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.

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 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.

Why is Instagram Worth 1 Billion?

There are many reasons why Facebook would pay a lot of money for Instagram.  Reasons such as: to improve its mobile revenues (of which it had none), to eat Twitter’s lunch, to eliminate a potential future competitor, and basically to maintain its growth and market value momentum.  Remember, Facebook is the internet's largest photo sharing site and it knows the power of photos very well but what I really want to tackle here is why 1 billion as opposed $500 million?

The simple answer is it was a privately negotiated transaction and Instagram had just recently raised money from Sequoia Capital at a reported $500 million valuation, so they weren’t going to sell for less.  Well done to get to 1 billion.  This means that Sequoia Capital and other firms that contributed money were essentially able to double their money in a very short timeframe.

Prior financing round valuations and existing investors’ requirements are value pegs but here is some theory around what price is possible.  In cases like this companies are paying a scarcity premium.  The argument being that, either by way of market position (i.e. if all your friends are on Facebook there is no point being on Orkut) or by way of proprietary technology, these targets have something the acquirer can only attain by buying them.

At this point a buyer is paying a price beyond the notional value of the target and encroaching on the value to the buyer.  The notional value is a company’s value independent of the potential strategic benefits to a particular buyer.  The value to the buyer is that amount of value the acquirer can produce with the target.  Not something they typically pay for unless forced to in a competitive situation.

To consider this by way of a generic example, let’s assume a billion dollar revenue company is paying 10 times revenue for an early stage company generating $1 million in revenues.  The target company’s technology will allow the billion dollar revenue company to increase its market share by 10%; a value of $100 million in revenues.  You can understand why the acquirer might pay $10 million for this company.

The conclusion is that a buyer paying a price below the value to the buyer is something that makes economic sense, even though the price may sound astronomical…. and if you are being approached by Facebook (estimated value of $100 billion) then there is a lot of room to pay a lot of money.  In my next post I will examine what Facebook could have paid.

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.

VTI Profit Margins Underwhelm

In the Spring issue of the Veracap Technology Quarterly we took a closer look at technology sector profitability.  While valuations have improved substantially, many mid-market technology companies still struggle with profitability.

On average only 55% of the technology companies included in the Veracap Technology Index (the “VTI” includes all technology sector companies trading on the TSX and TSX-V with a market capitalization between $10 million and $500 million) were EBITDA positive and, of those companies, the average margin was 12.1%.  The subsector with the most profitable companies was the IT Consulting & Services sector and the sector generating the highest margins was the Internet Software & Services sector with an average EBITDA margin of 15.3%.   In looking for an explanation of these results we believe the answer lies in the average size of the companies.  The average market cap of the VTI is only $81 million.  Of the companies not generating a positive EBITDA, 84% had a market cap of less than $100 million.  Canadian technology companies go public at a relatively small size and need to grow larger to achieve scale and improve efficiency.

The most profitable companies in the VTI were Mediagrif Interactive Technologies with an EBITDA margin of 33.6%, Enghouse Systems with an EBITDA margin of 27.2% and C-Com Satellite Systems with an EBITDA margin of 23.9%.  While nowhere near world leaders like Google and Microsoft which have generated EBITDA margins in the 40% range for years, these are nevertheless our strongest performers in the quarter. 

So do high margins translate to the best valued companies in the VTI?  In general yes, the above noted companies are in the top quartile in terms of an EBITDA multiple but there are exceptions as well such as C-Com Satellite Systems which ranks 3^rd in profitability but was valued at less than four times LTM EBITDA.

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.

Tech Companies Explode Out of the Gate in 2012

The Veracap Technology Index (“VTI”) composite share price has been on a tear since December 2011.  The VTI has more than quadrupled the S&P/TSX Composite Index, with a return 20.8% versus 5.0% for the period from December 1, 2011 to March 1, 2012 (and this excludes the stellar premiums awarded such take-over targets as Gennum and RuggedCom).  

To refresh our readers on the VTI, it includes all technology sector companies trading on the TSX and TSX-V with a market capitalization between $10 million and $500 million (Veracap’s area of focus).  As at March 1, 2012 this included 79 companies and of these 53 were up an average of 38%.

Technology sector valuation multiples have also increased sharply from 7.4 on December 1, 2011 to 9.8 on March 1. 2012.  The strongest subsector, in terms of valuation multiples, was the Software sector where companies such as Nightingale Informatix,  Redknee Solutions, and Posera-HDX contributed to an average last twelve month (LTM) EBITDA multiple of 13.2.   The Hardware & Equipment subsector brought up the rear with companies such as COM DEV International Ltd., Smart Technologies Inc. and LOREX Technology Inc. trading below five times LTM EBITDA.

