Setting the Deal Framework in the Letter of Intent

/in /by

A Letter of Intent marks a significant transition in the sale of a business. It moves the parties from preliminary discussions toward a defined transaction. The LOI should establish the principal business terms before the parties commit substantial resources to completing the deal. Most provisions remain nonbinding. However, certain provisions, including confidentiality and exclusivity, may create binding obligations.

Define the Transaction Economics

The purchase price represents only one component of an offer. Sellers should understand how and when they will receive the consideration. Accordingly, LOI deal terms should address purchase price, transaction structure, and the form of consideration. The LOI may also address seller financing, earnouts, rollover equity, escrows, and other holdbacks.

Working capital deserves particular attention. The parties should establish the methodology for determining the working capital target and any resulting adjustment. At this point in the negotiations, the parties should also identify whether the transaction involves an asset or equity purchase.

Address the Seller’s Continuing Involvement

Many transactions require the seller to remain involved after closing. The LOI should address significant expectations concerning employment, consulting, transition assistance, or continuing ownership. Compensation and responsibilities may also require discussion when the seller remains employed. Similarly, the parties should identify material noncompetition or non-solicitation expectations before proceeding.

Establish the Path to Closing

The LOI should provide a framework for moving from agreement to closing. This framework may address due diligence, financing, regulatory approvals, closing conditions, and the anticipated closing date. Before the process narrows, the seller should also understand the exclusivity period. During exclusivity, the seller generally stops discussions with competing buyers. The buyer then conducts confirmatory due diligence and negotiates the definitive purchase agreement.

Resolve Major Issues Early

The LOI cannot anticipate every provision contained in the final purchase agreement. Trying to negotiate every legal detail at this stage would also defeat its purpose. However, leaving significant economic issues unresolved may create problems later.

An experienced M&A advisor should negotiate the LOI deal terms with the entire transaction in mind. The advisor can identify economic issues that deserve resolution before exclusivity begins. Legal counsel should review the LOI before execution and address its binding and nonbinding provisions. A well-structured LOI does more than summarize an offer. It establishes the economic framework and provides a clear path toward the definitive purchase agreement.

How Capital Expenditures Shape Business Value

/in /by

EBITDA provides a common starting point for valuing privately held businesses. Yet two companies with identical EBITDA may command very different valuations. One reason involves the capital required to generate and sustain those earnings. Understanding capital expenditures and business value requires looking beyond reported EBITDA. Buyers want to know how much cash the business must reinvest after generating its operating earnings.

Looking Beyond EBITDA

EBITDA excludes depreciation and amortization, which represent noncash expenses. However, the assets underlying depreciation eventually require replacement or continued investment.

A company generating $2 million of EBITDA may require substantial annual capital expenditures. Another company producing identical EBITDA may require very little reinvestment. The second business may therefore generate significantly more cash for its owners. That difference may influence buyer interest and valuation.

Understanding Different Types of CAPEX

Buyers generally examine capital expenditures within several categories:

  • Deferred CAPEX: Investment needed to replace outdated or poorly maintained assets.
  • Maintenance CAPEX: Recurring investment required to sustain existing operations and earnings.
  • Growth CAPEX: Investment intended to expand capacity, revenue, or future earnings.

Viewed separately, each category provides buyers with different insights into the company’s capital requirements.

Deferred CAPEX may create an immediate economic burden after closing. A buyer may incorporate those required expenditures into its valuation or negotiations.

Maintenance CAPEX affects the recurring cash flow available from existing operations. Capital-intensive companies may require significant reinvestment simply to maintain current earnings.

Growth CAPEX requires different treatment. These expenditures support expansion rather than existing operations and may generate additional future earnings.

How CAPEX May Affect Valuation

Businesses with limited recurring capital requirements may convert more EBITDA into cash flow. Asset-light service companies often demonstrate this characteristic. By contrast, manufacturers, transportation companies, and other asset-intensive businesses may require substantial ongoing investment.

