CLARIFYING THE SELLER’S GOALS AND REALISTIC EXPECTATIONS

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Sell transactions require open communication between the seller and M&A advisor to navigate challenges along the way and produce a “close”. Even good “deals” may be derailed by “surprises”. In order to survive the process and move to closing, seller’s goals must be aligned with realistic expectations.

Maximizing the sale price may be the underlying intent on the sell-side of M&A transactions; however, it is not always the only objective of the seller. Many times there are more important economic and non-economic goals that must be understood by the M&A advisor. Goals that may include:

  • Use of seller/company owned facilities
  • Stock or asset sell
  • Seller retirement or employment
  • Status of key employees or family members in the business
  • Use of company name

Clarifying the seller’s goals needs to be well understood by the M&A advisor. There should be no uncertainty between the seller and the advisor during the sell process. Realistic expectations can be set, and a customized plan can be established to achieving or exceeding the seller’s goals.

THE BLIND SPOT!

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In M&A deals, the buyer is purchasing the future earnings of the business, along with the assets that will produce them. Although valuations are initially derived from earnings considerations, the resulting valuation includes the buyer’s right to receive the ordinary and necessary balance sheet of the business; the Company’s Enterprise Value.

The Company’s Enterprise Value includes the operating assets of the Company, except for cash and long-term debt. The balance sheet delivered to the buyer at closing, however, should be adequate for the continued operation of the business. Many times this leads to the Blind Spot of Working Capital (Current Assets minus Current Liabilities) delivered to the Buyer at the closing.

There are three important balance sheet targets that are usually established:

  • Cash (if any)
  • Working Capital
  • Net Assets

Working Capital, at closing, is rarely a concern from the seller’s point of view; establishing a Working Capital Target on the Balance Sheet, delivered at Closing, will require serious negotiations between the buyer and seller.

By not making clear what is being bought or sold, a serious misunderstanding may be created between the buyer and seller. This underlines the need for an experienced M&A professional to assist throughout the acquisition process.

STOCK APPRECIATION RIGHTS (SAR) PLAN: REWARDING & RETAINING KEY STAFF IN CONNECTION WITH BUILDING A BUSINESS FOR VALUE OR SALE

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Rewarding key personnel is an important element of many Middle Market M&A transactions. A Stock Appreciation Rights (SAR) Plan is a method for Companies to give their key employees a bonus if the Company performs well financially. Participants do not own stock nor are they required to purchase anything; however, their benefit from the SAR Plan is based on the increase in stock value. Owners/Sellers may use SAR Plans to accomplish the following with strategic employees:

  • Aligning employee goals with Company goals
  • Creating and increasing the Shareholder value
  • Retaining premier employees

Among the biggest risks to a Buyer is that the critical mass of key employees will disappear between closing and the start of business. Negotiating non-compete and nonintervention agreements with key employees may best be addressed at the same time the Company’s SAR Plan is introduced. M&A advisors should ensure that all exit strategy-related incentive and reward plans with key employees are revisited, reaffirmed and documented before launching the sale of the Company.

MERGERS & ACQUISITIONS VALUATIONS

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The Rule of Five holds that the Enterprise Value (the cash free, debt-free value of a business) of a Business is approximately five times its earnings before interest, taxes, depreciation and amortization (EBITDA), until demonstrated otherwise. The more informing M&A transactions are those closing at much greater multiples than five times EBITDA. There are several reasons M&A prices may be significantly higher:

  • Growth Rates: if the earnings stream is growing at a rate that will make the multiple paid today appear to be a five times multiple within two years of the acquisition.
  • Potential Synergies: if the value of expected synergies to the buyer, elimination of duplicate costs, access to new customers and markets, are almost immediate.
  • Use of Leverage: if the acquirer is able to generate greater returns with the combination of debt and equity.
  • Size: a larger company may possess greater stability and lower risk along with greater synergies and growth rates.
  • Sizzle: occasionally discipline and good judgment is overtaken by irrational exuberance to purchase.

With the help of an M&A professional, the Rule of Five provides a useful framework in constructing a rationale for a given purchase price.

THE BABSON COLLEGE SURVEY

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The Babson College Survey (http://www.babson.edu/executive-education/thought-leadership/premium/Pages/six-key-trends.aspx), directed by Babson College Professor Kevin J. Mulvaney, assesses and defines current trends that impact Buyers and Sellers of businesses.

Among the survey’s key findings:

  • It is still a Seller’s market for quality companies; Seller’s must develop a knowledgeable game plan to evaluate options and potential deal partners.
  • Underperforming companies are not viable deals and receive lowball offers and little interest from Financial Buyers.
  • Due diligence by Buyers has increased deal-making timeframes to 7–10 months.
  • The smaller the company, the higher the demands for Seller assistance (employment, consulting, earn outs, deferred payouts, etc.) from the Buyer.

Regarding financing for Buyers, the Babson survey projects an increase in the number of opportunities for every type of middle-market financing. The Survey found a strong rebound in SBA loans and the yields on mezzanine debt dropped to 12–14% from historical averages of 15-20%.

“It is a very good time for entrepreneur owners to begin planning for their capital event” commented Mulvaney. Whether buying or selling a business, the likelihood for success increases exponentially by having a qualified M&A professional on your Team!

