merger and acquisition process would be $12.5 million. Our buyer will pay him only $5 million and the seller will close thinking he got a fair deal without any market validation. This is a $7.5 million mistake that could have very easily been avoided by hiring a business sales professional that would have invited in multiple buyers and multiple competitive bids. Well, at least the seller avoided all investment banker fees. This is a sad end to a 25 year history of business excellence. Unfortunately it happens all the time.
Monday, September 29, 2008
Compare this to a C Corp stock sale. The stock is sold and there is no tax to the corporation. The distribution is made to the shareholders and they pay only their long term capital gain on the change in value over their basis in the stock. The difference can be hundreds of thousands of dollars.
Most buyers have it drilled into their heads by their attorneys that they should not agree to a stock sale because the buyer will inherit all of the assets and all of the liabilities of the corporation, even the scary hidden liabilities. A second reason buyers want to do an asset acquisition is that they get to take a step up in basis of all the assets and can depreciate them at a higher amount than inheriting those assets under their current depreciation schedule.
Early in the process with the seller, communicate to them your desire for a stock sale because of the punishing double taxation you will face with an asset sale. You could give him two purchase prices, one for a stock sale and a much higher one (30% higher) for an asset sale. If you try to introduce this concept late in the process, you will find it very difficult to recover.
What can you do to convince the buyer to agree to a stock sale? If you are in an environmentally sensitive business or one with potential product liability issues, you may have a tougher time. One thought would be to agree to stringent reps and warranties and maintaining 10-15% of the transaction value in an interest bearing escrow fund pending any unforeseen issues. This delayed payment is a far superior result than immediately losing 34% of transaction value with an asset sale.
If you have a sale that is heavily weighted in good will and intellectual property as opposed to depreciable assets, step up in basis is less of an issue because the amortization schedules for good will in an asset sale are essentially the same as in a stock sale. If there are a lot of hard assets, the step up in basis is real tax savings for the buyer using an asset sale. You may counter with an offer that says you will lower your price by an amount that more than offsets his loss of step up in basis if he agrees to a stock sale.
Another approach you could use is to move a little more of the transaction value into an earn out, deferred payment, and or some seller financing. Your argument is that you will agree to stringent reps and warranties and the deferred payment component acts as a quasi escrow account. If something goes wrong for them, they still have a portion of your money.
The key here is to understand the net after tax effects of the C Corp asset sale and Stock Sale. Set your transaction value target based on the after tax proceeds you will recognize. Give the buyer one price for a stock sale and a 34% higher price for the asset sale and use this as a negotiation point. Introduce this concept to your buyer very early in the process and avoid trying to bring this issue up late in the process.
Wednesday, September 24, 2008
When dealing with only one buyer, he is right. When there are multiple suitors, competitive market forces are allowed to function properly and true business value is established. I am often asked by a business owner what he should do when he is approached by an unsolicited offer. As a general rule, these buyers are only interested if they can get a bargain and limit the process to themselves as the only buyer.
First question I would ask the potential seller is, do you know the value of your business? If he says yes, my next question would be, how do you know? Have you had a recent valuation? Are you familiar with other comparable transactions? Are there rule of thumb valuation multiples for your business? Are you aware of any strategic value components your company may possess? Are you familiar with a discounted cash flow and terminal value approach to valuation?
If he feels comfortable with the value of his business, would this value be adequate for his financial future? What if a buyer was willing to meet his value criteria, but the seller were asked to take some as an earn out or some as a seller note? What offer would induce this owner to change his exit plans, assuming he was not already for sale?
In most cases, the buyer is very aware of the market and the owner is not nearly as well informed. The buyer most likely has made similar overtures to three to six other companies and is attempting to bring one bargain to closing. Because he has multiple opportunities, he has the leverage.
When talking to business owners who have gone through this unfortunate dance with a single buyer, several patterns repeat themselves. The first is that the seller is unable to pin the buyer down on the price and terms even after several months of buyer tire kicking. They are vague and evasive. They reschedule and delay meetings. They drag the process out. They introduce a partner deep into the process who starts hacking away at the terms and the deal shrinks. They discover minor issues in due diligence and act like there should be deal term and price adjustments. The seller gets deal fatigue.
The single buyer is emotionally detached from this process and thinks it is just part of his deal making skill. He is doing the same thing with multiple business owners simultaneously who have a much different emotional connection to the product of their life's work. The buyer is behaving badly and the owner really has no leverage to make the buyer behave. Most of the time the owner will simply blow up the deal after wasting months of time and a great deal of emotional strain. Sometimes he just caves in and sells out at the newly adjusted lower price. What a terrible outcome.
How should the business owner handle this? First answer is my company is not for sale. That usually scares the bottom feeders off because you are establishing a point of strength that you do not need to sell. Of course the buyer will say that everything is for sale. The next step would be to get mutual non disclosures executed and if you are sharing financials, you have the right to request his financials to make sure he has the financial ability to afford you. If it is a public company, you can check the public records for financials.
You really do not want to let the potential buyer do much more looking until he has submitted a qualified letter of intent. That basically says that if we do our due diligence and find out that everything you have told us checks out and we do not find any material surprises, we are willing to pay this much and on these terms for your company. Why would you let another company tear yours apart without knowing that their offer is acceptable to you once they do?
These are good steps, but I still have not solved your problem, leverage. You only have one buyer and you really have no pricing or negotiating leverage. For that you need multiple buyers. A business owner who has to run his business, which is already more than a full time job, normally can only process one buyer at a time. Therefore no leverage, no pricing power, no competition, no good result.
