Thursday, July 28, 2016

How You Sell Your Business Determines its Selling Price

How much is my business worth?  That depends. Of course it depends on profits, sales, EBITDA, and other traditional valuation metrics. A surprisingly important factor, however, is how you choose to sell it.  If your business is larger, complex, unusual, strategic, with a high component of intellectual property or technology and subject to a broad interpretation of value in the marketplace then how you choose to sell it can result in swings of literally millions of dollars in transaction value. The Graph above attempts to illustrate this concept:

The way to achieve the most value from the sale of your company is to get several strategic buyers all competing in a soft auction process. That is the holy grail of company valuation. There are several exit or value options. Let's examine each one starting with the lowest which is liquidation value.

Liquidation Value – This is basically the sale of the hard assets of the business as it ceases to be a going concern.  No value is given for good will, brand name, customer lists, or company earnings capability. This is a sad way to exit a business that you spent twenty years building. This method of selling often occurs when the owner has a debilitating health issue or dies and his estate is forced to sell.

Book Value - is simply an accounting treatment of the physical assets. Book value is generally not even close to the true value of a business. It only accounts for the depreciated value of physical assets and does not take into account such things as earnings power, proprietary technology, competitive advantage, growth rate, and many other important factors. In case you are working on a shareholder agreement and looking for a methodology for calculating a buy-out, Book value is a terrible metric to use. A better approach would be a multiple of sales or EBITDA. Minority shareholders often unknowingly sign shareholder agreements that provide a book value buyout if the minority shareholder decides to cash out.

Unsolicited Offer to Buy from a Competitor – This is the next step up in value. The best way I can describe the buyer mindset is that they are hoping to get lucky and buy your company for a bargain price. If the unsuspecting seller bites or makes a weak counter offer, the competitor gets a great deal.

How should you handle this situation so you do not have this outcome? We suggest that you do not let an outside force determine your selling timeframe. However, we recognize that everything is for sale at the right price. That is the right starting point. Get the buyer to sign a confidentiality agreement. Provide income statement, balance sheet and your yearly budget and forecast.

Determine the number that you would accept as your purchase price and present that to the buyer. You may put it like this, " We really were not considering selling our company, but if you want us to consider going through the due diligence process, we will need an offer of $6.5 million. If you are not prepared to give us a LOI at that level, we are not going to entertain further discussions."

A second approach would be to ask for your  number and if they were willing to agree, then you would agree to begin the due diligence process. If they were not, then you were going to engage your merger and acquisition advisor and they would be welcome to participate in the process with the other buyers that were brought into the competitive selling process. 

Another tactic from this bargain seeker it to propose a reasonable offer in a qualified letter of intent and then embark on an exhaustive due diligence process. He uncovers every little flaw in the target company and begins the process of chipping away at value and lowering his original purchase offer. He is counting on the seller simply wearing down since the seller has invested so much in the process and accepting the significantly lower offer.

Buyer Introduced by Seller's Professional Advisors – Unfortunately this is a commonly executed yet flawed approach to maximizing the seller's transaction value. The seller confides in his banker, financial advisor, accountant, or attorney that he is considering selling. The well-meaning advisor will often "know a client in the same business" and will provide an introduction.  This introduction often results in a bidding process of only one buyer. That buyer has no motivation to offer anything but a discounted price.

Valuation From a Professional Valuation Firm – At about the midpoint in the value chain is this view of business value. These valuations are often in response to a need such as gift or estate taxes, setting up an ESOP, a divorce, insurance, or estate planning. These valuations are conservative and are generally done strictly by the numbers. These firms use several techniques, including comps, rules of thumb, and discounted cash flow. These methods are not great in accounting for strategic value factors such as key customers, intellectual capital, or a competitive bidding process from several buyers.

Private Equity or Financial Buyer – In this environment of tight credit, the Private Equity Groups still have a good amount of capital and need to invest in deals. The very large deals are not currently getting done, but the lower middle market transactions are still viable. The PEG's still have their roots as financial buyers and go strictly by the numbers, and they have tightened the multiples they are willing to pay. Where two years ago they would buy a bricks and mortar company for 6 ½  X EBITDA, they are now paying 5 X EBITDA.

Strategic Buyers in a Bidding Process – The Holy Grail of transaction value for business sellers is to have several buyers that are actively seeking to acquire the target company. One of the luckiest things that has happened in our client's favor as they were engaged in selling their company was an announcement that a big company just acquired one of the seller's competitors. All of a sudden our client became a strategic prized target for the competitors of the buying company. If for no other reason than to protect market share, these buyers come out of the woodwork with some very aggressive offers.

This principal holds as an M&A firm attempts to stimulate the same kind of market dynamic. By positioning the seller as a potential strategic target of a competitor, the other industry players often step up with attractive valuations in a defensive posture.

