Shares Versus Assets: It is Mostly About Minimizing Net Taxes

Company acquisitions can be in the form of a share purchase or an asset purchase.  Both can accommodate the full transfer of a going concern business.  The fundamental difference is that in a share sale, the shareholders sell their shares and receive the proceeds personally (i.e. the legal entity that owns the assets changes hands) and, in an asset sale, the legal entity sells all of its assets including its name, IP, brand, customer contracts etc., and remains as a legal entity owned by the shareholders but now just has the sale proceeds as its main asset.  A second taxable step of distributing the cash to the shareholders will have to take place for the shareholders to make use of the proceeds.  Sellers that pursue this option may have plans for the company to re-invest the proceeds thereby deferring the tax impact.

So how are they different and which is better for a seller or a buyer?  Ultimately, it is after-tax free cashflow or net cash in hand that drives the value, purchase price and optimal structure.  The tax impact, whether it is reduced capital gains tax for the seller or lower go-forward income tax for the buyer, is usually the biggest driver in the decision between a share or asset sale. 

Buyers will prefer an asset purchase when the purchase price is largely allocated to depreciable assets because they will benefit from higher CCA going forward.  Sellers will prefer share sales when the $750,000 lifetime capital gains tax exemption has a material impact on the proceeds.  In some cases additional family members can benefit from the lifetime capital gains tax exemption by enacting an estate freeze and creating trusts for the children.  However, it must be noted that any shareholder will have to have owned their shares for at least two years for the lifetime capital gains tax exemption to apply so this can’t be done at the last minute. For a family with three children this can increase the exemption from $750,000 to $3,000,000; a big impact for transactions up to $5 million.  For larger transactions it becomes more complex for sellers as depreciable tangible property may incur taxable recaptured depreciation or, where a significant amount of the sale price is allocated to goodwill, 50% of the profit on the sale of Goodwill is exempt from tax.

Beyond tax there are other factors to consider such as:

-       Buyers prefer asset purchases because they avoid the issue of possible skeletons in the closet (undisclosed liabilities)

-       Buyers will seek more reps and warranties in a share purchase agreement as they look to protect themselves from potentially undisclosed liabilities

-       Sellers should consider the risks of possibly having to renegotiate key contracts with customers and employees in the case of an asset sale (where contracts include a change of control provision)

When selling your business, weigh the answers to the following questions to choose your path:

-       Will you benefit substantially from the lifetime capital gains exemption?

-       Will the lion share of the purchase price be allocated to depreciable assets or goodwill?

-       Will transferring contracts (customers/employees) be difficult?

-       Do you have a compelling opportunity to use the funds in the company?

The tax issue can be a complicated one, however, non-tax items such as obtaining customer consents, can sometimes trump it entirely and, if you are indifferent from a tax perspective, the flexibility to pursue either option may provide some helpful negotiating leverage.  For a more detailed analysis of both the seller and buyer impacts see the Veracap M&A Value Strategies newsletter here.

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

Valuation 301: The DCF and Forecasting

In my last post, I reviewed the various discounts and premiums to be applied in the market comparable approach to valuing a company.  Other approaches that use company specific earnings and cashflow include the capitalized earnings and the Discounted Cashflow (DCF) method.

A DCF requires a forecast of the company’s revenues and earnings and then a terminal value is established (to represent the value beyond the forecast period), all of this is then discounted to arrive at present values to be added up.  The discount rate must reflect the inherent risk in generating the cashflows and the terminal value must reflect the growth rate beyond the forecast period.  The cashflow used is “free cashflow” which requires adjustments for capital expenditures and working capital requirements and is net of taxes. Technically, the DCF is the more sophisticated valuation methodology but practically speaking the determination of the discount rate and the terminal value are highly subjective and small changes in assumptions can result in large changes in value.