For that you need multiple buyers. To accomplish that you need a merger and acquisition advisor or business broker or investment banker, depending on the size and complexity of the potential transaction. When we are contacted by an owner that has one of these buyers in pursuit, we simply throw that buyer in to the process. When it becomes evident that this is going to become a competitive buying process, they head for easier territory pretty quickly. In our many years of doing this and in the twenty five year history of my prior firm, in only one case did the original unsolicited buyer end up being the winner. And that final price was 35% greater than his original offer.
The unsolicited offer is originally attractive to the business owner because he believes that he will net much more from the transaction if he can avoid paying the investment banking fees. The practical reality is that being sort of, kind of for sale will depreciate your company's value. Either tell these buyers to go away completely or tell them you will have your investment banker contact them. This one buyer middle ground is not a good place for you or your company.
Friday, July 04, 2008
The purpose of this post is to demonstrate the importance of the tax impact in the sale of your business. As an M&A intermediary and member of the IBBA, International Business Brokers Association, we recognize our responsibility to recommend that you consult your attorneys and tax accountants for specific advice on your business sale transaction.
As a general rule, buyers of businesses have already completed several transactions. They have a process and are surrounded by a team of experienced mergers and acquisitions professionals. Sellers on the other hand, sell a business only one time. Their "team" consists of their outside counsel who does general business law and their accountant who does their books and tax filings. It is important to note that the seller's team may have little or no experience in a business sale transaction.
Another general rule is that a deal structure that favors a buyer from the tax perspective normally is detrimental to the seller's tax situation and vice versa. For example, in allocating the purchase price in an asset sale, the buyer wants the fastest write-off possible. From a tax standpoint he would want to allocate as much of the transaction value to a consulting contract for the seller and equipment with a short depreciation period.
A consulting contract is taxed to the seller as earned income, generally the highest possible tax rate. The difference between the depreciated tax basis of equipment and the amount of the purchase price allocated in an asset sale structure is taxed to the seller at the seller's ordinary income tax rate. This is generally the second highest tax rate (no FICA due on this vs. earned income). The seller would prefer to have more of the purchase price allocated to goodwill, personal goodwill, and going concern value.
The seller would be taxed at the more favorable individual capital gains rates for gains in these categories with an S Corp, LLC, Partnership, or Sole Proprietorship structure. An individual that was in the 40% income tax bracket would pay capital gains at a 20% rate. Note: an asset sale of a business will normally put a seller into the highest income tax bracket.
The buyer's write-off period for goodwill, personal goodwill, and going concern value is fifteen years. This is far less desirable than the one or two years of expense "write-off" for a consulting agreement.
Another very important issue for tax purposes is whether the sale is a stock sale or an asset sale. Buyers generally prefer asset sales and sellers generally prefer stock sales. In an asset sale the buyer gets to take a step-up in basis for machinery and equipment. Let's say that the seller's depreciated value for the machinery and equipment were $600,000. FMV and purchase price allocation were $1.25 million.
Under a stock sale the buyer inherits the historical depreciation structure for write-off. In an asset sale the buyer establishes the $1.25 million (stepped up value) as his basis for depreciation and gets the advantage of bigger write-offs for tax purposes.
The seller prefers a stock sale because the entire gain is taxed at the more favorable long-term capital gains rate. For an asset sale, (other than a C-Corp) a portion of the gains will be taxed at the less favorable income tax rates. In the example above, the seller's tax liability for the machinery and equipment gain in an asset sale would be 40% of the $625,000 gain or $250,000. In a stock sale the tax liability for the same gain associated with the machinery and equipment is 20% of $625,000, or $125,000.
The form of the seller's organization, for example C Corp, S Corp, or LLC are important to consider in a business sale. In a C Corp asset sale vs. an S Corp and LLC, the gains are subject to double taxation. In a C Corp sale the gain from the sale of assets is taxed at the corporate income tax rate. The remaining proceeds are distributed to the shareholders and the difference between the liquidation proceeds and the stockholder stock basis are taxed for a second time at the individual's long-term capital gains rate.
The gains have been taxed twice reducing the individual's after-tax proceeds. An S Corp or LLC sale results in gains being taxed only once using the tax profile of the individual stockholder. Below is a tax checklist:
Selling your business - tax consideration checklist:
1. Get good tax and legal counsel when you establish the initial form of your business - C Corp, S Corp, or LLC, etc.
2. If you establish a C Corp, retain ownership of all appreciating assets outside of the corporation (land and buildings, patents, trademarks, franchise rights). Note: in a C Corp sale, there are no long-term capital gains tax rates only corporate income tax rates. Long-term capital gains can only offset long-term capital losses. Personal assets sales can have favorable long-term capital gains treatment and you avoid double taxation for these assets with big gains.
3. Look first at the economics of the sales transaction and secondly at the tax structure.
4. Make sure your professional support team has deal making experience.
5. Before you take your business to the market, work with your professionals to understand your tax characteristics and how various deal structures will impact the after-tax sale proceeds. For example, a C-Corp stock sale at a lower purchase price could be much better than an asset sale at a higher price.
6. Before you complete your sales transaction work with a financial planning or tax planning professional to determine if there are strategies you can employ to defer or eliminate the payment of taxes.
7. Recognize that as a general rule your desire to "cash out" and receive all proceeds from your sale immediately will increase your tax liability.
8. Get your professionals involved early and keep them involved in analyzing various bids to determine your best offer. Know the impact prior to negotiating with your buyer because it is very difficult to change the deal at the eleventh hour due to your late discovery of the tax consequences.
