Tag Archives: process

Managing Operating Risk To Drive Value

In my previous post I said that if revenues are diversified and sticky then they are characterized as high quality.  A business with high revenue quality is one that will likely be around for some time to come, and is therefore highly valued.  However no business is risk free.  If your revenues are project oriented with little opportunity for repeat business, or you operate in an industry with low barriers to entry, or a people dependent business such as consulting, advertising or staffing, then what can you do to realize as much value as possible?

Mitigate the risks inherent in the business model by focusing on the following:

Differentiate your Product or Service
While at first glance, it may seem hard to differentiate a business in a well established and competitive sector, keeping an eye on consumer trends combined with creative marketing can often carve out a new profitable niche and present a tremendous growth opportunity.  Lululemon Athletica in the apparel sector and Chipotle Mexican Grill in fast food are examples of effective differentiation strategies.

Grow and Strengthen Customer Relationships
Reduce the unpredictability of project revenues by nurturing customer relationships.  If you can show that the same customers use your services several years in a row then you have an argument for revenue predictability.  If that list of customers is more than twenty then you have an argument for revenue diversity. Length of customer relationships is also a good indicator of a high quality product/service.

Focus on Execution Excellence
In a service business, it comes down to attracting and keeping the best personnel in order to deliver service excellence.  Human resources is a complex, multi-dimensional field and should include processes for recruiting, role definition and responsibility, position incentives and benefits, periodic feedback, and documentation and procedures to fill gaps in the case of unexpected departures.

Add Products and Markets
A one product company is riskier than a product line company.  A local company is riskier than one with a multi-national presence.  While it is easy to over-extend yourself, consider managed product and geographical growth to mitigate risk.

Cultivate Multiple Supplier Relationships
Don’t let your business become “captive” to a sole supplier of component parts.  Cultivate multiple supplier relationships to reduce supplier power and dependence.

Improve Profitability
Analyze your profit margin to see where you want to drive your sales — to higher-margin areas.  A trend of improving margins as a result of operational efficiencies and returns to scale will result in a higher valuation.

Protect Intellectual Property
IP can be patented, copyrighted or treated as a trade secret.  Identify the IP in your business and make sure it is protected and properly owned.

Build Your Brand
Spend time on all of the above will build your reputation and your brand.

The following chart summarizes various characteristics that drive company value.

op risks

Operating risk should be addressed by implementing formal processes.  A business with formal processes, systems and documentation reduces the dependence on individual talent and can quickly respond to exogenous shocks.  Items such as Service Level Agreements (“SLAs”), marketing plans, job descriptions, employment contracts, confidentiality agreements, professional codes of conduct, organization charts, etc. institutionalize a business.  Documented processes are transferable value.  Capturing and transferring knowledge will make the business more sustainable and more valuable.

If potential buyers feel that a business has a high risk profile, they will either not buy it, reduce the price they are willing to pay, or make a portion of the price contingent upon the business’s future performance.

Four Companies That Know How to Acquire

There have been numerous studies on the difficulties of successfully completing acquisitions.  Some studies note that 50% of all acquisitions fail.  I won’t debate what is a success or failure and over what time frame it should be measured here; what I will do is review four leading Canadian software companies and examine their acquisition records.  The four companies are Constellation Software Inc., The Descartes Systems Group Inc., Enghouse Systems Limited, and Open Text Corporation.  I have reviewed the acquisition transactions where financial metrics were available for the period from May 18, 2006 (the IPO date of Constellation Software) to September 30, 2014 and the following summarizes the results.

Acquisition Summary

The four companies had a combined Enterprise Value (EV) of $1.2 billion in 2006 which grew to $14.9 billion as at September 30, 2014, each generating double digit annual returns.

The challenge in attributing this value creation to an acquisition strategy is that not all acquisitions disclosed payment terms.  Of the 172 acquisitions completed in total, 82 had disclosed financial terms.  What we can assume about the acquisitions without financial disclosure is that they would have been relatively small.  The Ontario Securities Commission requires the filing of a Business Acquisition Report (BAR) when the target size is greater than 20% of the pro-forma combined company.

In looking at each company specifically, we discover a number of interesting metrics.

Of the 22 acquisitions with disclosed financial metrics completed by Constellation, only one was of a size (as measured by enterprise value) greater than 10% of the size of Constellation.  The average size of the acquisitions, taking out the one bigger one, was 1.7% of the size of Constellation.  The median target acquisition price paid was 1.2 times revenues and 5.1 times EBITDA.

Of the 23 acquisitions with disclosed financial metrics completed by Descartes, three were larger than 10% of the size of Descartes and the average size of the acquisitions, taking out the three bigger ones, was 3.0% of the size of Descartes.  The median target acquisition price paid was 2.8 times revenues and 8.8 times EBITDA.

Enghouse was quite a bit more aggressive than Constellation and Descartes, of the 16 acquisitions with disclosed financial metrics completed by Enghouse, five were of a size greater than 10% of the size of Enghouse.  The average size of the acquisitions was 12.7% of the size of Enghouse.  The median target acquisition price paid was 0.9 times revenues and we were not able to deduce a meaningful EBITDA multiple.

Finally, of the 21 acquisitions with disclosed financial metrics completed by OpenText, again, only two were of a size greater than 10% of the size of OpenText.  The average size of the acquisitions, taking out the two bigger ones, was 2.5% of the size of OpenText.  The median target acquisition price paid was 1.2 times revenues and the EBITDA multiple was not meaningful as a number of the targets were incurring losses at the time of the acquisition.

From the acquisitions with financial disclosure, we know that 82 acquisitions cost approximately $2.7 billion.  If we assume the acquisitions without financial disclosure were completed at each company’s average acquisition metrics, then this would add another $2.5 billion to the cost.   Based on these assumptions, a total of $5.2 billion was spent on acquisitions and $8.6 billion in value was created, suggesting the acquisition strategies created tremendous value.  While this is not perfect math, the simple truth is that when you look at the share price, each company has outperformed the TSX by a wide margin over the last 8 years.

There are many ways to study acquisition performance, from large worldwide/all industries studies to sector and geography specific studies.  While this data set is small, what we have observed is that the profiled companies have completed many small acquisitions.  There are a few bigger ones, but we would not call them transformational – those are the hard ones.  What we see here are a series of small, formulaic/cookie cutter acquisitions, rigorously held to reasonable valuation and payment terms.  Integrating acquisitions is hard but what this overview tells us is that if you establish strict parameters around size and value and you do enough of them, you get pretty good at it.

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.

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.