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Exit and Growth Strategies for Middle Market Businesses

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Tax Changes for M&A

By George Walden | May 30, 2018

It is that time of year, tax season is upon us and certainly on our minds. So how will the new 2017 Tax Reform Act affect M and A transactions?

I realize that taxes are not a subject that stimulates most people, but I’m certainly excited about what these changes mean for mergers and acquisitions. As you might guess, the most important change was the permanent reduction of the corporate tax rate from a graduated top rate of 35% to a flat, fixed rate of 21%. Additionally, the Alternative Minimum Tax was repealed.

These changes let companies control more of their earnings allowing them to potentially provide higher dividends to their shareholders, reinvest in capital assets and, of course, have available more money to purchase other companies.

Another important feature of the 27 Tax Reform Act is in many instances it diminishes the impact of double taxation on earnings and gains to shareholders. The act also extends the bonus depreciation rule to allow tax payers to deduct as much as 100% of the cost of most tangible assets such as machinery and equipment. This would allow the company to purchase new or used assets and fast track the write off. This does not apply to real estate and a couple of other asset categories.

For purchasers of companies, this means increased accelerated deductions. For sellers, exposure to increased depreciation recapture. The thought process is this type of deduction should cause an increase of asset transactions versus stock transaction for the buying market.


Buying Out A Controlling Partner

By George Walden | May 14, 2018

As an advisor for companies, I regularly encounter the situation of a minority owner wanting to buy out a controlling partner. This scenario, if handled poorly, can end in significant value destruction to the company. Owners should have a buy-sell agreement in place defining the actions that need to occur for one partner to buy out the other. Depending on the buy-sell agreement, there are a number of things a minority owner can do to make a smooth transition. Remember, this is not a situation where you’re trying to discount the value of the company. Fairness to your partner should be your first thought.

Number one, agree in advance how you both are going to measure the value of the company. What is the fair market value, should be assessed constantly? Number two, how will you and the company be able to pay for the buyout? This is an interesting dilemma for the business. This is not a situation where you’re borrowing funds to improve the company by adding equipment or funding a growth initiative. This is capital to be exchanged for equity. Banks don’t like situations that aren’t accretive. Is the company buying out the stock of the controlling shareholder or is the individual buying the stock?

A common solution to handle this situation is to have the company buy back the shares from the controlling partner in some form of structured payout, usually cash, a long term note, and occasionally, a performance upside. Another solution is to look at private equity to fund the buyout. Done with the right people, this can be a very attractive alternative because PE groups often have access to additional capital, providing financial stability, and they usually initiate growth strategies to accelerate company value.

Finally, the third, keep the conversation civil and positive. Strive to make the situation a win-win. Change is difficult for all parties in a negotiation. A poor attitude and arrogance can be very destructive to the company and to the current relationship. In closing, this is a situation where I advise using a third party negotiator such as your investment banker to facilitate the process especially if both principals trust the intermediary.


Collaborative Transactions

By George Walden | May 09, 2018

Recently, I was asked the question, “Can a transaction be a WIN/WIN?”

In sport’s we see winners and losers and assume business is that way. If someone wins then someone must lose. Too many sellers go into a transaction with the mindset, it is my company so it is my way or the highway. Strangely enough that mindset introduces risk into the equation. Risk is usually associated with a lower valuation. Unfortunately, for sellers with that mindset buyers have other options and tend to take their moneys somewhere else.

So, what can you as a seller do to make a transaction Win/Win.

1. Know your objective:
Before you decide to sell, get the expertise and advice needed to understand what you are trying to accomplish. The sale of a privately held company is a complicated process requiring knowledge, expertise and strong negotiation skills. Few business owners possess these traits at a level sufficient to complete a transaction. Have your company evaluated and prepared for the process of going to market. Understand,” what is” a fair market value for your company. Understand in advance what is important to a buyer. How they look at your business. Surround yourself with your team of professionals, accountants, attorneys, wealth advisors and M&A advisors before you go to market. Use them to assist you in filling in the gaps in your company. Allow them to do their job.
Remember: Negotiations commenced from a position of knowledge have a greater probability of achieving the desired outcome.

2. Full Disclosure:
Be an open book. If you have prepared your company properly you should be able to provide detailed information that is both accurate and verifiable. Be candid about the strengths and reveal early in the process any weaknesses.

3. Collaborate:
Be collaborative. The best deals are those where buyers and sellers are working together for the greater good. Negotiations about price are certainly a part of all transactions. But once price is established there are many things that can usually be done to facilitate the ease of transition and ensure additional value creation.

In closing, know your objective, be candid about both the strengths and weaknesses of your company and then work collaboratively to facilitate a better outcome.