Irrespective of the discipline brought to the process, multi-year forecasting can be challenging for any company and is particularly hard for early stage, new product/service companies.  I want to note three things about emerging company forecasts: (i) they should be bottom-up, (ii) they should be integrated, and (iii) they should sync with valuation expectations.  Many investor presentations will say: “…look, I only need to capture 1% or 2% of the market and I will reach $100M in sales”.  There are two problems with this statement, one you end up being a small market participant when VCs are looking for the sector winner and, two, you don’t say how you will get the 1%. 

Forecasts should be bottom-up, meaning, they should reflect specific actions such as: (a), we will hire Joe and he is going to call 100 prospects and he will close 5 deals and generate $1M in sales in the first year; then, (b) in six months we will hire Mary and she will...etc.  Forecasts should be integrated, meaning an income statement should feed a cashflow statement which should feed a balance sheet on a monthly basis for at least three years.  Based on this investors can clearly determine the use of funds and impact on the cash position.  Lastly forecasts should result in the expected valuation.  For example, if you are looking to raise $5M for geographic expansion and you are willing to sell 33% equity for this, your forecast better illustrate an aligned use of proceeds and justify a pre-money value of $15M. 

Once a sound forecast is prepared and the valuation math is solid, the question for the investor becomes; do I believe this team can, and will do a, b and c.  If they are comfortable with this, then the due diligence moves on to other items such as management’s past accomplishments, credentials, relationships etc.  While the value proposition and competitive differentiators are the primary attractions in a business plan, a sound, logical forecast is a core component needed to close a successful transaction.

While there are complexities in all valuation methodologies, it is perhaps most important to remember that value is relative and of the moment.  Whether that is relative to recent market information or relative in the context of an appropriate discount rate and terminal value.  It is affected by macro-economic factors such as public sentiment and company specific factors such as patents.  A valuation, like a balance sheet, is a representation at a moment in time but value changes on a daily basis.  Value does not naturally accrete with time.  When profit growth is accelerating there may be hubris but when it decelerates it will go away just as quickly.  When the collective wisdom decided that Apple’s growth would slow, it lost over 30% of its value in just three months.

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

Valuation 201: Comparable Company Analysis

Ever since I wrote “TheBasic Math of Valuations”, which explains the valuation differential between different asset classes, I have been meaning to write a follow-up on specific valuation techniques. There are market based approaches such as public company trading multiples and comparable transaction analyses and cashflow and earnings based methodologies such as the Discounted Cashflow (DCF) analysis.

 

In this post I’d like to look at market based approaches.  Let’s start with the easier one to explain; comparable company transaction analysis.  This is just like when your real estate agent shows you what houses sold for in your neighbourhood.  You compare your neighbour’s house in terms of number of bed and bathrooms, lot size, etc. and then you figure, well, if that one sold for $500K then, since mine is better, mine must be worth about $600K.  If you have a $200K mortgage you end up with net $400K after the sale.  The logic is the same for companies however it is very rare that you find: (i) a truly comparable company transaction, (ii) completed very recently (or else different economic conditions will have to be considered), and (iii) there is full information available on consideration components (i.e. cash, earn-out, amount of debt assumed, working capital adjustments, deal exceptions, etc.).  Public company trading analysis can provide trending and current day valuation comparisons but the challenge of assembling a good representative sample remains.

 

Both market approaches need subjective adjustments in order to derive at an attributable value range. Comparable transaction data and public company shares are typically available from larger public companies which means that, in order to attribute this data to a smaller private company, two types of discounts need to be applied, a small company discount and a private company marketability discount and, in addition, public company shares trade at a minority discount which raises the question of how much of a control premium to apply.

 

How are these discounts and premiums determined? Large public companies benefit from easier access to capital, lower cost of capital, in many cases a strong brand and generally scale, diversification of suppliers and customers and many more risk reducing attributes.  Small companies typically have higher customer concentration, a less established brand, less access to funding sources (be it banks or equity investors) and, private companies are illiquid; it takes a lot of time and effort to find the right buyer.  As such, small private companies are riskier than large public companies.  Every comparison is unique but generally speaking, more risk means a higher required rate of return.

