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

Friday, May 20, 2016

Positioning a Business for a Merger or Acquisition (Part 1)

A very helpful article purblished by Jim Grebey on Divestopedia

Takeaway: Be sure to prepare your business and yourself before you go to market.

Selling a business, in whole or in part, requires considerable strategic planning and preparation. Whether you are the CEO of a corporation looking for a new financial partner for a merger or acquisition, or the sole owner of a small business you’ve worked years to build and hope to find someone to carry on your life's work, successfully closing a deal and putting together an optimal sale will depend on the steps you take to prepare for this unique event in the life of the business.

Validate Your Value Proposition

An M&A event is unique because it is outside the day-to-day operation of the business and will require additional effort and, potentially, the addition of dedicated resources to be performed effectively. You will need to plan for this additional effort. Whether you are looking for someone to acquire the entire business or just trying to bring on a financial partner that will leave you in charge of operations, you need to position the business to fully demonstrate its value proposition.
Your business should be positioned well ahead of the anticipated deal closing date. Ideally, planning will start at least a year ahead of your intended closing (and two years is not unreasonable) to capture and optimize your return. Of course, you may not be able to delay the closing for that long for many reasons, which will then constrain the activities you are able to take to prepare. The steps you take to position your business, and the extent to which you are constrained from taking those steps, will affect the outcome of the deal.
There is a school of thought that you should always operate a business as if it’s for sale. I fully support that approach because it means paying constant attention to the optimization of the business' operating efficiency and paying close attention to its position in the market. This could potentially help limit your positioning activities. In practice, it may not be possible to do because there may be differences in the long-term versus short-term strategic approach you use when planning an exit. The argument is that continuing to emphasize a long-term strategy may enhance the value of the business, but are you ready to make the same capital commitments to a business when you’re looking for a near term exit as one you intend to operate long term? You will very likely be trading near-term financial performance against long-term capital improvements. Unless there is a quantifiable value proposition improvement, it may not make sense to invest in long-term improvements. Strategic planning that includes the detailed development and maintenance of a roadmap with key decision points for the business, including both near-term and long-term goals, is an important tool in making these decisions.

Set Reasonable Expectations

There are many reasons for seeking an M&A event, but some can best be described as "getting out from under." If you’re holding a fire sale and in a rush to exit, you probably won't achieve the same level of return as a business poised to move to its next stage of growth. It’s important that you have a clear understanding of your goals and reasonable expectations of the businesses potential. More importantly, you have to be prepared to take the necessary steps and provide the needed resources to accomplish your goals. If you are holding a fire sale, though, don’t be discouraged. Keep in mind that there are investors who look for fire sales.
Closing a good deal with the right investor takes planning and forethought. You may be an executive who regularly closes deals and moves from one business to another, or this may be the one time in life you make a deal to sell a business you’ve built from the ground up. You’re preparing to enter a high stakes game that you may just be beginning to learn the rules to... and there are people who play the game all the time.
Given the stakes, don’t be surprised if you find there are people who make up their own rules. Selling a business, whether you sell businesses frequently or this is a once-in-a-lifetime event, and whether you are looking for a strategic buyer or a financial investor, always includes an element of risk. This is a case of "let the seller beware." Given the stakes, it makes sense to seek professional help.

This is Not Like Selling Your Home

Some people mistakenly believe positioning a business is like staging a house. Staging a vacant house, by minimally furnishing it, is a marketing technique that allows prospective real estate buyers to envision themselves living in the home. Since your business is operating and not "vacant," a staging approach won’t work. An investor wants to see products moving off the shelves and services being provided to understand how the business operates and you’ll want the investor to see the business in operation to validate its value proposition.
For other people, positioning a business is about hiding the truth or somehow misleading potential investors about the shortcomings of the business. This is the "let the buyer beware" scenario. Hiding or falsifying information about the business is unethical and a fool's game that will be discovered in an effective due diligence and could end in litigation. Neither staging nor intentionally misleading is a good reason to position a business. Even problem businesses can be sold honestly to an investor looking for an opportunity to restore the business.
Even when you find yourself positioning a business for an asset sale, you will have work to do. The nature of business is that things can and do go wrong. Keeping a business at its peak operating efficiency is difficult. Markets change, major clients leave for reasons outside the business' control, and even nature disrupts the business' operations. Smart investors know this and understand that all businesses have warts somewhere. Investors will try to find the warts during their due diligence to help negotiate a better price. Be prepared to take the high road in negotiations by explaining, “We tried something. It didn’t work and we moved on.” Your goal is to be able to negotiate from a position of strength. You can’t do this if you ignored an issue or tried to hide it. You should have already factored any issues in your valuation. “Yes, we introduced a loss leader product to see if we could sell into that market, but withdrew when it became clear our price wasn’t supported.” “It wasn’t part of our normal operations.” “We included the expense of our experiment as an adjustment when we calculate the EBITDA for the business.”