ESOP

By George Walden | Apr 26, 2018

I’m going to talk about ESOP’s as a potential structure to be used by a business owner trying to sell his business. Why would you look at an ESOP, otherwise known as an employee stock ownership plan? Two major reasons.

One, legacy for your employees. Strategic and financial buyers often look to move businesses to make them more synergistic with other investments they have. If you form an ESOP, the company stays there, all those jobs stay there. All those people that helped you build that business, stayed there. Also there’s some empirical evidence that shows that employee owned companies do better and there’s fewer layoffs during recessions.

On a tax basis, the ESOP is a tax exempt entity. Therefore, no taxes are paid on the earnings that are generated through the company. This gives the company a significant advantage in terms of its cost of capital as it builds, as it builds its business going forward. Sellers can take advantage of certain other tax opportunities, such as a 1042 Exchange. So, from a ownership perspective, is something to really be considered. Particularly, if the business is a professional service business or has a specific contract with some vendor that they have to keep.


Why do you need to call an M&A Advisor?

By George Walden | Apr 16, 2018

 

Why do you need to call an M&A advisor when you get approached by a buyer?

There is a rule of thumb in my industry that I absolutely believe in. Your deal never, never, never gets worse with competition and I would submit, it never gets worse with good advisory. You would never want just one buyer for your house and believe for a minute that you were getting the highest value for your home. The same holds true for your business.

Think about it, just letting the buyer know you have an M&A advisor lets them know you have the potential for competition. If the buyer doesn’t deal fairly, you will have an advocate telling you this is not market and you can do better. Remember, the buyer will have their team. They will always be dealing from a position of knowledge and strength.

You have no idea how often we get told by buyers, we don’t like auctioned transactions. Why do you think they say that? They don’t like them because they usually have to pay more.

Here are just three of many reasons to get active advisory advice.

1. The clock is running: Another saying in my industry is “Time kills all deals”. Make sure the buyer has a sense of urgency. To many things can go wrong in a transaction that takes too much time. One common problem is your response to information requests may be taking too long, after all you have never done this before, and it makes you look like you don’t know what you are doing. Lack of preparation can may you look weaker as an owner. With too much time market conditions could change. If the business is starting to decline or the industry is capping or beginning a downturn all can affect the company valuation.

2. Advocacy: Having someone on your side in the promoting, negotiating and deal structure that understands what is current market, is very valuable. Coordinating the different offers and their variances can mean the difference between success and valuable dollars left on the table. The deal process, documentation, due diligence, legal issues, accounting issues, banking issues etc. can be very time consuming and grinding. This is at a time when you need to be focused on your business and performing to expectations. Many deal valuations go south due to the owner taking their eyes off the ball. What do you think happens to your valuation when the sales start to slip? I have never seen an owner told, we will pay you more because your business is not being managed correctly. Having an advisor who can act as your advocate and offload many of those issues, can be a very strong negotiating tool.

3. Expertise: Remember negotiations from a position of knowledge have a greater chance of success. The sale of a privately held company is a sophisticated process requiring knowledge, expertise and strong negotiation skills. Few business owners possess these traits at a level sufficient to complete a transaction.

In closing, while there are many good reasons for seeking an M&A advisor in a transaction, getting additional expertise, advocacy and creating a sense of urgency will improve your chances of success.


Management Led Buyout

By George Walden | Oct 23, 2017

Today we will continue our discussion on the different types of buyers for your business. If you have a management team capable of making business decisions and running your company, you might want to consider some form of management buyout. This was first popularized in the 1980’s. Since the existing managers are buying the company, they know the corporate culture and processes. They have the inside scoop on the business and in a transaction there should be, in theory, no learning curve.

Management teams rarely have the ability to fund the buyout through traditional bank financing alone without some outside capital infusion or owner financing. Said another way, the company can only support a fixed amount of debt. That difference between the debt limits of the company and the valuation of the company must be made up with an equity capital infusion. Enter the financial buyer, such as private equity groups and hedge funds. The MBO, like was done in the 1980’s, with a management team receiving a controlling interest in the company, has transitioned.

Today’s most common structures, more of a hybrid, with minority equity interests going to the management team in exchange for continuing to run the company or a buy in at a percentage of the capital structure. Private equity groups and hedge funds often support this type of structure in exchange for the financing and capital needed to underwrite the transaction. The financial group gets a strong operational management team with solid industry knowledge. The management team gets ownership, committed capital and usually, thoughtful oversight with a strategy for future growth.