Technology sector lifters and drags for the period from December 1 to March 1 include:

Lifters                                                 Subsector                                             %

Aastra Technologies Ltd.                    Communication Technology              Up 44.7%

Glentel Inc.                                          Communication Technology              Up 40.0%

Enghouse Systems Ltd.                     Software                                             Up 39.9%

Drags                                                  Subsector                                             %

Smart Technologies Inc.                     Hardware & Equipment                     Down 29.0%

Sandvine Corporation                         Communication Technology              Down 12.0%

DragonWave Inc.                                Communication Technology              Down 5.9%

Note: for companies with a December 1 share price greater than $1.00

For more M&A information on the Canadian technology scene please see our Spring issue of the Veracap Technology Quarterly.

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.

Has it Been Three Years Already?

In my last post I noted that now is a good time to pursue a divestiture or private equity transaction based on: (i) coming out of the recession in 2009 and seeing a general return to growth and profitability, (ii) historically low interest rates, and (iii), a tremendous amount of investible capital at private equity funds and on corporate balance sheets.  So how good is it?

The following is a chart of the S&P500 over the last three years. Since March of 2009, after reaching a low in the 675 area, the S&P500 is now 100% higher and flirting with recent highs.

The 10 year US Treasury yield index is below 20 (at a three year low resulting in a yield of 1.87%).

The facts are as follows: we are near a three year high in the S&P500; S&P500 earnings have improved every quarter since Q1 of 2010, interest rates are at three year lows and a recent study by the Wall Street Journal highlighted that "cash accounted for 7.1% of all company assets, the highest level since 1963."  In short a strong foundation for a healthy M&A market.

BUT, people are worried.  Worried about the European debt crises, US budget deficits, an ineffectual Congress, falling house prices and an unemployment rate of over 8%; hence the contradiction of improving earnings and historically low interest rates.  The expression “the market is climbing a wall of worry” reflects a scenario where the market goes up despite uncertainties.  This is positive in my mind because it represents a healthy tension between the bulls and the bears; no over exuberance with the potential of a crash but steady as she goes. According to Standard & Poor’s, the current consensus 2012 earnings forecast for the S&P500 is $103.70 which, at current levels, equates to a multiple of 13 times. Quite reasonable and therefore we are in a positive environment for M&A activity.

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 Window is Open

I noted in my last post that private company divestitures or equity financings can take between seven to nine months to complete (a financing can be quicker depending on the structure).  This may seem fast or slow depending on your perspective but that timeframe is typically not the whole story. 

Veracap's Value Enhancement Framework^TM (see “How Does an M&A Advisor Add Value to the Divesture Process?”) notes that an important part of the process is the planning stage.  For example, while preparing for sale it is critical that personal goodwill be transferred to intangible, company goodwill.  What this means is that owner-entrepreneur responsibilities and relationships are migrated to a management team that will stay with the business for an extended period of time.  The planning process may take several years to complete.

The next phase that can take years to complete is the transition phase.  Unless the owner-entrepreneur is no longer active in the business, the buyer will likely seek a period after the closing where the seller remains engaged to ensure a smooth transition and delivers on earn-outs, etc.

The planning and transition phases can add a number of years to the process, but here is the real kicker, investor sentiment and the economy.  In fact, a great opportunity to sell or raise equity at a premium may come along only once in a lifetime.  We all remember the internet bubble of 2000 and the more recent US real estate bubble in 2008.  If you assembled a good tech team and had a web related idea in 1999 or early 2000, you could fund a start-up at a significant valuation (I personally had an idea that was funded at a multi-million dollar value). 

The internet bubble crashed in 2000 and the US real estate bubble crashed in 2008 taking the whole world with it.  When a recession hits and profits are diminished, demand drops off and values naturally become depressed.  You could arguably sell your business in the 2009/10 timeframe but not at 2007 valuations.  As an owner-entrepreneur, when you thought your business was worth $20 million but you are told it is now worth $12 million, you are going to think twice about going to market.

