It is difficult to predict when a business owner may want or need to sell. In the past, owners typically passed businesses to their children, but that practice is not as prevalent in today’s society. Therefore, an owner should always focus on building a company that would attract the best price from a potential buyer. By recognizing the factors that affect value, an owner can prepare his or her company and maximize the ultimate selling price.
Owner Options
Today there are more options than ever for exiting a business, due primarily to the increase in the number of buyers. The reason for this is two-fold: the influx of capital into Private Equity Groups (PEGs) and the increase in operating companies actively growing via acquisition.
Most owners consistently receive solicitation letters from companies or advisors seeking acquisitions. Be wary of these solicitations. In some cases the buyers may be legitimate, but these advisors represent the buyer’s, and not the seller’s interest. Without a process by which multiple buyers compete for a business, it is unlikely that a business owner would receive the maximum price.
There are primarily two types of buyers: strategic and financial. Strategic buyers are operating companies. Many large companies have recognized the importance of growth through acquisition and have established corporate development departments staffed with former merger and acquisition professionals.
Financial buyers are PEGs or individuals interested in buying companies for a financial return. Their goal is to maximize return by leveraging a company with debt, growing it rapidly, and selling it in three to seven years. PEGs acquire companies with a minimum EBITDA (earnings before interest, taxes, depreciation and amortization) of $5 million or more, a proven management team, and infrastructure to grow. PEGs continue to raise funds from high net worth individuals, endowments, and pension funds at a breakneck pace. According to The Wall Street Journal, 295 U.S. PEGs raised $199.4 billion in the first three quarters of 2007, up from $154.1 billion in 2006.
With the advent of PEGs, a hybrid buyer—a strategic buyer owned by a PEG—has emerged. This buyer systematically makes add-on acquisitions of similar companies with EBITDA of as little as $1 million.
Current Economic Environment
Surprisingly, the credit crisis hasn’t significantly affected transactions in the lower middle market, defined as those with transaction values less than $100 million. While larger transactions with significant debt, such as the Chrysler-Cerberus deal, have had difficulty closing, the number of transactions in the lower middle market increased from 359 in the first quarter of 2007 to 508 transactions worth $12.36 billion in the first quarter of 20081. However, multiples for transactions in the $50 to $100 million range have fallen since their peak of seven times EBITDA in 2007 to six times EBITDA2. This is due in part to more stringent credit guidelines. Despite the reduction in multiples, 2008 is expected to remain a seller’s market.
Building Value
There are several factors affecting a company’s transaction price, but certain characteristics of the business are most influential. In order to create sustainable value, an owner should consider the following areas of his or her business:
• Products and Services – Attempt to move toward value-added products and services, which are more profitable than commodity products and usually more defensible in the marketplace due to less competition.
• Customers – Diversify the customer base and reduce customer concentration. This is the number one problem for many middle market businesses, and it typically results from having large customers such as Wal-Mart or Home Depot. While the sales growth is attractive, any concentration that is more than 25% of total sales for one customer can significantly lower company value. Ideally, no single customer should exceed 10% of total sales.
• Vendors – Maintain multiple suppliers for key raw materials to manage cost and risk.
• Management – Build a management infrastructure in operations and sales in order to sustain growth and profitability in good times and bad.
• Employees – Train employees and set up policies for their advancement. A skilled workforce can improve productivity and add value.
• Contracts – Retain an experienced corporate attorney. Structuring the business improperly can cost an owner hundreds of thousands, or even millions, of dollars in taxes or in the selling price. An owner should always be conscious of the effect of provisions in customer and vendor contracts on the marketability of their company. Assignment, change of control, and termination provisions or rights of first refusal are all examples of major stumbling blocks during transactions.
Other factors that affect transaction multiples include:
• Barriers to entry – High capital investment in plant and equipment and the cost of acquiring customers are examples of effective barriers to entry.