Another value driver that a good investment banker will employ is to establish a strategic fit between seller and buyer. The advisor will attempt to paint a picture of 1 + 1 = 3 ½.  Factors such as eliminating duplication of function, cross selling each other's products into the other's install base, using the seller's product to enhance the competitive position of the buying company's key products, and extending the life of the buyer's technology are examples of this artful positioning.

Of course, the merger and acquisition teams of the buyers are conditioned to deflect these approaches. However, they realize that their competitors are getting the same presentation. They have to ask themselves, "Which of these strategic platforms will resonate with their competitors' decision makers?"

As you can see, the value of your business can be subjectively interpreted depending on the lenses through which it is viewed. The decision you make on how your business is sold will determine how value is interpreted and can result in 20%, 30%, 40%, or even 100% differences in your sale proceeds.

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Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To learn more about our services for technology business sellers click to visit our Web Site MidMarket Capital

Tuesday, July 26, 2016

During Due Diligence What's Good for the Goose is Good for the Gander

One of the things I like best about representing small business owners as an M&A Advisor is that no two days are the same. Yes, deals have common elements, but it is those unique details at the margin that must be handled on the fly that can mean the difference between success and failure. To prepare our clients for those 80% deal elements in common we have written articles on each stage of the process and we review those articles with our client prior to the stage. So for example we will review the most commonly asked questions from buyers on conference calls and we will role play with our clients on answering these questions.

If the client knows what to expect prior to the stage, any bump in the road does not turn into a deal threatening event. We try to manage and control what we can, but more often than not something new surfaces that is new to our experience. How those surprises are handled often can be the difference between closing and the deal blowing up. In a recent transaction that we completed, we had one of those first time surprises. Luckily we were able to get past it and improve our preparation for the next deal and as an added bonus, resulted in this article.

Due diligence was coming to a satisfactory close and the definitive purchase agreements, seller notes, and employment contracts were moving through the process without a hitch. We were set to close on April 30 and ten days prior to closing the buyer said, we just want to see your closing numbers through April, so let's move the closing back 5 days. What were we going to do tell them no? I said, well you have already completed due diligence, are you concerned about the April numbers? He said, no, we just want to make sure everything is on track.

My radar went off and I thought about all of the events external to our deal that could cause the deal not to  close.  How many deals failed to close, for example, that were on the table during the stock market crash of 1987? The second part of my radar said that we needed to be prepared to defend transaction value one final time. I suggested he bring in his outside accountant to help us analyze such things as sales versus projections, gross margins, deal pipeline, revenue run rate, etc. We were going to be prepared. We knew that if things looked worse, the buyer was going to request an adjustment.

Now here comes the surprise. The outside accountant discovered that there was a revenue recognition issue and our client had actually understated profitability by a meaningful amount. This was discovered after the originally scheduled closing date and it meant that the buyer had based his purchase price on an EBITDA number that was too low. Easy deal, right? We just take his transaction value for the original deal and the EBITDA number he used and calculated an EBITDA multiple. We then applied that multiple to our new EBITDA and we get our new and improved purchase price.

I knew that this would not be well received by our buyer and counseled our client accordingly. He instructed me to raise our price. The good news is that we had a very good relationship with the buyer and he did not end discussions. He reminded us that he had earlier given in to a concession that we had asked for and we added a couple of other favorable deal points, but he did not move his purchase number.

We huddled with our client and had a serious pros and cons discussion. He did recognize that we had fought hard to improve his transaction. He also recognized that the buyer had drawn his line in the sand and would walk away. The risk that we discussed with our client was that if we returned to market, that would delay his pay day by minimum of 90 days. Also we pointed out that the market does not care why a deal blows up. When you return to the market, the stigma is that some negative surprise happened during due diligence and the new potential buyers will apply that risk discount to their offers.
Our client did agree to do the deal and is very optimistic about the company moving forward with a great partner.

In a post deal debrief with our client I told him that had I to do it again, what I should have said when the buyer requested the delayed closing is, "We know that if you find something negative, you are going to ask for a price adjustment. If we discover something positive will we be able to get a correspondingly positive adjustment. What is he going to say to that?

In reflecting on this situation, I wanted to use my learning to improve our process and I believe that I have come up with the strategy. In our very next deal I incorporated our new strategy. We got several offers with transaction value, cash at close, earnout, seller note and net working capital defined. In our counter proposals  we are now proposing the following language:

We propose to pay a multiple of 4.43 times the trailing twelve month (ending in the last full
month prior to the month of closing) Adjusted EBITDA, which using full year 2015 Adjusted
EBITDA of approximately $1,000,000 results in a valuation of $4,430,000. Adjusted EBITDA for the purposes of this determination will be defined as Net Income plus any One-time professional fees associated with this business sale (currently $42,000 for investment banker fees additional legal and accounting services).

