2011 Year-End Summary

I started this blog in August and it feels like we have already addressed some meaty topics.  Here is what I have covered so far.

M&A Acronyms

Terms like LTM, NDA, EOI, CIM, PSA and VTB explained.

How Much Information (and when) Do I Share With Potential Buyers?

There are four phases of progressive information release to smaller and smaller audiences in the acquisition/divestiture process.

Constructing a Buyer List

M&A advisors will use many resources to prepare a buyer list including proprietary in-house databases, existing relationships in industry and the private equity and fund sectors, business networks, associations, and commercial company databases.

What Makes a Good Buyer?

To state the obvious… companies with ability to pay and an interest in paying a premium.

Finding a Buyer: It is Rarely the One You Expect

Once you have started the process you can’t wait for the company that you thought would be your buyer to be ready. 

Attracting Foreign Buyers: The Benefits of M&A International

Canada has many leading specialised mid-sized technology companies that have emerged here and for them to realise full value in a strategic auction process they must access international buyers.

What Will a Strategic Buyer Pay?

A strategic buyer 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.

What Will a Financial Buyer Pay?

Private equity will act like strategic buyer when it comes to portfolio add-on opportunities.

Normalization Adjustments for Private Companies

Normalization adjustments are a delicate matter; too many and it raises a red flag, too few and you leave money on the table.

The Basic Math of Valuations – Why Mid-Market Companies Are Valued Lower Than Their Public Company Peers?

The risk-return curve is the most fundamental principle of corporate finance. 

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

The biggest driver in attaining a higher multiple is a company’s profitable growth prospects, and, this should already be evidenced by a historical growth record.

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

The ideal time to sell is when there are positive trends in revenue and earnings with the expectation of more to come.

Why is a Tech Company Worth Three Times Revenue?

There are two items of note in the title: (i) the valuation metric; a multiple of revenues and (ii), the notion that technology companies as a group are different from other companies.

How Does an M&A Advisor Add Value to the Divesture Process?

Veracap's Value Enhancement Framework^TM follows well defined planning and execution strategies in undertaking the sale of a company.

How Does an M&A Advisor Add Value to the Divesture Process: the Intangibles

An M&A advisor allows the principals and management to stay focused on the business and can wear the black hat as well as eat humble pie.

When is an MBO a Good Idea?

An MBO can be a good option if the buying management team is strong and interested in partnering with an institutional backer that can bring cash to the transaction.

Specialised Funds for Unique Needs

The Shotgun Fund^® will purchase common shares from departing shareholders when a shotgun clause or buy-sell agreement has been executed and the Succession Fund™ purchases shares from shareholders that are looking for liquidity and want to take "Chips off the Table".

Happy Holidays and if you have any thoughts for a topic in 2012, please let me know.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Specialized Funds for Unique Needs

I have noted before that there are over 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds such as Kleiner Perkins Caufield & Byers, Draper Fisher Jurvetson, General Catalyst Partners, and Sequoia Capital. 

If you have a business that is generating about $1 million in EBITDA or greater, then there is a good chance there is a fund out there that may have an interest, and probably investments, in your space, resulting in the possibility of a good transaction.  Even companies at break-even or in a loss position can find interest from the private equity sector, however, in these cases they are likely to be opportunistic or vulture funds which sometimes results in the sector being painted with a broad brush.  In general, private equity is smart money that can bring more than dollars to the table and, as such, can be a good partner for the right company.

The most ad-hoc type of fund is a special purpose acquisition fund, where accomplished individuals are able to secure backing, typically from high net worth individuals, in the $5 million to $20 million range to acquire a single company.  This is a financial buyer in the purest sense as there are no synergies to be realised, however, usually a board of directors is formed by well heeled and well connected partners who can then help with business strategy, customer leads and further acquisition financing.

Beyond this one-off type of fund there are established venture capital and private equity funds.  In my experience venture capital investors typically take a substantial minority equity position and look for investments that can return 5x to 10x (i.e. if they invest $1 million, they target a realization of $5M to $10M in a sale or IPO exit).  VCs don’t look to achieve their goals by acquiring additional companies in the space but rather by betting on, and working with, the expected winner in the space.  Private equity on the other hand, quite often seeks 100% ownership and will then continue to look for add-on or tuck-in acquisitions to grow and increase the market power of its investments.  Private equity comes in many varieties including Leveraged Buy-Out (LBO), Growth Capital, Distressed and Mezzanine Funds.  It is not unusual, given that these funds often have a finite period within which to raise money, invest it, and return it to investors, that one fund’s exit is another’s entry. 

