Category Archives for "M&A Update"
Back in 2005, our firm was engaged by the founder of a well-known Austin business that had been in existence for over 30 years. The company had revenue in excess of $10,000,000, an established brand, and a total of 75 employees. They had been very profitable, debt free, and the owner (then 70) owned the building and production yard. The general manager wanted to retire, and would remain with the business until it was sold, but this situation triggered the owner’s desire to sell.
We prepared a valuation analysis using the three approaches to value and methodology that were appropriate for this industry and size of business. Unfortunately, the seller’s valuation expectations were above the value range we suggested. His contention was that 30 years of consistent advertising had resulted in significant brand recognition in the marketplace, which should support a “goodwill” value in excess of our valuation.
While we agreed with that statement, the fact is that valuation of this size and type of business was primarily based upon revenue and earnings. There was no trademark, patent, or other intellectual property, just a great reputation that allowed him to charge a premium above his competitors. That premium was reflected in the earnings of the business, and the valuation was well in excess of the asset value, so there was a significant goodwill component to the value we had computed.
The only hurdle was that this business was a C corporation, and most buyers wish to buy the operating assets of a business versus the stock. We prepared a Confidential Business Review and began marketing the business at the asking price suggested by the seller. The economy was robust, so as earnings were increasing so was the value, and we believed that we could eventually find the right buyer who would want to acquire the business. About seven months into the engagement, we received a reasonable offer for the business. We negotiated the price and terms of the transaction, the parties came to an agreement and we had a signed Letter of Intent (LOI) on a Friday.
However, on Monday, our client called and said he needed to come by the office. He arrived and quickly stated that he needed to “cancel the LOI” and keep running the business. After a few minutes of discussion, he agreed to think about that decision for a couple of days before we informed the buyer. On Thursday, he said he had changed his mind and he wanted to proceed with the LOI and the transaction. The following Monday he called and came by again, this time set on cancelling the LOI. We had a meeting with the buyer and our client explained that he was just not ready to sell, so we terminated the LOI. We let things quiet down for a couple of weeks, and then set up a meeting to discuss the change of heart.
In that meeting, we discussed what we call “The Four Fears of the Business Seller.”
We took a break for a month, to let the seller address some of these fears, then resumed marketing the business. With the increase in earnings, we found a smart buyer who actually determined that buying the stock of the business at asking price was a wise financial move given that the corporation had no debt. Our seller had audited financial statements, so due diligence went smoothly and all parties were happy with the transaction.
The lesson from this transaction was that a business owner really needs to be comfortable with their exit plan prior to going to market. While this seller’s transaction went well, even at 70 he was having second thoughts as he didn’t have his plan firmly in place. The sale of the business is such an emotionally charged process for many owners that there is quite often a moment when they question the transaction.
The ebb and flow of selling a business can create a significant amount of anxiety and uncertainty for all those involved. Each transaction uncovers its own unique challenges, and part of being a trusted intermediary involves being proactive and effectively navigating through multiple road blocks to achieve our client’s objective. Selling a company is a transfer of assets. Selling your passion is a transfer of emotions.
Business owners have been asking how the new Tax Cuts and Jobs Act (TCJA) will impact private company valuations. CPA’s, attorneys, and business valuation experts have composed analyses, and we will summarize the significant areas that impact our clients – the owners of privately held businesses.
In general, most businesses will pay less in federal income tax due to lower tax rates beginning in 2018, which translates into higher after-tax profits and after-tax cash flow. As businesses are typically valued using EBITDA, which is computed “pre-tax”, most of the valuation methods would not change. However, one valuation method, Discounted Cash Flow, would be affected. Those businesses that are primarily valued using this method could experience an increase in value, although in most cases, not as much as one might think. In any case, we would not anticipate changes in the tax law to have a significant impact on transaction valuations.
When valuing a private business, experts must consider the economic conditions, industry trends, and regulatory environment that exist on the valuation date. In addition, the access to and cost of capital for a transaction, consisting of debt and equity weigh heavily into the equation. Currently, the market is very strong, and debt is relatively inexpensive, so that component of the equation is favorable. For the purpose of this discussion, we will limit the valuation impacts to those affecting the value of an enterprise stated on a “cash free” and “debt-free” basis.
