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How Do You Respond to an Unsolicited Offer?

Unsolicited offers tend to come at inopportune times.  While some are actually opportunistic, most come out of the blue when the potential seller is not ready to receive them.  Unsolicited offers for private companies tend to come from immediate competitors, customers or suppliers and, these days, private equity is also actively searching for new platform investments.

If unsolicited offers are common in your sector, here are some considerations to keep in mind.

Be prepared - if you are in a position to bring other credible buyers into the process quickly you will gain substantial negotiating power.  To accomplish this you should already be on other potential acquirers’ radar screens.  Make them aware of your capabilities, your value proposition and explore OEM / distribution relationships.  When multiple buyers are brought into the process, the negotiating power shifts significantly toward the seller, who can use a competitive process to maximize valuation.

Keep your options open as long as possible - a Letter of Intent (“LOI”) will almost always include an exclusivity clause.  This is because a signed LOI is an agreement in principle and expensive external resources (accountants and lawyers) will now be engaged for due diligence and closing the transaction.  Exclusivity means the seller cannot engage in terms discussions with any other party for the agreed upon period.  This shifts the negotiating power to the buyer.  If the buyer finds material valuation issues during due diligence and seeks a price adjustment, the seller has no recourse other than to compromise on terms or walk away from the deal. 

Focusing on a single buyer does not necessarily save time – sellers sometimes shy away from a formal process based on the amount of time and effort it will take.  However focusing on a single buyer does not always result in reduced effort. A buyer in an open-ended, uncompetitive situation will often continue to ask for more and more detailed information exhausting the seller in the process.

Perform buyer due diligence – what is the buyer’s long term strategy?  Is the buyer well capitalized or over-leveraged? If the buyer is a private equity group, what is their typical 'hold time' until a company is resold?  If the offer includes a note or an earn-out, the seller assumes buyer and/or performance risk. 

Bring an independent advisor into the process - unprepared companies tend to assemble requested materials in a rushed manner and answer questions ad hoc without a well formulated strategy.  By bringing an independent M&A advisor into the process you immediately formalize the process and create additional options.  Introducing actual or threatened additional buyers into the process will likely result in the initial buyer raising its offer. 

When you accept an unsolicited offer, most of the time you will leave money on the table compared to an offer arrived at through an auction process (even a limited one).  By acquainting yourself with the potential buyer universe and working with an independent advisor, you can quickly bring other interested parties into the process and improve your outcome substantially.

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&AInternational in Toronto.

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.

Working Capital is Always a Point of Negotiation in an M&A Transaction

The determination of the closing amount of working capital is always a point of negotiation in an M&A transaction.  Simply put; working capital is current assets minus current liabilities and is the liquid part of the balance sheet, where revenues are collected and suppliers are paid.  Working capital often includes a component of cash (or access to cash in the form of a bank operating line).  Working capital items requiring judgement include:

·         Collectability of accounts receivable; typically accounts receivable aged greater than 90 days are not recognized;

·         Level of inventory; it must be current, sale-able and of an appropriate size;

·         Any stretched account should be examined for its cause and the potential impact on the customer /supplier relationship.

So what is the right level of working capital on closing?  Buyers and sellers should seek to establish a “normal” level of working capital.  This normal amount may not be the “right” amount on the day of closing but is the average level of working capital throughout an agreed period of time.  A reasonable rule of thumb would be to assume the same time period that the valuation of the business is based on.

 The following business characteristics will affect the normal working capital amount:

·         Generally speaking, a fast growing company will need more working capital to fund receivable and inventory growth than a no-growth business;

·         if the business is seasonal (for example, heavily dependent on Christmas sales) then, around Christmas working capital will be high, initially with inventory and then after Christmas receivables;

·         if payables are required to be paid quicker than receivables are collected (like staffing companies that typically have to pay contractors every two weeks while  they get paid monthly) then working capital will need to be high;

·         if cash is collected quicker than it is paid (like an online referral business that collects cash, has no inventory and does not have to pay its suppliers for 30-60 days) then working capital can be low.

