Monday, March 09, 2009

Sell or Keep Your Business - The Numbers May Surprise You

Many business owners simply are too emotionally tied to their businesses to analyze it the way they would another investment. This post provides a framework that a business owner can use to dispassionately examine the cost / benefit of owning his business.

In our Merger and Acquisition practice we watch as business buyers go through an exhaustive analysis to determine if it is financially prudent to make a particular company acquisition. Some use EBITDA multiples or free cash flow multiples. Others use the classic discounted cash flow approach while another group might look at a payback period analysis or debt coverage ratios. They all have one thing in common, however. They do a financial analysis as the primary determinant in making a decision to buy or not to buy.

It occurred to me that a business owner, not necessarily a business seller, should do his own financial analysis to determine if he is better off owning the business or selling it. In other words, will a business owner make more money by selling the business and replacing his business salary and dividends with the investment income he would earn by investing the business sale proceeds?

Owner A Owner B Owner C
Owner Comp $137,500 $578,490 $800,000
Sale Price($000) $4,400 $17,600 $26,000
Tax & Fees($000) ($1,100) ($4,400) ($6,500)
Net Proceeds($000) $3,300 $13,200 $19,500
Investment Income $214,500 $858,000 $1,267,500
Gain (Loss)*** $77,000 $279,510 $467,500

*Representative examples for Illustration purposes
**Proceeds invested @ 6.5%
***Calculated as Income from Investments less Income from Compensation

When you look at it using this analytical discipline, it puts things into a whole new perspective. Now let's add another factor to make the analysis even more interesting. When a business valuation firm performs a discounted cash flow analysis to value a business, they typically take the projected cash flows for ten years and discount those cash flows to today's value using a risk adjusted discount factor.

They are attempting to calculate a terminal value which is the value of ten years of cash flow discounted to present value. For a small privately held company those discount factors typically are in the 20% to 25% range. The effective discount rate used in this terminal value calculation is the 20%-25% rate less the company's growth rate.

So for example, if the company growth rate was 5% and you used the 20% risk adjusted rate, your discount rate would be 20% minus 5% or 15%. This says that $1 of cash flow received after 1 year = 87 cents today. That $1 received after 2 years is worth 76 cents, and so on.
This is the same principal used in pricing corporate bonds. AT&T might carry a rate on their 30 year bond of 5% as a triple A credit. Acme Electric, a BBB rated credit, might carry a rate of 16%. This adjusts the rate of return based on the risk of possible default and compensates an investor for taking additional risk.

Back to our privately held company and the risk adjusted discount rate. What this 20% - 25% rate is telling us from a strictly unemotional, analytical standpoint is that future cash flows from a small business are considered quite a risky proposition.

Please refer back to the chart and look at Company C as an example. The owner is taking $800,000 per year out of the business. Why would anyone in their right mind sell this company and walk away from this golden goose? Similar companies in his industry with similar financial performance are selling for $26 million. When this company is sold, the owner will pay a total of $6.5 million in taxes and professional fees. His net cash proceeds are $19.5 million. Investing $19.5 million in a balanced portfolio returning 6.5% annually will provide the former owner $1,267,500 in investment income.

Compare this to the $800,000 that the owner takes home from his business annually and it shows that the owner is actually paying $467,500 for the privilege of running his company.
Of course the owner receives a great deal of satisfaction and psychic benefit from running this very successful business. One can not overlook the pride of ownership and accomplishment, prestige in the community, and the purpose and meaning in his life that business ownership provides. It is very difficult to try to attach a dollar value to that.

With an extra $467,500 of annual cash flow and an extra 50 hours per week many owners could find other equally rewarding activities like philanthropy and charity work, travel, family and friends, or pursuing the career they would want if money were not a concern. Owning a business has many rewards and it is often difficult for an owner to objectively step back and look at his ownership in a totally analytical way. With the number of businesses that we have represented for sale after a significant negative event, however, this kind of thinking would have been quite useful when they were still on top.

