2014 COMPLETE GUIDE TO MIDDLE MARKET M&A

POWERED BY AXIAL POWERED BY AXIAL 1 POWERED BY AXIAL 2 Introduction Dear Readers,

Thank you for downloading The Complete Guide to Middle Market M&A 2014. This ebook is a collection of the most valuable and popular articles published on Axial’s Forum. The included content, written mostly by fellow deal professionals and business owners, discusses the key trends in the middle market and best practices for navigating the transaction process.

The 75+ below articles reflect the diversity of the middle market community and cover a wide range of topics and themes. As a result, this ebook is divided into seven chapters:

Chapter One: Hiring an M&A Advisor Chapter Two: Finding the Best Buyers Chapter Three: LBO Essentials Chapter Four: Leveraging Technology Chapter Five: Completing the Best Transaction Chapter Six: Trends Shaping the Middle Market Chapter Seven: Valuation Best Practices

Thank you to all authors, thought leaders, and Axial members that share their insights on Forum. For more information about Forum, becoming an author, or Axial membership, please send an email to: [email protected]

Happy reading,

Billy Fink Editor, Axial Forum

POWERED BY AXIAL CHAPTER ONE: HIRING AN M&A ADVISOR M&A Advisors: The Overlooked Value Maximizer...... 6 How to Write the Investment Banking Engagement Letter...... 8 Understanding Investment Banking Fee Structures...... 10 CHAPTER TWO: FINDING THE BEST BUYERS Should You Keep Your Sellside Process Narrow?...... 14 Should Your Buyer List Include Financial Sponsors?...... 14 5 Differences Between Financial and Strategic Buyers...... 16 How Family Offices Approach Direct Investing...... 17 Family Offices: Fact vs. Fiction...... 18 Table of 5 Reasons to Sell to a Family Office...... 19 CHAPTER THREE: LBO ESSENTIALS Contents Inside the Leveraged Buyout Deal Process (Part I of III)...... 22 Inside the Leveraged Buyout Deal Process (Part II of III)...... 24 Inside the Leveraged Buyout Deal Process (Part III of III)...... 26 How Private Equity Screens for LBO Candidates...... 29 CHAPTER FOUR: LEVERAGING TECHNOLOGY What Do 89% of CEOs Do Before Talking to You?...... 32 Does It Matter That KKR Joined Twitter?...... 34 Social Media: An Overlooked Business Development Tool...... 35 How to Secure the Best Talent for Your Firm...... 36 Survey Says: Business Owners Use Technology to Find Capital...... 37 CHAPTER FIVE: COMPLETING THE BEST TRANSACTION 9 Things Every Business Owner Needs to Know Before Selling...... 40 Why IT Due Diligence Should Be a Critical Part of Every Deal...... 42 3 Things to Remember Before Signing an NDA...... 43 7 Pitfalls to Avoid Between LOI and Deal Close...... 44 Key Learnings from a Successful Search Fund...... 46 5 Common Mistakes to Avoid When Raising Capital...... 47 Should You Be Conducting Values Due Diligence?...... 49 8 Negotiation Techniques When Buying & Selling Companies...... 50 3 Ways to Keep Customers after an Acquisition...... 51 CHAPTER SIX: TRENDS SHAPING THE MIDDLE MARKET The Evolution of LP/GP Relationships: Moving Closer to the Deal...... 54 Could Freelancing be the Future of M&A?...... 55 Should Business Brokers be Franchised?...... 56 Will IPOs Ever Return to the Middle Market?...... 57 What Increasing Secondary Deals Means for the Middle Market...... 59 What the SEC’s No-Action Letter Means for M&A Brokers...... 60 Why the Traditional Search Fund Model is Changing...... 61 What is an Evergreen Fund Structure?...... 62 Two Trends Shaping the Future of Mezzanine...... 63 Zombie Funds: How the SEC is Arming Itself Against the Undead...... 64 CHAPTER 7: VALUATION BEST PRACTICES 3 Methods for Valuing Your Business...... 68 The Widening Valuation Gap...... 69 How to Improve the Value of Your Company Without Borrowing a Dime...... 70 5 Key Value Drivers When Selling a Company...... 71 To Maximize Valuation, Look to Sustainable Top Line Growth...... 72 Valuing Platform Companies vs. Add-Ons: The New Art of Negotiating...... 74

POWERED BY AXIAL 12 Critical Valuation Questions to Ask When Investing in Distressed Assets...... 77 POWERED BY AXIAL 5 CHAPTER ONE: HIRING AN M&A ADVISOR

M&A Advisors: The Overlooked Value Maximizer By Dan Lee | June 10, 2014

One of the biggest mistakes CEOs make when selling their business is underestimating the value that a seasoned and qualified M&A advisor can bring to a transaction. All too often, business owners reduce the role of M&A advisor to a glorified networker. It’s little surprise, then, that so many entrepreneurs are dismissive of seemingly exorbitant fees charged by advisors for what they perceive to be very little work.

With few exceptions, this understands your personal goals, and concern for company legacy, concern misconception couldn’t be further can help you undertake the strategic for management team, etc. — can from the truth. While it’s certainly planning efforts that will help you change the nature of the process. An possible for business owners to sell achieve them. advisor knows the different strategies their company on their own, they’ll of each buyer type and can help align likely make (very) costly mistakes your interests with theirs. Valuation throughout the transaction process. Valuation expectations will need to be a These mistakes can be avoided large part of your initial conversations Timing by hiring an M&A advisor. In fact, with an advisor. While your personal Many business owners often pursue M&A advisors play a critical role goals in a transaction may not be a sale for reasons that have nothing throughout the sale process that limited to value maximization, your to do with the business. Perhaps they sellers often overlook. advisor will try to understand your are burned out and want to retire, or Here are the critical ways in which expectations, adjust them as necessary, unexpected personal circumstances the right advisor can more than earn and let you know what else you might have accelerated their transaction their fees: need to do to meet your valuation goals. timeline. Whatever the catalyst, these Valuation is a careful equation of the situations can be dangerous, eventually UNDERSTANDING YOUR GOALS buyer, the timing of the transaction, the causing the business owner to sacrifice AND STRATEGIC PLANNING (6 state of the business, industry-specific transactions goals for expediency. MONTHS – 3+ YEARS) trends, and macro trends. Advisors have It is during these moments that an Though you might think you have a a sense of all of these factors and can experienced advisor can help balance pretty good idea of what a successful help direct the process to align with your the urgency created by personal timing exit outcome looks like, experienced valuation goal. issues with an outcome that still gets advisors can (and should!) make you a fair price for your business. you realize that there may be more However, this requires an established considerations than price when Post-Transaction Goals relationship and existing mutual selling your company. This is why it’s Business owners often have other understanding and trust. important to begin developing formal personal goals in a transaction that can relationships with advisors at least be just as important – sometimes more 2-3 years before you think you might important – than money. Each of these Determining the Ideal Process sell – it takes time to build trusted personal goals — including your desire In addition to helping a business owner relationships with someone who to stay after the transaction, earn-outs, evaluate the transaction goals and timeline, a good M&A advisor can

POWERED BY AXIAL 6 help a business owner identify the acquirers typically review hundreds if to stagger their outreach. Some best process for exiting the business. not thousands of teasers every year, advisors may also recommend “pre- Since many closely-held businesses so the teaser is a critical opportunity marketing” the transaction at this often experience intense family or to make a strong first impression. point, where they may contact a shareholder dynamics, which may handful of buyer contacts at the top In addition to the teaser, your advisor complicate the transaction, having of your list with whom they have will prepare a more comprehensive a full understanding of the available long-standing relationships. confidential information memorandum options is essential. For example, if you (CIM) and detailed financial statements want to sell the business to family or for buyers who express initial interest friends, a management buyout (MBO) THE TRANSACTION (3-9 MONTHS) in learning more about your company. or an Employee Stock Ownership Plan Going to Market These later documents will help the (ESOP) may be most appropriate. In The actual transaction process kicks buyer evaluate if they want to move the event you choose to pursue an off with your advisor “taking your on in the process and meet you and external buyer, an advisor can then help company to market.” This simply your management team. Lacking these you tackle the question of whether a means that they begin the process of necessary documents may cause many financial buyer or strategic buyer is reaching out to potential buyers, and potential buyers to not even consider more appropriate. gauging their level of interest in your your business. business. The initial outreach typically maintains your confidentiality, as the TRANSACTION PREPARATION teaser is usually blind and does not Building a Buyer List (1-3 MONTHS) disclose the identity of your business. During this stage of the process, many When it’s finally time to move forward This stage of the process is often advisors will also begin compiling a with a transaction, your advisor is broken down into multiple waves, as prospective buyer list. Your advisor’s instrumental in the preparation of key your advisor might first reach out to transaction experience and industry materials and the actual logistics of strategics (who typically take longer expertise will play a large role in their the transaction. to respond with interest) and other ability to build a diverse buyer list buyers in the top tier of your buyer that not only helps maximize your list. Buyers interested in learning potential valuation, but also enables Preparation of Marketing Materials more about your business will sign a you to achieve your non-valuation One of the most important M&A non-disclosure agreement (NDA) and transactional goals. documents your advisor will prepare request the CIM. is the executive summary of your Advisors will rely on their existing business, also known as the teaser. network of financial and strategic The teaser is how buyers, tools like Axial, Narrowing Down Candidates your advisor will and your own knowledge As various buyers confirm their interest pitch your business One of the most of potential acquirers to or withdraw from the transaction, to prospective important M&A compile the list. Building your advisor will help you navigate buyers, summarizing documents the ultimate buyer list is the process of narrowing down buyer your transaction part art and part science, candidates. At this point you should goals as well as your advisor and a qualified advisor expect to meet potential buyers high-level highlights will prepare is can help you identify the in-person (known as “management about your the executive most likely buyers for meetings”). As the process progresses business’ financial your business from among you should also begin receiving and operational summary of the thousands that may IOIs (indications of interest) and performance, your business, potentially be interested. LOIs (letters of intent). IOIs are industry and informal letters confirming a buyer’s also known as As the list is being finalized, market position, intent to purchase a company and the teaser. you and your advisor will management usually include valuation guidelines, review it to ensure you team, competitive transaction structure and other terms, are comfortable with all of advantages, and any due diligence expectations, and a the buyers on the list and prioritize other differentiators. Private equity timeframe for closing. LOIs are more the list in tiers that the advisor uses buyers and experienced corporate

POWERED BY AXIAL 7 formal, legally-binding agreements that the transaction become a distraction duties to the client. It outlines the serve as a precursor to the purchase that negatively impacts business terms and scope of the advisory agreement and describes the proposed performance during such a critical services provided. It rigorously details transaction in more detail. The period. For transactions involving the economic points that go to the execution of an LOI almost always gives highly complex family or shareholder heart of the relationship. that buyer an exclusive period during dynamics, your When negotiated which to conduct final due diligence advisor can also and structured before the transaction closes. serve as objective, When negotiated and properly, this third-party counsel structured properly, this contract can that helps your Negotiation and Final Due contract can be remarkably be remarkably business make Diligence powerful in decisions that powerful in aligning the If you’ve managed to generate interest aligning the maximizes a from multiple buyers, your advisor investment banker’s investment successful outcome has done a great job so far. However, interests with your own. banker’s interests for all stakeholders. their job is far from complete — they with your own. will continue to negotiating the final As you contemplate High degrees of agreement. Remember that price isn’t the role that an M&A advisor will play alignment will incentivize the banker to the only important consideration, and in your company’s sale and the return close a deal for you, with the optimal your advisor can help you evaluate the on investment from retaining one, valuation and terms. other important considerations in the consider too the added peace of mind However to successfully negotiate LOI. Your advisor’s ability to negotiate from being represented by someone this agreement, it’s imperative that on your behalf can not only come in you will come to trust with one of your executives understand the perspective handy because of their experience in most prized assets. of the investment banker and the leveraging buyers against one another Business Owners, Preparing for a Transaction specific motives that will encourage a for the best terms, but also because top notch transaction outcome. they serve as a buffer to prevent any hard feelings in the negotiation process Here are the seven most decisive points from affecting your relationship with to cover in your engagement letter. the buyer post-sale. How to Write

Once you sign an LOI, your advisor the Investment 1. FEE STRUCTURE will also be responsible for ensuring Investment bankers will typically a seamless due diligence process. Banking divide your advisory charges into two Depending on whether you have an functionally divergent groups: a (1) existing relationship with an M&A Engagement non-refundable deposit or retainer, and lawyer, they may also help you round a (2) success fee. out your “deal team” as you finalize Letter the purchase agreement and close By Kateri Zhu | June 25, 2014 The retainer is usually a flat fee. the transaction. While it’s sometimes paid out at the The engagement letter is one of beginning of the engagement, it’s the most important agreements usually paid on a regular basis over Peace of Mind the length of the mandate. The most Ultimately your advisor is able to between your company and the common schedule is payout on a add a tremendous amount of value investment banker. monthly basis. to your transaction through their It sets the stage for sellside processes, While it’s not directly linked to the experience and expertise. As much acquisitions, mergers, debt financings, completion of your transaction, paying as they are responsible for running and equity financings. It has an a mutually agreed upon retainer is your process as a trusted partner and overwhelming effect on the quality pretty standard and it demonstrates advisor, however, they’re also here to and depth of the investment banker’s your level of commitment to the sale make sure that you can stay focused process. Similarly, the investment on running your business and not let

POWERED BY AXIAL 8 banker should be putting a significant a significant amount of thought, time, memorandum, solicit interest, get amount of work into preparing and effort into preparing your team disclosure agreements signed, your company for sale and should and your offering materials to go to coordinate with buyers during their correspondingly be compensated for market. The sale process will span due diligence processes, receive offers, his efforts as the work is completed. several months and can result in a and negotiate a deal. number of divergent outcomes. The However, the success fee — and However standard length aside, the retainer, as discussed, should be a small not the retainer — should always be engagement term you negotiate should portion of their compensation and the most significant component of be driven by two things: (a) how much unfortunately, is also rarely sufficient the total compensation. This gives time your advisor needs to close your to cover the amount of time a solid both parties the best motives for an specific deal and (b) how long you can banker will invest in your deal process. optimal outcome. be reasonably bound to an exclusive High quality and trusted investment relationship with that advisory team. The success fee is usually paid out bankers take each mandate seriously at deal close. It’s based primarily on and dedicate themselves to closing three things: (a) deal type (e.g., buyside a successful transaction. How much 4. TERMINATION acquisition, sellside process, financing, of their time and energy would they Moreover, your letter should explicitly etc.), (b) the type of ownership sold be willing to risk if they’re not your outline the rights of termination (e.g., equity, senior debt, mezzanine exclusive advisor? after the term of mandate. Generally debt, etc.) and (c) transaction value. Moreover, deal processes generally speaking, most agreements are drafted It’s often expressed as a percentage of run better with one lead person or to automatically renew on a monthly the total transaction value and can also firm handling all buyer communication basis until canceled, in writing, by either include a progressive pricing schedule. and negotiations. Fewer cooks in the you or the banker. In other words, above a certain agreed- dealmaking-kitchen typically correlates upon price threshold, the success with smoother, more focused, more fee percentage calculated off the expedient, and ultimately more 5. TAIL PERIOD transaction value will rise incrementally effective The tail period is also with price. transaction a standard feature of A progressive schedule is an effective processes. Deal processes engagement letters. way to design a strong incentive for the Nonetheless, generally run better A tail is a length of banker to help you realize a valuation during your with one lead person time after the official that exceeds your goals. term during which a banker selection or firm handling all and negotiation transaction close would buyer communication still result in advisor 2. EXCLUSIVITY process you’ll compensation. Typically, Giving exclusivity to an investment certainly have the and negotiations. the tail period will be banker can be a daunting proposition. option to deny exclusivity to a twenty four months. It’s Naturally when you mandate an advisor banker. Simply in the interest of the and his or her team fails to meet note that the choice against giving client to seek a shorter rather than expectations, it’s a tremendous setback exclusivity may limit your ability to get longer tail period. with respect to time and financial a top investment banker in your corner. Tail periods are overwhelmingly resources. Moreover, reaching your common. This is primarily because goal of a closed deal has been likewise deal processes are (a) frequently delayed. And finally, when or if you go 3. LENGTH delayed for a variety of reasons and (b) back to market — presumably with a The term length specifies how long dependent on a number of players. It different banker — the fact you were the engagement — and therefore the would be reasonable to compensate already out in the market and could not accompanying exclusivity — lasts. your banker, subject to some time get a deal done could negatively impact A six to a twelve month term is pretty constraint, should the ultimate buyer investors’ views of your company. standard. This allows time for your be someone who was introduced by However, nearly all qualified investment banker to position the company, his or her team. For example, if a seller bankers will require exclusivity because send out teasers to potential buyers, and investor are connected by the a good banker is going to be putting prepare the confidential information intermediary and begin negotiations,

POWERED BY AXIAL 9 undertake diligence, but fail to finalize dictate that the client will cover any Your primary goal in negotiating the a purchase agreement during the expenses incurred by the advisor in the engagement coverage should be to official term, the intermediary should performance of its services. (a) balance a well defined scope of nonetheless be given credit when they engagement while (b) concurrently Nonetheless, it’s in your interest to close a deal nine months later. maximizing the services of the draft the letter such that you maintain investment banker to explore all possible Therefore, the fundamental purpose the ability to exercise some reasonable outcomes that will satisfy your goals. of the tail is to make sure that the control over these expenses. advisory team is compensated for Business Development, Business Owners, For example, clients frequently request their work when a deal is started, Preparing for a Transaction, Transaction that the banker provide a monthly report Process but not consummated, within the outlining the expenses incurred by his mandate term. Moreover, the tail also or her team. Additionally, its standard precludes a client from terminating an to place a ceiling on the dollar sum of engagement immediately prior to deal reimbursable expenses, barring pre- close in order to dodge the majority of Understanding approved exceptions in excess of said the advisory fee. ceiling. Moreover, it’s not uncommon Investment All this said, there are a number of to limit reimbursable expenses to reasons why a deal unrelated to your external, third-party, out-of-pocket Banking Fee advisor’s efforts can likewise close costs. And finally, the agreement should after the official term. For example, explicitly indicate that violations of these Structures if a buyer emerges two years later provisions will result in the expenses not By Cody Boyte | March 4, 2014 as a direct result of your efforts or being reimbursable. the efforts of another intermediary, Investment banking is a it would be unreasonable to pay the original investment banker. As a 7. COVERAGE sophisticated and exclusive result, clients will add safeguards to A sale process can result in a wide field, so it’s little wonder its the tail provision in order to limit it range of outcomes, from selling innerworkings are hard to grasp. to its intended purpose. only a portion of the company for a Pair the lack of clarity with the minority equity position, to raising The most common safeguard is a mezzanine debt, to launching a high stakes, and many business requirement that the tail apply only to strategic joint venture. Consequently, owners are tentative when deals with an investor or buyer that it’s important that the scope of was connected by the intermediary to engaging advisors. services provided and covered the client during the official mandate transactions are well defined. While investment banking services term. Definitions of “connected” can don’t come cheap, an experienced differ across mandates, but you should This provision will mitigate the and well-connected advisor can be minimally negotiate to restrict the pool probability that certain deals are a godsend when raising capital or of buyers triggering payment during not unintentionally roped into the selling your company. The value a the tail to those counterparties who confines of your contract or subject shrewd banker adds to the outcome received information from your advisor, to inappropriate far eclipses the cost. expressed an interest, and signed a fee structures. For That being said, confidentiality agreement. example, ultimately While investment it can be hard to raising mezzanine weigh the costs and capital may be a banking services don’t come cheap, an benefits without 6. EXPENSES great outcome for understanding how Your banker will always incur you. However, the experienced and well- fees are calculated. reimbursable out-of-pocket expenses fees due to a banker connected advisor can such as travel, research and material for raising mezzanine Though most fees preparation during the sale process. capital are usually be a godsend when and fee structures Most engagement letters will explicitly significantly lower raising capital or selling will be negotiated than raising a your company. between the comparable quantity business owner and of equity capital.

POWERED BY AXIAL 10 advisor on a deal-by-deal basis, there success fee is structured, has the bigger lift) and final outcome, among are a few terms to consider. Each biggest impact on banker incentives. other considerations. can have a significant impact on Understanding each can help you Starting in the ’70s and ’80s, the effectiveness of the advisor and decide how to negotiate fees as you success fees were based on the potential outcomes during the deal. work with advisors. Lehman Formula. Originally applied RETAINERS to financing engagements, formula UNDERSTANDING BANKING FEES The retainer is the fee paid just to was made famous as a template The fees in an M&A or capital raise have an investment bank work on your for M&A transactions. In a nutshell, process are structured to help smooth transaction. It is non-refundable and Lehman is a 5-4-3-2-1 structure: 5 out the conflicts that can arise when paid in monthly installments or upfront percent of the first million dollars, a company is being advised by an as a lump sum. They tend to be highly 4 on the next million, and so on, investment banker. Bankers or advisors negotiable: Bankers might waive a scaling down to 1 percent. are often in a conflicted situation retainer for a surefire deal, while riskier Today the formula is still a popular way where, if the fees aren’t structured well, projects could carry a steeper charge. of structuring success fees, though it’s better for them to sell a company This ensures that the advisor isn’t left inflation has made the traditional for less money more quickly. That way empty-handed if the deal flatlines. numbers unworkable. Instead they can move on to the next deal and The good news, though, is that the Double Lehman scale is more make another fee. While it might be money spent on retainer is usually prevalent: 10 percent of the first in your interest to get maximum value credited against the success fee million dollars, 8 percent of the second, for your company, and waiting 6 more when the deal closes. 6 of the third, 4 of fourth and 2 of months for a better offer everything thereafter. Variations on is no big deal, a bank has In general, retainers for the structure have also become more to keep the lights on and larger transactions are Ensuring that a common, tailored to each deal. The their advisory running. usually north of $100,000, bank will push Modified Lehman scale takes 2 percent or range from $50,000- Ensuring that a bank of the first $10 million and a lesser for the right 75,000 for a $20-$30 will push for the right percentage of the balance. outcome for million deal, according to outcome for your Basil Peters of Strategic SUCCESS FEES: NON-LEHMAN company comes down your company Exits Corp. Though variations of the Lehman to getting the fees right. comes down Formula are still very popular, different Banks, like everyone Think hard about the to getting the structures are starting to be used by else, are driven by riskiness of the company fees right. different firms. In particular, rather incentives. By ensuring compared to the retainer than reducing fees as a deal gets bigger, the incentives in the fee being changed. Banks some firms actually increase their fees structure are aligned that charge a large as they generate a higher sales price. with the your expectations will help upfront retainer but shrimpy drive the deal to the right result. success fees won’t be strongly “Many would argue that the most Often that means that as a business, motivated to get a deal done, while sensible formula is one where the you’ll have to decide whether you those that tout a success-only percentage of the consideration want a deal closed faster or for model probably do not close a increases the higher the selling price, more money. The choice can have a greater percentage of deals, just a thereby providing a better incentive to significant impact on which banker greater number. maximize price and not recommend the easy deal,” M&A expert Edwin to use and how to structure the SUCCESS FEES: LEHMAN STYLE Miller, Jr., writes. fees. Well structured fees facilitate The bulk of a banker’s pay comes successful outcomes. from the success fee. And how is the Escalating success fees above Nearly every banker structures their success fee calculated? Again, the certain benchmarks is one way to fees as some combination of a retainer percentages and terms vary on a case- incentivize bankers towards larger and success fees. The split between by-case basis, depending on the size outcomes — i.e. 1.25 percent of first retainer and fee, along with how the and complexity of the deal, the nature $100 million of value, 1.5 percent on of the transaction (equity raises are a value between $101 and $125 million,

POWERED BY AXIAL 11 2 percent thereafter. But regardless of the scale, the logic behind compensation is to incentivize the banker to do his or her job. That means resisting the quick solution and driving towards superior terms. In terms of strict success fees, the biggest deals aren’t always the most expensive. Often larger deals, while somewhat risky, can be completed more easily than mid-market deals. Mid-size exit transactions often carry higher percentages because the deals are trickier to finesse, involving fewer and less experienced buyers. OTHER FEES AND EXPENSES It may seem obvious, but it is worth noting that fees are determined by the value of the deal, not the proceeds to the seller. That is, bank debt or other liabilities may reduce the seller’s payout but not the fee base. And timing is another issue. Bankers often want to be paid at closing, which is reasonable in connection with a cash sale. However it gets more complicated, and more negotiable, when deals involve different financing components, like deferred payments, capital adjustments and promissory notes. Aside from retainer and success fees, targets will have to reimburse the banker for deal-related expenses, like travel, which on a large transaction can become significant. Deal-making discourages transparency, but it never hurts to simply ask the banker how fees were structured for comparable deals. It might reveal much, especially if the transactions involved private companies, but even general outlines make the process less inscrutable. Business Owners, Preparing for a Transaction

POWERED BY AXIAL 12 POWERED BY AXIAL 13 CHAPTER TWO: FINDING THE BEST BUYERS

Should You Keep Your Sellside Process Narrow? By Kateri Zhu | May 14, 2014

One of the single most challenging aspects of selling a business is getting your buyer pool right.

While you certainly want to include This demonstrates that even for bankers Adam Abramowitz, Senior Vice enough buyers to complete the with decades of execution experience, President at Intrepid Investment transaction, you also want to avoid it’s exceptionally difficult to accurately Bankers, concludes “as much as you sharing proprietary company identify the most likely buyers. might think you know who the likely information with more people than buyers are, until you pick up the phone Moreover, casting a wide net aligns necessary. How do you balance the and talk to a decision maker, you never with a sellside investment banker’s drawbacks of running a broad process know for sure.” The one consistent way obligation to maximize value for their with the benefits of having enough to mitigate the amount of money you client. All else equal, more buyers high quality buyers involved? leave on the table is to cast a wide net translate to a more competitive and start broad. Theoretically, it would seem prudent to process, and competitive deals beget keep your buyer pool tight. Historically, more competitive pricing. Business Owners, Data & Analysis, Deal sellside bankers would Professionals, News & Trends, Preparing for a Similarly, Transaction, Valuation frequently brainstorm a the same long buyer list and then “Bankers will sell an asset to principle trim the pool down someone in their top tier of applies to a handful that they buyers 55% to 60% of the to capital Should Your believe to be the most providers likely acquirers. The time. That means that 40% selling a Buyer List only buyers invited to to 45% of the time, the portfolio the bidding process buyer is going to come from company. Include Financial would ultimately end outside the top tier.” The vast up being those on majority Sponsors? that shortlist. of fund By Kateri Zhu | May 7, 2014 However, evidence shows that unless managers are measured by the internal you have a compelling reason you rate of return and cash on cash returns There are two kinds of buyers: should go broad, broad, broad. that they produce on their investments. financial buyers and strategic First, despite what many may believe, While there are privacy, resource, and buyers. Financial buyers, often it’s often an unexpected buyer that process considerations that come with called ‘financial sponsors’ or just ends up being a game changer. Joe May, broad deals, the higher your sale price Managing Principal at Graham Partners the stronger your IRR, and the stronger ‘sponsors’, include any company and Axial Member, explains that “bankers your buyer list, the better your chances that invests as a business: will sell an asset to someone in their top of ultimately securing a robust sale private equity funds, family tier of buyers 55% to 60% of the time. price. Adds May, “in order to maximize offices, commercial lenders, That means that 40% to 45% of the time, value for our investors, we typically go the buyer is going to come from outside a bit broader.” At the end of the day it’s mezzanine funds, independent the top tier.” truly a numbers game.