An example of a unique equity group is Argosy Partners.  Argosy Partners manages the Shotgun Fund^® and the Succession Fund^TM.  The Shotgun Fund^® will purchase common shares from departing shareholders when a shotgun clause or buy-sell agreement has been executed (i.e. your business partner offers you $5 million for your half of the business and you have 30 days to decide whether to sell to him or to buy him out).  Because of the time constraints in such circumstances, The Shotgun Fund asserts it can close a transaction in less than 5 days of first making contact.

The Succession Fund™ purchases shares from shareholders that are looking for liquidity and want to take "Chips off the Table".  The Succession Fund typically partners with continuing owner-managers who do not want to put their business up for sale prematurely, and who are reluctant to use significant leverage to accomplish their shareholder realignment objectives. 

If your view of private equity is that they will only buy companies at a discount, it may be time to take another look.  Private equity can be a good option for entrepreneurs looking for a variety of value enhancement or exit options.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

When is an MBO a Good Idea?

MBO stands for Management Buy-Out and describes one alternative for an owner-entrepreneur to exit his or her business.  Management can range from an experienced arm’s length team to family members who are active in the business.

The advantages of an MBO include:

• Low Transition Risk

The buying managers know how to run the business.  Management continuity is usually a big issue in the sale of a business and keeping management in place adds tremendously to the finance-ability of the transaction.

• Minimum Disruption

Putting a business up for sale creates a period of uncertainty that direct competitors can capitalize on.  While this threat is often overestimated, this rational will influence certain entrepreneurs to choose this path.

The drawbacks of an MBO include:

• Suboptimal Price

An auction process among strategic buyers that have the most to gain from the acquisition will most often realize the highest price.  One cannot predict what price a strategic buyer might pay. See: “What Will a Strategic Buyer Pay?”. 

In some cases management and the seller negotiate a fair and do-able price and in other cases an independent valuation is performed but in either case it is not likely to be equal to what a strategic buyer might pay.

• Suboptimal Structure

Unless there has been a plan in place for years, buying managers typically don’t have sufficient cash on hand to buy the business.  As a result, in most MBOs you will see vendor notes where the seller finances part of the purchase price for the buyer.

However, there is one big exception to the drawbacks and that is if the management team can attract the attention of a financial buyer.  I noted in “What Will a Financial Buyer Pay?”, that a financial buyer will pay like a strategic buyer when it is considering portfolio add-ons.  A strong management team that aligns itself with private equity that has other investments in the space can be a very strong buyer.  Now the question becomes: does the management team want to partner with an institutional investor and pay that much?

The decision to sell to management is one that should be addressed early and definitively.  Management should not be included in the auction process.  This creates a conflict of interest where management is incented to act in its self interest.  There are also expectations to manage.  If management is keen to buy the business but cannot come to terms with the seller, or cannot secure the financing, then they may be seriously demotivated and not work in the best interest of the auction process.

An MBO can be a good option if the buying management team is strong and is interested in partnering with an institutional backer that can bring cash to the transaction.  If the MBO is pursued simply because other options are not of interest then the seller must be satisfied with potentially accepting a lower value proposition.

 

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

How Does an M&A Advisor Add Value to the Divesture Process: the Intangibles

My last post was about whether an M&A advisor is worth the cost of managing the divestiture process and how he or she goes about realizing the highest value for his/her clients.  In this post I want to comment on the non-price issues that could arise and how an M&A advisor can keep the process running smoothly and ensure the post sale relationships are started on the right foot.

The following are three areas where an advisor improves the chances of a successful transaction:

·         Allows the business owner to concentrate on running the business

I noted in “How Do I Attract a High Multiple for My Business: The Sale Process” that the selling process is one that takes seven to ten months to complete and that performing below expectations during this time could lead to serious delays and potential difficult renegotiation.  Creating the offering materials and contacting/informing suitable buyers alone is a full time job for the first several months.  Working with an advisor allows the principals and management to stay focused on the business and its performance throughout the process – the process can be long and distracting but the business should remain priority one.

·         Shows serious intent to complete a reasonable transaction

Retaining an advisor demonstrates serious intent of the vendor, ensures objective expectations have been set during the planning phase and makes buyers aware that they will be participating in a competitive and professional process; something which can be leveraged during negotiations.   The sale process is often an emotional one and having an objective advisor can provide independent advise and direction which otherwise might not be possible.

·         Creates a buffer during negotiations to ensure positive post-transaction relationships

Another role advisors play is wearing the ‘black hat’ during the process.  Not only during potentially heated negotiations, but any time the process looks to be stalling, the advisor can shoulder the blame in order to put the process back on track.  Keeping the principals one step removed during difficult negotiations allows them to maintain a positive business relationship as they work through a transition with the new owners.

