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Exit and Growth Strategies for Middle Market Businesses

Archive for the ‘Acquisitions’ Category

Middle Market M&A

By Robert St. Germain | Nov 30, 2018

Business PlanningThe National Center for the Middle Market (NCMM), which is a collaboration between The Ohio State University’s Fisher College of Business, SunTrust Banks Inc., Grant Thornton LLP, and Cisco Systems, conducted a study in late 2017 that reported on the state of M&A within the middle market.
For the reader’s frame of reference, the NCMM defines the middle market as both privately and publicly held companies that generate between $10 million and $1 billion in annual revenues, of which, there are approximately 200,000 such companies in the U.S. In aggregate, they generate $10 trillion in annual revenues and account for one-third of private sector GDP and employment.
The stated purpose of this report was “…to inform both middle market executives and their external advisors and consultants in order to facilitate more successful deals in the future.” Its findings were quite illuminating:

  1. 60% of study participants said that inorganic growth plays an important role in their company’s growth strategy.
  2. Every year, roughly 20% of middle market companies complete an acquisition and about 5% of those companies sell to or merge into another business.
  3. Among companies that had completed a purchase in the previous three years, for 29%, it was their first deal while another 41% had limited previous experience.
  4. Among sellers in the previous three years, for 46%, it was their first deal and only one in 10 companies had significant previous experience with sale transactions.
  5. Middle market leaders said that finding the right target or buyer was one of the most confusing aspects of M&A.
  6. On the front end of an acquisition or sale, 41% of buyers and 43% of sellers found it difficult to assess the value of the business they were buying or selling.

In spite of the above findings, however, the study also found:

  1. Both buying and selling companies tend to rely mostly on their internal executives and top managers when searching for companies to buy or to whom to sell.
  2. Only about a third of buyers consulted an external law firm, and even fewer talked to consultants or investment bankers.
  3. Sellers were even less likely to bring in external advisors as part of their search for the right buyer.

The study did not provide any deal specific details (e.g. transaction prices as a function of a financial metric); but juxtaposing the first set of findings with the second set would lead one to infer that the deals generally referenced in the study were likely sub-optimal in outcome.

That inference comes from the companies’ cited paucity of deal making experience, as well as their general avoidance of using outside M&A experts to complement their relatively inexperienced internal resources.

So, one major take-away from this NCMM study is for buyers and sellers to first build a high quality deal team that certainly includes their appropriate insiders, but, importantly, also includes outside experts with deep and current M&A experience. Among those outside M&A experts should be an attorney, a CPA and an investment banker.

The investment banker on the team will add significant value by running a sophisticated buy-side or sell-side process in accordance with expected market protocols. That process will naturally include finding the right target or buyer, as well as assessing the value of the business being bought or sold, which were two of the weaknesses cited in the study when companies used internal resources only.
Investment bankers also add significant value by allowing management to keep their focus on the business while the buy/sell process is run in parallel; and, most importantly, by negotiating on behalf of management the best price and deal terms to optimize deal outcome.


M&A Trends in 2018

By Terry Fick | Jul 12, 2018

I was recently interviewed by Andy Jones of Private Equity Info about recent trends in mergers and acquisitions. Below are the highlights of our conversation.

Valuation Trends
The most prominent trend is in valuations over the past 3 years. We always see cycles, but this cycle has pushed company valuations higher than they have been in the 30+ years I have been in the industry. From businesses generating $2-3 million in EBITDA all the way up to $50 million in EBITDA, every company’s valuation is higher than in the past.

Baby Boomer Bulge in the M&A Pipeline
Being a baby boomer myself, I expected the past several years to have been almost a glut of sell-side opportunities. But it hasn’t happened. I think we all thought it would come to pass. The baby boomers are aging better than their parents did. Many are still having fun working 50-60 hours per week.
This is a friendly industry. We frequently talk to our competitors and we generally get the same feedback that we see ourselves. That is, when it was about time for the baby boomers to exit, the economy started doing well. So, these baby boomers’ businesses are making good money. Right or wrong, (mostly wrong), they tend to say, “If things are going great right now, why would I sell?”.
Sooner or later they are going to transfer their businesses. At some point, not only will their age start to make it more imperative, but the economy may start to turn down as well. If we are right, and it happens when the economy isn’t great, their valuations are going to plunge. If the seller-to-buyer ratio starts to shift (in favor of the buyer), that will drive valuations down further. For those that hang on until the last minute, all I can say is “looking back won’t be fun”.

I tell people, if I had a brother or sister or child with a business that was doing well right now and it wasn’t for sale, I would hit them with a two-by-four… unless they want to keep it for another 10 or 20 years.

