Thursday, August 25, 2016

Selling Your Business - Beware of the Tire Kicker

If you are approached by an unsolicited offer to buy your company, you might think this a good thing. If not handled properly, it could be a real drain on your company's performance. We are often contacted by a business owner after he has been approached by a buyer. He wants information from us on the merger and acquisition process, which we are happy to provide. He wants to wait, however, to engage our firm to sell his company  "until this situation with the buyer plays itself out."

The Single Buyer's Game Plan

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 drain your time, resources, 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.

I recently read a great article from a UK Business Advisor, Clinton Lee, that takes a little different but equally cautionary view of this Tire Kicker.

Once You Pin Them Down

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.  A second potential outcome is that when the offer does come, the owner doesn't know if it is a good or bad offer. Finally, once the buyer has tied up the owner with the LOI, he then proceeds to attack transaction value through every step of due diligence. He is the only suitor so there is nothing to stop bad behavior.

This is so costly to the business owner. Many owners repeat this process several times before they acknowledge the damage being done to their business. When they do eventually hire a merger and acquisition firm or a business broker, the company value has eroded substantially.

Even though we have watched this situation unfold from a distance many times, we have been frustrated by our lack of success in changing the owner's incurable optimism about this buyer.  Being the deal guys that we are, we needed to come up with a creative solution and a deal structure to move the business owner toward a better outcome. If we feel so strongly that this buyer will not be the actual buyer in the end, we should be willing to "carve out" that buyer in the form of a discounted success fee.

Put the Buyer into a Competitive Bid Situation

By George, that's it! If an owner has an identified buyer, we can incorporate a sliding scale discount on the success fee over time if this identified buyer becomes the actual buyer. If he becomes the actual buyer very quickly the discount is big. If the deal closes after five months of our M&A work, the discount has slid to zero because we have thrown him into the mix with several other qualified buyers and his offer will have been leveraged higher by 25% or more.

The benefits to the business owner with this approach are meaningful. First, if this is that rare occurrence of a legitimate buyer with a legitimate offer, the owner will not pay a big success fee for a small amount of work. Secondly, the owner can turn the burden of the process over to the M&A firm, freeing him up to successfully run his business during the process. Next, we end the endless, resource draining, tire kicking that erodes business value. Finally, by changing this from an auction of one to a truly competitive bidding situation involving the universe of qualified buyers, the owner will have no doubt that he got the best the market had to offer for his business.

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

Friday, August 12, 2016

Do You Know What Your Company is Worth?

Good insights from John Carvalho from Divestopedia

Do you know the value of your business? When I asked this question to business owners in attendance at a presentation I recently delivered, I was not surprised the majority weren’t 100 percent sure. Why should they care about value? No one ever asks for it. Banks, shareholders and government agencies never ask private business owners what their company is worth.
In reality, though, there are a lot of different stakeholders valuing your business every day, such as your employees, other banks, investors and customers. I would venture to guess that that alone should be a good enough reason to care about value.

What Buyers Look for in a Business

I recently found myself watching NBC’s "Shark Tank," where aspiring entrepreneurs pitch their business concepts and products to a panel of business moguls who have the cash and the know-how to make it happen. Hands down, the fastest way to get thrown out of the tank is to have an unrealistic valuation of your business.

So, think about it this way: If you had your eye on an acquisition, what would you look for? Putting yourself in a buyer's shoes is a great exercise to temper valuation expectations. I bet you would be looking for things like a diversified customer base, a systematic way of generating recurring revenue, barriers to entry from competitors and high margins, to name a few. So, be honest: Does your company have these characteristics?

Great Companies Drive Value

If building a company was a sport, the value of the company would be how we keep score. Jim Collins, author of "Good to Great," identified elite companies that have made the leap from good to great. Companies that make the leap were defined as meeting the following criteria:
  • 15-year cumulative stock returns at or below the general stock market
  • Followed by a transition point
  • Then cumulative returns of at least three times the market value over the next 15 years
What this suggests is that measuring corporate value is a key tool in tracking a company’s transition from good to great.