 

Minority Discounts and Control Premiums are two sides of the same coin.  Public company shares trade at a minority discount because any individual shareholder does not have enough influence (i.e. votes) to change the direction of the company.  However as soon as a control block is in play, the minority discount disappears.  Control premiums are tracked by Mergerstat and were on average 50% in the first quarter of 2012.  So how do the various discounts and premiums stack up?  Generally speaking, small private companies are valued below the trading values of public companies – even without the control premium applied. In other words, public minority share valuations are still higher than small private company control share valuations.

Both market approaches need subjective adjustments in order to derive at an attributable value range.  The question of whether a comparison of a $1 billion public company to a $50 million private company deserves a 30% or a 50% discount requires consideration of many factors and is best answered by an experienced, accredited professional valuator.

 

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

 

There is Plenty of Investment Capital Out There, Except For...

I have spoken before about the variety and depth of venture capital (VC) and private equity (PE) funds (see: Specialized Funds for Unique Needs).  To reiterate, there are over 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds; from special purpose acquisition companies (SPACs), to Leveraged Buy-Out (LBO), Growth Capital, Mezzanine and Distressed funds.

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 typically look to achieve their goals by acquiring additional companies 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 position of its investments.

In Canada there are quite a few start-up or incubation venture capital funds which will invest from several hundred thousand to $1M in promising ideas but, as-of-yet unprofitable companies. Some notable ones include: Extreme Startups, FounderFuel, GrowLab, Hyperdrive, and Version One Ventures.  There are also quite a few VCs and PEs that focus on profitable companies with investments of $5M and up such as Bedford Capital, Clairvest, Huron Capital, OnCap, Torquest and more.  But, where is the capital for companies that are profitable generating EBITDA from $0 to $1M?  This is the black hole of institutional investment.  If you have two or more years at profits of less than $1M, it becomes very hard to attract investment capital. 

What motivates the incubation funds is the possibility of a home run; the $5M folks are looking for typical private equity returns of 25% to 30% and find this area one where they can put some carry, or yield, into the structure to pay the bills, and they can grow to a ready exit either through IPO or sale.  The less than $1M profit, modest growth segment just doesn’t tick the boxes as well as the other segments.  Anyone that starts in this segment tends to move on to bigger deals.  One reason for this is (and I have heard this one a thousand times so I hate to say it) it takes as much work to close a small deal as it does to close a big deal (but the bigger deals just earn way more money); but also because it is a transition phase between the conceptual incubation funding, that relies on vision, and the proven entities where the valuation looks to cashflow.  Once cashflow is generated it tends to define the company.

Many good companies will have windows of equity financing opportunities.  They may be presented when the company is pre-revenue and has technology or customer commitments that put it ahead of the crowd; or it may be presented when the company is in accelerating revenue growth mode and, at that moment, the stars align with respect to market position and owner and investor value perception.  When the growth rate starts to decelerate and the owner’s value expectations continue to increase, that is when the window begins to close.  Entrepreneurs may act or pass on these opportunities, that is their choice, but just know that when you pass on an equity financing opportunity it may be gone forever.

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.

2012 Year-End Summary

As another year comes to an end, I thought I would organize a topic reference page around themes.  The following are select blog posts from the last two years.  Happy Holidays and if you have any thoughts for a topic in 2013, please let me know.

Terminology and Documentation
M&A Acronyms

An Overview of NDAs

What Does a CIM Include and How Do You Position It?

M&A Process

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

Attracting Foreign Buyers: The Benefits of M&A International

Milestones in the M&A Process: How Long Does it Take?

What is Due Diligence and What Does it Consist Of?

Winner’s Remorse: Does the M&A Process Lead Buyers to Overpay?

Preparing a Business For Sale

Normalization Adjustments for Private Companies

12 Situations to Avoid When Selling Your Business

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

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

Buyer Selection

Constructing a Buyer List

What Makes a Good Buyer?