Again, the purpose of this post was not to offer you tax advice (which I am not qualified to do). It was to alert you to the huge potential impact that the deal structure and taxes can have on the economics of your sales transaction and the importance of involving the right legal and tax professionals.
Saturday, June 28, 2008
The Baby Boomers are retiring in large numbers over the next ten years and the impact on the economic landscape of America will be dramatic. This article will examine those trends and the likely impact on business valuations over the next several years. From a 40,000 foot view the number of businesses that change hands will mirror the number of baby boomers that are retiring.
According to Federal Reserve's Survey of Consumer Finances, in 2001, 50,000 businesses changed hands. That number rose to 350,000 in 2005 and is projected to increase to 750,000 by 2009. Price Waterhouse reported in a Trendsetter Barometer Survey of Business Owners that 51% were planning on selling their company to another company compared with 18% anticipating passing on the business to a family member and 14% planning a sale to the company's management.
The trends point to more than a doubling in the number of businesses that will hit the market looking for a buyer by 2009. Simple economics and supply and demand would suggest that unless the number of buyers increases significantly, there will be an erosion in valuations for business sellers during this rush to the exits. Compare that to the relatively robust environment business sellers have enjoyed over the past 3 years. This period was supported by unprecedented Private Equity investments in addition to the available cash from corporations with rising profits.
Now we have the sub-prime situation impacting the available funds that the Private Equity Firms were using to highly leverage their mega deals and drive up transaction values. The good news for most privately held companies, 99.9% of your companies will not fall into the mega deal category. A larger privately held industry player or a publicly traded company is the most likely buyer. The economics are still positive for these buyers looking to add customers, product lines, technology or all three. A publicly traded company can still buy a private company for a good price and not dilute their share price.
Given this backdrop, what is a business owner who is anticipating selling his business in 2010, to do? Move up your sale timeframe, but not necessarily your exit timeframe. No, I am not talking in riddles. What I mean is that you should take your chips off the table with a sale transaction sooner rather than later. Your eventual exit could be in 2010 after working full time for the new owner for 1 year to transition customer relationships and intellectual property, followed by a limited consulting engagement for two years.
Too many business owners view their business sale and their retirement as a simultaneous event and end up delaying the sale to the day they want to stop working. That misperception can be very costly. Too many owners wait too long and end up selling because of a negative event like a health issue, loss of a major account, a shift in the competitive landscape, or just plain burn out. As you can see, none of these major reasons for selling puts you in a favorable negotiating position. As a general rule, the faster you want to disassociate yourself from your business, the more the buyer will want to deduct from his purchase price. Your desire to leave quickly is a red flag of risk to the new owner.
Your best outcome is to sell your business near the top and stay involved as an employee or consultant for a reasonable period. If you look at the transaction structures that are popular in the acquisition of closely held businesses, this approach makes a lot of sense. The more a business depends on the owner for its success, the greater the risk to the buyer. The greater the percentage of a selling company's projected earnings that is dependent on future new sales, the lower percentage of transaction value that the seller will receive as cash at closing. The greater the concentration of company sales to a small number of customers, the lower the price and the greater the earn-out component of transaction value.
Most privately held family businesses have one or a combination of these value detractors. Your selling strategy can mitigate the negative impact on selling price. By exiting before the necessity of exiting, your sales trajectory will more than likely be on the increase than on the decline. Buyers pay a premium for growth and discount for flat or falling sales. Unless your entire revenue stream is contractually committed over the next several years, most buyers will introduce an earn-out as a component of the total transaction value. This is a risk avoidance strategy that ties the total acquisition price to the future performance of the business post acquisition. It is also designed to keep the business seller engaged in the near term performance of the business.
In spite of the normal response from business sellers who want the entire sale price in cash at close, we believe that under the proper circumstances and properly memorialized in the definitive purchase agreement, earn-outs can be a big win for a seller. We normally try to tie the earn-out to future revenues of the acquired property. That is usually very easy to measure and to audit if necessary. Earn-outs based on future EBITDA or division profitability are more problematic because of the greater possibility for interpretation by the buyer. You all of a sudden get an accounting entry of corporate overhead in your financial reconciliation and your profit disappears.
Count on your original champion who negotiated your agreement not being involved by the end of the earn-out period. Make the agreement air tight in terms of how it is interpreted. A subtlety that we negotiated into an earn-out for a client was that the earn-out would be paid based on the greater of the sales price for the seller's product or 80% of list price, whichever was greater. You see, we can not control how the buyer runs the business once he has the keys, but we can control how the earn-out is calculated. This prevented the buying company using the seller's product as a loss leader in combination with their other products and shifting the revenue to other products at the seller's expense.
If you look at this preferred structure in conjunction with your sell now, exit later strategy, it can work in your favor. Wouldn't you want to be fully engaged and energized during your earn-out period and drive the value of the earn-out? As part of the new company, you now have 325 installed accounts instead of 25. Your sales force is now 25 strong compared to 2 sales people from your prior company. Your advertising budget is twenty times your old budget. You now have a network of 50 manufacturers reps supporting sales. Your new company's access to growth capital dwarfs what was available to your little company. Do you think you have an environment where you can achieve a sales growth far greater than what you could do on your own?
The key is to negotiate the earn-out that gets you to a transaction value comparable with an all cash at close offer that assumes your company sales grow at their historical rate.
For example, your offer if you back the buyer into the all cash at close offer is $5 million. Compare that to a deal that would provide you $3.5 million at close and another $1.5 million in earn-out if sales grew at 10% per year (your company's historical rate) for the next three years. Our contention is that the earn-out deal could be far superior. Given the much greater distribution power of the new owner, you could reasonably expect sales to jump by 25% per year, driving your earn-out to $2.5 million and resulting in a $1 million improvement in transaction value. You want to be fully engaged to achieve this result and that is exactly what the buyer wants.
