Tag Archives: M&A

How Do I Attract a High Multiple for My Business: The Sale Process

I noted in the previous post that there are two broad answers to the question of: how do I attract a high multiple for my business.  The first concerns the business itself and the second concerns the sale process.  The when, to who, why and how much of selling.  I will address the sale process in this post.  The sale process cannot transform an average business into a high multiple business but, by following a few guidelines, it can result in a higher transaction value.

When to sell is the most important item to discuss here.  Not only in the context of the economy in general but also with respect to the business’s performance and the owner’s objectives.  The ideal time to sell is when there are positive trends in revenue and earnings with the expectation of more to come.  Growth is very influential in attaining a strong multiple and, while valuation is determined by future prospects, historical performance is the most common way to get comfort with those prospects. By historical performance I mean at least two years of consistent growth. Many businesses grow in steps.  A pattern of revenues at $20 million for several years and then jumping to $25 million does not present a convincing growth trend. Another jump to $30 million the next year will go a long way to realizing a growth multiple.  Ultimately, whether a buyer is convinced depends on how the growth was achieved and what the current prospects are.

The selling process is one that takes seven to ten months to complete and therefore you will always run into the question of: “are you on track”.. “can we have a look at the latest quarterly numbers?”  To underperform at this point is a worst case scenario. If you are four to six months into the process, then you will have already received a number of expressions of interest and are likely working with a small group of seriously interested parties.  A quarterly profit number below expectations will open up the possibility of a revision to the value/structure in an LOI and may cause serious delay in the process as an alternate buyer may need to be found.

The second most important consideration in the selling process is who to sell to?  I have written several posts about how to identify the best buyer (and I will address management as an option shortly) but, as an overriding comment, I would say your M&A advisor needs to run a thorough and diligent process.  The four phases of a divestiture are: plan, prepare, market and complete (I will expand on how an advisor can add value in each phase in a later post).  A critical factor in achieving a successful sale is to keep as many options open as long as possible.  The seller has power when he/she has choice.

Finally, the why of selling is not a key driver from the perspective of realizing the most value in a transaction but it is a factor in the form of consideration and how long the process will take.  Remember, if the business is dependent on the owner-operator, he/she will not be able to leave the business upon its sale.  If the owner-operator has spent 20 years in the business, is nearing retirement, has made him/herself redundant, then he/she is in a position to structure the transaction to include as much cash as possible and make the transition period as short as possible.  However, if the reason to sell part or all of the business is to take advantage of an opportunity to accelerate growth then, by partnering with a well capitalized entity that can bring investment, sales or distribution resources to the table, you may expect to spend many more years with the business.  Finally, the best time to sell may have passed if the owner is no longer interested in the business (he/she is spending more time on other interests) or, he/she is compelled to sell for health reasons or changing competitive/technology dynamics that are substantially reducing the economic prospects for the business.

The sale process, from consideration to 100% out, can take many years and with economic uncertainty as it is, it is best to start the planning from a position of strength.

What Will a Strategic Buyer Pay?

Now that we have identified reasons for paying a premium; what is a premium? By definition, it is higher than the average price.  But if the market will ultimately determine the price, where do you start?

You start with the notional value.  A notional value determination is one in absence of an open market transaction, in other words, intrinsic or stand-alone value.  The notional value of an enterprise does not include what a strategic acquirer can bring to the operations (i.e. with a distribution network or sales force, etc.)  The notional value is determined through an extensive analysis of the company’s financial performance and market opportunities typically by applying a Discounted Cashflow Analysis (DCF) and/or a public company market trading and acquisition comparable analysis (I will provide more details regarding valuation analysis in a later post).

The notional enterprise value is driven by earnings and earnings potential and the risk associated with generating those earnings.  Earnings may be generated by levered or unlevered assets.  Enterprise value consists of term debt and equity (assuming a normal level of working capital), so if there is debt in the company, it must be subtracted from enterprise value to get to equity value, which is the net amount a seller can expect to receive.

A premium is the amount a buyer will pay, over and above the notional value, however, how the purchaser is being valued is a factor in this equation.  Only in rare cases will a buyer pay a price that is dilutive to the acquiring company’s forecast earnings.  An example is acquiring technology; whether it is a patent that doesn’t generate any direct revenues or whether it is a company that is losing money presently but is expected to be very profitable in the future.  In cases like this it may make sense to accept short-term dilution to earnings (i.e. an investment in future earnings) from an acquisition.