Finding a Buyer: It is Rarely the One You Expect

What Will a Strategic Buyer Pay?

What Will a Financial Buyer Pay?

Is There More Than One Buyer For My Business?

I Have a Buyer For Your Business

Buyers are Currently Paying High Prices for Businesses Like Yours

Valuation

Why is a Tech Company Worth Three Times Revenue?

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

Why is Instagram Worth 1 Billion?

Is Instagram Worth 1 Billion… only to Facebook

More Thoughts on Price Expectations

A Multiple of What (and When)?

It is all About the Platform

Choosing an Advisor

What Exactly Does an M&A Advisor Do?

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

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

M&A/Corporate Finance Options

When is an MBO a Good Idea?

Specialised Funds for Unique Needs

What About the Form of Payment?

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 is Due Diligence and What Does it Consist Of?

Due diligence is an investigation of a business or person prior to signing a contract.  More specific to a divestiture, it is the process of verifying the representations made in the CIM and other marketing materials provided to the potential acquirer by the seller.  For example, in a CIM we may state that the seller’s customer contracts have an average life of three years and that no single customer accounts for more than 5% of revenues.  The potential acquirer will extend an expression of interest based, in part, on this information (remember, while the CIM highlights all the facts that drive sustainable value – it still holds back competitively sensitive information).  Business due diligence is the act of examining all of the signed and valid customer contracts and, in this example, confirming that customer contracts do, in fact, have an average life of three years and that no single customer does account for more than 5% of revenues.

A seller should always keep due diligence in mind when thinking about the sale of their business.   We typically provide sellers with a due diligence checklist early on in the process so that they can take the first several months of the process to get organized and assemble the documents.  I would be happy to share a due diligence checklist with anyone interested (just email me).  The  documents required for due diligence include all material signed contracts such as customer contracts, banking agreements, funding contracts, shareholder agreements, employment contracts, as well as resumes, benefit commitments, internal financial statements, receivables/payables aging schedules, capital acquisition and depreciation schedules, tax records, asset listings, articles of incorporation, the minute book, and perhaps software architecture documents, product roadmaps, environmental assessments, historical board presentations, and ultimately customer and bank reference calls.  These are just a few of the items typically included but, generally speaking, it consists of everything material to the well being of the company.  Clients provide us with these documents and we scan them and selectively, and in stages, make them available in a virtual data room to be shared with relevant parties. 

Due diligence generally happens in phases.  Some due diligence is performed before exclusivity (i.e. a signed LOI) and most after.  The first phase of due diligence is business due diligence; this is where the acquirer’s executive and accounting teams figure out exactly how the revenue streams and products of the acquirer and target complement each other in order to determine how much they can pay for the target while meeting their own ROI targets.  Legal due diligence occurs during the exclusivity period and will include title searches and other searches to ascertain the target company is a valid company, owning the assets that it purports to own and operating within the regulations of the jurisdiction and that no lawsuits or claims are outstanding.  Once a certain amount of due diligence is completed parties typically initiate work on the purchase and sale agreement.  Sixty to ninety days is a typical timeframe from signing an LOI to closing the acquisition of a straight forward private company.

Finally, after exhaustive due diligence the seller will still be asked to represent that they did not withhold any information such as knowledge of potential lawsuits in a purchase and sale agreement.  In “What Does a CIM Include and How Do You Position It?”, I said: “ CIM must not over-promise or leave less than flattering facts out because it forms the basis of an expression of interest that may turn into an LOI and, ultimately a purchase and sale agreement.  Due diligence verification throughout this process will uncover all of the facts.” From the outline above I trust you will agree with me.

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 Exactly Does an M&A Advisor Do?

In “How Does an M&A Advisor Add Value to the Divesture Process?”, I noted that M&A advisors typically charge between 3% and 7% as a success fee for managing the sale process for a company.  The question I addressed then was, will engaging an M&A advisor improve your expected sale value by at least 5%?