POWERED BY AXIAL 14 investors, and other capital a driving force behind how much a Moreover with multiple parallel deal providers. Strategic buyers buyer is willing to pay. For financial processes running, investments that sponsors however, unless the deal the sponsor has to exit in the next include effectively everything is an add-on to an existing portfolio few months, capital that must be put else: the industrials business company, they structurally can’t benefit to use within a tight time frame, and buying an original equipment from operational synergies. The their own timing restraints, having the absence of these sizable benefits puts financial sponsors on your buyer list manufacturer, the media a ceiling on how much the business is will help keep the process on track and company buying a software worth to them, and moving forward. correspondingly, provider, and so on. DEAL CERTAINTY their upfront offer. Having the financial However, the primary tradeoff is that Secondly, involving financial sponsors are usually unable to Despite these sponsors on your buyer financial sponsors in pay as much for a business as strategic limitations however, list will help keep the your sellside process buyers can (details on why below). experience shows process on track and typically improves that it is actually deal certainly. The question: Is it better to limit almost always moving forward. Because sponsors are sellside deal processes to strategic a good idea to generally driven by acquirers or is there a sizable benefit to include financial a return targets, the including financial sponsors? sponsors in your buyer list. Here are amount that they’re willing to pay will be BACKGROUND the primary benefits. predominantly based on the exit price, forecasted performance, and the IRR that There are two core reasons why DEAL DISCIPLINE they need to hit. They will then use these financial sponsors tend to be unable to First, having financial sponsors in restrictions to solve for the entry price. pay as much as strategic acquirers. your sellside process helps with deal First, sponsors are under pressure to discipline and pacing. Anyone who has Consequently, while they generally pay hit a target return percentage on they ever tried to sell a business will tell you less than strategics, sponsors are often money they invest — which puts a that there are about 1,000 roadblocks happy to come to the table at some restraint on their entry price into every that you’ll have to hurdle to actually price level. close a deal. Between buyers needing investment. They’re not obligated to Eliot Peters, Managing Director at more time, being unable to make meet these return targets, but their RA Capital Advisors** adds that he decisions, wanting more information, ability to do so makes a dramatic will include financial sponsors on and unexpected hiccups, even the difference for (a) the amount of his buyer lists “no matter what.” Not most veteran M&A bankers have an carry received upon exit, (b) future only does it help with deal discipline, exceptionally tough time running an management fees and (c) whether but “it gives you deal certainty, expedient process. future funds can even be raised. The because they’re always there at a three main drivers of returns are However financial sponsors, as the price.” To have someone like that in entry price, exit price, and leverage. name denotes, are in the business of your process gives you a safety net, Consequently, buyers are rightfully sponsoring business growth. Because or insurance, which is something focused on pricing for a certain of this, they’re veterans when it comes that anyone trying to sell a company internal rate of return (IRR) during the to sellside deals and will typically go could only hope to have. acquisition process. through dozens of processes a year. *This applies unless the acquisition is an Secondly, sponsors usually* can’t As a result, sponsors tend to have add-on to an existing portfolio business. In that case, the combined company is much benefit from the operational synergies an excellent grasp of structure and that frequently result from strategic more likely to realize either cost synergies pacing: knowing what the standard or revenue synergies. The financial sponsor deals. Synergies occur when two transaction looks like, exactly what will then incorporate these bottomline companies perform stronger financially the next step is, and when you should savings or topline gains into their valuation than they do individually. This generally of the business and will be able to pay a be there. They know how a normal commensurately higher price. results from cost reduction, joint NDA looks, when to submit it, what talent and technology, or cross-market needs to be in the data room, and **Registered broker-dealer and member of FINRA/SIPC revenue growth. For this reason, how to structure an LOI. synergies almost always accompany Business Development, Business Owners, Deal strategic acquisitions and are often Professionals, Fundraising & IR, Negotiation, Preparing for a Transaction, Transaction Process, Valuation

POWERED BY AXIAL 15 invest capital, and realize a return on buyers focus heavily on synergies 5 Differences their investment with a sale or an IPO. and integration capabilities whereas financial buyers look at standalone Because these buyers have Between Financial cash-generating capability and the fundamentally different goals, the way capacity for earnings growth. and Strategic they will approach your business in a M&A sale process can differ in many One note of caution is that all Buyers material ways. There are five primary buyers cannot be nearly categorized. By Cody Boyte | February 6, 2014 ways they differ: Sometimes ‘strategics’ are just EVALUATION Because these buyers have looking to boost As you sell your company or raise OF YOUR their earnings and BUSINESS fundamentally different funding, understanding the key end up acting like Strategic goals, the way they will differences between strategic financials. Other buyers evaluate approach your business in a times, ‘financials’ and financial buyers can help acquisitions M&A sale process can differ already own a you understand their decision- largely in the company in your context of how in many material ways. making processes. Clarifying what space and are the business will each type of buyer is seeking can looking to make “tie in” with their strategic add- help you decide which fits your existing company ons, so they’ll evaluate your business situation best. and business units. For example, as part more like a strategic. By understanding of their analysis, strategic acquirers will As a quick refresher, potential buyers the motivations of the buyer, you can ask questions like: / investors fall into two primary understand how they’re determining categories: • Are the products sold to their your business value. customers? STRATEGIC BUYERS DETERMINING THE INVESTMENT These are operating companies that • Does your company serve a new MERITS OF THE INDUSTRY provide products or services and customer segment for them? Strategic buyers usually are more are often competitors, suppliers or • Are there manufacturing “up to speed” on your industry, its customers of your firm. They can economies of scale we can realize? competitive landscape and current also be unrelated to your company trends. As such, they will spend less but looking to grow in your market to • Is there intellectual property time deciding on the attractiveness diversify their revenue sources. Their or trade secrets that you’ve of the overall industry and more time goal is to identify companies whose developed that they want to own on how your business fits in with products or services can synergistically or prevent a competitor from their corporate strategy. Conversely, integrate with their existing P/L owning? financial buyers are typically going to create incremental long-term Conversely, financial buyers won’t be to spend a lot of time building a shareholder value. integrating your business into a larger comprehensive macro view of the industry and a micro view of your FINANCIAL BUYERS company, so they generally evaluate These include private equity firms an opportunity as a stand-alone entity. company within the industry. It is not (also known as “financial sponsors”), In addition, they often buy businesses uncommon for financial buyers to venture capital firms, hedge funds, partially with debt which causes them hire outside consulting firms to assist family investment offices and ultra to scrutinize the business’ capacity in this analysis. With this analysis, high net worth individuals (UHNWs). to generate cash flow to service a financial buyers might ultimately These firms and executives are in debt load. Financial buyers are also determine they do not want invest the business of making investments focused on understanding how to in any company in a given industry. in companies and realizing a return quickly increase the long-term value of Presumably, this risk is not present on their investments. Their goal is the company to ensure an acceptable with a strategic buyer if they are to identify private companies with return on their investment. already operating in the industry. attractive future growth opportunities While both buyer groups will carefully As the seller, the risk of having a and durable competitive advantages, evaluate your business, strategic sale process fail due to “industry

POWERED BY AXIAL 16 attractiveness” factors is reduced TRANSACTION EFFICIENCY To better understand how family by ensuring that you are soliciting Financial buyers are in the business of offices are going about their strategic buyers. making acquisitions. It it one of their direct investing strategies, Wilson core competencies to execute deals in surveyed his network and found STRENGTH OF BACK-OFFICE a timely fashion. Strategic buyers may some interesting qualities about INFRASTRUCTURE not have a dedicated M&A team, may the direct investments. Strategic buyers are going to focus be encumbered by slow-moving boards less on the strength of the target THEY PREFER MAJORITY of directors, bureaucratic committees, company’s existing “back-office” INVESTMENTS… territorial division managers, necessity infrastructure (IT, HR, Payables, When a family office makes a direct to check acquisition against internal Legal, etc) as these functions will investment, it almost always prefers projects, etc. often be eliminated during the post- majority investments. As Wilson transaction integration phase. Since From our experience, combine these explained, “Some [family offices] financial buyers will need this back-end factors and the process with strategic would like a strong majority leader, but infrastructure to endure, they will buyers can often take longer than with almost none are looking to make 50, scrutinize it during the due diligence financial buyers. No matter what, be 100, or 200 minority investments.” process and often seek to strengthen prepared for a 6-12 month process Making minority investments in private the infrastructure post-acquisition. before you decide to sell. companies is less beneficial for many As such, you’ll likely want to de- There is more to be said about the single and multi-family offices. “If they emphasize the importance and/or value many important differences between wanted to take a bunch of minority of your back-office infrastructure in strategic and financial buyers, but investments, they might as well go into discussions with a strategic, whereas these are the basics. public markets, buy some shares, and it’s important to be prepared for Business Owners, Preparing for a Transaction have more liquidity and transparent thorough evaluation of these functions reporting at the same time.” when having discussions with a By making majority investments financial buyer. instead, these families can offer THE IMPACT OF THE INVESTMENT more real strategic guidance to the HORIZON How Family business. “Since most family offices are Strategic buyers intend to own an founded around entrepreneurs, they acquired business indefinitely, often Offices Approach understand the markets and industries. fully integrating the company into As such, most of these families see their existing business. Financial buyers Direct Investing industry experience and knowledge as typically have an investment time By Billy Fink | April 15, 2014 the source of their money,” explained horizon of four to seven years. When Wilson. “They enjoy working in these they acquire and subsequently exit the The trend of direct investments types of businesses and it is natural business, especially in the context of to them to have confidence in making the overall business cycle, will have an by family offices continues to more money or preserving their important impact on the return on develop momentum. “Direct family’s worth this way.” their invested capital. investing has become very Majority investments within their core For example, if your business is popular with both single industries allow family offices to use purchased at the peak of a business family and multi-family offices,” their experience to build the business cycle for 8X EBITDA and the buyer explained Richard Wilson, and generate solid returns — a can only sell it for 6X EBITDA 5 years favorable combination for both the later, it’s tough to make an attractive founder of the Family Offices entrepreneur and the family office. return. As such, financial buyers are Group. “Nearly every family I …BETWEEN $500K – $5M going to be more sensitive to business know has exposure to direct or According to Wilson’s survey, “the cycle risk than strategic buyers, and largest volume of survey respondents they will be thinking about various exit co-investments.” are making $500K-$5M sized- strategies for your company before The decision to adopt hands-on investments.” While 48% of family making the final decision to invest in / investments is a reaction to family offices were looking to make buy your company. offices being dissatisfied with “getting burned in the public markets and trusting other people with large

POWERED BY AXIAL amounts of their money,” says Wilson. 17 investments between $500K – $5M, As a result, there is a new trend in to London to discuss co-investment only 11% were looking to make which family offices are becoming opportunities with a $2B and a $5B+ investments larger than $25M. more public. “They want to be known family, and while in town I recorded a in the marketplace to the right parties BBC World News TV interview on $1B+ This preference for smaller deals has because they want the deal flow. Not families and their single family offices. less to do with strategy than budget. many have this mindset today but Much of the interview focused on why “Families with [funds of] $50M-$200M that is a very early trend I’m just now these families are not spending more are more common than families with starting to see this year and I’m sure of their money to help the economy, ­$1B+,” explained Wilson. Unsurprisingly, will continue,” said Wilson. “There the perceptions of the ultra-wealthy, the size of the check generally are new family offices starting every and what it is like to work with them corresponds with the size of the family day. As the industry grows, there will every day. office. After appropriate portfolio be family offices that are set up that diversification, smaller families can only Below are some of the most common recognize the benefits of being public.” write smaller checks. misperceptions: We are already seeing this increased Wilson continued, “I know that our THESE FAMILIES DIDN’T FALL publicity on the Axial network. Over $1B+ clients almost always want to INTO THEIR MONEY the last three years, the number of write checks at a $5M minimum and None of the families that I have met to family offices on the network has it is only those single family offices date have come into wealth through grown 205% percent. Additionally, looking for concentrated positions in pure good fortune, such as winning the these family offices are resolving just a few industries or those larger lottery, or finding gold on their horse their dealflow issues by becoming $500M-$1B+ group who are looking to ranch, etc. Instead, almost all of them more active –the average family office do the $20M-$100M size deals. While have all started and grown successful pursued 20 opportunities in 2013, up looking closer at the data it is the larger businesses and worked long hours over from only 6 in 2011. single family offices and those families a long period of time. who have built out fully formed private Deal Professionals, Dealmaker Outlook, These families are largely savvy equity fund or private equity portfolio Preparing for a Transaction investors in their own right, they have divisions which are conducting these earned their wealth through navigating larger deals.” their industry and often leading it. This THEIR BIGGEST CHALLENGE means that investment bankers and Like any dealmaker, one of the biggest private equity funds approaching them challenges confronting family offices is Family Offices: should learn about where they made deal flow. “Many of these families don’t their wealth, how, and think of creative know how to find the relevant partners Fact vs. Fiction ways to work together instead of just or dealflow,” By Richard Wilson | The Family Offices pitching deals to these wealthy families. explained Group July 16, 2014 Many times families can be a source of Wilson. Like any deal flow, domain expertise, and capital “They do not dealmaker, It is surprising how often over a given period of time. know who one of the family offices and the ultra- SECRETIVE BUT NOT HIDING to trust, and wealthy are misrepresented While family offices and $1B+ families they don’t biggest are seen sometimes as secretive, have a lot of challenges in the media and how these hard-to-access, and under-the-radar, connections misconceptions can lead to a confronting they are everywhere. They are behind in the family offices negative view of the industry the charities we hear about, backing network.” overall. the venture capital funds, owning Since family is deal flow. the sports teams we cheer for, and offices have As part of my work with larger single refining the oil going into our cars. traditionally family offices — our team runs a family They are omnipresent yet secretive at maintained a discreet profile, it is office community with 77,000 global the same time. difficult for intermediaries and members, 2,000+ of which are single business owners to contact them. family offices — I recently traveled

POWERED BY AXIAL 18 Many family offices are secretive as a society we are playing the game THEY HAVE LONGER INVESTMENT because of a desire for the wealthy of capitalism and with the exception HORIZONS family to live a semblance of a normal of a few corrupt politically connected One of the biggest advantages of life, without the scrutiny of journalists billionaires, the rest of these individuals selling to a family office is their much commenting on their every vacation or are winners of this global game that we longer investment horizon. Most business stake. Also, the family office play. They should be studied, learned traditional investors — like private industry is so new that just now many from, respected, and seen as such. equity firms — are limited to 5-7 year organizations are starting to self- Deal Professionals, Dealmaker Outlook, investment timelines because of fund- identify as a single family office instead Fundraising & IR imposed limitations. Since PE firms of a holding company or loose team of must return money to their GPs at the professionals stewarding the wealth of close of the fund, they are limited in an ultra-wealthy family. how they can think about investments and what strategies they prioritize. As a As single family offices grow in number 5 Reasons to Sell result, many CEOs feel their PE-backers and maturity they should become less are too focused on the short term. secretive and a segment of them will to a Family Office employ public relations consultants By Ashleigh Schap | September 30, 2014 Family offices, however, are not limited and team members to help grow their to any specific timeline. This is because equity interests connected to the Twenty five years ago, the family offices do not have any fund family office and increase deal flow. average CEO was pushing structure; they are investing with their own money and can do so at their own WORKING WITH LARGE FAMILY 60 years of age; today, the timeline. They can hold companies OFFICES average age is closer to 54. for extended periods, allowing As I explained in a recent interview I What that means for the younger CEOs to stay on and grow have found these large family offices to the company or to sell with a much be highly professional and respectful capital market is that exit longer buyout period. This longevity is of time. While they are very busy, they horizons have shifted – and so particularly appealing for CEOs that are do take time to identify high-quality have the strategies CEOs are not looking to exit entirely, but merely partners and products – prioritizing using to sell their businesses. take a few chips off the table and begin recommendations from their peers planning for a transition. as high quality resources. While these In the early 90s, CEOs were families have excess wealth, if you considering more immediate exits as THEY HAVE STREAMLINED can provide genuine they were closer to DECISION MAKING insight on your area retirement age. Now, Family offices tend to be more of niche expertise, While these families the average CEO streamlined in their decision making you will be seen have excess wealth, still has more than processes. Since they are using their as valuable for the if you can provide a decade left in the own money and are often investing unique knowledge- genuine insight on workforce. But with within their industry of expertise, they currency you posses. markets at an all-time feel more comfortable making quicker your area of niche high, many are looking decisions and have more flexible DON’T BELIEVE expertise, you will be for ways to take some internal operations. THE GOSSIP capital out of their HEADLINES seen as valuable In contrast, private equity firms often businesses without Most newspaper need to conduct robust due diligence giving up total control. headlines on the processes and consider the interests ultra-wealthy focus on Traditional acquirers of their GPs. These extra steps can add wasted money, crashed Ferrari’s, family don’t always make a perfect match significant time and complications to disputes, or other negative aspects of for these situations, leading many of the entire process. being very wealthy. There are many today’s executives to work with family family disputes, but what goes on with offices. Here are 5 of the biggest these families is far from what the reasons why: media portrays and is not consistently negative. Some may disagree, and this is as political as I ever get, but I believe

POWERED BY AXIAL 19 THEY ARE A BIT MORE HANDS THEY HAVE INDUSTRY EXPERTISE OFF Most people prefer to stick with Additionally, family offices are often what they know; billionaires are no not interested in taking over the exception. As such, family offices management of the company. When tend to invest in the industry in which they make an investment, it is usually they made their fortune, providing an to encourage the already-existing invaluable source of advice and market growth of the company. This makes expertise for executives that stay on to them an ideal investor for an owner run the company. that is looking to stay on for another There are plenty of great reasons for 5-10 years. companies, particularly those with Private equity firms and strategics, younger CEOs and executives to sell to depending on their strategy, can family offices. Ultimately, it’s an option often be more heavy-handed with that can provide more freedom for their management strategy. They both acquirer and target. Family office may change the strategic direction of participation in direct acquisitions the company or bring in new senior has increased in recent years, and will management to better accomplish only continue to increase as the ultra- their goals. Similarly, strategic acquirers wealthy seek new ways to engage with will often roll the acquired business the capital market. into a larger company. Business Owners, Due Diligence, Preparing for a For a CEO looking to stay in place, the Transaction heavy-handed tactics can be a deal changer. Regardless of the investor, it is important to always discuss goals and expectations at the very beginning of the process. THEY PAY IN CASH PE firms will often pay for a portion of their acquisitions with cash and will finance the rest using mezzanine or senior debt, ultimately transferring debt to the target’s balance sheet. While this leveraged buyout strategy can encourage rapid growth and better returns for the PE firm, it also entails a bit of risk. And often, since a CEO is attempting to reduce their personal risk by taking chips off the table, this can be a choice they’re unwilling to make. Family offices, however, rarely use debt to finance their acquisitions. Instead, they prefer to pay in cash. This relieves the company from the debt burden often taken on by other types of financial buyers and leaves the company in a better position to weather future issues.

POWERED BY AXIAL 20 POWERED BY AXIAL 21 CHAPTER THREE: LBO ESSENTIALS

Inside the Leveraged Buyout Deal Process (Part I of III) By Kateri Zhu | April 2, 2014

What does a leveraged buyout transaction look like? In this three part series we will give readers a look behind the curtains of one of the most captivating types of deals on wall street: the leveraged buyout (“LBO”). There are ten primary steps to an LBO. This is the first installment of our trilogy and will cover the first four steps: sourcing, screening, the non-disclosure agreement, and due diligence.

STEP I: SOURCING and reach. And finally, they’ll use shortlist of high-value opportunities Before a buyer ever talks to a seller, databases such as Capital IQ, Factset, and ultimately to agree on a single before any negotiation happens, and Bloomberg to make sure that target that it will pursue to deal close. before a deal even gets off the they’re not missing something of which The skill with which a fund is able to ground, there’s a fund partner sitting every other market player is aware. identify the right target is arguably somewhere in America looking at the The primary driver of LBO returns is the second most influential factor entire universe of deal opportunities the degree to which the investor is able on performance, next to its ability and deciding on which one he wants to to source on a comprehensive level. to source at scale. Indeed, there spend the next six years of his life. Why is this the case? Because in order are a number of critical factors that This is what we call sourcing. to generate a strong internal rate of make a good buyout candidate but return (“IRR”) a fund needs to be able every fund’s angle is different. As a During the sourcing stage, the to both deliver extremely profitable consequence, the process by which primary player is the buyer. He’s improvements to the business, and a fund selects the opportunities with combing the landscape, sifting for buy it for a fair price at the start of the which it has the best angle is of critical enterprises possessing certain core deal. Unfortunately, most transactions importance to its financial success traits, researching them, weighing (and are auction processes wherein multiple (defined predominantly by IRR). recording in acute detail) investment capital providers — each with strong risks and benefits, and using all this During this stage, a fund will typically capabilities — are all bidding on the knowledge to inform his next move. take from several days to several same asset. As a result, funds that have weeks to construct a robust view Fund partners turn to several channels identified channels that enable them of a business. First, it’ll start with in this process. First, they’ll reach to source efficiently are almost always whatever public information the out to personal contacts including able to access proprietary deals that company has made available. This will associates at other funds, investment end up delivering huge dividends. include anything on the website, press bankers in the sector, and company STEP II: SCREENING releases, shareholder presentations, executives with whom they have Once a capital provider has potential customer pamphlets, ownership relationships cultivated over many targets on the table, a rigorous change announcements, and any years. Second, they’ll use dealmaking screening exercise commences. The financial figures the management tools such as Axial and LinkedIn to goal of this process is first to reach a team has released. If the deal substantively improve sourcing scale opportunity arrived on the investor’s

POWERED BY AXIAL 22 desk as a result of a teaser from do to create that value (reduce cost of to make, send it back to the seller an investment bank, he’ll also look goods sold? grow topline?), how much for approval or some negotiation over any business or financial data they would sell it for on the exit date, and, when they have reached a disclosed in that document. and what % return this all sums up to. consensus, send over a copy of the executed contract. Second, he’ll comb the landscape for Finally, the fund will take all this anything that may shed light on the information and aggregate it into STEP IV: DUE DILIGENCE core foundation and health of the a central document ranging from A signed NDA begins the first of — business. This includes third party a brief investment overview to a assuming all goes well — many rounds news mentions, independent profiles comprehensive deal memo. The memo of due diligence (“DD”). on the business and its leadership will include not only an overview of Put simply, due diligence is the team, customer testimonials, customer the company, the competitors, and the investigation of a target’s business by complaints; basically, anything that industry, but a thorough assessment the potential buyer. This step involves he can find on Google, and beyond. of the risks and benefits involved with the buyer, the seller, and if engaged, This is a critical step as — similar to a a buyout of the enterprise. Indeed, the buyer and seller’s advisors. product you would consider buying in a it’s not uncommon for buyers to do store — third party commentary is often a thorough round of internal analysis Buyside deal teams typically start with more comprehensive when it comes to before they ever talk to a company an initial 2 to 3 week diligence round, the good, the bad, and the ugly. owner. followed by a non-binding indication of interest, and then a much deeper The partner then undertakes a STEP III: NON-DISCLOSURE diligence round lasting 2 to 6 months thorough assessment of the industry AGREEMENT that will precede the letter of intent. in which the company plays. Who If the buyer decides that it wishes to are the competitors? What are move forward, it’ll want significantly During the multistep saga that is the their relative market shares? What more detail than what’s publicly diligence process, the investor will start differentiates our guys? Who is the available or provided in the teaser. To with a review of the seller’s confidential target consumer? Are there product access this data, he and the seller information memorandum (“CIM”). A or service substitutes? What are will sign a confidentiality agreement, well prepared CIM will generally include the performance drivers? What also frequently referred to as a non- a robust overview of the: are the typical margins (e.g., gross disclosure agreement (“NDA”). In • Business margin, EBITDA margin, net income short, the NDA is a legal document that margin, etc.)? How much do players protects any confidential operating • Operating history typically spend on capital expenditures, and financial information shared by • Industry dynamics working capital, the like? What does the buyer with the seller throughout the average accounts receivable and the transaction process, from being • Competitive landscape accounts payable cycle look like? Who disclosed with third parties. • Barriers to entry are the upstream providers? How fast The execution of the NDA officially is the sector growing? • Core customer base kicks off the deal. It’s the first point in Fourth, the fund will take the data it which the potential investor is given • Go-to-market strategy does have and build a financial model access to information that any public • Primary performance drivers of the potential transaction. The bystander won’t have. Moreover it’s • Scalability model answers the key question that the first time that the buyer and seller fund partners ask themselves: what will sit down at the table to negotiate. • Assets (e.g., intellectual capital, would the LBO look like if we were In more complicated transactions, patents, facilities, etc.) to execute it? It includes not only either a sellside investment bank, • Growth opportunities available (or often assumed) financial sellside legal counsel, buyside projections, but details on how much investment bank, buyside legal counsel, • Management team debt the transaction would entail (3.75x or all of the above, will also weigh in on • High level financials (ideally five EBITDA? 4.50x EBITDA?), how much the negotiations. years of historicals plus five years they would pay, how long they would Here, the buyer will review a copy of of projections) hold it, how much value they plan on the NDA, usually provided by the seller, creating during the holding period • Discussion of the company’s ability mark it up with any changes it wishes (usually 3 to 10 years), what they would to execute on said projections

POWERED BY AXIAL 23 • Summary of the auction process, In most transactions, the diligence generally conditional document that the proposed structure of the process is a two-way conversation. reflects available data, moves buyers deal, and expected timeline for While the target will usually kick onto a shortlist, and moves them expressions of interest (a.k.a. bids) off DD by circulating the CIM and through to the second round. giving investors access to its data Next, the buyer will set up meetings In the IOI the buyer will generally outline: room, by midway through diligence with the management team alongside buyers are often emailing the target’s • Approximate price range for the site visits, supplier meetings, management team, investment business; this can be expressed as customer interviews, and expert bank, and legal counsel to request an absolute dollar amount (e.g., $15 interviews, as appropriate. information. The primary goal of – $20 million) or multiple of EBITDA In addition the seller, sometimes aided diligence is to provide a comprehensive (e.g., 3.0 – 5.0x EBITDA) by sellside counsel, will usually set up picture of the target, communicate • Details on available funds (i.e., cash a virtual data room. The seller will risks, answer any questions, and — and equity) and debt financing then upload the following types of possibly most importantly — present sources information to this storage space: the information that will fuel the • Potential transaction structure • Specific information that potential buyer’s thinking around operational (e.g., cash vs. debt ratio, leverage buyers have requested; for improvements. tranches) example, a buyer considering the Business Owners, Deal Professionals, Due merits of consolidating real estate Diligence, Preparing for a Transaction • Management retention plan and shuttering underperforming • Intended role of equity owner(s) stores might ask the target for a after the deal has closed list of retail locations and the lease expiration date for each location Inside the • Key items needing further diligence • Information that gives the buyer Leveraged Buyout • Planned diligence timeline improved visibility but was too • Expected timeframe to close data heavy to include in the teaser Deal Process (Part or CIM; for example, scanned There are four primary purposes of the IOI. copies of the seller’s seven II of III) First, it allows the seller to retain primary supplier contracts, or By Kateri Zhu | April 9, 2014 higher participant quality by asking perhaps original terms for its two that buyers demonstrate a threshold outstanding bank loans This article is the second level of commitment to advance to the • Information that gives deeper installment in our three part next round. Second, it gives the seller insight or detail than the CIM; series on the leveraged buyout color both on buyer seriousness and for example, a seller distributing approximate valuation range. Third, it organic milk products might want (“LBO”). There are ten primary allows the seller to focus its time on a to break down performance by steps to executing an LBO. few players with which to have more intimate discussions. And finally, it product type, flavor, fat content, This section will cover the sequence limits the number of parties that are size, and SKU of actions that take you from the privy to the seller’s wealth of internal indication of interest, to the letter of • Information that becomes company data. Indeed, one of the intent, and to final deal negotiation. available over the course of the biggest tradeoffs of having a very deal process; for example, a seller STEP V: INDICATION OF INTEREST broad process is that a seller, in the launched the sellside process in After a cursory round of diligence process of executing a deal, risks November 2013 and posts its 2014 the seller will give its potential buyers giving away its most valuable trade financials to the data room in a deadline by which all interested secrets to an audience that’s larger March 2014 counterparties must submit their than it needs to be. indication of interest (“IOI”). All else equal, the volume of information After the buyer sends its IOI over, the presented in the seller’s data room will Put simply, an IOI is a first round bid seller can choose to either accept, increase with its size, the complexity for the business. It’s a non-binding, negotiate, or deny the buyer’s terms. of the transaction, and the number of potential suitors involved in the process.

