It Takes Two…
How to Sell your Company to an Institutional Buyer
By: Nicholas J. Malino Tango Equity, Inc.
Copyright Warning This document is the property of Tango Equity, Inc. Any infringement on our copyright interests will be prosecuted in U S Federal Court where a fine up to a maximum of US$100,000 statutory damages plus our court costs and attorneys' fees will be levied. 2 Tango Equity
Table of Contents Introduction...... 5 Chapter 1 About Buyers...... 7 Strategic Buyers...... 7 Tactical Buyers ...... 9 Financial Buyers ...... 11 Summary of Chapter One ...... 17 Chapter 2 Why this May be the Best Time to Sell ...... 18 The Magic of Leveraging...... 22 Chapter 3 Intermediaries and What They Do ...... 25 The Services...... 26 The Documents ...... 26 The Blind Summary...... 26 The Short Executive Summary ...... 29 Fees ...... 29 Discounting the Future and Its Relation to Purchase Price...... 31 Exclusivity ...... 32 Sample Definitions in a Listing Agreement...... 33 How Intermediaries Operate...... 33 The International Competitors ...... 34 The Independent Middle Market Specialty Firms ...... 34 The Main Street Business Brokers...... 35 Chapter 4 The M&A Process...... 37 Overview of the M&A Process...... 37 The Decision to Sell...... 38 Getting the Company Prepared for Sale ...... 38 Use an Intermediary or Do it Yourself ...... 41 The Documents ...... 45 Sidebar: Separating Due Diligence from Initial Assessment...... 50 The Letter of Intent ...... 51 Responding to the Letter of Intent ...... 61 Due Diligence ...... 72 Field Due Diligence ...... 74 Internal Primary Source Verification...... 76 External Primary Source Verification...... 78 Case Study – Due Diligence Diligence...... 79 Secured Debt...... 79 Data Reduction...... 83 Financial Analysis...... 85 Chapter 5 Fundamentals of Valuation ...... 86 Value and Purchase Price...... 86 Valuation Methods...... 87 Discounted future earnings method ...... 87 Comparable Multiples...... 90 Revenue Multiples ...... 91 A Comparison of the Methods...... 96 Tango Equity 3
Asset Based Methods...... 97 Chapter 6 Deal Structure...... 99 The Asset Transaction...... 99 The Stock Transaction ...... 99 Forms of Consideration...... 101 The Asset Sale and Purchase Agreement...... 102 Chapter 7 The Basics of Financial Statements ...... 105 The Income Statement ...... 106 Balance Sheet...... 110 Statements of Cash Flow ...... 113 Chapter 8 Summary of Tango’s Approach ...... 115 Start with the Buyers...... 115 Relevant Offering Memoranda ...... 117 Selective Engagements ...... 117 Shift Some of the Financial Burden from the Seller to the Buyer...... 117 The Tango Advantage – The 2% Solution...... 118 Advantages to Sellers...... 118 Advantages to Buyers ...... 120 Conclusion ...... 122 Index of Appendices and Exhibits ...... 123 Exhibit A-1 – Due Diligence Documentation...... 124 Exhibit A-2 - Buyer’s Detailed Due Diligence Checklist...... 125 Appendix B-1 –Short Blind Summary #1...... 167 Appendix B-2 Short Blind Summary #2...... 168 Appendix B-3 – Short Blind Summary #3...... 169 Appendix B-4 – Short Blind Summary #4...... 170 Appendix C – Seller’s Short Questionnaire...... 171 Appendix D – Non-disclosure, Non Circumvention Agreement...... 175 Appendix F – Sample Confidential Information Memorandum...... 183 Appendix G – Sample Financial Model...... 210 Appendix H – Executive Summary ...... 255 Appendix I – Non Binding LOI, RPP...... 258 Appendix J – Final Binding Letter of Intent...... 261 Appendix K – Asset Purchase/ Sale Agreement...... 263 Appendix L – Determination of Net Tangible Equity...... 317 Exhibits...... 318 Exhibit 1 – International Widget, Inc – LCFY Income Statement (by Quarter)...... 318 Exhibit 2 – International Widget, Inc – Recast LCFY Income Statement (Adj. EBITDA).....319 Exhibit 3 – International Widget, Inc – Balance Sheets Quarterly...... 320 INDEX...... 321 About the Author ...... 325 About Tango Equity...... 326 About the Author ...... 325 For Sellers...... 327 Seller’s FAQ ...... 328 For Buyers...... 331 4 Tango Equity
It Takes Two.... Tango Equity 5
It Takes Two…Selling Middle Market Companies to Institutional Buyers
Introduction
The purpose of this book is to discuss the advantages of selling a middle market business to an institutional investor; in particular those institutional investors referred to as private equity groups.
Today private equity groups are among the best buyers available for middle market companies. Private equity groups have billions of dollars that are specifically earmarked for investment in businesses operating in North America. The economic slowdown has resulted in a shortage of good-quality middle market opportunities for these buyers. As a result, good companies with revenues between $2 million and $150 million are very much in demand. Furthermore, many of the large consolidators in specific industries have also been affected by the economic downturn and are focusing their capital and human resources on their core business rather than looking for acquisitions. Private equity groups and other institutional and financial buyers are under pressure to invest their funds and to locate investment vehicles that surpass the miniscule returns of “safe” investments and avoid the volatility of the stock market.
We will begin by talking about buyers, and we will discuss the different types of buyers and what in general, each group is looking for. In addition to defining private equity groups and the major types of institutional investors, we will also discuss the overall M&A process, business valuations, business intermediaries and their role, and the due diligence process. The book is focused on institutional buyers and the case studies are often presented from the buyer’s prospective. This will give the seller of a middle market business a unique insight into the methodology often employed by institutional investors when making their investment and valuations decisions. After discussing the buyers, we will focus more on why a very good seller’s market now exists for middle market companies, especially with so many institutional buyers seeking acquisition opportunities.
Following this we will present some information on the various types of business intermediaries and discuss their roles and how thy can add value to a transaction. Next, we will discuss the M&A process itself and follow a particular transaction from the initial stages through due diligence and then complete the transaction in the following chapter on deal structure.
We will then present some current proprietary information regarding which industries are currently in demand and which are not considered attractive by the institutional investors. We have included quantitative analyses to demonstrate certain principles. Oftentimes we have gone into considerable detail in presenting some fundamental aspects of an issue that is relevant beyond the specific example.
Next, we will introduce the Tango Approach, and how we can provide solutions to some of a business owner’s issues. The Tango Approach to middle market M&A is unique. By following the Tango Approach an owner of a middle market business can reach the top echelon of 6 Tango Equity institutional business buyers in an efficient manner and save hundreds of thousands of dollars by doing so.
We have also included a chapter on basic financial statements and financial statement analysis. In order to understand deal structure it is important to become familiar with the concepts used in corporate finances. We will deal with certain aspects of corporate finance that are necessary to understand the M & A process and transaction structure.
Lastly, this book is intended to be a primer, and a basic overview. It is presents the rudiments of the M&A transaction process particularly those involving institutional business buyers. It is intended to familiarize a business owner with these processes, the language, and some basic points of corporate finance that is specific to M&A transactions. It is not meant to be a do-it- yourself manual. It does not provide legal advice or advice on tax matters. The book discusses a generic process and makes some observations on the legal and business aspects of various approaches to M&A transactions. However, the M&A process is not a one size fits all procedure. We have completed 56 transactions in the last several years and no two have been alike. Every one has idiosyncrasies and unique characteristics that make each transaction distinctive. Each buyer has its own set of acquisition characteristics and objectives and each seller has his or her own set of objectives. Although these differing objectives may appear to be in conflict or mutually exclusive, they present a puzzle. The solution becomes how to structure a transaction in which each party gets what it wants. In certain situations, if the two sets of objectives are mutually exclusive and without compromise, there is no solution. If that is the case, it is best to find out quickly before the parties waste too much time on a transaction that is not going to have a successful conclusion. However, most of the time there are solutions, although they are frequently not readily evident. Each transaction is unique, and there is almost always an optimal solution. It is the job of the M&A consultant in conjunction with the other professionals involved to utilize their expertise to discover that optimal solution. When a business owner has made the decision to formulate an exit strategy, one of the first steps is to gather a high-quality team to help with the process. The team should consist of a business intermediary or M&A advisor with experience in middle market transactions, a corporate attorney familiar with M&A transactions, and the corporate accountant. If a personal financial advisor will be managing the proceeds from the transaction, it is a good idea to get them involved early in the process because they could have constructive suggestions when structuring the transaction that would be specific to the seller’s future goals and objectives, that the other team members may not be aware of.
If you have any questions regarding anything covered in this book or require information on any other related matter, please call us at Tango Equity at 800-503-5868 or 212-586-7660. Tango Equity 7
Chapter 1 About Buyers
The name Tango Equity was selected for a very good reason, and it is not because any of us are very good dancers! In any successful M&A transaction, whether it be the sale of a local drycleaner or a multi-billion dollar international conglomerate, there is one overriding universal law. That is, to make a deal work it takes two (like the tango). A successful transaction is one in which the buyer and the seller each get what they want. It is a win-win situation. The buyer may get a business that will act as a platform or a cornerstone for a future expansion strategy, and the seller will receive a healthy return for their efforts from what may be his or her life’s work. I personally, have spent more than 15 years in the M&A industry, mostly on the buyer’s side in middle market M&A transactions and the most important thing that I have learned is to listen to the seller. To find out what is most important to him or her and then attempt to structure the transaction to satisfy those needs while simultaneously meeting the buyer’s financial requirements for the transaction, is what makes this part of the business an art and what separates the successful intermediaries from those who are average. Nevertheless, we will begin with a discussion of buyers in a broad sense. In general, there are three types of buyers – the strategic buyer, the financial buyer, and the hybrid buyer who is a combination of the two.
Strategic Buyers
A strategic buyer is a buyer that is already in the industry. Typically, a strategic buyer is a competitor in the industry although not necessarily a direct competitor. What is meant by that is that a strategic buyer operates in the same industry but may not provide specifically the same services. The strategic buyer may provide similar services, but not necessarily to the same mix of clients, or; the strategic buyer may provide similar services to a similar mix of clients but does so in a different geographical location. These motives of the strategic buyer are what essentially makes them a strategic buyer. The buyer is typically employing a business strategy to do at least one of three things:
1. Add to Service or Product Mix – Each of the two companies has a menu of products that they sell or services that they offer to their customers and clients. A common strategic business maneuver would be to acquire a business that offers services or sells products that are complimentary to, but different from, the products or services that they currently offer. This gives the acquiring company a new product or service line and the opportunity to cross-sell. Cross-selling refers to the opportunity to sell the goods or services of the newly acquired company to the customers of the acquiring company, and if the acquiring company has any goods or services that are not currently being provided by the target company, to be able to sell the goods or services of the acquiring company to the customers or clients of the target company. Cross selling is one of those concepts that works better in theory than it does in practice. 2. Add to or Change the Client Mix – Each company has a client roster and in assessing the viability of a merger transaction, the more the client lists overlap, the less attractive the business consolidation is. To demonstrate why this is true 8 Tango Equity
we can use an example from a service industry. If the selling company and the buying company are both providing services for the same client, it is unlikely that that client will increase the amount of services that it is buying from the companies subsequent to a merger. In fact, the contrary scenario is much more likely. If a company is buying services from four providers – A, B, C, and D. And, if each is receiving 25% of the business, the customer is probably doing so for a good reason. It may want to retain a competitive pricing environment, or to avoid reliance on one or two providers. If Companies A and B were to merge it is unlikely that the customer would continue to give the combined company (AB) 50% of its business. More than likely, it would identify and engage a new supplier or give each of the remaining suppliers one third of the business going forward. The merger will result in a decrease in sales. On the other hand, if there is little overlap in the client roster and better yet if there is significant diversity in the two customer lists regarding the size of customers, industries serviced, or relationships with national consumers, the merger can be very attractive. It is common for a company wishing to break into a new industry do so via a strategic acquisition. The acquiring company may have superior financial resources that will enable it to exploit the targets relationships with its unique customer base and expand the business more effectively. In the unusual situation in which a customer base has a large national geography, the concept of cross-selling seems to work better than it does in general. A target company having a contractual relationship with a national or international client may offer an opportunity for the acquiring company to expand this relationship subsequent to a merger transaction.
3. Add Geographic Locations – the third strategy is simply to add to a company’s geographical sphere of influence. If a company is operating regionally in the Northeast and has developed a significant market penetration in that area, marginal or incremental market share may be increasingly difficult and expensive to acquire. Expanding into new markets may be a viable solution to ensure continued growth, but growing a business from scratch in a new market is daunting, risky and expensive. Thus, the acquisition of a successful business in another region of the country is an attractive alternative.
Although the three reasons above are the most common business strategies that make a strategic buyer just that, there are also other advantages in the consolidation process. While the main motivations of strategic buyers is top line oriented, that is, focused on increasing revenues, there are also some favorable impacts on the expense section of the income statement. These consist mainly of certain active and passive consolidation efficiencies that are natural and favorable by- products of the process. These are also the main drivers in the acquisition criteria for a subgroup of the strategic buyers, which we will call the tactical buyers. We will discuss tactical buyers and their differences from strategic buyers shortly. Consolidation efficiencies consist almost entirely of the impact on the indirect costs. As discussed later, the indirect costs are operating costs that are not incurred in the direct production of revenue. Indirect costs include but are not limited to rent and utilities, administrative and clerical salaries, insurance, and office equipment leases. Active consolidation efficiencies, as the name implies, are actions that the buyer elects to Tango Equity 9 take and then completes subsequent to closing. Examples of active consolidation efficiencies are consolidation of back office functions such as billing operations, elimination of the duplication of administrative costs (both companies may have a CFO) and consolidation of office locations and the elimination of occupancy costs. In addition to the active consolidation efficiencies there are passive consolidation efficiencies. While they are not truly passive in an absolute literal sense they do require minimal action and are somewhat automatic. Examples would be savings from the consolidation of insurance policies and the savings resulting from the use of one independent auditor and legal support firm. In a typical acquisition the economic savings resulting from active and passive consolidation efficiencies amount to approximately 5% of the revenues of the target company. While this may not be the exact focus of the strategic buyer, the effects of these efficiencies are significant. A group that recognizes the significance of such efficiencies is a subgroup of this class of buyers which we shall call the Tactical Buyers, because their underlying business purpose for their acquisitions is more tactical than strategic.
Tactical Buyers
In the M&A industry, the tactical buyer is typically considered a strategic buyer. However the tactical buyer is employing more of a tactic than a strategy. The tactical buyers are not seeking companies that will bring on a broader service or product mix or a more extensive and heretofore untapped customer mix. Nor are these buyers concerned with extending their geographical sphere of influence. The tactical buyer is concerned with exploiting the consolidation efficiencies in a transaction, whereas in strategic transactions the net effect of the consolidation efficiencies tends to be around 5% of the target’s revenues, in a tactical transaction the percentage usually is much higher. The tactical buyer seeks companies with a complimentary but not overlapping client roster, a similar product or services mix and, usually, an identical geography. The ideal target acquisition for a tactical acquirer is a high gross margin company. This is because a high gross margin company has lower direct costs and higher indirect costs as a percentage of net revenues. In a business consolidation there is usually, little can be done to change the direct costs in a business consolidation. The direct costs are the costs used directly in the production of the revenue. For manufacturers typically direct costs consist of the cost of the raw materials that are used and the cost of the labor that puts the raw materials together. In a service business, the direct costs are the costs used to provide the services that the client or customer pays for. If you build more products or generate more services the direct costs increase. Direct costs are typically variable costs that fluctuate proportionately with the revenues unless a company is not being managed properly. In most cases, there is little that can be done in a consolidation to change these costs. Perhaps in a larger organization a few percentage points can be reduced because of volume discounts but there is not typically a lot of room for efficiencies. That leaves the indirect costs. Unlike direct costs, indirect costs tend to be more fixed and vary very little except when there are material changes in the levels of revenue. Indirect costs are not directly related to production or revenue levels but are still required in the production process. They are significantly more manageable and more easily adjusted following a business consolidation. The tactical acquirer focuses on these potential efficiencies to create a value-added situation. Because the indirect costs are virtually the only costs that can be managed, the tactical acquirer tends to focus on businesses with high gross margins. The gross margin is equal to net revenues minus direct costs. Thus, the higher the direct costs the lower the gross margin. 10 Tango Equity
Staffing Engineering Table 1 is a comparison of typical businesses Business Business in two different industries. Both are Net Revenue 10,000,000 10,000,000 achieving revenues of $10 million and both are realizing profits of 15% at the operating Direct Costs 8,000,000 5,000,000 level. The way each one of the gets there is quite different, however. The staffing Gross Margin ($) 2,000,000 5,000,000 business is a low gross margin business. Gross Margin (%) 20% 50% Most of the cost in this business is the cost of Indirect Costs 500,000 3,500,000 the temporary staff being sent to the company’s client worksites. Offices are very Operating Income 1,500,000 1,500,000 small and there may only be 2 or 3 15% 15% administrative staff for a single branch office. Table 1 – Industry Comparison Billing is usually simple and automated. The markup for the staffing business’s temporary employees is about 145%. The engineering company works on a much higher gross margin and subsequently its indirect costs are much higher. There are a lot of administrative costs and billing is more complex and must be overseen by the engineers. The markup for the direct hourly billable work is about 300% to 350%. This results in a much higher gross margin because the direct costs are relatively lower and the indirect costs for the same level of operating income are much higher. A tactical buyer would be more interested in the engineering company than the staffing company because the engineering company would be much more effective in producing active and passive consolidation efficiencies than the staffing company. As stated above the tactical buyer has an existing business and the business is in the same geographical territory as the target company. This gives the buyer an opportunity to combine operations while at the same time reducing administrative overhead and occupancy costs. In addition, there will be significant passive synergies arising from the consolidation such as insurance costs and the costs of having one audit instead of two. The savings that occur as a result of indirect costs reductions can be as high as 30% depending mostly on the relative sizes of the acquirer and the target. Larger targets acquiring smaller targets tend to realize greater cost efficiencies than like sized companies. It is also important to keep in mind that, when selling a company to a tactical buyer, if an office consolidation is to occur subsequent to the acquisition it will likely be accompanied by a significant workforce reduction. Tango Equity 11
Example of the effect of active and passive consolidation efficiencies in a tactical acquisition transaction.
Combined Acquiring Target Consolidation Hybrid Company Company Efficiencies Company Net Revenue $20,000,000 $10,000,000 $30,000,000
Direct Costs $8,000,000 $5,000,000 $13,000,000
Gross Margin ($) $12,000,000 $5,000,000 $17,000,000
Gross Margin (%) 60% 50% 57%
Indirect Costs $9,000,000 $3,500,000 -$2,500,000 $10,000,000
Operating Income $3,000,000 $1,500,000 $7,000,000 15% 15% 23% Table 2 – Consolidation Efficiencies
In this example, the acquiring company is a tactical acquirer and is acquiring a $10 million company that is also running at a 15% operating margin but with a slightly lower gross margin than the acquirer. The acquirer is going to close the target’s office and combine it into its existing operations. It is going to eliminate most of the billing and client service staff and all of the executive management. It will also realize significant savings from the reduction of occupancy costs and costs of medical, E&O and GL insurance. The combined company had a slightly lower gross margin but a significantly higher operating income. These results do not include the costs of acquiring the target company because we are only demonstrating the operational effects of the transaction. The acquirer had completed this transaction for a purchase price of $4.5 million, 50% cash at closing and the remaining 50% paid with a non-contingent note having a term of 3 years. The acquirer financed the acquisition with $1.5 million of its own capital and obtained additional financing using a line of credit to extend the terms to 5 years. The seller note was at prime plus 2% and the line of credit was at prime plus 4%. The first year’s debt service was approximately $1.1 million thereby reducing the pretax income to 19.7%. Nevertheless, the operating efficiencies were effective in producing a consolidation that will be immediately accretive to earnings.
Financial Buyers
Financial buyers are typically investment groups or investment companies. They are usually categorized by the general types of investments that they seek and the stage of the investment. In addition, they typically develop several industry specialties that become their area of main interest. A private equity group is an investment group that invests primarily in the ownership, or equity, of privately held operating companies. These companies may be seeking an investment partner either for expansion or for acquisition capital, or the owner may be trying to 12 Tango Equity
cash out some of his or her equity in the company, or the owner may be seeking a complete divestiture of the business as an exit strategy. In Europe the term “venture capital” is used to include companies, institutions, or individuals who invest in private equity regardless of the stage. In the U.S. venture capital usually refers to private equity investors that invest in early stage or pre-revenue companies. When we use the term Private Equity Group in this text, we will be referring to companies, institutions or groups of private individuals who invest in the equity of non-public operating (as opposed to startup or pre-revenue) companies.
A private equity group invests in companies because they have researched the industry and believe that economic conditions over the next 3 to 5 years favor that industry. Regardless of the industry, the private equity investor typically seeks transactions with the following characteristics:
1. Primary source of revenue is from specific targeted industries 2. Adequate revenues and/or EBITDA needs to meet the investment criteria of the fund 3. Company should be profitable 4. High-quality management team 5. Should have a stable established market with an opportunity for expansion. 6. Geographical location may or may not be important
The private equity group backs management. They are usually seeking strong management that would benefit from the addition of capital for expansion, acquisition, or other sound business reasons, that would improve revenues, reduce expenses, or give the company a strategic advantage in the marketplace. However, it is not always necessary that the existing management team remain. Very often the private equity group will have access to a stable of management talent in any particular industry.
Private equity investors expect to obtain a return on their investment of about a 30% compounded annual growth (CAGR). Their time horizon or holding period is typically from 4 to 6 years. At the end of that period they will plan to exercise some form of exit strategy which may be, (i) an initial public offering (IPO) or other going-public transaction such as a merger into an existing public company, or (ii) a sale to a strategic buyer, or, (iii) a sale to another financial buyer. In a going-public transaction the value of the company may be enhanced simply by creating a public market for the shares of the company. This pathway has the advantage of creating value while simultaneously providing an exit strategy for the investors. The difference between the value of a public company and an identical privately-held company is the liquidity multiple. The concept is that the ownership rights of a public company can be easily transferred by selling the stock in the public market, while the transfer of stock of a private company is restricted by a limited market of qualified individuals. Thus, the liquidity enjoyed by the owners of public company shares entitles them to a premium in valuation over the relative illiquidity of the privately held shares. The liquidity multiple can be easily demonstrated. Table 3 shows data for a hypothetical public and a hypothetical private company. Both have identical operating characteristics, and both have experienced identical financial performance. As a quick rule of thumb (more about valuations later), private companies are typically valued on multiples of cash flow and public companies are valued on multiples of earnings. The difference between cash flow and earnings or net income is income taxes, non-operational expenses, and non-cash Tango Equity 13
expenses such as depreciation and Public Company Private Company amortization. Therefore, cash Net Revenue 20,000,000 20,000,000 flow is somewhat akin to Earnings Before Interest, Taxes, Direct Costs 8,000,000 8,000,000 Depreciation and Amortization
Gross Margin ($) 12,000,000 12,000,000 (EBITDA), and is always higher Gross Margin (%) 60% 60% than net income or earnings. Since public companies are Indirect Costs 9,000,000 9,000,000 required to apply basically the same accounting principles, their Operating Income 3,000,000 3,000,000 net income or earnings should be 15% 15% comparable. Accounting practices vary more in private companies Non Cash Expenses 1,000,000 and typically the earnings have to EBITDA 4,000,000 be recast or normalized. Recasting or normalization recognizes Non-Operating exceptions for one time charges or Expenses 500,000 u nique impacts to revenue or expense line items, in order that Pretax Income 2,500,000 more standardized multiples can
Income Tax 1,000,000 be applied to arrive at a fair valuation. In this example, the Net Income 1,500,000 public company is valued at a price to earnings (P/E) multiple of EBITDA Multiple 5 20, which is approximately the PE Multiple 20 broad industry average. In this case the P/E = 20. We know that Value (Market Cap) 30,000,000 20,000,000 the earnings are $1.5 million so Table 3 – Liquidity Multiple the price is P = 20 * 1,500,000, or $30 million. In the case of the private company the valuation multiple of EBITDA is 5, resulting in a valuation of 5 * 4,000,000 or $20,000,000. The difference of $10 million is the liquidity premium. In this case, the process of moving the same company from a private company to a public company resulted in the creation of an additional $10 million in value. Although this is a frequently utilized strategy in creating value subsequent to an investment, it is also fraught with risks. For one thing, in our example, we simply employed a P/E multiple for the broader market. Industry multiples vary significantly and a wide variation also exists within the industry segment and from company to company. There are also significant costs associated with the “going-public” event as well as significant costs associated with corporate governance and reporting issues requisite in maintaining public company status. There is no assurance that the market will respond by assigning a favorable multiple to the company and the valuation based on the P/E may not be as high as expected. The best way to increase valuation is, as they say, the “old fashioned way” - to earn the higher valuation from an improvement in the fundamental operating characteristics of the company – 14 Tango Equity
revenue and earnings. However, to achieve improvement that will elicit a 30% annual return on investment (ROI) may be difficult to achieve.
The objective of a 30% CAGR return on investment is very ambitious, and requires a solid plan. The addition of value to a company to achieve the required rate of return (RRR) for the investment company is achieved either by the expansion of business by (i) obtaining additional capital for marketing, research or product or services development, or (ii) the consolidation of several similar businesses to exploit the active and passive consolidation efficiencies described above and by reaching higher levels of production to take advantages of pricing discounts and similar economies enjoyed by larger companies (Economies of Scale), and the application of financial leverage to increase the return on the invested capital.