The Benefits of Regularly Updated Business Valuations

For me, the same question always come to mind: Why haven’t valuations become more commonly adopted as a strategic planning tool for private businesses? Every year, companies engage accounting firms to audit, review or compile their books. This requirement is driven by banks, tax authorities and others that require financial statements verified by an independent third party. I truly believe that an annual valuation would provide most business owners with more insight into their company than audited financial statements.

As I see it, the benefits of using periodic business valuations as a strategic planning tool are:
  • Business valuation provides business owners with a quantitative measure of the corporate value created through the execution of a strategic plan.
  • Frequent business valuations will give owners a better understanding of which financial levers they can pull to drive the value of their business.
  • Like in "Shark Tank," knowing the value of the business gives owners increased credibility with potential investors and lenders.

A Better Valuation Tool

Here are my thoughts on a better valuation model compared to traditional valuations currently offered by most advisors:

Traditional Valuation:
  • Based primarily on financial information;
  • Only provides a value of the business at one point in time;
  • Limited recommendations on how to increase value; and
  • Engagement is over once a value is determined.
A Better Valuation Model:
  • Digs deeper into key market and operational value drivers of the business;
  • Current valuation sets a benchmark and provides a comparison to where you want to be;
  • Provides a clear understanding of strengths and weaknesses in the business, plus recommendations on how to improve; and
  • Determining the value of the business is just the beginning. The engagement provides constant monitoring and measurement of value to help business owners achieve wealth creation goals.
So, my question to you, private business owner, is a crucial one: How can you know if you are moving toward greatness if you don’t know or frequently measure the worth of your business?

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

Thursday, July 28, 2016

Most Business Owners Have a Serious Asset Allocation Issue

If several market meltdowns have taught us anything it is to make sure you are diversified over several investments and asset classes. Would your financial advisor recommend that you put 80% or more of your assets into a single investment? Of course not, but a large percentage of business owners actually have that level of concentration. 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, it is time to recognize the importance of planning for your business exit or business sale. It is time to move your thinking about your business from the method to provide income to your family and start thinking about it in terms of wealth maximization.  Above is a graphical comparison between a business owner and another high net worth individual. 

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. 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.

There are many complex issues involved in a business transition or a business sale. Poor decisions at this critical time can result in swings of hundreds of thousands or even millions of dollars. If you can take away one thing from this, it would be to actively get out in front of the process with your professional advisors. This decision and how it is executed will be the single most impactful event in your family’s financial future. You should consider 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 maximization strategies, position the company for sale, and create a soft auction of multiple buyers to maximize selling price and terms.
 As business owners approach retirement, they often seek help with investment decisions that employ sound diversification and liquidity strategies. Your business is generally the largest, most illiquid, and most risky investment in your total wealth portfolio. Your successful business exit should be executed with the same diligence, knowledge, experience and skill that you have regularly applied to the organizing, running and building your business.
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

Tuesday, July 26, 2016

During Due Diligence What's Good for the Goose is Good for the Gander

One of the things I like best about representing small business owners as an M&A Advisor is that no two days are the same. Yes, deals have common elements, but it is those unique details at the margin that must be handled on the fly that can mean the difference between success and failure. To prepare our clients for those 80% deal elements in common we have written articles on each stage of the process and we review those articles with our client prior to the stage. So for example we will review the most commonly asked questions from buyers on conference calls and we will role play with our clients on answering these questions.

If the client knows what to expect prior to the stage, any bump in the road does not turn into a deal threatening event. We try to manage and control what we can, but more often than not something new surfaces that is new to our experience. How those surprises are handled often can be the difference between closing and the deal blowing up. In a recent transaction that we completed, we had one of those first time surprises. Luckily we were able to get past it and improve our preparation for the next deal and as an added bonus, resulted in this article.

Due diligence was coming to a satisfactory close and the definitive purchase agreements, seller notes, and employment contracts were moving through the process without a hitch. We were set to close on April 30 and ten days prior to closing the buyer said, we just want to see your closing numbers through April, so let's move the closing back 5 days. What were we going to do tell them no? I said, well you have already completed due diligence, are you concerned about the April numbers? He said, no, we just want to make sure everything is on track.