What we are accomplishing with this language is that if the price can go down during the due diligence process, then the price can go up during the process. Why not formalize it because we know that in 99 times out of 100, if the company performance goes down from where it was when the bid was submitted, an adjustment will be applied by the buyer.  If the seller does not relent, the buyer will walk away.  The unwritten buyer's rule is that the price can only go down during due diligence. We are out to change that one-sided approach and even the playing field for our sell side clients.

Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To learn more about our services for technology business sellers click to visit our Web Site MidMarket Capital

Technology Business Sales - The Number One Cause of M&A Deal Failures

I believe one of the biggest reasons for M&A deals blowing up is a poorly worded Letter of Intent. The standard process is to solicit offers from buyers in the form of Letters of Intent (LOI). The terms and conditions are negotiated until one winner emerges and the seller and buyer dual sign the LOI which is non-binding.  This  basically gives either party an out should something be discovered in the due diligence process that is not to their liking or is not as presented in the initial materials.
When I say poorly worded, what I really should have said is that it is worded much to the advantage of the buyer and gives them a lot of wiggle room in how the letter is interpreted and translated into the definitive purchase agreement. The best comparison I can make is a lease agreement for an apartment. It is so one-sided in favor of the landlord and protects him from every conceivable problem with the renter. 
Business buyers are usually very experienced and the sellers are generally first time sellers. The buyers have probably learned some important and costly lessons from past deals and vow never to let that happen again. This is often reflected in their LOI. They also count on several dynamics from the process that are in their favor. Their deal team is experienced and is at the ready to claim that "this is a standard deal practice" or "this is the calculation according to GAAP accounting rules". They count on the seller suffering from deal fatigue after the numerous conference calls, corporate visits, and the arduous production of due diligence information.
When the LOI is then translated into the Definitive Purchase Agreement by the buyer's team, any term that is open for interpretation will be interpreted in favor of the buyer and conversely to the detriment of the seller. The seller can try to fight each point, and usually there are several attacks on the original value detailed in the dual signed LOI that took the seller off the market for 45-60 days.  The buyer and his team of experts will fight each deal term from the dispassionate standpoint on one evaluating several deals simultaneously. The seller, on the other  hand, is fully emotionally committed to the result of his life's work. He is at a decided negotiating disadvantage.
The unfortunate result of this process is that the seller usually caves on most items and sacrifices a significant portion of the value that he thought he would realize from the sale.  More often than not, however,  the seller interprets this activity by the buyer as acting in bad faith and simply blows up the deal, only to return to the market as damaged goods. The implied message when we reconnect with previous interested buyers after going into due diligence is that the buyers found some dirty laundry in the process. These previously interested buyers may jump back in, but they generally jump back in at a transaction value lower than what they were originally willing to pay.
How do we stop this unfortunate buyer advantage and subsequent bad behavior? The first and most important thing we can do is to convey the message that there are several interested and qualified buyers that are very close in the process. If we are doing our job properly, we will be conveying an accurate version of the reality of the deal. The message is that we have many good options and if you try to behave badly, we will simply cut you off and reach out to our next best choices. The second thing we can do is to negotiate the wording in the Letter of Intent to be very precise and not allow room for interpretation that can attack the value and terms we originally intended. We will show a couple examples of LOI deal points as written by the buyer (with lots of room for interpretation) and we will counter those with examples of precise language that protects the seller.
Buyer's Earnout Language:
The amount will be paid using the following formula:
-75% of the value will be paid at closing
-The remaining 25% will be held as retention by the BUYERs to be paid in 2 equal installments at the 12 month and 24 month anniversaries, based on the following formula and with the goal of retaining at least 95% of the TTM revenue. In case at the 12 and 24 month anniversaries the TTM revenue falls below 95%, the retention amount will be adjusted based on the percentage retained. For example, if 90% of the TTM revenue is retained at 12 months, the retention value will be adjusted to 90% of the original value. In case the revenue retention falls at or below 80%, the retention value will be adjusted to $0.
Earnout Language Seller Counter Proposal
The amount will be paid using the following formula:

-75% of the value will be paid at closing
-The remaining 25% will be held as Earnout by the BUYERs to be paid in 4 equal installments at the 6, 12, 18 and 24 months anniversaries, based on the following formula:

We will set a 5% per year revenue growth target for two years as a way for Sellers to receive 100% of their Earnout (categorized as "additional transaction value" for contract and tax purposes).

So, for example, the trailing 12 months revenues for the period above for purposes of this example are $2,355,000. For a 5% growth rate in year one, the resulting target is $2,415,000 for year 1 and $2,535,750 in year 2. The combined revenue target for the two years post acquisition is $4,950,750.