For these companies, buyers may analyze EBITDA less maintenance CAPEX alongside other cash flow measures. They may also examine historical spending, asset age, replacement schedules, and future capital requirements.

Preparing Before a Sale

Sellers should understand capital expenditures and business value before entering the market. Historical financial statements alone may not explain the company’s actual reinvestment requirements.

A well-prepared seller can distinguish maintenance spending from growth investments and explain unusual capital expenditures. An M&A advisor will incorporate this analysis into the company’s broader value story. Clear CAPEX analysis helps buyers understand how efficiently the business converts earnings into sustainable cash flow.

What Buyers Are Testing During Due Diligence

/in /by

A buyer does not conduct due diligence simply to collect documents. The process tests the assumptions supporting the proposed transaction. Before signing the Letter of Intent, the buyer develops expectations about the company’s earnings, operations, risks, and future opportunities. The buyer due diligence review determines whether the available evidence supports those expectations.

Validate the Financial Performance

Financial diligence examines the quality and sustainability of the company’s historical earnings. Buyers typically review financial statements, tax returns, monthly results, working capital, debt, and capital expenditures. They may also examine customer profitability, margins, revenue recognition, and the normalizing adjustments.

As financial scrutiny increases, buyers compare information from different sources for consistency. Material discrepancies may affect normalized EBITDA, purchase price, working capital, or other transaction terms. A Quality of Earnings analysis may provide additional financial diligence, depending on the transaction.

Understand the Business Behind the Numbers

Financial performance represents only part of the buyer’s analysis. Commercial and operational diligence examines how the company generates revenue and whether that performance appears sustainable. Buyers may evaluate customers, suppliers, employees, management, competition, backlog, technology, facilities, and operating systems.

They may also test assumptions concerning growth opportunities and potential synergies. Through this examination, the buyer develops a clearer understanding of the risks and opportunities underlying future performance.

Identify Legal and Transaction Risks

Legal diligence examines the company’s contractual relationships, ownership, compliance, and potential liabilities. Transaction counsel may review customer agreements, leases, employment matters, intellectual property, litigation, licenses, and corporate records.

The findings may influence transaction structure, representations, warranties, indemnification provisions, and closing conditions. Tax, environmental, insurance, information technology, and other specialized reviews may also become necessary.

Investigate the Exceptions

A comprehensive checklist provides structure, but effective diligence requires more than completing a standard document request. Buyers should investigate unusual trends, inconsistencies, and potential risks specific to the company. When an issue surfaces, the buyer must determine whether it changes the original investment thesis. Some findings require explanation. Others may lead to additional diligence, revised terms, or a decision not to proceed.

Prepare for Buyer Scrutiny

An experienced M&A advisor should anticipate the buyer due diligence review before taking a company to market. The advisor can help organize information, identify likely questions, and coordinate responses among the seller’s transaction team.

Preparation cannot eliminate legitimate business risks. However, it can prevent avoidable surprises from undermining buyer confidence after the LOI. Due diligence should confirm the transaction the parties negotiated. When it reveals a materially different business, the transaction may need to change.

Turning Business Valuation Into an Exit Readiness Plan

/in /by

Business owners often want to know what their companies are worth. However, understanding current value represents only part of effective exit planning. The more useful question is what drives that value and what prevents the business from becoming more valuable. Evaluating exit readiness and business value together may provide owners with a clearer path forward. It establishes a financial benchmark while identifying areas that deserve attention before a sale.

Establishing a Starting Point

A preliminary valuation provides an indication of the company’s current value based on its financial performance and other relevant factors. More broadly, the analysis may identify characteristics that positively or negatively influence buyer perceptions. These characteristics often become the company’s principal value drivers. Common value drivers include:

  • Customer Base: Revenue diversification, retention, recurring relationships, and concentration.
  • Profitability and Growth: Historical growth, margins, earnings consistency, and future opportunities.
  • Competitive Position: Differentiation, barriers to entry, market position, and competitive advantages.
  • Management Depth: Leadership capabilities, succession, and dependence on individual owners.
  • Products and Services: Quality, differentiation, demand, and recurring revenue characteristics.
  • Financial Reporting: Reliable statements, accurate reporting, and supportable normalized earnings.
  • Operations: Documented processes, scalable systems, technology, and operating efficiency.
  • Industry Dynamics: Growth prospects, consolidation, regulation, competition, and broader market trends.

