Bridge The Gap

Economic uncertainty, volatility in the capital markets, and financing restrictions have created a challenging environment for committed buyers and sellers in the lower middle market. Foremost, valuations have come under deep scrutiny. Having reached all-time highs prior to the pandemic, buyers and sellers may find it difficult to align valuation expectations. Some considerations for both parties to creatively bridge the valuation gap:

  • Earnouts – arguing for “COVID add backs” due to the extraordinary, one-time nature of the pandemic, sellers may obtain the full value for their business through an earnout. A simple, well-defined package, including performance metrics, time frame, and strategic plan, will align the buyer’s business objectives with the seller’s incentives.
  • Buyer’s Stock – to preserve cash, buyers may consider using their own stock to fund a purchase. Sellers may benefit from the future growth of the business, and if structured properly, may realize some tax advantages.
  • Seller’s Note – to preserve cash or if access to capital is an issue, buyers may request a Seller’s Note. Often loathed, a Seller’s Note may protect the purchase price, provide interest on the note, and have favorable tax consequences for sellers.

Despite the unprecedented circumstances of the current market, a knowledgeable M&A team can help you navigate the process and deliver a viable solution.

This Too Shall Pass

With the peak of the COVID-19 pandemic presumably in our rear view, the future for mergers and acquisitions in the lower middle market remains uncertain and unpredictable in the short-to-near term. Many strategic buyers (e.g. same industry or business) have adopted a wait-and-see approach to potential transactions, while financial buyers (i.e. private equity groups) have gone inward, focusing on securing and protecting their existing portfolio companies.

Potential sellers do not despair; according to the PWC report, “Succeeding through M&A in Uncertain Economic Times,” US public companies now hold more than four times as much cash as they did a quarter-century ago, and the capital that US private equity firms have available for investment but haven’t yet deployed has never been higher.

Business owners contemplating a liquidity event should start their planning early, consult with a knowledgeable M&A Team, and focus on maximizing value. A decrease in financial benchmarks from the COVID-19 crisis is expected and understandable. How your company and management team navigate this downturn will be critical to the value of your business.

COVID-19 Impact on Merger & Acquisition Transactions

Many acquisition processes are being put on hold pending further clarity on the broader health and economic consequences of COVID-19. In the future, the impact of the pandemic on buyers and sellers will be seen in a wide range of implications, including a “new” focus on:

  • Preparing for sale – is it the right time; what are current valuations; will full value be recognized.
  • Timing – in this period of uncertainty, additional time is needed to meet new logistical challenges for satisfying relevant requirements.
  • Due Diligence – heightened scrutiny in all areas of due diligence is seen; more robust inquiry regarding Force Majeure Clauses in key contracts; emergency preparedness and insurance coverages.
  • Acquisition agreements – allocating the increase risk brought on by COVID-19 between buyers and sellers in acquisition agreements through the mechanisms of earn-outs, representations & warranties, interim operating covenants, closing conditions, termination fees and special indemnification provisions based on coronavirus-related due diligence findings.
  • Financing – is attractive, long-term lending available.

Companies engaged in mergers and acquisitions should seek the guidance of their advisors to deal with current market volatility, increased risk and uncertainty posed by the spread of the virus.

The Doomsday Ratio

Is your company prepared to survive a Doomsday scenario? Without quantifiable measurements in place, it may difficult to know how your business is actually performing. Financial ratios or benchmarks are used to assess the financial health of a company. The company’s financial statements, primarily the income statement and balance sheet, are converted to a standardized format (ratio or percentage) and compared over time, to similar companies or the broader industry.

Liquidity ratios, specifically, are critical financial ratios in times of crisis. Liquidity ratios measure a company’s ability to pay off short-term obligations without raising external capital. Liquidity ratios include the current ratio, quick ratio, days sales outstanding, and the Doomsday Ratio. The Doomsday Ratio is the most conservative, assumes the worst (hence the name), and blatantly ignores any assets of the company except cash and cash equivalents. Calculated as cash and cash equivalents divided by current liabilities, the Doomsday Ratio determines the adequacy of the amount of cash on hand, and it’s most useful when tracked over time.

Financial ratios, including the Doomsday Ratio, are nuanced. An experienced M&A team can help you understand and navigate their impact on your business and operations.

The Strategic Exit

If you are considering a sale of your business in the near future, strategic buyers, or corporate acquirers, must be at the top of your prospective buyer’s list. Strategic buyers operate in the same industry or business and may include competitors, suppliers, or clients of your company. The main objective of strategic buyers is to find companies whose products or services complement or integrate seamlessly with their established enterprise for long-term value creation.

Motivated by economies of scale, new product lines, new geographical markets, more channels of distribution, or other synergistic opportunities, strategics are highly qualified buyers and among the very best purchasers of middle market businesses. AND, they pay more! Synergies and integration capabilities of the two entities creates additional value. Furthermore, you exit with the transaction, and overlapping costs are eliminated. With a deep understanding of your business, strategic buyers also ensure an efficient transaction process and timely close. Lastly, long-term clients win with new product and service offerings.