There can be drawbacks to management led buyout. Not every executive can make the transition from employee to owner, from the managerial mindset to the entrepreneurial. Not every team can handle the risk profile. It is one thing to receive a salary. It is another to take on the debt responsibilities and obligations of ownership. Another conceivable problem is the management team could become a competitor in the deal. This potential conflict of interest could work against the seller and lower the value of the company, even sabotage the deal.

There should always be an M&A adviser investment banker in this type of transaction to litigate the pitfalls. As a rule, having a management team capable of running a company makes a business more valuable to most prospective buyers. This best business practice is a goal owners should strive for.


Generational Family Succession – Mergers & Acquisitions Minute

By George Walden | Oct 17, 2017

Today we’re going to talk about generational family succession. Companies are sometimes passed on to the next generation. They can be the perfect vehicle for continued legacy transition. I grew up in a family business in the plastic extrusion and machining industry. I started working in the business when I was 14 I ran my own shift by the time I was 17. It was how I put myself through college, working four to midnight, and going to school during the day.
I love the business and grow up thinking I would be the owner one day. I went off to finish my master’s degree and when I came back, I found the company had been sold. Not the transition I expected nor wanted. Part of it was because it hadn’t really been discussed, but most of it was because, like most business owners, there was no thought or plan for a transition in place that addressed succession.

According to Forbes only about a third of family business survive the transition to a second generation. Fewer still make it to the third generation. Family business failures can essentially be traced to one factor. According to The Family Business Institute, that is a lack of succession planning.

Here are a couple of points I believe should be considered in evaluating family succession planning. Number one, the transition should be structured in advance and be thought of as a long term process. Just because you were born into a business does not make you the best qualified to run it. Family members should be honestly evaluated just like you would any other employee. Before being considered the recipient of the company, the family members must show a competence worthy of taking over the reins. That not only requires a succession plan but it requires a way to measure family member development and educational needs. This requires time, thoughtful milestones, and key performance indicators.

While it is important to be technically and tactically proficient on how the company operates. Family members also need to demonstrate leadership and managerial skills. If family members aren’t ready to take on all the roles necessary for success, consider outsourcing the gaps and work towards filling the voids through further training, education, or hiring practices.
Number two the company should be purchased by the next generation. The most common mistake I see in this form of transition is not treating the next generation as a true buyer for the company. If you were to ask most next generation family members that question they would unanimously agree the company should be gifted to them. That however does not create wealth for the parents. Family members should be required to buy into the company. They should have skin in the game. There is a place for gifting and the best structure actually has a component of both capital requirements and gifting.

Number three, have a system in place to handle conflicts and additional capital needs. Address in the beginning with a unilateral agreement or pact, how family members are to be treated. Establish for all members the terms and restrictions for a family member to be able to buy in, leverage, or transfer their shares of stock. Rules should be established in the beginning on how conflicts will be resolved.

Finally, establish the compensation and promotion policies of the company for all family members and how distributions will be handled in advance. In closing, transitioning your company to the next generation should be a thoughtful process designed to remove as many risks up front to avoid family conflict. There is nothing wrong with wanting to pass on your legacy to your descendants.


What is a financial buyer?

By George Walden | Aug 11, 2017

Financial buyers include Private Equity Firms (PEGS), Venture Capital Firms, Family Investment Funds and Hedge Funds. These financials buyers are typically looking for a return on investment. They are not necessarily industry oriented. In fact, they are often industry agnostic.

They are usually looking for a stand-alone entity that they can add systems and build on. These financial engineers often use leverage to structure their transactions and place an emphasis on the company’s cash generating capabilities to service debt. This process is called a “Recapitalization”.
In a recapitalization the owner exchanges cash for equity conveyed based on a current market value of the company. The average hold is between 3 and 7 years and in a second offering the “second bite of the apple occurs”. It is not uncommon for the second bite to be as large as the first, but certainly this is not guaranteed.

Using a typical 80%/20% split let’s value the company at a 100 million dollars. A common Recapitalization structure would look something like this. The owner and buying group agree that the company could carry 50% of the structure as debt. This means capital in the transaction is 50M. The owner is asked to put in 10M to get 20% of the company. The financial buyer puts in 40M. The owner receives 90M for the market value of the company and retains 20% percent of the equity in the go forward of the company.

Transactions with financial buyers are more of a partnership rather than an 100% purchase. They often will buy a controlling interest in a company but minority acquisitions are not uncommon. Especially for high performing companies. Why would the owner of a performing company want a financial buyer? To remove risk, gain liquidity, receive financial underwriting and an advisory team.
Financial buyers can be very flexible in their acquisition strategy and structure.