POWERED BY AXIAL 24 STEP VI: LETTER OF INTENT tax basis and stock deals benefit • Depending on the deal, a summary Assuming the seller and buyer agree on the seller from a tax and legal of the buyer’s expected escrow the terms of the IOI, the buyer enters perspective terms; this allows it to hold back a the next round of bidding and begins percentage of the purchase funds • Updated estimate of closing date an in-depth course of due diligence to cover future calls for past seller (“DD”). The aggregate time involved • List of tasks that need to be liabilities; this is generally highly with diligencing a buyout target is completed by closing negotiable and will sometimes generally between two and six months. • Approvals needed by the buyer be excluded from the LOI, and However because of the high time and (e.g., board of director vote) or presented for the first time in the resource commitment involved, the seller (e.g., permissions from purchase agreement buyer will usually negotiate and sign a regulatory agencies) to complete The LOI is an important milestone letter of intent (“LOI”) with the seller the deal in the successful sale of a company. after it has performed some diligence, While it doesn’t guarantee a closed but before it completes full DD. • Binding period of exclusivity; this is usually one of at least three deal, it’s a clear signal that the By definition, the LOI is the agreement binding clauses buyer has serious that documents, in detail, the buyer’s in the contract intentions. intention to execute the transaction The LOI is an and typically STEP VII: and is substantively more thorough lasts between important milestone NEGOTIATION and legally declarative than the IOI. In 30 and 120 in the successful sale The negotiation an LBO, it outlines the investor’s plan days; while the process involves two to buyout the business and discloses of a company. While duration might primary parties — the most important deal terms. it doesn’t guarantee a be negotiable, the seller and buyer More importantly it gives the buyer the presence closed deal, it’s a clear — and, depending exclusivity, which is effectively the right of an exclusivity signal that the buyer on the deal, several to purchase that business within a clause will almost has serious intentions. additional players — certain timeframe. It’s now common always be non- the sellside advisor for buyers to request an exclusive negotiable (i.e., investment negotiating period, which is meant to • Binding break- bank), sellside legal ensure that the seller is not shopping up fees; deals greater than $500 counsel, buyside advisor, buyside legal their deal to other bidders while million in aggregate value usually counsel, and buyside lenders. appearing to negotiate in good faith. include a fee schedule that The seller’s primary goals are to This is particularly important because protects the buyer from an owner complete the sale, maximize its sale buyers will frequently involve outside withdrawal; this can either be a price, and secure a favorable buyer consultants and legal counsel to help percentage (typically 6%) of the (meaning one that brings specialized with diligence, and as such, need total transaction value or a fixed experience to the table and / or with assurance that it’s not throwing money dollar amount which it has a synergistic relationship). at an assumed transaction while five As a result, though its advisors are other buyers are still in the mix. • Binding confidentiality terms that go beyond the original NDA almost always involved in negotiations The contract can be from two to ten (more below) the seller has the final pages long. It will usually include: • Management compensation say in valuation conversations and plans detailing which current bidder selection. • Details on the format of payment, executives should be retained whether cash, stock, seller notes, post-transaction, their equity plans, The buyer’s primary goals are to earnouts, rollover equity, or and their employment terms; this achieve a high internal rate of return contingent pricing is often worded vaguely to give (“IRR”) and a strong money multiple, the two most common measures • Transaction structure specs the buyer latitude since it may not of investment profitability. Funds defining the deal as a stock or asset be in a position to make broad are under pressure to hit a certain purchase; generally speaking, asset commitments to executives performance level because it (a) drives deals protect the buyer from prior • Any additional areas of due the amount of carry received upon exit, liabilities and provide a stepped-up diligence required by the buyer

POWERED BY AXIAL 25 (b) influences future management This multi-year period is when the fees and (c) determines whether Inside the buyer — now the owner — improves future funds can even be raised. The the business in ways that create three main drivers of performance Leveraged Buyout value. These levers are (a) earnings are entry price, exit price, and growth, (b) debt paydown, and (c) leverage. As a result, buyers are Deal Process (Part multiple expansion. rightfully focused on price and Earnings growth means that the leverage during the negotiation. III of III) By Kateri Zhu | April 16, 2014 business is becoming more profitable. The final acquisition price will be a This can be achieved by increasing the balance between intrinsic valuation, This article is the third and final topline (i.e., organic growth), improving market conditions, the buyer’s ability the bottomline (i.e., higher efficiency), to reach its fund performance targets, installment in our three part or cultivating inorganic growth (e.g., seller expectations, and competition series on the leveraged buyout acquisitions). Frequently it entails a for the asset. Most LBO investors (“LBO”). combination of the three. begin the valuation process (which Debt paydown means that the launches months before the LOI) by This chapter will cover the sequence of business is increasing its equity-to-debt identifying the maximum amount that actions that take you from the actual ratio. It accomplishes this by paying they could pay in order to hit their acquisition of the business, through the back borrowed funds and thereby return target. management period, and to its final sale. reducing leverage. In other words, the The sellside advisor’s primary goals STEP VIII: ACQUISITION company is not only generating excess are to close the deal and maximize This step launches the multi year cash, but using that cash to reimburse sale price. During negotiations it will period during which the buyer lenders that lent the capital to provide support, counsel, and often owns, manages, and helps grow the complete the buyout in the first place. represent the seller in conversations acquired business. Multiple expansion means that the with buyers. Every player involved in negotiating the business is being sold for a higher The buyside advisor is focused on deal — the buyer, seller, and depending earnings multiple than that at which helping the buyer find the right on the transaction, the sellside advisor, it was bought (i.e., the new buyer investment, closing the deal, and sellside legal counsel, buyside advisor, is paying more for every dollar of building relationships to support future buyside legal counsel, and buyside earnings today than the original buyer business. It will create internal financial lenders — work together to execute did). The earnings multiple is usually models to check valuation, assign the acquisition. expressed as a multiple of EBITDA independent credit ratings to the The financing structure is reviewed (e.g., 5.5x EBITDA) and is covered in target, and validate the target’s ability and vetted, the bookrunning bank more detail in our article on why LBOs to service a certain amount of debt. syndicates the debt, lenders wire generate higher returns. Multiple expansion is typically a product of The buyside lenders are the capital the funds, the new owner assumes improved growth opportunities, providers that fund the debt portion official management of the business, increased company size, more of a leveraged buyout (i.e., the revolver and new directors — this often efficient operations, favorable industry and term loans). Their primary goal is includes the fund partner that led dynamics, or a bull (i.e., strong) market. to put their cash into investments with the LBO and certain experts the fund a balance of decent risk and return believes to be value additive to the Before we move forward, one should characteristics. As a result, not only acquired business — take their seats note that these three types of value do they run their own due diligence, on the Board of Directors. creation are not easy to execute. but also often step in to negotiate STEP IX: MANAGEMENT Growing the bottomline by 4% or paying debt covenants aimed at mitigating This phase is, by far, both the longest down 3% of debt — perhaps — but borrower behaviors that might and often most important part of the to generate 20%+ of value every year increase default risk. process. It begins when the buyer requires a thoughtful process, a surefire Business Owners, Deal Professionals, Preparing purchases the company, ends when it’s blueprint, and rigorous execution. for a Transaction sold to another owner or goes public, and usually lasts three to ten years long.

POWERED BY AXIAL 26 As such, there are five general steps It outlines the strategic goals, tactical the right direction, and adjust course to methodically managing an LBO initiatives, necessary steps, which when there are better tactics for candidate. teams are involved, what changes achieving targets. must be made, and the execution Determining the potential. In Laying the foundation. This is the timeline. The best buyers will sketch this stage the owner defines a process of sculpting the business out the entire ownership period maximum value for the business. This to the game plan, and setting up and will, according to Orit Gadiesh process takes root throughout the necessary building blocks. It includes and Hugh Macarthur’s Lessons from first eight steps of the deal process, structural changes, matching Private Equity Any Company Can Use, and is accomplished by identifying employees to fundamental initiatives, include details on everything from day opportunities for improvement during and securing any necessary but 1 activities to overarching strategy. due diligence, management meetings, currently unavailable resources. external research, and internal analysis, History has shown that one of the During this stage, the company’s and subsequently incorporating them core advantages of financial sponsors performance typically accelerates and into financial models. over corporations is often their the owner will begin to track certain ability to identify the “few” activities The inputs to these models are the operating indicators and iterate on the that add the vast majority of the materials that the now-owner, formerly day-to-day game plan. value, and focus obsessively on those buyer, touches during the transaction activities. The owner’s aptitude in Optimizing financial efficiencies. process. As you might recall this defining these high impact efforts This step focuses on improving the includes public information, the minimizes the amount of time wasted cash efficiency of a company. It company’s website, the teaser, the on low-value-added efforts and entails the thoughtful application confidential information memorandum, enables it to exit in a short timeframe, of buyout economics to the historical and projected financials, while still maximizing returns. business. Specifically the owner will contracts, legal records, management concentrate on two things: meetings, interviews with customers, Aligning the stakeholders. The industry analyses, etc. primary goal here is to harness 1. Improving operating income leadership talent and put it towards Most buyers will create three models 2. Improving net working capital activities that facilitate the greatest gains during the deal process: a downside in earnings, margins, or cash output. Operating income, usually defined case, a base case, and an upside case. as earnings before interest and taxes The latter two reflect how the business The principal mechanism for alignment (“EBIT”), is a financial metric that would perform if management were to is a reward structure that puts gauges profitability. It is a primary successfully implement some or all of management and owners on the same focal point because it’s one of the core the improvements. The page. The arrangement drivers of cash flow. former will maintain a set of should incentivize the conservative — often very Most buyers company’s leaders to To improve income, owners undertake conservative — estimates. will create (a) embrace the game activities that optimize any financial plan, (b) tackle value line item above EBIT. This includes These financial models three models additive activities, and revenue, SG&A (selling, general, and serve as a benchmark during the (c) shoulder otherwise administrative) costs, COGS (cost of of future potential deal process: a burdensome tasks. goods sold), and other expenses. and illustrate what can be achieved over the downside case, Moreover, the most For example, if we’re dealing with a management period. a base case, and effective reward business that requires raw inputs, structures will usually the owner might run a search for Creating the game an upside case. encourage leaders to additional suppliers that can provide plan. The game plan is a be results-oriented, materials at a lower cost than the comprehensive framework proactive, and company’s existing suppliers. It for how the business can strategically nimble. The primary goal would then help the management reach its performance targets. is to foster an environment that is both team negotiate new contracts and metrics-driven and agile, such that phase these new partners into management is motivated to both take production. This type of activity on efforts that drive the company in would reduce COGS.

POWERED BY AXIAL 27 Improving net working capital (“NWC”) that both allows for uninterrupted For example, a good business can is the second component of financial customer supply and reduces the continue to generate additional cash- discipline. NWC is essentially the amount of cash tied up in idle on-cash returns while simultaneously amount of cash required to run the inventory. This action would reduce reducing IRR. As a result, incremental company: satisfy sales orders, pay current assets, thereby reducing net value creation opportunities usually operating expenses, and service short working capital, and thereby increasing need to be sizable in order to justify term debt obligations (i.e., those due free cash flow. delaying an exit past a certain point. within one year). On the other hand, an owner might Owners typically exit LBOs in one of Net working capital = Current assets – choose to optimize net working capital four ways: Current liabilities by increasing current liabilities. For 1. Strategic buyout example, it might help the leadership Current assets = Accounts receivable team negotiate its supplier contracts 2. Secondary buyout (i.e., a sale to + Inventory + Prepaid expenses + Cash from cash to credit — or more another financial sponsor) + Marketable securities plausibly — from the current credit 3. Management buyout Current liabilities = Accounts payable + terms to more lenient credit terms Accrued liabilities + Short term debt (e.g., 30 day versus 45 day payment 4. Initial public offering Moreover, working capital is a use of period). This type of activity would Strategic buyouts occur when the cash. Higher working capital translates reduce the amount of cash tied up in company is sold to a corporation, to lower liquidity. Lower working working capital and increase the cash commonly referred to as a “strategic capital translates to higher liquidity. flow liquidity of the business. buyer” or “strategic”. This metric is of crucial importance The best financial sponsors are This usually happens because the because the higher the working capital, those that handle the management corporation sees value in vertical the higher the amount of cash tied up period extremely thoughtfully and integration or the company’s product in running the day-to-day operations, meticulously. They are able to identify portfolio, customers, intellectual and the less financially efficient the both the company’s strengths and its property, patents, brand, leadership, or business. Capital providers are development areas, select the right synergy potential. (meaning most impactful) areas for similarly focused on NWC because These exits also tend to offer the it gauges operating liquidity and is improvement, come up with a game plan, execute on this plan, optimize the highest exit value because a strategic’s likewise one of the the core drivers of synergies and lower cost of capital cash flow. financial skeleton, and change course when the hypothesis warrants editing. (a result of lower leverage and a To optimize (meaning decrease) correspondingly higher credit rating) working capital, owners undertake STEP X: EXIT will be factored into the dollar sum activities that minimize current This step marks the end of the that it’s willing to pay to purchase the assets (“CA”) or maximize current ownership period. On average, the business. liabilities (“CL”). exit occurs five years after the original purchase of the company. It can range Secondary buyouts occur when For example, an owner might from between three and ten years out. the company is sold to another implement a more proactive financial sponsor. The decision to exit is almost always collections process and solicit This usually requires a high degree of customer payments closer to the point a difficult balancing process. The (a) current sale prospects for the leverage and a favorable cost of capital, of sale. This would reduce accounts because the new buyer needs to be receivable, thereby reducing current company have to be weighed against (b) untapped opportunities to create able to achieve high returns a second assets, thereby reducing net working time around with the same business. capital, and thereby increasing cash future value and (c) incentives to exit flow. Similarly, an owner might limit before the IRR flattens*. Consequently, secondary buyouts the company’s cash balance to the Why is this? Although good buyout are often an outcome of the amount needed to meet day-to-day candidates usually exhibit strong original buyer electing to exit within expenses, thereby lowering current performance beyond just five or even a certain timeframe in order to assets and increasing cash flow. In ten years, the downward pressure maintain a high IRR, and therefore addition, an owner might identify on IRR increases in tandem with occur predominantly with high the optimal amount of inventory — investment length, as returns are performing businesses. spread over more years.

POWERED BY AXIAL 28 Additionally, these exits typically come achieving substantive cash-on-cash of equity required to acquire a with less of a premium than a strategic returns and maintaining a high IRR. company, and then further magnifies buyout, given the absence of cost or Business Owners, Deal Professionals, Preparing those returns through the favorable revenue synergies and the generally for a Transaction tax treatment that interest payments more restrictive sponsor debt terms. receive under US tax code. Management buyouts (“MBOs”) Not every company is a viable LBO occur when the existing management candidate, however. team purchases the business back How Private Detailed below are a set of from the current owner. Equity Screens for characteristics that deal professionals This type of exit occurs in a very typically seek when assessing a target specific scenario: when the financial LBO Candidates company’s viability for an LBO-style sponsor wants to exit, members of the By Kateri Zhu | May 28, 2014 change of control transaction. management team wish to make the HARD ASSETS transition from employees to owners, The leveraged buyout (“LBO“) Banks lend more cheaply against and there are no competitive bids from has become well-practiced hard assets as collateral. If your other buyers. among private equity assets consist predominantly of your MBOs typically require a substantive employees, it can be very challenging amount of external financing and professionals, and is now to gain bank financing. Bank debt is will usually entail a combination of standard industry practice as usually collateralized by the physical equity and debt funding from the a means by which to acquire assets of the company, so the more management team, third party capital private companies. plentiful, sizable, valuable, and stable providers, and sometimes the seller. the assets – machinery, inventory, Yet it can be used by any capital receivables, real estate – the more Initial public offerings (“IPOs”) provider with the experience, available and cheap the leverage occur when the owner decides to sell credibility and business to secure the for your deal becomes. While these his stake in the public markets rather confidence from the financing sources hard assets certainly help the credit than to a private buyer (e.g., another required to execute an LBO. structure, intangibles like brand sponsor or a strategic). The LBO gained prominence in the names, goodwill, and human capital This involves going through the process 1980’s thanks to Jerome Kohlberg have nonetheless become increasingly of making the company a publicly and his associate, Henry Kravis. These important considerations in an LBO. traded entity but, depending on the two joined forces with the latter’s STEADY CASH FLOWS markets, may result in a lower or higher cousin, George Roberts, to conceive Free cash flow is king in an LBO, and value than a strategic or secondary what would become a private equity it’s generally defined as the amount buyout. Moreover, IPOs almost always triumvirate with the birth of their firm, of cash that a business generates in offer only a partial exit to the owner, KKR. Today over 2,800 private equity excess of what’s required to maintain with the complete exit coming in firms exist in the US alone, buying its current operations. The reason subsequent secondary offerings. thousands of companies each year. this is so critical is because the free *In certain highly successful leveraged As its name implies, the use of financial cash flow of a company’s operations buyouts, the decision to exit is weighed leverage, or debt, is one of the primary determines how much leverage that against the time at which IRR drops to elements that distinguish an LBO from company is capable of supporting a certain threshold rather than when a traditional acquisition executed with without imperiling its ability to stay it flattens. For example, if a company cash or stock. Leverage can enhance solvent in a downturn. is generating 70% IRR over the first equity returns to the sponsors, who MATURITY OF MARKET two years, an investor will most likely have discretionary control over all cash Companies selling into an established, choose to retain the investment even flows that exceed the debt payments well-defined market (e.g., automotive if the IRR will almost certainly decline incurred. Because interest payments valves, soft drinks, etc.) are more over the next several years. This on debt are tax-free, leverage improves conducive to an LBO than those selling illustrates the balancing act between equity returns by reducing the amount into a fledgling market (e.g., social networks, nanotech, etc.). Indeed

POWERED BY AXIAL 29 while an entity’s growth prospects NON-CORE CORPORATE BUSINESSES IMPAIRED BY are important, they are secondary DIVISIONS UNDERLYING INDUSTRY to stability. A mature market with Sometimes some of the subsidiaries Sometimes businesses with attractive predictable demand, steady revenue, or divisions of large conglomerates no long-term earnings capacity are and no eminent game-changing, longer make sense or fit in with the held hostage by a poor underlying competitor-crushing disruptions is future of the company’s plans. In these industry or economy, causing deflated ideal for a buyout because the cash instances companies will “spin off” trading prices and valuations. Such flows of the company are likely to be these less relevant divisions, realize opportunities are attractive, offering substantively more predictable. the cash, and reinvest it in accordance a chance to buy companies for cheap with the new strategic directives of before an expected rebound in the LOW CAPITAL EXPENDITURE the organization. In October 2011 for market price. REQUIREMENTS example, Smith & Wesson announced The lower the annual investment Bottom line: understanding how that it was spinning off its security required to operate a business, the private equity firms screen for division to concentrate on its more better. Consistently high levels of and think about LBO feasibility is profitable firearms business. capital expenditure are unwelcome, exceptionally beneficial to advisors as they consume cash that could BUSINESSES WITH SUB-PAR evaluating which assignments to otherwise go toward paying interest MANAGEMENT take on, entrepreneurs thinking payments, principal debt payments, or The most successful private equiteers about who to sell to, management dividends to the equity holders. often possess high degrees of teams considering an MBO, and specialization, and for that reason, corporations evaluating which buyers NON-CORE ASSETS can add tremendous value to the will be interested in purchasing their There are few ways to boost cash organizations that they acquire. It’s non-core divisions. flow more painlessly than to liquidate meaningfully more easy for savvy non-vital assets that carry an attractive Business Owners, Preparing for a Transaction, industry veterans to spot solid value to the right bidder. If a publisher Sourcing Deals, Transaction Process businesses that are underperforming derives the majority of its topline from as a consequence of poor digital media but maintains a costly management. Such a business is an and unprofitable printing press, it can attractive LBO candidate to a buyer sell the latter for cash. An experienced that is confident in its ability to more financial sponsor keen on leaning out efficiently operate the company and of a business often spots this kind of survive the debt burden. low-hanging fruit quickly, and might move to sell anything of value that’s BUSINESSES LACKING A not functionally synergistic with the SUCCESSION PLAN core business. This qualifier is especially pertinent today as baby boomers retire in FORCED DIVESTITURES the United States and leave healthy Regulators from time-to-time mandate businesses lacking heirs. Private equity corporate spin-offs for antitrust firms typically love these companies as reasons. For instance, if two coal they present opportunities to acquire companies merging would cause their a high quality business that needs combined revenue or market share to minimal help, but comes with an owner eclipse acceptable antitrust thresholds, that simply wishes to cash out. the approval of the merger would be contingent upon spinning off certain mines to a third party. The regulatory divestiture typically presents a buyer with a good deal, as the sale process is typically extremely hurried so as not to delay the proposed merger.

POWERED BY AXIAL 30 POWERED BY AXIAL 31 CHAPTER FOUR: LEVERAGING TECHNOLOGY

What Do 89% of CEOs Do Before Talking to You? By Billy Fink | October 8, 2014

In a survey of 769 business professionals who run, advise, or invest in private businesses, we asked how digital tools are being used in the transactional space and about the opportunities that they present.

In the changing deal environment, a Graph A. few things are clear: the web is now FIRST STEP FOR A NEW CONTACT the first part of the deal process, professionals are seeking digital 2% information and connections, and the 6% online world is heating up competition for the best deals. Go online Below are 3 important trends that Discuss with a mutual contact emerged from the results: Do nothing YOU MUST BE ONLINE 92% Unsurprisingly, the first step for deal professionals when being introduced to someone new is to go online. In fact, in a world where the handshake is often the final step, 92% of business Graph B. professionals start relationships by FIRST STEP FOR A NEW CONTACT going online – both looking up the person and looking up the firm. 100% Do Nothing Refer to Graph A. 80% Offline As it turns out, only 6% of the Find a mutual contact respondents indicated they would first to ask about them 60% ask a mutual contact about a potential Online business partner. Look them up on LinkedIn 40% Online For CEOs, 89% go online for the first Google their name step. Googling a person’s name or 20% going straight to a company’s website Online is the point of first touch when it Go to their website comes to researching a potential 0% financial or business partner (36% and CEO/ Intermediary/ Investor/Buyer Lender Business Advisor 35% respectively). Sixteen percent of Owner

POWERED BY AXIAL 32 CEOs go to Linkedin first and only 11% Graph C. find a mutual contact to ask about the person in question. PRIMARY ONLINE STRATEGY (%) Deal professionals say they will go to a company’s website (48%), before they use Google to search a name 9% (27%) or go to Linkedin (18%). Very Creating competitive advantage few (4%) deal professionals turn to 39% 23% a mutual contact prior to first touch. Marketing my company/services Interestingly, professional networks like Networking with partners/customers Linkedin are more popular with capital 29% providers — lenders, investors and Research & evaluating information acquirers (23%), versus intermediaries — advisors and bankers (15%). Refer to Graph B. The prevalence of online communication and outreach helps Graph D. confirm that deal professionals need to invest in both inbound and outbound PRIMARY ONLINE STRATEGY (%) online business development channels 100% to best capture interest from all relevant counterparties. 80% Research & VARIED USE FOR ONLINE TOOLS evaluating information While the data confirms that an 60% Networking with overwhelming number of deal partners/customers professionals and CEOs engage with 40% online tools and social media, the Marketing my company/services specific strategies vary. Across the 20% board, respondents agree that online Creating competitive tools can best aid any part of their job advantage that requires research and evaluating 0% information. Thirty-nine percent of all CEO/ Intermediary/ Investor/Buyer Lender respondents, 41% of deal professionals Business Advisor and 27% of CEOs say so. Within the Owner deal professional category, it’s the capital providers who believe they can unlock networking advantages by using online and social tools (37% vs. 26% of Graph E. intermediaries). Twenty-six percent of CHANGING COMPETITION (%) intermediaries also say marketing is the number one opportunity. 4% Refer to Graph C. The results also point out a disconnect Increasing between CEOs and the transaction 34% professionals that serve them in how Staying the same they believe online tools and social 62% Decreasing media can power their networking goals. 32% of deal professionals say networking with partners and