Discounted Cash Flow (DCF) method and weighted cost of capital (WACC)
The most notable impact will pertain to the Discounted Cash Flow (DCF) method of valuation and on the computation of the weighted average cost of capital (WACC). Free cash flow for a “C” corporation specifically will increase by the reduction in the tax rate from 35% to 21% - which computes to a 40% reduction in the rate. While EBITDA is computed by adding back depreciation and taxes to net income, taxes paid must be deducted from EBITDA when forecasting free cash flow in a DCF computation. This means that with taxes reduced, future cash flows will increase. While depreciation is added back, capital expenditures are deducted from future free cash flow. However, the new tax law contains enhanced depreciation tax breaks, which will typically be used by businesses to take advantage of growth opportunities and increase future cash flow. The amount of this increase cannot be estimated in the DCF analysis.
The next variable which affects DCF valuation is the weighted cost of capital (WACC), which is impacted by both the cost of equity and the cost of debt. The after-tax cost of debt is computed by deducting the tax savings from the interest paid, so lowering the tax rate actually raises the cost of debt component of WACC. While the new law includes a limitation on the amount of interest that can be deducted for taxes, companies with less than $25million in revenue are exempt from the interest expense limitation. The pre-tax cost of debt is generally less expensive than the cost of equity, so the mix of debt to equity on future estimated cash flow will affect the DCF valuation also. While the future cash flow and the cost of debt will both increase with the new tax law, it is generally true that valuations using the DCF method should increase based upon the new tax law.
The effect on the market approach for private companies is more difficult to estimate, as this method relies on actual transaction history, and there is very little transaction history post passage in 2018. A general statement is that there should be some positive impact, as buyers are buying the future, and the tax law will lower taxes on “C” corporations, and certain types of pass-through entities.
If all else remains constant in the business, the new tax laws should have a positive impact on valuations, although the amount is difficult to determine. However, a business with demonstrated growth opportunities, a solid management team, and consistent profits will still command the most interest from acquirers, regardless of changes in tax laws. For additional information on the valuation of closely held businesses, please contact the professionals at Corporate Investment.
Businesses with enterprise values above $10 million are primarily sold to institutional investors. Those acquirers fall into two broad categories: financial and strategic. This article discusses the four most common types of financial buyers, sources of funding, and investment horizons.
Private Equity Group, or PEG. A private equity group, or firm, is an investment management company that provides financial backing and makes investments in operating companies through a variety of investment strategies including leveraged buyout, venture capital, and growth capital. The PEG is responsible for finding suitable business opportunities, screening those opportunities, and selecting ones to pursue. A Committed Fund is the most common of the following three PEGs.
PEG Committed Fund or a fund with committed capital has set up a “Fund” which receives money from institutional investors, such as pension funds, college endowment funds, and high net worth individuals. Corporate Investment recently worked with a private equity fund that invested money from a high profile college’s endowment fund. The private equity group reviews the acquisition candidates, selects the desirable ones, manages the acquisition, and monitors the investment in the business. Each “Fund” typically has a defined investment horizon, which is typically 5 - 7 years, meaning the investors anticipate receiving their capital back and related returns in that time frame. The managers of the “Fund” are typically paid a management fee and participate in the gains realized on the investments made by the “Fund.”
A Fundless Sponsor or independent sponsor is a type of capital group or individual seeking acquisition candidates without having the equity financing required to complete the transaction up front (hence, they are “fundless”). Fundless sponsors raise the equity required to fund an acquisition after they have executed a letter of intent (“LOI”). Fundless sponsors may consist of a single individual or group of individuals with years of experience in investment banking and traditional private equity, who accumulated a significant amount of capital. They will then split off and operate a small office, and with their track record, there are other investors that will invest alongside them in business acquisitions. The typical investment horizon for fundless sponsors is also 5 - 7 years, but may be longer.
