Milestones in the M&A Process: How Long Does it Take?

Milestones in the divestiture or private capital raising process are similar and generally as follows:

Divestiture Milestones

Having said that, the following is an actual example of a divestiture of a private company.  In this case, the owner and 100% shareholder wanted to retire and was well prepared to initiate the process.  The business was a very profitable software business operating out of one location servicing a diversified customer base.  In short, an attractive acquisition opportunity supported by a motivated seller.

The engagement letter to commence the process was signed May 11th, a Wednesday.  That Friday we met with the company for an information gathering and strategy session.  One week later we met again, this time having completed a first draft of a potential buyer list, a Confidential Information Memorandum (CIM) and the teaser.  First emails and calls to potential buyers commenced on may 26th; first books (CIMs) were sent on June 10th; and expressions of Interest (EOIs) were requested by June 30th.

Getting a sense of market interest and indicative value can be a fast process; in this case about seven weeks.  Key contributors to a speedy process are client readiness and working as expeditiously as possible on the factors that the selling team can control.  While only half-way through the process (with management presentations, requesting and negotiating LOIs and due diligence yet to come), the selling team will have a good sense of the market interest and whether a good deal is possible at this point in the process.

Many things, both economic and company specific, can change during the selling timeframe and it is strongly in the seller’s and advisor’s interest to complete the process as quickly as possible.

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How Much Information (and when) Do I Share With Potential Buyers?

There are four phases of progressive information release to smaller and smaller audiences in the acquisition/divestiture process.

The first document used is called a teaser and is typically only one to three pages in length.  The teaser is a “blind” (i.e. no information from which the company identity can be deduced) overview of the acquisition opportunity and is sent to pre-approved qualified buyers whereupon interested parties must sign an NDA to receive a CIM.   The teaser is constructed so as not to be able to identify the company specifically and can be sent to as many as hundreds of potential acquirers (particularly as there are thousands of private equity funds out there).

The second document is the Confidential Information Memorandum (“CIM”) where the number sent maybe several to as many as twenty or more.  CIMs are only sent to qualified buyers who have signed an NDA.  CIMs vary in level of detail but typically range from 40 to 100 pages.  A CIM describes the nature of the business (i.e. product/service range, revenue model etc), suppliers, customers, competitors, a management profile, high level financial information such as historical revenues and EBITDA and a balance sheet.  In many cases it will also describe the market the company competes in and the competitive dynamics and growth opportunities the company faces.

One must appreciate that a CIM is a selling document and therefore opportunities tend to get more time than threats.  However, it is important to provide all relevant information in a CIM because potential buyers will be asked to issue an expression of interest based on the CIM and they will then be afforded due diligence to verify for themselves that all that is represented in the CIM is accurate and complete.  Customers, key suppliers or key management are not necessarily mentioned by name in the CIM.  The CIM undoubtedly raises questions which are typically answered by the agent or in concert with management.  It is important to protect competitive intelligence at this point as there will be only one successful buyer and this company should not be put in a position where its competitors now know sensitive information about the company.

The third stage is one where, based on an acceptable expression of interest, seriously interested parties are afforded a management presentation.  Only the top three to six (depending on the price range, the quality or potential threat of the bidders) are typically selected for this phase.  At this point more detailed information is shared with the goal of securing a LOI that will contain as few conditions as possible.  The dance here is one between protecting sensitive information and disclosing enough information to ensure that the final LOI is one that will be quickly translated into a purchase and sale agreement.

The final stage is exclusive due diligence and closing.  At this point the seller is an open book, so it is of utmost importance to have a high level of confidence in the selected party.  Private companies are typically not ready for due diligence.  Such a detailed level of record keeping is not required and generally not a priority for private companies.  The agent will usually issue a due diligence request list early in the process and it often takes some time for the company to prepare the information.  Each request is different but some items to expect include: monthly financial statements, a receivables aging list, revenue analysis by customer/by product/service, customer/supplier/strategic agreements, details on patents/IP/software architecture, employment policies and contracts, details on any environmental/legal claims and more.