Based on a purchase price of $2,355,430, the 25% earnout would be valued at par at $588,857. We can simply back into an earnout payout rate by dividing the par value target of $588,857 by the total targeted revenues of $4.95 MM.

The result is a payout rate of 11.89% of the first two years' revenue. If SELLER falls short of the target they fall short in the payout, if they exceed the amount, they earn a payout premium. Below are two examples of performance:

Example 1 is the combined 2 years' revenues total $4.50 MM - the resulting 2 year payout would be $535,244.

Example 2 is the combined 2 years' revenues total $5.50 MM - the resulting 2 year payout would be $654,187.

Comparison and Comments: The buyer's language contained a severe penalty if revenues dropped below 80% of prior levels, the earnout payment goes to $0. Also they have only a penalty for falling short and no corresponding reward for exceeding expectations. The seller's counter proposal is very specific, formula driven and uses examples. It will be very hard to misinterpret this language. The seller's language accounts for the punishment of a shortfall with the upside reward of exceeding growth projections. The principle of both proposals is the same - to protect and grow revenue, but the results for the seller are far superior with the counter proposal language.
Buyer's Working Capital Example:
This proposal assumes a cash free, debt free balance sheet and a normalized level of working capital at closing.
Seller's Working Capital Counter Proposal:
At or around closing the respective accounting teams will do an analysis of accounts payable and accounts receivable. The seller will retain all receivables in excess of payables plus all cash and cash equivalents. The balance sheet will be assumed by the buyer with a $0 net working capital balance.
Comparison and Comments: The buyer's language is vague and not specific and is a problem waiting to happen. So for example, if the buyer's experts decide that a "normalized level of working capital at closing is a surplus of $400,000, the value of the transaction to the seller dropped by $400,000 compared to the seller's counter proposal language. The objective in seller negotiations is to truly understand the value of the various offers before countersigning the LOI.  For example, an offer for cash at closing of $4,000,000 with the seller retaining all excess net working capital when the normal level is $800,000 is superior to an offer for $4.4 million with a net working capital requirement "at normal levels". i.e.$800,000.

These are two very important deal terms and they can move the effective transaction value by large amounts if they are allowed to be  loosely worded in the letter of intent and then interpreted to the buyer's advantage in translation to the definitive purchase agreement. Why not just cut off that option with very precise and specific language in the LOI with formulas and examples prior to execution by the seller. The chances of the deal going through to closing will rise dramatically with this relatively easy to execute negotiation element.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To learn more about our services for technology business sellers click to visit our Web Site MidMarket Capital

Business Sale Negotiation - Our Most Unusual Deal Term

The deal process is very stressful so every once in a while it is refreshing when we can break the tension with a good laugh. In retelling this story I am changing the names to honor the privacy of our clients and buyers. So let me set the stage. We have negotiated and have received a dual signed letter of intent between our client, a privately held healthcare information technology company and a much larger publicly traded company. We are ending due diligence and have had some very stressful discussions regarding the future role , title, salary and duties of our founder/seller. We were able to come to agreement and had started the process of crafting the definitive purchase agreement. So the basic economics of the deal are set, but just need to be memorialized in a formal contract.
I get a call from our client, let's call her Sarah. She says that she is going to fax me over a document and after I read it, to call her back. A minute later the fax starts to print out a page from the buyer's annual report where they identify the price and terms of another acquisition they had completed during the reporting period. I recognized the company because Sarah and I had discussed it before and she had shared that the company was similar to hers in terms of product offering and revenues. In my mind I had formulated a potential transaction range for this very similar company. 
We had been able to negotiate what we felt was a very favorable deal for our client, well beyond a typical EBITDA financial buyer valuation.  Because it had strategic value to a couple of the major players in the space and we had them both competing for the acquisition, we were being valued at a multiple of revenue not a multiple of EBITDA.
Back to the fax. I start reading the deal terms being described about this very similar company and the valuation was significantly above our lucrative offer. I call up Sarah and the first thing she says to me is, "I want Becky's deal." Becky was the owner of the other acquired company and she and Sarah were professionally acquainted.  Being the cool-headed deal guy that I am, I stammered, "Sarah, I looked at this deal and there is no way I can justify the price that the buyer paid for them."  She said to me, "Didn't I tell you that Becky was having an affair with the buying company's previous CEO?"
OK now is my time to actually be cool-headed. I said, "Well Sarah, are you prepared to come up with that deliverable, and how will your husband feel about that deal term?" Silence followed for what seemed like an eternity.  Soon the silence was broken with a very loud and hearty belly laugh from the other end of the phone.  Finally she said, "OK, OK, I get it. Let's get my deal done."
Whew, I dodged a bullet there and even got a funny story out of it. It was not funny until the substantial wire transfer had hit Sarah's bank account.

Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To learn more about our services for technology business sellers click to visit our Web Site MidMarket Capital