Search Funds are vehicles for entrepreneurs to raise funds from investors interested in making private equity investments. In the first two examples shown here, the PEG wants to rely on existing management to continue to run the business day-to-day. In the search fund model, a small group of investors back an operating manager(s) to search for a target company to acquire. The manager typically has an established track record in a specific industry, and wishes to take over day-to-day management. Search funds may have a longer investment horizon, and be more flexible.
Family Offices are a relatively new entrant into the financial acquirer mix. These are private wealth management advisory firms that serve ultra-high-net-worth investors. They are different from traditional wealth management shops in that they offer a total outsourced solution to managing the financial and investment side of an affluent individual or family. Family offices serve multi-role functionality as well as wealth management, including, accounting, security, and property management. Family Offices can be Single Family or more recently, Multi Family offices. More recently, many family offices have hired an experienced professional from a traditional private equity firm to search for companies to acquire. Corporate Investment recently dealt with two large family offices who have hired individuals from private equity firms to help them source, acquire, and manage their acquisitions of entire companies. They typically have a longer investment hold period than traditional funded private equity firms.
Our client, the seller, must align their objectives in the transaction with the right type of purchaser. Knowledge of the type of funding, risk of being able to close, and investment time horizon of purchasers must be taken into account for us to successfully achieve our client’s goals.
An understanding of the types of institutional buyers is very important, as private equity buyers are now actively investing in lower middle market companies. Over the past 8 years, significant institutional funds have been committed to private equity firms, and the competition for middle market companies (revenue above $100 million) has increased dramatically, leading many firms to lower their sights and seek investments in lower middle market companies.
There are about 350,000 companies with annual revenues between $5 million and $100 million, compared with less than 30,000 companies with revenues above $100 million, according to Forbes magazine. “Interest in the lower middle market has grown substantially,” according to Probitas Partners Private Equity Institutional Investors Trends for 2017 Survey. “In 2017, 63 percent of institutional investors said they are focusing on the U.S. small market buyout sector.” (Mergers & Acquisitions magazine, October 2017).
This development is extremely positive for Central Texas business owners, as the competition for a well managed, profitable business to acquire leads to attractive transactions.
As a business owner, perhaps the most flattering event that may occur is an unsolicited call from a “buyer” who asks, “Would you like to sell your business?” Do you turn down that call? Certainly not! Someone is calling to pay you lots of money, perhaps top dollar, for your business that you have worked so hard to build. So you take the call, and the buyer asks to set up an introductory meeting. The buyer could be a strategic or financial buyer that believes, “Your business is a great fit for our acquisition strategy.” That statement translates in the business owner’s mind to, “This buyer will pay top dollar for my business.” However, the business owner is about to begin an extremely complex and emotionally taxing process that will engage him/her in many, many hours of data gathering, meetings, information exchange, financial questions, legal questions, intense negotiation, and hopefully, a positive outcome. Although that outcome will more likely occur 6-9 months down the road, if at all.
Most of the time, the seller will not have really thought about the answer to that question, which is much more complex. Do you have the answers to each of the following questions?
However, the question that most sellers have not considered is this, “If I only negotiate with one buyer, will I ever know if I received the best price?” There is a very old saying in the M&A world, “If you only have one buyer, you don’t have a buyer, they have you!” The buyer controls the timeline, controls the information flow, and controls the process – they have all of the leverage. At a minimum, the business owner should engage an M&A professional to level the playing field. The best case would be for the seller to engage an M&A professional to run a “limited process” in parallel with the unsolicited offer. The investment banker prepares a brief outline of the business, and contacts 6-10 of the best possible buyers, and will usually find other interested parties. This strategy shifts the leverage back to the seller, and allows the business owner to “keep the buyer honest.”
One of the strategies of a buyer who is in an exclusive process with a seller is to stretch out the process, which is emotionally taxing to the business owner, emotionally draining over time, and results in “deal fatigue.” The buyer may keep asking for pieces of information, delay in actually putting a written offer together, or ask for concessions after the offer is made. Without any leverage, the seller’s only option is to walk away from the table and terminate the process, which is very difficult after significant time, energy, and emotions have been invested over 6-9 months. Most of the time the seller has invested so much time, energy, and resources in the transaction that they agree to concessions just to get to closing.