·         Private companies may not manage their working capital as efficiently as they can.  They may leave cash in the business for tax reasons.  This will inflate working capital, so it is important to determine the level required by the business.

To determine normal working capital, cash flows should be examined for cyclicality and fluctuations for a minimum of the last 12 months.  Sometime before closing, a target closing balance sheet should be prepared reflecting a normal level of working capital.  Excess cash is typically distributed before closing and the actual level of working capital is not finalized until some time after closing.  If it is higher than the normal level of working capital, the seller receives the excess or, if below the agreed upon amount, the buyer is due a credit.  In some cases reserves are held in escrow for the purpose of funding a potential working capital deficiency. 

As every business and every seller is different, working capital will always be a point of negotiation in an M&A transaction.  The working capital issue is more complex than one would think and the amount of capital that is required for working capital can affect the value of a business.  Once you fully understand the cash flows in a business you can settle on a reasonable level of working capital.

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.

The Purchase and Sale Agreement

The Purchase and Sale Agreement (PSA or SPA in the case of a Share Purchase Agreement) is one document in a set of final documents that completes a company divestiture transaction.  Other documents typically include employment agreements, escrow agreements, non-competition agreements, releases, and more depending on the type of transaction being contemplated.

The closing documents are most efficiently prepared after a detailed LOI (Letter of Intent) has been agreed upon.  Remember that an LOI normally seeks exclusivity for the potential buyer as they will then commit to proceeding in the time-consuming and expensive due diligence and legal closing process.  For the seller it is critical that all potential “deal-breaker” issues are addressed in the LOI because exclusivity requires them to no longer engage with other interested parties.  It will be difficult to re-engage these parties should the exclusive closing process fail.  I noted before that a CIM should be positioned to present a company in a most positive manner but must not over-promise or leave less than flattering facts out because it forms the basis of an LOI and a PSA.  Due diligence will verify the assertions made in the CIM and the reps and warranties in the PSA will hold the seller to them.

A PSA is a sizable (typically more than 50 pages) document and will contain many common sections such as definitions, purchase price, representations and warranties of the vendor(s), the company and the purchaser, covenants and closing arrangements. There are various studies on common PSA parameters.  Here are select Canadian parameters for 64 PSAs closed in 2010 and 2011.  It should be noted that this is a small sample of reporting company acquisitions primarily in the resource and financial sectors.

54% of the deals were all cash purchases and 53% were share, as opposed to asset, purchases.

21% of the deals included an earn-out and 38% of these tied this earn-out to either revenues or EBITDA for a period of 1 to 3 years.

70% of the deals included post-closing adjustments and 70% of those included working capital as an adjustment metric.

47% of the deals included an escrow between 5% and 10% and 86% did not create a separate working capital escrow.

83% of the deals included a Material Adverse Change (MAC) clause and 86% of those included general economic and financial market downturn carve outs.

40% of the deals included caps on claims equal to the purchase price.

78% of the deals included full disclosure reps such as a “no undisclosed liabilities” rep.

47% of the deals included a survival time to assert claims of 2 years.

40% of the deals included breach of rep or covenants minimum basket amounts in the 0.5% to 1.0% range of the deal value.

This sample provides a preview of the many legal issues to be tackled in negotiating a PSA.  While the percentages are not absolute, they should guide expectations.  If you want to achieve parameters substantially different from the ones noted above, it would be wise to bring these to the attention of the counter-party at the LOI stage rather than spending a lot of time and money on the PSA and, ultimately not closing a transaction.

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

Valuation 301: The DCF and Forecasting

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

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

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

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

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

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

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

Valuation 201: Comparable Company Analysis

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

 

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

 

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

 

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

 

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

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

 

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

 

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

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

Venture capital investors typically take a substantial minority equity position and look for investments that can return 5x to 10x (i.e. if they invest $1 million, they target a realization of $5M to $10M in a sale or IPO exit).  VCs don’t typically look to achieve their goals by acquiring additional companies but rather by betting on, and working with, the expected winner in the space.  Private equity on the other hand, quite often seeks 100% ownership and will then continue to look for add-on or tuck-in acquisitions to grow and increase the market position of its investments.

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

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

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

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