We have seen many businesses return to strong profitability in 2010 and 2011 (depending on their fiscal year end) and with a number of years of sales and margin growth, strong valuations can yet again be achieved.  While bubbles are extremes there are always hot and cold sectors from time to time where strong valuations are realizable.  Some current examples of hot sectors include cloud based virtualization such as Software as a Service (SaaS) and Platform as a Service (PaaS), social media, mobile marketing, penny auction and deal-of-the-day web sites.  A once hot but now cold sector, ironically, is the solar sector.

We cannot predict when the next recession will begin.  The finance community refers to IPO windows; when they are open an IPO is possible, when they are closed it is not.  The process of preparing and positioning to sell your business, or equity in your business, can take many years and an economic downturn can add several more years to that.  As for right now, based on: (i) coming out of the recession in 2009 and seeing a general return to growth and profitability, and (ii) historically low interest rates, plus a tremendous amount of investible capital at private equity funds and on corporate balance sheets, I would say the window is open.

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.

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

Milestones in the divestiture or private capital raising process are similar and generally as follows:

Milestone	Timeframe
Preparation of the marketing materials (by the advisor in concert with the seller) and due diligence materials (by the seller).	The documentation including a teaser, CIM and buyer list, while iterative with the seller, can be completed within four weeks. Preparation of the due diligence materials is highly company dependent and can take from several weeks to several months.
Engaging potential buyers and securing expressions of interest.	Potentially to many parties; up to 2 months.
Management meetings and supplemental information provisioning; securing and negotiating the final LOI.	With the top 3 to 5 parties; up to 2 months.
Due Diligence and drafting/negotiating the purchase and sale agreement.	With the final party; 45 to 60 days.
Total	7 to 9 months

Having said that, the following is an actual example of a divestiture of a private company.  In this case, the owner and 100% shareholder wanted to retire and was well prepared to initiate the process.  The business was a very profitable software business operating out of one location servicing a diversified customer base.  In short, an attractive acquisition opportunity supported by a motivated seller.

The engagement letter to commence the process was signed May 11^th, a Wednesday.  That Friday we met with the company for an information gathering and strategy session.  One week later we met again, this time having completed a first draft of a potential buyer list, a Confidential Information Memorandum (CIM) and the teaser.  First emails and calls to potential buyers commenced on may 26^th; first books (CIMs) were sent on June 10^th; and expressions of Interest (EOIs) were requested by June 30^th. 

Getting a sense of market interest and indicative value can be a fast process; in this case about seven weeks.  Key contributors to a speedy process are client readiness and working as expeditiously as possible on the factors that the selling team can control.  While only half-way through the process (with management presentations, requesting and negotiating LOIs and due diligence yet to come), the selling team will have a good sense of the market interest and whether a good deal is possible at this point in the process.

Many things, both economic and company specific, can change during the selling timeframe and it is strongly in the seller’s and advisor’s interest to complete the process as quickly as 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.

Veracap Launches Mid-Market Technology Index

While there is an S&P/TSX Information Technology Sector index, it consists of just six companies and five of those have a market cap greater than a billion dollars.  Due to the small number of companies included, it is susceptible to company specific risk influences.  As an example, the S&P/TSX Information Technology sector index was down 18.5% January to November 25^th largely due to RIM falling over 70% during this period.

The Veracap Technology Index (the “VTI”) includes all technology sector companies trading on the TSX and TSX-V with a market capitalization between $10 million and $500 million.  As at November 25, this included 75 companies.

There are 179 technology companies listed on the TSX and TSX-V, further segmented in the following subsector classifications: Hardware & Equipment, Internet Software & Services, Communication Technology, Software, and IT Consulting & Services.  As at November 25^th, 88 listed companies had a market cap of less than $10 million and the average market cap in the VTI is $70 million.

We feel the VTI is a better representation of Canada’s vibrant mid-market technology sector.  The VTI composite share price outperformed both the S&P/TSX Composite Index and the S&P/TSX IT sector index since the beginning of 2011 with a year to date return of -8.4% versus -14.7% and -18.5% respectively.  Technology sector valuation multiples crossed the S&P/TSX Composite index in mid August as the latter was dragged down by falling commodity prices. 

Since the beginning of 2011 VTI companies have been trading at an average valuation of around 9.0 times LTM EBITDA.  The strongest subsector, in terms of valuation multiples, was the Software sector where companies such as Guestlogix, Redknee Solutions and March Networks contributed to an average LTM EBITDA multiple of 12.9. The Communications Technology subsector brought up the rear with companies such as Aastra Technologies, Sangoma Technologies, and C-Com Satellite Systems trading below four times LTM EBITDA.

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.

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.