Here I would like to outline exactly what an advisor does in the process of a sale mandate.  At this point I am assuming that pre-mandate matters such as preparing a business for sale, value expectations and timing from a business and market perspective have been discussed and it is agreed that it makes sense to proceed.

The advisor side of the deal team typically includes a senior lead such as a Director or Managing Director plus at least one Associate or Analyst as support.  In addition, in our case, there are usually international resources involved through our M&A international alliance.  Our M&A partners can do as little as buyer introductions to as much as negotiating and structuring deal terms.

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.  We typically identify what we are responsible for in our engagement letters as follows:

·              Conduct a review of the company in order to better understand the nature of its operations and value proposition to prospective partners including:

o      a review and analysis of the historical and prospective financial results of the company;

o      a review and analysis of operational, marketing, technical and other information regarding the factors that influence the cash flow prospects and risk dynamics of the company;

o      discussions with management regarding the operations of the company;

o      a review and analysis of public information and other available information pertaining to the company and the industry in which it competes, and

o      a review and analysis of transactions that have taken place in recent years among businesses whose operations are similar to those of the company.

·              Prepare company overview materials in consultation with the company, which will provide prospective partners with an understanding of the nature of the company and allow them to assess value;

·              Conduct a search to identify suitable potential partners, guided by any criteria provided by the company;

·              Contact and screen potential partners;

·              Assist the company in the preparation of due diligence documentation, a management presentation and related materials for review by possible partners;

·              Negotiate with possible partners;

·              Work with the company’s legal counsel, tax advisors and other advisors to assist the company in structuring the transaction so as to meet its financial objectives; 

·              Review the documentation in respect of the transaction; and

·              Other functions as required in support of the transaction, and as agreed to from time to time.

The whole process may take six to eight months and the M&A team will spend somewhere between 300 and 500 hours on a file.  M&A advisors will have a lot of familiarity with legal documents and tax issues, but ultimately lawyers and accountants are required in the areas of due diligence, purchase and sale contracts, and tax planning.

M&A advisors often highlight how competitive bidding between several eager buyers resulted in an extraordinary price for their clients but, like the over-night success story ten years in the making, a completed divestiture relies on a foundation of thorough planning and process.

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.

It is all About the Platform

I have mentioned the word platform several times in my posts, however, the word actually means different things in different circumstances, so I thought I should clarify.  Private Equity (PE) looks for platform investments and sellers look for platform buyers but they are not necessarily the same thing.

A platform investment for a PE is an investment/acquisition in a new space that it intends to grow in.  For example, when Vector Capital bought 20-20 Technologies in July of this year, they announced it as a platform investment.  Before the acquisition Vector had holdings in consumer software (Corel) and digital media (RealNetworks) but nothing in computer-aided design software for the interior design and furniture industries.  In a platform investment, the buyer is looking for a market leader that it can use as a platform for growth.  Subsequent acquisitions or “add-on” investments will be one way to achieve this growth.  The investment criteria differ between platform and add-on investments in that they are typically stricter for a platform investment. A platform investment would ideally be on the larger end of a PE’s size range and be bought at a good price.  There is more risk in a platform investment because it comes with the challenges of learning a new sector landscape and the target company’s competitive position in it.  When considering add-on investments the PE is effectively acting as a strategic buyer and looks to exploit potential synergies between the buyer and the target.  Add-on investments are also called “tuck-in” or “tuck-under” investments because they tend to be smaller than the platform investment.

The other way the word platform is used is to describe a type of buyer.  A platform buyer is a strategic buyer looking for a platform to grow its revenues by adding complementary products, personnel, technology, etc.  Platform buyers are good buyers because, (i) they can pay a good price because they bring a growth opportunity to the target, and (ii) they will leave the existing assets (brands, people and legacy) in tact.  As an example, we were engaged to sell a pattern recognition company in the field of product quality control.  The technology would scan a production line and identify products that did not meet certain quality parameters.  In this case, the ultimate buyer was the US Department of Defense, who paid a strong premium and who then used the technology for facial recognition for national security purposes. 