As a business seller you have many factors that can greatly impact your selling price. Getting multiple buyers involved is probably number 1. A very close second, in the near term future is the timing of your sale. The economic trends are against you postponing the sale part of your exit. You can always sell now and retire later.
Hopefully, before selling a business, you meet with a CPA or tax accountant and get an estimate on how much of your proceeds will be going directly to Uncle Sam if you pay them in a lump sum at time of sale. You don't want to save this surprise for after all is said and done, because not only will it most likely be a shock, but you will have given up your chance to do anything about it.
Planning is everything. For this article I will assume you are not doing a 1031 business exchange, that is selling your business and buying another similar business taking into consideration all the IRS guidelines and timelines. It's pretty rare to see this, but it can defer all of your capital gains tax if done correctly. A 1031 Exchange is more commonly implemented with real estate.
Depending on how the business is sold, the gains may be taxed as long term capital gain, short term capital gain, ordinary income, etc. and if you are selling an asset in a C-Corp you may face double taxation. So, the idea is to minimize your tax bill and maximize your proceeds no matter what situation you are in.
One option is with a Self Directed Installment Sale. The structure must be in place before the buy/sell agreement is signed. The gist is to receive the sale proceeds in installments and only pay capital gains tax as you receive the income. This has the effect of allowing the majority of money you would have paid immediately in taxes to continue earning compounded interest for you for many years, thus increasing your bottom line by a significant amount.
The details are a bit too complex to fully outline in a short article, but both an LLC and a Trust are created for you and set up meet IRS criteria for favorable taxation of installment sales. Your asset gets transferred to the LLC prior to sale, and your buyer purchases from your LLC. The trust buys the shares of your LLC from you via an installment agreement and you pay taxes on your gain only as you receive the payments.
You, the seller, are able to control when the payments begin and how long they will be spread out. This allows for maximum flexibility to control your income, and plan for future tax savings as well. Since your buyer paid cash in exchange for your property, you are not dependent on them to make the installment payments and you have transferred the risk of refinance or default. This is done by using an independent third party administrator and your money is safely invested in a principle protected insurance product to be used solely for the purpose of paying the installments.
If you pass on before receiving all of the payments due, the remainder of the installment payments pass to the beneficiaries of your choice.
Seeing an example of a taxed sale vs. a Self Directed Installment Sale side by side will show you how much of a difference in overall return this strategy will provide. This can make the process of the sale more palatable and provide a dependable income stream for retirement.
The tax benefit of this approach is similar to your 401K or IRA account. You reduce your current income by the amount of your annual contribution and thus defer the tax you would have paid on that income amount. Those funds are invested in stocks and bonds and grow in value, sometimes dramatically, for the period before you retire and start taking distributions. When you start distributions, the amount is treated as ordinary income and you are taxed at your much lower (you are no longer working and earning a big salary) income tax rate at the time.
The Self Directed Installment Sale allows you to similarly defer your capital gains tax from the sale of your business. Instead of paying all of your capital gains at time of sale, you set up your SDIS to pay out your sale proceeds over time. If you pay all of your capital gains tax at time of sale, that money is gone forever. However, with this vehicle, you spread your receipt of the sales proceeds out over, 15 years for example. When you receive your distribution, you are then taxed for the portion of that distribution that is attributed to the capital gains - generally about 15%.
The difference in after tax proceeds are dramatic and are demonstrated by a complex analysis called an illustration. I will try in an abbreviated fashion, however, to demonstrate the potential impact. If you sold your business and you had a capital gain of $3.46 million, your lump sum capital gains tax payment at a 15% rate would be $519,000. In the SDIS you would keep the entire sale proceeds of $3.46 million and take distributions over a 20 year period or whatever period you chose. You receive an annual payment over 20 years, that would consist of 1/20 of the principal, 1/20 of the capital gains, plus investment returns.
If we did an illustration of this case and compared selling the business and paying all the capital gains up front and invested the remaining proceeds in a 6.85% compound growth portfolio versus the SDIS paying 1/20 of the capital gains annually, you would gain an $831,000 advantage in after tax proceeds. Not to bad for a little advanced planning.
Saturday, April 26, 2008
We normally achieve a better initial valuation from industry strategic buyers that build other synergy factors into their purchase valuation models. In this article we will present some situations where the private equity model is a superior solution for the business seller. We will also present, as one of my colleagues calls it, the "mathamagic" of a good private equity acquisition. Below are four scenarios where private equity may be the best solution.
A company in need of growth capital
A company where one partner wants to retire and sell and the other partner wants to continue to run the business for several more years
A business owner that has 85% or more of his net worth tied up in the business and is "business poor"
The business owner that is nearing retirement and wants to take some chips off the table from a position of strength
Before we explore these in greater detail, below are the general investment criteria for most private equity buyers:
Leading market share or Rapidly Growing Market
Established brands and/or strong customer relationships
Strong sales and distribution capabilities
Platforms with potential for expansion into new products, services and technologies
A minimum EBITDA level (private equity firm specific) – Small $2 million to $5 million, Medium $5 million to $10 million, and Large greater than $10 million
A minimum transaction size and equity investment level (private equity firm specific)
Management teams interested in retaining an ownership stake
A hypothetical transaction:
The business owner is 50 years old and has reached a crossroads point in his company. The business is doing $25 million in revenue and producing an EBITDA of $3 million. The owner is considering taking the company to the next level with either a major capital expenditure or a major expansion of his sales effort. However, he is at the point where he should be diversifying his assets and not plowing an even greater percentage of his net worth back into his business. He loves his business and is not ready to retire.