The experience of having closed many transactions also provides the benefit of a portfolio of workable alternatives available during negotiations and deep knowledge of structural pitfalls (for example, tying an earn-out to the lower end of an income statement) and last but not least, a network of strong deal-friendly lawyers and accountants.

The Veracap Value Enhancement Framework^TM illustrates that opportunities for value enhancement are created through timing the sale, preparing for the sale, valuation and pricing initiatives and how to realize on the value that has been created through building deal momentum in the search for buyers, preliminary due diligence, deal structuring, negotiations and closing BUT if you don’t manage the soft factors you may not close at all.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

How Does an M&A Advisor Add Value to the Divesture Process?

M&A advisors typically charge between 3% and 7% as a success fee for managing the sale process for a company.  The contingent structure of a success fee means the advisor gets paid a nominal percentage if the deal is satisfactory to all parties.  Sounds reasonable.  The percentage, while small, can amount to hundreds of thousands of dollars and, when viewed in this light, vendors begin to question the value for money.  So the question is, is an M&A advisor worth, say 5% of the realized amount or, in other words, will engaging an M&A advisor improve your expected value by at least 5%?

The alternatives to working with a trusted advisor typically fall in three buckets: (i) respond to an unsolicited offer; (ii) approach other members of the existing management team or, (iii) approach a competitor.  Veracap's Value Enhancement Framework^TM enables business owners to realize their personal and financial objectives by introducing appropriate planning and execution strategies in undertaking the sale of their company.   The chart below illustrates that opportunities for value enhancement are created through timing the sale, preparing for the sale and valuation and pricing initiatives. It demonstrates how to realize on the value that has been created through building deal momentum in the search for buyers, preliminary due diligence, deal structuring, negotiations and closing.

So will engaging an M&A advisor improve your expected value by at least 5%?  While I do not have empirical evidence to present, I can say that most of the time we see at least a 5% improvement between the average acceptable expression of interest and the signed LOI.  I have also seen this difference be as high as 100%.  The price improvement during the managed auction process will be the greatest when you have at least two interested parties at the table who both have plenty of room above the intrinsic value of the business to the value to the buyer (see What Will a Strategic Buyer Pay?).  

The main difference between the Veracap framework and do-it-yourself alternatives is that the latter are typically reactive as opposed to proactive.  An M&A advisor will: (i) position the selling company as a strategic fit for target buyers; (ii) present the opportunity to numerous logical and capable buyers; and (iii) manage the process along a defined and orderly timeline, in order to generate the highest premium possible.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Why is a Tech Company Worth Three Times Revenue?

First off, let me clarify that the number, three times revenue, is the actual average revenue multiple of over 85 private company digital media M&A transactions that we have tracked in the years 2009 and 2010.  If you would like a copy of this report please email me at dvanderplaat@veracap.com.

Now, of course you can’t generalize when it comes to assessing the value of a business, but there are two items of note in the title: (i) the valuation metric; a multiple of revenues and (ii), the notion that technology companies as a group are different from other companies.

So why do people speak of a multiple of revenues when they are referring to the value of a technology company?  First of all, if there is no EBITDA to speak of (i.e. the company is in a loss position/operating with a burn rate), then a multiple of EBITDA is meaningless; and, second, what if the EBITDA margin is at a very low level, much lower than the long term expected average?  What we are really describing here are two early stage phases that many technology companies go through.  The first stage is the start-up phase where companies incur a burn rate and the second stage is the initial growth phase, where it enjoys rapid growth but has not yet achieved the economies of scale to cover its relatively large product development (R&D) and marketing (product/service launch) costs.  In cases like this, while it doesn’t account for many possible differences in business models, the multiple applied to revenues is used as a proxy of future normalized EBITDA.

Many established software companies generate very healthy EBITDA margins.  Margins of 40% - 50% are not unusual (both Microsoft and Google EBITDA margins exceeded 40% during the last two fiscal years).  Equally revenue growth can be very strong, particularly in the early stages.  So what does a growth multiple combined with strong margins translate to, in terms of a revenue multiple? It could be 3, 4, 5 times, and we have seen strategic acquisitions as high as 10 times revenue.  Three times revenues with 50% EBITDA margins equates to six times EBITDA, not that different from traditional metrics.