I spoke earlier of a PE acting as a strategic buyer and looking to exploit synergies.  Synergies can come about in constructive or destructive ways.  A destructive way would occur when a direct competitor buys a company for its customer base.  In this case, if the buyer has excess capacity, it could shut down the acquired company and service the customers using its existing product and plant, thereby growing revenues and improving margins (synergies) but leaving the target decimated.  On the other hand, a platform buyer will consider the target company’s customers, personnel, or technology as complementary rather than redundant. In this case the target retains the existing customer base and also adds the acquirers’ customers thereby growing revenues by a higher factor than in the previous example and creating more value.  As a result, a platform buyer is a good buyer.  They can pay more because they can create more value and they retain the brand, team and legacy of the seller.

In the first instance the word platform refers to the vehicle that will form the basis of a sector growth strategy and in the second case it refers to the assets that generate complementary growth.  Either way, it is all about the platform.

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 Does a CIM Include and How Do You Position It?

C.I.M. stands for Confidential Information Memorandum and it is the main overview document provided in the private company divestiture or private placement financing process.  A CIM is made available subsequent to signing an NDA and presents detailed company information as a basis for an indicative value discussion.

The CIM is typically prepared by the adviser and ranges from 40 to 100 pages.  CIMs describe the nature of the business (i.e. products/services, strategy, differentiation, revenue model, etc.), its history, ownership, legal structure, suppliers, customers, competitors, market opportunities, management, growth prospects, and high level financial information such as historical revenues, EBITDA and a balance sheet.  Customers, key suppliers and key management do not have to be identified by name.  It is still important to protect competitive intelligence at this point as there will be only one successful buyer and the company should not be put in a position where its competitors have access to sensitive information about the company.

The reader of a CIM will be looking to better understand the value proposition of the company and to identify attributes that drive sustainable value. Some examples of questions to be addressed include:

-       Has the seller transferred his/her relationships and know-how to ongoing management?

-       Are the revenues of a recurring nature or project based?

-       What are the key sustainable differentiators of the product or business model?

-       Is the customer base diversified / is the business reliant on key suppliers?

A CIM must not over-promise or leave less than flattering facts out because it forms the basis of an expression of interest that may turn in to an LOI and, ultimately a purchase and sale agreement.  Due diligence verification throughout this process will uncover all of the facts. 

CIMs are different for early stage financings versus divestitures.  In the former case, it is more like a business plan outlining intentions and how to achieve them whereas for a divestiture it is more of a description of the business and the market the company competes in.  In the case of raising capital you need a detailed and logical use of funds explanation and this use of funds needs to generate a positive incremental return on investment.  In the case of a divestiture it is not so black and white because, in my view you would only include a forecast if you expect it to be substantially different from past trends. If you have a strong historical growth record and you expect this to continue then it may be best to just provide an estimate to the end of the current fiscal year.  This is because you don’t know what the buyer may be thinking and he/she may actually envision a future that includes leveraging its assets to construct a forecast that is much higher than what you would have prepared.

Should a CIM be written for the best buyer/investor? What I mean by this is, if there is a well capitalized large company acquiring businesses in your space, should the CIM be written to appeal directly to this potential buyer?  My view is yes and no.  Yes in that, you should exploit every angle to best position the company and no in the sense that you would do 90% of that anyway as you write the CIM to highlight sustainable value drivers.  A CIM undoubtedly raises further questions, and this is a good thing because it allows advisors to engage potential buyers on the opportunity, add color, clarify any misunderstandings and strengthen the main selling points specific to that potential buyer.  In short, create a two-way exchange of information and gain a better understanding of a buyer’s strategy which can be leveraged during negotiations.

In the end, a CIM is a marketing document and should present the business in its best light.  There is an art to writing a good CIM.  A good CIM provides all of the basic information plus it paints a rich picture of opportunities.