It’s not uncommon for strategic buyers to act like financial buyers and make acquisitions to boosts top-line revenues and earnings, or for financial buyers with portfolio companies in your space to make strategic add-on acquisitions. An experienced M&A Team will understand the different buyer motivations and help facilitate a successful transaction.

Balance Sheet Analysis

In most merger & acquisition (M&A) transactions, valuations are determined based on the income and cash flow of the company. Furthermore, the character and makeup of the balance sheet must also be assessed when evaluating a company for a transaction. Negotiating balance sheet target values should be an early and meaningful part of Middle Market transactions. These outcomes may significantly alter the value of the total transaction value.

Working capital is generally defined as the current assets less the current liabilities of a company. For purposes of an M&A transaction, understanding and establishing an “adequate” level of working capital is very important and generally included in the purchase price. Typically, cash and bank lines of credit are not included in the calculation of transactional working capital.

There is no standard convention for determining “adequate” working capital in a transaction. Significant differences will occur between the sell-side and buy-side points of view. An experienced M&A team may derive an additional 5% to 15% of the purchase price in negotiating adequate working capital.

The Value of Confidentiality

Nearly every M&A advisor would agree that confidentiality is the foundation upon which successful transactions are built. Confidentiality is paramount throughout the M&A transaction process, but this is especially true when it concerns:

  • the seller’s employees
  • the seller’s customers and vendors
  • the seller’s competitors and the public
  • public companies and the possibility of insider information

Middle Market business owners vary in their employee disclosure approach. Some choose to refrain from disclosing any information to employees; confiding only with trusted advisors. Whereas other owners may control the disclosure; dictating the dialogue with the intent of alleviating employee concerns.

A comprehensive nondisclosure and/or confidentiality agreement should be designed in a manner that prevents a seller’s business from being harmed by disclosing to outside parties the actual name of the company, the financial and business details of the company (typically outlined in the Confidentiality Information Memorandum), and especially, the “proprietary juice” that differentiates the company from its competitors.

Often downplayed as a formality of doing business, confidentiality should be addressed by buyers and sellers and their respective M&A teams early in the transaction process.

Quality of Data Drives Deals

The quality of data is the most commonly overlooked risk factor of business owners pursuing a sale of their business in the marketplace. Owners must be able to provide prospective buyers with evidence to support their earnings and their adjustments to earnings. Poor data quality is usually linked to:

  • Antiquated accounting systems
  • Incorrect revenue recognition
  • Untimely account reconcilement
  • Outdated financial records and software
  • Weak or non-existent controls over assets
  • Important contracts that are not retained
  • Notable transactions that are not fully documented
  • Difficulty extracting data from company systems

Few hard-driving entrepreneurs perceive the cost of keeping accurate accounting records on the accrual basis and updated IT systems to be value-added costs; however, neglect of these key functions not only reflects poorly on the owner and their ability to run the business, but it may even sacrifice the buyer’s ability to close a deal.

If you are considering the sale of your business, engage an experienced M&A Team to assist with mitigating risk factors such as quality of data before approaching prospective buyers.

Be Prepared!

It is impossible to list all the issues and decision points that may arise in the course of selling or preparing your business for sale. Every Merger & Acquisition transaction is different. A successful sale requires early preparation from the seller to optimize the sales value of their business and minimize the risk of a failed transaction. The planning process begins with:

  • Clarify Seller’s Goals – assess the seller’s expectations and goals within the current market conditions to determine the best exit strategy and the right type of buyer.
  • Know the Challenge – the seller must be willing to simultaneously operate a successful business and manage the sales process.
  • Know the Buyers – the seller must identify the right buyers; where the right buyers see value, the value drivers, and the deal making and breaking issues.
  • Strengths, Weaknesses and Corrective Actions – perform sell-side due diligence followed by corrective actions.
  • The Presentation – position information gathered in sell-side due diligence to educate buyers of the benefits of owning the business.
  • Forming Your Team – it is critical to identify key internal individuals and external advisors.

Let’s talk today.

Integration: The “Real Work” Begins…

Leading up to a transaction, buyers and sellers of companies can’t help but be enthusiastic about the endless opportunities that lie ahead. With all the synergies, growth possibilities and efficiencies to be realized; what’s not to be excited about!?

This Honeymoon phase may continue post-transaction, but as integration becomes a reality, the excitement dissipates and pressures to capitalize on expectations intensify. Although opinions may vary on the approach to post-transaction integration, all can agree; an integration strategy must be established. This strategy should include:

  • Unifying management teams behind a shared purpose
  • Setting priorities and time frames; aggressively following/adjusting accordingly
  • Training staff for immediate concerns
  • Monitoring productivity while remaining client-focused
  • Anticipating and managing staff turnover
  • Addressing cultural issues
  • Measuring the impact of all major decisions
  • Communicating throughout the process!!!

In order for a transaction to be successful, months of preparation, negotiation and bargaining are required. It’s no surprise that exhilaration typically follows a deals consummation. However, it’s equally important that buyers and sellers understand that post-transaction integration begins on Day 1, if not sooner, to ensure the new entity’s success.