It's More Like Selling Your Car

Actually, positioning a business is more like selling a car than selling a house. It’s hard to keep the car clean, waxed and polished when you're driving around town, but when you know a potential buyer is coming by to see it, you will want to wash it and vacuum the floor mats. If you’ve been performing regular maintenance on the car you won’t need to take the time to change the oil or do any of the other things that should be done as part of the normal maintenance.
Routine maintenance should be done on a periodic schedule... and you should have those records to show a buyer. A car buyer may look at the dipstick to see that the car has clean oil, but showing the receipts for the regularly scheduled maintenance you've performed adds value. Showing the records for the normal operation of your business is also a primary way to demonstrate value. You want to demonstrate that the business has been maintained. If the car’s oil is dirty or the level is low, the buyer is likely to try to use this to negotiate a lower price. The same is true for a business. If your business uses specialized equipment, showing maintenance records for that equipment or a regular upgrade of your software says a lot about the value of your business.
If the business is operating well but starting to show its age, you may want to improve its value by updating the software to the latest version or installing the latest machine tools. To continue the car analogy, you might improve the curb appeal of the car by adding a new set of tires to get more value.
Effective positioning means you are prepared to make the tradeoff between the expenses of an upgrade against your sale price and keep a potential investor from negotiating the price down by saying it will cost them to do the upgrades. Positioning needs to be performed with your anticipated negotiating strategy in mind well before you get to the deal table.

Prepare to be Prepared

It takes committed resources to correctly position a business. Collecting your records in preparation for due diligence, recasting your financials to identify valid financial adjustments, identifying potential strategic partners, reviewing the legal structure and ownership of the business, writing a business plan that will serve as a marketing brochure for the business and on, and on... If your business is going to operate at its most efficient, your staff will be busy and may not be available for these additional duties, and you will not want to expose yourexit strategy to your staff. You need to consider bringing on a team that is committed to the success of the sale.
Read more in part two of this series where we explore some of the specific steps you will need to perform in order to effectively position your business and improve its value proposition.

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, May 09, 2016

Deal Momentum: A Key Factor When Selling Your Company

Great Article on Divestorpedia by Rose Stabler.

When you're selling your business, the worst enemy is time. Don't be a casualty; follow these 14 tried and true ways to push deal momentum forward to a successful close.

When selling a business, time is not your friend. Time is the enemy of all deals. In fact, "Time kills all deals" is an expression that can be associated with a number of different industries, but is especially relevant to business acquisitions.

So, the key to a successful deal is to prepare well, come out strong, and maintain momentum throughout the business sales process. The deal clock is set in motion as soon as your company hits the business-for-sale market, not later in the process when a buyer presents the first offer.

So, to generate deal momentum, a business owner should be ready for the trip to the marketplace before the train leaves the station. This means organize your documentation and vet potential roadblocks that can derail or delay reaching the done-deal destination.

Don’t let time work against you. Ready up with these 14 karats of knowledge so when the sale train does leave the station, it will have the momentum necessary to reach a timely closing:

1. Know when it is a good time to sell YOUR business.

Usually the best time to sell is when sales and profits have been increasing each year and signs indicate the trend will continue. Current market conditions also play a role in prices paid for good businesses. Since "today’s market offers the best environment for small business sales that we’ve seen in years," selling a little early in order to ride the rails of a good market may be a better risk than waiting for the next train that may never come. Lance Tullius, Managing Partner of Tullius Partners, spells out the all-too-familiar scenario of waiting too long in his article, "Sell Too Early."

2. Know why you want to sell.

A committed resolve to sell is essential. One of the first questions buyers ask is, "Why is the owner selling?" They ask this question to measure, in their minds, the probability that there may be skeletons in the closet.

3. Know the company’s best features and its blemishes.

Yes, highlighting the awesomeness of your business should take center stage. But no company is perfect. Be ready to disclose the warts too. Buyers do not like surprises, nor do business brokers or other members of the professional team involved in the sale process. Problems uncovered late impugn your integrity and threaten the price--and the deal. The more issues brought to the table and worked out in advance, the better chance of a smooth closing.

4. Know what you will do after your business is sold.

If you don't have a plan in mind, you might find yourself getting cold feet or feeling a little off balance when that first offer comes along. Be sure you won't balk when momentum starts picking up.

5. Know the value of your business.

Get a business valuation by a reputable firm to understand what to expect in the current marketplace. This is an initial step in determining if the sale would meet your objectives.

6. Know that your asking price is based on reality....

…a reality that buyers and their lenders can believe in. The buyer will look at return on investment and their lenders will require that the deal make sense in terms of debt repayment. Over-priced businesses do not get sold.

7. Know that you are current on all taxes.

This includes sales taxes, unemployment taxes, payroll taxes, state income taxes and federal income taxes. Delinquencies in taxes of any kind can stop a deal in its tracks.

8. Know that operational details are not just in your head.

Buyers want organized records, files, contracts, policies, employee records, training manuals, how-to manuals, business processes, systems and controls that are reliable and organized to keep things going after you're gone.

9. Know that your business can operate without you.

The value of a business is built upon the sustainability of operations without its leader. Key employees and staff who run daily operations are the key to its future. Most businesses are unsellable if the owner "IS" the business.

10. Know who you are, who you are like, and who your competition is.

Buyers will survey your company’s landscape to scope its position in the market.

11. Know your numbers.

Be able to provide accurate financial statements and tax returns and produce key financial reports and performance metrics.

12. Know that your team is ready.

Be sure that your trusted advisors will be able to assist you in the transaction. A meeting with your attorney and accountant, for instance, will play a role in gathering all necessary documents for your business broker before going to market. Your team of advisors needs time for preparation in order to effectively support you in the transaction.

13. Know that you can provide the roadmap to even greener pastures.

Buyers are interested in the future. A growth plan and marketing plan will help a prospective buyer understand where opportunities exist and what could be done to take the business to the next level.

14. Know what's most important to you in the grand bargain.

Be prepared for the pull and tug. Don't get bogged down in minor details. Stay focused on your key issues. Understand your absolutes vs. wishes. Such preparedness will go a long way while negotiating the different scenarios on price and terms. How the deal is structured to meet the needs of buyer and seller can make or break a transaction.

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