My radar went off and I thought about all of the events external to our deal that could cause the deal not to  close.  How many deals failed to close, for example, that were on the table during the stock market crash of 1987? The second part of my radar said that we needed to be prepared to defend transaction value one final time. I suggested he bring in his outside accountant to help us analyze such things as sales versus projections, gross margins, deal pipeline, revenue run rate, etc. We were going to be prepared. We knew that if things looked worse, the buyer was going to request an adjustment.

Now here comes the surprise. The outside accountant discovered that there was a revenue recognition issue and our client had actually understated profitability by a meaningful amount. This was discovered after the originally scheduled closing date and it meant that the buyer had based his purchase price on an EBITDA number that was too low. Easy deal, right? We just take his transaction value for the original deal and the EBITDA number he used and calculated an EBITDA multiple. We then applied that multiple to our new EBITDA and we get our new and improved purchase price.

I knew that this would not be well received by our buyer and counseled our client accordingly. He instructed me to raise our price. The good news is that we had a very good relationship with the buyer and he did not end discussions. He reminded us that he had earlier given in to a concession that we had asked for and we added a couple of other favorable deal points, but he did not move his purchase number.

We huddled with our client and had a serious pros and cons discussion. He did recognize that we had fought hard to improve his transaction. He also recognized that the buyer had drawn his line in the sand and would walk away. The risk that we discussed with our client was that if we returned to market, that would delay his pay day by minimum of 90 days. Also we pointed out that the market does not care why a deal blows up. When you return to the market, the stigma is that some negative surprise happened during due diligence and the new potential buyers will apply that risk discount to their offers.
Our client did agree to do the deal and is very optimistic about the company moving forward with a great partner.

In a post deal debrief with our client I told him that had I to do it again, what I should have said when the buyer requested the delayed closing is, "We know that if you find something negative, you are going to ask for a price adjustment. If we discover something positive will we be able to get a correspondingly positive adjustment. What is he going to say to that?

In reflecting on this situation, I wanted to use my learning to improve our process and I believe that I have come up with the strategy. In our very next deal I incorporated our new strategy. We got several offers with transaction value, cash at close, earnout, seller note and net working capital defined. In our counter proposals  we are now proposing the following language:

We propose to pay a multiple of 4.43 times the trailing twelve month (ending in the last full
month prior to the month of closing) Adjusted EBITDA, which using full year 2015 Adjusted
EBITDA of approximately $1,000,000 results in a valuation of $4,430,000. Adjusted EBITDA for the purposes of this determination will be defined as Net Income plus any One-time professional fees associated with this business sale (currently $42,000 for investment banker fees additional legal and accounting services).

What we are accomplishing with this language is that if the price can go down during the due diligence process, then the price can go up during the process. Why not formalize it because we know that in 99 times out of 100, if the company performance goes down from where it was when the bid was submitted, an adjustment will be applied by the buyer.  If the seller does not relent, the buyer will walk away.  The unwritten buyer's rule is that the price can only go down during due diligence. We are out to change that one-sided approach and even the playing field for our sell side clients.

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

When You Sell Your Business Owner Perks Disappear

When representing business sellers it is important to recognize that this is usually their first and only experience in selling their business. No matter how smart they are, there is no replacement for experience in this complex process.  Also, any mistakes made during this process are usually very expensive, time consuming or both.  Finally, it is usually an emotional roller coaster for the owner - Am I doing the right thing? is this the right time?  What is going to happen to my employees and my customers? Is this the right buyer? Are these the best price and terms I can get?

Because this process is so foreign and the emotions run so high, a seemingly simple action on the part of the buyer, if not anticipated and not prepared for, could disrupt or even blow up a mutually beneficial transaction. If our client gets surprised by a deal event and that event does  some damage, I take that on as my responsibility. It takes only one deal to blow up to turn you into a serial client preparer.