Marketing Acquisition Acquisition Acquisition Acquisition Consolidation Capital Hybrid #1 #2 #3 #4 Efficiencies Application Company Net Revenue 20,000,000 25,000,000 15,000,000 10,000,000 7,000,000 77,000,000
Direct Costs 8,000,000 10,000,000 6,000,000 5,000,000 2,800,000 31,800,000
Gross Margin ($) 12,000,000 15,000,000 9,000,000 5,000,000 4,200,000 45,200,000 Gross Margin (%) 60% 60% 60% 50% 60% 59%
Indirect Costs 9,000,000 11,250,000 6,750,000 3,500,000 -3,500,000 2,100,000 29,100,000
Operating Income 3,000,000 3,750,000 2,250,000 1,500,000 2,100,000 16,100,000 15% 15% 15% 15% 30% 21% Table 4 – Effects of Consolidation Efficiences
As an example, as demonstrated in Table 4, an investment group completed a set of transactions, acquiring four related companies within a year, with aggregate revenues of $70 million. The purchase price for all four companies was $31.5 million or three times cash flow. Since these are high gross margin businesses the consolidation resulted in active and passive consolidation efficiencies of $3.5 million or 5% of aggregate acquired revenue. In addition, the investment group capitalizes the hybrid organization with an additional $1 million in working capital which is added to the sales and marketing effort. Transaction costs are an additional $1.5 million. The investment of $1.0 million for marketing results in $7 million in incremental revenue, and creates $2.8 million in additional direct costs. Part of the additional revenue can be supported by the existing SG&A infrastructure and it was only necessary to add an additional $2.1 million in incremental operating costs. As a result, the hybrid company now has $77 million in aggregate revenues and operating income of $16.1 million or 21%. Tango Equity 15
However, the investment group still needs to pay the sellers the additional working capital and the transaction costs – a total of $34 million. This is accomplished by structuring the transaction by a process called leverage. The art of constructing a successful rollup is the art of optimizing the leverage on the company. If a company is over leveraged there is a risk of a catastrophic event – default of loan payments and possibly bankruptcy. If a company is under leveraged then the investor is tying up capital that can be put to better use. The trick is to determine the optimal amount of leverage in a transaction and to structure the deal accordingly.
In this case, the transactions were financed similar to the previous case with a few differences. In this transaction the buyer used $12.5 million of their own money. This was one third of the total acquisition cost. The remainder of the purchase price was seller financed at prime plus 2% and was later refinanced with a five year note with the company’s primary institutional lender at prime plus 4%. In the first year the Company earned almost $16.1 million and paid $5.1 million to service the debt leaving income before taxes of just under $11 million.
Net Terminal Value and ROI
This group did no further acquisitions. It operated the Year 5 company for an additional five years and sold it to a Net Revenue 98,273,680 strategic buyer. During this time the company’s revenues and EBITDA grew at 5% per year and in the Direct Costs 39,309,472 fifth year the revenues were approaching $100 million
Gross Margin ($) 58,964,208 and the operating income was a little over $20.5 Gross Margin (%) 60% million. Operating income had remained fairly consistent over the period subsequent to the Indirect Costs 38,326,735 acquisitions and consolidation. The company is sold to the new strategic buyer at the same purchase price Operating Income 20,637,473 multiple used for the original acquisitions. The 21% terminal value or sale price was just under $62 million and the proceeds were reduced by $8.4 million to Multiple 3 retire the outstanding debt owing to the primary Terminal Value 61,912,419 institutional lender. This left a net terminal value of less: debt 8,400,000 $53.5 million. The original investment was $12.5 Net Terminal Value 53,512,419 Original Investment 12,500,000 million which meant that the compounded annual Return on return on that investment was 43.8%. In this case, the Investment (CAGR) 43.80% management team was promised and paid a 15% Table 5 – Determination of Net equity claw back bonus for achieving their Terminal Value and ROI performance criteria during the holding period and they were paid $8 million. This reduced the ROI of the investment group to 38.1%
Both strategic and financial buyers have their own advantages for a seller. Strategic buyers may be in a position to pay more because of the immediate active and passive operational efficiencies that they can achieve. Financial buyers may be better capitalized and are more likely to leave the target company intact at least for a period of time. So, which of the two would be preferable? The answer is a combination of both. 16 Tango Equity
The Ideal Buyer
The ideal buyer has the positive characteristics of each of the above groups of buyers. The ideal buyer is often a financial buyer of a private equity group that already has holdings in the particular industry sector in which the seller’s company operates. There are thousand of private equity groups in North America. Nearly all of them that have been in business for any length of time have investments called portfolio companies. The portfolio companies are businesses that they own or in which they have made significant investments. Large private equity groups have holdings across dozens of industries and have many portfolio companies. Smaller equity groups focus on a single or a limited number of industries that they are bullish on and that they have some “on-board” expertise in. This, then, is the ideal institutional business buyer. One that already has holdings within the industry who acts like a strategic buyer having the ability to justify a higher purchase price multiple and one having the financial capacity of an institutional business buyer.
This ideal buyer not coincidentally describes Tango buy-side clientele. Tango is engaged by institutional buyers to act as finders for these buy-side clients. Our buyers engage Tango to seek out companies that fit well with their existing portfolio companies. Because we work mainly on the lower end of the middle market, predominantly with companies with revenues between $2 million and $150 million, most of the time our buy-side engagements are specifically for target companies that are already in the buyer’s portfolio. As such, our clients are financial buyers that behave like strategic buyers. We seek out sellers that fit the acquisition criteria of our buy-side clients. We only contact those companies for which we are certain we have qualified buyers.
Another great benefit of this arrangement is the assurance of confidentiality associated with a limited distribution of the seller’s company’s information. There are 4,000 private equity firms in the US and hundreds or thousands of strategic buyers. However, there are only a limited number of qualified and interested buyers for any single business. Many bankers, brokers, and M&A intermediaries try to contact these buyers by sending notices to thousands of prospects. There is a national competitors boasts that their listings are sent to 17,000 prospective buyers. The problem is that there are not 17,000 prospective buyers for any company. There are at best a few dozen that are qualified financially, economically capable, and operationally suited for any specific transaction. The risk in such a broad brush approach is that confidentiality will be breached. There are a limited number of middle market companies in any industry and even a two or three paragraph general description of the operations, and unique characteristics of a specific company may be sufficient to make the company recognizable to competitors, creditors, clients, employees, landlords, or critical vendors. Tango’s approach is to target these ideal buyers and to focus on them first. We start off with the prospects which hold the highest likelihood of success and approach them, limiting exposure while increasing the probability of a successful transaction while at the same time protecting confidentiality. Tango Equity 17
Summary of Chapter One
1. There are three types of buyers for middle market companies: a. Strategic buyers who are competitors of the Seller’s business and are frequently able to afford a higher multiple because they are already invested in the industry and are able to take advantage of economic efficiencies. b. Financial buyers who are usually institutional investment funds that invest in middle market businesses. Financial buyers have time horizons of up to 6 years and will then contemplate an exit strategy. Since these are well-capitalized institutions, they tend to be good partners, solid credit risks and have the financial resources for additional capital to grow the business. c. Ideal buyers are financial buyers with existing investments in the seller’s particular industry. They can take advantage of the consolidation efficiencies like a strategic buyer and provide the financial depth and resources of a financial buyer. 2. Tango’s buy side clients are financial buyers with strategic holdings across numerous specific industries. 3. Tango’s limited, focused distribution enhances the probability of completing a successful transaction while protecting confidentiality. 18 Tango Equity
Chapter 2 Why this May be the Best Time to Sell
Bernard Baruch said that he always made money by selling his companies when he didn’t have to. We are currently coming out of a period of economic downturn, perhaps even a recession. With only a few exceptions, most businesses are down. Companies that deal with the trading of precious metals are doing well, as are most segments of the healthcare industry, all sectors related to homeland security, and many businesses involving residential housing construction are coming off all time highs. However, for the most part business in other sectors is not that great. Business owners that we speak with in the staffing industry had experienced revenue downturns of 20-25% and many engineering companies are off 10% or more. With such an economic situation, what might be the dynamics that would lead someone to opine that this may be a good time to sell a middle market business?
The Three Dynamics
There are three dynamics that make this one of the best markets for selling a business to an institutional investor in the middle market.
1. The Entire Market Has Been Depressed
There is probably a difference in the reaction to the economy between pure strategic and financial buyers. During economic downturns strategic buyers tend to stand still, except for those that are very well-capitalized and not experiencing any business related stress on their own businesses. However, in many cases, strategic buyers tend to be “bottom feeders” during periods of business downturns, and try to focus on picking off some distressed businesses that may be forced into foreclosure or liquidation due to unfavorable economic conditions, or even those that may experience some pressure to make the sale. However, because most strategic buyers are going to be too concerned with the maintenance and control of their own businesses, they do not want to be distracted with acquisitions unless they have a great opportunity.
Financial buyers realize that there are a few sectors that are doing well in this economy. For the most part, we are withdrawing from a recession or at least an economic downturn, but recovery is slow and business in many sectors is still weak. Financial buyers are sophisticated investors and realize that this downturn is not just a phenomenon of a particular business or a particular industry but part of a broad and recurring economic cycle. Institutional investors are not too concerned with the next quarter or even the next year. Good solid businesses are affected by general economic downturns but still remain solid investments. The time horizon for investments is longer term for the financial buyers, probably four to six years. A strategic buyer especially a publicly-traded one, may have to demonstrate the benefits of the transaction almost immediately. We are fortunate enough to be operating in the world’s largest economy and despite the hardships of periodic economic slowdowns, there are only a few who do not believe that the economy will recover and be better than ever over the long run. When the economy recovers, a solid, well-managed business is going to deliver above average returns. An Tango Equity 19
institutional buyer will realize this and their valuations are going to be determined by their performance expectations during the next five or six years in which they are going to own and operate the business.
There are two other positives with regard to the current economic conditions. First, the debt market is attractive and debt financing is available at rates lower than most financial buyers have seen in their lifetime. The prime rate as of this writing is 4%. Prime rates have not been below 4% since April 13, 1956. This has the effect of making debt financing attractive and available. In addition, the general consensus seems to be that the worst part of the downturn is over and better times are on the horizon. Such a fact would make this an ideal time to make an investment.
2. Alternative Investments are Unattractive
A second and very powerful market dynamic is that there is a paucity of attractive alternative investments. One investment alternative is fixed income securities such as corporate or government bonds and bank instruments. Once again, reference is made to the historically low levels of the prime rate of interest. These investment alternatives such as government or municipal bonds are also at historically low yields. Traditionally, these have never been investment alternatives for private equity groups, but they may have been more frequently utilized as investment alternatives for the fund’s limited partners.
Since, it was not mentioned earlier, I will take the opportunity to explain very briefly how most private equity investment funds are structured. Private equity groups (“PEGs”) usually create limited partnerships and they set about collecting capital or commitments to capitalize their funds from a set of Limited Partners (LPs). The LPs are usually insurance companies, retirement funds, colleges and universities, and high net worth individuals. The fund will have stated investment criteria that may be either broadly or narrowly defined depending on goals of the specific fund. Because the fund would probably never invest in a treasury bill since it does not fit with the investment criteria of the fund, the LPs do have that option. However, these investments are not very attractive at the present time, because the current returns on such investments are historically low. There is, therefore, considerable pressures applied by the LPs on the PEGs to source and commit the fund’s capital into investments that can produce returns far in excess of some of the “safe” alternative investment instruments. If the PEGs are unable to source deals acceptable to the LPs, the LPs will be disappointed and may either withdraw from the fund, if they are able to, or at best, decline to participate in the capitalization of subsequent funds.
We have talked about the unattractiveness of the “safe” investments of high quality corporate and government bonds and other obligations and bank instruments. The investors also have another alternative which has always competed with private equity and that is public equity or stocks. (Although it should be understood that stock represents an equity investment in a corporation, regardless of whether it is publicly- traded or privately held, for the remainder of the section when talking about stock or 20 Tango Equity
stock I will be referring to the ownership of publicly traded companies.) The LPs have always preferred to hold the majority of their invested assets in common stock. At the same time, they recognize the importance of diversification and as a result a portion of their invested assets are available for investment in private equity. During the past several years prior to 2003, the broad market for common stock has performed erratically. The Dow Jones Industrial Average lost one over one-third of its value from its close in 1999 to it low in 2003 before recovering much of that value,
Dow Jones Industrial Average
open high low close change 12/31/1997 6,462 8,299 6,353 7,908 22% 12/31/1998 7,908 9,380 7,401 9,181 16% 12/31/1999 9,184 11,569 9,063 11,497 25% 12/31/2000 11,502 11,750 9,655 10,787 -6% 12/31/2001 10,791 11,350 8,062 10,022 -7% 12/31/2002 10,022 10,673 7,197 8,342 -17% 12/31/2003 8,342 10,462 7,417 10,454 25% 1/5/2004 10,453 10,544 10,384 10,544 1% Table 6 – Stock Volatility
and the more technology rich NASDAQ has lost nearly 70% of its value from its close in 1999 to its low in 2003 and has since recovered only about 50%.
Date Open High Low Close Change 12/31/1997 1292.7 1748.6 1194.4 1570.4 0% 12/31/1998 1574.1 2200.6 1357.1 2192.7 40% 12/31/1999 2207.5 4090.6 2192.7 4069.3 86% 12/31/2000 4186.2 5132.5 2288.2 2470.5 -39% 12/31/2001 2474.2 2892.4 1387.1 1950.4 -21% 12/31/2002 1965.2 2098.9 1108.5 1335.5 -32% 12/31/2003 1346.9 2015.2 1253.2 2003.4 50% 1/5/2004 2011.1 2047.4 1999.8 2047.4 2% 9/16/2004 2011.1 2153.8 1750.8 1904.1 -7% Table 7 – NASDAQ Composite Index- Stock Volatility
Combine this stock performance with the instances of corporate misfeasance (Tyco), the poor management decision making process and monumental write-off (Time Warner), mismanagement and buffoonery (Lucent), and outright criminality (Enron, WorldCom) and there is additional incentive to redirect some of the investments from stocks to private equity. Again, this puts additional pressure on the private equity groups to find good deals in the middle markets.
3. Supply is low and Demand is High The third dynamic, and perhaps the most important of the three, is rooted in one of the most basic economic tenets – the law of supply and demand. Simply put, at the present Tango Equity 21
time, the demand for good middle market private equity deals is very high and the supply is very low.
$1,600.00 $1,400.00 $1,200.00 $1,000.00 $800.00 $600.00 $400.00 $200.00 $0.00 1998 1999 2000 2001 2002 2003
Chart 1 – Total Value of M&A Transactions
In 2003 the deal flow in the North American middle market is nearly the lowest that it has been since 1996. As a middle market M&A professional, I can assure you that this dearth of deal flow is not a result of a lack of demand. We receive hundreds of calls each month from associates and directors of private equity groups looks for deals. The paucity of the deal flow arises as a result of a scarcity of availability of high-quality middle market businesses. Our belief in talking to numerous business owners is that there is a perception, that given the market conditions of the previous several years, this is a bad time to sell their company. As explained above, this is not necessarily the case, and; to the contrary, it is probably one of the best times in recent history to be a seller of a solid middle market business. There is definitely a major imbalance with demand far surpassing supply. We are at a high point in a seller’s market.
Summary
The three market dynamics creating a strong seller’s market are:
1. The entire market is depressed which will affect strategic buyers but probably not financial buyers. Financial buyers are concerned with long-term time horizons and there is an almost universal expectation that the economy will improve and is already starting to improve. In addition, the debt market makes financing for transactions available and attractive. This will assure that the down market and below average performance of selling companies should not adversely affect valuations. 2. Alternative investments are safe fixed income securities that are paying unacceptable rates of return or stocks that have not performed well over the past five years and have further been rendered unattractive by instances of corporate governance, mismanagement, and criminality. The reduced attractiveness of these alternative 22 Tango Equity
investments is pushing money into the private equity arena, and pressuring private equity groups to source and complete successful transactions. 3. The combination of the poor economy and slow recovery has reduced the supply of high- quality middle market business properties, and the unattractiveness of alternative investment vehicles, attractiveness of debt financing, and timing of an imminent economic recovery has increased the demand for high-quality middle market business properties. 4. Tango’s buyers are predominantly private equity groups in these categories and they are very anxious to complete transactions at fair multiples. They are some of the most active consolidators in the business and have available funds of from $65 million to $5 billion.
Additional Information
The Magic of Leveraging
We commonly hear, especially from political aspirants and incumbents that debt is something to be avoided at all costs, and that it borders on evil. Leveraging is the process of adding debt for the purpose of increasing return on an investment. In this case, far from being evil, debt is a tool when utilized effectively can increase the return on investment. The prudent application of debt is fundamental to our capitalist economic structure and is what makes the entire system operate efficiently. Without debt, few people would own new cars and home ownership would be a rarity. The following is an example of the effective use of debt.
Assumptions Discount Rate 4% Internal Growth Rate 8%
Operating Results Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Revenue 100 108 117 126 136 147 Operating Income 20 21.6 23.4 25.2 27.2 29.4 Multiple 3 3 Purchase Price (60) 88.2 Table 8 – Acquisition and Post-Closure Scenario
In this case, we are considering an investment for five years. This target company has initial revenue of $100 and an operating income of 20%. The purchase price multiple is 3. We are buying this business and the purchase price is $60 ([$100 * 20%]*3). We are presented with three deal structure alternatives. In the first scenario, because we have the capital, we pay the entire purchase price in cash at closing. The company has no debt and there is no leverage. In the second scenario, we put down $30 and borrow thirty dollars from either the seller or an outside institution. The annual interest rate is 10% and the entire amount is paid down in one final balloon payment with interest. In this case we will pay back $45 in year five representing the principal and five years of simple interest. This is a case of moderate leveraging with half of Tango Equity 23 the consideration coming from the buyer and half of the consideration from debt. In the last scenario, we present a highly leveraged situation. In this case, we are putting only $10 of our own money into the deal. Once again, the financing will either come from the seller, an outside institutional lender, another nontraditional financing institution, high net worth individuals, or perhaps a combination or permutation of these sources.
Before going on with this example, be aware that there are several tests which determine if a business is safely leveraged or over leveraged. Two of the most common are the coverage ratio and the leverage ratio. The coverage ratio is annual Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) divided by the total annual interest (INT). It is an indicator of how many times the Interest is earned by the company during the year. The banks, lenders and all the parties would like to see this number as high as possible. It is very encouraging for a company to be able to earn 4 or 5 times the Int payments. The Leverage Ratio is the Total Debt (Debt) divided by the EBITDA. It can be thought of as an indicator of how many years it would take for the company to pay back all of the debt if that is all that it did with its earnings. Again, debt is not something to be avoided It is a tool that allows us to make the most efficient use of capital. Without it there probably would only be rare, and small M&A transactions and private entrepreneurs would be ball-and-chained to the businesses. The capital within the business would become illiquid and exit strategy options would be extremely limited. The universe of buyers would be reduced to that small number of investors who have sufficient cash to pay for the business. This would result in limited demand and materially lower purchase price multiples. Under such conditions starting a business would not be attractive. Debt creates capital markets and capital markets are essential to free enterprise. The prudent application of debt allows capital markets to function efficiently.
Back to the example. We have three financing alternatives for a single transaction and these were the five year operating results:
Operating Results Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Revenue 100 108117 126 136 147 Operating Income 20 21.6 23.4 25.2 27.2 29.4 Multiple 3 3 Purchase/Sale Price (60) 88.2 Table 9 – General Financial Circumstances and Post-Clousure Scenario
The company’s revenues grew at a rate of approximately 8% and operating income stayed at the previous average of 20% so that in year five the company’s revenue was at nearly $150 million and operating income, which for the sake of keeping this example simple, we will say is the same as EBIDTA or cash flow and is just under $30 million. Based on these characteristics, the owners sold the company for slightly over $88 million. We will compare the rates of return under the three funding alternatives that were described above. 24 Tango Equity
Alternative Financial Structures In all three scenarios the terminal Alt 1 Alt 2 Alt 3 value is going to be the same. Investment Amount 60 30 10 Also, the returns from the Financed Amount 0 30 50 distributions of the cash flows of Terminal Value 88 88 88 the business are going to be the Repayment of debt 0 30 50 same. In this example, we Interest 15 25 assigned a future value (FV) to the Net terminal value 88 43 13 stream of cash flows from the FV of Operating operations of the business. These Income 109 109 109 distributions are put into a “safe” Total Return 197 152 122 investment vehicle at 4% interest Investment 60 3010 and the $109 is the future value of ROI 26.80% 38.30%64.90% these streams of cash flows (This Table 10 – Effect of leveraging and comparison on ROI is the future value of the stream of on different financial transaction structures cash flows from the operating income as indicated on the operating income line on Table 6). The only difference is how the financing was arranged. In Alternative #1, we paid the entire purchase price from our own funds and there was no financing component. So, the $88 terminal value was not reduced by a repayment of debt. Adding in the FV of the cash flows of $109. Therefore, the $60 has grown to a value of $197 and over the five year term the Return on Investment (ROI) was 26.8% In the second alternative, the terminal value of $88 was reduced to $43 after the debt and the interest on the debt as paid off. Again, adding the $109, we have a total return of $152 on an investment of $30 resulting in a five year return of 38.3%. In the final alternative, the highly leveraged situation, the terminal value of $88 paid for the company was reduced to a net terminal value of $13, and adding the $109 FV of cash flow, that scenario had a return of $122. However, in the highly leveraged investment we only invested $10, so our return was nearly 65%. This example demonstrates the effectiveness of leverage in economizing capital and increasing ROI. It may be superfluous to note that leveraging only works when there are attractive alternative investments where the unused capital can be invested at a rate of return in excess of the 26.8% earned in alternative #1. In the absence of such investment alternatives you would need to include in the calculation the opportunity cost of the idle capital. Thus, if in this case the $50 remained uninvested throughout the five year holding period, the incorporation of the zero return on that portion of funds would have to be calculated into the overall rate of return, and the ROI would actually be much lower than Alternative #1 and #2. Tango Equity 25
Chapter 3 Intermediaries and What They Do
There are three general classes of M&A intermediaries that provide financial consultative services and other services prior to and during M&A transactions. These three are the large international bankers, the independent middle market specialty firms, and the main-street business brokerages. These groups are defined by the size of the markets within which they provide services and the services that they provide to those markets.
The large international bankers have target Large International Competitors and markets above $100 million in revenues. In Middle Market Intermediaries the higher end of the middle market, that is, companies with revenues below $100 million Target Market and above $5 million, about 25% of the $5,000,000 to $200,000,000 transactions are represented by these large Goldman Sachs international firms in combination with the Houlihan Lokey middle market specialty firms. The Large Geneva International Bankers have wide name Capital Advisors recognition and seemingly unlimited financial resources compared to the other two classifications. On the opposite end of the spectrum are the very small “main street’ business brokers. The “sweet spot” for these S Middle Market companies are businesses with revenues Businesses below $2 million and the largest of the main E Professionalstreet franchises, deals with companies with L Partners average revenues of around $250,000. These 25% Program L 50% brokers are most comfortable selling pizza 25% restaurants and dry cleaning establishments. E However 25% of the deals in the lower end R of the middle market are represented by these S companies. The reason is that this is very much a relationship driven business. An owner of a middle market business may have a longstanding relationship with the main street business broker through the golf club or Small and Indie Brokerages and Practices other local social setting. In the middle between the large international competitors Target Market $100,000 to $1,000,000 and the small main street brokers are the independent middle market M&A specialty Gains Business Brokers firms (the “Independents”). The Sunbelt Business Brokers Independents are M&A professionals. Many Regional Companies are former or non-practicing attorneys. Individuals Practices Almost all are alumni from the corporate world with extensive experience in corporate finance. About half of these companies are Picture 1 – Distribution of Middle Market M&A Services 26 Tango Equity single practitioners and the majority of them have developed their practice around a specific market vertical in which they have special experience or familiarity. The Services In general, there are thousands of companies that perform M&A financial consulting services in North America. Most of these competitors work exclusively or at least predominantly on the sell- side of a transaction. They solicit business owners often within a certain specifically-defined vertical market, and upon winning the engagement, are nearly always engaged for a period of exclusivity, most often for one year with a one or two year run-out period. They then begin the process of packaging the Company and seeking a buyer. During the run-out period the consultant is entitled to a commission subsequent to the completion of a transaction occurring with a buyer introduced to the Company by the consultant during the term of that contract, including extensions. Some companies such as the Geneva Companies, one of the largest national service providers also provide pre-engagement seminars which business owners are invited to attend. At these seminars the rudiments of the sale process are described and valuation and pricing parameters are explained. In some cases, the majority of the consultant’s revenue is generated from the publication of these sales documents making them primarily financial publishers and providers of ancillary services rather than true middle market M&A transaction consultants. All M&A consultants also charge success fees for their services. Many of them charge up-front engagement or mobilization fees to cover the cost of marketing, publication and research. Engagement fees range from a few thousand dollars to nearly forty thousand dollars. Companies that charge engagement fees under $10,000 typically do so to cover the costs of production, research, and marketing. Companies that charge engagement fees in excess of $10,000 are usually in the business of writing offering memoranda. They make a profit on this process and are less motivated to actually complete the transaction. At the other extreme, some companies do not charge engagement fees at all. They are compensated solely on the success fees produced when the transaction is completed. While this sounds attractive, such engagement should be approached with caution. The intermediary needs to produce at lease two documents, a short 1 or 2 page blind summary and a more detailed offering memorandum. In addition, they will have to market the business to their clientele or if they don’t have buyers, they will have to pay for mailing lists, or carry out research to prepare databases to find buyers. They will have to follow up with potential buyers and if they do it with determination and ambition they will incur significant mailing, telephone, and overnight courier costs as well as the time and personnel costs required to put the information together and then distribute it. If a selling intermediary does not charge anything up front it would be good to ask them how they intend to market your business to make certain that they are going to provide all of the support and documentation that is necessary to properly present the business to an institutional financial buyer. As stated above there are at least two and usually three documents that the middle market intermediary should prepare. The Blind Summary and the Offering Memoranda are always necessary and an Executive Summary is frequently included as well.