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How Do You Respond to an Unsolicited Offer?

Unsolicited offers tend to come at inopportune times.  While some are actually opportunistic, most come out of the blue when the potential seller is not ready to receive them.  Unsolicited offers for private companies tend to come from immediate competitors, customers or suppliers and, these days, private equity is also actively searching for new platform investments.

If unsolicited offers are common in your sector, here are some considerations to keep in mind.

Be prepared – if you are in a position to bring other credible buyers into the process quickly you will gain substantial negotiating power.  To accomplish this you should already be on other potential acquirers’ radar screens.  Make them aware of your capabilities, your value proposition and explore OEM / distribution relationships.  When multiple buyers are brought into the process, the negotiating power shifts significantly toward the seller, who can use a competitive process to maximize valuation.

Keep your options open as long as possible – a Letter of Intent (“LOI”) will almost always include an exclusivity clause.  This is because a signed LOI is an agreement in principle and expensive external resources (accountants and lawyers) will now be engaged for due diligence and closing the transaction.  Exclusivity means the seller cannot engage in terms discussions with any other party for the agreed upon period.  This shifts the negotiating power to the buyer.  If the buyer finds material valuation issues during due diligence and seeks a price adjustment, the seller has no recourse other than to compromise on terms or walk away from the deal.

Focusing on a single buyer does not necessarily save time – sellers sometimes shy away from a formal process based on the amount of time and effort it will take.  However focusing on a single buyer does not always result in reduced effort. A buyer in an open-ended, uncompetitive situation will often continue to ask for more and more detailed information exhausting the seller in the process.

Perform buyer due diligence – what is the buyer’s long term strategy?  Is the buyer well capitalized or overleveraged? If the buyer is a private equity group, what is their typical ‘hold time’ until a company is resold?  If the offer includes a note or an earn-out, the seller assumes buyer and/or performance risk.

Bring an independent advisor into the process – unprepared companies tend to assemble requested materials in a rushed manner and answer questions ad hoc without a well formulated strategy.  By bringing an independent M&A advisor into the process you immediately formalize the process and create additional options.  Introducing actual or threatened additional buyers into the process will likely result in the initial buyer raising its offer.

When you accept an unsolicited offer, most of the time you will leave money on the table compared to an offer arrived at through an auction process (even a limited one).  By acquainting yourself with the potential buyer universe and working with an independent advisor, you can quickly bring other interested parties into the process and improve your outcome substantially.

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What About the Form of Payment?

Public company take-over bids typically consist of all cash or a combination of cash and shares.  This is largely because the board of directors of a public company agreeing to an earn-out will be subject to serious questions (read lawsuits) if things turn out other than expected.

Consideration in private company acquisitions will usually include a sizable portion in cash (50 to 100%) but will often include an unsecured note and/or an earn-out as well.  This is typically because: (i) the buyer does not have (or have access to), the amount of cash required to complete the acquisition (particularly in the case of an MBO), (ii) the greater risk surrounding private companies (risks such as customer concentration, dependence on key suppliers, etc.) and (iii), buyers can usually stretch to a higher price if the purchase price is not all cash.  For example, $25 million all cash vs. $30 million two-thirds cash and one-third note …which one would you pick?

There are a number of issues to consider when assessing the likelihood of realizing deferred consideration.  A dollar not received at closing is a dollar at risk.  In the case of a vendor note, the first question is, can it be fully secured by hard saleable assets (such as land, a building or other fixed salable assets owned by the acquirer).  This is not often the case.  If the amount is under-secured (i.e. 50% asset coverage) or unsecured, the terms have to reflect increased risk and due diligence should be performed on the buyer to get comfortable with its risk profile and prospects.  The higher the risk the higher the interest rate, and the more covenants and timely reporting are required.  Perhaps the most important item is timely reporting allowing for quick remediation.  Issues such as lawsuits, product defects/recalls, loss of customers can turn the fortunes of a company very quickly.