The norm is that an acquisition is accretive to the purchaser’s earnings.  An example of an accretive acquisition is best illustrated with an example of a publicly traded company (Company A).  Say Company A trades at 12 times EBITDA of $10M (i.e. an enterprise value of $120M) and the target is purchased at 7 times EBITDA of $1M (a price of $7M).  The go forward enterprise now generates $11 million (excluding synergies) and with a multiple of 12 (assuming the market likes the acquisition and views the pro-forma combined company as having similar prospects), the enterprise value is now $132M.

While the example is simplistic, the concept that I want to highlight is, what if the notional value is $5M?

Perhaps during a divestiture process there would have been several expressions of interest at $5M but the winning bidder had to pay more.  Company A could have paid $10M (10 times EBITDA – as it trades at 12 times EBITDA) and it would still have been accretive.  How much of a premium should Company A pay? This is the technical dance; the grey area between the intrinsic value and the value to a buyer.

So what will a strategic buyer pay?  They will pay somewhere between the notional value and the value to the buyer.  Creating a competitive bidding environment can persuade the winning buyer to pay more than the notional value and share some of the value to the buyer with the seller.

M&A Acronyms

The field of M&A is full of acronyms, appropriate I suppose as the descriptor of the field is one.  In actual fact, mergers are very rare (in order for a transaction to be recognized as a merger under GAAP it has to meet numerous accounting criteria) and the activity really consists of acquisitions and divestitures or A&D.  In any case, I thought it might be helpful to clarify some acronyms used in the M&A process.

One of the first documents used in the M&A process is a no-names summary description of the opportunity typically called a teaser.  If the teaser is of interest then parties will sign an NDA or CA (Non-Disclosure Agreement or Confidentiality Agreement) to receive more detailed information about the company.  The comprehensive information document is called a CIM or just IM or sometimes OM (Confidential Information Memorandum or Information Memorandum or Offering Memorandum).

In order to assess whether parties reviewing the CIM are worthy of moving forward they are typically be asked to issue a non-binding EOI or IOI (Expression of Interest or Indication of Interest) which will identify a valuation range, rationale and transaction structure parameters.

If the EOI is acceptable, potential purchasers are furnished with still more information typically in the form of monthly income statements, revenue and customer analyses and whatever else is important to the potential purchaser under the circumstances.  At this stage the potential purchaser and seller will meet in person and a Data Room is set up that will contain the actual contracts to allow the purchaser to verify that everything that has been represented to date is actually true (these days more and more data rooms are virtual data rooms in cyberspace).

Subsequent to this an LOI (Letter of Intent) is sought and upon signing the LOI, a period of exclusive due diligence is awarded to the single final successful party.  Once the potential purchaser is sufficiently comfortable, work will begin on the PSA (Purchase and Sale Agreement) and signature on this document and its many companions will consist of the closing.  The PSA will define the deal structure which may contain a hold-back and/or a VTB (Vendor Take Back).  A hold-back is typically for a period of less than one year and contingent on receivables being paid, customers being retained or any indemnity claims the purchaser may have a right to as defined in the PSA.  A VTB or vendor note is a purchase loan from the seller to the buyer.  This is typically subordinated to a senior lender (i.e. a bank) and is usually of a term longer than one year.

On the financial/valuation side there are acronyms such as EBT, EBIT and EBITDA (Earnings Before Tax, Earnings Before Interest and Tax, Earnings Before Interest, Taxes and Depreciation and Amortization (non-cash items), EV and TEV (Enterprise Value and Total Enterprise Value), FYE (Fiscal Year End), LTM (Last Twelve Months), and YOY (Year Over Year).

For further terms not mentioned here please see: http://www.divestopedia.com/dictionary.

An Overview of NDAs

Non Disclosure Agreements (NDAs, also called CAs for Confidentiality Agreements) are contracts that stipulate that information received from a counterparty will only to be used for the purpose as defined in the NDA and that it will not be used as a basis for competitive tactics or shared freely with others.  NDAs are signed in cases of divestitures but also for joint ventures and other collaborative and strategic relationships.  The term of an NDA is typically 1 to 3 years and the appropriateness of the term depends very much on the rate of change in the company and the industry in which it operates.

NDAs may include non solicitation and/or non circumvention clauses.  Non-solicitation clauses can apply to customers and/or employees.  Non circumvention clauses protect entrepreneurs with great ideas from well capitalized parties acting on the idea without acknowledging or compensating the entrepreneur.