The Documents
The Blind Summary
The blind summary, as the name implies, describes the company without revealing the name of the company or giving too many details that would enable readers not familiar with the industry to Tango Equity 27 determine the identity of the company. The purpose of the blind summary is to give qualified buyers sufficient information on the business property for them to make a decision as to whether it may be an investment they would consider pursuing. The blind summary is also known in the M&A industry parlance as the “one-pager”, although it is frequently two and sometimes three pages. An important caveat that should be mentioned at this point is in regard to the distribution of the blind summary. While most professionals are very prudent in the distribution of the blind summaries, frequently, some intermediaries post the blind summary on Internet sites or otherwise make it available to persons or entities without sufficiently qualifying them as buyers. While this is generally not a problem for very small business such as dry cleaners and restaurants, of which there may be hundreds in even a small urban location, the posting of blind summaries of middle market companies on sites available to the general public or sources that have not been carefully screened may result in a breach of the confidentiality of the business transaction.. While these blind summaries only contain very superficial financial information and a limited description of operations, they typically contain sufficient information for someone familiar with the business to infer the identity of the company. Those familiar enough with the business possibly identify the company are probably not potential buyers but rather employees, customers, competitors, and perhaps landlords or creditors. As part of any seller’s due diligence, a question to ask any financial consultant whom they are considering engaging should be, “How will you market my business?” If the answer includes the use of the Internet, a prudent recommendation would be to request that the consultant not market your business by placing a blind summary on the Internet or any other forum that is accessible to anyone who is not a fully qualified buyer. Internet sites such as www.bizbuysell.com and www.mergernetwork,com are great and useful venues for very small business establishments to reach a wide audience of buyers without betraying confidentiality. These sites do not work for middle market companies. Consider this ad from Mergernetwork:
#21069 — Manufacturing Mint This Nevada coin minting business, is one of three private mints in the US. It has operated from a 6,000 square foot plant in Las Vegas, NV, since 1984.
This company has produced coinage, gaming tokens, amusement tokens, transit tokens, commemorative coins, and medallions for customers world-wide.
Due to health problems and age, the owner is selling all the assets of the company, including furniture, fixtures, approximately $10 million in equipment, customer lists, operating methods and standards, trademarks, patents, a $386,000 (at cost) stock of commonly-used blanks, and the company's proprietary production machine and processes, known as Kaleidocolor™ and Kaleidoprint™. It also includes four URLs. The mint Manager would like to work for the new owner.
This business has the following attributes: * Extremely limited competition (only 2 direct competitors) * Attractive profit margin * Large potential market * Global demand for products * Wide variety of products * Reputation for the highest quality products * Able to produce product in titanium and other hard metals. * Complete turnkey operations; including on-site: minting, machine shop, die cutting, planchet production, coin finishing, packaging, token destruction services, and art department. * Assets in place for expansion of product line and capacity to an estimated 341 million annual units * Unique equipment and processes 28 Tango Equity
* Trademarks, copyrights, patents, and websites are included in the sale * Huge customer list
The business volume and profit peaked in 1993, and in 1996 the owner started slowing the business down. Currently, the company fills reorders and, occasionally, takes on special orders.
This is, essentially, an asset sale, and is being sold on the potential for a strategic buyer. The equipment is in excellent working order and is capable of producing nearly 350 million pieces annually.
Picture 2 - MergerNetwork
I would venture to say that any employee of this company seeing this ad would immediately know that he or she is about to experience a big change! At Tango, we only allow qualified buyers to have access to the blind summaries of our sell-side clients. Although all of our blind summaries and Confidential Information Memoranda are available on our web site, they are posted on a secure site and can be accessed only by those specific buyers to whom we have emailed the link. The Internet is still the best-available technology, but the method of distribution on the Internet requires careful planning and an adequate technological infrastructure to maintain the confidentiality of the broker’s client’s sensitive information.
The Confidential Information Memorandum (CIM) The second document that is always produced is the Confidential Information Memorandum (“CIM”) or a Confidential Business Description. If the assignment is for the purpose of raising capital, the document will be a Prospectus. We will remain focused on the description of circumstances concerning the sale of a business. The CIM will take various forms depending on the banker or intermediary that is involved with the engagement. Some are quite short with a few pages of narrative on the company, the company’s history, operations, the products or services, sales and marketing, clients, pricing structure, and anything that sets the business apart from the competition or gives it a unique or defensible market position. Resumes or CV of only the top management should be included. If you have 40 long term employees with advanced degrees, this is a very important and should be disclosed in the narrative. If the company has special trophy projects or relationships, that should also be disclosed in the narrative. It may include descriptions of the inventory, fixed assets and real estate if it is relevant. The rest of the document typically contains the financial information on the company and usually consists of a set of historical financial statements prepared by an outside accountant on the accrual basis of accounting and in accordance with Generally Accepted Accounting Principles (GAAP). This section will also contain a section of recast financials. The recast is completed by taking the basic financial data and making adjustments that result in the calculation of a normalized EBITDA. Adjustments made during a recast typically include items such as extraordinary and non-recurring revenues, charges or expenses, income taxes, depreciation and amortization, any non-business related expenses that were charged to the business, unusual charges or revenue windfalls and owner’s draw, perks, and bonuses. This gives the buyer an accurate glimpse of the cash flow that the business is generating and what is available for the owners. This is probably the most important number in the document. The seller and the consultant should spend a great deal of time going over the financials to determine the accuracy of these calculations; this will entail a very exhaustive analysis. Tango typically performs the recast with the seller and one of it senior financial analysts, they are usually Tango Equity 29 reviewed by a CPA prior to publication. The recast of earnings is done usually as an addendum to the Company’s statement of operations, or income statement. Other documents that should be included are balance sheets and a statement of cash flows. The minimum financial information that should be presented in the document is (i) income statements for the last three completed fiscal years, (ii) a current income statement, (iii) a current balance sheet, and (iv) a recast set of income statements. Ideally, we would prefer to include (i) income statements, balance sheets, and statements of cash flow for the last three years, and (ii) recast income statements for the last three years. Some companies perform research and collect data on the state of the industry and include lengthy descriptions of the industry, a history of the industry, the industry outlook, and possibly may include pages of demographic research. If the company is located in Atlanta, for example, there will be several pages on the positive outlook for growth and business in the Atlanta region. In some cases such “fluff” can constitute 80% of the document. Some sell-side intermediaries charge as much as $40,000 for preparing documents such as these. The fact is that most of the prospective buyers for good middle market companies are going to be sophisticated financial buyers who have teams of MBAs doing industry research or from strategic buyers who know the industry a whole lot better than the student interns or associates who did the research for these books. Such inclusions are superfluous and useless fluff that actually detract the prospective buyers from focusing on the business. Institutional buyers simply do not have time to wade through the fluff.
The Short Executive Summary
The Short Executive Summary is not a document that most intermediaries create. It is one that is very useful for an institutional buyer. At Tango, a Short Executive Summary is prepared for every sell-side engagement. It is a matter of knowing what your buy-side prospects like to see. Most of our buyers are private equity groups and other institutional investors. Before they decide to take a look at a business they usually present the deal to the partners or to a committee to bring that group into the loop, allowing them to ask some questions and solicit their input on the industry and the business. And, if necessary, receive their authorization to proceed in the pursuit of the transaction. The Short Executive Summary is our way of helping the internal deal sponsor with this process. The short summary is an effective part of the information to pass along at such committee meetings. It is a concise document of three to four-pages that is meatier and more substantive than the blind short summary and more concise than the CIM. This, confidential document works better for these groups. If we didn’t prepare this document then it would be up to the deal sponsor to create it. Not only do we feel that our summary portrays our sell-side client more effectively, but it is a nice helping hand for the buyer. It makes his or her life easier. We believe that service is important and gets deals done and maintains strong relations with the institutions.
Fees
Success fees are typically calculated based on a Lehman formula. The Lehman Formula is a sliding fee schedule that is based on the size of the transaction. Lehman formulae are calculated on the total transaction price or Total Invested Capital (“TIC”). The TIC may be defined variously in agreements from different brokers but, TIC usually consists of the value of all cash, stock, notes, 30 Tango Equity assumed liabilities and other consideration. It is closely related to the total sales price in typical GAAP purchase accounting. A typical or Standard Lehman formula is 5% of the first million of TIC, 4% of the second million, 3% of the third million, 2% of the fourth million and 1% thereafter. However, there are numerous variations of the Lehman concept. A very common derivative is know as a Double Lehman that begins at 10% and then drops to 8%, 6%, 4%, and 2% at the million dollar thresholds. These two are probably the most common. Other sell-side intermediaries offer a flat fee approach and charge as little as 2% flat fee for a transaction up to $10 million, and 11/2% thereafter. By way of a specific comparison:
Total Invested Capital 2,000,000 3,000,000 5,000,000 10,000,000 Standard Lehman 90,000 120,000 150,000 210,000 Double Lehman 180,000 240,000 280,000 380,000 Flat Fee 40,000 60,000 100,000 200,000 Table 11 – Comparison of commonly Used Success Fee Formulas at Various Amounts of Total Invested Capital
On a deal with $2 million in Total Invested Capital (TIC), an intermediary who uses the Double Lehman starting at 10% would be paid 10% of the first million ($100,000) and 8% of the next million ($80,000) for a total of $180,000 total fees. Utilizing the Standard Lehman the broker would start at 5% would be paid 5% of the first million ($50,000) and 4% of the second million or $40,000 for a total of $90,000. An intermediary using a flat 2% across the board rate the seller would pay $40,000 total for the same transaction. Similarly, in a transaction with $5 million of TIC, under a Standard Lehman the charge would be $150,000 ($50,000 + $40,000 + $30,000 + $20,000 + $10,000) and using a Double Lehman the charge would be $280,000 ($100,000 + $80,000 + $60,000 + $40,000). The flat fee broker’s charge would be 2% of $5 million or $100,000. On larger transactions, flat fees drop even more to 1½ % for deals in which the TIC is over $10,000,000. Flat fees are always lower than the Standard or Double Lehman formulas. Another key difference in pricing among middle market intermediaries is that they are typically paid their entire fee at closing. Some intermediaries have a policy of getting paid when the client gets paid. By doing so, the intermediary’s interests are perfectly aligned with those of their client. There is an old saying in the business that goes, “Tell me the price and I’ll tell you the terms, or tell me the terms and I’ll tell you the price.” Price is important but terms are every bit as important. Most M&A consultants are paid their fees in toto at closing. Typically, even contingent consideration is estimated, often at the maximum payout, and paid to the consultant at closing. Certain other intermediaries work on a different business model. Engagements are typically exclusive for only a short term, and success fees are paid as the client/seller is paid regardless of the structure of the transaction. This is a very important concept for the seller for two reasons: The first is simply economics. Middle market deals are rarely structured with 100% cash at closing. There is typically some portion of the purchase price paid at closing and some portion that is paid in a note over time. The reason for this is that the buyer wants the seller to continue to have some vested interest in the continued success of the business. In many cases, a single individual or a small group of individuals developed the business from scratch for several decades to create a Tango Equity 31 successful enterprise of value. It is often difficult to assess the impact that the owner or the owners exercise in just a few weeks of due diligence. By deferring a portion of the acquisition over a short time into the future, the buyer is assured of the continued cooperation and assistance of the former owner, and; for him or her to be available when the new owner needs advice, expertise, or possible intervention with an ornery or difficult customer or key employee. In addition, in larger transactions, the financial statements and, thus, the company performance is audited or reviewed by an outside, independent auditor. In public companies quarterly reports are filed and investor conference calls are staged during which investors and analysts can ask tough questions to management about the performance of the company over the preceding periods. Despite the recent scandals involving many of the major accounting firms, this process still creates a strong level of credibility to the buyer with regard to the financial and operational condition of the company. In most cases, a similar level of corporate governance is typically not exercised in private companies, especially smaller, closely held companies. For these and perhaps other reasons, private middle market M&A transactions typically involve some cash at closing and some portion of the total consideration paid out in an interest bearing note of two to five years. In most M&A transactions the sell-side M&A consultant is paid at closing for the full fee based on the total invested capital even though the seller may not have received that compensation as of yet. This is very important in the seller’s economics and is worthy of a quick example.
Deal Structure Purchase Price 5,000,000 In this transaction, the buyer is paying $5 Cash at Closing 2,500,000 million for a company with $2.5 million in 5 year note 2,500,000 cash at closing and $2.5 million in a five year note. Under a double Lehman the Impact of Paying Fees broker would be paid based on the entire $5 Upfront million of consideration at closing. Under this scenario, the seller would receive Intermediary #1 Intermediary #2 $2,500,000 from the buyer at closing and Cash at Closing 2,500,000 2,500,000 would have to pay the broker $300,000 Success Fees 280,000 50,000 leaving him or her with $2.2 million. Net to Seller Under a flat fee and a “broker gets paid from Cash at when the seller gets paid” model the seller Closing 2,220,000 2,450,000 would pay only $50,000 or 2% of the Table 12 – Paying of fees at closing vs. over amount that the seller actually received at payout period closing and they would wind up with an additional $230,000 or an additional 10%. Adjusted for capital gains taxes, the seller would still end up with more than an additional $200k in his or her pocket. My belief is that the “we get paid when you get paid” model is the fairest and best structure. That is because it precisely aligns the intermediary’s interest with the economic interest of the client. As mentioned earlier, price and terms cannot be separated.
Discounting the Future and Its Relation to Purchase Price
We will now discuss an economic concept of “Discounting the Future”. Discounting the future is simply an arithmetic calculation that states in quantitative terms that a dollar today is worth less 32 Tango Equity than a dollar next year. Discounting future dollars is also referred to as present value which is another way of stating that we can apply a mathematical calculation to determine what that dollar next year is worth today. Discounting the future and present value are arguably the most important concepts in economics and finance. This only underscores the importance of the terms of the deal. Most intermediaries get paid on the TIC at closing regardless of when it is paid to the client. Even if the broker negotiates a transaction with a buyer in which the buyer pays 10% cash at closing and the other 90% on a twenty-year note. In such an extreme scenario, the M&A consultant would probably end up with more in their pocket than the seller at closing! Admittedly, that was an extreme example. However, the point is that the method used by most M&A consulting firms results in their compensation not being truly aligned with the seller’s best interests. We believe that the fairest method is to align the intermediary’s interests with those of the client. The intermediary should be compensated based on their ability to get the best price and the best terms for their clients. The intermediary should be willing to live with the deals that they make for their clients exactly as the clients do. This gives the intermediary a tremendous incentive to get the best deal with regard to both price and terms.
Exclusivity
Nearly all business brokers, M&A intermediaries, and investment banking institutions specializing in M&A who work on the sell-side of the transactions are engaged by the seller for some period of exclusivity. Typically, this period is one year with a one or two year run our period (Sometimes also called a holdover period). During the run-out period, the consultant is owed a commission if a deal is completed with a buyer that was introduced to the seller or made aware of the availability of the transaction during the term of the original exclusive engagement of the intermediary plus any extensions. There are two factors that a seller should be aware of regarding the period of exclusivity and the conditions of the commission payout. First, the period of exclusivity should be reasonable. The broker or intermediary needs time to write up the documentation, do some research, recast the financial statements. These tasks may require that the consultant communicate with the company’s accounting firm and possibly its legal firm. Then, in marketing the company, time is needed for research and then to actually make contact with probable buyers. This entire process takes time and often a qualified buyer may be in the middle of another transaction and would like to wait at least two or three months before seriously considering another transaction. Considering these factors, a one year period of exclusivity is usually reasonable. A longer period should not be considered, and if there is a fair holdover provision there should be no reason for this period to run any longer than that. Some intermediaries, especially those with previously identified buyers may only require a very short period of exclusivity. Often these run as short as 90-daya. These intermediaries have a great deal of depth and experience as well as a technological infrastructure that enables them to assemble the necessary documentation in a time-frame of as little as two weeks. And, having already identified pre-qualified buyers the process can get underway significantly faster. As a result, these intermediaries can effectively engage a sell-side client for a much shorter period of exclusivity. An important caveat to sellers is to avoid brokers whose engagement agreements do not contain a specified term. Recently, a staffing firm in New Jersey engaged Tango for the sale of their company. When a buyer was found, another broker claimed a commission for an engagement that was signed four years earlier. The engagement letter did not have a term and the broker interpreted this as the equivalent of a perpetual contract Tango Equity 33 and stated that they would seek their commission at any point in the future regardless of their level of participation in facilitating the transaction. In this case, the original broker had sent out several hundred letters to regional and local competitors and on this basis insisted that they had made the buyer aware of the opportunity. Although it is unlikely that a court would uphold such a claim, in this situation, the broker’s threat of a claim could have disrupted the transaction. We settled the dispute by agreeing to share our commission with the original broker. The point is that a one-year period of exclusivity is reasonable. More than that should be considered suspect and if a broker or other intermediary recommends an engagement without a specific term, just run the other way! The other caveat is how to define whether or not a broker or intermediary is responsible for locating the buyer and whether that intermediary actually introduced the opportunity to the prospective buyer. During the period of exclusivity it really doesn’t make a difference. This is not an unusual arrangement and is justified as long as the broker or intermediary continues his or her involvement in the transaction and acts as a financial advisor to the seller and negotiates terms and conditions, facilitates due diligence and otherwise contributes to the successful completion of the transaction. The importance of defining how another broker or intermediary is credited with introducing an opportunity is more important during the holdover period. If a deal is concluded with a buyer that was introduced to a seller during the exclusive period of the contract but the closing of the transaction takes place after the expiration of the period of exclusivity but during the run-out period the broker or intermediary is still entitled to a commission. Care should be taken in examining the engagement letter to determine how the intermediary is defining that which constitutes an introduction of a buyer to the client. To use an extreme example in a loosely written definition of introduction a broker may be able to purchase an exhaustive list of names of companies and submit a letter to each and claim that they have made the introduction. Any transaction now completed for up to three years will be commissionable to the broker or intermediary. To be safe, it is best to insist that the sell-side agreement includes a clause stating that it be necessary to have had some actual communication with the buyer prospect for that transaction to be commissionable to the engaged intermediary subsequent to the period of exclusivity.
Sample Definitions in a Listing Agreement
“Buyers” include firms of which seller was aware or with whom seller had a business relationship prior to introduction of the transaction opportunity by TANGO, if (i) the opportunity to pursue the particular transaction when such opportunity was located and introduced to buyer by TANGO or (ii) TANGO's relationship with such opportunity or TANGO's efforts to effect a transaction materially contributed to the opportunity becoming a closed transaction. "Closing" means the event which causes the exchange obligations of a transaction agreement to become binding on buyer and seller. "Transaction" means a merger, combination, acquisition or investment or other capital transaction and includes (but is not limited to) such transactions as a stock purchase, sale or exchange, asset acquisition or sale, or capital contribution or loan. “
How Intermediaries Operate 34 Tango Equity
Operationally, the traditional business model consists of a staff of sellers and doers. In very small practices this is the same person. In larger firms, the senior staff, partners and principals, consisting of seasoned individuals with extensive networks in one or more vertical targets markets are responsible for identifying, and closing engagements for the company’s services. The company also employs support staff members, associates and researchers, who perform the research, examine databases, recast financial statements, interact with potential buyers, and provide most of the input on offering memoranda and prospectuses. In most cases, the associates are usually compensated by salary and the Partners are usually compensated from a share of the success fees. Currently, the market is composed primarily of individual practitioners who compete with the traditional professional advisory services model found in consulting firms, national accounting firms, and investment banks.
The International Competitors
International firms enjoy competitive advantages that independents cannot easily overcome. The Internationals have strong name recognition - Goldman Sachs, Morgan Stanley, J.P. Morgan Chase. They have a network of resources from which they can draw from to augment market, sales, and transaction related activities. Many of the internationals firms have solid, reputations and transaction histories from which they gain instantaneous credibility. Finally, they are able to present a high-quality image as a result of their superior financial and support resources and professional marketing personnel. Another benefit realized by these firms is the use of proven, demonstrable processes that define the structured processes of the transaction. While each deal is unique, the underlying processes, supporting documentation and required inputs and outputs are very similar. Demonstrating defined, repeatable processes to a potential customer gives that customer a level of confidence that these systems are very clearly understood and have been successfully executed numerous times in the past. Another advantage of clearly defined and documented processes is that key components of the process may be delegated from the ‘rainmaker’ to support personnel, freeing that individual to focus his or her expertise on the creative aspects of the transaction and increasing deal flow. Finally, the reach of these firms can extend well beyond that of any independent competitor. Beyond the expense incurred for advertising, these firms also have a larger base of existing customers and a network that may expand over multiple practices within these firms. Finally, larger firms have historically completed more transactions. This affords them the opportunity to leverage the experience into repeatable processes, using technology where appropriate, to demonstrate past success to potential customers. Fortunately for the other middle market intermediaries, these international competitors typically do not compete in the lower end of the middle market. Typically, their services are focused on businesses with revenues greater than $150 million.
The Independent Middle Market Specialty Firms Tango Equity 35
The independent middle market specialty firms (the “Independents”) can still compete effectively in this space. A key advantage in choosing an independent is the personal attention to the transaction by the “rainmaker”, who is also responsible for providing the client service. Another advantage to a potential customer in choosing one of these lesser known, smaller firms may be a detailed understanding of a specific market niche or geography of the individual providing the service. While an individual’s network may not be national, it has been personally developed and honed, allowing that individual a more refined understanding of specific opportunities in an albeit smaller market segment. Another obvious advantage is a more cost-effective service due to significantly less overhead cost. Another important factor for the independent service providers in the middle market is that the lower middle market opportunities are not necessarily financially appealing to the larger international firms. Even the largest of the international entities have limitations to their resources, and may choose to focus these resources on higher dollar volume opportunities than the lower middle market may offer. This barrier to competition works in favor of the independent. The benefits of hiring an independent M&A consultant are obvious. A potential customer has many valid reasons for considering the services of an independent or smaller organization. However, the weaknesses of the independent relative to the larger firm with the recognized name are equally apparent.
The Main Street Business Brokers
Of the three categories that we have discussed, it is the business brokers who close the most deals and have the greatest number of sell-side business properties in inventory. They do complete a large number of transactions. However their average transaction is considerably lower than that of the Independents, probably averaging about $250,000 per transaction. Their average fee per transaction is relatively low on an absolute basis, ranging from $10,000 to $25,000. As a result, there is a need to close a lot of deals.
Main street business brokers come in a wide variety of competencies. They can be very hard or very easy to deal with. Many are well-versed in corporate finance but some are not familiar with basic financial statements or deal structure, sometimes having trouble with rudimentary concepts of corporate finance such as accrual accounting.
In some states such as California and Florida, business brokers are required to have a real estate broker’s license. The purpose of such a requirement is unclear and demonstrates an evident lack of understanding on the part of the state’s lawmakers of the field of mergers and acquisitions. These are significantly different businesses. In the rare cases in which real estate is involved with a business transfer most M&A intermediaries enlist the services of a realtor. Most realtors, however, are unfamiliar with the rudiments of deal structure, recasting of EBIDTA or Inventory Turnover. The two services have very little in common. In each industry the subject properties are marketed much differently, contracts are negotiated differently, and buyers are located differently. It is like saying that an airline pilot must have an automobile driver’s license. Florida is not the only state with this rule nor is it the only state with its share of governmental buffoonery. 36 Tango Equity
At any rate, we have already said that main street business brokers fall along a long continuum of competency from top level financial professionals to those of less competency and experience. Many sources are available to find main street business brokers. www.bizbuysell.com or www.mergernetwork.com contain searchable databases of business brokers with contact information.
We recommend that if you are a company with revenues above $10 million you and your company’s interests would be best served by engaging one of the independent middle market M&A consultants. If you are not familiar with a good one please call us at Tango, because we have worked with hundreds of these intermediaries and know competent professionals and professional organizations in nearly every region, and would be happy to make a referral. Tango Equity 37
Chapter 4 The M&A Process
Thus far we have talked about some of the participants in the process, the buyers and the intermediaries and why we, as industry insiders, believe that this is a prime seller’s market. In this chapter, we will discuss the process and go specifically into the typical steps from the decision to sell, preparing the company for sale, getting assistance, the ancillary documents, the marketing process, the sales process, and through to the closing process.
Overview of the M&A Process Regardless of the intermediary that is selected, his or her objective should be to make the selling process as easy as possible, handling all transactions with extreme confidentiality, professionalism and expertise in order to sell a business and maximize its value. Critical to optimizing the chances of completing a successful transaction is in meeting a buyer’s key requirements by providing them with: 1) Information they require and can verify 2) Information that is presented in a compelling format and in a manner that a buyer understands, 3) Answers that address a buyer’s concerns quickly and candidly, and 4) A structured process that makes it easy to purchase. An experienced intermediary will lead you through each step of the following M&A process.