At this point manufacturing, service, retail and distribution income statement ratios are all in well established ranges but technology companies can typically achieve stronger margins, quicker growth and, in some cases, generate sticky recurring revenues which reduce the risk associated with these revenues.  There are consumer product innovations from time to time that are low-tech and achieve tremendous growth (think of infomercial products like Sham-wow or Spanks) but in general the growth sectors in the North American economy are technology sectors like Software as a Service (SaaS) and Platform as a Service (PaaS) as well as search/comparison engines, e-commerce, social media and mobile applications (also clean tech and bio tech which I personally don’t see that much of).  Companies in these sectors can leverage digital distribution (where the cost of manufacturing and delivering an incremental copy is negligible) and the reach of 80% broadband and 90% mobile penetration to generate very robust growth.

So are technology companies different from other companies?  In a word, yes.  Many are venture funded and achieve substantial market penetration, creating tremendous value while still unprofitable and therefore, while nowhere near perfect, a multiple of revenues can be used as a common metric for technology companies in various stages of growth.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

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, as a result of 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.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

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

There are two broad answers to this question.  The first concerns the business itself and the second concerns the sale process.  The how, when and why of selling.  I will address the business issues in this post; not to say invent a new mouse trap but from the perspective of what factors you can influence in your existing business to improve value.

In “The Basic Math of Valuations” I presented the risk return curve.  A company will attract a higher multiple if it moves to the left on the risk return curve; i.e. a higher multiple is paid for lower risk, but, the biggest driver in attaining a higher multiple is a company’s profitable growth prospects, and, this should already be evidenced by a historical growth record. 

Let’s look at the public markets for an illustration.  The dividend discount model asserts that the fair value of a stock is the present value of all future dividends.  The formula is as follows: fair value of a stock = DPS(1) / Ks-g, where the expected future dividend stream is divided by the required rate of return (Ks) minus the expected growth rate (g).  If a dividend is $5.00 and the required rate of return is 20% then the fair value of the share price is $25.00 ($5.00/0.2) according to this model.  If the expected growth rate is 10% then the fair value jumps to $50.00 ($5.00/0.1).  The growth rate lowers the required rate of return and increases the fair value of a stock.  In this case, 10% per annum growth translates into 100% price improvement.  That is a tremendous amount.  The real world experience is not as exact but the illustration demonstrates the logic and impact of growth prospects on company value.

The same logic applies to EBITDA growth for private companies.  Returning to the example provided in the previous post - a company sustainably generating $5 million in EBITDA is valued at $20 million, four times EBITDA, the equivalent to generating a 25% return on capital per annum - if this company were growing at 20% per annum, the multiple could quite readily improve to 6 or 7 resulting in a valuation of $30 to $35 million.  Again, not quite as exact as the formula but the results are still very substantial.

Now, turning our attention to reducing risk, here are some factors to consider:

Is the owner redundant?

The first thing to address when considering selling a business is to put a strong management team in place that can run the business without the owner.  An owner-operator who is the chief product developer or maintains all of the customer relationships will not be able to exit the business upon its sale.  He/she will have to commit to staying with the business until a suitable replacement solution is implemented.

Is the customer base diversified?

The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a smaller company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration.  While the growth that it drives will increase value the associated risk of these revenues will reduce value.

Are the revenues recurring or project based?

Does every fiscal year start at zero?  What I mean by that is, if your revenues are project based then you are always searching for the next deal.  Consulting companies typically face this challenge.  Along the same lines, a one product company is more risky than a diversified product and services company. 

These are three examples of situations where reducing the risk will increase the multiple but the concept applies in general; any combination of improving profitable growth prospects and reducing risk will increase the value of your company.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

The Basic Math of Valuations – Why Mid-Market Companies Are Valued Lower Than Their Public Company Peers

For public companies, analysts express the value of a company as a multiple of earnings.  It is called the price-earnings ratio or P/E ratio.  If the price of a stock is trading at a low multiple (say eight times earnings) and its prospects are strong, it would be good value; at 50 times earnings that same company would probably be expensive.  For private companies we typically look at a multiple of EBITDA. Let’s say a company has been valued at $20 million; it can sustainably generate $5 million in EBITDA, then it is valued at four times EBITDA.  As I noted earlier, four times EBITDA is equivalent to generating a 25% return on capital per annum; more if cheaper debt is used to lever the equity (for an explanation of this see my “What Will a Financial Buyer Pay?” post).

How do you decide if that is a proper risk adjusted rate of return for your capital?  Risk adjusted is the key word here.  To figure this out we have to start at the risk-free rate and build on layers of risk to see where comparable assets should be priced.  We start with the risk-free rate.  The risk free rate is the rate generated by the most secure assets possible.  The proxy for this is typically federal governments.  They can print money at will so you can be assured you will get your money back (what it will be worth is another matter).  Countries such as Canada, Germany, Austria, and the Netherlands are rated AAA by S&P and are as close to risk free as you can get and therefore set the proxy.