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, March 01, 2009

Selling a Business - New Rules for Merger and Acquisition Success

In today's environment the methods that middle market M&A firms used to complete business sale transactions no longer work. This post discusses the new approach necessary to get the visibility necessary to complete the sale of a privately held business.

If you are a business owner considering selling your business, most likely you will interview several business brokers or merger and acquisition advisors. In the process you might hear, "We have lists of qualified buyers." Some potential business sellers find this phrase almost hypnotic. It congers visions of this group of well funded, anxious buyers who can't wait to pay a generous price the moment they are made aware of this great opportunity.

For the larger business owners that are interviewing M&A firms, this "qualified buyers" claim deserves a careful investigation. These M&A firms have lists of hundreds of private equity firms with their buying criteria, business size requirements, minimum revenue and EBITDA levels and industry preferences. All M&A firms have pretty much the same list. There are subscription databases available to anyone. The better M&A firms have refined these lists and entered them into a good contact management system so they are more easily searchable.

The approach these M&A firms with these Private Equity lists employ is to blast an email profile to their list and if they get an immediate and robust response, they will focus on the deal and work the deal. What happens to the 90% of sale transactions that clearly do not fit either the minimum EBITDA and revenue requirements or the conservative valuations of this group of buyers?

Those deals requiring contact with strategic industry buyers usually go into dormant status. They will not be actively worked, but will occasionally be presented in another email campaign, mail campaign or at a private equity deal mart (industry meeting where many M&A firms present their clients to several PEG's).

For the business owner that has paid a substantial up front engagement fee or healthy monthly fees, this is not what you had in mind. The way to get a business sold is to reach the strategic industry buyers. That is not easy. Presidents of companies (the buyer decision maker) do not open mail from an unknown party. So, mailings do not work. Let me repeat that. In a merger and acquisition transaction, mailings do not work.

Presidents of companies do everything possible to keep their email addresses confidential, so email blasts on a broad scale are not possible. Telemarketers are not skilled enough to pass through the voice mail and assistant screening gauntlet. If you have ever tried to present an acquisition opportunity to IBM, Microsoft, Google, Hewlett-Packard or Apple, let's just say it would be easier to get into a castle with a moat full of alligators.

The investment bankers from Morgan Stanley or Goldman Sachs can generally get an audience with any major CEO. However, the fees they charge limit their clientele to businesses with north of $1 billion in revenues. So how do $15 million in revenue businesses get sold? You need to locate a boutique M&A firm that will provide a Wall Street style, active selling process at a size appropriate fee structure.

What does this mean? The approach that consistently produces a high percentage of completed transactions is the most labor intensive and costs the most to deliver. It is an old fashioned, IBM, dialing for dollars effort, starting at the presidential level of the targeted strategic buyers. It usually takes ten phone dials and a great deal of finesse to penetrate the gauntlet and get a forty five second credibility opportunity with the right contact.

If you are able to pass that test and establish their interest, you ask them for their email address so you can send them the blind profile (two page business summary without the company identity) and confidentiality agreement. This is a qualifying test. The president will not give you their email address unless they are serious about the company you have described for sale. If the president is not the appropriate contact, his assistant will generally direct you to the correct party. When that happens, we update our contact management database with this information so on the next M&A engagement we go directly to the proper contact.

Our first engagement in an industry requires a great deal of this discovery process. With each subsequent engagement in an industry, we become increasingly efficient and improve our credibility and brand awareness. There is generally an advantage to engaging an M&A firm that has experience in your industry. After several transactions in a niche, we become that more efficient and effective. Our list truly becomes a list of "qualified buyers."
For example, by our fourth engagement in healthcare information technology, we know the specialty of the top 300 players, we know the lead on M&A deals, we know his direct dial number, email address, and most importantly he knows us.

