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.

THE OFFERING MEMORANDUM: FRAMING THE STORY

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The mergers and acquisitions (M&A) sales process begins with the preparation of a thorough Offering Memorandum (OM). This critical document provides the framework for profiling a company and positioning it for sale.

An effective OM requires collaboration between the Sellers and the M&A advisor to capture the essence of the business. These conversations will include:

  • Company overview – history, who we are, what we do
  • Define the core business – processes, technologies
  • Strengths and weaknesses – success factors, opportunities, challenges, shortcomings
  • Description of the industry & competition – market analysis
  • Financial and/or contractual obligations
  • Description of the work force – key executives/managers, backgrounds, personnel
  • Major contracts and customers
  • Normalized and recast financial statements – including original statements prepared by an independent CPA

A properly prepared OM should summarize essential business information with the intent to engage numerous prospective buyers in a negotiated sale of the business. The OM will serve as the backbone of the negotiations process; providing a clear and detailed story, ensuring a successful transaction.

THE LONE WOLF: A SELLER’S NIGHTMARE

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“Having only one buyer is the same as having no buyers,” is a statement often quoted by professionals in the M&A marketplace. After exhausting every qualified financial and strategic buyer, private equity firms, and the like, and to no avail; what is a Seller to do about the lone prospective buyer?

Seller rest assured, if you’ve hired a qualified M&A professional, expect them to make the best out of the situation and to have a cache of standard negotiating tools applicable to “The Lone Wolf.” This set of tools will include:

  • Patience – confidence in one’s position
  • Strategic aura of indifference – “I care, but not THAT much…”
  • Seller vulnerabilities – knowing buyer’s lack of awareness
  • Buyer constraints – understanding buyer also has time pressures/constraints
  • Set a minimum walk-away price – in advance; adhere to it

Although not ideal, having a “Lone Wolf” can lead to a successful transaction with the proper M&A team in place and a plan for dealing with scenarios as such, preferably on the front-end.

IN THE YEAR 2030… SUCCESSION PLANNING

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There are four types of valuations used to understand middle market transactions and helpful with succession planning:

  • Fair market value, hypothetical concepts, most commonly used in estate, income and gift tax planning or litigation support.
  • Preliminary estimate of value in the market-place; will include strategic values recently paid in an industry.
  • Investment value, value particular to potential buyers.
  • Final transaction value, actual value paid in a closing transaction.

The use of a valuation may be the catalysts for business owners to operate their companies in the most value-enhancing manner. In the future, the market may be over-crowded with companies for sale; the opportunity to create significant owner-value should begin immediately. Experienced investment bankers should be able to advise sellers as to general price ranges, and identify positive and negative value drivers so as to maximize the final transaction value of the business.

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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