If he sells to a strategic buyer, for example, he may get a higher initial price. For this example, let's say that he can get $25 million from an industry strategic buyer. A private equity firm that specializes in his industry offers him a company valuation of $21 million and wants him to invest some of that equity back into the company and have he and his team remain on board to run the company. The "mathamagic" is as follows:
Sale price $21 million
Total debt used to fund the transaction (65%) $13.65 million
Total equity investment required $7.35 million
Private equity firm portion (70%) $5.145 million
Owner reinvestment portion (30%) $2.205 million
The beauty of this model for the owner is that the private equity firm welcomes the equity reinvestment by the seller at the same leverage that the PE firm employs. You might think that if the owner invested $2.205 million into a company valued at $21 million that his ownership percentage would be 10.5% ($2.205 million divided by $21 million). Because the PE firm relies on debt leverage, the owner gets to reinvest with his ownership equity on a par with the PE firm. Therefore, his $2.205 million represents 30% of the equity in this company and he now owns 30% of a $21 million company. One could argue that he really owns 30% of a $25 million company based on the strategic company valuation. The economics of the initial transaction are:
Company selling price $21 million
Owner equity reinvestment $2.205 million
Owner pre tax cash proceeds $18.795 million
Owner value creation
Value of 30% interest in $25 million company $7.5 million
Add cash proceeds from the sale $18.795 million
Total post sale value $26.295 million
Now let's look at how this can get really exciting. First, the owner has secured his family's financial future by taking the majority of his company value in cash allowing him to greatly diversify his asset portfolio. He still gets to run his company. He receives an industry standard compensation package with bonuses as an employee CEO.
He gets to retire in another five years, which was his original schedule, when the PE firm exits from their investment. Finally, he now has a deep pockets partner to actively pursue his growth strategy. With a private equity firm that specializes in his industry, this is very smart money. They leverage their industry contacts and industry expertise to expand markets and distribution.
They actively pursue tuck in acquisitions to add to the organic growth that they help orchestrate. For purposes of this example, we will assume that the PE group invites the previous owner to invest in these tuck in acquisitions at the same leverage so that his ownership is not diluted. Over the next 3 years they make several small acquisitions totaling $12 million and they employ the same 65% debt. The total equity requirement is $4.2 million. The previous owner reinvests $1.26 million to retain his 30% position.
Fast forward 2 more years (typically 5 year holding period) and the company is now at $100 million in revenue and is a valued target of a big strategic industry player. The PE firm sells the company for $225 million. Our owner's final cash out is valued at $67.5 million. Not a bad outcome for our business owner. Below is a more in depth look at the situations that this strategy can be successfully employed:
A company in need of growth capital – This is a cross roads decision for an owner. He recognizes the potential in his market, but in order to capture it, he must make a substantial investment back into the business either in the form of debt or his own capital. He determines that having a deep pockets partner with industry presence and momentum provides him a superior risk reward profile.
A company where one partner wants to retire and sell and the other partner wants to continue to run the business for several more years – often a successful business is run by two partners with a meaningful difference in age. One may be 65 years old and is a 70% owner in the business and the junior partner is 50 years old and a 30% owner. The senior partner decides that he wants to retire and wants the junior partner to buy him out. The junior partner does not have access to the capital required. Now he is faced with the company being sold to an industry buyer and he looses his desired management control and his normal retirement timeframe. This is an ideal situation for a PE group to acquire the senior partner's equity and retain the rest of the management to run and grow the business.
A business owner that has 85% or more of his net worth tied up in the business and is "business poor" – This is a fairly common situation and sometimes for marital harmony, the business owner decides to unlock the liquid wealth in his business. The spouse is often in competition for her mate's time with the mistress – translation the business that occupies 60 plus hours of his time per week and much of his thought outside of business hours. That is bad enough, but when every spare dollar is plowed back into the business to support his growth goals, that can be the breaking point. The conversation might be something like, "You keep telling me we are wealthy, so where is the vacation, the new house, the spending money we should have?" It just might be the right time to recognize your life's priorities.
The business owner that is nearing retirement and wants to take some chips off the table from a position of strength – I can not stress enough how important this can be to your family's financial future. You are 60 years old and you want to retire in five years. Your company is doing great and you still have the energy and desire to run your business. Why would you sell now? There are several compelling reasons.
This strategy requires the business owner to view the business sale and their retirement as separate, contingent events. One answer is to move up your sale time frame, but not necessarily your exit time frame. While this scenario may be difficult to envision at first, it can be very advantageous. Too many owners wait too long and end up selling because of a negative event like a health issue, loss of a major account, a shift in the competitive landscape, or family demands. So, the best decision is to sell your company to a PE group 5 years before you plan to retire, put the bulk of your net worth into a diversified portfolio of financial assets, and agree to run the company for the PE firm for five years.
An additional, unsettling factor for business owners contemplating retirement are potential changes to the tax code. Democratic party leaders, including the major presidential contenders, have put forward proposals to change the current tax structure. Business owners and other "wealthy" citizens should pay close attention. Most of the proposals would increase personal income tax rates and other forms of taxation.
For example, the current 15% tax rate on capital gains, previously scheduled to expire in 2008, has been extended through 2010 as a result of the Tax Reconciliation Act signed into law by President Bush in 2006. However, in 2011 this lower rate will revert to the rates in effect before 2003, which were generally 20%. It could potentially go higher, if the federal budget deficit worsens and Congress adopts a "tax the wealthy" philosophy. The 2 democratic candidates are in favor of a 25% or higher capital gains tax rate.