To improve our odds of deal completion and success we make sure our clients are prepared for each stage of the deal, from  the number one question - why are you selling,  to the conference calls, corporate visits, frequently asked questions, letters of intent, buyer negotiations tactics, post closing adjustments, etc. The way we do this is every time we encounter something during a deal that our client should be prepared for or could cause an issue if not properly handled, we write a short article about it.

Then when we are coming up on a particular deal element or deal stage, we send our client the article to read and then we discuss it with them. This is, very importantly, not reacting to the emotions during the heat of battle, but more like a run through practice prior to the big game.  The team usually does better if they are prepared for the fake punt rather than experiencing it with the score tied with two minutes to go in the fourth quarter. So our dry run is done with no pressure, prior to the event, and most importantly,  with emotions in check.

Just when I think that I have seen all the "gotchas" there are after fifteen years of grinding out deals, and that my article library was complete, we had a new issue come up which caused several hours of nervousness within the seller's team and the buyer's team.

We had all of the major deal terms worked out and detailed in a very comprehensive Letter of Intent and were requesting that the partner sellers countersign it to agree to go into quiet period and buyer due diligence.

One of the partners was completely on board but the other could not get his head around not retaining all of his owner perks - company lease on a luxury vehicle, fully paid cell phone, home internet service and a few others. For his future employment with the new company those would be handled at a much less generous and customary employee expense treatment.

I was a little taken aback by this and my first thought was, "is this guy going to blow up a deal for what amounts to less than one half of 1% of deal value? Then I remembered why we have written all of these articles. In the heat of battle, this guy was dealing with all of the emotions of turning his clients, employees, and even a good part of his identity for the past decade, over to a new caretaker. I really could not blame him for not displaying some good old fashioned emotionally detached logical thinking. What I had to do was to step back and see if I could provide some solid logic so that he would get beyond this potential  deal breaker(while I was talking myself off the ledge as well).

It went something like this. Bill, remember in the memorandum we made all of those adjustments to remove owner perks from your financials and applied those adjustments to increase your EBITDA. Well those were very powerful because the buyer looked at those expenses as being eliminated after he owned the company and when he applied his 5X multiple your adjusted EBITDA, it  resulted in an increase in your sales price of 5 times your eliminated expenses. Now if you want the buyer to incur those expenses once he owns the company,  will  you be happy with an adjusted purchase price reduced by 5 X those expenses?  Believe me, you are much better off with multiplying the perks  by 5 and receiving that bump in transaction value.

It was beautiful, logical, insightful, but at the end of the day, his partner convinced him to take the deal.

Well, at least I have another article, a little more wisdom, a couple of more gray hairs, and can prevent this from happening on the next deal.

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, July 11, 2016

11 Reasons to Use Earnouts in the Sale of Your Company (Part 2)

Here are the final five of 11 reasons earnouts should be considered when selling your technology (or other) company from our article published in Divestopedia

In part one, I listed six out of the 11 reasons why a technology (or other) business owner should consider an earnout as part of his/her sale transaction structure: 1) earnouts offset your historic small sales; 2) buyers' multiples are at pre-1992 levels (and the implications of such); 3) investors' skepticism tends toward a better price for you with an earnout; 4) buyers like sellers willing to share post-closing risk; 5) getting part of a watermelon is better than all of a grape (and what I mean by that); and 6) there is a guaranteed multiple with an earnout. Here are the final five reasons to consider an earnout:

#7 Earnouts More Attractive to Buyers Who Need Their Cash

Strategic corporate buyers are reluctant to use their devalued stock as the currency of choice for acquisitions. Their preferred currency is cash. By agreeing to an earnout, you give the buyer’s cash more velocity (ability to make more acquisitions with their cash) and, therefore, become a more attractive candidate with the ability to ask for greater compensation in the future.

#8 Earnouts Help Break Negotiations Impasse

The market is starting to turn positive which reawakens sellers’ dreams of bubble-type multiples. The buyers are looking back to the historical norm or pre-bubble pricing. The seller believes that this market deserves a premium and the buyers have raised their standards, thus hindering negotiations. An earnout is a way to break this impasse. The seller moves the total selling price up. The buyer stays within their guidelines while potentially paying for the earnout premium with dollars that are the result of additional earnings from the new acquisition.