POWERED BY AXIAL 33 customers is the single biggest sourcing than fundraising or IR. Social opportunity that online channels Does It Matter media can help become a point of provide. Meanwhile, CEOs are more differentiation and branding, driving bullish on using online channels to That KKR Joined real business results. One of the market their company’s product and primary problems for private equity services (34%). Twenty-one percent Twitter? historically has been the ‘private’ agree that networking is the number By Cody Boyte | May 1, 2014 nature of their business. PE groups one opportunity that technology and often try to stay out of the spotlight, social media represent. This year, KKR, a titan of private resulting in few business owners understanding why they exist or why Refer to Graph D. equity joined the social media fray with their first ever tweet. they should be trusted. COMPETITION IS INCREASING But that’s probably not the best The use of online strategies and tools It commemorates their 38th strategy going forward for most has accelerated the competition within anniversary. Though Carlyle private equity groups. Using social the private capital markets. No longer and Blackstone have been media well can help answer the confined to specific geographies or questions CEOs have about your personal networks, deal professionals on Twitter since 2011 and 2012 business. Why are you the best buyer and business owners can now respectively, KKR apparently or financier for a company? How reach counterparties all across the needed to do deeper due will you treat their employees? What country. As a result, an overwhelming diligence on the benefits of the strategies do you tend to employ? 62% of respondents indicated that How do you think about running a competition was increasing for their platform. business? What does your company respective businesses. Only 4% If Carlyle, Blackstone and KKR are all really care about? indicated it was decreasing. active in social media, should everyone Competition in traditional private equity Refer to Graph E. be active? Likely – but probably for different reasons. has started to look more and more like As competition increases, it is critical venture capital the last few years. With to be discoverable online. The above For the public giants, so much money research proves that deal professionals like KKR, the benefit floating around, access and business owners alike are utilizing of social media is If Carlyle, Blackstone to capital is no longer online tools and strategies to help find as another channel and KKR are all active a major problem for of communication the right partners. If you do not have in social media, should quality companies. For a developed presence, your ability and helping their the most part, every to compete in today’s private capital investors understand everyone be active? private equity group markets are slim to none. the firm’s stance Likely – but probably is looking for similar on different issues. A Note on Methodology for different reasons. criteria – solid, growing It’s not entirely businesses that can Respondents included Axial Concord separate from attendees and subscribers to the scale with good investor relations. management teams. Axial’s online publication, Forum. All With thousands of respondents self-identified as either a Like good startups, great middle market shareholders, and a much broader companies also usually have the upper business owner/CEO, investor/buyer, audience with which to engage, lender, intermediary/advisor or other hand in choosing the private equity having multiple channels of mass group that will buy or fund them. type of deal professional. Results communication is valuable — especially were collected between September if your competitors are better at it. At Venture capitalists tend to be a 30 and October 5, 2014. Surveys were the time of writing, KKR’s 364 Twitter little bit ahead of the curve because distributed in person and also via email. followers pales in comparison to they have to be – the business is Client Acquisition, Data & Analysis, Deal Carlyle’s 6,217 or Blackstone’s 27,400+. cutthroat, returns are unpredictable Professionals, Preparing for a Transaction and only the best generate positive The benefit is slightly different for returns. A decade ago, few VCs were smaller, private shops. Middle market well known publicly. Today, Brad Feld, private equity has other challenges, Fred Wilson, Mark Suster, Tomasz usually more associated with deal

POWERED BY AXIAL 34 Tunguz and others are finding that SOME MID-MARKET engaging in social media helps Social Media: PROFESSIONALS ARE ALREADY them communicate their ideas to ACTIVE ON SOCIAL MEDIA prospective CEOs more readily. It An Overlooked Sussman, however, is not the only deal helps them win better deals because professional and advisor using social great companies connect with their Business media. This type of engagement is ideas and approach them first for taking place already in the middle investment. Development Tool market – but it’s the exception rather By John Grimley | JG | Communications than the rule. Some forward thinking As David Hornik – the first venture September 3, 2014 middle market advisors are actively capitalist to begin blogging over a engaged on a variety of social media decade ago – wrote, “blogging has Mid-market deal professionals, platforms where they are attracting become an incredible megaphone. Over needle-in-the-haystack deals that non- the years, millions of people have read from private equity social media engaged advisors won’t be. what I have to say about venture capital professionals to investment and entrepreneurship.” He continued, bankers, often face the “In combination with the powerful challenge of being perceived as Some forward thinking amplification of social platforms like Facebook and Twitter, VentureBlog has simply a vendor to mid-market middle market advisors proven a valuable tool for me and my C-Suite executives – their are actively engaged on firm to rise above the noise.” services indistinguishable from a variety of social media Many middle market CEOS are their competitors.­ platforms where they engaging in social media regularly However, social media is increasingly are attracting needle-in- as well. They’re using it to read the becoming a tool to help overcome this news, connect with employees and the-haystack deals that misconception. Kevin O’Keefe, CEO market their businesses. But they’re non-social media engaged of Seattle-based LexBlog Inc., a social also using it to connect with thought media solutions provider to the legal advisors won’t be. leaders. They’re reading articles by services sector, outlines in a blog post potential partners, capital providers how attorney David Sussman is using and future acquirers. Are you part of social media to distinguish himself Many of these social-focused advisors their conversation? among his peers as a “value generator.” are relying on their blogging as a Just as investors prefer investing in O’Keefe cited Sussman: “We are source of activity for their business- lines not dots, CEOs prefer to really reminded constantly that without oriented social media engagement. know their partners before engaging in value, we have no chance for business For example, mid-market advisors a transaction. Learning how to become continuity. CEOs and ‘C’ level are using the content they create on a part of deeper conversations with executives want to be engaged and blogs to actively engage online with a wider range of business owners I refuse to be considered a ‘vendor’ C-suite executives and referral sources before they’re interested in a doing a to our client-partners.” O’Keefe both nationally and internationally – transaction can give you a leg up when continued: “Sussman shared with his thereby expanding their sources of it comes time to work together. Social associates how using social media for deal flow from sources they might media is where many of the discussions less than a year has built his credibility not be exposed to were it not for this happen – both on Twitter and LinkedIn. and reputation.” considered online presence. Differentiation happens one tweet and Among those investment banking firms connection at a time. that are already blogging are Allegiance Deal Professionals, Future of Capital Markets, Capital Corporation of Dallas, Texas, Sourcing Deals and Corporate Finance Associates of Laguna Hills, California. Among

POWERED BY AXIAL 35 private equity groups, New York’s WHO’LL BE NEXT? Health Point Capital actively blogs. Mid-market advisors are increasingly turning to highly efficient social media And international law firm McKenna, channels like blogs to reach targeted audiences. Social media is cost and time Long & Aldridge LLP maintains Middle efficient, and allows busy mid-market professionals to secure more deal flow in Market Money Blog, which provides less time and with less expense than traditional networking. “insight and guidance into legislation, Importantly, mid-market advisors can customize their efforts with their own regulation and trends to assist unique service offer and ideal potential client base in mind. For example, you are entrepreneurs and emerging growth able to share industry-specific articles or highlight successes of your portfolio companies address corporate finance companies. For those mid-market advisors not yet fully engaged on social media, and regulatory hurdles”. the adoption process is quite simple and there are many advisors already engaged SOCIAL MEDIA USAGE BY THE on social media that are well worth emulating. C-SUITE EXPANDING RAPIDLY Client Acquisition, Deal Professionals, Dealmaker Outlook, Sourcing Deals These advisors have already recognized a very important trend: the use of social media by those who are the consumers of middle market corporate How to Secure the Best Talent for advisory services are expanding rapidly. “Social media is emerging from its Your Firm adolescent phase and is rapidly By Vik Ashok | SpareHire October 30, 2014 maturing”, reports social media analyst and advisor Jeff Bullas. Indeed, The M&A world is often characterized as having high employee “In 2010, the Fortune 100 were churn and as a result, very high human resource costs. Improving participating on social media but not your HR process is a sure-fire way to gain efficiency, cut costs, and to the extent they are now. The social networks were used for broadcasting ultimately run a more profitable enterprise. but there was limited engagement. How have PE Firms and Investment Banks Historically Sourced Talent? [Recently, companies] are having constant conversations with their Most PE shops and investment banks have traditionally relied on two main talent customers and followers and creating acquisition channels for experienced hires: vast amounts of digital content, CHANNEL PROS CONS reports Bullas. Personal • Reference leads to high • Small pool of talent Search Engine Journal provides a networks degree of comfort detailed infographic reflecting a “steep • No cost curve of the user growth rate in all age ranges and demographics, and Recruitment • Targeted search • Small pool of talent Firms the continuing pervasiveness of social • Initial vetting handled by • Expensive (25-30% of first- networking into every facet of work, recruiter year compensation) play and life in general.” • Interview logistics • Inflexible (heavy emphasis As these middle market executives handled by recruiter on full-time placements) and decision makers begin seeking knowledge through common social These strategies left many lower middle market firms unable to find top-tier networks, the deal professionals with talent because they could not afford expensive placement firm fees and could not an already-established presence will match compensation offered by larger firms. To make matters worse, a growing reap significantly larger benefits than startup scene in the US has created intense competition for talent, with many their slow-to-adopt competitors. financial services professionals leaving the industry to work at startups or start their own companies.

POWERED BY AXIAL 36 However, a new recruitment option The combined effect of freelancing and the cost of finding talent. If you run a that solves some of the challenges tech-enabled hiring platforms means small M&A shop, make sure you are associated with existing channels is that you no longer need to commit taking full advantage of the internet to rapidly gaining traction: web-based to a full-time hire upfront. Through manage your HR efforts. hiring platforms. services like SpareHire, you can hire Client Acquisition, Deal Professionals, Sourcing employees remotely and on a part- TECHNOLOGY IS SUPERCHARGING Deals time basis to meet your work demands. RECRUITMENT AND REMOTE Additionally, you can test run a WORK potential employee with a real project, The proliferation of social networking rather than theoretical case studies in already has made the professional Survey Says: an interview. For example, by having world more interconnected than the potential employee build a financial ever before. LinkedIn has created Business Owners model for a live deal, you can examine the concept of a publicly viewable real work product and gain valuable Use Technology to resume and is now a major force in insight into the employee’s work style online recruitment, with 130,000 jobs and personality before committing Find Capital posted per month (as of 2012). In to a full-time hiring decision. This is a By Billy Fink | August 20, 2014 Q2 2014, LinkedIn generated $360M particularly valuable option if you are of revenue from Talent Solutions a VP-level or senior-level professional (recruitment-related activities) – 60% To better understand the at a resource-constrained lower of its revenue for the quarter. More mindset of today’s private middle market shop, where your time traditional job websites such as is far better spent on deal sourcing, company executive, we Monster.com and TheLadders.com structuring, financing and other value- collaborated with the Financial allow you to access large groups of add activities. talent in an instant. These technology Executives Networking Group platforms vastly increase the pool of Since the stakes on both sides are (FENG) to survey financial available candidates vis-a-vis traditional generally lower for projects than executives in the United recruitment channels such as personal full-time hires, freelance projects offer States about their needs and networks or headhunters. the added bonus of enabling you to tap into higher caliber talent than you uses for capital. The 250+ Remote work has also significantly otherwise could have. An ex-Goldman expanded the pool of available talent. responses have offered some banker may be working on a startup Thanks to ubiquitous high-speed unique insights into how these of his own and be willing to help with internet, video conferencing (Skype), a model or investor presentation, but decision makers are thinking and robust file sharing mechanisms is unlikely to join a boutique M&A about the private capital (DropBox, Google Docs), managing shop on a full-time basis due to the remote workers has never been easier. markets and about growing opportunity cost. Freelance projects With people now using technology to their businesses. offer a viable way for you to access this work together through virtual offices top-tier talent. Three major themes emerged: all over the world, the way we do business has fundamentally changed. SO WHAT? #1: THERE IS A NEED FOR CAPITAL Thanks to the strong network effects One of the biggest takeaways from TECH-ENABLED JOB of the internet, accessing high- the survey is the overwhelming need MARKETPLACES LOWER THE caliber talent on demand has never for capital. Sixty-nine percent of the STAKES FOR HIRING DECISIONS been easier. Remote work is quickly respondents indicated that they would Thanks to the proliferation of tech- becoming a major component of be looking for capital in the next 12 enabled job marketplaces and remote our economy. As information flow months. These capital seekers were work, access to new talent is at an all- and liquidity continue to increase, particularly concerned about obtaining time high. This is especially important technology should significantly reduce “enough” capital — either from existing for lower middle market firms, which sources or from new sources. are now able to access a rapidly growing pool of freelance talent. If the financial executives were to secure their desired amount of capital, they would allocate the money to

POWERED BY AXIAL 37 a variety of purposes: operations, #3: TECHNOLOGY IS IMPACTING expansion into current markets, RELATIONSHIP BUILDING repaying new investors or lenders, When business owners decide they do acquiring new business, and R&D. want to tap the private capital markets Working capital needs and expansion (and 67% said they will in the coming (both in current and new markets) months), there is an indication that seem to be the clearest pain points for they are expanding their relationships the respondents. with technology and the internet. Of those that have used technology, 60% #2: BUYING AND/OR SELLING have indicated that software and When it comes to larger transactions internet tools have made the process — like buying or selling a business — of identifying relevant options and the conversations have been a little opportunities easier. This is a trend we different for these financial executives. are seeing as more and more business On the acquisition front, 51% of owners look to the internet to learn respondents talk openly about more about the private capital markets. acquiring new businesses or expanding Business Owners, Data & Analysis, Preparing for in new markets. When asked if they a Transaction would acquire a competitor, an overwhelming 77% said they would if the conditions were right. Significantly fewer business owners talk openly about selling their own business. According to respondents, only 29% have had an open discussion among chief stakeholders about the idea of selling the business to a new owner. As M&A activity in the middle market continues to heat up, it is prudent for many CXOs to begin having these conversations in order to be prepared to respond to increasingly proactive outreach from investment bankers and other advisors. In fact, 45% of respondents indicated they have heard from more investment bankers this year than the year before. In order to avoid wasted opportunities, financial decision makers should begin internal conversations about the opportunities for their company so they are ready when the right relationship or deal comes their way. The respondents also indicated that, if they were to sell their business, the current price of the business would be the single most important factor when considering the transaction. Second would be other financial considerations, like guarantees or earn outs.

POWERED BY AXIAL 38 POWERED BY AXIAL 39 CHAPTER FIVE: COMPLETING THE BEST TRANSACTION

9 Things Every Business Owner Needs to Know Before Selling By Mason Myers | Greybull Stewardship August 21, 2014

When selling your business, it pays to learn lessons from others. Most business owners will not get a second chance to do it well, and it is such an important process for your employees, your customers, and your own bank account that you want to maximize your chances of success.

I have been involved in over 30 that the sale process could be a half- files and processes can impact how business purchases – most with to full-time job by itself and they are potential buyers view your business. I between $1 million and $5 million well served by setting up an internal think this is because every impression in profit — and have earned scars management structure that can keep is important as buyers are operating from broken deals, learned many the business on track during the with very little information so every humbling lessons, and burned the months of a sale process and getting little thing leaves an impression. Being midnight oil doing my best to craft outside help (see below) to help organized conveys to buyers that this the perfect win-win arrangement. manage the process. is a well-managed business. And, it Even now, I learn something will save you tremendous time to be 2) GET EXPERT ASSISTANCE new or experience something orderly and organized when it comes You will come out ahead, both unpredictable in each transaction. time to produce documents and many financially and psychologically, when other things for the buyer, particularly Here is the best of what I have learned: you hire an adviser to help with the during due diligence. process. The payoff will come on 1) PUT TIME ON YOUR SIDE multiple fronts. First, they save you 4) GAAP ACCOUNTING Most business endeavors are easier tremendous time in talking with buyers, Make sure you speak the language and better when time is your friend. preparing documents, and providing a of business, banks, and investment The opposite is also true — it is difficult buffer to allow your business to stay on professionals. For some business to optimize the results of a business track during the sale process. Second, owners, selling a business is like sale if you compress the time available they have experience navigating the entering a foreign land where the to work all of the components. This sometimes confusing waters of a sale primary language is GAAP and EBITDA. applies to both the time available each process. Third, they can broaden the To operate effectively in this foreign week and the time from the start to net of potential buyers, which is very land, you need to understand the the finish of the overall process. important to maximizing the highest basics of GAAP (Generally Accepted It is wise to begin thinking about probability and highest valuation of a Accounting Principles). I have had selling your business well before sale. Networks like Axial will also help business owners tell me that “cash is you want to or need to. Sometimes you widen your net. all that matters”, or that “I have my it takes years to craft the best own way of accounting that works 3) ORDERLINESS IS GODLINESS trends in your business, get proper for us”. That is fine, but investors Appearances matter in the sale of your accounting processes in place, get will not understand your particular business. It is surprising how much the the management team in place, and language very well. Therefore, you appearance of your records, reports, find the best investment banker. I need to make sure that your financial recommend that owners anticipate statements are presented using GAAP

POWERED BY AXIAL 40 and it is often worth it to hire a firm 6) MONOGAMY HAPPENS AT that you will find several buyers for to do a review, an audit, or a Quality of DIFFERENT POINTS FOR THE whom your business is a great fit and Earnings analysis to get your company BUYER AND THE SELLER the timing is perfect. For many buyers prepared and ready. In the balance of power, the seller is who may be great for your business, it usually most attractive during the may be bad timing as they are focused The number one pitfall can be early part of the process since there on raising money for their fund, or situations where the business receives are multiple buyers considering just one of their portfolio companies just cash before delivering the product one purchase. However, once the became distressed, or the partners or service. To business owners, they seller selects a buyer and signs a are fighting. There are so many things often consider that cash to be revenue. Letter of Intent, the seller becomes behind the scenes that affect how In GAAP, that is not revenue until the monogamous and loses some of that buyers behave that you will never know product or service is delivered, and advantage. It is important for sellers to what is truly happening in their minds. this can make the company’s revenue understand that there is still much that The best strategy is to cast a wide net, appear dramatically different. There can distract or dissuade the buyer from determine who is interested, and do is nothing that hurts your credibility that point forward. The due diligence not waste time with any other buyers more than financial results that are better check out. And, the buyer could (even when you think to yourself, “they significantly different when prepared easily get distracted with other deals, would be perfect!”). via GAAP — it just makes you look or other companies in their portfolio, unprofessional and naive. 8) EVERYONE FREAKS OUT or their cousin Vinny who loses the SOMETIME DURING THE PROCESS 5) GETTING KEY CONTRACTS family fortune. The seller is wise to In nearly every purchase and sale I have AND LEASES ASSIGNED TO THE keep wooing the buyer all the way until seen, there has BUYER the closing. been a moment A wise investment banker once told To ensure a To ensure a successful when the business me, “no one is more arrogant than successful close, owner has freaked a landlord in a tight market.” That is close, business owners business owners out. This is quite true, and unbelievably frustrating when should keep the underlying should keep normal and usually a landlord is holding up the sale of the underlying business performing, keep a good thing your company. Most stopgaps occur business (better to have because the landlord will not assign impressing the buyer with performing seller’s remorse the lease to the new owner or he is various elements of the (frankly, it is before the deal using this point of leverage to extract really good if the business, and understand happens) as it some economic concessions from you business results that the buyer is not allows everyone or the buyer. I recommend that you keep getting to step back out begin to review your key contracts and married to the deal until better during of the details leases years in advance of the sale and the check clears the bank. the sale process), and make sure attempt to get them “assignable” at keep impressing the deal is really your option to avoid being “held up” the buyer with a good thing by a landlord or key customer. This various elements of the business, for all involved. It is such a grueling happens all the time. Right now, I and understand that the buyer is not and emotionally charged process for have one acquisition being held up by married to the deal until the check many owners that there is quite often landlords trying to extract value for clears the bank. At some point, sellers a moment when they question the assigning the lease to the new buyer. need to transition from adversary transaction. And, I have another acquisition that to partner with the buyer, and they has been held up for 3 months while a When you do freak out, please don’t also need to keep reinforcing the few large Fortune 500 companies are call the buyer names. Just this week, attractiveness of the business until the reviewing some key customer contract I had a seller call me all the names in deal is done. assignments. It is not good to have the book because they misunderstood your big sale held up by these factors. 7) A DEAL IS ALL ABOUT FIT AND something only to realize it was their TIMING error. It is no one person’s fault that Along with everything else, selling a the process is frustrating and time- business is a numbers game. You need consuming. Most everyone is trying to find a way to maximize your chances their very best to do the right thing.

POWERED BY AXIAL 41 9) CONTROL THE LAWYERS concerns too often receive insufficient 3) VERIFY THAT THE One business owner called the process consideration. While IT due diligence TECHNOLOGY CAN BE the “tyranny of the experts.” When rarely uncovers information that kills SUPPORTED you have not sold many businesses, a deal, it has the potential to save This broad area includes basic things, it often feels safe to rely heavily on the acquiring company thousands of such as whether or not the target lawyers, bankers, accountants, and dollars during the transaction. company has a clean copy of the others from the expert universe. This source code for their technology, or This article will explore the top nine is important to a point. It is also whether they own the rights in the reasons to conduct IT due diligence important to not let them drive first place. These issues come up when acquiring a company. the process too much. You are the more often than you might think. Even decision-maker. You have good 1) BE SURE THE TECHNOLOGY IS if there is a viable copy of software business judgment. If you have REAL source code and all ownership rights questions, ask them. Ultimately, A financial or legal expert simply can’t tell are in order, are the people who wrote however, you will need to make the if a target company’s product is real. You the software still employed by the business decisions about how to can’t rely on a PowerPoint presentation target company? Don’t expect any of do the deal (is the lawyer trying to or even a product demo to confirm this information to be volunteered – impress you or helping you get a deal?). authenticity — it’s too easy to create you have to look for it and you can’t There always comes a moment where something that looks great but doesn’t make any assumptions. everyone must tell his or her attorneys do what it’s expected to do. Ideally you 4) UNCOVER LICENSING RISKS to back down and get the deal done. should have an expert in the target It’s not uncommon to find that a company’s specific technology and Business Owners, Preparing for a Transaction startup or small technology company industry review source code, product has not properly licensed all of its plans, etc. At a bare minimum, you need production or development software. to have a technical person sit in on a It’s not always intentional – in the demo and ask questions. If a technology Why IT Due frenzy of getting a product developed expert from the acquiring company or and into the market, any number of investor isn’t available, consultants can be Diligence Should administrative tasks can fall by the hired for this purpose. wayside. Whatever the reason, at some Be a Critical Part 2) DETERMINE THE point the fact that additional licensing of Every Deal TECHNOLOGY’S COMPATIBILITY costs are due will come to light. You Even if the technology is real, you want it to be before the transaction Jim Hoffman | Besler Consulting July 15, need to know if it’s compatible with closes, not after closing or the 2014 the acquiring company’s technology. expiration of any holdback period for If the target company uses leading reps and warranties. In too many M&A edge or proprietary technology, it may 5) ESTABLISH THE transactions, even those not integrate easily, if at all, with the TECHNOLOGY’S SCALABILITY acquiring company’s legacy systems. related to software and If you determine that the target This can have serious ramifications for company is real and is generally technology companies, IT the integration of the companies, the compatible with the acquiring due diligence is, at best, an maintainability of the software and company’s technology, it is important the retention of key employees at the afterthought. I’ve even been to also consider the scalability of the target company. involved in deals valued in the technology. How will the software high eight figures where IT Even in an acquisition where the or systems behave if the number due diligence accounted for, target’s main product or services isn’t of customers doubles, or increases completely focused on technology, it’s tenfold? Will the technology expand maybe, 1-2% of the overall due valuable to understand the platforms gracefully with a low marginal cost, or diligence effort. used for business services such as will significant growth require a large email and CRM. After the deal closes, investment in new servers or other There is no doubt that financial and integrating or migrating these services hardware? In the worst-case scenario, legal due diligence are critical, but IT may require significant resources, and it’s best to understand what will be required as soon as possible.

POWERED BY AXIAL 42 a complete re-architecture of the combine them after the deal occurs. Despite their prevalence, NDAs technology may be required. Even if Are you sure the technical platforms are a tricky thing. The idea of this doesn’t kill the deal, it represents are compatible? Can you evaluate a significant cost that needs to be the skill sets of the target company’s “confidentiality” changes for uncovered and included in the terms of IT staff to determine if there is any each firm and for each business. the transaction. overlap with the acquiring company’s To help demystify this ambiguous staff? Confirming the synergies can 6) IDENTIFY THE KEY EMPLOYEES document, we recently gathered help avoid sunk costs and maximize the ASSOCIATED WITH THE several financial sponsors, benefits from the transaction. TECHNOLOGY intermediaries, and business owners IT due diligence includes interviews 9) DISCOVER HIDDEN GEMS to discuss their respective opinions with some or all of the target It’s not unheard of for the technology on the NDA, common roadblocks, and company’s technology staff. Through staff at a company to be working on negotiation tactics. these interviews, you can get a good projects that the senior management YOUR NDA IS A MARKETING feel for the personalities involved. Will of the company isn’t aware of. These PROCESS they work well in a larger organization, experimental projects aren’t likely to end up While technically a legal document, the if that describes the acquiring in the target company’s CEO’s PowerPoint NDA should be considered a marketing company? If these are important of company products. The right technical tool. “The NDA typically serves as employees, you may need to put expert can make the connections between the first point of interaction between employment agreements or retention these “secret projects” and the strategy an investor and the company,” one bonuses in place to be sure the key and technology of the acquiring company. attendee explained. “You want to make players remain post-transaction. These projects are often uncovered during this first step as easy as possible.” Incorporating these plans into the the employee interviews of IT diligence. initial agreement can ensure that the The NDA is a temperature gauge These are just some of the most necessary employees are motivated to for what the rest of the negotiation important reasons to conduct an stay and keep the technology sustained. process will be like; if the two parties effective IT due diligence effort. cannot agree on an NDA, they will Having a technology expert on 7) DETERMINE THE be unlikely to align on terms for the the due diligence team is the best APPROPRIATENESS OF CURRENT much longer, more complicated solution, but when that’s not possible, LEVELS OF RESOURCES agreements further in the process. Like Many smaller companies scrape by the IT Due Diligence Guide can go any marketing interaction, you want to with minimal resources when it comes a long way towards increasing your think of the counterparty and preserve to things like networking and other IT appreciation of the IT concerns your company’s brand. infrastructure. Has the target company involved in your transaction. If the negotiation process becomes put off making needed investments in Deal Professionals, Dealmaker Outlook, Due order to artificially inflate profitability? Diligence too difficult, it can be a major red If the systems are noticeably outdated, flag. Lee Miklovic of Opus Capital you could be walking into a large Partners previously told us, “We will front-end investment that should be not move past the first stage of a included in the sale price. Are you 3 Things to deal if the banker or broker is not confident that your legal or financial willing to accept changes to an NDA experts would notice? Remember Before that is otherwise one-sided and not market-based.” Miklovic admitted 8) IDENTIFY OPPORTUNITIES FOR Signing an NDA to passing on as many as 25% of COST SAVINGS investment opportunities because of By the same token, technical Billy Fink | June 12, 2014 poorly-constructed NDAs or NDA- knowledge is needed when it comes related negotiations. to determining a realistic level of NDAs have become so synergies in the transaction. Don’t commonplace in middle market Since the NDA is the first official assume that simply because both transactions that many deal encounter, it is important to treat it as the acquiring and target companies professionals have begun such and to not overly complicate the have data centers, you’ll be able to first of many agreements. Considering overlooking their importance.