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 About the Form of Payment?

Public company take-over bids typically consist of all cash or a combination of cash and shares.  This is largely because the board of directors of a public company agreeing to an earn-out will be subject to serious questions (read lawsuits) if things turn out other than expected.

Consideration in private company acquisitions will usually include a sizable portion in cash (50 to 100%) but will often include an unsecured note and/or an earn-out as well.  This is typically because: (i) the buyer does not have (or have access to), the amount of cash required to complete the acquisition (particularly in the case of an MBO), (ii) the greater risk surrounding private companies (risks such as customer concentration, dependence on key suppliers, etc.) and (iii), buyers can usually stretch to a higher price if the purchase price is not all cash.  For example, $25 million all cash vs. $30 million two-thirds cash and one-third note ...which one would you pick?

There are a number of issues to consider when assessing the likelihood of realizing deferred consideration.  A dollar not received at closing is a dollar at risk.  In the case of a vendor note, the first question is, can it be fully secured by hard saleable assets (such as land, a building or other fixed salable assets owned by the acquirer).  This is not often the case.  If the amount is under-secured (i.e. 50% asset coverage) or unsecured, the terms have to reflect increased risk and due diligence should be performed on the buyer to get comfortable with its risk profile and prospects.  The higher the risk the higher the interest rate, and the more covenants and timely reporting are required.  Perhaps the most important item is timely reporting allowing for quick remediation.  Issues such as lawsuits, product defects/recalls, loss of customers can turn the fortunes of a company very quickly.

Earn-outs are tricky as well.  Earn-outs are more prevalent when the seller presents a strong growth forecast (for which he/she wants value).  If the seller will not entertain an earn-out, does that mean he/she does not believe in the forecast? They are not usually ironclad.  Many earn-out proposals begin with a premise along the following lines.  If you achieve $5 million in EBITDA you will earn another $x amount in purchase price.  Does this mean that if the company generates $4.9 million you get nothing? … and how is EBITDA calculated?  The acquiring company could incur discretionary expenses that you would not incur, or layer on additional overhead or, most drastic, a fundamental change of business direction could be required?

There are many possible situations to consider and many creative mechanisms and approaches to making vendor notes and earn-outs work.  For example, if the seller agrees that 75% of the earn-out will be paid if 75% of the target revenues are reached then he/she should also seek 125% of the earn-out when 125% of the revenues are reached.  Earn-outs can be tied to achieving development milestones, securing customer contracts but if earn-outs are based on the financial statements, then the higher up the income statement (i.e. sales vs. profit) the better… less room for manipulation. From a legal perspective it is important that purchase and sale contracts are clear, account for all possible scenarios, and that security is properly perfected in all relevant jurisdictions.

Un(der)secured notes and earn-outs can get very complex and this is where experienced advisors and lawyers really earn their stripes.

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.

A Multiple of What (and When)?

I discussed the pitfalls of relying on publicly available value comparisons in a recent post but what if an owner of a similar business to yours says “I sold my business at a 10 times multiple!”? or you hear, the tech sector is trading at a 25 multiple.  Early stage companies trade at 2 to 3 times.  The question is a multiple of what?

For public companies the most noted multiple is that of after tax net income.  For early stage companies it is quite often a multiple of revenues because, either they are not profitable or, they are in high growth mode, where profit levels are depressed as a result of higher than long-term average spending on R&D and product/service marketing.  For established private companies, the most commonly cited valuation metric is a multiple of EBITDA. 

EBITDA stands for Earnings Before Interest, Taxes and Depreciation and it allows for comparison of profitability by canceling the effects of different asset bases (by cancelling depreciation), different takeover histories (by cancelling amortization often stemming from goodwill), effects due to different tax structures as well as the effects of different capital structures (by cancelling interest payments).  The drawbacks of using EBITDA are that it doesn’t account for maintenance/required capital expenditures (CAPEX) to sustain the business and, because it is a non-GAAP metric, it is often presented on an adjusted basis excluding (sometimes questionable) one-time items thereby boosting profitability.