#9 Improving Markets Support Hitting Your Earnout Targets

The improving market provides both the seller and the buyer growth leverage. When negotiating the earnout component, buyers will be very generous in future compensation if the acquired company exceeds their projections. Projections that look very aggressive for the seller with their pre-merger resources, suddenly become quite attainable as part of a new company entering a period of growth.
An example might look like this: Oracle acquires a small software company, Company B, that has developed Oracle conversion and integration software tools. Last year, Company B had sales of $8 million and EBITDA of $1 million. Company B had grown by 20% per year. The purchase transaction was structured to provide Company B $8 million of Oracle stock and $2 million cash at close plus an earnout that would pay Company B a percentage of $1 million a year for the next three years based on their achieving a 30% compound growth rate in sales. If Company B hit sales of $10.4, $13.52, and $17.58 million, respectively, for the next three years, they would collect another $3 million in transaction value. The seller now expands his/her client base from 200 to 100,000 installed accounts and his/her sales force from 4 to 5,000. Those targets should be very easy to hit. Let's assume that through synergies, the buyer improves net margins to 20% of sales and the acquisition produces $2.08, $2.70, and $3.52 million of additional profits, respectively. They easily finance the earnout with extra profit.

#10 Earnouts Get You Compensated Before Window of Opportunity Closes

The window of opportunity in the technology area opens and closes very quickly. An earnout structure can allow both the buyer and seller to benefit. If the smaller company has developed a winning technology, they usually have a short period of time to establish a lead in the market. If they are addressing a compelling technology gap, the odds are that companies both large and small are developing their own solution simultaneously. The seller wants to develop the potential of the product to put up sales numbers in order to drive up the company’s selling price. They do not have the distribution channels, the time, or other resources to compete with a larger company with a similar solution looking to establish the industry standard.
A larger acquiring company recognizes this first-mover advantage and is willing to pay a buy versus build premium to reduce their time to market. The seller wants a large premium while the buyer is not willing to pay full value for projections with stock and cash at close. The solution: an earnout for the seller that handsomely rewards him/her for meeting those projections. He/she gets the resources and distribution capability of the buyer so the product can reach standard setting critical mass before another large company can knock it off. The buyer gets to market quicker and achieves first-mover advantage while incurring only a portion of the risk of new product development and introduction.

#11 Earnouts Can Save You Tax Dollars

You never can forget about taxes. Earnouts provide a vehicle to defer and reduce the seller’s tax liability. Be sure to discuss your potential deal structure and tax consequences with your advisors before final negotiations begin. A properly structured earnout could save you significant tax dollars.

Reasonable Earnouts Significantly Improve Your Transaction Value

Smaller technology companies have many characteristics that make them good candidates for earnouts in sale transactions: high growth rates; earnings not supportive of maximum valuations; limited window of opportunity to achieve meaningful market penetration; buyers less willing to pay for future potential entirely at the sale closing; and a valuation expectation far greater than those supported by the buyers. It really comes down to how confident the seller is in the performance of his/her company in the post-sale environment. If the earnout targets are reasonably attainable and the earnout compensates him/her for the at-risk portion of the transaction value, a seller can significantly improve the likelihood of a sale closing and the transaction's value.

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

Tuesday, July 05, 2016

11 Reasons to Use Earnouts in the Sale of Your Company (Part 1)

New article published on Divestopedia

The purpose of this article is to present earnouts to sellers of technology companies as a method to maximize their transaction proceeds. Sellers have historically viewed earnouts with suspicion as a way for buyers to get control of their companies cheaply. Earnouts are a variable pricing mechanism designed to tie final sale price to future performance of the acquired entity and are tied to measurable economic milestones such as revenues, gross profit, net income and EBITDA. An intelligently structured earnout can not only facilitate the closing of a deal, but can be a win for both buyer and seller. Below are 11 reasons earnouts should be considered as part of your selling transaction structure.