So, on engagement four in XYZ industry, we put together the blind profile and confidentiality agreement. We get our seller client to approve our list of targeted buyer prospects. We generate our daily hot list of the 20 contacts we will call. We either talk with them directly of leave a voice mail asking them to watch their email for our acquisition opportunity. Our open rates and response rates go up by a factor of 10 X with this labor intensive approach.
Having credibility and brand awareness in an industry helps because we ask them in the email to reply back if they are not interested. We can then update their status on this deal and not continue to try to contact them.

When they are interested, they sign and return the confidentiality agreement. We then email them the Confidential Acquisition Memorandum (the Book). We enter a hot list follow-up in 5 business days. If they remain interested, they will generally have a list of questions they send us. We work with our clients to provide a written response and update the memorandum with a fluid FAQ section that is constantly updated with each interested buyer. This saves us and our clients a great deal of time answering questions only one time.

We have incorporated our FAQ list into our marketing process very effectively. Any time we provide a written response to a buyer, we update the book and we update a stand-alone FAQ document. This FAQ document contains all the questions in date order from all of the buyers. Every time we update the list with new questions, we send it out to every buyer that has previously executed the confidentiality agreement.

Here is our not so subtle message to the buyers, "You are not the only buyer involved in this process." The impact is amazing. The buyers behave much better and they move the process forward at a better pace than they normally would.

Once a buyer's questions are answered, we usually arrange a conference call and Web Demo if appropriate. If the buyer remains interested, we then arrange a buyer visit. This is prepared with the seller as we coach him on what questions to expect and what message he needs to convey.

We also carefully orchestrate the rules and regulations of the visit with both buyer and seller including the visit premise so the employees do not get worried or suspicious. It could be a new banking relationship, an insurance company, or a strategic alliance.

If the buyer remains interested, they may ask for some much more detailed information. At a certain point we have to draw the line on information flow and push for a qualified letter of intent, LOI. In general a LOI says that if we carefully examine your books and records in a due diligence process and confirm everything you have told us so far and discover no materially adverse items, we will pay you $xx for your company with these deal terms and this transaction structure.

In return for that, the buyer will usually require a quiet period. That means that for the due diligence period – usually 30 to 60 days, the M&A advisors are precluded from shopping the deal any further to other potential buyers. This is also called a standstill. If the due diligence is completed without major incident, the buyer's team starts preparing the definitive purchase agreement.

Buyers will often try to misbehave during this process and attack the transaction value with each little nit they uncover. Because we have provided ample reminders to the buyer that there are other interested and qualified buyers involved (remember the FAQ's), we generally are able to discourage this costly behavior.

Once the due diligence is completed, the buyer's team starts preparing the definitive purchase agreement. This is quite detailed and restates the deal terms and conditions and surrounds that with pages of reps and warranties. The business people refine and negotiate the business points while the respective legal teams negotiate the legal points. If there is an impasse, the top business person on each side generally attempts to balance the risk reward legal issue with sound business judgment.

We are almost there. A closing date is set and the parties usually convene in the conference room of the buyer's or seller's outside counsel. The stacks of contracts are reviewed one final time by counsel and the signors walk around the table, adding their signatures. The banker is called and the order is given, "wire the funds." Mission accomplished.

As a business seller, you must recognize that a business sale is a very difficult process. The closing ratios for many of the bigger middle market firms is well below 50%. Our feeling is that the more passive mailing campaign, Private Equity email blast, approach is simply a model that no longer works in this busy, information overload world of the large company CEO.
Think about Oracle trying to sell a $500,000 software project to Fortune 500 companies with a mailing. What about IBM selling a large company on a 10-year $150 million data center outsourcing project with an email blast?

This sounds pretty silly when you think of it. Of course they do not do that. They have highly trained, highly compensated, and highly skilled salesmen that call at the highest levels of corporate America and present the strategic case for their complex and expensive offering. These companies are the best at what they do and understand what it takes to maximize their performance. With a business sale, you have the same type of highly complex, strategic, and expensive proposition. What makes you think that your business sale will be accomplished by any other process than a direct sales approach by highly trained M&A professionals calling on the presidents of the buying companies?

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

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