The worst result can be a transaction that does not meet the seller’s financial needs, falls apart at the eleventh hour after the buyer has obtained sensitive information, or the seller does not have any real plans for life after closing.
We met with the owners of an excellent business about 15 months ago, who had been approached by a strategic buyer. The owners are at retirement age, and very open to a transaction. Almost 50% of the consideration for the business in the buyer’s current offer was in the form of an “earnout”, however, and that was a real concern. We suggested engaging our firm to work with that buyer to improve the terms of that offer, while also contacting 6-8 other possible buyers to solicit additional offers, for two important reasons. First, to gain leverage with the one buyer, and keep that process moving, and second, to let the seller know what other buyers might offer for the business. The seller chose to “go it alone” with the one buyer. Their CPA called us 10 months later and said that the deal never closed, and the seller is back to square one, weighing their options. The seller has now invested significant time, energy, and emotions into a process that did not produce a result, and will probably be starting all over again.
Selling a business is a significant event in the life of a business owner, and must be planned well in advance to achieve the best result. While it’s very flattering to receive “the call” from a buyer wanting to discuss buying your business, the reality is that a business owner should not begin the exit process without:
Our firm is routinely contacted two or three times a year by attorneys and CPA’s introducing us to business owners that received “the call,” and the transaction did not happen. They are now ready to engage in a well-planned, well-executed, competitive process designed to close a transaction at a fair price in the open market.
What is an "Earn-out" as it relates to the sale of a business? An earn-out is a contingent payment agreement whereby the buyer agrees to pay additional money for the business upon the attainment of certain post-closing performance targets. An earn-out is a financial tool used to bridge the gap between the seller's price expectations and the buyer's perceived value for the business. The most common reason for a gap between the offer and the seller's price expectations results from the two parties to the transaction having differing views of "business risks." The sale of a business is extremely complex, and involves risk factors related to revenue, customer retention, the management team, and many others, which are viewed through different lenses by the buyer and seller.
Let's remember - in an "all cash" purchase, the buyer has all the risk, therefore the selling price will usually be at the lower end of the spectrum. In a transaction with cash plus a promissory note to seller, there is some level of risk tied to the promissory note - so the seller can justify a price that is a bit higher than "all cash." If an earn-out is included in the transaction structure, the seller expects to receive more for their business, but the last piece of the consideration is tied to future events, so both parties share the risk.
Earn-out structures will be very specific to each transaction. A typical earn-out structure may start with "If revenue in year #1, year #2 and year #3 after closing is equal to or above these targets, "X", "Y", and "Z", then the seller is paid a certain amount each year." As simple as that concept sounds, each earn-out structure will be as unique as the business itself. Many times the seller wants the earn-out tied to gross revenue, while the buyer typically wants the earn-out tied to EBITDA. At that point, the negotiation begins, and the actual measured performance often ends up tied to a metric somewhere in between revenue and EBITDA. In our experience, the least amount of computations that must be made to compute the earn-out will result in the most desirable structure.
Our firm recently represented the seller in a transaction whereby approximately $6,000,000 of the price was fixed, and another $3,000,000 of the consideration was based upon an earn-out tied to gross profit earned each year for the first twenty four months after closing. This company was in a cyclical industry, and the seller believed that the industry would maintain their momentum for several years. The buyer was not willing to pay the full price without some part being tied to future performance. The seller was willing to stay with the business through the term of the earn-out, to insure that it would be met. This client has now collected the targeted payments for year one, and is now completing year two.
One tip to remember is that earn-outs should not be "all or none," but rather based upon incremental levels of the performance metric. They should also be structured whereby meeting the target on a cumulative basis over multiple years will still trigger payments, even if one year was below the target (a "lookback provision").
Our firm does not begin marketing a business with an earn-out in mind, but it may be an appropriate financial tool used to facilitate a transaction in certain situations. Earn-out structures are complex and require the seller to evaluate the risk they are willing to assume in utilizing that structure to achieve the maximum consideration. A seller will need an experienced M&A professional and transactional lawyer to carefully negotiate the earn-out and make sure their agreements are well drafted.