Earn-outs are tricky as well.  Earn-outs are more prevalent when the seller presents a strong growth forecast (for which he/she wants value).  If the seller will not entertain an earn-out, does that mean he/she does not believe in the forecast? They are not usually ironclad.  Many earn-out proposals begin with a premise along the following lines.  If you achieve $5 million in EBITDA you will earn another $x amount in purchase price.  Does this mean that if the company generates $4.9 million you get nothing? … and how is EBITDA calculated?  The acquiring company could incur discretionary expenses that you would not incur, or layer on additional overhead or, most drastic, a fundamental change of business direction could be required?

There are many possible situations to consider and many creative mechanisms and approaches to making vendor notes and earn-outs work.  For example, if the seller agrees that 75% of the earn-out will be paid if 75% of the target revenues are reached then he/she should also seek 125% of the earn-out when 125% of the revenues are reached.  Earn-outs can be tied to achieving development milestones, securing customer contracts but if earn-outs are based on the financial statements, then the higher up the income statement (i.e. sales vs. profit) the better… less room for manipulation. From a legal perspective it is important that purchase and sale contracts are clear, account for all possible scenarios, and that security is properly perfected in all relevant jurisdictions.

Un(der)secured notes and earn-outs can get very complex and this is where experienced advisors and lawyers really earn their stripes.

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A Multiple of What (and When)?

I discussed the pitfalls of relying on publicly available value comparisons in a recent post but what if an owner of a similar business to yours says “I sold my business at a 10 times multiple!”? or you hear, the tech sector is trading at a 25 multiple.  Early stage companies trade at 2 to 3 times.  The question is a multiple of what?

For public companies the most noted multiple is that of after tax net income.  For early stage companies it is quite often a multiple of revenues because, either they are not profitable or, they are in high growth mode, where profit levels are depressed as a result of higher than long-term average spending on R&D and product/service marketing.  For established private companies, the most commonly cited valuation metric is a multiple of EBITDA.

EBITDA stands for Earnings Before Interest, Taxes and Depreciation and it allows for comparison of profitability by canceling the effects of different asset bases (by cancelling depreciation), different takeover histories (by cancelling amortization often stemming from goodwill), effects due to different tax structures as well as the effects of different capital structures (by cancelling interest payments).  The drawbacks of using EBITDA are that it doesn’t account for maintenance/required capital expenditures (CAPEX) to sustain the business and, because it is a non-GAAP metric, it is often presented on an adjusted basis excluding (sometimes questionable) one-time items thereby boosting profitability.

The relationship of an EBITDA multiple to other multiples can vary widely across industries.    For consulting or software companies, that typically don’t or can’t carry long term debt and have little investment in fixed assets, EBITDA is often the same as earnings before tax.  For capital intensive companies, an EBITDA multiple of five might be the equivalent to an EBIT multiple of seven.  When we speak of a five times EBITDA multiple for a private company, the value may actually be the same as 15 or 20 times net income after tax for a profitable public company.

The period the multiple applies to is also important. While valuation is conceptually a forward looking principle, the standard is to use a historical multiple as a result of the difficulty of predicting what the next 12 months of earnings might be.  Some variants of timeframes used are “run-rate” (annualizing the last month or quarter), “latest twelve months” (LTM, typically calculated on a rolling four quarters basis), or last calendar or fiscal year.  Why does the timeframe matter?  Let’s look at a fast growing public company such as Apple.  On August 20th, its market cap was approximately $620 billion.  Its latest fiscal year ending (EBITDA was $35.5 billion and its 12 month consensus forecast EBTIDA was $55.8 billion.  People will say Apple is trading at 17.5 times EBITDA but the more proper metric is that it is trading at 10.7 times forecast EBITDA, a difference of 70%.

Finally, in addition to the specifics around the multiple, there are many bigger picture questions such as: did the buyer assume the debt; were there working capital adjustments; was the amount paid in cash on closing or will it be paid over time? Different answers to such questions will also measurably impact the net multiple paid.  So the next time someone tells you they sold their business for a great multiple, think about a multiple of what and when.

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