PREPARING Ź MARKETING Ź BUYER’S Ź NEGOTIATING INVESTIGATION
2 weeks (varies) 4 weeks (varies) 6 weeks (varies) 4 weeks (varies)
Due diligence – Determine key Provide Solicit final prepare and gather buyers list supplemental prospects data information Determine valuation Contact buyers Negotiate with range Buyer’s site selected buyer Execute visits Develop Executive confidentiality Sign definitive Summary (“Teaser”) agreements Buyer’s due agreement and Confidential diligence Information Evaluate levels Close transaction Memorandum of interest Form list of buyers to Communicate contact Complete draft with employees agreements and possibly Finalize customers confidentiality letter Table 13 – Timeline for the M&A Process 38 Tango Equity
The Decision to Sell
As I had quoted earlier, the best time to sell is before you have to. If you realize that you are in a situation in which you are forced to sell, then it is the circumstances that will drive the process and you will have limited options. You are definitely in a weaker position when you are negotiating in a transaction that you cannot walk away from. We are currently working with a client who wants to retire and be out of his business in five years. He engaged us recently to begin the process – this is very smart planning. If you have made the decision that it is time to develop an exit strategy, start the planning process now and be in control. The other important part of this first step is to come to grips with the reality of this decision. You will no longer own the business, a business perhaps that represents your life’s work. It is very difficult to accept this realization and you must be prepared mentally and emotionally for it. The sales process is most likely going to take a long time, and there will be a lot of disappointments and a lot of unexpected turns. The average transaction takes seven months to complete from the engagement of the intermediary to the closing. From the experience of 56 middle market transactions ranging in transaction value from $2 million to $85 million, I am familiar with many situations where at some point in the process it appeared as if there was absolutely no chance of getting to a successful closing. But somehow, after riding that roller coaster for several long grueling months, the deal was completed. Success - there is no feeling like it! One other thing to realize before getting into the process is that the buyer doesn’t really care about the sweat and the sacrifices that you put into the process. A business owner may recall the time he or she missed the Thanksgiving Dinner with the family, or begged out of a daughter’s recital because of an important client presentation. These events have no relevance to the business situation and have to be removed from the thought process. The prospective buyer will be making a quantitative decision based on cash flow and business backlog and that’s not callousness, it’s reality.
Getting the Company Prepared for Sale
Once the decision is made and you are mentally and emotionally prepared for the rigors ahead, the first step is to get the company prepared for sale to optimize value and the probability of getting to a successful closing.
! 90% of successfully selling a business lies in the preparation
Advantages of being prepared:
Ź The Company will exude a higher level of professionalism, which will increase the buyer’s confidence in your business and its value.
Ź You will have the ability to better anticipate the buyer’s objections and develop concise answers to quickly address their concerns
Ź Often the process uncovers opportunities to improve the operations of the business and thus increase its profitability prior to selling Tango Equity 39
Ź Develop a succinct and compelling case for the viability and growth potential of the business
Ź Responding to a buyer’s requests in an effective and efficient manner, will shorten the timeframe to complete the transaction and increase the likelihood of closing the transaction.
! All of the above advantages will significantly increase the probability of selling the business at a higher price
There are numerous methods of valuing a business enterprise, as we shall examine in a later chapter, but the most commonly employed methodologies are based on discounting future cash flows. Since, present and historical cash flow is an important index in predicting future cash flows it is important to maximize the business’s cash flow. There are no secrets about the methods of improving cash flow. One has to simply adhere to all the traditional business methods. Reexamine the expenses associated with leased equipment, see it there is any room to squeeze vendors, review each expense line item and determine if the business is running optimally. Try to look at your business as an outsider would and ask yourself why you do things in a certain way. Perhaps that’s the way they have been done for a long time and just maybe there is a more efficient way.
It is also a good idea to separate the real estate from the transaction. Institutional buyers are interested in the enterprise value of the business and typically do not want any of the associated real estate. It can complicate the transaction. Perhaps the real estate can be removed from the business entity, be sold separately and then leased back to the company, or you as the owner can agree to retain the real estate and lease it back at FMV.
It is also important to get all of your books and records in order. Appendix x shows a list of common documentation required prior to and during the due diligence process. All of these items should be available, ordered and easily accessible. The purchase of a business may be a bit of an art unto itself but the process is not immune to the old adage that “perception is reality”. If books and records are disorganized and difficult to retrieve, the perception may be that the company is poorly operated and disorganized and that the information that is being provided is flawed and perhaps incomplete. The perception is that this deal may be a lot riskier than it actually is. As Tom Peters said in one of his many excellent books, in referring to a customer’s perception of the airline industry, that “if there are coffee stains on the pull-down tray, it means that the company does not have a maintenance program for its aircraft.” Of course the correlation is inaccurate, but perception is reality. In the same vein, if there are any skeleton’s, problems, issues, latent or potential liabilities, now is the time to bring them out. You should disclose any and all negative issues to the buyer as well as the positive issues. Any legitimate buyer is going to perform a thorough and invasive due diligence process. It is better for the seller to address these items with the buyer before the buyer discovers them himself or herself. The latter raises clouds of suspicion as to what more may not have been revealed. A buyer will be able to deal with a lot of bad news if he or she believes that you are being honest with them. 40 Tango Equity
It is also a good idea to get references from your best customers or clients. The most important factor in the buyer’s due diligence is the examination and determination of the future revenue streams. Expenses can be managed but the client base has been built up over the years and it is important for the buyer to have a strong level of confidence that revenues are going to continue at the present levels or increase.
The last recommendation is to look at the company from a buyer’s perspective. We stated earlier that it is helpful to look at the company as an outsider to see if there are any methodologies, policies or procedures that may be able to be improved, or if new technology can enhance or render the company more efficient. What I am asking here is a little different. What will a buyer see when they drive up to the building, how will they be received at the reception area, and what will be the first thing they see when they enter. The first impression must be one that elicits the perception of a well-run and successful professional organization of value.
If we are really going to look at our company as a buyer would it would be important to learn as much as your can about the buyer in advance of any meeting or telecom in order that you may bring up some points that you may feel are important to the buyer based on their acquisition characteristics. Your advisor should supply your with information on the buyer and detailed information on their investment criteria. Here are some of the more common top criteria:
The company's key managers should have a proven track record and an exceptional ability to communicate the company's story to employees, customers and investors. They should have a deep commitment to creating value for shareholders.
The Company should have a strong proprietary position
There should be a large, clearly-defined market for the company's products or services
There should be an easy to understand and realistic, timely exit strategy for achieving liquidity for investors. If we were to ask 100 institutional investors what their most important acquisition criteria is in a new business (which we did), over 90% would respond that management is the top criteria. Every one will mention management within the top three. It is important then for the owner or top manager to be featured at these meeting and teleconferences. Following initial introductions the advisor should usually drop out of operational discussions between the buyer and the seller. If you hire a consultant who is fond of talking remind him or her that you will be the point person at these meetings and you will take control. With that being said, discussions of the financing of the transaction, that is, purchase price and terms and conditions should be completed primarily by the buyer’s principal and the seller’s agent. There are some very good reasons for this that will be discussed later. Tango Equity 41
Use an Intermediary or Do it Yourself?
If you are a business owner and you have been approached or courted by a potential buyer, and, if you are comfortable with that buyer and are satisfied with the price, and would like very much to conclude a transaction with him or her, then an M&A intermediary is probably not necessary. In this case, you can engage an M&A attorney, or use your corporate counsel if he or she has experience in M&A transactions. I would like to emphasize that it is very important that your legal representation in the transaction be somewhat of a specialist in M&A. Corporate attorneys who have been involved in only a few M&A transactions cannot be expected to detect all of the important nuances of an M&A transaction. M&A, like bankruptcy and Intellectual Property law has a unique set of skills that must be employed and requires the expertise of a professional with special education and experience. On the other hand, if you do not have a buyer, or if you are not sure if the price is fair, or if you want to determine if you can get a better price in the open market, then it would be advantageous to engage the services of an M&A intermediary. There are several good reasons that a seller of a middle market business should consider engaging an intermediary in formulating and executing an exit strategy. 1. Value-added – In a comparison of transactions in similar industries, it was found that transactions involving sell-side intermediaries had Total Invested Capital (“TIC”) (which is comparable to purchase price) that were 20% higher than transactions in which the seller was unrepresented. As previously stated, the fees of M&A intermediaries vary considerably but none that I am aware of charge 20%. As a result, from a purely economic standpoint, engaging an intermediary is an immediate value-added proposition. 2. Experience – Most entrepreneurs are very good at what they do and have an excellent ability to grasp new principles and generate high-quality thought processes. But, M&A professionals introduce concepts and situations that are totally unfamiliar to most business people and entrepreneurs. M&A intermediaries know how to package and present a company. Many intermediaries who have access to buyers are intimately familiar with the acquisition characteristics that their buyers are seeking, and all of them are very familiar with the concepts of corporate finance needed to recast financial statements. They are also able to demonstrate the characteristics of the Company that will optimize its value. Most business owners only sell one business in their lifetime, and it should be pursued with the assistance of capable professionals. 3. Finding the buyers – Some have argued that M&A in the middle market is similar to real estate brokerage. As we have previously argued, nothing can be further from the truth. For example, when selling a house, the broker wants as much exposure as possible. Many real estate agents, when marketing a residential property will send letters or postcards announcing the availability of the property to all of the seller’s neighbors. This universe may contain some likely buyers and may produce future referrals for the agent. The more people who know about the 42 Tango Equity
availability of the property the better. Just the opposite is true in selling a business. The general distribution of such information would be disastrous, especially in a services business. However, in any business it is dangerous for competitors, creditors, employees and customers to be aware that a business owner is considering an exit strategy. The process must be discreet and the information distribution selective. Most M&A professionals know buyers , or they know how to find the buyers. Some, like Tango, already have the buyers and are intimately familiar with their acquisition criteria. In each situation buyers or buyer groups can be contacted on a limited, targeted, selective and confidential basis. 4. Qualification of buyers – Many M&A intermediaries have groups of pre-qualified, highly motivated buyers with excellent financial resources. If a business owner attempts to sell a business him or herself or engages a broker who will solicit buyers from the general public or with the use of mailing lists, then a great deal of time is going to be spent in qualifying the buyers. Frequently, especially if Internet advertising is involved, most of the buyers are not going to be qualified. By being qualified we mean that they have the financial resources or the access to the financial resources to complete the transaction. This is a very time consuming process and involves obtaining proof of funds from the prospective buyer’s banks or financial backers. 5. Assistance in the negotiation process – Many business owners are excellent negotiators. Like M&A intermediaries they practice this skill in their business often every day. Even in these circumstances, the M&A intermediary plays an important role. Although negotiations are rarely combative, they are frequently contentious and always confrontational. The buyer and the seller have competing interests, and there are hundreds of details that need to be worked out in order to make it to the closing table. Issues that are going to result in some heated discussions cannot be avoided. By using an intermediary to negotiate on behalf of the seller, the relationship between the buyer and seller remains pristine. This is especially important when there is going to be a relationship that needs to work, at least temporarily, subsequent to the closing. This always makes the process go easier and increases the chances of getting to a successful completion of the transaction. Another reason that is somewhat inexplicable is that buyers will relate to and confide in the intermediary certain information that he or she would never tell the buyer directly. This makes the intermediary an important conduit of information that could be invaluable in getting a deal completed. 6. Documentation – Another value added service that many intermediaries offer is document review and preparation. Many experienced intermediaries can actually prepare many of the documents involved in a transaction from a Letter of Intent to a definitive Asset Sale/Purchase Agreement. Note, that we, or most other intermediaries do not provide legal advice. However, we can prepare the documents for the business owner’s M&A attorney to review. Also note that in transaction protocol the control of the documents is usually the buyer’s prerogative. The buyer usually initiates the process and writes up the first draft of each document. However, there have been times that the buyer has requested that Tango Equity 43
the intermediary write up a LOI for their attorneys to review since the intermediary may be most familiar with the details of the transaction. Most middle market M&A intermediaries will gladly do this to facilitate the deal, again not as legal advisors but as facilitators who can produce the document for legal review. Even if the buyer wants to initiate and control the documents, Tango and many of the other experienced intermediary firms can provide their assessment and review and perhaps save some legal expenses or at least act as a “second set of eyes”. 7. Confidentiality – Finally, there is the issue of confidentiality. It is almost impossible to protect the confidentiality of the transaction if the owner is acting as his or her own agent. An intermediary can discuss a potential transaction with a seller’s cross-town competitor without revealing the name of the business. This is not possible if the owner is not using an agent. In general, it makes the first step of the marketing of a business, the point before a confidentiality agreement is signed and detailed information is exchanged very difficult, if not impossible. If, after these admonitions, a business owner still decides to represent him or herself, then we extend our sincere best wishes for success and offer that if any business owner has any questions on the process or would just like to run an idea past the M&A experts here at Tango, we would be pleased to offer any assistance we con without obligation. We really enjoy doing what we do. We are in the business of putting buyers and sellers together and always enjoy discussing business issues. We promise to give you sound advice and the best of our knowledge and experience whether you are our client or not. However, we are now going to proceed in the description of the process by assuming that you have chosen the prudent course and engaged an intermediary to assist you. We will also describe Tango’s process, which is generally similar but slightly more accelerated than most of our competitors.
Case Study – the Value of the Intermediary It is often difficult to arrive at a strict quantitative economic appraisal of value-added services. This is especially true in situations in which the level of effort and scope of services to be provided are difficult to even estimate. In the sale of a middle market business it is understood that certain research must be obtained, valuations determined, methods of marketing, packaging and positioning established etc. These services are not that difficult to put a price to. The real “value-added” proposition is, “what is the addition of these services going to add to the bottom line?” In the end, how much of a difference in sales price are the services going to make. To the extent that the difference in the present value of the total consideration to the seller with the services compared to the present value of the total consideration without the services exceeds the price of the services, then value has been added and the services are “worth the price”. As already mentioned, it has been reported that the average sales price in transactions in which the seller is represented by a business intermediary has exceeded the average purchase price in transactions in which the seller had no outside representation by around 20%. This would be a good indicator that the cost of even the most expensive business intermediary (about 10% of sales price) is justified. However, there is rarely a way of making such an estimation of value in 44 Tango Equity the absence of independent variables that may confound the factual basis of the analysis. At best this is only conjecture. Fortunately, Tango’s consultants did experience a set of circumstances that present an actual analysis. Tango was engaged by a medium-sized temporary staffing firm based on the East Coast. The Company had been in existence for approximately 3½ years and had grown to a little over $30 million in revenues and was approaching a break-even point. Gross margins were at 27%, which is in excess of the industry average; so the fact that the company was not yet profitable was due to start up costs and the working capital requirements of a fast growing business. The company wished to accelerate it expansion plans through an acquisition strategy, and engaged Tango to contact and assess companies that were possible acquisition candidates, and then to negotiate and conclude transactions on behalf of the company. Tango located a company fitting the client’s acquisition criteria in the Southwest. The target company had no outside financial consultant and the seller represented himself in the negotiations. The target company had the following characteristics: Revenues were $21 million, gross margin was $4.6 million, operating income was $1.68 million and adjusted EBITDA was $1.882 million. The deal was negotiated by Tango for a purchase price of $4.2 million, consisting of $1 million in cash at closing and the balance of $3.2 million secured by a five-year note. Tango’s client commenced due diligence and the preparation of the necessary documents. During the later stages of due diligence the CEO of the buyer experienced a personal tragedy which forced the buyer to Discount Rate 5% withdraw from the transaction. If the Buyer Rep Seller Rep transaction had taken place 1998 1999 the seller would have Revenue 21,000 18,700 received $4.2 million, but Gross margin 4,620 4,114 since 76% of the 22% 22% consideration was paid with Operating Income 1,680 1,496 a five year note, the present Adjusted Ebitda 1,882 1,676 8% 8% value of the $3.2 million ppm 2.5 3.2 note was only $2.77 million purchase price 4,200 4,787 using a 5% discount rate. cash at closing 1,000 4,308 Therefore the actual present Contingent note 3,200 479 value of the total Non contingent note consideration was $3.77 PV 3,768 4,740 million. Approximately Seller Commissions - 95 nine months later, Tango’s Effective ppm 2 2.8 client was still not ready to effective gmm 0.8 1.1 reenter the acquisition effective rm 18% 25% arena and estimated that they probably would not be so inclined for the foreseeable future. Iin exchange for some consulting fees that were still owed, Tango requested and was granted, permission by the client to solicit several potential acquisition candidates.
The Southwestern staffing company described above engaged Tango as its financial consultant and Tango prepared the documents described later in this book and actively marketed the Tango Equity 45 company. At that time the trailing twelve month performance had deteriorated somewhat and the company had the following operating characteristics: Revenues were $18.7 million, gross margin was $4.1 million, operating income was $1.5 million and adjusted EBITDA was $1.676 million. Approximately 6 months after the sell side engagement had commenced the company had an offer which Tango negotiated and was structured as follows: the purchase price was $4.787 million which was offered in two components. First, there was $4.308 million in cash at closing and second, there was a non contingent note for $479k. The difference in the purchase price was $587,000 and, since 90% of the purchase price was paid in cash at closing the present value that the seller received was $4.74 million for a difference in actual present value of $972,000. This can be looked at in two ways – when Tango represented the buyer, the buyer paid nearly $1 million less, and when Tango represented the seller, the seller received $972,000 more. However, this is still not an “all things being equal” comparison because the revenue, gross margin, and EBITDA of the seller were lower in the second transaction. The difference of $972,000 was for a company that should have been valued at a lower amount. The effective purchase price multiple of EBITDA was 2.0 when Tango represented the buyer and 2.8 when it represented the seller, a difference of 38%!
The Documents
As stated above, most brokers and intermediaries prepare at least two main sales documents to market a business property. In addition, there are several additional deliverables that an engaged M&A intermediary typically provides to its client.
DELIVERABLES DESCRIPTION
Due Diligence Data will be gathered to assist in the valuation, the creation of the Executive Summary (“Teaser”), and development of the Confidential Information Memorandum (“CIM”)
Valuation We will determine a price range for your business, utilizing various valuation methods
Short Blind Summary (“Teaser”) The Short Blind Summary (“Teaser”) will highlight key information regarding your business, and will help to solicit interest from buyers while maintaining your anonymity
Executive Summary Usually prepared for institutional buyers. It is a highly condensed version of the CIM
Confidential Information After a non-disclosure agreement is signed we will provide Memorandum (CIM) buyers with a CIM which will provide a buyer with all the information they require to make an initial offer
List of Buyers We will provide a list of buyers that we will contact directly to solicit offers
Table 15 – Typical Deliverabales from M&A Consultant 46 Tango Equity
The process will begin with the collection of the various information that is needed to assemble the CIM. Next a valuation is performed to determine the proper pricing. This is an important point which will be discussed in greater detail in Chapter 5. The first marketing deliverable is the short “blind” summary, also known as the one-pager, although it is frequently two pages but rarely three pages. The one pager reveals the company’s revenues, gross margin, and EBITDA (cash flow) from operations. It also identifies the Company’s industry and service area and discloses a general location of the headquarters of the company such as Northwest, USA, Southeast, USA, Brazil, China, etc. This is followed by a short description of the business without sufficient distinguishing characteristics as to enable the buyer to ascertain the identity of the company. There are several examples of blind short summaries in Appendices B-1 through B-4. When a client company engages Tango (and the process is similar for most middle market M&A intermediaries), the seller immediately receives a seller’s kit electronically. The seller’s kit contains two questionnaires and a sample of a Non- Disclosure Agreement (NDA). The seller does not have to sign the NDA; it is included just to show the client the document that is being used prior to disclosing confidential information to any prospective buyer. The first questionnaire is the Seller’s Short Questionnaire (Appendix C) and is used to create the blind summary. Ideally, it is best to have the Short Questionnaire completed on the same day that we are engaged, but certainly within one or two days. If an engagement is signed in the morning we like to have several buyers identified and contacted by the following afternoon. Tango, like other middle market M&A intermediaries, has a database with extensive information about all of our buyers and their acquisition criteria and their portfolio companies. Because we have frequent contact with most of our buyers, their acquisition criteria and portfolio holdings are very up to date. In addition, we have a program known as a “Spider” which searches the web sites of our registered buyers to search for press releases or new additions to their acquisition portfolios. Our database will return several matches of the characteristics of the seller’s company with the buyer’s acquisition characteristics and/or portfolio holdings. We usually contact these companies within twenty-four hours of receiving the engagement to tell them a little about the opportunity and let them know that a one-pager will be prepared and sent to them by email in the next day or two. This creates a level of expectation in the buyer and the buyer will certainly at least take a look at the opportunity when it arrives in their email. When the seller completes the Seller’s Short Questionnaire, the intermediary creates the one-pager. The one-pager is posted to a secure web site and a message is generated and sent to each matching buyer in our database by email.
Property No.297001 Listing Date - 3/15/2004 Click Here to View Short Summary Business Name: Manufacturer of Promotional Products Business Type Business Services Business Services Manufacturer and Assembler of Logo/Promo Products Revenues $6,500,000.00 EBITDA $1,500,000.00 Location Southeastern USA This Company is a nationally recognized manufacturer and assembler of logo and promotional products for businesses in the hard goods promotional/advertising industry. The Company’s products are sold through a network Tango Equity 47
of distributors in North American and Europe. Specialty is products with unique lighting via compact, self- contained LEDs.
Table 16 – Example of email listing
The email gives a very short description of the opportunity and provides a link to the secure web site where the registered buyer can view the blind summary. Over the next few days to few weeks there will be expressions of interest from the buyers on the newly offered business. During this time the seller and the intermediary will complete the Seller’s Long Questionnaire (Appendix E). Some intermediaries may not supply this but will work from a similar checklist to ensure that all of the information for the CIM has been gathered and reviewed with the client. While the information is being assembled and the CIM is being prepared, buyers will be contacting the M&A intermediary and requesting additional information on the company, still realizing that very few details can be provided in the absence of a signed NDA. However, there may be some questions that are critical to the buyer that can be answered, and which were not included in the short summary. For example, “Is it a Union Shop?” is frequently asked with regard to manufacturing operations, and a question that can be answered without compromising confidentiality. If the buyer is still interested, he or she will be provided with a Non- Disclosure Agreement (NDA), also known as a Confidentiality Agreement. Upon the buyer’s execution of the NDA, the intermediary will provide the Confidential Information Memorandum immediately via email. The CIM is in a secure .PDF document format, which does not allow it to be modified or copied to another document.
Marketing Timeline
WEEK 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 Production of Short Summary Production of Offering Memorandum Short Sum. Distributed to Prospects Expressions of Interest received Dist of Offering Memorandum Telecon Management Meetings Negotiation of LOI Field Due Diligence Data Reduction Preparation of Sale Documents Final Contract Negotiations Document Review Preparation of Schedules Closing Table 17 – Marketing Timeline Over the next 2-3 weeks, expressions of interest will continue to be received from the buyers. Tango representatives make direct telephone contacts with each of the most likely buyer prospects and solicit their reaction to the opportunity. Each of the prospective 48 Tango Equity buyers will be obliged to execute an NDA in order to receive additional information. The confidentiality agreement prohibits the buyer from disclosing the information contained in the Offering Memorandum and any confidential information that is exchanged between the parties during the negotiations. Also in this agreement the buyer is prohibited from contacting or soliciting any one in the company without the express written consent of the seller. It also prohibits the buyer from disclosing that there are discussions proceeding with the selling company or from even mentioning that the company is for sale. It also limits the usage of the information obtained during these discussions to being used for its own internal evaluation of the company. In addition, any of the buyer’s consultants or advisors who shares this information must agree to be bound to its terms. The intermediary will require verification of such consent. Occasionally, the buyer will object to some part of the CA, usually the term. In these cases the intermediary will negotiate acceptable terms with the buyer or the buyer’s attorneys. In cases in which there are material changes in the CA, it is the duty of the intermediary to inform the seller and pass along the changes with their recommendations for approval prior to the disclosure of any confidential information. When the intermediary has an acceptable NDA fully executed and in place he or she will forward the Confidential Information Memorandum to the prospective buyer. The CIM is a detailed description of the company, and includes raw financial data from the past several years and frequently, depending on the circumstances of the transaction, financial projections for up to five years along with supporting documentation.
TOPICS DESCRIPTION
Executive Summary Overview / history of your Company. Vision / overall strategy for business. Objective of the memorandum
Business Summary Description of products and services
The Opportunity Why this is a good investment opportunity
Sales and Marketing Description of sales and marketing organization and activities. Pricing trends. Sales and marketing personnel compensation and incentive arrangements, including rationale. Company’s competitive position, by product or service line. Closest competitors, service and product offerings. New entrants to market including service and product offerings. Company advantages relative to competing products / services.
Customers Key target customer base for future marketing. Current customer concentration by type, geography, revenue, product line. Description, analysis of customer prospect pipeline (list of prospects and stage of discussions, probability to close).
Operations Description of Company facilities, locations - if a division, shared facilities with rest of the Company; separation issues. Suppliers - description, names, level of dependence, and concentration. Alternative sources of supply. Tango Equity 49
TOPICS DESCRIPTION
Management and Employees Dependence on key personnel, detail number of employees by functional area, and status of employee relations. Expectations for headcount growth by functional area. Compensation structure, significant employment contracts.
Financial Overview – Management discussion of financial performance. Income, Cash Flow, and Historical and Normalized Balance Sheet Statements (last 3-5 years). Includes the recast financial statements
Financial Review – Projections Describe financial and qualitative assumptions. Income, Cash Flow, and (Optional not typically included) Balance Sheet Statements (projected 3-5 years).
Legal List of business entities, companies or organizations related to the Company through any official or unofficial ownership or business ties. Status of any current or threatened litigation. Legal issues relating to the sale of business.