Moving From Valuation to Exit Readiness

A valuation identifies what the company may be worth today. Allston Advisory Group’s Exit Readiness Assessment takes the analysis a step further. The assessment evaluates the business from the perspective of a prospective buyer. It identifies strengths, weaknesses, risks, and opportunities that may affect a future transaction.

Building on those findings, the owner may prioritize improvements based on their potential impact and required implementation time. Some issues may require relatively simple changes. Others, such as management development or customer diversification, may require several years.

Creating a More Marketable Business

As progress develops, owners may measure improvements against the original valuation and assessment. This process creates accountability and helps management focus on meaningful value drivers. Owners should periodically revisit exit readiness and business value as the company changes. The assessment should evolve alongside financial performance, management, customers, operations, and market conditions.

Preparing for an exit does not mean committing to a sale. Instead, it creates options. A preliminary valuation establishes where the business stands today. An Exit Readiness Assessment helps determine what the owner should do next.

Structuring an Earnout That Works for Buyers and Sellers

/in /by

Buyers and sellers often agree on the quality of a business but disagree on its value. Different expectations about future performance frequently create that gap. A seller may expect continued growth based on recent performance and identified opportunities. Meanwhile, a buyer may hesitate to pay today for results that have not occurred.

An earnout may help resolve this disagreement. A carefully designed earnout structure makes a portion of the purchase price contingent on future performance. In effect, the seller receives additional consideration if the business achieves mutually-agreed upon performance objectives after closing. The buyer, however, avoids paying the full amount unless those objectives materialize.

This arrangement may help bridge a valuation gap, but it also creates new risks. Once the transaction closes, the seller may no longer control decisions affecting earnout performance. For this reason, buyers and sellers should negotiate the earnout terms as carefully as the purchase price. Several provisions deserve particular attention.

Performance Metrics: The parties should select objective, measurable, and clearly defined performance metrics. Revenue, gross profit, EBITDA, or customer retention may provide appropriate measures.

Measurement Period: The agreement should establish when performance begins and ends. It should also define how frequently the parties calculate results.

Accounting Policies: Both parties should agree on accounting principles and calculation procedures before closing. Clear definitions may reduce disagreements over post-closing results.

Operating Control: Sellers should understand how buyer decisions could affect the earnout. Staffing, pricing, expenses, acquisitions, and resource allocation may influence performance.

Caps and Floors: The parties may establish minimum thresholds or maximum payments. These provisions can define the potential range of contingent consideration.

Payment Security: Depending on the circumstances, sellers may negotiate protections supporting future payments. Escrow arrangements, guarantees, or other security provisions may provide additional protection.

Dispute Procedures: The agreement should establish a process for resolving disagreements over calculations. An independent accountant may provide a practical mechanism for certain financial disputes.

Equally significant, the earnout structure should reflect objectives that the acquired business can reasonably achieve. Unrealistic targets may create conflict rather than bridge the valuation gap. Sellers should also recognize that an earnout differs substantially from cash received at closing. Future payments remain uncertain until the required performance conditions are satisfied.

Buyers face risks as well. Poorly designed earnouts may influence operating decisions, create conflicting incentives, and complicate integration after closing. For these reasons, experienced M&A, legal, accounting, and tax advisors should address earnout provisions before executing definitive agreements. Early coordination may identify potential disputes while the parties still have negotiating flexibility.

No earnout structure can eliminate every risk. However, clearly defined terms may align expectations, reduce uncertainty, and help buyers and sellers bridge differences in value.