Let’s say the 10 year risk free rate is 3%.  What is the next bucket of riskier assets?  State bonds, Municipal bonds, AAA corporate debt, AAA preferred shares?  All riskier, but lets jump straight to S&P 500 equity.  What is the risk premium of a top tier, multi-billion dollar S&P 500 company?  About 5% to 7% (note: even within the S&P 500, there are riskier subgroups.  i.e. cyclicals vs. consumer staples).  Adding this risk premium to the risk free rate, you get approximately 10%.  So getting back to my introduction, buying a S&P stock at 10 times earnings may very well achieve a proper risk adjusted return.

The concept of the risk-return curve is that it measures the risk premium required for riskier assets.  The idea is that you should be indifferent between different asset classes on the curve because you are being properly compensated for the additional risk.

Intuitively, it makes sense that a small private company is riskier than a S&P 500 company but what are the specific drivers of this?  A small private company typically has fewer customers, more customer concentration, comparatively a less established brand, a limited R&D budget, less access to funding sources (be it banks or equity investors) and much less liquidity for the holders of its equity to name a few key drivers and, as such it is riskier than an S&P 500 company. 

So is four times EBITDA a fair value for a small private company?  It could be, but it depends on many company specific risk-return factors such as its growth prospects, the nature of its revenues (highly recurring or project based) and the size and diversity of its customer base.  I will expand on these factors and their impact on valuations in future posts.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

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.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

What Will a Financial Buyer Pay?

Now that we have examined the logic that drives a strategic buyer, what logic drives a financial buyer? 

First of all, what is a financial buyer?  A financial buyer is one who is buying strictly for a financial return.  Financial buyers include individual investors, who have either saved up or cashed out, and institutional funds such as Venture Capital Funds, for early stage high growth opportunities, and private equity funds, which come in many varieties (including Leveraged Buyout, Growth Capital, Distressed and Mezzanine Funds).  There are over 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds such as BlackRock, Onex and Kohlberg, Kravis Roberts.

How does a financial buyer compete in a world with well capitalised strategic buyers?  Two ways: leverage and portfolio tuck-in acquisitions.

If cheap credit is readily available (i.e. leverage) then financial buyers can be very competitive.  Here is an example.  Company A, a stable profitable company, generates $10M of EBITDA per annum and a financial buyer is prepared to pay the notional value, let’s say it is 5 times EBITDA or $50M.  In this case, assuming no growth, the financial buyer will expect an ongoing stream of EBITDA of $10M or a 20% return on capital per year. 

Let’s say a strategic buyer is willing to pay 6 times EBITDA or $60M.... how does the financial buyer compete?  In a word... leverage.   By using 50% debt and 50% equity, the financial buyer can pay $65M and generate a similar risk-adjusted return on capital deployed.  Here is how it works.  The financial buyer secures $32.5M in debt financing (at 3.25 times EBITDA this will likely include subordinated term debt (“sub-debt”) as well as secured bank operating and capital loans) at a combined rate of 8% per annum.  Now the company earns $7.4M after debt interest payments and the net capital (equity) used is only $32.5M, so the return on equity is now 22.8%, on a risk-adjusted basis close to the 20% originally targeted (one could argue that a higher risk adjusted return is required but the point is made.  More about the risk-return equation later).  How did this come about?  Secured debt is a cheaper (and tax deductable) form of capital than equity and, therefore adding debt to a capital structure – while it increases the risk - concentrates the return on equity and can improve equity value.

Another way a financial buyer can compete with a strategic buyer is to look for tuck-in acquisitions.  Financial buyers typically look for opportunities where they can make additional acquisitions in the space to grow the company to a meaningful market position and enhance value by building a larger, stronger competitor.  The financial buyer’s first acquisition in a sector will be for a target financial return but with the foresight that subsequent acquisitions will build incremental value.  In this case, a financial buyer becomes a strategic buyer.  I said earlier that financial buyers buy strictly for a financial return but in many cases financial buyers envision growth strategies that make them quasi strategic buyers.

So who will pay more?  A strategic buyer or a financial buyer?  I can think of examples where both financial buyers and strategic buyers have paid seemingly exorbitant sums for companies (for example Goldman Sachs buying into Facebook at a $50 billion valuation (over 30 times run-rate revenues) and HP buying 3PAR for 11 times revenues) but if I were to look at the average transaction, I would say strategic buyer. 

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

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.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.