Table 18 – The CIM Topics The CIM begins with an executive summary which includes the objectives of the CIM. It also contains a detailed description of the business, a discussion of the investment highlights and a description of the opportunity. The sales and marketing systems are described as well as the operations. There is a discussion of the competition and the Company’s competitive advantage, and the unique marketing advantages that the Company enjoys. Biographies of the key management personnel and the sources of the company’s revenue which consist of a description of the products and services that the company provides or produces. If the company is seeking a capital or equity partner, there will be a section on the uses of funds, which will describe why the funding is necessary and how it will be put to use. The last section will be the financial section and if the company is simply being offered for sale this will consist of a section summarizing the raw financial data consisting usually of income statements, balances sheets, and statements of cash flow typically for the last five years. These statements are typically prepared in accordance with GAAP on the accrual basis of accounting. Also in this section will be a restatement or normalization of the income statements for at least the past three years. The process of recasting or normalization, as explained above, adjusts for the owner’s draw and any unusual, extraordinary or non-recurring expenses or revenues. The recasting is intended to estimate the cash that the business is generating for the owners under standard operating conditions. The review of the offering memorandum may take from a few days to a few weeks. In many large groups, if one of the members finds a deal attractive and believes that it is a good fit with the company’s investment strategy, he or she may sponsor that project. The sponsor will prepare some summary information and report to a committee or executive group or perhaps just to the rest of the members about the company, the prospects, the management and how it fits in with the other investments that the Company has made or how it can benefit from the transaction. When dealing with institutional investors, the intermediary usually prepares a short executive summary for the prospective buyer. This is a document that runs two to five pages and presents the company and the transaction in a very condensed format. The buyers find this document very helpful in these 50 Tango Equity presentations. Appendix H is an example of an Executive Summary. Often, the intermediary will also provide registered buyers with editable copies of the executive summary in order that they may be customized for internal purposes. Over the next several weeks, expressions of interest, questions, and requests for additional information from new and existing buyer prospects will continue to be addressed. At this point, the process begins to move more quickly and to perhaps proceed in several directions simultaneously. Some buyers would like to proceed directly to a face-to-face meeting with management. Sometimes there is a request for additional financial or operational information. Most often, following the prospective buyer’s review of the offering memorandum, the intermediary will arrange a conference call between the prospective buyer’s representatives and the management or owners. The intermediary usually sets up and facilitates the conference call and coaches the seller and apprises him or her on the buyer and the buyer’s idiosyncrasies and “hot” and “cold” issues. The intermediary will initiate the call and make the introductions and suggest a format for the meeting. However, by and large, it is recommended that the intermediary not be a participant in the conference call. The call should be a forum for the buyer and the seller to interact and to learn about each other’s objectives and their respective companies. Similarly, in preparing for meetings, the intermediary should provide coaching, insight, and assistance to the seller and then step back. In some instances the M&A intermediary may not attend even the initial meeting between the seller and the buyer. The intermediary will however, follow up with both the buyer and the seller to get their feedback and assessment and then proceed to facilitate the process and keep it moving forward.
Sidebar: Separating Due Diligence from Initial Assessment To a large extent the buyer controls the process after the initial distribution of information – the one-pager, the executive summary and the offering memorandum. All experienced intermediaries realize that buyers carry out their process differently. Some move quickly to engage the seller in face-to-face discussions and others prefer to examine financial information in some detail and make their initial assessments “by-the-numbers” rather than by their assessment of management’s prowess and the sector’s attraction. It is the intermediary’s responsibility to move the process along and to get the prospective buyers what they need to make the decision to proceed and to be able to perform their analysis of the valuation of the business. The initial assessment that the buyer needs to make is whether or not this business fits his or her acquisition criteria, if the Company’s position in the industry is attractive, and if competent management is in place or available. The information required to make this decision should be available in the documentation initially provided and supplemented with a few telephone conversations or meetings with the owners and/or management if they are not one in the same. When the prospective buyer has made a decision that this is a suitable investment property, the next step is to determine at what purchase price this investment would make sense. To do this it is necessary to obtain information that will enable the buyer to formulate a quantitative assessment of the future cash flows expected from the business. To do this the buyer can examine historical data and make inquiries to management concerning the future Tango Equity 51 prospects of the business. At the end of this step the buyer is in a position to arrive at a valuation and to engineer a deal structure that accomplishes the buyer’s economic objectives, and; to the best extent possible, fulfills the seller’s requirements. At this point the buyer is ready to submit his or her offer. The last step in the process is to perform a prudent and thorough investigation of the data provided in the valuation process as well as the material representations made by ownership and management during initial and ongoing discussions. As one would assume, the due diligence process is lengthy, invasive, and costly for both buyers and sellers both in human and financial resources. Management will be tied up, distracted, and stressed. Professional fees will be incurred and unforeseen problems will usually be encountered. My point here is that it is incumbent upon the intermediary to exercise discretion in balancing between what the buyer needs to make a valuation decision and what is due diligence information. Asking for the balance of Accounts Receivable is basic information required to make a valuation decision; an Account Receivable detailed aging report is a due diligence item. Capital Expenditures and Accounts Payable are necessary to determine the valuation of the business property. Details of these schedules are due diligence items. Whether or not there is outstanding potential litigation and management’s assessment of the aggregate economic impact are important in assigning a valuation; the details of that litigation and management’s assessment of the aggregate economic impact is a due diligence item. In summary, information is gathered from primary sources and from management’s representations to arrive at an economic valuation, which is then reduced to writing in the form of the Letter of Intent or similar document subject to final due diligence. Subsequent to this, the sources and representations are verified to the extent that is reasonably feasible in the due diligence process. The two steps should not be confused and it is mainly the responsibility of the sell-side intermediary to tactfully monitor, control, and direct the process.
The Letter of Intent Over the next 2-8 weeks many additional meetings and teleconferences will take place. The buyers will be analyzing the data being provided as well as doing their own additional industry research. This is another reason why it is wasteful and unnecessary to pay an intermediary $15,000 to $40,000 to produce an offering memorandum containing 40-50 pages of industry statistics, long range geographical demographics and analyses and broad economic indices. Typically, they are not read by the buyers, and if they are read, they are in most cases revised or ignored in favor of their own data. At some point there is going to be a buyer, who, after finishing preliminary meetings and research is prepared to move ahead with the transaction. Most intermediaries will not quote an asking price to the buyer, but will provide the buyer with a general idea of the seller’s expectations. What may be said is that the seller does not have unreasonable expectations. The seller believes that because of these very specific compelling reasons, that the company should sell on the higher end of the range or perhaps at a premium. The seller is also looking for the greater part of the compensation to be in cash and paid at closing, but will consider some level of financing. The saying is that, whoever mentions a price first loses. 52 Tango Equity
Typically, the next step is the Letter or Intent (“LOI”). When a buyer has reviewed readily available information and is comfortable with management it usually will be prepared to make an offer. This usually takes the form of an LOI. The buyer will usually contact the seller’s agent and verbally describe the circumstances of the proposed transaction. If the proposal is close to what may be acceptable, the intermediary will request that the general points of the offer be put in writing. This takes the form of a non- binding LOI. Sometimes, especially if the buyer is a publicly traded entity the buyer may not want to call the Letter of Intent a Letter of Intent. Often you will see these non- binding LOI’s called Recitations of Principal Points, or a Memorandum of Principal Points or a Recitation of Potential General Terms or any number of similar derivatives. . Although this document is not binding on either party some companies especially public entities will go to lengths to make this clear in the document. This is because if a LOI were binding or otherwise implied that there was the creation of an obligation by the buyer or that there was some significant probability that the underlying transaction were imminent or likely to occur, there may be an obligation to report the fact to the public. Consequently, you will often see language in a LOI that “this is not an agreement, or an agreement to make an agreement,” and it is “not intended to be a document upon which either party may place reliance”. While on an initial reading this verbiage may invoke some consternation on the part of a seller, it is typically more innocuous and meant to definitively state that, at this point in time, a transaction is not imminent or even likely. The non-binding LOI is a very important document since it sets forth all of the major deal points. Appendix I is a sample LOI or in this case a “recitation of Principal Points”. The Recitation describes in a fairly high, but not definitive, level of accuracy how the buyer is proposing that the transaction work. When a buyer calls an intermediary and outlines what he or she has in mind regarding the possible circumstances of a transaction, the intermediary should first determine whether the deal has a chance of success before wasting any time. The intermediary may suggest certain modifications that may better coincide with the business owner’s objectives. As mentioned earlier, in our experience, the most important things to keep in mind in engineering the structure of a successful transaction was to listen to what the seller wants and to try to determine what his or her objectives are and what is really important. This is even more important to the business intermediary who is representing a seller. There is another tenet that many intermediaries try to assiduously adhere to and that is never to negotiate without a written offer, and; as previously mentioned, do not be the first one to name the price. If a buyer has described an offer, and it is believed that it is at least a worthy of consideration the intermediary should ask the buyer to put the offer in writing. If the buyer will not put the offer in writing, the intermediary should propose to put the offer in writing for them just as they described it. If the buyer still does not want to put the offer in writing, then simply tell them that we are unwilling to proceed without a written offer and let them decide whether they would like to forgo the opportunity. This step can save a great deal of time and avoid misunderstandings later. The LOI or recitation that is attached in the Appendix is a uaeful guideline for the terms that should be covered in an initial non-binding set of deal points. At this early stage in the M&A process we don’t want to get bogged down in the process of negotiating the minute details of the transaction but we do need to have sufficient details to be able to evaluate the offer. The initial LOI should at least explain: Tango Equity 53
1. What is the exact deal structure? a. Asset vs. stock sale b. What exactly is the buyer buying? 2. The consideration a. What is the total consideration? b. How is it going to be paid? c. If there is cash at closing, how is it going to be paid? Will there be and conditions that would warrant an adjustment to the cash at closing? d. Is there a Note? How is it going to be paid? What are the specific terms and conditions of the Note? What is the interest and term? Are there any contingencies? How is the note to be secured? e. Is the buyer suggesting any Contingent Consideration and an earn-out 3. If we agree to this what are the buyer’s “outs” a. Is there a financing contingency? b. What about due diligence? Is there a due diligence contingency? If so, is it necessary that there be a certain level of material adversity before the buyer can pull out of the transaction? 4. What are the major reps and warranties that the buyer is asking for? 5. What indemnifications are being requested? 6. Is there an employment contract or consulting agreement with the present management or owners? If so, what are the general conditions and are the basic terms and conditions clear? 7. Is the buyer requesting a lock up period? If so, for what period and how does the seller benefit by giving the buyer a lock up?
We have included a sample Recitation of Potential General Terms in Appendix I. Because the LOI is such an important document it may be useful to review in some detail.
The purpose of the non-binding letter of intent is twofold. First, it is to determine the exact circumstances of the offer. As we pointed out earlier, the price and the deal terms go hand in hand and it is impossible to interpret the value of one in the absence of the other. When we have this information it is possible to make a decision as to whether this is a viable offer worthy of pursuing or conceding that the parties are just too far apart and it is best not to waste any additional time on the expectation that some compromise can be achieved and a transaction concluded. If we have arrived at the decision that this offer is viable and worthy of pursuing then the next step is to begin to negotiate the binding letter of intent. We first look carefully at the sample Recitation of Potential General Terms to determine whether it covers all of the terms that we want to see covered in a non-binding letter of intent.
First, this is a LOI that was developed for a buy side client. Keep in mind that in this case the intermediary was representing the buyer and some of the terms and conditions put forth in this letter would be omitted if it were developed on behalf of the seller. The terms and conditions in this Recitation are significantly more harsh and severe than we would like to see in a situation in which we were representing the seller. 54 Tango Equity
To begin, note that the introductory paragraph makes a point of clearly stating that this is not a binding agreement.
“This is not an agreement or an agreement to make an agreement and is not intended to be a document upon which either party may place reliance.”
There can be no misunderstanding of the fact that this is not a binding agreement. It may not be exactly the language that a seller would like to hear, but there can be no mistake in its clarity.
Our first question is “what is the deal structure?” Again, this Recitation is very clear in stating that this is a Purchase of Assets (as opposed to Stock, see Chapter 6) of International Widget Inc. This is stated in the reference line, and again in the introductory paragraph and still again in Section 1. The Recitation goes on to explain some of the items that would be included in the asset purchase and perhaps more importantly what is not included. In this case, cash and cash equivalents are being excluded. In other words, the deal is going to be specifically for the operating assets and the owner is going to take all of the cash out of the business. The Recitation has now answered the questions, “What is the deal structure?”, “Is it an asset or a stock deal?”, and “What exactly is the Purchaser buying?”
The next question is with regard to the consideration. This is the substance of the Recitation and there are a lot of questions that need to be answered. First, “What is the consideration?” The purchase price is $3.5 million and it is going to be paid in two components. The first is going to be a payment of $2 million that will be paid at closing via a wire transfer. The remainder of $1.5 million is going to be paid with a three-year note. The Recitation states that this note will carry imputed interest, which means that the note carries 0% stated interest, and payments will be made annually in arrears in equal installments of $500,000 each. The note is going to be secured by the assets of the company. The fact that the buyer is offering that the note be secured by the assets of the company implies that they are probably not going to offer other tangible security to the note. We can discuss the importance of this later, but for now, suffice it to say that, with regard to the consideration, the Recitation is pretty clear about what is being offered for the company and how it is going to be paid. Another important fact is that the buyer has tied the amount of the cash at closing to that which they are defining as the Adjusted Net Tangible Equity value. The Adjusted Net Tangible Equity is the net tangible equity less the assets not transferrred, in this case cash and cash equivalents. Also note that this adjustment apparently can go either up or down. The purpose of this adjustment is primarily to prevent any unusual and non routine transactions or distributions from taking place in the period from when the binding LOI is executed until the closing of the transaction. Keep in mind that there will be an adjustment to the cash at closing based on this stipulation. Even during a short period of time before closing on the transaction, there would be AR’s continuously being converted to cash, WIP converted to Finished Goods and AR and services being provided to create additional WIP. The concept here is valid - if the buyer is paying for a certain expected cash flow which will be generated by the business assets, which business assets have been valued equal to the net tangible equity, and the value of those assets were to change then the valuation should also change, either Tango Equity 55 up or down depending on whether the equity increased or decreased. The main reason that there is a provision such as this is to replace a commitment to run the business in the ordinary course which is considerably more subjective. Under such a provision the seller agrees not to make any unusual distributions, purchases, bonus disbursements etc. The concept of the net tangible equity adjustment adds a quantitative aspect to that covenant. We would expect that there still would be a ordinary course of business covenant in the final Asset Purchase/Sale Agreement unless that document is to be executed at closing which often happens, especially with publicly traded companies for the same disclosure reasons discussed above. In this specific case, the buyer’s biggest concern was that since the seller was keeping the cash and cash equivalents that there may be an opportunity for the seller to attempt to accelerate the conversion of the AR to increase the company’s cash and consequently he would get more cash up front out of the deal. Under the conditions proposed here the seller can still do that but that would cause the AR to decrease by that amount of the increase in cash and thus the Net Tangible Equity would drop and the Cash Payment at Closing would also drop by the amount to the AR that was converted. So, the seller can still accelerate the conversion of the AR but it would be economically neutral to both the seller and the buyer.
The next point to determine is, “what are the buyer’s outs”? If this offer is accepted, what is the buyer proposing to be bound to do? In this case the buyer is suggesting that he or she has an “out” if the buyer is unable to retain enough key personnel to continue to operate the company at the current revenue levels. This is probably going to be more important in service organizations that it is going to be in a manufacturing environment. Many service organizations are relationship-driven businesses. Many of the sales staff or the service managers have established relationships with the clients. Much of the customer’s loyalty is to the individual providing the services or overseeing the provision of the services. If the new owner cannot retain that particular individual, that business may be lost. While this is a fairly specific prerequisite, the buyer has another “out” in Section 13. Section 13 is a due diligence out and broadly states that the agreement will be subject to the satisfactory findings in the buyer’s due diligence investigation.
“will be subject to Buyer's satisfactory findings from its due diligence investigation “
This is an extremely broad exemption and basically says that the buyer can get out of the transaction for any reason if he or she wants to. Again, at this point we are not going to argue the merits of the proposal but simply whether or not it covers all of the salient issues that need to be addressed at this stage of the transaction.
The next question, on our checklist is, “What are the major representations and warranties that the buyer is asking for?” The final Stock or Asset Purchase/Sale Agreement is going to contain sections detailing the representations and warranties that are being made by the buyers and the seller. A representation is a statement that is made to induce the buyer to completing the transaction that the buyer would not have agreed to had that assertion not been made. If the representation turns out to be false or misleading the contract may be voided at the option of the buyer. A warranty is a guarantee. Representations (“reps”) and warranties are very important parts of the document. If one of the parties executes an 56 Tango Equity
agreement in which they make certain representations which later are found to be untrue, this may constitute a default in the agreement and trigger the default remedies. In this case, the buyer has stated that he or she is going to be expecting that the seller make several reps and warranties and has even added a preferred remedy for “curing” such breaches. In Section 10 the buyer is requesting that the seller provides a warranty that all of the Accounts Receivable (“AR”) and the Work in Process (“WIP”, or “Unbilled Receivables”) is collectable and fully earned. The buyer is shifting the risk of collectability to the seller although the buyer is buying those accounts as a part of the purchased assets in Section 1. Furthermore, the buyer is suggesting the remedy by stating that he or she will have the option of set-off or recoupment. This means that if a portion of either of these accounts is not collected, the buyer will either deduct that amount from the note (set-off) or demand that the seller repay some of the consideration already paid by the buyer (recoupment). In Section 11, the buyer is affirmatively stating that they are not going to assume any of the seller’s liabilities except those expressly included in an assumption agreement. This is one area of the proposed agreement that really requires some clarification. Specifically, what liabilities does the buyer expect to assume in the assumption agreement. It would be expected that the buyer would assume all of the booked balance sheet obligations since they are purchasing all of the associated assets, but the seller’s intermediary would need to confirm these expectations and the buyer should be requested to clarify his or her intentions with regard to the liabilities that are going to be assumed.
Addressing the issues The next issue is perhaps the most frequently contested and the mutually issue in any purchase/sale agreement. This is the issue of exclusive inherent indemnification. In Section 12, the buyer is requesting conflicts in the that the seller provide a disclosure of all current or known indemnification potential claims or occurrences that might result in claims. provisions of an asset It would be obviously very difficult to disclose all PSA requires a skilled occurrences that might result in claims as the seller is and experienced M&A probably not aware of such. The section goes on to say attorney that the seller will retain liability for all claims and will indemnify the buyer from any action brought against the buyer or the purchase assets as a result of any action, act, omission, etc. This issue is usually more contentious in a stock transaction that in an asset transaction, but in either structure it is something that has the potential to burn up more attorneys’ fees than any other section of the document. The buyer has also requested that it have a right of set off and recoupment of amounts that it has to pay to settle claims or preserve a customer relationship. Each of these requests complicates the matter considerably. Implied in the request to settle claims is that the buyer is going to retain the right to control its defense in a claims issue and to negotiate a settlement. If the seller is granting an indemnification to the buyer for any claims brought against it or the purchased assets and the buyer is also controlling the defense of such claims, there is little incentive for the buyer to contest a claim. Rather than wasting time bargaining for a settlement, the buyer would be much better off by simply agreeing to the payment demanded in the claim and then exercising its right of recoupment to be reimbursed for the settlement charges. Furthermore, as this is expanded to include actions that must be taken to preserve a customer relationship the implication is that a formal Tango Equity 57 legal claim may not be a prerequisite to a settlement followed by recoupment. To provide an example, imagine that the seller is a provider of business services, and three months following the closing of an asset transaction, a customer complains that a pre closing job was not completed according to the specifications agreed to. Although it appears that the services were performed properly, the actual scope of work in the contract is a little unclear; the buyer opts to perform the additional services for the client in order to preserve the customer relationship. The buyer then sets off these actual costs of services against future payments on the note, which is still owed to the seller. If the terms, as suggested in the Recitations were accepted, it would appear that the buyer would be justified in exercising such a set off, although there probably was not a conclusive basis for the customer’s claim. As mentioned earlier, this represents a general and very real conflict that makes this indemnification provision particularly difficult to resolve. If the buyer is controlling the defense of any claims against it, there is little incentive for the buyer to expend much time and effort to resolve a matter since the economic impact of the settlement is going to be borne by the seller. In addition, the buyer (who is the new owner at this point) has a vested interest in preserving a good relationship with the customer. On the other hand, if the seller is in full control of the defense, the seller (now the former owner) has no privity with the client and very little interest in resolving the claim quickly and under terms that may be attractive to the customer. This is a problem because despite the legal separation of the purchased assets and the seller’s company that did the work. The new company and the new owners are going to bear the economic fall-out from the bad will generated by the failure to resolve the claim and the buyer may lose a customer. The customer generally does not care who owns the company now, who owns the assets and, who indemnified whom. The customer wants the problem resolved and for the company to fix it. To reach a fair agreement under such directly mutually exclusive conflicting conditions requires the skills of a very good, very experienced, M&A attorney and financial consultant.
The buyer is also offering a three-year employment agreement to the seller, John Smith for $200,000 and the usual benefits offered to other executive level employees in the firm. It will be necessary to negotiate satisfactory terms for termination and severance, but these are addressed in the final Asset Sale/Purchase Agreement. The buyer has also introduced the possibility of a performance bonus and stated that the subject would be covered by the parties to the agreement prior to the closing. While this is probably acceptable at this point, the circumstances of the seller’s participation in management following the conclusion of the transaction would determine whether we would want the performance-based bonus tied to earnings or revenue or a compromise factor such as gross margin. If the seller in going to remain in control of the organization the net income milestone may be acceptable, but in most cases, it is better to tie the bonus to a line item “higher” in the income statement such as gross margin or revenues. These are easier to track and less prone to disputes as to whether or not certain expense items should be included or excluded when determining net income. Revenues are, of course, easiest to monitor but does not insure that the company is going to be profitable at those revenue levels. 58 Tango Equity
The final item on the checklist necessary to determine whether this recitation contains all of the information that we need to make a decision is the lock-up period. In this case, the buyer is asking for a 90-day lock up. A lock-up period is a time when the business is really taken off of the market. Typically, the seller’s intermediary will continue to send the blind one pagers to prospective buyer making inquiries but will not send out any confidential information. Also, during this time the Company is not presented to any additional prospective buyers. The sell-side intermediary will typically tell all interested parties that the company has is under LOI and we will distribute the short non- confidential summaries and the buyers can return a CA to us for use at a later date in the event that the present transaction does not take place. With regard to sharing the information within the recitation with other buyers, we at Tango typically do not recommend this, even in the absence of an affirmative “no-shop” covenant. Doing so is bordering on unethical business practice. Statistically, when a buyer and a seller reach the stage of a binding letter of intent there is a 50/50 chance of the transaction closing. Consequently, at this point the deal is by no means imminent, so the seller’s agent would not want to shut the process down completely but will remain in compliance with its, and its client’s obligations under all our covenants and maintain ethical business practices. The buyer’s request for a ninety day lock up is not unreasonable, but we will probably try to reduce it as much as possible. Also, the buyer is asking for liquidated damages for violating the exclusivity provision. I would think that this is fine and actually works to the benefit of the seller for reasons that will be explained in later sections.
At this point, we have made the determination that the Recitation was completed adequately and contained sufficient information to make a decision on how we would like to proceed. We now have to begin formulating ideas with regard to changes to the Letter of Intent that we would like incorporated into a binding Letter of Intent which shall then form the template for the drafting of the definitive Asset Purchase/Sales Agreement (PSA). There was one more piece of information that we required before making this Letter complete and that was a clarification of what liabilities the buyer was contemplating on assuming pursuant to the Assumption Agreement. This will be one of the most important documents in an Asset Purchase/Sale after the actual Asset PSA. We have corresponded with the buyer and the buyer has told us that his/her intentions are to assume all of the liabilities booked on the closing balance sheet. This determines the assumed liabilities. It is important that the seller make sure that all of the outstanding liabilities are booked preferably on the balance sheet that is given to the buyers during their initial due diligence and prior to the receipt of the non binding Letter of Intent. If there were any additional liabilities that were left off the balance sheet, they will now affect the purchase price by reducing the cash at closing if the net effect reduces the adjusted net tangible equity value.
This is an important point in the seller’s preparation for the sale of the company. The point is to make certain that all of the liabilities of the company are identified and included on the balance sheet. Typically, a buyer will review the company’s financial statements and arrive at a proposed purchase price and deal structure based more on the historical income statements and the pro forma, go-forward income statements. The buyer will consider the balance sheet in terms of what assets they are going to receive and Tango Equity 59 determine if they are sufficient to generate the revenue expectations. Also, what liabilities are going to be assumed and, what is their impact on the current valuation and the net terminal value at the end of the investment horizon? Since a multiple is going to be applied to the EBITDA, the income statements are considerably more powerful in calculating the going forward value of the company than the balance sheet. On the other hand, the buyer is going to want to be assured of a certain level of working capital and tangible net worth to be delivered at closing. If this were to decrease, then the seller can rightfully expect some adjustment to the purchase price. For this reason it is very important that the balance sheet be accurate and contains all of the liabilities that have been incurred. For an organization that monitors and books Work in Progress, it is important that this also be accurately calculated. In preparation for the transaction the seller should err on the side of caution on the balance sheet. That is, err on the side of lowering the tangible net worth shown on the most current balance sheet. And, the seller should err in the opposite direction on the income statement, to optimize the cash flow. Please note well, that I am not suggesting that anything be misrepresented. All books and records should be accurate in all particulars, but accounting is an inexact practice and there are areas in which judgment needs to be exercised, and in these cases, the decision can be guided by these recommendations for the most favorable outcomes for the seller.