THE IMPORTANCE OF THE THREE-PARTY MERGER & ACQUISITION TRANSACTION

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Almost all M&A transactions consist of a three-party event: the seller, the buyer and the tax collector. A myriad of tax issues must be considered and understood as part of the valuing, pricing, negotiating and structuring of a deal. Proper planning will minimize the tax collector’s share of the deal and maximize the remaining value to buyer and seller.

Significant tax elements that reoccur in Middle Market deals include:

  • Stock versus asset purchase deal
  • Purchase price allocation; basis step-up in the acquired assets
  • Forms of entity: C and S corporations, LLC or partnerships, Sections 338(h)(10) & 754 elections and built-in gains tax
  • Capital gains versus ordinary income
  • Types of consideration: cash, buyer’s stock, notes
  • Capital gains versus ordinary income
  • Tax attributes of carryovers; net operating losses, tax credits and high tax basis in assets
  • Sales and other transfer taxes

Professionals can perform a careful evaluation of the pros and cons of alternative tax issues; incorporate those strategies into the initial negotiations and documents; and minimize disputes later in the process.

NON-DISCLOSURE CONFIDENTIALITY AGREEMENTS, THE ACQUISITION PROFILE AND THE EXECUTIVE SUMMARY

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It is most appropriate to have targeted buyers sign a Non-Disclosure Agreement (NDA) or a Confidentiality Agreement (CA) before exchanging sensitive information regarding a seller’s potential acquisition target. Will the potential buyers sign? It depends, most times it will be signed; sometimes only after negotiating various details; potentially slowing down the sale process.

A carefully crafted Acquisition Profile (AP) and Executive Summary (ES) by the seller and M&A professional may be used to bridge the time delay between approaching a targeted buyer, establishing their level of interest and their signing of the non-disclosure confidentiality agreements. The AP and ES must achieve the proper balance of disclosing enough company information to establish buyer interest; however, not so many details as to unmask the company before the potential buyers sign the NDA or CA.

The Acquisition Profile and Executive Summary may include; company highlights, overview, services, client base and sales territory, acquisition considerations, desired transaction, and financial information summary. In cooperation with one another, the seller and the M&A professional must decide on the best approach given the unique circumstances of the sale process.

SO HOW MUCH IS IT WORTH; VALUATION VERSUS VALUE?

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Although both methods use the same reference data and terminology, there is a difference between a formal valuation and the M&A transaction value of a Company. These variations can most simply be thought of as: formal valuations value entities that own businesses and M&A bankers value businesses.

The formal valuation tends to be the approach used by the buy-side of a transaction; the use of simple multiples, Discounted Cash Flow (DCF), Lending Test Approach (LBO Method), appraisal of key assets and real property appraisals.

M&A value is determined in the context of an economic asset; what will the business return be to the acquirer. The investment value is found in the people, timing, company specifics, industry specifics and strategic fit.

A skilled M&A professional should have the ability to contrast the two different but related approaches in market transactions. A proper determination of the Investment Value of your Company will help to identify the best buyers, and enable the sell-side team to articulate a compelling business case for acquisition. Understandably, the best buyers are those who are willing to pay the highest price, because the acquisition will add the greatest Value.

WHO IS ON THE HOOK?

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Earn-out agreements are useful but contentious tools in M&A transactions to bridge disagreements. In an earn-out, the seller agrees that a portion of the deal consideration will be contingent upon the future performance of the company.

Sellers must participate in estimating their earn-out expectations and in due diligence of the likelihood of collection. The possibility of payout is increased by:

  • Confirm buyer’s creditworthiness and ability to run the business.
  • Verify the buyer’s plan for operating the business.
  • Ensure the formula for earn-out payments is clearly specified and that you have the right to examine financial information related to the earn-outs.
  • Understand buyer’s plans that may endanger key customer and supplier relationships, employee retention or the company’s cash flow.
  • Make certain the earn-outs are beneficial to the buyer.
  • The earn-out period should be less than two years.

At the end of the day, getting paid depends on the reputation and character of the buyer. Experienced M&A professionals will ensure the sellers understand the potential reduction of earn-out compensation from buyers’ post deal remorse, misinterpretation of provisions, “management” or possible manipulation of financial results.

HOW SELLER’S WEAKNESSES ARE MADE BUYER OPPORTUNITIES

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It is important for the Seller to address Company weaknesses up front in the Offering Memorandum (OM) as opposed to later in the sales process. If not disclosed early, Buyer discovered weaknesses will certainly have price implications and challenge the Buyer’s confidence in the Seller’s management ability and honesty.

A simple list of common weaknesses includes: uncollectible receivables, obsolete and slow-moving inventory, non-transferable licenses and contracts, unprotected intellectual property, personal property owned by the Company, expiring leases, pending lawsuits and contract disputes, a concentration of revenues in a few clients, contracts that are losing money and lack of clear title to key assets.

An effective OM will not only disclose weaknesses but will allow the professional to frame the weaknesses as opportunities for the Buyer. The M&A Professional will position the Buyer’s resources as bringing significant results to the Company’s operational and financial performance as a result of the Seller’s weaknesses.

Before the execution of a Letter of Intent (LOI) and while multiple potential Buyers exist, disclosed weaknesses can be more favorably negotiated at a time when the Seller’s leverage in the deal is the greatest.

Allston Advisory Group is an experienced boutique M&A advisory firm providing a variety of services to lower middle market companies. See our footer for contact information.

(502) 742-2933
[email protected]
P.O. Box 21266, Louisville, KY 40221

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