We are in an extremely favorable market for business sellers. Buyers have abundant capital to deploy, interest rates are low, and the economy in Texas is doing well – even with the pull back in oil prices. However, the best advice to a business owner that is thinking of an exit, is to “take control and start planning today.” Engaging experienced advisors who understand the business sale process will prove invaluable to the business owner who wants a successful outcome.
As a business owner, your opportunity for the greatest influence on maximizing sale proceeds occurs before you go to market. Once you start the process of marketing your business to qualified buyers, the ability to correct the “deal killers,” is extremely limited due to the time factor. These must be solved before going to market. The most common “deal killers” are listed here:*
*As presented in Exit Planning: The Definitive Guide, by John H. Brown, CEO of Business Enterprise Institute
Here's an excerpt from a great article on Mergers & Acquisitions:
Although the big picture for middle-market M&A may be dimming, there are still lots of bright spots, including the lower middle market – which we define as deals valued at between $10 million and $250 million.
Many private equity firms that focus on the lower middle market say 2015 has been a great year. In a symbol of the sector’s health, Audax Private Equity celebrated the firm’s 500th closed deal in September, when portfolio company Advanced Dermatology & Cosmetic Surgery added Dermatology of Northern Colorado.
Read more: http://bit.ly/1YpVZ4l
The January issue of Mergers & Acquisitions magazine reported that 2014 was the best year for the middle market since 2007. It went on to say: "Confidence in the economy, cash on corporate balance sheets, dry powder in private equity funds, low interest rates and high stock prices all combined to create a nourishing ecosystem for deals throughout 2014."
Our firm's experience in 2014 was consistent with this thought, and the first 90 days of 2015 have begun with robust buyer activity.
A September 2014 white paper co-authored by Mark Jansen, PhD candidate, and Adam Winegar, at the McCombs Business School, UT Austin, concludes that business valuations in desirable cities such as Austin average 16% more than in other locations. This analysis is based upon a study of over 16,000 transactions. The study states: "The 16% premium is robust to controls for local economic characteristics, industry concentration, and the liquidity and availability of capital in the local transaction market. We introduce a new measure based on how noneconomic characteristics of a city affect its desirability and find that firms located in cities with higher values of our measure sell for a significant price premium."
The paper goes on to explain: "Unlike a public firm, the largest shareholder of a private firm is often the firm's CEO. This makes the location's desirability, even the portion unrelated to the cash flows and risks of the firm, important to at least one of the shareholders of the private firm. In a competitive environment, the entrepreneur pays a premium for a firm in a desirable location and this premium represents the value that the entrepreneur places on desirability."
Austin is consistently on lists of desirable cities in the U.S. The study says: "Using the inclusion of a city on a 'best places' list as our initial proxy for desirability, we find that entrepreneurs pay an economically meaningful 16% premium for firms located in areas that have desirable features that are distinct from local characteristics that would affect firm cash flows or risks. This indicates that entrepreneurs' valuations of private firms are different from valuations of purely financial assets."
The white paper notes that transactions with enterprise values greater than about $20 million, when acquired by a public company or private equity group, do not have this premium.
At Corporate Investment, our conversations with M & A advisors in other parts of the country confirm the results of this study. The velocity of buyers on engagements in Central Texas, versus a transaction in other areas, is also much greater. Buyers from many other areas of the country, specifically California and Illinois, exhibit significant interest in Texas businesses driven by to their desire to relocate to Texas.
As we reflect on the third quarter of 2014, we have seen several trends develop that are impacting valuations as well as the number of sale/recapitalization transactions of closely held businesses. Some of this industry data was also developed from the recent M&A Source conference held in Austin November 17- 21. 56 private equity firms were in Austin for the Expo, plus 180 M&A intermediaries from across the U.S.
Two trends were noted at the conference:
First, contract terms that previously were reserved for the upper middle market are now appearing in lower middle market transactions. Items such as representation and warranty insurance policies, previously only used in the upper middle market, were now being employed in lower middle market transactions. We recently were involved in a $15,000,000 EV transaction in which the private equity buyer, based in New York, was purchasing a "representation and warranty insurance" policy from AIG. These policies had normally only been used in larger transactions. Items such as "clawback" provisions may now appear in the purchase agreements of lower middle market transactions. In addition, many acquirers are engaging accounting firms to perform a "quality of earnings" review as part of due diligence.