Beating Double Taxation Using Personal Goodwill

/in /by

Purchase price represents only one measure of a successful business sale. Sellers should also consider how transaction structure affects their after-tax proceeds. For certain owner-managed businesses, personal goodwill in a business sale may create a valuable tax planning opportunity. However, the facts must support its existence and individual ownership.

Goodwill represents intangible value beyond a company’s identifiable assets. Customer relationships, reputation, expertise, and industry connections may all contribute to goodwill. Typically, the company owns much of this value. In some businesses, however, a portion may belong personally to the individual shareholder. This distinction matters because personal goodwill represents an asset owned by the individual rather than the corporation. Therefore, the individual may sell that goodwill directly to the buyer.

The potential tax benefit may become particularly significant when selling a C corporation. An asset sale may otherwise expose proceeds to both corporate and shareholder taxation. When properly structured, proceeds allocated to personal goodwill bypass the corporation. Instead, the shareholder receives consideration directly for an individually owned asset. The shareholder may also receive long-term capital gain treatment when applicable requirements are satisfied. Meanwhile, the buyer generally receives an amortizable intangible asset.

Still, personal goodwill cannot simply be created during negotiations. It must exist before the transaction and remain owned by the individual. Several factors may support personal goodwill in a business sale:

  • Personal Relationships: Customers, suppliers, or referral sources have meaningful relationships with the individual owner.
  • Reputation and Expertise: The owner’s reputation, knowledge, or experience contributes directly to the company’s success.
  • Individual Ownership: The individual, rather than the corporation, owns the goodwill being transferred.
  • No Employment Agreement: The owner has not transferred personal goodwill through an employment agreement with the corporation.
  • No Noncompete Agreement: The owner has not transferred personal goodwill through a noncompetition agreement with the corporation.
  • Supportable Valuation: A qualified valuation establishes a reasonable allocation between personal and enterprise goodwill.

These requirements make early planning essential. Sellers should determine whether personal goodwill exists before negotiating the transaction structure with prospective buyers. A valuation professional may then quantify the personal goodwill when the facts support it. The transaction documents should also clearly reflect the ownership and transfer of that asset. At the same time, the seller’s tax advisor and transaction attorney should evaluate the proposed structure. The M&A advisor may coordinate these considerations with the broader transaction economics.

Personal goodwill in a business sale will not apply to every transaction. However, qualifying owners should evaluate the opportunity before entering the sale process. When properly supported and structured, personal goodwill may reduce tax exposure and increase the seller’s after-tax proceeds.

SOURCES:

https://www.foxfin.com/personal-goodwill

https://www.thetaxadviser.com/issues/2015/apr/tax-clinic-07-apr-2015/

How to Compare Competing M&A Offers

/in /by

Business owners receiving multiple offers may naturally focus on the highest purchase price. However, headline price tells only part of the story. Two buyers may offer the same purchase price while providing significantly different economic outcomes. Therefore, comparing M&A offers requires evaluating both price and transaction structure.

The analysis should begin with the consideration each buyer proposes. Cash at closing generally provides the seller with the greatest certainty and immediate liquidity. However, many transactions include other forms of consideration. These may include seller notes, earnouts, buyer stock, rollover equity, or deferred payments. Each form carries different risks and potential rewards. A $2 million seller note, for example, does not equal $2 million cash at closing. The seller must wait for payment and assume the buyer’s credit risk. Additionally, the note’s interest rate, maturity, collateral, and payment terms affect its value.

Earnouts require similar analysis because payment depends on future performance. Sellers should evaluate the performance requirements, measurement period, payment terms, and their ability to influence results. Rollover equity presents a different tradeoff. The seller gives up current liquidity in exchange for continued ownership and potential future appreciation. Buyer stock may also create uncertainty. Its value depends on the buyer’s financial performance, liquidity, transfer restrictions, and other investment considerations.

Beyond consideration, sellers must examine adjustments that affect actual proceeds. Working capital requirements, assumed debt, transaction expenses, and other obligations may materially change cash received at closing.

Escrows and indemnification holdbacks may further reduce immediate proceeds. Although these amounts remain part of the transaction consideration, the seller may not receive them for months or even years.