Increased Valuations Impact on Deal Structure
I don’t think higher valuations are impacting deal structure. We don’t see any more or less earn-outs or notes than we used to as a percentage of transactions. But increased valuations have impacted two things:

One, due diligence is much tougher than before. With buyers paying high multiples, they are making sure to look under every rock, that it’s a squeaky-clean deal.

And two, there is more renegotiation of price than there used to be during the due diligence phase. The rubber band is so tight, the deal has no flexibility. If one little thing is out of place, the buyer wants to re-trade. We see this from both corporate buyers and private equity firms.

Main Challenges in Closing Deals
Most deal challenges now are related to due diligence. It’s almost to the point of being silly. There are a lot of questions being asked and analyses being done that really aren’t relevant.

Quality of Earnings (QE) is the driver of due diligence… and it has become onerous. It can be a difficult process because so much of it is a matter of opinion, not fact. That is the biggest challenge of any deal, the buyer’s QE.

We encourage our clients to do their own due diligence prior to entering the sale process, to have more robust data rooms and to hire someone to do a Quality of Earnings analysis. The buyers are still going to do their own due diligence work. But if the seller has a reputable firm do QE in advance, then the seller has some ammunition to fight gray-area claims that come from the buyer’s QE later. Furthermore, if there’s a real issue, like a revenue recognition issue that needs to be addressed, the seller can address it early in the process rather than having a surprise in the third month of due diligence.

Difference in Contract Terms
The biggest difference in contract terms now is the use of rep & warrants insurance. This insurance is becoming a significant piece of offers and is now used on a larger percentage of deals (including smaller deals). We are seeing a lot of contracts include reps & warrants insurance to give both sides a better feeling about who is going to pay for any future problems with the deal.

Reps & warrants insurance takes the risk off the seller for future discoveries where a rep & warrant is breached. With this insurance in place, instead of having a $5 million cap on reps & warrants going forward, the seller might only have a $500,000 cap. Anything above this is taken care of by the insurance company.

The buy-side usually purchases this insurance because it is easier to collect from an insurance company if a claim is valid than from someone who may now be your partner. So, there’s also a social reason for it. You hate to sue your partner. Buyers now use this as an extra bit of ammunition when they are bidding on a deal.

There are probably a dozen companies aggressively offering reps & warrants insurance for M&A transactions. There were perhaps as many as 3,000 policies written last year (2017). Now, with sufficient history with these policies, the underwriters are realizing there are very few claims.

We are also seeing heftier letters of intent (LOI), meaning that more of the detail that used to be reserved for the final purchase documents is at least addressed in the LOI due to sellers’ concerns about re-trading.


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.


When Will The Buyer Stop Asking All These Annoying Questions?

By Robert St. Germain | Mar 19, 2018

Business sellers often reach the point in the sale process where, in complete exasperation, they start asking the above question of their investment bankers.

The short answer is that questions will be put to the business seller by the impending buyer right up to closing.

Yes, the due diligence phase of the business buy/sell process can be very demanding and very frustrating, especially for the seller. For the first time, they are being asked to share what previously had been closely guarded information with whom are, likely, complete strangers. And that goes against every natural instinct of sellers for whom, theretofore, absolute secrecy was the order of the day to keep any and all info that could possibly be used to their disadvantage from employees, suppliers, customers, and competitors.

On the other hand, the seller must understand that it is the buyer who will be taking on the responsibility for a lot of capital in some combination of debt and equity to make the acquisition. So, the primary reason for all those “annoying” questions is to help the buyer assess the likelihood of replicating or improving historic cash flows to support the debt component of the capital package while generating the necessary return on the equity component.

Those capital components typically will be provided, in part, by the buyer and, in part, by third parties in the form of at least one lender and, perhaps, at least another equity investor. Each supplier of capital to the transaction will have their own set of questions coming from their own unique perspectives. Additionally, each supplier of capital will be assisted by their own set of advisors who will each have their own set of questions to protect the interests of their respective clients.

In aggregate, there will be many questions, some of which the seller very likely will never have asked themselves during their ownership tenure, and some of which will require an extra work effort to answer.

Sellers that engage the services of investment bankers (IB) to lead them through the sale process will be advised in advance of what to expect during DD and how to prepare.  Further and very importantly, the IB will advise the seller both on how to legally protect themselves from compromise in the information exchange and how to stage the release of various types of information only to when it is absolutely necessary to the process.


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.


Why do potential acquisitions fail to close?

By David Sinyard | Aug 14, 2017

The termination of a purchase agreement entails significant costs for both the buyer and the seller. Research suggests that relational aspects are as vital as financial considerations.  The role of personal rapport between executives, as well as the importance of the bidder’s reputation, have major impact. First, private equity groups appear to consider the relational aspects of buying entrepreneurial and/or private businesses.  The importance of their reputation and of building rapport illustrate that non-financial aspects are important. Second, sellers should.. Read more »


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.