Finally, the baby boomer retirement issue presents another compelling reason to sell now and retire later. Experts project a doubling in the number of businesses that will hit the market looking for a buyer by 2009. According to the Federal Reserve, in 2001 50,000 businesses changed hands. That number rose to 350,000 in 2005 and is projected to increase to 750,000 by 2009.
As the overall population ages and sellers outnumber buyers, the laws of supply and demand point to an erosion in valuations for business sellers. At this point, the trend looks to be gradual. However, as we have seen recently in the prices of certain stocks and debt obligations, a "rush to the exits" can precipitate a sudden, calamitous drop in prices.
As I said at the beginning, I had a somewhat narrow view on selling businesses to private equity groups based strictly on the initial company valuation compared to potential strategic buyers. I am now enlightened and can more objectively view the potential outcomes for the business owner that encompass the owner's retirement time frames and risk reward profile. A private equity firm can provide an initial – secure your family's future - cash out. An industry specialized PE firm with a track record can provide, not just the first bite, but often a very exciting second bite of the apple when you exit together in five years.
Friday, March 21, 2008
The buyers, especially experienced buyers, know that one of the key mistakes is to underestimate the amount of time and effort it is to institutionalize this new business. It takes a good deal of time to transfer the intellectual capital from the target company to the buying company. Converting customer loyalty to the new entity is not an automatic. Meshing corporate cultures can be problematic and good employees may leave. The owner is almost always viewed by the buyer as a critical element to the future success of the new division.
How is this reflected in the transaction? If the buyer views the owner as the center of her company's universe, owning all the customer and supplier relationships, possessing all the intellectual capital, and taking on the identity of the company, the transaction will involve a large earn out over several years. If the owner has done a good job of developing a management team and has delegated herself out of day to day operations, then the cash at close will be much greater and the earn out period will be reduced.
A great deal of a buyer's due diligence will focus on the owner's current role in the business and her role post acquisition. Forgive me for a broad generalization, but most lower mid-market businesses we have worked with have an owner that is a passionate subject matter expert that started the business almost as an afterthought. They are not necessarily skilled as CEO's and really do not enjoy the administrative duties required to run a small business. One of the reasons they are selling is to remove themselves from that grind of administrative duties.
That is a great platform to present to the buyer. The buyer usually has the infrastructure to handle that and does it much better than the target company. They are buying the smaller company in order to leverage their assets and grow at a much more rapid pace than the smaller company could grow on their own. The buyer wants to remove all the barriers for their new subject matter expert, provide her additional resources and support, and let her do what she does best – sell her product or service.
As the business seller, if you take that message to the buyer, you will find that the buyer will feel more comfortable about the risk profile of the potential acquisition and you will get more favorable terms. Unfortunately, many times the seller over communicates how tired they are and how much they want to get away from the pressure cooker environment they currently have. We have literally watched this unfold in the most unfavorable way for our sellers. When this message comes out, the earn out period gets extended and the cash at close gets reduced. The more the seller wants to get away the greater the buyer's attempts to lock her up for an extended period.
The lesson here is that if you are a smaller mid-market company and you want to receive the maximum value for your business, count on staying involved for a reasonable period of time post acquisition to insure the success of the buyer's new division. The buyer will structure the transaction so that you do have a vested interest in this success. It is acceptable to the buyer that you do not enjoy the day to day duties of being a CEO. They are counting on that because they already are performing that function. You can proactively present your vision of your new role in a way that will be received very positively. I want to be the product evangelist. I want to be the promoter at industry events, speaking engagements, blogs, and industry publications. I want to focus on integrating the two companies and helping with the strategic plans. If you position it this way, the buyer will be more generous with the cash at close and will be less likely to try to lock you up for an extended earn out period.
Dave Kauppi is the editor of The Exit Strategist Newsletter, a Merger and Acquisition Advisor and President of MidMarket Capital, Inc. MMC is a private investment banking and business broker firm specializing in providing corporate finance and business intermediary services to entrepreneurs and middle market corporate clients in a variety of industries. The firm counsels clients in the areas of M&A and divestiture, family business succession planning, valuations, minority interest shareholder sales, business sales and business acquisition. Dave is a Certified Business Intermediary (CBI), a licensed business broker, and a member of IBBA (International Business Brokers Association) and the MBBI (Midwest Business Brokers and Intermediaries). Contact Dave Kauppi at (630) 325-0123, email firstname.lastname@example.org or visit our Web page http://www.midmarkcap.com/exit
Sunday, February 03, 2008
1. Customer Diversity If too much business is concentrated in too few of your customers, it is a negative in the acquisition market. If none of your customers accounts for more than 5% of total sales, that is a real plus. If you find yourself with a customer concentration issue, start focusing on a program to diversify.
2. Management Depth An acquirer will look at the quality of the management staff and employees as a major determinant in acquisition price. You should make the move of assigning your successor a year in advance of your scheduled departure date. If you have a strong management team in place, you should try to implement employment contracts, non-competes, and some form of phantom stock or equity participation plan to keep these stars involved through the transition.
3. Contractually Recurring Revenue All revenue dollars are not created equal. Revenue dollars from a contract for annual maintenance, annual licensing fees, a recurring retainer fee, technology license, etc. are much more powerful value drivers than projected sales revenue, time and materials revenue, or other non-recurring revenue streams.