• Sales growth and profitability – Sustainable and manageable sales growth and high profit margins typically translate into higher transaction multiples.
• Industry – Historically the size of end markets were a very important indicator of value. But recent buyers have shown more interest in niche markets with higher growth because they offer higher profitability opportunities.
• Economy – Businesses affected by the economy are cyclical. Any effort that reduces the cyclicality by offering counter-cyclical products and services can add value. In the current economic environment, transportation, logistics, energy, consumer staples, and other defensive industries are more active.
Considering A Sale
There are a number of reasons for considering a sale. Often an owner wants to retire and lacks a succession plan. Sometimes, one partner may want out. The net worth of a majority of business owners is tied up in their businesses, and owners should consider monetizing business assets in order to reduce risk.
An important consideration is timing. While it is almost impossible to perfectly time any market, most owners should consider selling when times are good in their business and industry. As with other investments, they can become emotional about the prospects of their businesses and, as a result, hold on too long. Sometimes events out of an owner’s control affect value, such as shifts in the industry to more technical products or to offshore production.
Selling a business is typically a one-time, life-changing event for owners.
It is imperative to have competent advisors, both financial and legal. A financial advisor may take the form of a business broker or an investment banker. Business brokers typically sell businesses to individuals in transactions with a price of less than $5 million. Investment bankers are usually licensed by FINRA (Financial Industry Regulatory Authority) and focus on selling businesses for more than $5 million to strategic or financial buyers. Similar to large investment banks, such as Merrill Lynch and Goldman Sachs, boutique investment banks run a confidential and professional auction for smaller companies.
An investment banker plays the role of quarterback, guiding a client on what price to expect and running a deliberate, competitive process designed to maximize transaction value. Just the presence of an investment banker can sometimes increase the transaction price because buyers realize that they cannot take advantage of the seller.
A typical competitive process lasts six to nine months and consists of three phases: development, marketing, and closing. During the development phase, the investment banker will learn everything about his or her client, conduct a financial analysis, and prepare a Confidential Information Memorandum (CIM). The CIM presents the company in its most favorable light with appropriate addbacks to financials. Addbacks may consist of one-time, non-recurring items, excess owner compensation, or cost savings that a buyer may be able to attain. Identifying the appropriate addbacks is an art and can translate into significant value for the owners.
Prospective buyers are also identified during this phase. Most owners believe that they know the perfect buyer for his or her business, while in reality a different party is often identified through this process. The number of prospective buyers can range from 20 to 120, and that pool can include strategic and/or financial buyers, depending on the situation.
During the marketing phase, buyers are contacted by the investment bankers to qualify their interest in the proposed transaction. If interested, they receive the CIM after executing a confidentiality agreement. The investment bankers organize site visits, manage the bidding process, and analyze the offers.
The field is narrowed to buyers whose offers are most credible. Two of the most important risk factors to consider are: risk that a buyer may not receive bank financing and risk that the buyer may change the price. It is imperative to determine if a buyer can and will close in a timely fashion based on the proposed terms. The investment banker will negotiate a letter of intent with the buyer identifying key items, such as transaction structure (e.g. cash, stock and earn outs), management contracts, working capital issues, and other meaningful provisions that translate into real dollars at closing.
During the closing phase, it is the investment banker’s job to facilitate due diligence and assist legal counsel in incorporating the business terms into legal documents (e.g. asset purchase agreement, management contracts, non-compete agreements, etc.).
Most owners don’t like to spend exorbitant amounts of money on legal counsel; however, buyers typically retain large firms that have executed hundreds, if not thousands, of transactions. Legal documents are complex and significantly affect a seller’s liability after the sale. An experienced merger and acquisition attorney working on the seller’s behalf will understand market terms on key contract provisions—such as representations, warranties and indemnification—and can level the playing field.
As discussed, there are more options available today to business owners seeking a full or partial liquidity event. By understanding value drivers and using competent advisors, business owners can significantly enhance the value of their business in a transaction.