Second, minority recapitalization transactions are becoming much more popular in current transactions. Business owners who are not ready to retire or give up control of the business, are able to cash out some of their equity, diversify their net worth, but continue to run the company, as well as maintain control. As the company grows, the eventual sale in 7-10 years may yield a substantial premium over current valuations, due to increase in EBITDA, as well as multiple expansion based upon the increased revenue and earnings. EBITDA multiples for well-run operations, with deep management teams and EBITDA in excess of $3,000,000 are seeing multiples between 5 and 6 times adjusted EBITDA in some cases.
As we complete the first quarter of 2014, we have seen several trends develop in M&A that are impacting valuations, as well as the number of sale/recapitalization transactions of closely held businesses. In 2013 and Q1 2014, we closed numerous transactions across the state, in varied industry sectors, including an Austin-based client company that was acquired by a public company based in Europe. Our opinion is that the M&A market is extremely favorable to sellers today. This was reinforced by a recent article by Andy Greenberg, CEO of GF Data, who stated:
"The primary drivers of middle-market deal flow - company and industry performance, capital availability, macro-economic conditions, and public equity values - are more favorable to the private business seller than at any time since the mid-2000s, but the volume of change-of-control deal activity is just not on par with these favorable market conditions."
In addition, an article in the New York Times on February 11, 2014, contained the following:
"The market is further constrained by a lack of companies willing to sell, as they wait for the economy to improve further", said Milton J. Marcotte, head of the national transaction advisory services practice at McGladrey, an accounting, tax and consulting firm for private equity. "That intensifies competition among buyers. We've been doing this awhile, and I don't remember a time when it was really quite this competitive," said Mr. Marcotte.
We also know from our industry sources that private equity firms are collectively sitting on about $1 trillion in capital that they must invest. So, with well-capitalized buyers in the market, what is holding back sellers of closely held businesses? We believe that many sellers are skeptical when we discuss what is clearly a "sellers' market". They have heard this before. However, we can verify that multiple offers for good businesses, especially in Central Texas, is the norm rather than the exception.
So, is now the time for business owners to ask themselves if it is a good idea to have a significant amount of their net worth tied up in their privately-held business? We have noticed businesses have recovered from the 2008-2009 recession, and now the business is doing quite well, and thus, the owners ask "why sell now?" Unfortunately, history shows that recessions happen in 7-10 year cycles, and most of us cannot predict the future very well. Selling at the top may have appeal as the smart move. But we know that it is difficult to accurately predict the ideal time. Our message to business owners is don't wait for uncontrollable factors, such as health issues or other personal factors, to force you into an exit strategy. The better course of action is to take control and plan your exit in a way that maximizes value. We believe that the only way to maximize value upon the sale of a privately held business is to run a well-managed process that leads to multiple offers.
So if it's a "sellers' market", what impact is that having on valuations? It varies, of course, by industry and size of company, but some broad parameters do apply. The following appeared in the GF Data article:
"The non-institutionally-owned businesses offering neither above-average financial characteristics nor a management solution post-close that continued the march towards closing in the first months of 2013 traded at an average of 4.4 TTM Adjusted EBITDA." GF Data, March 2014.
Two salient points in that statement: These businesses were neither above average, nor did they have a strong management team after acquisition, yet were still getting a multiple of 4.4 times TTM Adjusted EBITDA. So if a business has better than average financial performance and a solid management team, it should command an even higher multiple. This is supported by a recent New York Times article, in which David Humphrey, a managing director at Bain Capital, noted:
"Valuations for clean, easily extractable businesses are quite high."
So going forward in 2014, we expect continued high demand for Central Texas businesses with upward pressure on pricing for well-managed, profitable businesses. There were over 150 Private Equity Groups at the recent ACG conference in Houston, intensely focused on finding solid acquisitions of both platform and add-on businesses.