Financial Buyers are not necessarily operators and often want to get behind a management team or the current owner to protect the operational viability of the company. Financial buyers provide more than money. There is usually an advisory role such as you would see with a board helping you to direct and build a vision for corporate growth. Financial buyers usually have a system in place to facilitate add-on acquisitions. After a platform acquisition they often buy additional companies to gain market share, mimicking a strategic buyer, with the goal of maximizing their return when they exit the investment.

I have heard many times over the year’s financial buyers ruin good operational companies. The evidence just doesn’t support this, in fact financial buyers often build phenomenal companies with their thoughtful approach to the numbers and systems. Most sellers should look harder at this type of buyer to understand how to raise the value of their company and implement what is important to attract the Financial buyer’s attention.


What is a Strategic Buyer?

By George Walden | Jul 05, 2017

A strategic buyer is typically an operating company that usually has some relationship in the product line or service sector you are in. You would often consider them a competitor, supplier and perhaps even a customer of your company. Bottom line is they usually have strong industry knowledge.

Strategic buyers are looking for synergies or additions. These synergistic benefits are often the motivation behind the acquisition. As a result, valuations can be higher for a strategic buyer, because the synergies created can bring greater returns. There is an expression in my industry, solve a problem for a strategic buyer and the solution can create very different valuation math.

    • 1. Expansion can be vertical, such as acquiring a supplier or customer or
    • 2. Horizontal, expanding in news markets or products.

Strategic acquisitions tend to be accretive. Economies of scale and scope usually come into play in strategic acquisitions.

As I implied during the last M&A minute. The Strategic buyer doesn’t always need your management team, personnel, facilities, or back room services. They often bring their own capabilities to the table. Where there is duplication, those positions, services and processes are often consolidated or eliminated. Their goal is usually one of integration to their existing systems. As a general rule, they tend to be all or nothing in the acquisition meaning they will typically buy only a 100% of the company.

Strategic acquirers are just one of the two primary types of buyers. Next month we will dig deeper into the other primary group and that is Financial buyers.


“Who Will Buy My Business?”

By George Walden | Jun 22, 2017

Who Will Buy My Business?

As a Merger and Acquisition advisor I am often asked, “Who will buy my business?” As a rule, they fall into two primary generic categories and then several additional categories.

Mergers & Acquisitions Minute #12

A strategic buyer is typically an operating company that usually is competing in the product line or service sector you are in. You would often consider them a competitor, supplier and perhaps even a customer of your company. Bottom line is they usually have strong knowledge of your industry. They are usually looking for synergies or additions.
Strategic buyers don’t always need your management team, facilities, or back room services. They often bring their own capabilities to the table. Their goal is usually one of integration to their existing systems. They tend to be all or nothing in the acquisition meaning they will typically buy only a 100% of the company.

Financials buyers are typically looking for a return on investment. They are not necessarily industry oriented. In fact, they are often industry agnostic. They are usually looking for a stand-alone entity that they can add systems and build on. These financial engineers often use leverage to structure their transactions and place an emphasis on the company’s cash generating capabilities to service debt.
Often they buy additional companies to gain market share, mimicking a strategic buyer, and increase their return when they exist the investment. They are not operators and often want to get behind a management team to protect the operational viability of their investment.

An ESOP (Employee Stock Ownership Plan) is used to provide a market for the shares of a departing owner of a profitable, closely held company. The Company sets up a trust fund for their employees and contributes either cash to buy company stock, contributes shares directly to the plan, or have the plan borrow money to buy shares. There are usually favorable tax consequences to an ESOP benefitting both the owner exiting and for the company continuing forward.
Interestingly, there is a lot of anecdotal evidence that empowering your people often causes better performance of the company accelerating growth and earnings. You should consider an ESOP, when you want your company to continue through your people. When you want your employees to have a long term stake in the company. With an ESOP you can sell any portion of the company you want and even in certain instances retain control.

Sponsor your management team. Consider an MBO, a management lead buyout. If your team is capable and has the in house expertise to run your company, they are a terrific option for selling some or all of your company. The financial community likes nothing better than getting behind a team with a plan.
While traditional bank financing or debt can occasionally be difficult to obtain, private equity groups and seller financing can often bridge the gap and facilitate this form of transition.

Generational transition- I have had the privilege to represent company’s transitioning, by passing the company on to the next generation. They can be the perfect vehicle for continued legacy transition.
However, just because you were born into a business does not make you the best qualified to run it. The most common mistake I see in this form of transition is not treating the next generation as a true buyer for the company. In my opinion there should be an investment into company with the next generation buying their way into the family business.

There are many ways to transition your company when the time to sell occurs. The next few episodes we will dig deeper into what these types of transitions look like and at their individual characteristics.