#1 Earnouts Offset Your Historic Small Sales

If the likely buyer is a large, publicly traded company, the acquisition of an emerging technology company with relatively small sales will not move the needle in terms of stock price. This will dampen the effect of potential upside for the smaller company that agrees to take stock in the buying company. Generally, for smaller acquisitions, the buying companies are reluctant to use their company stock as the transaction currency. The earnout allows the seller to leverage his/her upside on the very focused performance on his/her product as it performs under the new owner. Let's look at a hypothetical example:

Small Company A has current sales of $2.5 million and is acquired by Large Company B, which has sales of $20 billion. If Company A's sales increase from $2.5 million to $5 million, $10 million and $25 million in years one to three post-acquisition, respectively, it is almost invisible when lumped in with $20 billion sales level. Therefore, there will be little movement on the stock price. A far superior outcome for the seller would be to have a three-year earnout that would pay him/her 10% of revenues over the base level. So, take the total sales for the three years post-acquisition of $40 million, subtract the combined target level of $7.5 million and you get $32.5 million. Multiply this by 10% and you get an earnout payment of $3.25 million. This normally will be far greater than the increase in the large company's stock value over the same period.

#2 Buyers' Multiples at Pre-1992 Levels

Buyer acquisition multiples are at pre-1992 levels. Strategic corporate buyersprivateequity groups, and venture capital firms got burned on valuations. Between 1995 and 2001, the premiums paid by corporate buyers in 61% of transactions were greater than the economic gains. In other words, the buyer suffered from dilution. During 2008 to 2013, multiples paid by financial buyers were almost equal to strategic buyers' multiples. This is not a favorable pricing environment for tech companies looking for strategic pricing.

#3 Investor Skepticism Equals Better Price with Earnout

Based on the bubble, there is a great deal of investor skepticism. They no longer take for granted integration synergies and are wary about cultural clashes, unexpected costs, logistical problems and when their investment becomes accretive. If the seller is willing to take on some of that risk in the form of an earnout based on integrated performance, he/she will be offered a more attractive package (only if realistic targets are set and met).

#4 Buyers Like Sellers Willing to Share Post-Closing Risk

Many tech companies are struggling, and valuing them based on income will produce some pretty unspectacular results. A buyer will be far more willing to look at an acquisition candidate using strategic multiples if the seller is willing to take on a portion of the post-closing performance risk. The key stakeholders of the seller have an incentive to stay on to make their earnout come to fruition, a situation all buyers desire.

#5 Part of Watermelon Better Than All of Grape

An old business professor once asked, “What would you rather have, all of a grape or part of a watermelon?” The spirit of the entrepreneur causes many tech company owners to go it alone. The odds are against them achieving critical mass with current resources. They could grow organically and become a grape or they could integrate with a strategic acquirer and achieve their current distribution times 100 or 1,000. Six percent of this new revenue stream will far surpass 100% of the old one.

#6 Guaranteed Multiple with Earnout

How many of you have heard of the thrill of victory and the agony of defeat of stock purchases at dizzying multiples? It went something like this: Public Company A with a stock price of $50 per share buys Private Company B for a 15 x EBITDA multiple in an all stock deal with a one-year restriction on sale of the stock. Lets say that the resultant sale proceeds were 160,000 shares totaling $8 million in value. Company A’s stock goes on a steady decline and by the time you can sell, the price is $2.50. Now the effective sale price of your company becomes $400,000. Your 15 x EBITDA multiple evaporated to a multiple of less than one. Compare that result to $5 million cash at close and an earnout that totals $5 million over the next three years if revenue targets for your division are met. Your minimum guaranteed multiple is 9.38 x with an upside of 18.75 x.

In the second half of this two-part article, I will explain the final five of the 11 reasons why you should consider an earnout when structuring the sale of your business.

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

Friday, May 27, 2016

How Middle Market Business Acquisitions Are Financed

Valuable article by John Carvalho on Divestopedia.
I have found that many owners of lower mid-market businesses lack adequate knowledge on how a business sale is actually financed by a potential third-party acquirer. This is understandable given that most business owners will only go through the process of selling a business once. Unfortunately, this lack of knowledge is a contributing reason many deals are not consummated. Sellers are not the only ones to blame, though. Many buyers, and even their advisors, don't realize what it takes to finance the purchase of a business in the lower middle market. Buyers make unrealistic offers and when they approach a financing institution, the deal is rejected. Here we'll take a look at the specifics of financing in middle market business acquisitions.