4. Proprietary Products/Technology This is the area where the valuation rules do not necessarily apply. If strategic acquirers believe that a new technology can be acquired and integrated with their superior distribution channel, they may value your company on a post acquisition performance basis. The marketplace rewards effective innovation and yawns at commodity type products or services. Continue to look for ways to innovate in all facets of your business. If you create a technology advantage in your company, think what that could mean to a much larger company.
5. Penetration of Barriers to Entry In its simplest form, a large restaurant chain buys a small family owned restaurant to acquire a grand fathered liquor license. Owning hard to get permits, zoning, licenses, or regulatory approvals can be worth a great deal to the right buyer. The government market is extremely difficult to penetrate. If your product or service applies and you can break through the barriers, you become a more attractive acquisition candidate.
6. Effective Use of Professionals Reviewed or audited financials by a reputable CPA firm cast a positive halo on your business while at the same time reduce the buyer's perception of risk. A good outside attorney reduces the risk even more. A strong professional team is a great asset in growing your business and in helping you obtain maximum value when you exit.
7. Product/Sales Pipeline Smaller companies often are more agile and have better R&D efficiency than their high overhead big brothers. In technology, time to market is critical and big companies evaluate the build versus buy question. Small companies that develop new technology are faced with the decision of developing distribution internally or selling to a larger company with developed channels. A win/win scenario is to sell out at a price, in cash and stock at closing, that rewards the smaller company for what they have today, plus an earn out component tied to product revenues with the new company.
8. Product Diversity A smaller company that has a quality portfolio of products but may lack distribution can become a valuable asset in the hands of the strategic buyer. A narrow product set, however, increases risk and drives down value.
9. Industry Expertise and Exposure Encourage your staff to publish articles and to speak at industry events. Encourage local and industry reporters to use you as the voice of authority for industry issues. Your company is viewed in a more positive light, gets more business referrals, and an industry buyer will remember you favorably as an acquisition candidate.
10. Written Growth Plan Capture the opportunities available to your company in a two to five page written growth plan. What additional markets could we pursue? What additional products could we deliver to our same customers? What segments of our current market offer the most growth potential? Where are the best margins in our customer base and product set? Can we expand in those areas? Can we repurpose our products for different markets? Can we license our intellectual property? What about strategic alliances or cross marketing agreements? Documenting these opportunities can add to the purchase price.
When it comes to unlocking the market value of your privately held company, it is not limited to the bottom line. Profitability is hugely important, but the factors above can result in significant premiums over traditional valuation approaches. When you sell Microsoft stock, there is no room for interpretation about the market price. The market for privately held businesses is imprecise and illiquid. There is plenty of room for interpretation and the result for the best interpretation by the marketplace is a big pay off when you decide to sell.
Dave Kauppiis the editor of The Exit Strategist Newsletter, a Merger and Acquisition Advisor and President of MidMarket Capital, representing owners in the sale of privately held businesses. We provide Wall Street style investment banking services to lower mid market companies at a size appropriate fee structure.
To minimize future taxes and third party liabilities, the majority of buyers prefer to purchase selected assets of the seller rather than its stock. The total taxes associated with the asset sale of a C-Corp is typically more than 50% of the corporate gain (i.e. approximately 40% of the gain over the basis is taxed at the corporation's income tax rate. The gain often drives that corporate rate to the highest level because the gains are treated as ordinary income by the corporation. When the remaining funds in the C-Corp are distributed to the shareholders, they are taxed again at the individual shareholder's capital gains tax rate, normally 20%.
In many cases, C-Corp shareholders receive offers for asset rather than stock sales. Due to the huge tax implications discussed above, the sellers often reject an offer at current fair market value because the net after tax proceeds from the transaction is too low to meet their personal financial requirements. The C-Corp then asks for a higher price and negotiations stall.
How C-Corp Shareholders Can Increase Their Net Gain After Taxes
There is a solution to this dilemma that enables the shareholders of the C-Corporation to increase their net gain after taxes significantly from an asset sale. The following is a summary of how this strategy works.
C-Corp shareholders sell the operating assets of the Company to an asset Purchaser at the negotiated fair value. C-Corp shareholders leave the cash proceeds from the asset sale inside the Company. Then, C-Corp shareholders sell the stock of the Seller to another purchaser ("Stock Purchaser") in an independent transaction that does not involve the original Purchaser in any way.
In such a transaction, the Stock Purchaser pays the C-Corp shareholders cash upon closing of the stock sale and the Stock Purchaser assumes the ongoing liabilities of the Company, including the corporate tax liability (approximately 40% of the corporate gain) from the sale of the assets of the Company. The shareholders, relieved of the corporate gain liability, are now only responsible for paying the capital gains tax, approximately 20%, on the proceeds received from the Stock Purchaser from sale of the stock.
The transaction works because the Stock Purchaser is in a position to shield the gain from the asset sale with solution assets from other operations. Subsequent to the sale, the Stock Purchaser re-engineers the Seller into a new line of business that is expected to be profitable.
As the new owner of the Seller, the Stock Purchaser is responsible for running the Company on an ongoing basis and satisfying the current and future corporate tax liabilities of the Seller.
Here is an example of how it works:
Let's assume the corporate gain resulting from a C-Corp asset sale is $10M. The shareholders would typically net approximately $4.8M after taxes (in most states) after paying taxes on both the asset sale and the personal capital gains taxes upon distribution of sale proceeds. Utilizing the solution described above, the C-Corp shareholders could net as much as $6.4M after taxes. This represents a gain in take home cash of more than 30% as compared with the traditional asset sale scenario.