POWERED BY AXIAL 43 the document from a marketing Although intermediaries and financial of success. But, the process perspective can help remove some of sponsors have worked with hundreds is far from over. There are the initial roadblocks. of NDAs, many business owners will sign a handful of NDAs in their life, many steps that still lay ahead YOU NEED TO READ THE ENTIRE making it extremely important. that can derail or ruin the THING While it is important to be Many business owners “paper up and transaction. Below are 7 pitfalls accommodating in the negotiation, it lawyer up,” explained one Member. to be aware of between the is still necessary to take the document Since they are not sure about the LOI and the closing of the seriously. Lawsuits can emerge years normal procedures, they often feel the after a NDA is signed, and ensuring you need to become excessively cautious transaction: have obeyed all included clauses can and protective. It is the job of a good 1. FIRST, GET THE LETTER OF protect you in case of litigation. M&A advisor to help the business INTENT DONE WELL, AND READ owner understand the real nature of Even if the agreement seems like a ALL THE LEGAL DETAILS. the NDA and where emphasis should boilerplate template, be sure to read The first step to moving from letter of and should not be placed. it carefully. The last thing you want is intent to closing is to make sure that to discover an unfavorable clause after If the business owner is still nervous everyone understands all elements of you have executed the agreement. about the agreement, try to determine the letter of intent, and that the letter if there are other complicating factors. of intent has a reasonable amount One example of an overly-inclusive, As one Member explained, “Most often, of detail. Misunderstandings and one-sided clause that was discussed these businesses have complex family miscommunications will blow-up a deal during the breakfast was: dynamics and they are just as worried very quickly if the parties have different “Neither party shall attempt to about the secrecy of their family as the interpretations of the terms. contact, deal with, profit from, or in secrecy of their business. They don’t In the midst of negotiation, it may be any manner solicit any of the other want their neighbors knowing what tempting to leave a detail for later, or party’s personnel, business contacts or grandpa was up to.” hope the other party didn’t notice associates, customers or vendors, or Fully understanding the business owner some important detail, or leave an use the Confidential Information in a perspective can pave the way for a open item to later. There is no one manner competitive, either directly or healthy negotiation process. way to do things, but if you truly want indirectly with the other party.” the deal to happen, I have had much Deal Professionals, Negotiation, Regulatory/ more success taking the extra time to BUSINESS OWNERS ARE Legal NERVOUS explain a term or go over something Some of the largest again to make sure that everyone is roadblocks in an NDA Some of on the same page. The LOI sets the pace for the rest of the process, so it is are rooted in the the largest 7 Pitfalls seller’s inexperience important to do it well. roadblocks with the private capital to Avoid 2. KEEP THE BUSINESS ON markets. While they in an NDA BUDGET AND PERFORMING WELL. may be exceptional at are rooted Between Ensuring that the business remains running their company, in the seller’s on track is critical during the process their knowledge tends LOI and from LOI to closing. Although it may to wane for these inexperience take a great deal of focus to close the transactions. Since they with the private Deal Close deal, keeping the business running have spent much of their capital markets. Mason Myers | Greybull according to plan is necessary for the life building this business, Stewardship November transaction. This is the most important, they are afraid of making 6, 2014 of many things, to balance during the costly mistakes. closing process. Among private equity When selling your business, As a result, business owners tend to be buyers, you will hear wisdom shared more focused on every detail of the reaching the Letter of Intent from investor to investor with things agreement, hoping to avoid any risk. (LOI) stage is a great indicator such as, “95% of all bad deals were off

POWERED BY AXIAL 44 budget during the closing process.” that they would not make if they were Most serious buyers will perform The buyer will be watching every not selling the business. In particular, a “Quality of Earnings” accounting twitch of the business with extreme do not change a strategy to fit the due diligence on your company. This scrutiny. To a buyer, there is nothing buyer until after the close. means that they will review, in detail, more comforting than seeing the the financial statements that you have 3. IF SOMETHING BAD financial results come in as expected. previously presented to make sure the HAPPENS, INFORM THE BUYER Even better for everyone is having earnings presented are high quality. It IMMEDIATELY. the financial results come in ahead of is inevitable that they will find various Business results are rarely perfect budget. Yes, this is true even when you adjustments that make the earnings and on budget. If something happens, are the seller wondering if you could a bit better and a bit worse than the best policy is to be up-front and have gotten more for your business expected — that is normal. However, inform the buyer immediately, just as because it makes the buyer want to it will save sellers a ton of time if they you would want to be informed if your close the transaction even more and have performed their own analysis to roles were reversed. If done well, this maybe some small horse trade will find the unusual items or the items can increase the buyer’s confidence go your way in the end (and, there is that the buyer may ask about. It is in the seller and the business. If done always one more horse trade). much more efficient to be prepared poorly, it can torpedo the transaction up-front than to scramble around When the financial results are not on in a heart beat. In one recent situation trying to understand the questions target, it forces the buyer to spend where I was not directly involved, yourself and to explain what the time and energy trying to figure out the seller lost several clients in late buyer may be finding. if the miss is a short-term November blip or something more I have seen sellers try that was 5. BE ORGANIZED. fundamental. Better to going to The buyer will need all sorts of avoid having the buyer to to be clever and change reduce information about the financial results, think twice about anything. some aspect of the their legal, insurance, human resources, revenue major contracts, etc. Of course, the Most deals require the seller business during the last by >20% seller wants the information to be to operate the business as months or weeks to try (probably strong and supportive of the picture usual during the closing and tweak the deal to be only for that was painted during the sale process. This should be more favorable to them. a few process. Almost equally as important obvious and intuitive to all months, is how the information is organized involved. However, I have This never works. but it and presented. Buyers appreciate seen sellers try to be clever wasn’t indications that the company is well and change some aspect totally managed and organized — such of the business during the clear). The seller did not tell the indications provide more confidence last months or weeks to try and tweak buyer until the December and January to the buyer. the deal to be more favorable to them. financial statements were ready, and This never works. First, it is counter to 6. MANAGE THE LAWYERS — it cratered the deal. They may have the spirit of the deal to keep operating DON’T LET THEM MANAGE YOU. had a chance to save the deal if they the business as normal, and it’s very The lawyers view their job as doing had been up-front immediately. More difficult to change any reasonable everything they can to protect you, importantly, they should have done size organization from their normal so they will always take the most everything in their power to keep operations without creating problems, conservative path and recommend those clients and keep the business on both intended and unintended. the most protected, conservative track (or presented more conservative Furthermore, it is in the seller’s position. There is nothing wrong financial forecasts that accounted for interest to keep the business operating with that, but if both parties take that some potential lost clients). normally just in case the transaction same stance, there is no room to find a does not close. It is a fact of life that 4. HAVE SCRUBBED AND middle ground that makes sense. The not all deals close after a signed letter ANALYZED YOUR PREVIOUSLY lawyers work for you — you should of intent. The seller needs to be aware PRESENTED FINANCIAL have the confidence to tell them what of this and not make any adjustments STATEMENTS. you want, make the final business

POWERED BY AXIAL 45 decisions around the deal, and not let The company I bought is a simple to 2. BE OPEN WITH EMPLOYEES the lawyers manage you. Finishing understand business that conducts fire BECAUSE THEY ARE THE the Letter of Intent does not mean hose and related fire equipment testing COMPANY’S GREATEST ASSETS that all the deal decisions are done. for firehouses across the country. It The first day a new owner walks on the There are many more small details was an honor to find a company that premises is the first day the acquisition and decisions in the final documents, helps keep America’s heroes safe should be announced to every and both parties need to continue while on the job. What is not simple is employee. Afterwards, they will all have compromising and negotiating the the actual process of taking over the one question in mind: “what does this details that are not covered in the company — a process that requires a mean about my job?” In my company Letter of Intent. careful juggling of previous ownership, the employees are the most important financing, and employees. asset to success and letting them know 7. COMMUNICATE WELL WITH their jobs are safe is the first step in EVERYONE INVOLVED. I’ve learned 4 important lessons since gaining their trust. Special effort needs to be made to my purchase that may prove useful for communicate (probably more than soon to be business owners. The second step is asking them what you think) among all the parties. they liked, didn’t like, and what they 1. SETTLE ON THE RIGHT And, special effort should be made would improve about the company FINANCING DECISIONS FROM THE to think about the best methods today. The feedback was tremendously RIGHT SOURCES to communicate everything. Never helpful. The best lesson I learned was Finding the right financing can be take a shortcut by firing off an email that payroll checks could sometimes just as difficult as finding the right when a phone call would be better. take too long to get to each worker. company. The best combination of Everyone is on edge, and making sure By figuring out a way to optimize the debt to equity can be confused by the to communicate enough — and via flow from hour entry to check in hand I plethora of choices, such as SBA loans, the best method possible — pays off made everyone a little bit happier. seller financing, owner retentions, and big time. partner splits.It is important to keep Without that valuable input from my Deal Professionals, Negotiation in mind that the cheapest source of employees, I would have never known funding may not always be the best about this relatively easy-to-solve pain option. An example of this is seller point. I learned that the transition of debt. Given today’s low interest rates, ownership for a company is a rare Key Learnings why would anyone decide to take on opportunity where management usually more expensive seller paper? can make changes not hampered by from a Successful The benefit of course is non-financial. tradition and employees can be critical By having the seller take a financial in making sure those changes are for Search Fund position in the company post-sale, the the better. Tony Bautista | Long Trail Leadership buyer is almost guaranteed that they 3. HEED THE ADVICE OF September 17, 2014 will have the full cooperation of the PREVIOUS MANAGEMENT seller to help if any issues arise. This You bought the company to improve After having spent 12 months may be worth more than any non- it, that’s a given. However, do realize compete or consulting agreement as a “searcher” I finally got what that the company is where it is today between the parties. every buyer dreams about: a because of previous management. company to call my own. The Just as important is the flexibility of all There is information contained in ink had not even dried on the the parties involved. Be sure to analyze habitual routines and dialogues that both upside and downside revenue usually can’t be gleaned during due purchase and sale documents scenarios so everyone understands the diligence. risk and rewards. The downturn of only when it struck me that Something as simple as imitating the a few years ago hurt many companies transitioning from the search to way in which previous ownership as their revenues were hit hard yet would talk to customers can give actually running a business are banks still demanded payments. I spent insights into how the company two entirely different tasks. many weeks sharing best case and keeps its customers happy. Physically worst case scenarios with each funding source and confirmed they will still be committed.

POWERED BY AXIAL 46 creating a script based on customer Sometimes a fast growing company conversations will allow new ownership 5 Common can be given credit for the last quarter to analyze current protocols so they results annualized, but that’s the can be iterated on in the future. Not Mistakes to Avoid exception rather than the rule. everything will make sense at first, but Investors are particularly unimpressed the best way to figure out what works When Raising with a great idea and an entrepreneur and what doesn’t is to try it for yourself. who models earnings five or ten years I know I’ve been surprised many times Capital out. Discounting cash flow back to today by doing or saying things to customers Jeff Villwock | Villwock Advisory Services may be worth $10 million on paper, but that at first I thought wouldn’t work, October 28, 2014 generally an idea – even a fully baked but after seeing how they responded, idea that only needs capital to start – isn’t I better understood the original Raising capital for a business, worth anywhere close to that amount. reasoning and kept the original whether it is a start-up or a approach. During the negotiations, mature company, can be an Recently a CEO of a company that has work out an appropriate transition been operating for six months called timeline that allows you to gain the extraordinarily frustrating and us. He had a $10 million acquisition knowledge you need to successfully time consuming experience. ready to be funded. Between his small run the business. Entrepreneurs want to operate platform and the acquisition, he told me that the business would be worth $100 4. TAKE IT SLOW and grow their business, not million. He was willing to give up 20% of Being at the top of the management raise capital. But the fact is the company for $20 million, using $10 hierarchy usually means being able that for most businesses, million to complete the deal and another to institute changes quickly. However, $10 million for growth capital. do not mistake quick with effective. the entrepreneur or CEO is While some changes should be made responsible for raising capital. Regardless of how good the idea is – or immediately, do not rush decisions how good the acquisition is, a deal isn’t When attempting to raise capital, CEO’s without being fully informed or happening at anything close to that very often make some crucial mistakes. having the hands-on experience. My valuation. Why should an investor pay These mistakes not only can dictate advice is to run the company as it $20 million for 20% when he could whether or not the business will be able has always been run for the first few theoretically pay $10 million for 100%? to raise capital, but also how long it will months. As new ownership grows It makes no sense – but the CEO was take and the ultimate cost of the capital. more confident, improvements can absolutely convinced that someone Using the wrong assumptions, raising be made slowly over time. would find this highly attractive. capital can be impossible. For example, I would advise not to When raising equity capital, use a We believe there are 5 common mistakes change the benefits package during FINRA licensed investment banking that CEO’s make when raising capital: the transition period. Such a change professional. You should expect them can cause unease in the company’s 1. UNREALISTIC EXPECTATIONS to provide you with an expected range already anxious employees and it may OF VALUE of values prior to a formal engagement. result in the loss some of its best Most of us has watched Shark Tank They should have the resources to performers. Ease employees into at least once. Just watch one episode show the valuations of companies the changes and you can reduce the and you will likely see this mistake. The similar to yours, and to detail any probability for a mutiny. entrepreneur goes to professional private market M&A transactions that investors with a company that did have occurred. For many companies the transitional $100,000 in sales last year and phase can be difficult. The most 2. EXPECTING TO RAISE CAPITAL confidently tells the Sharks he will important goal is not to lose the QUICKLY sell 10% of his business for $1 million. company’s momentum. Dealmakers We also get calls from CEOs who What’s the chance of this CEO getting should be aware that the acquisition is want to raise capital and the CEO funding? Zero. just the beginning of the journey for a confidently tells us that his business new owner. With few exceptions, investors is so compelling that we should be Deal Professionals, Dealmaker Outlook, Post- will pay for what you have already able to close a deal in 30-60 days. Transaction done – not what you believe you will Or worse, he has a payroll to cover do in the future. Transactions are and hopes we can be in talks with generally priced as a multiple of last someone next week. twelve months revenue or earnings. POWERED BY AXIAL 47 The reality is that raising equity capital purchase contracts, Board governance It’s all good when the investment is generally takes at least 4 months, and and a variety of other issues will easily made, but most investors don’t just any CEO should expect and plan for take 6 weeks. write a check. They review every aspect 6-12 months. of your business is great detail, and Four months have elapsed, if that costs you money, time & effort. Why? everything goes smoothly – and frankly, that rarely happens. 4. FISHING IN THE WRONG POND – Private equity firms are working on KNOW YOUR TARGET INVESTOR dozens of deals at the Be realistic about the Entrepreneurs looking for capital same time. On the first time involved. typically don’t know where to look, or contact, they want The reality is that 3. EXPECTING TO who their target investor is. The CEO to see an Executive raising equity capital RAISE CAPITAL of a company with $10 million in sales Summary of the WITHOUT might have heard that KKR is a great proposed transaction. generally takes at INVESTING TIME & partner – but KKR won’t touch a $10 That Executive least 4 months, and MONEY million business. Summary is normally any CEO should A corollary to a 2-5 page document Who do you target? Venture capital? Expecting to Raise outlining the company, expect and plan for Private equity? Family offices? Wealthy Money Quickly, is the its prospects and why 6-12 months. friends? Customers? Suppliers? New expectation raising it needs capital. If joint venture partners? money doesn’t cost the firm is interested, money. In many cases, the best capital is capital this is followed up by a Confidential coming from a strategic partner – Information Memorandum. Entrepreneurs often forget that raising someone whose investment will help capital normally entails significant The investment banking firm you succeed. legal, accounting, travel and for those preparing the Executive Summary and that hire a banker, investment banking CEO’s need to “fish in the right Confidential Information Memorandum expense. It’s not as easy as setting pond”. Sending a packet to 100 will normally require four weeks to up a couple of phone calls resulting venture capital investors is a waste of gather the information from the in someone falling in love with the time, energy & money. Having a single company, perform its due diligence, business and writing a check. conversation with the right party may write the materials and generate a result in capital. A quality investment list of potential investors who may be The process generally entails a banker who knows your business, your interested in the opportunity. significant amount of expense to get industry and the market will be worth to a Letter of Intent for the investment, In week 5 the private equity firm is far more than the fee they charge if and then the due diligence starts. A contacted. It normally takes a week they can make the right introduction. data room may need to be set up, or two to get a Non-Disclosure normally at a cost of $5,000 or more. 5. CEO PLAYS LAWYER Agreement signed, the Executive Much of the entire history of the Entrepreneurs often want to save Summary sent and feedback received company is loaded into the data room, money by being their own lawyer. from the private equity firm. including all significant contracts, What’s the old saying? “A lawyer In week 7, the Confidential incorporation documents, financial representing himself has a fool for a Informational Memorandum is documents and detailed information client!” Well, a non-lawyer representing delivered. Normally firms are given on all aspects of the business. himself is arguably worse. four weeks to process this information Due diligence teams will converge on In today’s world, it is easy to find a internally, to ask questions of the your office, talking to your employees, document on the internet and edit. bankers and if interested, to provide getting into your financial systems, and But transaction lawyers know how to the bankers with an initial proposal, or outside accountants will scrutinize protect their clients, and what deal term sheet. every aspect of your financial terms are customary, or mandatory in By the time the Term Sheet is delivered, statements. At the end of the process, a private placement. They make sure 10 weeks have already gone by. Even any “dirty laundry” will most likely have that the regulatory filings are done – if the Term Sheet were instantly been found, and the quality of your many CEOs have no idea that the SEC accepted, due diligence (legal, financial financial statements and systems will needs to be notified of most private & operational), negotiating stock be tested. placements through Regulation D.

POWERED BY AXIAL 48 Entrepreneurs often are willing to pay to have direct and clear conversations a broker or finder a fee on a successful Should You Be around values. “To flush out these raise. After all, if Joe can introduce me [value-related] issues, we sit down and to an investor who writes a check for Conducting Values discuss the owner’s plan,” he explained. $10,000,000, why not pay him a fee? “We want to really understand how the Due Diligence? owner sees the future of the company.” Most CEOs don’t know that unless Joe Billy Fink | March 20, 2014 is part of a FINRA licensed firm and WHEN SHOULD IT HAPPEN? it is the firm, not the individual, who Investors conduct all types “This conversation can happen at any formally does the private placement, time before the closing of the deal then Joe, the CEO and the company of due diligence to uncover — but the earlier in the process, the have taken on a huge risk. skeletons in the closet. Legal better,” said Coughlin. “For a successful deal, there still needs to be a level of Securities law says that if a non-FINRA due diligence can uncover trust, and the earlier the conversation, licensed person is paid a success fee, outstanding lawsuits; cultural the easier it is to develop the trust then the investor can, at any time, ask due diligence can explain high and have a sincere connection around for all their money back. So five years business values.” after the investment, the company turnover rates; IT due diligence has a financial downturn and is nearly can root out any incorrect However, don’t have the conversation bankrupt. The investor can demand patent filings or licenses. too early. Prematurely discussing that the investment be rescinded and these values can undermine the entire ask for all their money back. Of course But what type of due diligence purpose of the conversation. Coughlin a company in this situation can’t pay uncovers future conflicts with the explained, “If you tell them you want to back the money, so the investor sues current owner-operator? sit down to talk about business values, the CEO, and will most likely win. As financial sponsors partner with they won’t do it unless they think a transaction is likely.” Raising capital has always been difficult, business owners, alignment between but since 2008 it has become even the two parties — especially regarding The ideal time for the conversation is more difficult. The good news is that the future of the business — is critical “sometime after an LOI, but before the the private equity firms have a lot of to a successful transaction. closing of a deal.” capital to invest today, and everyone is “One of the most important things WHAT SHOULD BE DISCUSSED? very busy putting money to work. This we do when speaking with a business This diligence of values needs to be is the best environment since 2006. owner is to ensure that we have an more than another management Realize that raising capital requires understanding of their business values meeting, and it shouldn’t be mere lip a significant amount of your time, and the end-result of the desired service. Candor and honesty are helpful energy and will cost money. Budget transition,” said Kevin Coughlin of in ensuring the relationship starts out the time required and the financial, Coughlin Capital. To address these on the right foot. “There are certain accounting and legal resources issues, Coughlin Capital employs a type changes in governance and operations required to complete the process. of ‘values due diligence.’ we want to implement and there needs to be a base level of trust between the Raising capital is stressful enough According to Coughlin, misaligned business owner and us. As a result we without having unrealistic expectations. values can threaten the success of an need to buy into each other.” Building Hopefully this article is helpful in investment. “Our values, with regard that mutual trust is critical to ensuring framing your expectations and to how the business will be run, need optimal post-transaction efficiency. increasing the probability of your to align. If they do not, it can cause success. significant headaches and hurdles in To gauge the mutual respect, Coughlin the future. If the values are clearly Business Owners, Preparing for a Transaction likes to discuss topics like “how conflicting, it’s a non-starter.” we will treat each other as owners, As a result, Coughlin likes to conduct how customers will be treated, how values due diligence in addition to the employees will be treated, how vendors regular financial, legal, and operational will be treated, how the day-to-day diligence. Instead of relying on regular operations will be run, etc.” management meetings, it is advisable

POWERED BY AXIAL 49 He added, “While the owner’s business the buyer with any recourse against values are not a reason to invest in 8 Negotiation the seller if costly problems arise the business, they can be a reason to immediately after the transaction? Is walk away.” As a matter of fact, they Techniques When there any seller financing? By creating have been. “We walked away from one many terms beyond just price, buyers deal in the past two years for business Buying & Selling and sellers can find out what are the values-related reasons. We had the top priorities for the other side, and conversation and it became clear right Companies this allows both sides to ultimately away that there wasn’t a match. We Peter Lehrman | February 27, 2014 make concessions to the other would prefer to walk away from a good to keep the deal moving forward. deal than do a deal that would fail.” If you want to master Perhaps the seller is comfortable with an earn-out provided the buyer HELP STAND OUT negotiation, it’s going to take is willing to pay a higher price. If you The values conversation, in addition time, talent, homework and don’t put an earn-out term on the to helping prevent future conflicts, practice. However, there are a table, the deal might be off. can also help you stand out from the few key negotiating techniques competition. “I really believe that MAKE STRATEGIC CONCESSIONS most of these retiring entrepreneurs and resources that are crucial “Concessions are often necessary in want more than a simple check; for success when closing a negotiation,” says Harvard Business they want a real transition with real business investment, growth School professor Deepak Malhotra. mentorship…they want succession,” capital, or M&A transaction. “But they often go unappreciated and previously explained Benjamin Gerut unreciprocated.” Malhotra offers of the Kuzari Group. Since buyers seek to acquire four strategies to make sure your companies at the lowest possible concessions are returned in kind. He continued, “Buyers must care about price and most favorable terms, and • First, make sure that your the employees. After working with many business owners and entrepreneurs counterpart is aware that you have of these people for years or decades, it is are looking to realize the fruits of given up something of value. hard for me to imagine an owner being their labor by maximizing price and comfortable simply selling to a PEG • Second, define how your favorable seller terms, negotiation skill without any comfort as to the long-term counterpart can return the favor. is critical to completing any significant future of the company and its human Then demand it. financial transaction. Despite the resources.” By having these explicit tension, there is always one critical goal • Third, if you don’t trust your conversations, you can help demonstrate that buyers and sellers share: getting counterpart to reciprocate, make to owner-operators that you are a deal closed that benefits them and a contingent concession. In other dedicated to having parallel values. their stakeholders. words, offer to yield on something Deal Professionals, Dealmaker Outlook, Due only if the other side meets a To that end, here are eight negotiation Diligence certain condition. tips and techniques that we’ve found can help entrepreneurs, investors • Fourth, make concessions in and strategic buyers accomplish their installments. Malhotra points out common goal of closing the deal. that people are happier to find two $10 bills on consecutive days REMEMBER: PRICE ISN’T than one $20 bill. We like our EVERYTHING good news spread out, including When it comes to the sale or purchase in negotiations. of a company, it’s very easy to fixate on the price. It’s a key piece of the KNOW YOUR “WALK-AWAY” negotiations, but hardly the only one. NUMBER The terms matter too. If it’s not a full A buyer or seller needs to enter sale, what stake is being transferred? negotiations with an understanding How much control? Does the buyer get of the reasonable range in potential the first refusal for future transactions? sale prices for the asset. You should Does the sale agreement provide know what’s the highest and lowest

POWERED BY AXIAL 50 price the asset could reasonably sell advantage in the negotiation. If William Ury is an accessible and useful for. Just as important, buyers and you’re not in that position, playing primer on the topic. And Harvard Law sellers must know their “walk-away coy might be the ideal strategy to School’s Program On Negotiation has a number”; this number is your final avoid low-balling yourself. For those blog and free newsletter. threshold for consummating the curious about research on the subject Business Owners, Deal Professionals, deal. This will depend on your BATNA, the academic paper “First Offers as Negotiation or Best Alternative to a Negotiated Anchors” is an enlightening read. Agreement. Knowing your walk-away DON’T FEAR SUNK COSTS number going in takes research and As negotiations progress, it’s easy to preparation, and sticking to it will get tunnel vision. So much time has 3 Ways to Keep help you stay disciplined. been spent and effort has been exerted, Customers after KNOW YOUR OPPOSITION how can you walk away empty-handed? In order to get the other party to Sometimes you have to because that’s an Acquisition agree to a deal, you need to intimately the best option. As was already pointed know what their interests are. Getting out above, it’s important to know your Billy Fink | February 27, 2014 To Yes, one of the “Bible” books on alternatives and walk-away number negotiations technique, recounts that before you enter the negotiations. Any merger or acquisition is rife the 1978 Camp David negotiations with uncertainty. And customers SHAKE HANDS, THEN SECOND started with Israel and Egypt positing GUESS can be the most sensitive to that irreconcilable claims to the same piece After the deal is done, second-guessing uncertainty. Worried about how of land. It was only when the sides can be helpful. Research has shown recognized the other’s real interest– the transaction will impact their asking yourself what more could you Egypt’s wanted its previous borders have done following negotiations can end experience can cause them and Israel wanted its security–they make you more effective. A 2009 to flock to different competitors. were able to realize an agreement both study from professors at Haas, Kellogg, sides could accept. Egypt got the land As an article in WSJ explained last and Ohio University found that the but promised to demilitarize it. Also year, “Customer defections are a second guessers learn more and remember that there’s a distinction major reason why more than half perform more effectively in the between your negotiating counterpart of all mergers fail to deliver the future. Not all self-reflection is equal and the organization they represent. intended improvement in shareholder though. The experiments found it’s His or her compensation structure and value.” The article continued, “The better to think about what else you career goals could be playing a role trouble is that merged companies should have done rather than what in their decision-making. Understand tend to focus primarily on quickly you did but should have avoided. what’s driving him or her helps you capturing synergies and avoiding major “Particularly effective negotiators increase your bargaining power. technology disasters. They typically learn from experience by mentally lose sight of customers at the time MAKING THE FIRST OFFER ISN’T adding rather than subtracting from when they are most likely to bail.” ALWAYS A BAD THING, IT’S OFTEN reality,” wrote the researchers. A GOOD THING While there are many components to RESEARCH, RESEARCH, You’ll often hear the advice to not tip consider in executing a successful post- RESEARCH your hand, let the other guy show merger integration, customer focus is As a number of the tips above already his cards and make the first offer. critical. Below are three ways to avoid suggested, the buyer and seller But there’s a clear advantage to losing customers during an acquisition need to walk into negotiations after making the first offer: it anchors the or merger. doing their homework. You need to discussions. Studies have shown that research the asset, its value, your COMMUNICATE the first named price in a negotiation negotiation counterparts and other Probably the most important strategy significantly influences subsequent textbook (and non-textbook) due to prevent customer attrition is prices in the discussion. There’s also an diligence items beforehand. clear and effective communication. advantage to using precision when you If customers feel uncertain about name your price. There is a caveat: this For those curious to read more about direction of the merger, they will strategy is especially useful when you negotiations, the aforementioned be very sensitive to any dips of are confident you have an information Getting To Yes by Roger Fisher and

POWERED BY AXIAL 51 communication and service. “You A recent Deloitte report, which “Potential client loss is an immediate can not afford to miscommunicate reviewed customer attrition in fear when an executive — or in some with them, or you risk losing them,” bank mergers, explained, “Another cases executive team — jumps ship. explained Bob Hatcher of BetterSell common reason for [customer] For service industries like advertising, Solutions. “Whether you are a highly switching was receiving compelling law, and consulting, where clients are efficient ‘low cost provider’ or a high competitive offers from other attracted to the human assets rather end, consultative ‘trusted advisor’ your institutions. Specific experiences in than the production side of the clients want to know how the merger this category include offers of more business relationship, the likelihood will affect them.” appealing products, improved returns of significant client losses when a on savings, loans with lower interest team leader leaves is even greater,” However, not all communication is rates or more flexible lending terms, explained Michelle Rogan in a recent good communication. A recent Bain or services that made banking more INSEAD article. study learned that the “companies convenient.” While these examples that do the best job of retaining One of the best ways to prevent are specific to commercial banks, customers — and attracting new customer attrition thanks to employee the implications hold true for all ones — adopt the customer’s view of turnover is through multiplexity or, businesses across all industries. the merger as they make important as Rogan explained it, “diluting the integration decisions. They typically The best way to mitigate the threat control held by individual executives establish teams tasked with evaluating from pilfering competitors is to make by creating a number of ties between every step in the integration and every clear the value of the newly-combined the client and the company.” If change that is made through the eyes or newly-acquired business. Firms can relationships with clients “were held by of the customer.” In short, “they act as “go on the offensive and proactively several agencies in the firm, no single the customer’s advocate.” communicate their strengths and the agency or executive could control the benefits of the acquisition for the relationship, and the likelihood of client This ability for the company to put customers,” explained the Deloitte loss following an executive departure itself in the customer’s shoes allows report. “These communications can [is] significantly lower.” it to understand the pain point and remain positive and go beyond simply then effectively and appropriately This strategy may be tricky to assuring customers that the changes communicate around those problems implement post-merger, since it may will be minimal and that the service will and questions. send the wrong signal to customers, not be disrupted.” businesses with existing multiplexity Once identified, it is critical for customer- If push comes to shove, it can also be are inherently more resistant to facing employees (typically salespeople) valuable to arm salespeople with tools customer attrition during turnover. to have consistent answers to these necessary to “deliver an exceptional questions. “How your people talk and Deal Professionals, Post-Transaction experience during a time of change,” answer questions from clients and explained Laura Miles and Ted Rouse prospects is critical to their retention,” in a WSJ article. “That sometimes explained Hatcher. “Train them in how to requires empowering employees in answer questions and to ask questions. new ways — such as enabling them Train them to anticipate questioning to immediately offer discounts or sequences and to answer them refunds.” This ability to respond assertively and with confidence. These to competitive offers encourages are the people who will implement your a better customer experience and communication plan.” reduces the likelihood of attrition WATCH OUT FOR COMPETITORS through competitors. Effective communication also helps ENCOURAGE MULTIPLEXITY with another post-transaction Sometimes, unfortunately, the reason threat to customer retention: for customer attrition comes from competitor thievery. Very often, within. Mergers or acquisitions can when competitors hear the news of cause significant turnover post- a merger or buyout, they will try and transaction, especially in lower middle use customer uncertainty and doubt market transactions where the to their advantage. founders are exiting entirely. In these businesses, personal relationships are critical to the client. POWERED BY AXIAL 52 POWERED BY AXIAL 53 CHAPTER SIX: TRENDS SHAPING THE MIDDLE MARKET

The Evolution of LP/GP Relationships: Moving Closer to the Deal Cody Boyte | August 26, 2014

Over the last few years, relationships between limited partners and general partners in private equity have started to evolve. For a time, GPs had a pretty tremendous advantage. The public markets weren’t producing predictable results, real estate was down, and emerging markets were still rocky. LPs were sold on the IRR of previous funds and, with few other places to put their money, would commit fairly quickly.