Now that we have all of the information, it is necessary to determine whether this transaction is worthy of acceptance or rejection. If the terms in the LOI were not close enough to the seller’s expectations, the intermediary’s recommendation would be that there should not be a formal counteroffer. At that point, if the seller’s expectations are realistic, the intermediary should simply telephone the buyer or the buyer’s agent and inform them that the consideration is too low and, although many of the other terms would be acceptable, we are just too far apart and we probably should not waste our time or the time of our client. Following this, two things may occur. Either the buyer will walk away or he or she will submit a more reasonable offer. If the buyer walks away most likely they were “bottom-fishers”, just fishing for a company that would be willing to accept an extremely low offer for the business. In that case, it was best that we didn’t waste any more time with them. In this example, if the seller and we believe that an offer is below our expectations, but is close enough to be within “striking distance”, there is still a possibility of being able to complete a transaction. Likewise, the terms are not exactly what we would want but there is room for negotiation and compromise. If the seller and its intermediary decide that it is a sufficiently good starting point, the next step is to make a counter offer. Usually, buyer’s are somewhat defensive about their documents and their unwritten but universally understood privilege of being the party that “controls” the document preparation. It is infrequent that the buyer would supply the seller with a modifiable copy of the Recitation such as an unprotected MS Word document. Most of the time the document is supplied in a secure .PDF format or other format which will not allow modifications. Even today, some of the more “technically-challenged” buyers may even still transmit documents via fax. In the next section, we will review our response to this Recitation. 60 Tango Equity
Sidebar – The Objective of the LOI – from the Eyes of the Seller. The focus of this chapter has been to inform the seller of the critical points that should be contained in any first initial to buy his or her business. For the most part we simply discussed what information should be included. This same advice can be given to the buyer. An initial written non-binding offer should be a document that accurately describes the basic transaction in general terms but lacking detail. At this point we what to make certain that there is a good chance that the parties can come to an agreement on the major points which are typically transaction structure and consideration. If we know that we are close to agreement on these items then it is worth our time to go further down the road with the seller and to commit more time and human resources to the transaction. This is another good reason for avoiding the temptation of requesting and reviewing too much initial information. Up to this point, we are making most of our decisions on the seller’s representations. We are, “taking his or her word for it”. That is acceptable. There will be an appropriate time for verifying these representations during the due diligence phase of the transaction. If we find that some of the representations are incorrect or untrue, we then have grounds for a modification of the deal either in a change in the terms and conditions or an adjustment to the purchase price. We have said, that from the seller’s standpoint, it is necessary to get to a point that the seller and its intermediary have sufficient information available in the LOI to be able to determine whether the deal, as presented, has the potential to be economically beneficial to the seller, and to be actually completed. What is the buyer’s objective? Most intermediaries tell their buyer clients that the purpose of the initial LOI is to get a counter offer. The buyer usually does not want and does not expect the seller to accept the initial offer. Most sell-side intermediaries tell the seller never to accept a first offer for this same reason. Now, there are some buyers, usually strategic buyers, who are going to say that they do not like to waste a lot of time negotiating letters of intent. They say that they are going to make their best and final offer in the initial letter of intent and if it is not acceptable to the seller, they will just move on to the next transaction. We can usually get a good idea of which of these buyers are serious and which are either bluffing or can be grouped with the “bottom fishers”. However, even if an offer is 20% lower than what the seller was willing to accept, we would recommend to the seller that they still submit a counter offer with some modifications. The reason is that a buyer may often be suspicious if the first offer is accepted and perhaps be thinking, “What did I miss?” and to commence the due diligence process with the intent finding that missing skeleton. Typically, when Tango is engaged on the buy side as a buyer’s advisor we usually tell the buyer that the purpose of the initial LOI is to simply get a counter offer. If the offer is crafted properly, it will be a proposal that is high enough that we are not looked upon as a non-serious buyer or a “bottom fisher”, but still low enough so it will be unacceptable to the seller. We want the seller to submit a counteroffer. When the counter offer has been made, then the boundaries of the transaction will be established. If both parties believe that they can do a deal between those boundaries then the chances of concluding a successful transaction have increased greatly. It is now worth our full and concerted efforts to expeditiously pursue a closing. Tango Equity 61
Responding to the Letter of Intent
The most efficient method of response is to review the LOI line by line and then make suggestions for modifications to be included in the binding LOI. We have included a copy of the final binding LOI in Appendix E, and will describe the seller’s initial counterproposal. The final binding LOI represents the results of several iterations of the Recitation and several days of negotiations between the buyer and the sellers’ agents.
Preamble The first sentence states that the transaction is going to be a purchase of the assets rather than the stock of the company. Typically, a buyer prefers an asset transaction while the seller prefers a stock traansaction. We will discuss in some detail the differences between an asset transaction and a stock transaction in the Chapter 6. For purposes of getting the binding LOI structured, let us assume that the asset transaction as proposed is acceptable. Of course, in the final binding LOI, the verbiage stating that this is not an agreement or an agreement or make an agreement will be removed and replaced by wording stating that this is an agreement that the parties have entered into for the purpose of arriving at a definitive Asset Sale/Purchase Agreement.
Paragraph 1 If there are any additional excluded assets that the seller would like to retain they should be included in this section. Some examples include personal cars, computers, or other personal property that is being carried on the books of the company. These items may not even be on the schedule of fixed assets, but it is best to stipulate any extraordinary personal items that are not part of the transaction. This can avoid some misunderstanding and confusion later. If there are any such items, they should be recited as excluded assets. Typically, the buyer will have little problem with excluding things like cars and computers, or even boats and homes that have been included on the inventory of company assets. As we mentioned previously, the buyer would usually calculate the value of a business based on some algorithm of future earnings and typically not on asset value. The assets not being used in the production of income are of little relevance. The benefit to the seller to having these excluded in the early stages is that it prevents them from being used as negotiating points later. In this case, the buyer had accepted all of these proposed modifications which included allowing the seller to keep his personal automobile and a computer that he wanted to take for his home.
Paragraph 2 This section addresses the total consideration and the first partof the payment. In this situation the company had $7.2 million in Gross Revenues and $6.1 million in Net Revenues (For an explanation of the difference between gross and net revenues or any of the other financial terms please refer to Chapter 7). The adjusted Cash Flow or EBITDA was a little under $1.1 million. We were estimating a cash flow multiple of around 4 and wanted to have most of the purchase 62 Tango Equity price paid in cash at closing. The buyer is proposing that 57% of the total consideration be paid up front. In the initial counter offer we are going to ask that 75%, or $3,225,000, of the total consideration ($4.3 million) be paid in cash at closing and the remainder be paid by way of a note which will be addressed later. Next, there is the issue of the adjustment to cash at closing for a material change in the adjusted equity value and the post closing adjustment. There are several things that we would want to clarify and change here. First, we would determine from the seller where he would expect the adjusted net tangible equity to be on the closing date. Many businesses are somewhat seasonal. In this example, the business was moderately seasonal. Most of the work was performed during the summer months and about 60% of the revenue was earned during the second and third quarters. During the first and fourth quarters the business experiences a slowdown. However, this business was also characterized by a very slow turn in receivables. The receivables turned about four times a year meaning that the Days Sales Outstanding (“DSO”)was about 90. This means that, on the average it takes about 90 days for an account receivable to be collected. With these facts in mind, as well as a pretty good understanding of the business we can estimate that early in the first quarter of next year, when we would expect this transaction to close, that the work that was done in the busier summer and early autumn months already has been turned into AR and that those AR have been converted into cash. The billings from the slower late autumn and early winter months have been billed but not converted into cash. In January when the transaction is expected to close, we will anticipate that the AR will be lower and the cash balance will be higher. Based on the method by which the adjusted net tangible equity is calculated we can reasonably expect that the Adjusted Net Tangible Equity will be lower in January than it was on October 31, 2003. Under these circumstances we would recommend that the adjustment be made to the note rather than to the cash at closing. The concept of the adjustment based on the adjusted net tangible equity is a fair one. If the equity falls, then the buyer is getting less and should pay less. Therefore, we accept that notion but to enhance the value to the seller, for whom we were working in this particular case, we would try to minimize the economic impact of the adjustment. However, if, on the other hand, the combination of the seasonality and the slow receivables turn suggested that the adjusted net tangible equity may be higher, then we would prefer the adjustment to be made to the total of the cash at closing. In either case, we would want to emphatically state that the adjustment will be made either up or down depending on whether the adjusted net tangible equity has risen or fallen. The agreement implies, although it does not state that this is a reciprocal adjustment. The final change to this section would be to add a definition to the term “materiality”. What exactly is a material change? In this case, I would simply apply a numerical definition and perhaps remove the term materiality and substitute $10,000 or $25,000. This is adjustment can become a nuisance. If the adjustment is going to be made to the note, as it finally was in this case, the note that was delivered by the buyer at closing is going to have to be cancelled and a new note substituted for the new amount. If the adjustment is to be made to the cash at closing then there is going to have to be an exchange of checks from buyer to seller or from seller to buyer. If the amount of the adjustment is only a few thousand dollars, it may just not be worth the time and expense if doing this. In addition, as a matter of firm clarification it would probably be clearest to request that the December 31, 2003 Adjusted Net Tangible Equity value be stated in this section and on a Schedule attached to the Recitation illustrating the calculation of the adjusted net tangible equity. By way of a further explanation, if it is not clear, the Adjusted Net Tangible Equity is Tango Equity 63 determined, in this case by first taking the Total Assets and subtracting the Total Liabilities to arrive at the Total Net Equity. Next, by subtracting the non-tangible assets, such as goodwill or certain amortized assets (in this example there are none) from the total net equity, one is left with the Tangible Net Equity. Finally, by subtracting the non-transferred or excluded assets which consists of the car, the computer and the cash and cash equivalents you are left with the Adjusted Net Tangible Equity, in this case $647,903. This calculation is going to be restated on the closing balance sheet, which will be estimated on the closing date, and there will be an adjustment to the cash at closing in the amount of the difference between the Adjusted Net Tangible Equity on the closing balance sheet and $647,903. If the Adjusted Net Tangible Equity on the closing balance sheet is greater than $647,903, the value of the note will be increased by the amount of the difference. If the Adjusted Net Tangible Equity on the closing balance sheet is less than $647,903, the value of the note will be lowered by the amount of the difference. The agreement also calls for a final adjustment within 90-days following the closing. This is typical since it usually not possible to produce an accurate set of financial statements almost in a real- time sense and to have them ready at closing. When the final financial statements are prepared within the next several weeks, the same exercise will be repeated by comparing the final Adjusted Net Tangible Equity value with the Adjusted Net Tangible Equity value estimated at closing and the Note will be adjusted again. In this case, the parties agreed to a final purchase price of Four Million Dollars with $2.7 million paid in cash at closing or approximately 2/3 of the total consideration. The remaining 1/3 of the purchase price will be paid in the form of the Note. In addition, the buyer has agreed to apply any adjustments occurring from a negative change in the Adjusted Net Tangible Equity against the Note rather than against the cash at closing and language was inserted which stated that the adjustment will go up or down depending on the amount of the final closing Adjusted Net Tangible Equity value.
Paragraph 3 31-Dec-03 TOTAL ASSETS $2,036,155 In this section the amount of the Less: Total Current Liabilities $781,132 note has been changed to $1.3 Less: Total Long-Term million. We have also Liabilities $226,007 renegotiated the interest rate and Less: Goodwill and Amortizable Assets $0 the buyer has agreed to pay Total Tangible Net Equity $1,029,016 interest at a rate of Prime plus 2% and the payments will be made EXCLUDED ASSETS quarterly instead of annually. Owner's Automobile, Net of Since the note will be secured only Depreciation $7,000 by the assets of the selling Computer, Net of Depreciation $500 company, we will also ask for a Cash and Cash Equivalents $373,613 “quick trigger” default Total Excluded Assets $381,113 mechanism. We believe that this is too much detail for inclusion in Adjusted Net Tangible Equity $647,903 the LOI, but basically the "quick Table 19 - Calculation of Adjusted Net Tangible Equity trigger” means that in the event of a default on any payment owed to the seller will have a rapid means 64 Tango Equity of default and foreclosure on the assets. This default mechanism is important, especially when a significant portion of the consideration is in the form of a note secured by the assets.
Paragraph 4 No changes were made to Paragraph 4. The buyer basically has an out in the event that all of the key employees decide that they would only work for the former owner and without the former owner they would prefer to remain unemployed or will establish employment elsewhere. Since this is an asset purchase all of the employees are going to have to be terminated by the old company and rehired by the new company. All of the contracts or employment agreements were made with the old company. If the employer has the right to assign these rights to the buyer and the new company, this will be part of the agreement. Frequently, the seller is not able to assign the rights of the company to another party without the consent of the employees. This sounds like a much larger problem than it usually is. The former owner is usually instrumental in getting the contract rights assigned and the employees rehired. It is very important, especially in asset purchases, to maintain close communications with employees, especially key employees, immediately subsequent to the closing of the transaction. It also brings up the dilemma of maintaining confidentiality while making the determination that the new owner is going to be able to maintain a sufficient number of employees to maintain the business. Typically, if key employees are brought into the process fairly early, and if the buyer can have open communication with the key personnel, the buyer can usually lock up those employees, with employment agreements that are contingent upon the closing of the transaction and gaining a good estimate, based on their insight, as to whether they may encounter difficulty in retaining the rank-and-file employees. Typically, rank-and-file employees will usually be retained if they will not incur economic loss or deterioration in their working conditions subsequent to a change of ownership. There are, of course, exceptions, as there are to every general rule. If, for example, a company is struggling for solvency, a buyer may have to come in and institute reductions in the workforce and reductions in compensation. In these cases, the remaining staff may recognize that the only way to revive the company and give it a chance for survival is to support the new owners and cooperate in the adjustments. In these cases, it is typically our recommendation that such reductions are sufficient to insure that further reductions will not be necessary for at least several months. We also recommend that the plan and the objectives are honestly and straightforwardly communicated to all of the employees, not just the key staff. There are other exceptions and strategies for handling circumstances such as these that are beyond the scope of this book.
Paragraph 5 This paragraph is unchanged and addresses the non-competition issue. Typically, buyers like to have a period of non-competition that exceeds the pay out period by at least one year. The reasoning for this is that it is unlikely that the seller is going to go into competition with or otherwise impair the assets while the buyer is still paying him or her. The seller would be acting contrary to his or her own best interests. However, when the full payout has been completed, there might be a temptation to get “back in the business”. One year after the payout is a reasonable period for the buyer to establish itself as the new owner and the primary point of contact for the customers in manufacturing the products or providing the services. In our example, the seller is also being provided an employment agreement. It would be expected that Tango Equity 65 the restrictive covenants in the non-competition agreement would be contained in the employment agreement. In negotiating restrictive covenants it is important that the restrictions not be overly broad. They should be constructed around the initial statement of the paragraph, which is to “protect the value of the purchased assets”. If the covenants are very broad or exceed that which is needed to protect the value of the Purchase Assets, the courts may view the restrictions as overly broad and unenforceable. The courts will typically not participate in the drafting of less restrictive covenants, but rather deem the entire agreement unenforceable. The seller is also going to be restricted from using the corporate name of the company. Note that this is an asset sale and the company, International Widget, Inc. is going to continue to exist, albeit as a shell company without any assets or operating activities. However, the buyer is going to incorporate a new entity and operate it under the business name of International Widget. This is because the rights to the business name and its inherent goodwill will be transferred as part of the purchased assets. With regard to the hiring of IWI or the buyer‘s employees, the seller have requested and the buyer has agreed that the owner, Mr. Smith, will be allowed to hire IWI or the buyer’s employees with the written consent of the buyer following the acquisition. Depending on the size of the buyer, this paragraph may have to be massaged a little more. If the buyer is a large company and Mr. Smith goes into a non-competitive business, he may inadvertently hire a former employee of the buyer. While this would not result in a competitive impairment of the Purchased Assets or the buyer, it would technically violate the restriction. Even in the case in which the buyer is a small or medium sized company, this language should be included since it is not the intent of the parties to restrict free enterprise by preventing the inadvertent hiring of employees or former employees as that was not the original intent of the parties in establishing this covenant. In this case, the buyer was not a large company and this was not an issue.
Paragraph 6 This paragraph is simply an obligation to deliver audited financial statements prepared on the accrual basis of accounting in accordance with GAAP. Many small companies are cash-based taxpayers and may not have accrual statements. Most institutional buyers in the middle market are going to insist on accrual statements and it may be necessary to have the seller’s accountant prepare these if they do not exist. The difference between cash and accrual statements can be significant especially in companies having a slow receivable turnover or significant inventories. Accrual statements are prepared by accounting for economic events when they occur regardless of when the cash portion of the transaction occurs. Cash statements only recognize economic events when the cash portion of the transaction occurs. Thus, on an accrual basis, revenue is recognized when it is earned, that is, when the services are performed or the product is delivered even if the payment for these services or goods is not made until a later date. A seller that does not have an accrual statement should check with his or her accountant to determine if it is possible to create accrual statements and to inquire about the cost of producing such statements. Most middle market businesses have accrual statements even if they may be using the cash basis for tax purposes because accrual statements do a much better job of matching revenues and expenses, therefore assisting the management of the business. The buyer also prefers audited financial statements for the most recently completed fiscal year and CPA prepared unaudited interim financial statements for the most recently completed period. 66 Tango Equity
These interim statements should be as close as possible to the execution of the Asset Purchase/Sale Agreement. In addition, updated financial statements should be prepared for the “stub period”, which is the time from the execution of the Asset Purchase/Sale Agreement to as close as possible to the closing date. There are two important concepts here. First, the seller may not have audited financial statements. Most privately held companies do not and for most non-public companies this is an unnecessary expense. There are three common levels of statements prepared by independent accountants. The lowest level is the production of compiled statements. Compiled statements represent the minimum or lowest level of involvement of the independent accountant. As the term implies the statements are simply compiled from the information that is provided by the company and no additional testing or verification of the information is performed by the accountant. Usually this level is sufficient for a company to conduct and manage its operations and to have a good handle on what is going on with regard to the financial performance of the company. The next level and perhaps the most often used is reviewed statements. The difference is that in a review the independent accountant analyzes the company’s financial statements and interviews the management. However, the accountant is not required to perform specific tests does not have to evaluate the firm’s internal controls. The highest level of diligence is applied at the audit level. In the case of an audit the auditor attests that the audit was performed in accordance with generally accepted auditing standards. Also, the auditor expresses an opinion that the financial statements fairly express the financial position and operating results of the company in accordance with generally accepted accounting principles. In addition to the services performed in the review, the auditor also performs substantiation and verification procedures on the data provided. Audits are consequently the most expensive of the three not only because of the level of effort and scope of the services provided, but also because of the potential liability. Having audited statements is usually not required or expected by a buyer. Alternatively, having audited financial statements is very attractive to the buyer and may actually increase the valuation of the company by: 1) reducing the level of due diligence that the buyer needs to perform to ascertain the accuracy of the statements and 2) lessening the perception of risk in the transaction. Generally speaking, the expense of having annually audited financial statements is not worth the valuation differential, and unless there is some other compelling reason for the audit, it is sufficient to have reviewed statements prepared. If a buyer is requesting audited statements, it is important to find out the reason for the request. Often, if the buyer is a publicly traded company, and the acquisition is large enough to be considered a “significant subsidiary”, the target company must have audited financials or the existing financial statements must be audited prior to being included in the annual report of the publicly traded buyer. It is usually not possible to avoid this audit requirement. If the seller does not have audited statements, the seller will have to find out from his or her independent auditor, first, if the existing financial statements are “auditable” and second, if they were auditable, what would be the price of the audit. The number of years going back that the financial statements need to be audited are dependent on several tests indicative of the relative “significance” of the significant subsidiary test involving the buyer’s company. There will be occasions that due to circumstances occurring in the intervening time period, such as executive management departures, the existing financial statements cannot be audited. In all likelihood, the transaction will not take place in these situations if the buyer absolutely requires audited statements. The cost of auditing previously unaudited financial statements, if possible, is going to be significant, especially if the audited statements are going to be included in the operating results of a publicly traded company because such inclusion will result in a significant increase in the legal exposure Tango Equity 67 of the auditor. When representing the seller, Tango would typically ask that the buyer bear the cost of producing the audited statements. Typically, there would be a provision that the seller would assume or bear a portion of the cost if the results of the audit differed materially from the financial statements presented to the buyer. Fortunately, in this case, the seller already had audited statements and was able to comply with the request. In this paragraph the remaining obligations of the seller are to produce a set of financial statements as close as possible to the date of the execution of the Asset Sale/Purchase Agreement and another set as close as possible to the closing date. The buyer is then going to be responsible for producing the financial statements for the closing date. The reason that this agreement is requiring statements as close as possible to the date of execution of the Asset Sale/Purchase Agreement and the closing date rather than on these dates is that frequently a closing will take place between accounting periods and in some businesses it is difficult, if not impossible, to produce interim statements in the middle of accounting periods.
Paragraph 7 This section addresses the seller’s order backlog. In some industries there is no such thing as order backlog and in others it is an essential planning and forecasting tool, which is aggressively monitored by management. The section is effective in that it rather clearly defines what is meant (and not meant) by the term “backlog”. There is a small problem in the paragraph and it concerns the warranty that the buyer is requesting that the backlog schedule be substantially accurate. The term “substantially accurate” is really quite subjective. An effective agreement is one that does not leave any room for misunderstanding and is thoroughly understood by all of the parties. In this case we have avoided the definition and we will address it in the final agreement. Both parties will agree for now that the backlog schedule shall be warranted as being substantially accurate, and what is meant by substantial will be determined later as will the other important point of how the parties will assess the accuracy. Backlog in itself is a “mushy” concept. We use this highly technical term to describe something that is based on best guesses and expectations. Very few firms can predict with a high degree of certainty what their future revenues are going to be. Some industries have better sources than others. This is referred to as “visibility”. Some industries such as the aircraft manufacturing industry need to have orders well in advance and there is a great deal of work in process at any time that is recognized as revenue as the aircraft approaches completion and its date of delivery. Other industries such as the temporary staffing industry have very low visibility; orders come in perhaps a week in advance and often only a few hours before the service is delivered. As a consequence, backlog is based on the nature of the industry, a combination of history, seasonality, and soft and firm, written and implied customer commitments, and the seller’s warranty needs to be very limited. As long as this is made clear to the buyer and nothing is intentionally misrepresented, the seller should not have breached any warranty. 68 Tango Equity
Paragraph 8 There is a probably not too much to say about this paragraph. Reasonable access for the buyer’s due diligence team is necessary to move the project along. We will discuss the due diligence process in much more detail later in this chapter.
Paragraph 9 The most basic terms of the employment agreement include the amount of the salary and the length of employment. If there were anything else that is major or essential and unique it would also be a good idea to address those issues at this point. However, the normal details of the agreement should be negotiated later after the binding LOI is completed, unless it is expected that there may be some particularly sensitive or critically important issues that may affect the transaction. If some part of the consideration is going to be paid in an earn-out of if any part of the note is contingent upon the operating performance of the company, it may become crucially important to define the owner’s responsibilities and scope of authority at this early stage. Since this transaction does not involve any contingent payout we are not going to revise the standard verbiage of the LOI. Nevertheless, in the final agreement, we are going to address the most important issues in any employment agreement. As stated above, we are going to need to define the seller’s responsibilities and scope of authority to execute those responsibilities. It would also be important to establish the reporting hierarchy and perhaps the most important is to negotiate the conditions under which the seller can be terminated. The buyer needs to be able to manage the business and the selling owner needs to be assured that he or she will not be terminated without cause. This is a difficult and important dilemma and one which is compounded by the fact that frequently sellers, who have been entrepreneurs all of their lives or have run the business on their own for several decades, often have a difficult time adjusting to becoming employees. Some are, in a sense, unemployable. The seller should consider this in the very first phases of determining an exit strategy, and in constructing the transaction. In most cases, if a selling owner is active in the business, a buyer is going to insist on a seller staying on with the company for a reasonable transition period. However, assisting a new buyer during a transition period and being a part of the company’s ongoing strategy subsequent to a transfer of ownership infer a completely different responsibilities. Likewise, from the point of view of a buyer, the buyer has to be certain that if the seller is needed to assist in the transition, that he or she is available, and motivated, and has the incentive to ensure the company’s ongoing success. If for some reason it doesn’t work out, the buyer will have the option, as a last resort, to replace the seller as manager and try to salvage the business.
Paragraph 10 This section introduces two new concepts. First, the buyer is asking that the seller warrants the collectability of the net accounts receivable, that is, the accounts receivable (both billed and unbilled) less the reserves and discounts, and; that all of the receivables have been “fully-earned” prior to closing. This concept is significantly different from simply shifting the risk of collectability from the buyer to the seller. Not only is the buyer asking for the seller to accept the risk of collectability but also to warrant that all of the billings have been fully earned prior to closing. The buyer is asking the seller to warrant that nothing has been pre-billed or any revenue has not been recognized prior to its being earned. This also implies that all products have been Tango Equity 69 delivered and are satisfactory, and all of the services have been satisfactorily completed. If a client or customer disputes some part of the invoice and either claims that the product was not up to specifications or the services were not fully completed as stated in the scope of services in the contract, then new products would have to be delivered or additional services would have to be provided. This warranty applies both to the accounts receivable (billed receivables) and to the work in process (unbilled receivables). In many service businesses it is often difficult to estimate work in process. Work in process is often an estimated cost of what is going to be converted into an account receivable. It is very likely that the work in process to be converted into AR is probably going to increase the AR by an amount that is more or less, but probably not the same as the booked work in process. Note also that this representation is absolute and will be applied in the absence of any intent to deceive on the part of the seller. The seller is being requested to warrant that all of the accounts are collectible. If some part of a customer order was not delivered or some part of the service was not performed, the seller’s knowledge of the error or shortcoming is irrelevant. This brings us to the second of the two new concepts which is the notion of set-off and recoupment. Set-off will allow the buyer to deduct any uncollectible AR or any unconvertible WIP from amounts owed to the seller on the note. It is not indicated how this would be set off, that is, whether it will be set-off against the next payment due (which would be the preference of the buyer) or against one of the later payments (which would be the preference of the seller). Recoupment means that the seller will have to pay back to the buyer any of these amounts that are uncollectible or unconvertible from the cash at closing or anything that has been already paid to the seller. The concept of set off and recoupment in this case is valid. It is in concordance with the concept of separation of predecessor and successor, which in its simplest form states that, “whatever occurred before the closing is the seller’s and whatever occurs after the closing is the buyer’s, and that the financial statements are accurate at the time of closing.” The consideration is based upon these financial statements and the anticipated cash flows, and to the extent that something occurs after the closing that renders the closing financial statements inaccurate, the consideration should be adjusted to correspond to the facts as they actually exist. This concept also takes into account the fact that no amount of due diligence is going to uncover every and all details that the buyer needs to know and there is really no way of forseeing future events and how they are going to effect the current state of the business. These concepts are used throughout the LOI and will be applied to the final Asset Sale/Purchase Agreement in making decisions on how to address certain issues. If both the buyer and the seller are in agreement with the concept of separation of predecessor and successor then coming to agreement on smaller issues later as we make progress through the process is going to be easier. Notwithstanding the above, there is a potential problem with this section. The problem is what are the buyer’s restrictions or lack of restrictions on applying its rights of set off and recoupment under this section. For example, if the company’s terms are net-30 days and a customer has not paid in 30 days, can the buyer apply the right and set off the theretofore uncollected amounts from a note payment due to the buyer, or does the buyer have to go through the normal process of dunning and subsequent efforts before he or she can be able to exercise the right of set off. These details are probably better left for the final agreement but typically such financial statement issues are resolved over a longer term. The buyer should have an obligation, and normally will be obliged, to extend the company’s customary collection efforts in its attempt to resolve a claim, just as they would be applied to AR earned and invoiced after the closing. It is 70 Tango Equity usually easiest and fairest to monitor the purchased accounts receivable and work in process and to prepare a final reconciliation two or three quarters after closing.