Saturday, January 12, 2008
We are often approached by business owners at a crossroads of taking the company to the next level. The decision in most cases is whether they should bring on the one or two hot shot sales people or channel development people necessary to bring the company sales to a level that will allow the company to reach critical mass. For a smaller company with sales below $5 million this can be a critical decision.
For frame of reference, prior to embarking on my merger and acquisition advisor career, I spent my prior 20 years in various sales capacities in primarily information technology and computer industry related companies from bag carrying salesman to district, regional, to national sales manager and finally Chief Marketing Officer. So when I look at a company, it is from the sales and marketing perspective first and foremost. I am sure that if I had a public accounting background, I would look at my clients through those lenses.
So with that backdrop, let's look at what might be a typical situation. The company is doing $3.5 million in sales, has a good group of loyal customers, produces a nice income for its owner or owners, and has a lot more potential for sales growth in the opinion of the owner. Some light bulb has been lit that suggests that they need to step this up to the next level after relying on word of mouth and the passion and energy of the owner to get to this stage.
I have either spoken with more than 30, primarily technology based companies over the years that have faced this exact situation and can count on one hand the ones that had a successful outcome. The natural inclination is to bite the bullet and bring on that expensive resource and hope your staff can keep up with the big influx of orders. The reality is that in most cases the execution was a very expensive failure. Below are several factors that you should consider when you are at this crossroads:
1. The 80 20 rule of salesmen. You know this one. 80% of sales are produced by 20% of the salespeople. If you are only hiring one or two, the likelihood is that you will not get a top performer.
2. The president of the company and decision maker has no sales background so the odds of him making the right hiring decision are greatly diminished. He will not understand how to properly set milestones, judge progress, evaluate performance objectively, or coach the new hire.
3. To hire a good salesman that can handle a complex sale requires a base salary and a draw for at least 6 months that puts him in a better economic condition than he was in on his last job. So you are probably looking at $150,000 annual run rate for a decent candidate.
4. If you have not had a formalized sales effort before, you are probably lacking the sales infrastructure that your new hire is used to. Proper contact management systems, customer and prospect databases, developed collateral materials and sales presentations, sales cycle timeframes and critical milestones and developed competition feature benefit matrixes will need to be developed.
5. Current customers are most likely the early adapters, risk takers, pioneers, etc. and are not afraid of making the buying decision with a small more risky company. These early adaptors, however, are not viewed as good references for the more conservative majority that needs the security of a big company backing their product selection decision.
6. Your new hire is most likely someone that came from a bigger company in your industry and may be comfortable performing in an established sales department. It is the rare salesman that can transform from that environment to developing the environment while trying to meet a sales quota. Throw on top of that the objection that he has never had to deal with before, the small company risk factor, and the odds of success diminish. Finally, this transformation from a core group of early adapters to now selling to the conservative majority elongates the sales cycle by 25% to as much as double his prior experience. If you don't fire him first, he will probably quit when his draw runs out.
With all this going against the business owner, most of them go ahead and make the hire and then I hear something like this, "Yes, we brought on a sales guy two years ago who said he had all the industry contacts and in nine months after he hadn't sold a thing and cost us a lot of money, we fired him. That really hurt the company and we have just now recovered. We won't do that again."
What are the alternatives? Certainly strategic alliances, channel partnerships, value added resellers are options, but again the success rate for these arrangements are suspect without the sales background in the executive suite. A lower risk approach is to outsource your VP of Sales or Chief Marketing Officer function. There are a number of highly experienced and talented free lancers that you can hire on a consulting basis that can help you establish a sales and marketing infrastructure and guide you through the staffing process. That may be the best way to go.
An option that one of our clients chose when faced with the six points to consider from above was to sell his company. This is a very difficult decision for an entrepreneur who by nature is very optimistic about the future and feels like he can clear any hurdle. This client had no sales background but was a very smart subject matter expert with an outstanding background as a former consultant with a Big 5 accounting firm. He did not make the hiring mistake, but instead went the outsourcing of VP of Sales function as step 1. When their firm wanted to make the transition from the early adapters to the conservative majority, the sales cycle slowed to a crawl. Meanwhile their technology advantage was being eroded by a well funded venture backed competitor that had struck an alliance with a big vendor.
They engaged our firm to find them a buyer, but then we encountered the valuation gap. Our business seller thought his company was worth a great deal and that he should be paid with cash at close for all the future potential his product could deliver. The buyer, on the other hand, wanted to pay based on a trailing twelve months historical perspective and if anything was paid for potential, that would be in the form of an earn out based on post acquisition sales performance.
With a well structured earn out agreement and the right buyer, our client will reach his transaction value goals. His earn out is based on future sales, but his effective sales force has been increased from one (himself) to 27 reps. His install base has been increased from 14 to 800. Every one of the buyers current customers is a candidate for this product. The small company risk has been removed going from a little known start-up with $500 K in revenues to a well known industry player, publicly traded stock with a market cap of $2.5 billion.
He avoided the big cash drain that a bad sales person hiring decision would have created and he sold his company before a competitor dominated the market and made his technology irrelevant and of minimal value.
My professional contacts sometimes tease me and suggest that I think every company should be sold. That may be a slight exaggeration, but in many instances, a company sale is the best route. When a business owner is faced with that crossroads decision of bringing on a significant sales resource that will be faced with a complex sale and the executive suite does not have the sales background, a company sale may be the best outcome.
is a Merger and Acquisition Advisor and President of MidMarket Capital, representing owners in the sale of privately held businesses. We provide Wall Street style investment banking services to lower mid market companies at a size appropriate fee structure.