But for many funds, the simpler times that 85% of LPs are not planning to re- Though some LPs have had allocations of raising a fund and returning capital up with GPs whose last two funds they for emerging managers in the past, in a decade are drawing to a close. LPs backed. Instead, they’re seeking fresh the proportion seeking ideas beyond are increasingly scrutinizing results relationships and ideas. Nearly 70% generalist buyout funds seems to be of individual deals, digging deeper of North American LPs are planning slowly climbing with LPs trying to find during fund due diligence and either to back new, first time funds directly real beta in individual managers. co-investing or funding individual deals rather than relying on funds of funds to DEEPER DUE DILIGENCE more often. In many cases, the belief find new deals. But, as LPs search for the best returns, that GPs are investing to get fees, not Coller Capital partner Stephen Ziff they are looking beyond simply the team. carry, is what pushes LPs towards explained to Investments & Pensions different models. “The LPs we talk to are looking for Europe, “Often, talented individuals evidence of a repeatable model,” Hugh The problem has been exacerbated or teams will leave big franchises MacArthur, Bain & Co’s head of global as more and more funds are created. that perhaps aren’t offering them the private equity, recently said to the Wall According to Preqin, there are now challenges they expect, in order to start Street Journal, “The due-diligence 2,199 funds in the market — a record up on their own – and LPs that know process is a lot more intense than it level. The shifting dynamics and sheer them well are prepared to back them.” was seven or eight years ago.” number of funds is causing many LPs As a result, the amount of competition to seriously reconsider their existing is continuing to grow. Instead of simply listening to a few relationships and investments. The pitches and signing off on a fund, LPs Although one recent study found ability to raise another fund in the have started digging into past funds on that the top private equity funds had future may come down to being a deal by deal basis. They’re beginning persistent outperformance of other creative during fundraising and further to recognize that they can do much funds by 7-8% per year, one of the aligning pay with results. of the same due diligence on funds as paper’s authors noted, “The problem is their funds do on potential acquisitions. LPS ARE LOOKING FOR NEW GPS that there is a lot of luck mixed in with GPs now need to have a much better As LPs start considering ways to the skill. If you want to find the truly understanding of their value add and shake up the model, they’re starting skilled managers, you’ll probably have their competitive landscape. to look past their traditional “core to look at something more than just relationships.” Coller Capital found in past performance.” Investors are starting to ask about their Global Private Equity Barometer deal sourcing strategies, what made

POWERED BY AXIAL 54 each deal successful or unsuccessful, These days, professionals are using and whether the investment patterns Could Freelancing technology to build careers on seem to be repeatable or were simply established online work marketplaces luck. As we’ve found in our own be the Future of like Elance and oDesk. They are conversations with different private finding customers through Angie’s equity groups, few have repeatable M&A? List and ZocDoc, and using platforms sourcing strategies. Vik Ashok | SpareHire June 26, 2014 such as Airbnb and Lyft to transform themselves into independent hotel THE ERA OF CO-INVESTMENTS M&A has historically been operators and taxi drivers. Even AND DEAL-BY-DEAL pedigreed ex-big firm lawyers are INVESTMENTS an old-fashioned industry making lucrative careers as freelance The biggest changes, however, seem to characterized by large corporate lawyers, finding short-term be in the structure of the investments institutions and structured legal projects through platforms such themselves. With more than 60% of career tracks. However, a as Axiom Law and UpCounsel. In many the LPs surveyed by Prequin for their cases, these freelance lawyers are special report on co-investments change is on the horizon. supporting M&A events for smaller noting that they’d trade lower hurdles For most M&A professionals, a career companies who cannot afford the high for lower fees, it’s obvious that LPs starts at investment banks, where cost associated with hiring a big firm. are seeking new ways to get access thousands of analysts are hired each to private equity at lower cost. And year and rigorously trained in financial IS M&A NEXT? they’re not waiting for the funds to analysis, Microsoft Excel, market The investment world is no different. change on their own, they’re pushing research, and presentation building. At SpareHire, we are seeing more the changes. While a few climb the ranks to become and more M&A professionals choose freelancing as a career, driven by a few As the Coller report noted, nearly a relationship-focused managing recent industry dynamics: quarter of LPs have backed GPs on a directors, the majority leave, switching deal-by-deal basis in the last 5 years. to investment careers at private equity 1. As is the case in the legal industry, Prequin’s report found that of the firms and hedge funds, strategy careers training programs at large LPs they tracked, “43% are actively at large corporations, or abandoning investment banks equip thousands seeking co-investment rights when the M&A world altogether. of new professionals with robust committing to funds, and a further 11% This rigid structure is beginning skill sets every year, creating large are considering such opportunities.” to evolve as many entrepreneurial pools of talent with valuable skills Even Pensions & Investments noticed dealmakers choose to branch off and to offer. the discrepancy between direct returns pursue freelance options or establish 2. Most banks have pyramidal and fund returns in a recent article, their own boutique shops. Technology, organizational structures, forcing noting that the public data from shifting industry dynamics in the talented mid-level and junior CalPERS showed direct investment net M&A industry, and a generational shift professionals to leave in search IRR of 12.8% versus an 11.4% net IRR for towards freelancing are accelerating of other careers while senior its commingled funds. this trend. professionals stay in place. With LPs becoming more sophisticated, TECHNOLOGY & FREELANCE 3. Industry headwinds such as private equity funds will have to find The power of technology-enabled declining management fees have new ways to create alignment whether freelancing can be seen in a variety caused investment firms and it’s through investments on a deal-by- of industries. transaction service providers deal basis, co-investment commitments, (e.g. strategy consulting firms, or through more flexible terms on fees. Many of the most familiar industries accounting firms, advisory firms) Investors are willing to back new teams, rely on freelancers to deliver services to recalibrate their HR structures direct invest and dig much deeper into to customers, including software and work with less. the actual strategies used by different development, medicine, journalism funds to ensure they’re getting the and law. Nearly 33% of the entire U.S. 4. The industry’s demanding work returns they need. Are you prepared? workforce is made up of freelancers, schedule leads to a high churn and this number is expected to swell to rate, and many talented M&A Deal Professionals, Dealmaker Outlook, 40% by 2020. Fundraising & IR professionals voluntarily leave the industry each year to raise families and pursue other passions.

POWERED BY AXIAL 55 The result is a large, experienced pool technology is making it easier and FRANCHISES ALLOW FOR of talent looking for new opportunities. easier for you to create an independent GEOGRAPHIC TAILORING career. Harnessing this technology One of the most important benefits While freelancing is by no means can help you promote your services, of a franchise model is that it allows new to M&A – anyone from the expand your network, engage with for a firm to offer region-specific industry knows at least a handful other M&A professionals, and find new services. “I was convinced that of former investment bankers work opportunities. the industry operated differently turned independent brokers –these throughout the country,” explained types of freelance roles have Deal Professionals, Future of Capital Markets Roger Murphy. “Local business traditionally been limited to seasoned customs dictate commission rates, professionals with rolodexes. whether you charge the client upfront Thankfully, technology is making Should Business fees, or how the closing process works.” it easier for these talented Regional franchises allow brokers M&A professionals to function Brokers be to simultaneously access a national independently, and for younger footprint while offering services unique professionals to gain experience Franchised? to the region and location. and build their networks. Instead of Billy Fink | August 7, 2014 Additionally, having franchised offices relying solely on personal contacts, the across the country allows each office to modern deal professional leverages build the right relationships in the right tools and networks to succeed. As competition in the private capital markets reaches an locations. “To succeed in a region, you In particular, people are becoming need to have relationships with the best more comfortable engaging in large all-time high, many individual lenders, attorneys, CPAs, etc. in order to transactions online (not the case five business brokers are finding assist your clients in getting deals done,” years ago). Rather than scrambling their livelihood less and less said Murphy. Staying up-to-date on all to source transactions through small predictable. Business owners these relationships can be challenging personal networks, investment bankers, without specialization by region. capital providers and companies are increasingly searching ADMINISTRATIVE SUPPORT & are now connecting and engaging the internet, making brand BRAND CONSISTENCY through a host of crowdfunding awareness and access to a A franchise model allows for unique sites like AngelList or online business economies of scale — particularly development platforms like Axial. wider network of experts when it comes to administrative Online marketplaces like SpareHire that much more important in support. Murphy said that it was make it easier for independent finance securing a client. a “gross misuse of time for business professionals to find short-term Many believe the best strategy for brokers to have to do both the projects and for boutique investment smaller, independent M&A advisors dealmaking and the back office work.” firms and advisory shops to find and and brokers is to join a franchise. engage flexible talent. Instead, his strategy is to “allow the “It is getting increasingly harder brokers to do what they do best, which All of this is made possible by the to provide great service to your is spend their time with the clients and internet – small, closed networks clients as a small brokerage firm developing referral networks while are quickly being replaced with and a franchise system is a viable they leave the back office functions larger, more interconnected ones solution. Brand name recognition to the us at the corporate office.” He characterized by better information and economy of scale can make the continued, “Our brokers can now focus flow and increased interaction. process much simpler,” said Roger entirely on the dealmaking part of the Murphy of Murphy Business Brokers. WHAT’S NEXT? business. My hope is that our people The economy is becoming more To learn more about the business have more time to be out with the entrepreneurial every day. Whether broker franchise system and why a client and making deals ” you are an independent M&A broker would join one, we spoke with Murphy, like many other brokerage professional who just left a big firm Murphy and Mason Myers of Greybull franchises, is enabling the brokers and is looking to freelance or an Stewardship, a recent investor in his to focus solely on building and industry veteran seeking flexibility, new brokerage franchise. maintaining the relationship by

POWERED BY AXIAL 56 covering most marketing needs. “We requires an immense amount of effort, create all the marketing materials for experience, and skill. Every individual Will IPOs Ever them that they will need: print, email broker ends up building their own campaigns, and other lead generating brand and skill set, which may be Return to the programs. We also provide all the positively or negatively affected by the website material, do all the technology other brokers in their office. Middle Market? work, manage e-mail systems, etc.” Billy Fink | July 24, 2014 As Murphy explained, “Getting people IMPROVED ACCESS TO properly trained is also a challenge.” IPOs are in vogue right now. INFORMATION He continued, “Our industry is Mason Myers also pointed out that woefully lacking in formalized training In the last month alone there the franchise model offers unique programs. For years, we have required was the best IPO week since informational benefits for brokers every person to come to Florida for 2006 and PE IPOs reached their as well. “Whether it is market one week of initial training. There highest ever level. comparables, transaction information, is a lot of stuff we throw at them or general regional knowledge, a — it is like drinking from a firehose.” But, not all companies are getting network of brokers can invest in Murphy and Myers are planning to access to the IPO party. These marketplace and deal information grow the education program even flotations have largely been reserved which an independent broker could more. But, can classroom education for much larger firms with significant never afford,” explained Myers. effectively prepare a new advisor on market caps. all the intricacies of a process? What He continued, “When you are part of The small- and medium-sized about more advanced training for a network, you have a lot of expertise businesses have largely been ignored in experienced brokers? available to you. If it is a type of the IPO market for years. And chances business you haven’t sold before, And, inevitably, there is always the are — due to regulatory concerns, there is someone in the network with flight risk. After spending hours and investor preferences, and the experience selling that type of business. dollars training and equipping a new increasing effectiveness of the private The whole is bigger than the sum of the franchisee, there is the risk that he capital markets — the smaller IPO will parts because the entire network can will take that regional specialization, not return. take advantage of the experience of all relationships, and knowledge to create Here’s why… the people in the network.” an independent brokerage in the community. Neither Myers nor Murphy COMPLIANCE CHALLENGES BUT, THERE ARE CHALLENGES considered this a very serious risk, In a recent interview, Marc Although there are benefits to being believing that their franchisees would Andreessen explained that regulatory part of a franchise model, it comes stay within the Murphy family as long burdens are one of the primary with its own challenges and difficulties. as it continued to offer great training reasons that IPOs became unfeasible “One of the biggest challenges is the programs and a very effective network for smaller companies. startup time it takes for new people to of support and knowledge. earn money — about 9 months or so,” “The compliance and reporting explained Murphy. “We try to shorten Client Acquisition, Deal Professionals, Future of requirements are extremely that process so that the franchise can Capital Markets burdensome for a small company,” become profitable as soon as possible.” explained Andreessen. “It requires This uncertain profitability and the fleets of lawyers and accountants who irregular revenue streams for most come in and do years of work.” While offices can create a serious burden on these regulations are intended to business. It can also be tricky for a new protect the small company, he believes broker just starting out it has “the opposite effect.” An even larger challenge is ensuring Andreessen is primarily referring to the consistency of brand and talent. the Sarbanes-Oxley Act of 2002 (aka Unlike other retail franchises, which Sarbox), whose controversial Section can succeed with formulaic repetition, 404 dealt a blow to small company success in the private capital markets IPOs. The section was so problematic

POWERED BY AXIAL 57 that the SEC learned that 70% of small management (charging 1% a year for expenses) and you can calculate that a stock companies considered going private must have a market capitalization of about $300 million.” again after Sarbox’s Section 404 was The changing nature of the average public investor made the opportunity for implemented in 2002. small- and mid-cap companies much less appealing. Since these savvier investors While compliance may have driven cared less about smaller IPOs, these companies received less coverage from down the small company IPO, it isn’t analysts and were traded less frequently. As a result, many of small companies in these regulations that are keeping the public market became unprofitable. The consequence of poor trading can still smaller IPOs dead. After all, the JOBS be felt today — just look at Crumbs’ recent bankruptcy. Act modified Section 404 to be more Since the mass return of the individual investor to the stock market is unlikely, accommodating for small firms. The these developments in investor habits have proven much more problematic — results have been underwhelming. and permanent — for the smaller IPO than the more transient regulatory matters. As Steven Davidoff and Paul Rose explained in their research paper THE GROWING EFFECTIVENESS OF M&A on The Disappearing Small IPO, Although shifting regulations and investors accelerated the initial decline in small “Percentagewise, the number of small company IPOs, the primary factor that has kept small companies off the public IPOs [in 2013] was one of the lowest markets is the effectiveness of the private capital markets and M&A. since 1996. The trend instead is toward Over the past twenty years, there has been an explosion of deal professionals ever larger IPOs. The number of large around the United States. The growing number of private equity firms, search IPOs was the largest since at least 1996.” funds, investment banks, and M&A advisors has dramatically increased a private INVESTOR SAVVINESS company’s ability to tap into the private capital markets. The opportunities have If not regulation, then what killed only improved as technologies — like Axial, AngelList, etc. — have developed. the small IPO? Many pundits point to Many business owners and entrepreneurs have realized that partnering with investor savviness as a factor in the financial sponsors or strategic acquirers can offer comparable opportunities as demise. Back in the 1990s, the primary an IPO, without the additional headaches or risks. As a result, even if the investors investor in a company’s IPO was an and regulators changed back, many private companies would still remain private. individual. Today, hedge funds and mutual funds dominate the stage. As John C. Coffee, Jr. explained, “Issuers conduct IPOs for multiple reasons: (1) to raise capital; (2) to create a public market and give their founders liquidity; As Andreessen continued in his and (3) to generate the highest valuation for their firm through the efforts of interview, “The problem is the underwriters.” With a slight exception for #2, partnering with the right financial shareholder base itself has changed sponsor or strategic acquirer can be just as effective as going public. dramatically. You’ve had a dramatic rise in hedge funds. Very short-term The fact that SMBs are favoring a first stop at the private capital markets can be trading and dramatic rise in short- seen in the amount of capital raised by a company before it goes public. selling. If you’re a public company, you become the shuttlecock between warring longs and shorts. They bat your stock around like it’s a chew toy.” Axial Member Tom Courtney, of The Courtney Group, identified a similarly important impact from mutual funds. “Most mutual fund managers do not want to own more than 5% of a company (because they have to report it to the SEC) and want to be able to sell a position in 3-5 days without moving the price of the stock. Add to this the economics of the mutual fund business, that an equity mutual fund (Source: WilmerHale) typically becomes a profitable business at around $200 million in assets under

POWERED BY AXIAL 58 The companies that went public over THE SLOWDOWN IN OTHER EXIT that they could under their ownership, the last four years had raised on CHANNELS leaving less juice for the buyer.” If the average more than $70M pre-IPO, The recent spike in secondary buyouts second sponsor is unable to grow the leaving many of them simply too large is likely a reaction to dissatisfaction business sufficiently, the only takeaway to be acquired. After raising that much with the public markets. Although IPOs for the LP is additional fees and money, you generally are seeking a were a preferred exit strategy just a prolonged capital illiquidity. $250-1B+ exit, which is well beyond few months ago, a dismal week of GOOD FOR LOWER MIDDLE the means of most strategic and PE flotations in early April caused many MARKET acquirers. As such, the only option still PE firms to LPs, however, available is an IPO. reconsider the tend to be more strategy. In that LPs, however, tend to be The appeal of staying private has open to these week, 8 of the become even more important in recent more open to these flips flips when the 10 IPOs debuted years. As baby boomers begin to retire, when the deal involves two deal involves two below their they are concerned about the legacy differently-sized expected range differently-sized sponsors — of their business, and are seeking sponsors — like — the worst like a lower middle market strategies that can ensure a dynasty a lower middle performance of their choosing. Choosing the buyer/ firm selling to a larger firm. market firm since 2004. investor of their business can help selling to a larger secure that strategy. Fearing that the firm. As one LP Deal Professionals, Future of Capital Markets, public markets commented, Post-Transaction, Valuation could not offer desired returns, sellers “The first sponsor professionalizes turned to their other primary options: the business and grows it to a ‘decent strategics or secondary buyouts. While size’ before selling.” Not only are larger PE firms often prefer to sell to strategics, firms hungry for deals, ones that have the current environment — high dry already had institutional presence are powder, low deal flow, low interest rates, likely to have fewer skeletons in the What Increasing and pressure to exit portfolio companies closet or hair on the deal. — has made sponsor-to-sponsor Secondary Deals The current popularity of these transactions a very appealing alternative. ‘upward sells’ is favorable for lower Means for the CAUTIOUS LPS middle market firms. As smaller Although secondary deals may be on firms partner with exiting business Middle Market the rise, not everyone is happy about owners, they can help professionalize Billy Fink | May 27, 2014 it. “The surge in secondary deals is the business without extracting all generally a good thing for GPs, but not of its growth potential. Since larger If it feels like there have been necessarily so for LPs,” writes Luisa firms are clamoring for the deals, the more sponsor-to-sponsor Beltran in her article. business could be transitioned at a healthy valuation. transactions this year, you’d For LPs, a sponsor-to-sponsor be right. While these deals transaction may offer no benefit. Jeff Tim Shanley, of Huron-backed Victoria Golman explained, “Many of the [LPs] Fine Foods, confirmed the benefits of have always been a viable exit are in both buyer’s and seller’s funds, these small-to-large secondary deals strategy, they are rising to new therefore, they don’t get liquidity and during one of our recent events. At the levels of popularity. end up investing in the same company discussion, Shanley explained that the at a higher price.” sponsor-to-sponsor transaction can be “Preliminary data from the first quarter particularly valuable for the operating LPs find this situation particularly of 2014 show about 45% of PE exits company if the company is sold to a troubling when there is doubt that coming from secondary buyouts,” more experienced sponsor. In addition the second sponsor will be able to writes Devin Matthews in a recent to their experience, larger firms are grow the business further. Golman article. The frequency is a notable able to write larger checks to further continued, “Often, the private equity increase from the 41% from 2011 – 2013 accelerate the growth of the company. and the estimated 36% pre-2008. seller has wrung whatever savings and efficiencies out of the company He cited the the franchise industry as

POWERED BY AXIAL 59 a prime example; newer private equity completion of the M&A Transaction, transactions are created equal, firms will purchase regional stores to control and actively operate the and neither are all intermediaries. bring them to the national level. Upon company or the business conducted with Different protections are required exit, once that next level is reached, the assets of the business.” along the spectrum of financial the more experienced players have transactions, especially when Accordingly, M&A Brokers must developed an interest and can take the different financial players are evaluate each transaction on this company even further — aiming for involved. Second, it marks a move two-part test – does the buyer have a strategic exit at the end of their 5-7 away from the SEC’s historical control, and is that exercised through year window. focus on transaction-based active management of the company? compensation as the hallmark Deal Professionals, Dealmaker Outlook, The SEC provides further guidance – indicator of broker registration. Fundraising & IR control is presumed if the buyer “has the right to vote 25% or more of a class Together, there is a reasonable basis to of voting securities.” believe the SEC might provide future relief from broker-dealer registration As long as these conditions are met, What the SEC’s for private equity fund sponsors that unregistered brokers may: receive transaction-based fees for No-Action Letter • represent both buyers and sellers facilitating securities transactions for Means for M&A of private companies their portfolio companies. Brokers • advertise the business Such a relief from the costly • negotiate the transaction, and registration requirements should Matt Catalano | March 25, 2014 bolster middle market and lower- • receive transaction-based middle market M&A. Eliminating On January 31, 2014, the compensation without any these costs, historically passed onto Securities and Exchange limitation as to the size of the buyers and sellers of companies, will transaction. unlock value in transactions and Commission issued a no-action This emphasis on control and active promote a more efficient flow of letter, providing “M&A Brokers” owners underscores the intent of capital. And, an increase in compliance relief from broker-dealer the SEC’s no-action letter – to offer will decrease the legal risks associated registration requirements in relief when a buyer is not a passive with unregistered brokers illegally facilitating securities transactions. limited circumstances. investor and in need of the protection broker-dealer registration is intended In the meantime, on Capitol Hill, the In other words, the SEC will not to provide. Active owners will protect United States Congress is having recommend enforcement action themselves by learning about the a conversation about simplifying against unregistered brokers that target through due diligence, and, registration requirements for M&A facilitate a securities transaction, therefore, are not as susceptible to Brokers. On January 14, 2014, the involving the transfer of control of a questionable solicitation tactics and House unanimously passed H.R. 2274 to privately-held company “to a buyer conflicts of interest that originally amend the Securities Exchange Act of that will actively operate the company,” created the regulation. 1934, and the same version of that bill as long as certain conditions are met. The SEC’s no–action letter also is now in the Senate Banking, Housing, The no-action letter brings clarity represents a shifting mindset and Urban Affairs Committee. and legitimacy to an industry that may serve as a harbinger of The SEC and profession long hampered things to come interprets the by uncertainty and impractical in private M&A The SEC’s no–action letter laws of Congress, interpretive guidance – finally, securities and until a bill is making clear the activities in which regulation. also represents a shifting passed into law, unregistered brokers may engage in. First, it is an mindset that may serve the no-action To bypass the registration, M&A acknowledgment as a harbinger of things letter serves brokers must abide by a certain set of by the SEC that to come in private M&A as interpretive not all securities guidance, conditions. One of the most critical securities regulation. conditions is that the buyer(s) “will, upon effectively granting

POWERED BY AXIAL 60 M&A Brokers relief from broker- “Overall, there is greater awareness is endless work and one needs to be dealer registration, subject to the among young entrepreneurs of the able to overcome the challenges.” conditions therein. need for older entrepreneurs to sell NEW STRATEGIES DEVELOPING their business,” explained Professor It is important to note, that M&A As young entrepreneurs adopt Yudkoff. “These exiting business Brokers should proceed with caution the search fund model in greater owners need an investor that can – relief is transaction-based and state numbers, they are also seeking to both help them take chips off the regulations will still apply. change it. “There has been increasing table and take over managing the diversification of the search fund Deal Professionals, Dealmaker Outlook, business.” Many young businesspeople model recently,” explained Bautista- Regulatory/Legal are recognizing this fundamental Saeyan. “People are spotting demographic shift, and are trying to inefficiencies in traditional models and capitalize on the opportunity. Why the are shifting appropriately. One such searcher is Kousha Bautista- “One of the most popular alternative Traditional Search Saeyan of Long Trail Leadership. “I was models is many searchers are now particularly drawn seeking one or two Fund Model is to the search fund partners that will model because it sat Changing “I was particularly support them with between the two drawn to the search committed capital By Billy Fink | March 19, 2014 poles of corporate and advice, instead of life and startup life,” fund model because going to 20 different In recent years, the traditional he explained. “While it sat between individuals. It is a real I knew I wanted to search fund model has the two poles of partnership,” said run a business, I didn’t begun to evolve to address corporate life and Bautista-Saeyan. feel comfortable some of the common shouldering the risk startup life.” Besides addressing concerns — namely around of creating a new the logistical lack of experience and lack of company. The search challenges of the committed capital. fund model is less traditional model, this risky, but still exciting.” new model helps to mitigate some To learn more about these concerns expressed by intermediaries AND A GROWING DIVERSITY developments, we spoke with and business owners — namely While these searchers are similar in Professors Yudkoff and Ruback inexperience and lack of committed their desire to run a business, they of Harvard Business School and capital. “The new model is appealing are quite diverse in their skill sets and Kousha Bautista-Saeyan of Long to searchers and business owners experiences. “I am impressed by the Trail Leadership. alike since it brings committed breadth of successful patterns in our capital, energetic youth, and ‘gray hair’ A GROWING NUMBER OF searchers,” commented Professor experience to the table,” explained SEARCHERS Richard Ruback, also of Harvard Bautista-Saeyan. “The combination of Although the search fund community is Business School. “It is not the case that young searchers to run the business still relatively small, it has been growing any one set of experiences makes for a combined with more senior partners in popularity. “An increasing number successful searcher — there is no one offers an appealing partnership.” of talented, young businesspeople are size fits all. Our searchers are usually in being drawn to the idea of acquiring their 30s and have had substantial work While many of the new searchers have smaller firms and then running them experience, on which they are able to adopted this partnership model, it is as CEO,” explained Professor Royce build in a very productive way.” not easily reproducible. “While more Yudkoff of Harvard Business School. appealing, this is a much more difficult Instead of a specific professional track, “Here at HBS, the number of people model to replicate since you have to the most successful searchers tend to taking courses on this subject is up 8x find one or two HNWIs that trust and have the same qualities that make for over the past 3 years.” believe in the searcher,” said Bautista- any successful entrepreneur. “Tenacity, Saeyan. “The cost to each investor is General interest in the strategy has energy, and interpersonal competence significantly higher, since the risk and grown in response to many baby are three qualities that help make for a capital are not diversified, but the boomers reaching the retirement age. successful searcher,” Professor Yudkoff likelihood of success is higher and they commented. “The search fund process are more willing to offer advice.”