Tax consequences also deserve careful consideration. Different transaction structures and forms of consideration may produce substantially different after-tax proceeds.

Once these factors are understood, the seller can compare each offer on a cash-equivalent basis. This analysis considers the timing, liquidity, risk, and probability of receiving each payment. For instance, a lower-priced offer with substantial cash at closing may outperform a higher offer containing significant contingent consideration. Conversely, rollover equity may make another offer attractive when the seller wants continued participation.

An experienced M&A advisor will help owners evaluate these differences and identify the tradeoffs within each proposal. Legal and tax advisors should also evaluate contractual protections and after-tax consequences.

A competitive sale process gives sellers the opportunity to compare more than purchase prices. It allows them to evaluate price, structure, certainty, timing, and risk across multiple buyers. Comparing M&A offers requires looking beyond the headline number. The strongest offer is the one that best balances economic value, certainty, and the seller’s transaction objectives.

From Reported Earnings to Normalized EBITDA

/in /by

A company’s historical financial statements tell buyers what happened. However, they may not accurately represent the earnings a buyer expects after closing. Privately held businesses often contain expenses, income, or accounting treatments that require further analysis. Normalized EBITDA adjustments help identify the company’s representative operating performance.

The process begins with reported earnings. From there, an M&A advisor evaluates financial results and identifies items that may not continue under new ownership. For example, an owner may receive compensation significantly above or below a market rate. Adjusting compensation to market levels may provide a more representative earnings picture. Likewise, owners may run personal or discretionary expenses through the business. These expenses may include automobiles, travel, insurance, or other owner-related benefits.

Nonrecurring expenses may also affect reported earnings. Litigation costs, relocation expenses, unusual repairs, or one-time professional fees may warrant adjustment under appropriate circumstances. Conversely, normalization is not limited to adjustments that increase EBITDA. Nonrecurring income or unusually low expenses may require downward adjustments.

Common categories of normalized EBITDA adjustments include:

  • Owner compensation and benefits
  • Related-party transactions
  • Personal or discretionary expenses
  • Nonrecurring income and expenses
  • Non-operating income and expenses
  • Related-party rent above or below market
  • Unusual accounting treatments
  • Other items unlikely to continue after closing

Each proposed adjustment should be reasonable, supportable, and relevant to the transaction. Buyers rarely accept adjustments simply because a seller labels an expense as nonrecurring. Instead, sellers should provide documentation supporting the nature and amount of each adjustment. Invoices, payroll records, contracts, leases, and financial statements may provide useful evidence.

More specifically, adjustments should reflect the expected economics of the business under new ownership. They should not create an artificially favorable representation of future performance. This distinction becomes particularly significant when buyers apply a valuation multiple to EBITDA. Even a modest adjustment may materially affect indicated enterprise value when multiplied several times. For instance, a supportable $100,000 adjustment affects value beyond the adjustment itself. At a 5.0x multiple, that adjustment represents $500,000 of indicated enterprise value.

Still, sellers should expect buyers to scrutinize every adjustment during due diligence. Aggressive or poorly documented adjustments may undermine credibility and create disagreements later in the process. For that reason, an experienced M&A advisor should identify and support adjustments before presenting the company to prospective buyers. Doing so creates a more credible financial presentation and reduces avoidable disputes.

Properly developed normalized EBITDA adjustments help buyers and sellers evaluate the same underlying earnings base. That common starting point supports more informed discussions about value, price, and transaction structure.

NACVA’S 2015 40 UNDER 40 HONOREES!

/in /by

Allston Advisory Group is pleased to announce that Senior Managing Director Nolan K. Kapp has received national professional recognition. Specifically, the National Association of Certified Valuators and Analysts, (“NACVA”) has selected Kapp as a 2015 NACVA 40 Under 40 Honoree.

NACVA recognizes emerging leaders throughout the business valuation and financial consulting professions. The program identifies professionals who demonstrate achievement, leadership, professional expertise, and a commitment to advancing their respective fields.