Lower Mid-Market Deals 101

The lower middle market accounts for more than an estimated 90 percent of the total number of all middle market companies in most global economies, so the lack of knowledge on deal structures is a significant succession planning issue.

Businesses in the lower mid-market, especially those with enterprise values below $20 million, are often stuck in no man's land. They are too small to be an impactful acquisition target for sizable strategic buyers or private equity groups, but too large for an individual buyer to finance. Typically, a competitor of relative size, high-net-worth individuals or investor groups are the most likely potential buyers. For these buyers, capital is not endless and they want to stretch their own equity investment as much as they can. 
When I assist clients in the acquisition of a business, I start by assessing an appropriate valuation, while at the same time determining a financing structure that I believe is achievable. All financing structures will consider some level of the following:
The appropriate amount of each source of capital is based on the specific circumstances of the deal.

Bank Financing

The level of bank financing that can be obtained on the purchase/sale of a business is based on two things:
Let's take, for example, the purchase of a business with a negotiated purchase price of $10 million. If this company has $8 million in assets, an acquirer will be able to obtain more bank financing than if the business had $5 million in assets. Similarly, if this business has $4 million in EBITDA, the purchaser will be able to get more financing than if there was only $2 million in EBITDA. This is a pretty obvious and straightforward concept.

At a very high level, banks will require the acquired company to maintain a number of specified covenant ratios. Covenants that I have commonly encountered are debt to equity of 2.5:1 and a debt servicing coverage of 1.25:1. A financial model that forecasts profitability, asset levels and free cash flows will assist in determining the right level of bank financing that can be obtained. The allowable level of bank financing in a deal is a very mathematical calculation, but it is based on very subjective future projections. Having clear and defensible assumptions within these projections will go a long way toward obtaining the necessary level of financing from a bank. 

Vendor Financing 

The right level of vendor financing is not as easy to quantify as bank financing. From my experience, vendor financing on lower middle market deals range from 0% to 30% of the purchase price. This level moves up or down depending on a number transactional risk factors including, but not limited to:
The appropriateness of the amount is based on qualitative characteristics and, of course, is negotiated between the vendor and purchaser. Banking institutions also like to see a certain level of vendor financing in a deal because it ties the selling owner to the business and ensures (to some extent) that they are committed to a successful transition.

Vendor financing is one of the most contentious issues in closing the sale of a lower mid-market business. Vendors raise concern over the security (or lack thereof) available for aseller's note because bank financing will always take priority. The banks will also most likely ask for assignment and postponement, which will place restrictions on the repayment of the seller's note if the company is in breach of its covenants. 
No doubt there is risk for the seller around vendor financing, but buyers require a certain amount to compensate for the transitional risk items noted above. If a vendor is adamant about reducing the level of the vendor financing, they will need to provide evidence on how the transitional risks can be mitigated.


The appropriate equity level is the easiest amount to figure out because it is just the remaining required capital to close the deal. Unfortunately, you must first nail down both the bank and vendor financing, which is sometimes difficult to do.

A bank will always require the purchaser to have some skin in the game. Much like vendor financing, banks want to ensure that the buyer is committed to making the deal work. From my experience, the lowest level of equity from a third party purchaser that a bank will allow is 15%. This might be lower in the case of a management buyout where the bank is already comfortable with the expertise and commitment levels of the existing management team
Buyers will usually stretch to use the least amount of their capital in order to increase their return on equity. Sophisticated buyers are looking to generate equity returns of 25% to 35%. No buyer (at least in my experience) will use all of their own cash to finance a deal.
Most business owners don't understand how a business for sale is financed by a third-party acquirer. Unfortunately, this lack of knowledge can be the fundamental misunderstanding that causes such deals to fall through. If your mid-market business is on the auction block, take some time to learn about how potential purchasers will pay for it. It can make all the difference in getting the deal you want.

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