POWERED BY AXIAL 61 WHEN AND WHY TO INCLUDE A ONE MANAGEMENT FEE SEARCHER ON A BUYER LIST What is an Myers explained, “one of the most The growing popularity and obvious benefits [of evergreen funds] changing models has caused many Evergreen Fund is the one management fee.” In intermediaries and business owners to traditional firms with multiple funds, warm up to the searcher model. Structure? there can be layers of management By Billy Fink | February 25, 2014 fees, creating an expensive experience “Merger advisors are becoming more for the LP. aware of the value of a searcher and Traditional PE funds have been look at this trend as helpful to solving Alternatively, evergreen funds have, some of their problems,” explained losing some luster in recent “just one fund with one management Professor Yudkoff. “When a business years. High management fees, fee, making it more manageable, more broker has a seller who wanted to illiquidity of the LPs’ investment, transparent, and a good advantage for retire from a smaller firm and sell it, and the strategy of selling the LPs,” explained Myers. While the newer they knew they would have a problem fund structure doesn’t eliminate the [drawing the interest of] private equity best companies earliest have management fee, it greatly reduces the — because of the size of the business left many investors frustrated layers of tension. and owner wanting to leave. Searchers with the standard fund IMPROVED LIQUIDITY give more options to business brokers Evergreen funds also satisfy some than they had before.” protocol. LPs because of the improved liquidity Although the perception from As a result, there has been a lot of mechanism. “Because there is liquidity intermediaries is improving, not all conversation around how funds will every four years, it is easier for LPs businesses are meant for a searcher. evolve from the standard 2-20 fees. to adjust commitments,” said Myers. As Professor Ruback explained, “very One strategy that has generated While LPs should plan to invest for large and/or overly complex businesses significant attention is the evergreen more than one four-year cycle, the are not appropriate for searchers. It is fund structure (aka permanent capital flexibility is reassuring to many. hard to imagine the searcher stepping PE vehicles). Still, the model doesn’t offer perfect in, for example, to a business with “In an evergreen fund structure, the liquidity — these are private $100 million in revenue and being fund has an indefinite fund life,” companies, after all. “The biggest prepared to take on that management explained Axial Member Mason Myers challenge [for evergreen funds] is challenge. There are certain challenges of Greybull Stewardship. “Every couple valuing the portfolio at four-year [associated with] that type of business of years — typically four — LPs have intervals,” explained Myers. “Without a that pure energy and tenacity cannot the ability to exit or to change their buyer writing a check, valuing private overcome.” investment in the fund. At the end of companies can be imperfect.” This However, if the business is “within the the four years, the portfolio is valued challenge makes it difficult for LPs to scope of an energetic, well-trained 30 and some carry incentive is calculated predict exactly how much money they year old with valuable experience” or for the GPs.” will see in return. is “in the range of $0.5 – $3 million in Evergreen funds Additionally, there EBITDA,” the business owner should are becoming are challenges seriously consider a searcher. Evergreen funds are becoming more popular associated Deal Professionals, Fundraising & IR, Sourcing because they more popular because they with returning Deals help alleviate help alleviate two of the deployed capital two of the major major complaints among LPs: mid-investment. If, complaints expensive management fees for example, many among LPs: LPs decided to call expensive and illiquid investments. their capital at the management end of one four- fees and illiquid year cycle, the investments. GPs would be in a very difficult situation. However, most payouts can be handled through company profits, other LP buy-ins, and notification clauses in the contract.

POWERED BY AXIAL 62 This general uncertainty, combined PE structure. “Fixed term funds will Mezz has largely been forced into a with the novelty of the structure, has probably always be a common corner by PE firms chasing returns caused wariness in some LPs. structure because they work well in and unitranche lenders rising in many situations,” he said. “However, prominence. To counter the squeeze, BUSINESS OWNER FOCUS I do think there is becoming a lot many mezz firms have already dropped Many LPs overlook this wariness more diversification warrants from their for the biggest benefit of the in fund structures and agreements or lowered evergreen structure: total focus on strategies — which their return goals — but the portfolio company. This focus The two primary allows companies to with little success. allows GPs to build a more trusted challenges facing find capital sources that relationship with the business owner The two primary are best aligned with mezzanine right and drive growth, instead of IRR. “In challenges facing their needs.” now are the rise a traditional structure, you may be mezzanine right now are motivated to sell soon so your IRR Myers concluded, in unitranche the rise in unitranche looks good, so you can raise a second “Evergreen funds will lending and the lending and the focus on fund,” explained Myers. “Those sort continue to grow as LPs focus on returns. returns. of types of pressures are lesser in and business owners THE RISE OF evergreen fund structures. Because alike look for new UNITRANCHE evergreen structures have no specific strategies that are better LENDING time frames, the business owner can for certain companies. And, I expect One of the biggest threats to set the growth rate and business there will be other structures that mezzanine right now is unitranche strategy that is best for the business, people conceive of over time. As the lending, the strategy of combining not necessarily a strategy imposed by market becomes more diverse, fluid, senior and subordinated debt into one fund level restrictions.” and larger, there will be more sources package with a blended interest rate. of capital for business owners which is He continued, “The longer-term As Burkhart explained, “The success of a good outcome.” focus of the fund removes a lot of the unitranche lending…has continued and pressure to put money to work and Client Acquisition, Deal Professionals, has now moved into the lower middle exit investments based on motivations Fundraising & IR, Future of Capital Markets market.” While it can be a little more or limitations at fund level.” expensive than traditional mezz, this more complete package has become Ashby Monk, executive director of the more appealing for both lenders and Global Projects Center at Stanford Two Trends borrowers alike. University, sees the similar importance of the fund. He wrote, “the GP can Shaping the The rise of unitranche lending has been focus like a laser on value creation particularly important in the lower over the long-term and not worry Future of middle market. “Unitranche is generally about ‘exits’; ‘bankers’; ‘timelines’; etc. more useful for smaller deals, because This should prevent rent seeking and Mezzanine the strategy is not suitable for broadly financial gearing, while reducing costs.” By Billy Fink | February 18, 2014 syndicated loans,” explained Steven He continued, “I think it’s got legs. And Bills in a recent Buyouts article. I know quite a few people on the LP Despite the overall popularity, Bills noted, “the emergence of side agree with me.” mezzanine financing has been unitranche financing has put additional BUT…REMAINING NICHE experiencing some trouble pressure on mezzanine…Unlike Despite the generally positive recently. The strategy that conventional senior-subordinated reception to — and performance of capital arrangements, lenders can — evergreen funds, Myers does not thrived in the hot buyout present unitranche deals to borrowers believe they will become the primary market has struggled to at a single, blended interest rate… maintain its relevance in while eliminating the inter-creditor agreements that can cause difficulties today’s cooler conditions. in bringing a deal to close.” “Overall, traditional mezzanine is in a tough spot right now,” explained Joe Burkhart of Saratoga Investment Corp. POWERED BY AXIAL 63 CHASING RETURNS John Thornton of Tregaron Capital The lackluster M&A activity in recent agreed. “If you want to do mezz in Zombie Funds: years has impacted the decisions of the lower middle market, you have to many business owners and investors, be willing to get skin in the game,” he How the SEC is especially with regards to valuations. said. “Even though it is structured as The desire to make up debt, the risk is much Arming Itself returns — amidst a more like equity. relatively cold market “If you want to do Because they are tiny Against the — has caused many mezz in the lower companies, the risk Undead equity investors to middle market, you return is such that blur the traditional you need to do work. By Cameron Cook | AccuVal-LiquiTec debt-equity line. have to be willing to There are generally September 9, 2014 get skin in the game,” better returns, but As Burkhart explained, more risk because Private equity funds can many mezzanine they are smaller, more produce good returns, but lenders are getting fragile companies.” squeezed as PE shops begin moving into some inevitably will not. And the smaller markets. “The pressure PE Thornton is versed in this strategy some, too, will become illiquid. sponsors have to deploy their capital in a because Tregaron has jointly issued Enter the zombie fund, a low volume market,” is causing them to mezz and equity in several of its own “write larger equity checks which closes deals. He explained, “For control deals, private equity fund (or hedge the gap between the senior debt and the we typically provide both the equity or venture-capital fund) that equity — where traditional mezzanine and the mezz debt. Since these are contains hard-to-value illiquid usually exists.” typically small companies and small investments that have gone deals, there are not many third party Bills also noted the impact of mezz players out there that would be bad and lingered beyond the returns picture. “In the past, interested, so providing all the required the funds’ targeted lifespan. subordinated debt promised investor junior capital is the only way to get returns in the mid-to upper teens, Zombie funds often have deals done.” while returns from private equity stale valuations that foster sponsors approached 30 percent. Still, it’s important to note that the reporting of much higher Today, top-quartile equity returns are mezzanine isn’t going away. Ronald more like 20 percent, so that the kinds Kahn of Lincoln International values than current fair-value of returns once delivered by mezzanine explained those best suited for mezz measurement would produce. are now going to the equity part of the loans are, “The highest quality deals Preqin data, reported in June 2013, capital stack.” backed by well-capitalized, well- indicated there were 1,200 zombie known sponsors. Because these are LEARNING TO SURVIVE funds with $116 billion of assets in the most sought after financings, As traditional mezz shops get squeezed funds that had reached the end of senior lenders are eager to lend to by this unintentional pincer attack, they their expected holding period and these credits, making it easier to club will need to adapt. Burkhart believes had no successor fund planned. And up the number of lenders needed that one of the best solutions would the original value of the investments to complete the financing, while be for these mezz shops to move away tied up was far greater than that. The the increased competition among from pure lending, a strategy which number of zombie funds is likely to lenders tends to result in more he is already seeing. “Many traditional rise over the next several years, as favorable terms for a borrower.” mezz shops are evolving into more older funds with non-performing growth-oriented investors,” he Deal Professionals, Dealmaker Outlook, assets reach the end of their original explained. “They are structuring their Sourcing Deals expected holding periods. investments as debt with a significant The greater prevalence of these funds equity component and the use of can threaten private equity standing proceeds will be for growth purposes. with both regulators and LPs alike. This investment style requires different skill sets, has more risk, but has better upside for the investor.”

POWERED BY AXIAL 64 WHERE ARE THE ZOMBIE FUNDS? Investors complain that the It is clear that overvaluing assets Zombie funds are typically older and unrealistically high values on these could prove problematic for fund at the end of their expected holding underperforming, hard-to-sell assets managers if the SEC does not find the periods. They should be put to rest, produce inappropriate fees charged proper documentation to support the but the higher stale valuation of well beyond the investors’ originally reported figures. fund assets and attached investor intended holding period. For pension HOW TO PREPARE YOURSELF: agreements keep these ill funds funds, these stale (higher than fair PROFESSIONAL, UNBIASED alive. Because of the assets’ illiquidity value) figures can affect management VALUATIONS CAN HELP and the investment terms, investors fees, prevent an accurate valuation As the private equity industry has are locked into these funds, which of funds available for paying retiree evolved, so have the valuation continue to accrue management fees benefits and tie up resources that standards and accounting guidance without a strong likelihood of a future could be invested elsewhere. available. Most newer limited-partner payoff. If the assets in question were HOW THE SEC IS ARMING ITSELF agreements (LPAs) establishing a immediately sold, then the market The SEC has become increasingly private equity fund now require would likely pay a lower value than the aware of this situation as pension firms to provide quarterly and annual value being reported, and the funds, as funds have increased their investments financial statements using Generally well as their investors, would recognize in such alternative asset classes, and Accepted Accounting Principles significant losses. they are beginning (GAAP). These principles require Consider this to take action. financial statements to report the example: A The SEC has become Bruce Karpati, fair-value measurement of portfolio private equity increasingly aware of chief of the SEC positions, using fair value as defined fund with an Enforcement in Accounting Standards Codification expected term this situation as pension Division’s Asset (ASC) 820 – Fair Value Measurement. of 10 years made funds have increased Management Unit Depending on the conditions, auditors a $500 million their investments in such explained at the often require valuations of hard-to- investment in Private Equity value assets held by private equity several Internet- alternative asset classes, International funds to be performed by independent related start-up and they are beginning to Conference in valuation professional. companies in 2013, “To launch take action. Engaging an independent valuation 2000. The start- this initiative, we firm helps avoid management biases up ventures, used data about while encouraging consistency, along with funds’ portfolios professionalism, due-diligence several other investments the and looked for funds with unusually practices and depth of analysis. This fund held, proved disappointing. low liquidity compared to their peers. naturally benefits investors, but it Reporting states that the In examinations and investigations benefits private equity firms as well. investment in these companies of the target funds, we look for Beyond averting the gaze of the SEC, is now worth $100 million, but misappropriation from portfolio this type of reporting helps build this figure is based on a valuation companies, fraudulent valuations, lies the reputation of the fund manager, analysis of the businesses that was told about the portfolio in order to creating a fundraising competitive performed internally two years ago. cause investors to grant extensions, advantage during the next round. It turns out that the real fair value unusual fees, principal transactions, On the other hand, firms known measurement exit price is likely as well as other situations that for holding and charging ongoing less than $1 million. Even though concerned us. We think the zombie management fees on zombie funds will the fund is nearly dead, the higher manager issue is significant and given face increased difficulty raising capital valuation being reported and the the large amount of capital raised in future cycles as the misalignment of terms of the original agreement in 2006 and 2007, will likely become fund manager and investor interests means that investors will pay higher more important when those vintages becomes clear.Using a professional fees for a longer period of time reach maturity.” firm also can help management in the than should be warranted. audit process, reducing audit time and expenses.

POWERED BY AXIAL 65 In addition, regular professional valuations can help address other potential problems. Without strong valuation procedures: • A fund’s net asset value could be inaccurate • Large swings in net asset values could occur unnecessarily due to the sudden updating of stagnant valuations • Poor internally prepared valuations and valuation practices could lead to litigation from investors and stakeholders • Auditors might provide a qualified opinion to financial statements or refuse to issue financial statements altogether • Institutional limited partners in private equity groups (those that need to produce GAAP-based financial statements), such as pension funds, investments funds and endowments, could not offer timely accurate performance reports to their boards, investors or beneficiaries More frequent, independent fair value measurements are one of the tools needed to avoid zombie funds and the SEC examination and reputational damage they cause. As industry regulations increase and scrutiny continues, best-in-class firms will engage the expertise of independent, third-party professionals to analyze the hard-to-value assets, helping prevent a financial fright. Deal Professionals, Dealmaker Outlook, Fundraising & IR, Post-Transaction, Regulatory/ Legal

POWERED BY AXIAL 66 POWERED BY AXIAL 67 CHAPTER 7: VALUATION BEST PRACTICES

3 Methods for Valuing Your Business By Jaime Raczka | January 21, 2014

You’ve decided to sell your business, and one of the things on the top of your mind is naturally valuation. You’ve hired a banker or advisor and they’ve come back with an estimated valuation range that just isn’t want you were expecting. So how did your bankers arrive at their unsatisfactorily low conclusion – isn’t valuation as simple as applying a relevant revenue, EBITDA, or free cash-flow multiple to your business?

While multiples are a common a variety of non-quantitative factors valuation because they reflect real- shortcut for valuation, conducting and adjust the valuation accordingly. time, real-world valuation data. The a thorough valuation is much more key consideration for utilizing trading Let’s look at some of the primary complex than slapping a multiple comp valuation is to make sure considerations a banker will review on an income statement line item. you have the right universe of peer when it comes to some of the most Determining the value of a business companies – which companies are the common valuation methodologies: can be an opaque and somewhat closest reflection to you in terms of subjective process. So, how exactly, DISCOUNTED CASH FLOW (DCF) size, product mix, growth potential, etc. then, does a banker go about If bankers had a crystal ball into the Bankers will ideally look at a peer group approximating what a business is future, DCFs would be a great way of somewhere between 5-15 businesses, really worth? to value a business. Instead, DCFs but in addition to simply looking at involve a huge amount of discretion in the group average, a smart banker will Any banker worth her salt is going to projecting what a company’s business focus on the companies that look most start a valuation exercise by utilizing will look like for the next 5-10 years. like your business, and consider these multiple methods to narrow in on the Operational assumptions for the model companies’ multiples more heavily right number range. There’s more than are typically provided by a company’s than the group’s average. Helping your one way to value a company, and no management team, so a banker needs banker understand the key differences one method is more accurate than to consider that the validity of the between the peer group and your any other. While intuitively it makes data (and therefore the valuation) will firm can help her understand which sense that all valuation paths lead to heavily rely on management’s ability to companies are most relevant and the same end result, the reality is that accurately predict the future. will have the biggest impact on the once the numbers have been crunched, valuation of your business. a banker is most likely going to end Most buyers, as they start to negotiate up with a handful of independent, with you, are going to attack many of TRANSACTION COMPARABLES estimated values for a business. the assumptions you’ve made about Using transaction comps are hit-or- future growth. By helping your banker miss as a method for reliable valuation. Here’s where the real work begins: understand which line items are highly The challenge with transaction comps looking carefully at the ranges of predictable and which you believe are is that there are likely a limited valuation that your different methods more variable, you’ll be able to get a number (if any) of truly comparable have produced and using qualitative, better valuation for your business and transactions for a banker to consider. subjective insight to distill your various help them in negotiation with a buyer. Assuming a banker is able to compile valuation estimates into a single range a list of transactions that make that makes sense. For each method of TRADING COMPARABLES sense, the data surrounding the valuation, a banker is going to consider Most bankers typically love using trading comp multiples to determine transaction (such as purchase price) is rarely publicly available. And when

POWERED BY AXIAL 68 it is, a banker isn’t going to know that are over-leveraged and struggling what portion of the price paid was The Widening with significant competition. Those standalone valuation and what portion companies have not seen the same was attributable to other factors Valuation Gap increases in valuation multiples because (synergies, control premiums, etc.). By Billy Fink | January 29, 2014 there is some basic deficiency with And finally, recency matters – market the company.” Since these companies conditions, industries, etc. change. “In March 2013, I wrote that we require significant overhaul, and are So, depending on what’s available, should see record valuations in less certain to deliver solid IRR, financial transaction comps can run the gamut 2013 — and, in fact, we did,” said sponsors are not willing to pay as much. from being virtually ignored in a Schmitt believes these companies can valuation process to being a lynchpin John Slater of FOCUS Bankers. still be bought for 5-7x EBITDA. in a negotiation of value. Often, as an Indeed, the high valuations of late have As long as investors are seeking high IRR, industry insider, you’ll have information been noteworthy. However, while they will be willing to pay high valuations. about recent company acquisitions valuations have been on the rise, certain Although these premium valuations are that your banker isn’t aware of or companies — especially the high-quality already at near-record levels, they could doesn’t know much about. By filling her ones — have benefited from bubble-like continue rising in 2014 if… in with more details, she can build a valuations. As Slater explained, “The very more realistic model for your business. good companies are routinely seeing …CAPITAL REMAINS CHEAP AND north of 10x EBITDA.” INTEREST RATES STAY LOW Your banker has now run all the One of the most critical factors numbers, made the necessary The reason for the exponential rise is buoying high valuations has been adjustments, and hopefully determined the overarching focus on returns. While cheap cash. “There is a twofold factor a valuation range. If it sounds like better companies have always been able driving valuations,” explained Schmitt. conducting a valuation isn’t quite as to fetch better multiples, the desire to “One is the low cost of debt which has formulaic as you might have thought, make up lost yield has driven investors to been stable and broadly available and that’s because it’s not. No valuation offer higher and higher valuations. the banks’ aggressive desire to grow method will ever truly account “The market bifurcated itself in their commercial loan portfolios has for all the unique attributes and been beneficial to the M&A market.” idiosyncrasies of a business. The best a 2008 and 2009,” Rick Schmitt of AccuVal explained. “On the one He continued, “The second is the banker can do is account for as many high supply of money available to variables as possible and settle on a hand, businesses which have a solid business plan that is scalable model buyers. The money for leveraging good range that makes the most sense. By companies is coming cheap and there staying involved in the process and and/or produce a product with limited distribution, and less competition are is a lot of competition in order to fund providing information your banker deals. When you see WACC being may not have access to you can more highly desired. In this type of company private equity funds can take influenced by the lower cost of debt, it ensure you’re getting the most realistic helps to justify high multiples.” Given valuation range. these business, put in additional capital, and quickly grows sales and profits.” that PE firms now have $1 trillion in dry And, though your banker is going to powder, paying high price tags is easier. do their best analysis to predict an This ability to quickly scale the business with little additional work is appealing However, any changes to interest accurate valuation range for your rates could rapidly deflate valuations. company, remember that valuation to any GP concerned about his IRR. As John Carvalho of Stone Oak Capital As Slater remarked, “once interest is never perfect and that the only rates go up, valuations will fall.” But, true way to find out the value of your explained, “PE firms are willing to really overpay for a business that fits that won’t likely happen this year. business at any given point in time is “Right now,” explained Slater, “the to approach the market of potential their model because they know they can make the returns on the back end. predominance of analysis says that we buyers completely comprehensively are in a deflationary period and interest with an excellent presentation of your Since there is so much concern about yield, a business that can deliver solid rates will probably stay somewhere business. That is the one final say on your near where they are.” company’s valuation — the price that the returns is worth a high price.” market of buyers is willing to pay. Schmitt continued, “On the other hand, Schmitt agreed, “Many of the banks we work with are projecting that interest Business Owners, Valuation there is still a broad base of companies rates will remain stagnant for 2014.”

POWERED BY AXIAL 69 …STOCKS CONTINUE TO RISE Profit company to a Profit Leader Although the stock market has How to Improve improves value by 2.7X and becoming dipped in the past several days, a Value Leader by another 2.2X for a the general growth over the past the Value of Your combined improvement of 4.9X. year has helped encourage higher MOVING UP THE CHAIN valuations. As Schmitt explained, Company Without So how does an owner move up the “The investment world looks to the value scale from being an average publicly traded marketplace to guide Borrowing a Dime company, to a Profit Leader, and them for what is anticipated for By Gary Ampulski | Midwest Genesis ultimately to a Value Leader? How growth in industries and the relative October 7, 2014 long does it take and what kind of market returns. With the increased Investment is involved? indices in the S&P and NASDAQ, the Business owners can improve buyers have a guideline supporting the value of their companies Going from an Average company to higher multiples for the M&A market.” without any outside investors, a Profit Leader. In general, there are As the stock market continues to four major factors that contribute to rise, comparables will also rise as well, according to a study conducted achieving profit leadership (defined as helping to naturally raise valuations. over the last two years on having margins in the top quartile of the industry): …STRATEGICS COME OUT TO PLAY business value creation. The Despite their cash-laden balance study derives results from • Optimizing product and sheets, strategics have been relatively consideration of industry customer mix inactive recently. “The part that we benchmarks and a Private • Continuous Cost Reduction don’t yet understand is why there isn’t greater demand from strategics,” Capital Market valuation model • Customer value based pricing explained Slater. “In a slow growth applied to data gathered over • Business Process Optimization economy, these strategic acquirers the last two years. The model need acquisitions to grow, and it Most business owners appreciate the doesn’t make sense that they are not is based on input from over 835 benefits of continuous improvement more active.” privately held business owners with the first three items. But the who have received written kinds of improvement that a good Corporate development offices may Business Process Optimization effort look to capitalize on the extra cash by offers for their companies can produce over a two-year period acquisitions that immediately add to during this period. can significantly impact Total Cycle the bottom line. While the results of The study helps conclude that there time in the Order-to-Cash process, our Corporate Development Survey New Product Time to Market, Delivery revealed that 43% of corporate are four different levels of privately- held companies. Those with: Below Lead Times, Operational Productivity, acquisitions are driven by accretion Revenue Increase, Defects, and Margin. or synergies, the recent rise in stock Average Profit, Average Profit, Above prices may also spur many companies Average Growth/Profit, and Low Risk Becoming a Value Leader. The last step to make acquisitions simply on the Companies. These factors – and the in the value enhancement process basis of multiple arbitrage. company’s industry, size, growth, for an owner is focusing on those and risk – are all primary drivers of things that impact value in the eyes As Carl Shapiro mentioned in his New valuation. While valuation is a function of a potential buyer. While size and York Times article, “…deals occur of profitability, the valuation multiple profitability are important, other when corporate profits are high and is relatively independent of profit factors need to be considered as well. the stock market is feeling bullish: or profit margin and the valuation An investor must consider the risks corporate executives seem unable to multiple is most influenced by the involved in creating a stream of profits resist going on a shopping spree when company’s investment risk more than that can be counted on to generate an their stock is soaring and they have lots anything else. acceptable return on what is invested. of cash on hand.” The real opportunity for an owner is to Investors have lots of options for Business Owners, Deal Professionals, Valuation move up the value chain from one level where to put their money and the to another. Moving from an Average attention is going to be on the places that provide the best return for the least risk.