Every NDA will include clauses that describe when the agreement does not apply; such as (i) if the information falls into the public domain, other than as a result of a disclosure in violation of the agreement; or (ii) if the information is already known to the recipient at the time of its disclosure; or (iii) if it is independently obtained or developed by the recipient.  The reasons for these are fairly self evident.  You can’t stop a person from acting on information that they already know or is publicly available (that everyone else can act on).

NDAs may need to be adjusted for different jurisdictions and for certain counterparties.  For example, NDAs usually address what the recipient should do with the information once one party determines the process is over.  This may include returning or destroying the information; however, in certain jurisdictions companies will want to retain a copy of the information in case it is required to be disclosed pursuant to applicable law, regulation or legal process.  Private equity and venture capital groups typically add a clause to protect their ability to invest in, or operate companies in the same or related fields of business as that engaged in by the company.

Certain companies will not sign NDAs at all (at least not in the initial stages).   IBM will not review blind teasers (i.e. a summary without disclosing the company name) and requires all introductory information to be marked “non-confidential”.  Microsoft’s policy is that NDAs are executed on the condition of aligned business group(s) willing to sponsor an engagement.  These companies see so many proposals and are in so many businesses that they have simply decided that it is not worth the expense of processing NDAs at an early stage.

So, do NDAs really protect you from counterparties using the provided information against you? And if someone contravenes an NDA, can you prove it?  Can you sue them.. yes, will it be worth it?  Rarely.  My view is you should always put an NDA in place before you share information but then use caution and share only select information that will not potentially harm your business.  Don’t view an NDA as a bullet proof vest.  Continue to be guarded particularly in the areas of new business partners, potential new customers and key employees.

Normalization Adjustments for Private Companies

Historical operating income of private companies often requires adjustments in order to present a number that a buyer can reasonably expect.  Profitable private companies will try to minimize their taxes payable.  This is simply good business practice.  However, one must be reasonable; for example, the spouse of an entrepreneur is paid $100,000 per annum for bookkeeping services.  In a small company that may be overpaying him/her and it may just be an approach to lowering household personal income tax; whereas, if he/she were to be an accredited accountant in a large company, it may even be underpaying him or her.  The tax authorities apply reasonability tests; the latter is reasonable, the former may not be.  Since tax minimization usually results in lower income (and therefore lower income tax payable); the adjustments will increase EBITDA and thereby provide the basis for a higher valuation of the company.

Adjustments are generally made for one-time events, discontinued parts of the business (or parts that are not being sold) and ongoing expenses that are either not necessary to run the business or not at market pricing.  Some examples of one-time items include start-up costs, certain product development/deployment costs, costs associated with new legislation or regulations, and lawsuits.  Ongoing expenses may include superfluous expenses such as luxury cars, boats and planes, summer homes expensed as regional offices, payments to family members not fully engaged in the business or at rates above the market rate, business trips that are really/mostly family vacations, personal tax and legal advise and personal bonuses or dividends that would be at the new owner’s discretion.  Conversely, when times are tough, entrepreneurs may pay themselves less thereby smoothing the impact of volatile revenues.  Entrepreneurs may wish to exclude bad debts or legal fees that they feel are excessive but in most cases these are recurring and necessary business expenses and therefore should not be eliminated.

Normalization adjustments are a delicate matter.  Too many and it becomes a red flag, raising concerns such as, “what are they trying to get away with here?” or, “with so many adjustments, does this reflect poor customer/supplier relationships? or, “there is probably more to it than that, I wonder what they are not telling me?”.  If your adjustments are not viewed as legitimate you lose a tremendous amount of credibility and negotiating power.  Also, what normalization adjustment should not do is make assumptions about a particular buyer and suggest that the business can run without certain expenses that a particular buyer might not incur.  This is the value to a buyer that you can point out in discussions but a buyer will rarely pay for improved prospects that it can bring to the table unless it is forced there by way of a competitive auction (see “What Will a Strategic Buyer Pay?”).

So far we have talked about income statement adjustments, because they are the main value driver, but we must also look at the balance sheet.  The company’s competitive position and economic prospects drive the valuation but then a balance sheet that is different from what is expected/required will result in adjustments to this valuation.  Redundant assets should be stripped and, on the other hand, if productive assets need to be replaced then adjustments may be required that have a negative impact on valuation.