The relationship of an EBITDA multiple to other multiples can vary widely across industries.    For consulting or software companies, that typically don’t or can’t carry long term debt and have little investment in fixed assets, EBITDA is often the same as earnings before tax.  For capital intensive companies, an EBITDA multiple of five might be the equivalent to an EBIT multiple of seven.  When we speak of a five times EBITDA multiple for a private company, the value may actually be the same as 15 or 20 times net income after tax for a profitable public company.

The period the multiple applies to is also important. While valuation is conceptually a forward looking principle, the standard is to use a historical multiple as a result of the difficulty of predicting what the next 12 months of earnings might be.  Some variants of timeframes used are “run-rate” (annualizing the last month or quarter), “latest twelve months” (LTM, typically calculated on a rolling four quarters basis), or last calendar or fiscal year.  Why does the timeframe matter?  Let’s look at a fast growing public company such as Apple.  On August 20^th, its market cap was approximately $620 billion.  Its latest fiscal year ending (EBITDA was $35.5 billion and its 12 month consensus forecast EBTIDA was $55.8 billion.  People will say Apple is trading at 17.5 times EBITDA but the more proper metric is that it is trading at 10.7 times forecast EBITDA, a difference of 70%.

Finally, in addition to the specifics around the multiple, there are many bigger picture questions such as: did the buyer assume the debt; were there working capital adjustments; was the amount paid in cash on closing or will it be paid over time? Different answers to such questions will also measurably impact the net multiple paid.  So the next time someone tells you they sold their business for a great multiple, think about a multiple of what and when.

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.

Winner’s Remorse: Does the M&A Process Lead Buyers to Overpay?

When managing a company divestiture, there comes a point when interested parties are requested to provide non-binding expressions of interest (this is the first indication of value based on reviewing the CIM and answering select questions, see: How Much Information (and when) Do I Share With Potential Buyers? ).  An expression of interest outlines a value range, structure and other criteria, on which potential buyers are prepared to move forward.  It is requested so as not to waste the seller’s time with potential offers that will not meet the needs of the seller.  When there are multiple expressions of interest for a company, they typically form a normal curve around the company’s notional value. 

Non strategic/financial buyers are typically at or below notional value (E1..E4) and strategic buyers are typically at or above the notional value (E4..E7).  The parties engaged to go forward in the process will be the ones above notional value (E6..E7) suggesting that they may be ready to pay a higher price than fair value, however, fair value is very much in the eye of the beholder.

A strategic buyer may pay more than the notional value for a business for reasons of competitive strategy (i.e. prevent your competitor from strengthening its footprint) or when the seller has certain assets that complement the buyer’s assets thereby allowing for the potential to create value through synergies. The value of a business is different to every potential buyer.  To a financial buyer (one that does not have the potential for synergies, but may nevertheless be able to bring special expertise to the table) a business may be worth the notional value which maybe six times EBITDA, generating a 17% non-levered ROI (maybe more  than 30% with 50% debt); but a strategic buyer could pay seven times EBITDA and expect to generate even more based on synergies.

So does the M&A process lead buyers to overpay?  Not necessarily; the process extracts the highest price for the seller by appealing to potential buyers that will benefit most from the purchase.  The buyer has to weigh the risks and benefits of the price they will pay versus not getting the business. Overpayment has been in the news lately with HP writing off $8 billion of goodwill from its $13 billion acquisition of EDS and Microsoft writing off $6.2 billion of goodwill in its Online Services Division where it houses the acquisition of aQuantive (which it acquired for  just over $6.3 billion).  The onus is on the buyer to correctly estimate the realisable cashflow from a purchase and then to execute on its plan.  Many things can go wrong in execution but the fact remains that if there is more than one buyer at the table it is highly likely that the winner will have paid more than notional value.

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.