Paragraph 11 We have already clarified that the buyer intends to assume all of the liabilities on the balance sheet and according to the structure suggested by the buyer, the seller is going to have to provide a schedule of assumed liabilities, which will be in a separate Assumption Agreement. This will then be a very important schedule that the seller needs to prepare and should contain every booked liability as well as any potential liabilities that are not booked, if there are any. The buyer is also asking for indemnification against any liabilities that the buyer is going to have to pay subsequent to closing that were not booked and that the buyer is going to have to pay. These are liabilities that were incurred prior to closing but not booked on the financial statements and not included in the schedule of assumed liabilities. We will call these “latent” liabilities. They occur more frequently than you would imagine. We would estimate that in 75% percent of the transactions that we have been involved with, there was some issue with latent liabilities. Usually, it involves a vendor that was remiss in sending an invoice to the Company in a timely fashion. The seller forgets about it and the liability does not appear on the balance sheet or on the schedule of assumed liabilities. Two months after closing, the vendor realizes that the invoice should have been sent three months ago and issues an invoice to the company. The buyer, who is by that time the new owner, receives the invoice and, since it is not a booked or assumed liability, will send it to the seller for payment. Since this is an asset deal, technically any liabilities that are incurred and not assumed by the buyer remain an obligation of the selling company. The seller’s company probably now has no assets, assuming that all of the assets have either been sold or otherwise divested and the proceeds from the sale and divestiture have been distributed to the shareholders. In practice, the buyer may be pressured by a vendor who is unaware of the transaction and unconcerned that the buyer has only purchased the assets of the business. The fact that the buyer is continuing to operate the business as before under the same business name makes it difficult for the buyer to demonstrate otherwise. The buyer can show the vendor the asset purchase/sale agreement, if this is not confidential information, but many vendors will not understand the difference between an asset deal and a stock deal and insist that the buyer make the payment anyway. Now the seller may simply pay the invoice and the matter is settled, but perhaps the seller has an issue with the invoice or simply is inclined to dispute it since the seller has no further need of the services of this vendor and the credit standing of the non-operating company is moot. This may not be a huge problem if the new owner of the business has alternative suppliers for the product or services that the vendor had been supplying, and the buyer can simply switch vendors and let the seller and the vendor work it out. However, such a misunderstanding may upset the relationship with the vendor, and if it is a critical vendor, it may result in the buyer not being able to receive critical goods or services or being forced to secure them from alternative sources which may be more costly. In any case, the new owner may find that the company’s credit has been unjustifiably damaged. Clearly there needs to be language in the final agreement that will compel the seller to promptly pay a vendor for such latent liabilities. That is the reason that the buyer has stipulated that, if the seller fails to retire a latent liability, the buyer will have the right to pay this debt and set off the amount of the payment against future amounts due to the seller or to request reimbursement from amounts already paid. However, we have the same conflict as we have encountered several times already and will also encounter again in the next section. The seller has an obligation to indemnify the Tango Equity 71 buyer in this situation but the seller has little incentive to settle these obligations if there is some disagreement with the party owed the payment. The buyer has the right to be indemnified but cannot have carte blanche in settling such disagreements because the buyer (who is now the owner) has no incentive but to resolve the dispute since he or she is going to pass the cost along to the seller in any case. The final resolution will be included in the final Asset Purchase/Sale Agreement and how it is resolved will be dependent on the type of industry and business involved, the probability of the occurrence of a significant latent liability, and the skill and cooperation of the attorneys drafting the agreement.
Paragraph 12/13 This section involving general indemnifications is probably the most contentious section of this or any sale agreement whether it be an asset transaction or a stock transaction. Included here are many of the issues of conflict that we have discussed above but on a much broader sense. The buyer is asking the seller to provide indemnification against all actions that may be brought against the Purchased Assets or the buyer from transactions performed by the seller prior to closing. We have added reciprocal language providing the seller with similar indemnification for events occurring subsequent to the closing. The buyer is going to indemnify the seller for all of its acts after closing and the seller is going to indemnify the buyer for all of its acts up to closing. The language implies but does not specifically state that each indemnified party will be in charge of its own defense, and this is where the main problem lies. If one party is controlling the defense and a third party is providing indemnification there is incentive on the part of the indemnified party to reach a quick settlement and get back to business. There clearly needs to be some mechanism that is going to protect the indemnified party while at the same time providing that the indemnifying party can be protected from having to provide indemnification for a frivolous complaint or an unfair settlement. The other issue with paragraph 12 is that the buyer is requesting that the right to indemnification be extended to payments that it must make or actions that it must take to preserve a customer relationship. The implication here is that there does not have to be any legal action in effect before such payments can be made. Clearly, this would need to be addressed more clearly in the final agreement.
Paragraph 14 We have changed this paragraph to make the condition of satisfactory due diligence investigations reciprocal. The seller is also going to be performing due diligence on the buyer especially since the seller is going to be extending credit to the buyer. Both parties need to be comfortable that the other party can perform satisfactorily.
Paragraph 15 This section simply states that each party will be responsible for its own fees. The stipulation referring specifically to paragraph 6 is to make clear that although the buyer is requesting that the audited statements be a condition to the closing that the seller is still going to be the responsible party for the production of the statements. The final Asset Sale/Purchase agreement will also contain a provision stating that the broker’s fees will be paid out at closing. 72 Tango Equity
Paragraph 16 Finally, in paragraph 16, the parties agree that the terms and conditions of the Recitation as well as the Recitation itself are considered Confidential Information under the definition provided in the Confidentiality Agreement that both parties have executed the intermediary. By being considered Confidential Information the terms and conditions of the recitation cannot be used for any other purpose except for the evaluation of the suitability of pursuing a sale and purchase of the assets of the Company. The Company specifically agrees that it will not use the terms and conditions of the agreement to compel another party to make an offer or change an offer. The intermediaries, as parties to both of these agreements is also so bound to protect the confidentiality of the terms of the Recitation. And, as stated earlier, even in the absence of such a contractual restriction, it is contrary to most intermediary’s policy to disclose the details of a buyer’s offer to another potential buyer while the transaction is in progress or even after the transaction has been either completed or terminated. At this point we have completed the final binding Letter of Intent. It is now time to begin the process of due diligence. Oftentimes the due diligence is broken down into two phases – the field phase and the data reduction phase. Most often, the due diligence occurs simultaneously with the production of the final purchase/sale documents, but frequently the buyer will prefer to wait until a portion of the field due diligence is completed before incurring the expenses associated with the document production. Institutional buyers typically have their own in house counsel who have completed numerous transactions for the firm and know the policy, procedures, forms, and formats the company prefers to utilize. In these cases the document production process is simplified and may often take place in conjunction with the field due diligence.
Due Diligence As we had stated earlier, the information provided to get to the valuation and the Letter of Intent phase was supplied by the seller and for the most part, it was accepted as presented. During the valuation phase the buyer was presented with financial statements and perhaps projections of future revenue expectations, as well as representations as to the length and quality of the contracts and the general information regarding to capital and operating leases, real estate and equipment leases, and the company’s staffing levels and production capacity. The seller may have represented that the company can accommodate a certain increase in revenue without additional administrative personnel, and that the administrative systems were adequate and up- to-date. He or she may have stated that the capital equipment is operating and well maintained and that no significant new capital expenses are expected for the near future. The buyer has accepted all of these representations and made his or her valuation and offer based upon these representations. The due diligence phase of the M&A process begins when these representations are tested. Each buyer and each buy-side intermediary has a particular approach to due diligence. Each is certainly not unique and basically contains the same objectives. There is no hard and fast rule about how to conduct a due diligence investigation. One technique that is frequently employed is to set an objective of creating an end product and then determining the information that is required to produce that product. Very often, the end product is the preparation of set of operating financial statements on a pro forma basis for three to five years into the future. To accomplish this it was necessary to collect all of the data that was utilized to Tango Equity 73 make the initial assumptions about the revenues, direct expenses and selling. General and administrative expenses for the period. If there are to be operating efficiencies then they need to be incorporated and the time of their occurrence determined. It would be necessary to anticipate the timing and create an implementation schedule of all of these changes. In other words, the objective of the due diligence in this case is to create a business plan for the company going forward. In cases in which the acquisition involves consolidations of operating businesses rather than the acquisition of stand alone businesses, the procedure becomes considerably more complex than testing the existing operating assumptions. However, the basic objective remains the same. A good due diligence procedure creates a pro forma operating financial model of the business going forward. The other good thing about this approach is that, for better or worse, it provides the buyer with a good standard with which to assess the effectiveness of the due diligence process. In the absence of any extraordinary circumstances, if you come fairly close to the expectations, then the due diligence has been performed very well. If your projections are too high or too low, then your process was probably not as effective as your would want it to be. Even in businesses with very low visibility and a fairly short or inconsistent operating history, good pro forma estimates can be achieved through a thorough and disciplined due diligence process. In almost any business the most important aspect of due diligence is to generate a projection of the go-forward revenues. The revenue generating capacity of the business is usually the most critical item that the buyer is purchasing. In most cases, it has taken many years to build up the client list, instill customer loyalty, and create brand recognition that is responsible for the current level of revenue. Expenses, although very important, are significantly more manageable. If we discover that expenses are 10% higher than anticipated it may be possible to make the necessary adjustments, but if revenues are off by 10%, it may not be possible for the company to recover, at least while maintaining operating margins. As stated earlier, indirect costs are typically fixed costs and do not vary with the fluctuations in revenues. Because of this, if the revenues were to drop by 10% the operating margins would likely drop by much more depending on whether the business operates on a high or low gross margin. While each buyer’s approach to due diligence may vary, it is typically a lengthy, detailed, and highly invasive process. The due diligence that we will examine here can be split into two phases – the field due diligence phase and the data reduction phase. During the field due diligence phase the data is gathered, sorted and reviewed, and there are meetings with the key people associated with the business and perhaps many others in the organization. We refer to these as high-level and low-level internal sources. High-level sources refer to points of information received from individuals higher in the organization. Low-level sources are points of information that are received from lower or subordinate individuals in the organization. As one drills-down for information the data is gathered from more low-level sources. The more low-level sources that are necessary, the more invasive the process becomes. Usually, the solicitation of lower level sources yields richer, more refined data. As the data becomes more refined the process becomes more invasive. During the data reduction phase the buyer usually packs up his or her collection of data and goes home and tries to put it into a format the can be used for the predictive financial modeling. These two steps can further be broken down: 74 Tango Equity
I. Field Due Diligence a. Data collection and review (including physical assets) b. Internal Primary Source Verification c. External Primary Source Verification II. Data Reduction a. Production of pro forma financial statements
Field Due Diligence
Data Collection and Review Appendices A-1 and A-2 are lists of required due diligence material for a specific transaction. Any due diligence checklist will change depending on the industry and the specific circumstances of the transaction. The material usually begins with high-level material and becomes more specific. The highest-level material is the information on the corporate entity. The buyer wants to see a certificate of good standing and will require another certificate of good standing from the state in which the entity is incorporated at closing. The buyer is also requesting copies of the articles of incorporation and by-laws and any amendments to the by- laws. It will be necessary to supply a complete list of shareholders. In closely held corporations, this usually consists of just a few individuals or other corporate entities. However, even in small businesses, there may have been stock that was distributed to employees or former employees or, under special circumstances, to creditors. Whatever the reason, having a large number of shareholders may sometimes be problematic. If the shares are widely distributed and the principal shareholders are greatly diluted, it may be difficult to gather the required number of votes to approve the transaction, or more likely, it just may be more difficult to obtain accurate information about the shareholders. Since this is an asset transaction, the latter situation is less of a problem for the buyer and more of an issue for the seller. If the seller can locate sufficient shares to approve the transaction, the buyer in an asset transaction is going to pay the consideration to the Company and the Company (which is now, subsequent to the transaction an empty corporate shell rather than an operating company) is going to have to make the distributions to the shareholders according to the by-laws, shareholder agreements and laws of the State in which the company was incorporated, assuming that it is a corporation). Most of the other information in the Company section is fairly self-explanatory, although we should add a note of explanation to the buyer’s request for an employee roster with functional job titles and only with names of key employees. Even at this point, the buyer does not want to have the entire employee roster revealed to him or her at this point. This is because it is still rather early in the process and there is still a good chance that the transaction will not occur. (At the LOI stage, statistically, there is only a 50/50 chance of a successful transaction being completed). If the transaction were not to occur and the entire employee roster were revealed the buyer would have restrictions, perhaps up to two years, on the future employment of any of these individuals. Confidentiality Agreements vary and often the seller will request that all employees be covered under the no-hire provision even if they are not specifically disclosed to the buyer. Tango Equity 75
More often, this protection applies only to those employees who are specifically disclosed in writing to the buyer. Seller’s should take caution to make sure that all employees who are disclosed in any way to the buyer are protected, not only those who are specifically disclosed in writing. Any employees who are introduced to the buyer during the due diligence process should be protected under the confidentiality agreement even if they are not specifically disclosed in writing. Buyers should be cautious not to execute a confidentiality agreement in which they agree across the board not to hire any employee of the seller not disclosed in writing, who were not engaged in discussions during due diligence, because this may impair the buyer’s ability to operate its businesses, in the future - even those businesses that are non-competitive,. The remainder of the due diligence checklist is fairly straightforward, and the above discussion on disclosure of employee data segues into another concept of major importance in this stage of the process. We have already stated that there is a 50% chance that the transaction may not close at the point that the very invasive process of due diligence is commencing. How can we achieve a balance between the buyer’s need for sufficient information necessary to make a major decision and the seller’s need to maintain confidentiality? At this point, we are not referring to the buyer’s improper use of the confidential material. Since we already have a valid, enforceable Confidentiality Agreement, and we are dealing with a reputable buyer, that should not be an issue. However, the due diligence process itself may make certain parties, such as employees, aware of the possibility of that such a change of control transaction is being considered. Buyers may want to interview some employees outside of the top key employee group from whom it would be impossible to keep the pending transaction confidential. Buyers may wish to speak with creditors and lenders, or perhaps landlords, or critical vendors. It is also very likely that the buyers will want to talk to clients or customers, first, to satisfy their due diligence requirements and second, to make certain that these clients are willing to remain with the company following a change of control. There may be many reasons for speaking with these persons, but in doing so the fact that the transaction is being contemplated is going to be revealed. In almost any organization, the fact that there may be a change in ownership has the potential to be a very destabilizing event. Employees somehow always seem to expect the worst when such a transaction is about to occur. Change in general, leads to some level of discomfort brought upon by the anxiety of uncertainty, which leads to loss of productivity due to loss of focus. This effect is especially evident in service organizations in which revenue is derived from the work produced directly by staff members. Production from the workforce definitely decreases in times of uncertainty. What’s worse is that once this occurs it is difficult, if not impossible, to recover. If the deal fails to close (and remember there is only a 50/50 chance of a successful completion at this point), the staff is still aware that the owners have decided to execute an exit strategy and change is on the way in the not-too-distant future. It is not unusual that the rate of personnel turnover will increase during these periods. To the contrary, the other fact that should typically lead to improved behavior and productivity is a change in ownership, especially when it involves a financial buyer. This will probably benefit the employees of the acquired company. In all likelihood, they are going to have a stronger, better-capitalized partner, with more opportunities for career growth, especially if the institutional buyer’s plans include an expansion strategy. An institutional buyer typically realizes that in order for a transaction to be successful, the staff must have the perception that the transaction will result in at least economic neutrality for them. If they believe that their opportunities are better with the new management, they will be happier 76 Tango Equity and thus more productive. Perhaps their compensation and benefits remain the same but their opportunities for growth are expanded. Nevertheless, there are many good reasons for keeping the transaction confidential as long as possible, or until a point is reached that the transaction seems almost imminent. However, the key management may not be able to answer all of the questions and it may be necessary to confer with other employees, creditors and even customers. The following types of information sources are Primary Sources:
Internal Primary Source Verification We have said that revenues are probably the most important item that a buyer has to verify during his or her due diligence investigation. During the data collection stage the buyer has probably been provided with a set of revenue projections or backlog depending on the particular industry. The revenue may consist of some “hard” contracts or firm commitments from customers along with some “soft” commitments. Most businesses have a larger amount of soft commitments than they do hard commitments. In addition to these, the company will have a portion of its revenue that is made up of “on-going” work, which is work that is represented by no written or verbal or otherwise represented commitments from customers but simply “walk through the door each quarter”. If a company has no customers commitments, such as retailers, but simply relies on on-going business as a source of revenue the buyer is going to want to review comparable periods, usually monthly or quarterly to determine trends and to justify the revenue projections. In this case, the buyer will make inquiries to the seller to justify the expectations. The process is somewhat difficult to really obtain quantitative data in the absence of some form of customer commitments. In other businesses, the buyer will receive the projections in the form of revenue being derived from specific clients on particular projects over a specific period of time. This analysis is considerably more difficult to perform but yields much more useful and accurate results. If a seller provides a set of schedules with revenue projections by specific client, it would be prudent to review these clients and the underlying contracts one by one, in great detail to get a sense of the accuracy of the projections and the assumptions upon which they are based. The revenues are so important in the due diligence process that we recommend that this not be done in an audit-type fashion, in which a representative sample is examined, but rather, whenever possible in an exhaustive fashion. It is usually worth the time and effort, unless it is simply impractical, to review and verify the entire schedule of revenue generation. Whatever the process, the verification stage should involve drilling down to the lowest level in the organization that is the primary source of the revenue generation. If this is a services organization this process would entail speaking with whomever is most familiar with a certain particular project and verifying how the revenues are going to be generated, if the customer is completely satisfied with the services delivered or performed to date, and whether there are sufficient resources in the company to complete the delivery of the services in accordance with the revenue projections. As a result of the interviews, there will be some changes to the projections and more accuracy and a higher degree of comfort in the revenue expectations. In some companies, especially smaller ones, the owners or the key personnel may be familiar enough with the projects to act as the primary source, but often it is necessary to descend a little lower in the organization to get to the person responsible for the project and who controls the client. This again brings up the issue of confidentiality and achieving that delicate Tango Equity 77 balance between the buyer’s need to verify information from primary sources and the sellers desire to protect confidentiality.
Employees First of all, it is the preferred course of action, if at all possible, to get the buyer the information that is needed with only the involvement of the key employees and management. The last thing that a buyer or a seller would want is to come in and shake up an organization by announcing a transfer of ownership or otherwise having the staff anticipate that there is a possibility of a transfer of ownership and then not having the transaction take place, or having the stability or the value of the organization impaired by the fact that confidentiality was not upheld. It is bad for the business owner because he or she is left with an impaired asset, and it is bad for the buyer because he or she will probably have an impaired reputation that would hinder him or her in future transactions. If there is no other way and as a last resort, if it is going to be necessary to bring the due diligence to levels below the management and key employees it is usually best to bring the transaction out into the open. If many employees are going to have to be interviewed it is going to become increasingly difficult to keep the transaction confidential. The best way to do this is to be very honest with the staff and explain what is happening and bring them into the loop telling them what procedures are going to take place, what they should expect to happen over the next several months and, most importantly, what it is going to mean to them if the transaction takes place. They should be introduced to the buyer and the buyer should be allowed to explain his or her plans going forward, the growth, capitalization and expansion plans. The owner needs to charge the message with some enthusiasm for the expectations of getting to a successful transaction while at the same time moderating that enthusiasm with the message that if the deal does not happen, that too is acceptable and the company will continue on it course. If done properly, it can greatly increase the effectiveness of the due diligence process and give the buyer a much higher level of comfort, but if not done correctly or not addressed at all, it can be a disaster. Occasionally, when only a few employees need to be involved in the due diligence process, the buyer can gather information by being introduced as a banker or prospective creditor or investor, who is considering extending a line or credit or perhaps considering an investment in the organization, or even as a customer. In such a manner, the buyer may be able to gain some primary source information without revealing that a change of control transaction may be imminent. The drawback of this approach is that it is not being upfront with the staff that is involved. This may lead to some resentment when they are made aware of the facts, but that may take place even if the transaction is keep completely confidential and only announced at the time of closing. As such, employee involvement below the level of executive or key management in due diligence activities is almost an all or nothing situation. It should be decided either to keep the entire transaction confidential until the closing, which in most cases is highly preferable, or to bring the deal out in the open and share the vital information with the entire staff understanding that the information will certainly become known to creditors, landlords, competitors and customers. 78 Tango Equity
With the exception of the information needed to obtain a comfort level with the projected revenue data, there is not a lot of information that needs to be verified from internal sources too far below the highest levels of the organization. Shareholder information, organizational charts, insurance information, disclosure of liabilities, creditor information, contract information, tax returns, explanations of accounting methods, partnering agreements, and outside agreements can all be verified from either high level internal sources or external sources. Therefore, if the revenues do not need to be verified by either lower-level primary internal sources or high-level external sources (customers), it is usually possible to adequately verify the revenues and all of the other due diligence material without compromising the confidentiality of the transaction. Whatever technique is employed at the end of this stage, the buyer will have to review all of the documents and verify the information in those records with the primary internal sources, most importantly the revenues.
External Primary Source Verification The majority of the second stage verification of the source data is going to come from internal sources, primarily from management. However, there are a number of external primary sources of verification.
Accountants The accountants are going to be the most important resource for external primary source verification. The analysis of the financial information is the most important criteria used to establish the value of a company and the independent accountants are the most important primary external source in verifying this information. The buyer will typically receive the financial data in advance and have a number of questions on them. Although management is going to be the best source for verifying the revenues, the income statement data is a very valuable source of information. The management needs the statement of operations to manage the company but the balance sheet data is typically less familiar to them. Management will oftentimes refer the questions on the balance sheet, such as the handling and structure of debt to the accountants. The accountants will know the details of any lines of credit or term debt with the primary institutional lender or alternative lenders as well as how this debt is secured and details of the assignability and change in control provisions. This is going to be a very important aspect of the transaction if there is any institutional debt. Typically, institutional debt is secured by all of the assets of the company. In such cases, the buyer must be concerned with not only the terms of the note but also with the liens on the assets. This can be addressed in several ways. Either the buyer is going to pay off the debt due to the lien-holder (which is the preferred technique), or, the buyer is going to pay the shareholders and the shareholders are going to pay off the lien-holder from those proceeds and the lien-holder is going to supply a certificate rendering the assets free and clear of all liens and encumbrances. The third alternative is for the buyer to assume the debt. In this case, the purchase price would have to be adjusted since the assumed debt is part of the purchase price in purchase accounting. At this point, we would like to describe a transaction that did not go well as a result of incomplete due diligence in this matter. I think it is an important case study and one worth taking the time to describe. Tango Equity 79
Case Study – Due Diligence Diligence
The deal was an asset transaction and the target was a subsidiary of a medium sized diversified services company. We will call it Mountain International, and it was based in central New Jersey. As a part of the transaction, the buyer was to pay considerable cash at closing. With this cash at closing Mountain was to pay off the primary institutional lender. The primary institutional lender held a perfected first lien on all of the assets of the company. The transaction was an asset deal. The seller claimed that due to the sensitivity of the transaction and their relationship with the primary institutional lender (“PIL”) the buyer could not communicate with the PIL prior to the consummation of the transaction. The seller further represented that it would warrant that they would immediately pay off the PIL and provide the buyer with a certificate that the assets would be free and clear of a liens and encumbrances just as soon as the transaction was completed. The buyer found the deal very attractive and agreed. This was a big mistake. Following the transaction, the seller paid off some creditors but did not pay the PIL. The assets remained encumbered and technically owned by the PIL. Although the seller had agreed to pay the PIL from the proceeds of the cash at closing, they did not and it was then a matter for litigation, which took several years to resolve. That is why tenet #1 is no matter how good a deal seems, if it seems that the buyer or the seller is not being completely honest with you on a material matter, simply walk away, better yet, run away from the transaction.
Secured Debt In working through the resolution on how to handle secured debt in a transaction it is always necessary to involve the creditor. If the Company or the Company’s accountants claim that it is not possible to include these creditors or to speak with them, it is not a safe transaction and a buyer should not proceed.
Attorneys The seller’s attorney is going to be a key person or persons in the transaction, regardless of the role that they play as a provider of information as a primary external source of information verification. The company’s corporate attorney, general counsel (an internal primary source), and SEC counsel, if the Company is a public company, will typically provide information on the status of licenses and permits required to do business. This is especially important if the company is operating in a highly regulated industry. They will also be able to address the reporting status of the company if it is a public Company and if not public just the general issues of the company’s bylaws, amendments, board of directors meetings, loans to and from insiders and shareholders, as well as outstanding stock and stock option plans. The outside corporate counsel will also be the primary point of contact for issues regarding Intellectual Property and issues regarding patents and patents pending, copyrights, trademarks and all documents, registrations, owned or held by the company. The buyer will usually be responsible for conducting the lien searches, but the corporate attorney will be the individual who will address any problems. There are almost always problems with lien searches, because for some reason, reporting agencies or those who are responsible for providing information to reporting agencies are typically inconsistent,thus resulting in reports 80 Tango Equity that are frequently inaccurate. It is sometimes difficult to determine the facts when the agencies do not provide complete information or fail to provide accurate data sets. Finally, the corporate counsel is going to be responsible for providing primary source information with regard to pending and threatened litigation. They are also going to be the best source for information on past litigation and how previous actions involving the company were resolved.