In particular, the NACVA 40 Under 40 program highlights professionals who have established themselves as emerging leaders before the age of 40. Honorees represent different areas within valuation, financial consulting, litigation support, accounting, mergers and acquisitions, and related advisory services.

ABOUT NOLAN K. KAPP

Kapp serves as Senior Managing Director of Allston Advisory Group, an independent mergers and acquisitions advisory firm. In this capacity, he advises privately held companies on mergers and acquisitions, business valuations, and exit strategies. At Allston, Kapp works closely with business owners preparing for significant financial and ownership transitions. His responsibilities include financial analysis, business valuation, transaction preparation, buyer identification, negotiations, due diligence, and transaction execution. Beyond technical expertise, successful advisory work requires an understanding of each business owner’s individual objectives. Accordingly, Kapp focuses on developing transaction strategies that reflect both financial considerations and the owner’s broader goals.

ABOUT ALLSTON ADVISORY GROUP:

At the same time, the recognition reflects Allston Advisory Group’s commitment to providing disciplined financial and transaction advisory services. The firm serves privately held, lower middle market companies across numerous industries throughout the United States.

Notably, NACVA and the Consultants’ Training Institute emphasize professional excellence, technical quality, leadership, and innovation within the financial consulting profession. Through these efforts, the organizations bring together professionals from across the valuation and advisory communities. Throughout 2015, NACVA will recognize the honorees through several of its professional publications and communications. Among them, featured outlets will include The Value Examiner, QuickReadBuzz, Association News, and other NACVA distributions.

Taken together, NACVA 40 Under 40 recognition represents a significant professional achievement for Kapp and Allston Advisory Group. Moreover, it reinforces the firm’s continued commitment to serving business owners through complex valuation and M&A decisions.

Calculation of Value: The Precursor to an Exit

/in /by

Business owners considering a sale should understand their company’s potential value before beginning the transaction process. A Calculation of Value may provide an efficient starting point for that analysis. In a calculation engagement, the valuation professional and client agree on the valuation approaches and procedures to perform. Therefore, the engagement generally has a narrower scope than a formal business valuation.

The valuation professional applies the agreed procedures using relevant financial, operational, and market information. The resulting calculated value may be expressed as a single amount or a range. Typically, a calculation engagement may include the following characteristics:

  • A defined and more limited scope
  • Agreed valuation approaches and methods
  • Agreed procedures and analytical requirements
  • Lower professional fees than a comprehensive valuation
  • A calculated value expressed as an amount or range

For business owners contemplating a sale, the Calculation of Value may serve several practical purposes. First, it establishes a preliminary reference point for evaluating potential transaction value. Equally, the process allows owners to compare their expectations with financial performance and marketplace evidence. This comparison may reveal a significant difference between expected value and supportable transaction value.

In that event, an owner may decide to postpone a sale and focus on improving the business. Management may then address specific factors affecting value before approaching prospective buyers. Among other areas, owners may improve profitability, strengthen management, diversify customers, or reduce owner dependence. They may also improve financial reporting, develop recurring revenue, and address operational weaknesses.

A calculation engagement may also help owners evaluate whether a transaction supports their personal financial objectives. If the expected proceeds fall short, additional preparation may provide a better course of action. Crucially, the calculated value should not create an artificial ceiling for the company’s eventual sale price. Different buyers may assign different values based on their strategies, synergies, financing, and return requirements.

For this reason, an M&A advisor should consider the calculated value alongside potential buyer motivations and current market conditions. A competitive sale process may then test those assumptions against actual buyer interest. Moreover, performing this analysis early may identify issues that buyers may uncover during due diligence. Addressing those issues beforehand may reduce surprises and strengthen the company’s preparation for the market.

A well-executed Calculation of Value gives owners a more informed starting point for the M&A process. It may clarify expectations, identify improvement opportunities, and support better decisions about whether and when to pursue a sale.

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

Our Newsletter

Follow us: