Company value is a function of the buyer’s expectation of future cash flow, factored for the buyer’s perceived risk of not achieving that cash flow.  There are many factors that will affect the buyers’ perceived risk.  These include things like whether the company’s industry has good growth prospects, whether the company’s products are proprietary or commodity, and how capital intensive the business is.  The buyer’s understanding of the effects of these factors is typically negotiated as a higher or lower valuation.

However, there are five factors that are so significant that they don’t affect price: they affect the fundamental ability to sell your company and complete a deal.  For this reason, these are considered Deal Killers.   If a company has one or more of these attributes, it will be difficult to find any buyer.  Any buyer will very likely discount the value to accommodate the risk that these Deal Killers bring.

Over the course of my next five blog posts, I will be discussing the five most significant Deal Killers, along with recommended antidotes to diminish the effect of these situations on the deal.

Deal Killer #1:

NO MANAGEMENT DEPTH.   This Deal Killer is the most common, the easiest to resolve, and the one that sellers resist the most.  Nothing will kill a deal faster than the buyer’s perception that the keys to the company’s success are locked inside one individual. Read more »

The biggest issue that we have with selling a business, that drives value, is the organizational depth.  A business owner that does everything from start to finish has a much tougher time getting full value out of the business.  A buyer is going to want to see organizational depth and structure:  someone in charge of sales, someone in charge of production or the services being delivered, and a strong financial executive.  You really need to start working today to remove those responsibilities from yourself so that you have a fully capable organization.

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Posted by John Hammett.

Above average financial performers are still accounting for the bulk of completed business sales during the first quarter of 2011.  Valuations and multiples have held steady for three consecutive quarters and the market seems poised to continue its slow yet steady improvement. 

For an explanation about the historic trends in middle-market business activity, read this month’s Middle Market Pulse.

Posted by John Hammett. 

DOES YOUR COMPANY HAVE ONE OR MORE OF THESE POTENTIALLY FATAL ISSUES TO SELLING A COMPANY?

As we enter the second half of 2011, many companies’ sales and earnings are recovering.  For the first time since 2008, owners are seriously thinking of selling.

This is a good time, too, for private company owners to be selling.  Public companies (strategic buyers) have over $1,800 billion of cash sitting on their balance sheets and private equity funds (financial buyers) have over $500 billion in cash they need to invest.  In addition, banks have some $900 billion in excess cash to help both types of buyers to finance those acquisitions.

Owners who are preparing to sell need to be careful of what we call the five Deal Killers.  These are company attributes that can stop buyers cold when they look at a deal.  Deal Killers are not always fatal if company owners recognize them and take action ahead of time to reduce their effect. Read more »

Above average performers (defined as greater than 10% revenue growth and greater than 10% EBITDA margin) accounted for over half of all M&A transactions in 2010.  In addition, these above-average companies were awarded healthy valuation premiums.  This is a clear “flight to quality” that is driving up valuation multiples on the best companies available in a market with limited sellers.  We have seen an improving trend in market M&A activity during the past 4 quarters and see that trend continuing well into 2011.  You can read about what defines an “above average performer” and which industries have experienced an uptick in activity in the March issue of CFA’s Middle Market Pulse.

Posted by John Hammett.

During stable market conditions, most private company deals are valued between four and six times trailing earnings.  However, the overall supply of companies for sale and demand for acquisitions from financial and strategic buyers plays into the valuation of transactions.  Clearly, the $3.2 trillion (yes, trillion) capital from investors, lenders and corporations will drive demand.

This is good news for company owners who are slowly re-entering the market to sell their companies.  With capital overhang that exceeds two years of historical investment, multiple buyers with substantial resources will be bidding for companies to acquire.

The extra good news is that this kind of supply – demand imbalance creates a “seller’s market” where, at least in the early stages, more money will be competing for the few sellers that come into the market early in 2011.  The historical data of the most recent seven years shows that deal multiples rise as deal flow increases.

To view the complete article, click here.

Posted by John Hammett

Randy Schwimmer, of Churchill Financial, offers good insight into 2011 expectations for middle-market deal flow in his latest news posting. Here are the key points he makes (note in particular his comments about the “value gap” in the sixth paragraph:

Is it too early to be disappointed in 2011 deal flow?

The question occurs to us, even though it’s only mid-January, because primary issuance has been strangely quiescent.