POWERED BY AXIAL 70 Reducing the risks involved with The good news is that based on the To identify the best buyer and maximize generating a future stream of profits application of benchmarking, Business purchase price, the business owner and for a privately held lower middle market Process Optimization and investment the investment banker should both be company is what gives rise to valuation modeling for lower middle market able to articulate the value drivers for multiples that take a Profit Leader from companies in the commercial print the company. Clearly articulating these a 3X multiple of operating income to a space, there is significant opportunity points can help a potential investor see Value Leader with a 5X multiple. for owners to increase the value of their the value of your business. companies. If you haven’t undergone Most investment models consider Below are 5 key value drivers that must a business process re-engineering at least eight areas that contribute be discussed as early as possible in the evaluation effort recently it might be to becoming a Value Leader. Each process so that all parties are on the time see what can be gained by getting area has a number of additional same page: some help in this area. There are also a dimensions and levels that give it number of M&A professionals that can 1. CUSTOMERS character and better definition. The help you understand all the investment One of the most important value study shows how the sensitivity of risks associated with your business today drivers to discuss is your customer. an acquisition model applied to the and how to minimize them in the future. An understanding of how a business manufacturing industry can improve makes money and who its customers value. The model considers the risks of Conventional sports wisdom states are is essential for any PE firm and deal a private company investment as a key that offense wins games but defense negotiation. Too often, I see write-ups component. The value model used in wins championships. In business when or pitch books of a business that do this study includes variability around it come time to sell, profit leadership not explain how the business makes 25 different components contained will get you a good price but a business money. You must be able to answer in eight major categories including: with minimum risk will capture the that question; you have to succinctly Financial performance, Growth & ultimate premium. Doing both is “a be able to tell someone how the Scalability, Concentration Issues, Asset grand slam”! Making it happen takes company makes money. Management, Recurring Revenue, longer than ordering up a breakfast Competitive Barriers, Customer item at Denny’s but the return is You also have to be able to speak to Satisfaction, and Management Strength. nowhere near comparable. how you acquire customers. What is the profile and size of your customer The results show that Valuation Business Fundamentals, Business Owners, base? How do you engage with Multiples for Average Private Preparing for a Transaction them? Having a more organized CRM Companies range from 2.5 – 3.7, 2.7 – and legitimate salesforce, while not 3.8 for high profit companies and up to necessary for a successful deal, can 5X for high value companies. 5 Key Value help demonstrate to an interested PE THE BENEFIT OF BENCHMARKING firm that you are working with regular, So what’s important to maximizing value? Drivers When sustainable customers. With a business, Size, Growth, Cash Flow, Last, but not least, you also have to Risk and Timing are all important. If you Selling a Company be able to speak to how you lose are a seller, nobody is going to pay for By James Darnell | KLH Capital August customers. If your customers are able what you put into the business, they will 14, 2014 to abandon your business overnight only pay for the value they perceive they with little to no switching costs, it will can get out of it. Even most strategic Accessing the private capital be a red flag for many private equity buyers have their own unique reasons markets can be tricky — firms. If you have customers that can for assigning value and they are often leave next week without pain and related to either the growth or cost especially for first time visitors. heartburn, that’s not a good thing. synergies that can be extracted from the Whether you are considering a While it is not an insurmountable acquired business as it is integrated into recapitalization, a management challenge, the deeper entrenched your the owner’s existing operation. Strategic business is in the customer’s life and buyers may or may not share some of buy-in or buy-out, or a business, the better. those synergies with the seller in the family transfer, there are key form of an increase in purchase price. considerations that should 2. INDUSTRY & END MARKETS be discussed and understood In addition to your customers, it is imperative to be able to comment on before any company is brought to market. POWERED BY AXIAL 71 the size of addressable market. There makes investors very nervous. When it comes to financials, the is no need for detailed reports, but Most PE investors want to see a numbers will be what they will be. At you must have a sense of the number fundamental, tangible reason why your this stage of the process, the investor of potential customers and trends in business exists. If you are relying on is probably most interested in seeing that space. Is your industry growing or opportunistic inefficiencies, there is a how organized your business is. The shrinking? Is there heavy regulation? great deal of risk that your business will numbers need to be reliable. We don’t These types of extra-company factors be squeezed out by larger competitors want to be in a situation where we’ve can make realizing a successful or those with vertical integration made a deal, then did some diligence investment difficult for most PE shops. capabilities. You need to demonstrate only to discover that we were misled. that your firm will be around for a long In those situations we have to break PE investors are also concerned about time because it is addressing a clear the deal, which is disappointing for businesses that are highly discretionary. need — and one that no one else can everyone involved. The more confident For example, if your business offers easily replicate. we feel in your ability to track numbers, a completely discretionary item, that the more confident we will feel about means the purchase can be put off 4. COMPETITION the deal. However, don’t worry about during downturns and economic As the interested investor gets the too many add-backs or no CFO — just uncertainty. That is a big risk in future lay of the land, he will also need be systematic with the process. cash flows and, unsurprisingly, a red to know about the level and type flag for many PE investors. Similarly, of competition surrounding your Business Owners, Dealmaker Outlook, Preparing if a business is very cyclical, it can company. You will need to effectively for a Transaction be challenging for an investor. Most be able to address the presence of any PE firms use some form of leverage competitors and how you differ from during an acquisition, and leverage and them. What are the variables? Price? cyclicality is a very risky cocktail. It can Service? Location? To Maximize go sideways on you very quickly. if there is no competition, then you still Valuation, Look to To help assuage an investor’s concerns, need to explain why the customer is you should demonstrate that your buying from you. Are they buying from Sustainable Top business tracks along with the general your firm because of the salesperson? economy. If you can show solid Or because of the right price? It may Line Growth financials from 2007-2010, that is a sound like a silly question, but it is By Ed Marsh | Consilium Global great sign that your business is not fundamental to why a company exists. Business Advisors October 29, 2014 particularly subject to cyclicality or The more and better you can answer customer discretion. the question, the more value you can Business objectives of company demonstrate in your business. 3. SUPPLIERS owners vary as much as the We already discussed the addressable 5. MANAGEMENT & FINANCIALS individuals themselves. Some market and your customers, but now it Only after understanding the full seek moderate growth for is time to consider your suppliers. The ecosystem in which you company two questions you need to address are: exists will the investor begin to look stability in a ‘lifestyle’ business, into the company itself. Understanding Are their any supplier concentrations? while others pursue breakneck the key stakeholders and management If your business is being influenced growth for the “rush” and of the business is absolutely crucial to by your supplier because of their a successful deal. satisfaction. consolidation or control of the market, that is not a deal killer, but it Getting deals done in the lower middle is something that must be disclosed market is so much more about the to the PE firm as soon as possible. It is psychology of the stakeholders than important to understand the costs and actual financials. You need to make risks of switching suppliers. sure everybody is happy. This is why most PE firms will spend so much time Can a supplier go straight to your getting to know the management team customer? If that is the case, it and making sure there is a fit. If you try and fit everyone into a predetermined box or equation, the deal will fail.

POWERED BY AXIAL 72 As companies mature, and owners Managers must squarely confront the 3. The source of growth determines age, those objectives often evolve. For dissonance that exists in common its profitability and repeatability. every company there’s a moment when approaches to managing top line It’s easy for companies to adopt the theoretical and distant prospect revenue growth vs. operations and tactics that will bump the top of a transition suddenly becomes real bottom line cost factors. Rigor and line in the short term but have and immediate. Some owners carefully scientific management are commonly consequences to sales and plan and prepare themselves and their applied to the bottom line while top profitability in the longer term. companies in advance – others react to line growth is managed with stale Revenue growth needs to be circumstances. Regardless of the path methods. Just as companies might built on strategies which create by which they arrived, that moment have added another inspection cumulative inertia and which can focuses participants intently and station at the end of a line before be clearly measured and managed exclusively on a company’s bottom line. they embraced operational excellence, for continuous improvement. today companies add another This focus is both understandable and 4. Diversity of revenue also impacts marketing program (e.g. SEO or social natural. Most companies habitually its value to an acquirer. Just media) or another sales resource attend to the bottom line by rigorously as concentration risk incurs a (inside rep making cold calls) to fix managing operations and costs. They discount, conversely broadly inconsistency in the top line. often implement lean initiatives for diverse top line revenue increases key business processes, and managers IT’S TOO EASY TO THINK OF IT appeal. Diversity can be achieved rely on “dashboards” of financial JUST AS REVENUE across product lines, industries performance metrics to flash early The direct connection between a and geographic markets, including warnings of trends. There’s a strong strong, growing top line and enterprise globally even for SMBs. and common culture in American valuation is clear. But consistent top 5. Global diversification not business that focuses management line growth, and the approaches that only vastly increases market attention on the bottom line. create it, have additional tangential opportunity size, but also provides implications to maximize valuation that Companies grooming their financials a further layer of revenue security are often overlooked. for an impending transition have little to the extent that markets are choice – the only place to readily 1. Business owners can often somewhat decoupled – economic “move the needle” in the short term is substantially improve their cycles aren’t directly correlated. to cut costs. valuation by accepting a higher All growth isn’t equal, as they say, “earn out” component. When THE BOTTOM LINE IS CONNECTED and the source of revenue growth that income stream is uncertain, TO THE TOP LINE impacts its value. business owners are naturally The “bottom line” snapshot doesn’t provide hesitant to take an earn out. But if MANAGING GROWTH OR much texture, but it is the inexorable the income stream is reasonably RUNNING THE BUSINESS sum of the top line and the costs. As secure (and who knows this better Every manager faces the challenge of such, it’s an indicator. But the science than the current management) balancing competing priorities and of business valuation recognizes the a larger earn out component resource constraints. Their first job inherent limitations of a static indicator shouldn’t be unnerving. When is to run the business, and there’s no and therefore works with a projected revenue growth is a function of a easy answer to the question, “How do profit stream. In other words, it’s a video broad, diverse and systemic effort, I grow in a way that strengthens my compared to a single snapshot. Cutting it’s easier to “bank on.” business and increases our resilience costs is equivalent to posing the snapshot and viability?” while the ongoing storyline is primarily a 2. Security of future revenue. reflection of the top line. Similarly, earn-out aside, a buyer It’s easiest to answer that first in the will carefully consider the security negative. Don’t just add another rep, The challenge for companies, whether of the revenue stream and the another trade show, another series of they are embarking on a 3-5 year trend – not just the magnitude magazine ads, etc. Simply doing more program preparing for a managed today. The same consid­­­erations of what isn’t exceptionally effective transition or simply bolstering that influence the seller will impact won’t make it so. resilience and vitality to increase value the buyer’s comfort with future for current owners, is to grow the top revenue. line consistently. Doing so requires a change in business mindset.

POWERED BY AXIAL 73 The real answer is to reengineer your • Gets you found attainable by pressing harder on the revenue growth model, and there are • Establishes credibility and converts accelerator of traditional approaches. two customer centric themes that traffic to prospects Rather it takes an enlightened and bold guide successful initiatives: approach to business development • Builds authority gradually and • Enable buying nurtures prospects into leads analogous to the revolution on • Focus on the right prospects operations of the last two decades – and • Supports buyer requirements, it takes time to build. Companies that These are deceptively complex – both largely virtually, through their in tactical execution and in the buying process to convert leads forge ahead will thrive. mind-shift that is required for most into customers Business Owners, Dealmaker Outlook, Preparing companies to succeed. for a Transaction • Leverages the vast reach of digital ENABLE BUYING tools to create a flow of “referrals” Back in the last millennium, buyers from leads & customers needed sales reps since they were BUILD A BUSINESS WITH THE Valuing Platform the link to the information buyers RIGHT BUYERS needed in a world of asymmetric This sounds simplistic, but very few Companies vs. information distribution. Sales cycles companies really execute it well. were generally linear and predictable. Typically companies define their targets Add-Ons: The The periodic direct contact between reflexively based on historical success. buyer and rep created a tempo and a That’s a self-limiting approach for New Art of series of progressive ‘yeses’, afforded several reasons: the rep the opportunity to keep tabs Negotiating on the buy side process and status, • Industries and markets evolve – By Rick Schmitt | AccuVal-LiquiTec and allowed capable reps to sell – to traditionally strong verticals will October 14, 2014 influence the process. likely slow, and future growth will come from different areas Today buyers no longer need reps Could today’s increase in for information (except in late-stage • Ideal buyers at one stage in a “add-on” transactions mean negotiations.) And buyers who have company’s growth are often less that valuation multiples are on always disliked “sales reps” now use profitable during another phase the rise? technology not only as a proxy for • Most companies identify target Over the past few years, PE firms reps, but to avoid them (hide behind buyers and markets based on have been heavily involved with caller ID, etc.) a product centric approach vs. add-on acquisitions, rather than There is still a critical role for a talented, an empathetic understanding platform companies. (In 2012, add-on creative sales person – but sales, as customer business value drivers acquisitions represented approximately most companies persist in practicing it, • Traditional models tend to limit one half of all PE buyout activity.) With is dead. Today the ‘secret’ to revenue sales geographically (by region, the economy on more solid footing, growth is to help people buy. That’s country, continent, etc.) but more businesses — including large and tough enough if your product is a cup today the digital reach of sales small privately held companies — are of coffee – it’s downright challenging if and marketing is without border, returning to the M&A marketplace. your’s is a complex sale. and global transactions are vastly That means more opportunities for The key is buyer empathy and an simpler and safer acquiring platforms, and broader approach that leverages digital tools THE VALUE OF GROWTH possibilities for supporting add-ons. to establish thought leadership and Not only does the old bromide that a At the core, these new platform/add-on authority. Companies can create a dynamics are causing a shift in the art framework that builds relationships ‘business that isn’t growing is therefore of performing business valuations, as with buyers through a virtual sales dying’ apply, but for companies preparing value can differ significantly based on process. It: for a transition (and every company the viewpoint of the deal participant. should be!) growth must be sustainable, This means it is more important than predictable, and secure. That’s not ever for a company to have a holistic understanding of the market.

POWERED BY AXIAL 74 WHAT ARE PLATFORM For example, the platform acquisition SYNERGIES AND SNAGS: WHAT’S COMPANIES? WHAT ARE ADD- of Whole Foods, currently valued at IMPORTANT TO WATCH? ONS? $13.9 billion, has rolled in a number of Analyzing possible synergies makes a The key characteristic of platform smaller add-ons, including independent critical difference when valuing add- investments and add-ons are grocers, a coffee maker, a vitamin ons. The most desirable add-ons can summarized as follows: brand and more. These add-ons bring benefits like: take advantage of the platform and • Platform investments typically • Lowering costs by merging sales create synergies that help increase include companies in high- staff with similar expertise the sales penetration and/or decrease growth industries that command the operating costs for other add- • Expanding sales into regions significant market share. They ons. These synergies make both the not currently served, either often are well managed, are platform and add-ons more valuable. domestically or internationally reasonably capitalized and have broad distribution and market Keep in mind, a company might • Increasing product offerings exposure. These companies likely represent a platform to one buyer and • Cross-selling/upselling have multiple avenues of growth an add-on to another. For example, as opportunities for existing products and clear opportunities to leverage of the publication date, there were their position in the market. They rumors that Whole Foods itself might • Eliminating duplicate management typically command a premium be acquired by the Florida-based Publix • Consolidating financial functions, price when sold. grocery chain, valued at $24.1 billion. such as treasury and tax • Add-on companies often aren’t WHAT’S THE VALUE OF A • Eliminating idle manufacturing viewed as industry leaders and BUSINESS THAT HAS DIFFERENT capacity might suffer from issues with VALUES TO DIFFERENT BUYERS? management, undercapitalization, The simple answer: It’s worth what • Boosting buying power lack of broad distribution or someone is willing to pay for it. In recent years, most add-on limited exposure to their industry. Platforms and add-ons don’t require transactions have involved target Combining platform companies different valuation techniques. The companies within the lower-middle and add-ons through acquisitions valuations of both types of companies market classification, with valuations can leverage the value of both, use common approaches such as between $5 million and $50 million. considering the built-in efficiencies discounting projected cash flows at The sluggish economy from 2010 of combination and the realization of an industry rate of return, and the to 2012 presented opportunities to economies of scale. market approach, which compares one a number of “smaller” companies business to the sale of similarly sized that traditionally might have been WHAT ARE THE “BUY AND BUILD” businesses in the same industry. The overlooked by big PE firms without the BENEFITS? difference in valuations comes in the benefits of an add-on. The PE firms’ PE players seek the perfect balance art of estimation of the future cash desire to put capital to work, along between acquisitions of platform flows, or the level of comparability to with prior platform acquisitions, made companies and value-boosting, sales of similar companies. these acquisitions logical during this incremental add-ons. When fleshing time period. out an offering in one industry — It’s critical to clearly understand the let’s say the grocery business — it companies and the internal factors But generally, lower-middle market makes sense to use a key company’s impacting their attractiveness to businesses haven’t always had the established name, infrastructure and the broader market. These include access to capital or professional management capabilities to maintain sales, distribution, cost structure, management to help them intrinsically a stable presence in the market, then management and capitalization — and grow. The benefits afforded by selling leverage the increases in overall value the many detailed facets within each of to a PE firm help to correct a number as add-on companies are acquired. these categories. of issues. However, the additional costs required to repair a stagnant or troubled company can lower valuations. Some common drawbacks that affect add-on valuations include the following:

POWERED BY AXIAL 75 • Lack of sales distribution But valuing add-ons gets more complex, WHERE ARE THE BIG particularly when PE firms need to put OPPORTUNITIES? • Management gaps capital to work and grow acquisition Industries considered “recession-proof” • IT fragmentation categories. They’re able to offer higher are commanding heavy interest. Oil • Less detailed accounting and prices, in terms of EBITDA multiples, and gas. Medical and pharmaceutical. understanding of cost structure but that doesn’t always mean they will. Food. Software. Most commonly, deals are sourced by investment bankers Imagine a lower-middle market grocer. • HR issues, such as increased costs working on the buy or sell side, looking As a standalone company, let’s say the when merging benefit platforms for ideal targets to maximize value. business, which generates $6 million • Cost of merging operational of EBITDA when considering all of its Some PE firms search for logistics standalone benefits and issues, might complementary companies shortly The cost and time to fix these common receive a five times EBITDA multiple, after platform acquisitions, if there’s issues affects the desirability and price or a $30 million valuation. However, not much work needed to stabilize the paid for an add-on. a prospective PE firm plans to platform company. For other platform roll up this company into a larger deals, the process is longer and more Since the synergies of a transaction platform, so when considering complex and thus delays the process of and the associated projected cash the combined, projected EBITDA, finding add-on candidates. flows may vary from buyer to that’s now $8 million. This might As for businesses, is it better to be buyer, the resulting valuation by a result in a sale that appears to be acquired as a platform or add-on? specific buyer can be different than a multiple of eight times current It’s situational. Platforms traditionally a market consensus projection. EBITDA, increasing the value based command a premium. But the right When capitalizing a buyer-specific on the trailing EBITDA and market add-ons, though they might be smaller, cash flow analysis, the results of the perception of value by 33 percent. valuation are often referred to as may negotiate similar, higher multiples the “investment value” rather than That’s where negotiating skills come in the right circumstances. into play. If there’s competition the “market value” of the business. WHAT DOES THIS MEAN FOR PE to buy this grocer, then the PE In today’s fast-paced environment, FIRMS? firm might be forced to pay a these variations in perceived “value” Negotiations are rarely straightforward, higher multiple relative to recent are part of what buyers have to and calculations based on synergies transactions for similar stand-alone deal with when competing for the and costs are only becoming more businesses. This converts some roll- purchase of a business. complex. Is there a simple formula up synergies of the buyer back to the for choosing the right valuation WHAT’S THE NEW ART OF seller, and puts more pressure on the for a platform or add-on? No. But NEGOTIATING? PE firm to intrinsically grow post- understanding the total picture and The right platform companies generally merger to justify the premium. command a premium. Competition the benefits of combination is key to sets the price for these companies. If the PE firm chooses to pass on the increasing the leverage of acquisitions With growth in the M&A market and deal due to the seller’s request for a and overall value. more prominent companies entering higher valuation, then this might mean Deal Professionals, Dealmaker Outlook, the playing field, there’s no doubt we’ll the benefits of synergy of this potential Negotiation, Valuation see more deal making — sometimes acquisition will accrue to another with hefty multiples paid — for major PE firm that elects to complete the platforms. In late June, the aluminum transaction. Ultimately, the fit with the company Alcoa announced a nearly platform and opportunity for post- $3 billion acquisition of Firth Rixson merger synergistic growth represent (owned by Oak Hill Capital Partners), a key factors in negotiating the final manufacturer of jet components; Alcoa value between the buyer and the seller. is attempting to increase its presence in the aerospace market. This is one of numerous examples of the desire to expand market share.

POWERED BY AXIAL 76 1. WHAT ARE THE UNDERLYING other factors might not go away as 12 Critical ASSUMPTIONS? the economy or industry recovers. Understand the assumptions Make sure projections incorporate any Valuation underlying the projections. changes the company needs to make in Assumptions should be reasonable and order to address the underlying causes Questions to Ask well-supported. Make sure it is clear of financial distress. exactly how the distressed company 5. ARE COSTS OF DISTRESS When Investing in will meet its projected revenue growth. PROPERLY REFLECTED IN THE Discuss whether projected operating Distressed Assets PROJECTIONS? profit margins are really obtainable. By Cameron Cook | AccuVal-LiquiTec Distressed companies often have July 29, 2014 2. SHOULD THE PAST BE RELIED extra costs that relate to or stem from ON AT ALL? financial distress. These may include Valuations of underperforming The company’s historic but are not limited to restructuring businesses have peaked in performance might not be a good consultant or turnaround management benchmark of how the financially fees, extra legal expenses from labor recent years. While the overall distressed company can perform in litigation, severance pay or expenses process of valuing financially the future. Be careful of projections from employee terminations, extra distressed versus healthy that simply “assume” the company accounting expenses due to stronger will reach the same levels achieved reporting requirements from banks companies is largely the same, in the past. For some businesses, and investors and even retention some modifications are needed. returning to the performance level bonuses to retain key personnel. Private equity groups and of the prior peak may take years; Similarly, litigation and settlement other investors in distressed for some, it will never happen. costs for outstanding warranty claims, environmental liabilities and other legal 3. ARE THE PROJECTIONS BIASED? assets must be aware of disputes should be properly factored Studies have found that analysts these nuances when running into projections. who prepare projections and predict discounted cash flow (DCF) earnings more often overestimate 6. ARE PROJECTED CAPITAL models. Heightened focus than underestimate. This “positive EXPENDITURES ADEQUATE? on due diligence procedures, bias” is common, particularly in down In an effort to conserve cash, it is times when many companies simply common for distressed companies especially the source of assume they will be able to get back to to defer capital expenditures for financial projections, is essential. where they once were. Management is maintenance, replacement and new When valuing a financially distressed expectedly optimistic. But projections development. Projections should capture business as a going concern, it is need to fully consider pressures the full capital expenditures needed assumed the company will move the market will apply to prevent the to return the company to the level of forward under some plan of recovery company from achieving projected production assumed in the forecasts. performance targets. rather than be shut down and 7. IS PRODUCTION CAPACITY liquidated. Under this going concern 4. WHAT IS THE REAL CAUSE OF ADEQUATE TO MEET THE premise, the DCF method of valuation THE FINANCIAL DISTRESS? PROJECTIONS? is often relied upon. Be sure the cause of financial distress In a similar vein, a distressed company’s Following are 12 questions to ask is known, understood and addressed plan of recovery might be to produce during the preparation or examination by the company. Sometimes the more of a particular new line of of financial projections. These economy is blamed for business product or to sell more “commodity” questions will improve understanding decline but other contributing factors or “standard” product, which may of risk, mitigate surprises and, such as a permanent shift in consumer require increased production capacity. ultimately, improve investments. preference or the strengthening of Further, projections often project a competitor are overlooked. Those production levels that go beyond the current capacity of the company.

POWERED BY AXIAL 77 Make sure projections incorporate 10. IS THE TIMELINE TO RECOVERY projections uncovered through this the expansion investment required REASONABLE? examination will help determine the to achieve those production levels or Restructuring can take time, and appropriate discount rate applicable to moderate production forecasts to fit working through legal challenges takes the company. This match between the current capacity constraints. management resources away from risk of the projections and the discount operations. The length of time needed rate used is critical to an accurate 8. IS THE PERSONNEL EXPENSE to establish a stable level of future valuation. ADEQUATE TO MEET THE performance is often longer than PROJECTIONS? Deal Professionals, Dealmaker Outlook, projected. The projected timeline of Labor, at all levels, is often reduced Preparing for a Transaction, Valuation recovery is most likely over optimistic. to a very lean level during periods of financial distress. Projections should 11. ARE THE TAX ATTRIBUTES take into account the full extent of OF THE COMPANY PROPERLY additional production, sales and PROJECTED? management personnel needed Net operating losses (NOLs) can affect to support forecasted increases in the projected cash flow of a company production and sales. Looking at working through financial distress. The historic or industry labor hours to company might be able to use NOLs production ratios might test the to offset future income tax payments, reasonableness of labor assumptions. resulting in enhanced future cash flows. But the availability of NOLs and their use 9. ARE PROJECTED INVESTMENTS are dependent on several factors. The IN WORKING CAPITAL ADEQUATE? extent that NOLs can provide benefit to The additional investment in working the distressed company being valued capital needed to support the needs to be taken into account in the projected business operations needs DCF analysis accordingly. Question to be included in the projected cash forecasts that show tax expenses flows used in the DCF analysis. This projected at a constant tax rate. can be challenging, particularly in poor economic times or distressed 12. WHEN WERE THE situations. In order to increase cash PROJECTIONS CREATED RELATIVE flow, a distressed company might try TO THE VALUATION DATE? ARE to accelerate accounts receivable or THERE OTHER PROJECTIONS? even factor them, sell down inventory Projections created a significant time to bare levels and at the same time before the valuation date may no stretch accounts payable. This longer accurately reflect the expected temporarily increases cash flow but performance of the company as sacrifices working capital levels. These of the valuation date. Make sure reduced levels of working capital are that projections are timely and best likely not sustainable and, during the represent the most likely performance recovery period, the company will need of the distressed company. If there to invest in working capital to restore are best, most-likely, and worst a more functional level. Assumptions cast projections available perhaps regarding inventory turnover, accounts a probability weighted valuation receivable collection rates and the methodology is appropriate. willingness of suppliers to extend terms These questions and others can should be realistic. provide insight and help assess the risks of projections used in the valuation process. The risk of the

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