One of our readers – an advisor to a top PE shop, with decades of deal experience – suggests that sellers started working before last November’s election to beat an expected tax deadline. By the time Congress cut the final tax deal on December 16, it was too late to stop some of those transactions, leading to a “one-time surge” in the 4Q.

Of course with [lots of] cash, and few new deals in the offing, investors are all dressed up with no place to go…except the secondary market.

So how long will it take for all this good news to reach the buyout world?

A savvy investment banker friend speculated that the value gap that kept buyers and sellers apart last year may be persisting. Sellers are bullish about earnings prospects for 2011, so are insisting on higher price tags. Buyers, though, remain skeptical of management projections, not wanting to pay up for trends that may not prove out.

If so, what gets PE buyers off the schneid? A nice run-up in equities, says our deal guru. The M&A game is all about building confidence with investors, he says, and 12,000 on the Dow could do the trick.

But there’s been a lot of blood under the bridge. Real confidence may take more time to return than people think. And that assumes no nasty surprises, like a muni bond scare.

Read the full article here.

Posted by John Hammett

After a career spent buying and selling companies, I’ve learned that the essence of a deal comes down to this simple fact:

A company is sold when its value is greater to the buyer than it is to the seller.

This obvious statement raises the more complex question: Why is the value of the same company different for the buyer and the seller? This can also be answered in a simple, though perhaps less obvious, statement:

Value is the future cash flows to the owner over time, discounted by the owner’s risk discount rate.

Now, this starts to get more complex. The values are different because the cash flows over time will be different for different owners, and because each owner has a different discount rate. In addition, the discount for the same owner will change over time.

Here are two examples from the owner’s perspective:

1. Think of a company owned by a relatively young person in his mid thirties. You don’t often hear of these owners selling their companies. Here’s why: for this owner, he expects to get a 30-year return of future cash flows. Plus, he will expect to grow those cash flows at a rate greater than inflation over the 30 years.Equally important, his discount rate for risk is low. His rate is low because he has a 30-year window to adjust and recover from the bad things that will happen along the way. He can weather a three-year recession and still be building value when the economy recovers. His health is good, so there is little risk that he will be forced to sell his company during a period of lower M&A valuations.
2. Now think of a company owned by a person in his sixties. His future income stream is really only three or five, or maybe seven years long. He cannot expect significant growth in that income stream in those few years. He is not prepared to make extra investment of time or money to accelerate growth. Even if he had an idea to stimulate growth, there is little time to implement it, it would have risk and the rewards may come after he is retired.The other piece of this owner’s equation is that his risk discount rate is much higher. His company faces risks daily from the economy, increasing taxes, regulations, new competitors, lost key employees and his own personal health. With a short time horizon to recover, this owner runs the risk of significantly diminished cash flow when it is time to sell. The inability to recover from all these risks put a high discount on future earnings. The combination of these two factors – cash flow and risk – is exactly why owners decide to sell their companies when they approach the end of their careers.

So, what does it look like from the buyer’s perspective? Read more »

Do you really understand the impact of the coming tax hikes on capital gains and income?

Our office has been working on a five-year business plan for a client that has really exposed the impact of the tax increases coming in 2011 and 2013.

Not only are increases in capital gains taxes going to take a bigger bite out of the proceeds of the sale of a company, but coming increases in income taxes and health-care taxes will take a bigger bite out of the income to owners who continue to own their companies.

We are all aware that the expiration of the Bush Tax Cuts will increase capital gains rates in 2011. For a company owner who is a resident of Minnesota, this will cause a 6.5% reduction in the after-tax proceeds the owner will take away from a sale.  Not everyone has noticed that the new Health Care bill also increases capital gains beginning in 2013.  When this kicks in, owners will take home 11.4% less compared to today’s tax rates.  This means that the company must be worth 6.5% more next year and 11.4% more 2 years later, just to stay even. Read more »

Today’s Wall Street Journal included an editorial (see below) that reports that the Financial Reform bill now in Congress will likely disqualify 77% of private party investors who have historically capitalized small, private companies.  This will have a major impact on capital formation for private companies with less than $20 million in revenues.

Angels Out of America – How the Dodd Bill Harms Start-Ups

Senator Chris Dodd’s 1,400-page financial reform bill contains many economic land mines, and here’s one of the worst: Provisions that would make it harder for business start-ups to raise seed capital. Read more »