Outside Directors If the company has a long history with numerous management changes the outside directors may be able to lend some insight into the company’s history. Also, if there have been some unusual transactions or related party deals, the outside directors may be a good primary source of information. Apart from special circumstances such as these, the outside directors are usually not the most important primary external sources of verification.
Majority Shareholders If the operators are not the majority shareholders or if there is another majority shareholder who is not active in the business, it is necessary to speak with that individual to find out why the investor was attracted to the Company and if the company fulfilled his or her expectations. Also, there should be inquiries to determine if the company has any outstanding obligations to the shareholders based on any written or verbal representations that were made to induce them to invest in the company.
Insurance Agents Since our example is an asset transaction, it is going to be necessary for the buyer to communicate with the insurance agent or to otherwise secure coverage for the new business going forward. Keep in mind that this transaction is a sale and purchase of assets and the existing policies including general liability, professional liability, director’s and officer’s coverage will apply to the seller’s company which is going to be without assets following the transaction. The assets are going to be placed into a new company or the buyer’s existing company. The buyer may have an insurance company that he or she has been dealing with and will probably want to get quotes from these existing carriers as well. However, it is often more economical to deal with the seller’s current insurance carrier, providing the company has a good claims history, because the existing insurance company knows the company and its operations and will probably offer more attractive rates. Nevertheless, the buyer needs to have all of the policies ready to take effect in anticipation of and contingent upon a closing. On the sellers part, although the seller will have no on-going business subsequent to closing, they are going to want to maintain a “tail” policy that will cover them from latent liabilities that might arise from claims subsequent to closing for events that occurred prior to closing. These policies are extensions of the reporting period for the existing business and are necessary if any of the policies are written on a claims made basis. This coverage will be significantly less costly than coverage for a business with normal operations and also is best secured from the same insurance provider as the active policy. The buyer should also insist that the seller maintain such a tail Tango Equity 81
policy as it will avoid future confusion with regard to successorship issues if an action is brought against the Company in a pre-closing claim.
Trade Creditors and Vendors We have already clearly stated above the reason why it is so important to meet with secured creditors. However, it is important to have an understanding of exactly how all of the creditors are going to be handled. In most cases, as in the International Widget example, the liability for booked trade payables is going to be assumed by the buyer. The trade creditors are important to the ongoing success of the business since they are providing goods and services that will allow the Company to produce its good and provide its services and to generate revenue. For a buyer, it is important to establish whether or not there are any critical vendors, or vendors with whom there exist any special covenants or relationships. For example, the company may have an extremely favorable long-term contract with a supplier that is allowing it to maintain margins in excess of the industry standards. Again, since in this example we are dealing with an asset sale, the favorable contract with the vendor may not be assignable. The buyer may not be able to take advantage of the favorable contract conditions unless the contract can be assigned to the new company or the supplier is willing to extend similar terms to the new company. In addition, it is a good idea to speak with the major and critical vendors to assess the strength of the relationship and the credit standing of the Company. Again, although it is not the responsibility of the buyer to assume liability for unbooked liabilities (liabilities that are not on the balance sheet and on the Schedule of Assumed Liabilities) in an asset transaction, it is little comfort if a critical supplier is holding up production because of an unpaid invoice.
Landlords Whether the transaction is an asset deal or a stock deal, it is usually important for the buyer to meet with the landlords of material real estate leases. Most leases are not assignable without the consent of the landlord, and this would affect all asset transactions. Also, many leases have a change of control provision, which states that a material change in control of the company can give the lessor an option for the termination of the lease. Occasionally, in smaller transactions, real estate leases may require personal guarantees by one or more of the principals of the company or a so-called “good-guy” clause. This clause is a step back from a personal guarantee and obliges the tenant to quit the premises after a period of default, and if the tenant fails to vacate, the principal will have to personally guarantee the period of tenancy following the default. The seller will want to be released from these personal guarantees if they exist and the landlord is going to require that the buyer be at least as creditworthy as the seller who is being replaced.
Customers By far the most sensitive external primary source of verification is the Company’s customers. Again, we are confronted with the competing requirements of the buyer’s need for information verification and the seller’s need to protect the business. Just as in the case of employees, the rule is that if the revenues can be verified by the examination of primary source documents and interviews with the key personnel involved in providing the goods or services to the clients or 82 Tango Equity customers, it is preferable to actually contacting the clients or customers or otherwise having the transaction revealed to the clientele. Once again, this verification is especially important in an asset transaction because most contracts are not unilaterally assignable. Following an asset transaction, in most cases the new owner is going to have to have each contract assigned or novated to the new company. This is, at best, an arduous process and at worst an opportunity for the client to extricate itself from the obligations under the contract, if for any reason, the client is dissatisfied with the Company, or the Company’s performance or is of the belief that the situation may present them with an opportunity to negotiate more favorable conditions than the existing contract. When government agencies are involved, the process becomes even more onerous and the contract may not be easily assigned and may, in fact, not be able to be legally assigned because of the government entity’s competitive bidding requirements. In an asset transaction, the buyer is providing the services with, what is technically, a new company. Despite the fact that the products are being manufactured in the same plant, run by the same operators, managed by the same personnel and provided at the same cost, the fact that they are being delivered by a new corporate entity may require a new round of competitive bidding or may even trigger some punitive measures against the company which was originally awarded the contract for lack of fulfillment. It is a little bit easier to gather information about the stability of the relationship and the likelihood of additional work going forward without actually interviewing the client. Interviewing the client is a last resort strategy because it is a process that is dangerous both for the seller and for the buyer. The seller has revealed to the client that he or she is planning an exit strategy, if not now, at some point in the not too distant future. This may adversely affect the customer’s decision-making process in the distribution of additional work in the future when choosing from its other suppliers. Also, there is a risk to the buyer. If a particular customer interview goes exceptionally bad, the seller may claim some liability on the part of the buyer for interference in the contractual relationship between the client and the company, if the transaction does not take place. For this reason, it is very important that if it is decided that customer interviews are going to take place, the questions be carefully agreed upon beforehand and that the buyer always conducts these interviews in the presence of a key employee, manager, or owner of the Company. One of the best ways that we have found to gather this external primary source verification information without the direct intervention of the buyers is to have a project manager or account executive call or email the client with a few direct, frank questions. How are we doing? Anything we can do to improve? What are your thoughts as to when the XYZ Project might be getting underway? This is the type of thing that should be done periodically anyway, but it is typically ignored because of the time constraints of running the day-to-day operations. In this case, the information is obtained and if the deal does not occur the seller is left, not with a shook up client, but with some valuable information on how to better serve and thus secure additional ongoing work from the client.
Others Other individuals, groups or organization that a buyer may like to speak to depending on the specific circumstances of the transaction, are outside principals of material licensing agreements, outside principals of material partnering, co-operating, or joint venturing agreements, and parties who may be involved in material potential litigation that has not yet developed into a claim. Needless to say, this is not an exhaustive list. There may be others that the buyer would like to contact that are specific to the circumstances. Tango Equity 83
Lien searches The buyer will perform a lien search to gather information on the actual ownership interest in the assets of the company. This is accomplished by a UCC-1 search. An UCC-1 is a form used for commercial financing using the assets to secure a loan under the provisions of the Uniform Commercial Code (UCC). As mentioned earlier, the system is somewhat inefficient and these searches often contain errors, which would need to be clarified. Creditors are typically very diligent in filing UCC-1s to protect their interests, but less diligent in releasing them when the debt has been satisfied.
Data Reduction
Following the field investigation, the buyer will have to that point collected a great deal of raw data and, to a reasonable extent, verified the data collected and the representations that have been made by the seller. The objective of data reduction is to assemble this verified information and attempt to get an idea of what we have. It is basically a business plan going forward.
One of the most efficient ways to compile the data and put it into a meaningful format is to produce a complete set of go-forward pro forma financial statements. As was stated earlier, this set of projected financial data is the ultimate objective of the first two phases of the process. In addition, it is prudent to also produce a schedule of red flag items and an operational checklist. The red-flag items are problems that, based on the due diligence investigation thus far, have a reasonable chance of occurring and negatively affecting the operating plan. The operational checklist is a preliminary set of actions that must be successfully implemented for the assets to perform as expected. Appendix G contains a complete set of pro forma financial statements derived from a due diligence investigation. Most intermediaries will have either a proprietary off-the-shelf software suite with which they can use to develop a high-quality set of pro forma financials statements, with supporting schedules and assumption pages that would allow a sophisticated reviewer to not only be able to examine the set of prospective financial statements, but also to determine all of the underlying details, exhibits, information and assumptions that were utilized to generate the statements. Thus, the prospective financial model will include, at the highest level, the pro forma income statements, balance sheets, and statements of cash flow. The revenue line item in the income statement will be supported by a summary of the different sources of revenue depending on the type of business. In turn this should be able to be tracked back to the primary source of the revenue down to the specific client and to a specific project when possible. In addition, any underlying assumptions that support the revenue projections should also be evident. With regard to the expense side of the income statement, in the example included in Appendix G, we have separated the direct costs from the indirect costs and created separated details for each. As we did with the revenues, the assumptions that were used to generate these line items should also be clear and understandable.
Following the income statement is the balance sheet which is supported by operating assumptions that are included in the operating cost assumptions. Included here are the Days 84 Tango Equity
Sales Outstanding (DSO) and the Days Payables Outstanding (DPO). In addition, if there is to be any seller debt or additional institutional debt there should be a separate amortization schedule included. This information will also be necessary for the income statements. Finally, the pro forma statement of cash flows, will gather information from the income statement and the balance sheet to produce the estimated cash flow. Typically, initially many buyers create a set of financial statements without a financing source in order to determine the amount of cash that will be required to finance the transaction and then utilize the model to determine the optimal financing design.
Red-Flag Items Imagine that a Company that is being considered for an acquisition has a rather large services contract with a municipal government agency. The company is in the second year of a five-year contract. The buyer has spoken to the manager of the contract for the agency and found that the agency is pleased with the performance of the company under the contract thus far, and does not anticipate that there would be a major problem in continuing to provide services under the contract subsequent to a change of control. However, the contract has a specific change of control provision, which would allow the contract to be rebid, at the discretion of the agency upon notification of the change in control of the engaged company. The contract manager for the agency thinks that he can get the contract novated to the new company. However, since the inception of the contract, prices for the Company’s products have fallen and the current contract is about 15% higher than the current market rate. The agency’s contract manager cannot be 100% certain that his superiors will not force him to rebid the contract. It is not possible to approach the contract manager’s superiors as it is an impossibly bureaucratic system and, at any rate, it would not be prudent to draw attention to the price differential. In this case, the buyer has to deal with an incomplete data set. This is an example of a red-flag item and the quality and character of this uncertainty would be taken into consideration in deciding whether or not to go forward with the transaction.
Operational Checklist The items comprising the operational checklist are major action steps that need to be completed in order to make the operating plan succeed. For example, a selling company has a service branch that is just about breaking even. It is in a small market and it has been difficult to gain market share. It is distracting management from devoting their attention to the larger more profitable markets. It would make sense to close it, but there is a real estate lease that runs for another year, and it is unlikely that the buyer would be able to find a short-term sublessee. If the service operation were to be closed now the company would incur a loss due to the cost of the run-out of the lease. This would be an item that would be included in the operational checklist. It is going to be necessary to wind down the operations coincident with the lease expiration. The financial model will be developed considering the planned closing of this facility. Tango Equity 85
Financial Analysis
The final objective of the process is to produce a complete set of pro forma, or going forward financial statements that include an income statement, or statement of operations, a balance sheet and a set of statements of cash flows. These statements will be used to provide the final information relative to the valuation of the Company and, if the transaction is completed, to provide a baasis with which to measure the success of the transaction. There are a number of financial modeling programs that can be used to generate these statements and most buyers will have their own that they are comfortable with. In all cases the input data is that which has been gathered during the initial research and due diligence process. The general categories of input data will be those used to determine revenues, direct costs and indirect costs, as well a capital expenditures and information regarding the amortization of any debt being assumed or arising out of the transaction. It is helpful to be able to look at the revenues from the source data. It is also very important when soliciting financial investors or capital sources to have a complete set of detailed, defensible pro forma estimates of the future performance of the investment. That is, the line-by-line revenue data per client or per product line that was developed by the Company and verified during the due diligence process with the client managers or product managers and/or the clients and customers. From this low-level data the information can be rolled up into a higher level of total revenue by customer or by product line and then finally into a revenue summary which will be equal to the revenue line item in the income statement.
The direct costs should contain details on all direct costs and a section on direct costs assumptions. This should roll up into a direct costs summary page, which is the basis of the direct costs section of the income statement.
The indirect or operating costs will be detailed in the same way with an additional section on operating cost assumptions. This will also roll up into an indirect costs summary page, which is the basis of the operating cost section of the income statement.
Capital expenditures should be estimated and included in the cash flow section of the financial statements. The capital expenditures will have to be depreciated and the allocation of these charges to earnings during their useful lives should be included in the depreciation costs under indirect or operating costs.
Debt that is assumed or incurred for the purpose of completing the transaction or that is required for expansion or other provisions in the operating plan should be amortized and supported by an amortization schedule. Interest and principal payments should be added to the statement of cash flows and the interest payments to the non-operating expenses on the income statement.
If all goes well, all the untold hours of working and reworking the numbers will result in a meaningful balance sheet and all of the other financial statements. Appendix G is an example of such a final product. 86 Tango Equity
Chapter 5 Fundamentals of Valuation
There are literally dozens of methods by which a business can be valued. Some of these have some very specific applications for which they are best suited; others can be more generally applied. Some are more applicable to publicly held businesses and other better suited for closely held private businesses. In analyzing a privately held business, the evaluator is at a disadvantage and faces a more difficult challenge than making the same analysis for a publicly held business. Public firms are required to produce and publish financial operating data quarterly and to generate this data in a specific manner, while privately held companies, for the most part, have no such requirements. Valuation, in a sense my be estimated by Market Cap or Market Capitalization value which is represented by the value of all of the outstanding shares of the company at the current price. A better estimation can be made from the Aggregate Value which is the Market Cap adjusted for certain classes of debt. Neither of these, however, is an accurate indication of the price that one would have to pay to acquire the company. Another important difference between valuations of public and private companies is that, public companies are more often valued on earnings and the ratio of the price of the stock to its earnings is an important valuation criterion. Therefore, earnings are important to a public company and showing strong earnings every quarter helps to maintain the price of the stock, thereby enriching the shareholders, which is the ultimate objective of the Company’s management. In a private company, especially a closely held private company, the management’s emphasis is less on earnings and more on cash flow. The privately held company is managed to a large extent to minimize earnings in order that they may be able to lower taxable income and to decrease taxes thereby maximizing cash flow. We have previously discussed the process of recasting or normalizing the financial statements to make the financial statements more representative of the actual cash flow from operations. This is an important consideration in several of the methods for determining value. There are three main general methods for providing a valuation of a business.
Value and Purchase Price
We would like to make a distinction here between the terms of value and purchase price. When we refer to value, we are referring to the price that a specific entity is willing to pay for a business enterprise. That specific entity arrives at the price that they are willing to pay based on their specific objectives for the investment with regard to rates of return and operational efficiencies. As beauty is in the eye of the beholder, value is in the eye of the purchaser. Two purchasers may value an identical business very differently because of different required rates or return or the ability of one to apply operational efficiencies or synergies to realize a higher yield on an identical investment. Purchase price is the value to a specific purchaser. Purchase price estimates are based on general criteria of a broad universe of purchaser and may not correlate to the value of a business to a specific purchaser. Tango Equity 87
Valuation Methods There are three main categories of methodology for arriving at a valuation for a specific business. They are the 1) discounted future earnings method, 2) the comparable multiples method, and; 3) several Asset-based methods. Each category is described in brief below.
Discounted future earnings – This is a method of taking the future cash flows of the company and discounting them back to the present. We have previously discussed the concept of discounting the future. It is a method of determining value and it is probably the best method for providing a custom valuation of a business for a buyer.
Comparable Multiples – There are actually several methods of purchase price determination that are employed extensively as “rules of thumb” or estimates. They are based on comparing statistics from recently completed transactions within the industry. Depending on the industry the most commonly used multiples are the EBITDA multiple, the Revenue Multiple and the Gross Margin Multiple. The comparable multiples method offers a fairly simple estimate of approximate purchase price expectations.
Asset-based methods – There are several different asset based methods that are used to valuate private companies, usually in limited, special situations. Some of these are fair market value, book value and liquidation value.
Discounted future earnings method
An Ideal Method
We will begin by explaining the discounted future earnings method and applying it in an example. We have previously discussed the concept of discounting the future and explained why money today is worth more than the same amount of money tomorrow, which is worth more than the same amount of money next week, which is worth more than the same amount of money next year, etc. The concept is that if you had the money today you could put it into a “safe” investment and it would grow at some theoretical “ risk free” at some rate, which we referred to as the discount rate. The discounted present value is determined by projecting the cash flows over a period of time in the future and discounting them back to the present time. This is referred to as the present value (PV). The present value is then determined according to:
n
n PV = ¦ Cash Flow1 / (1+r) I=1
The present value is the sum of the cash flows each divided by some discount rate. The result is that the further out the cash is received the more it is discounted. In this case, if the cash flow 88 Tango Equity was $100 per year and we assess this cash flow over 5 years. The actual cash received would be $500. If we were to use a discount rate of the current 5-year Treasury bill rate, which as of December 21, 2003 is 3.16% the sum of the discounted cash flows would be $456. Which is arrived at by [100/(1+.0316)^1]+ [100/(1+.0316)^2]+ [100/(1+.0316)^3]+ [100/(1+.0316)^4]+ [100/(1+.0316)^5], or, 97+94+91+88+86 = 456.
Year Cash Flow Discounted Cash Flow 0 0 0 1 100 97 2 100 94 3 100 91 4 100 88 5 100 86 Total 1,000 456 Table 20 – DCF #1
This analysis compares the cash flows of the investment to a very safe investment, a 5-year U.S. Treasury bill. If the U.S. government ever defaults on a Treasury bill then we probably have bigger problems than this particular investment. In this case, if a buyer were to pay $456 for this stream of cash flow totaling $500 over the five-year period, the buyer would obtain the equivalent of 3.16% return on the investment. It obviously does not make sense to make a comparison to a relatively high-risk investment to such a safe investment. Even with a substantial amount of due diligence and a stable economy there is significant risk in an investment in an operating business. There are risks of clients defecting, of employees leaving, of technology changing, of competitive challenges, and of uncontrollable economic or political factors arising that may cause a material adverse change in the projected, prospective cash flows. There is a well-established principle in corporate finance that risk and reward increase proportionally. As risk increases investors are going to demand a higher return on their investment. As such the discount value needs to be increased to reflect the greater amount of risk. The discount value will then reflect the required rate of return the investor (the buyer) needs to accept the risk of the investment. As the discount rate increases the sum of the discounted cash flows is going to decrease and consequently the present value of the investment will decrease. The higher return is known as the risk premium. It is not uncommon to expect a 30+% return on a high-risk investment, which amounts to approximately a doubling of the investment value every three years. At a 30% discount rate the same set of cash flows becomes: Year Cash Flow Discounted Cash Flow 0 0 0 1 100 77 2 100 59 3 100 46 4 100 35 5 100 27 Total 500 244 Table 21 – DCF #2 Tango Equity 89
In order to receive a 30% return on the same set of cash flows the buyer would have to pay only $244 for this stream of cash flows. However, there are two dynamics that must be taken into consideration in this model. The first is that if this were a growing business the cash flows would not remain static at $100 per year. If the buyer can make the assumption that the cash flow would grow by 10% each year, and is still comfortable with the 30% return in making this assumption then the stream of cash flows would change to:
Year Cash Flow Discounted Cash Flow 0 0 0 1 110 85 2 121 72 3 133 61 4 146 51 5 161 43 Total 671 311 Table 22 – DCF #3
Factoring in the annual growth rate of 10%, the buyer would be willing to pay $311 for this increased stream of cash flows. The final dynamic that will be considered in this example is the fact that at we just arbitrarily made the assumption that the buyer has a 5-year investment horizon. The investment horizon could just as well be ten years or twenty years. However, the longer the investment horizon, the more uncertain the revenues, economies, and other factors that may impact the business become. It would now make sense that the required rate of return for the investment would also increase and the impact of the cash flows in the later years would diminish. We can even assume that the buyer is going to hold the investment forever, and we can, using the application of the calculus, increase the returns continuously for an infinite number of years. However, apart from being an exercise well beyond the scope of this book, it would also require the assumption of the buyer’s corporeal immortality which is impractical if the buyer is an individual, but not if the buyer is a corporation with is considered to be an entity in perpetuity. Since we are discussing institutional buyers we can safely adhere to the 5 year time horizon for the analysis and remain consistent with the temporal considerations of the majority of these buyers. This brings us to the final dynamic, which is the fact that in almost all cases the business is going to have some value at the end of the investment horizon and this has to be taken into consideration. The model is incomplete since it just considers the value of the cash flows and not the terminal value of the business. If we were to make the assumption that at the end of five years the buyer is going to be able to sell the company at an EBITDA multiple of 5.5, and that the EBITDA in this case is the equivalent of the cash flow, then the discounted cash flow model becomes: 90 Tango Equity
Year Cash Flow Discounted Cash Flow 0 0 0 1 110 85 2 121 72 3 133 61 4 146 51 5 1046 282 Total 1,556 550 Table 23 – DCF #4
In this final refinement of the model, the fifth year cash flow is $161 from the operations and an additional $886 from the sale of the business at an EBITDA multiple if 5.5 (5.5 * $161 = $886). Now the total cash flow for the fifth year is $1,046 and discounting this back to the present is an additional $282 for the final year. In this case, the buyer would be willing to pay $550 for the company.
Although we have refined the discounted cash flow model for growth and for the net terminal value of the company we still have a very simplistic model. The discounted cash flow model is quite flexible and can be adjusted for things like financing, residual debt, and partial ownership positions. All of these can be factored into the model based on how they affect the annual cash flow or the terminal value of the company. Otherwise, the model will work the same way with these adjusted amounts being discounted back to the present and the sum of the discounted cash flows plus the discounted net terminal value yielding the purchase price that would yield the buyers their required rate of return.
We stated that this is an ideal method for the determination of the purchase price of a business, and; as long as all of the variables are known it is. This brings us to the biggest problem in the application of this method. This is by far the best method if the variables are known. The most important variables are the determination of the future cash flows and the net terminal value, which are not known and not that easy to ascertain. This underscores the importance of the proper recasting and normalization of the financial statements on the seller’s side and the due diligence process on the buyer’s side. The due diligence process must include the formulation of a complete set of financial projections for the life of the investment on the buyer’s side. This process is important in determining the buyer’s expectations for the anticipated rate of return on invested capital and serving as the road map for the future operation of the business.
Comparable Multiples
As mentioned above, the comparative multiple approaches typically arrive at an estimate of a company’s selling price as opposed to a valuation. This approach is very industry dependent and should be evaluated on the most current available industry-specific data. There are a number of comparative multiples but those most commonly employed are multiples of earnings, multiples of revenues and multiples of gross margin. In all of these approaches the numbers are multiples Tango Equity 91 based on total invested capital. Total invested capital (“TIC”) means the fair value of all related components of a transaction, including (but not limited to) all payments, exchanges or other contributions in any form (e.g. cash, credit, tangible assets, intangible assets, shares, options, warrants, earn-outs, contingent consideration, notes, escrowed funds or assets, assumption of debt, etc.) made by the buyer, or its shareholders, principals, members, affiliates, related parties, financing sources or any others on any of their behalf. As we have emphasized earlier, any transaction cannot be evaluated solely on its transaction value but must be regarded in terms of total invested capital and the terms under which that consideration is distributed to the seller. The example of the impact of discounting on the future value of cash flows in the previous section should demonstrate why this is so important.
Multiples of Earnings
We alluded to the multiple of EBITDA methodology in the example above. Multiples of EBITDA are probably the most commonly utilized quick estimation method. Typically, business brokers and M&A intermediaries will use a multiple of EBITDA to give the seller a quick evaluation of the range of the anticipated selling prices. There are numerous databases that brokers and intermediaries have access to from which they will research the industry and obtain the most current data. These data are usually based on information from closed transactions. EBITDA multiples across all industries ranges from about 2.5 to about 7. The EBITDA multiple is calculated as follows:
EBITDA multiple = TIC/adjusted EBITDA
However, it is important to emphasize that these ratios are very industry dependent and your M&A consultant will need to research the latest data to retrieve these multiples. In addition, the industries that are more in demand will command higher multiples and those in less demand will typically exhibit a lower multiple. During the fourth quarter of 2003, businesses in the all aspects of healthcare and homeland security were very much in demand while businesses in agriculture, forestry and heavy construction garnered much less demand. For current industry information the Tango Index may be referenced. The Tango Index is explained in Chapter 8.
Revenue Multiples
Revenue multiples are used less often than EBITDA multiples to estimate a company’s probable selling price. However, it is useful when, for one reason or another, the EBITDA may be misleading or as a backup or “sanity check” on the EBITDA multiple. Across all industries, the revenue multiples probably range from .25 to 1.5, with most transaction occurring between .35 and .75. The revenue multiple is calculated as follows:
Revenue Multiple = TIC/Total Sales
If it is estimated that the average business will generate EBITDA of 10-15% of revenues, the rule of thumb would indicate that a company with revenues of $1,000, based on the EBITDA 92 Tango Equity multiple would have an expected selling price of $300 to $750. Based on the revenue multiple we would expect a selling price of between $350 and $750. Similar to the EBITDA multiple, the revenue multiple is very industry specific and the M&A intermediary can research commercial databases to determine the most current revenue multiple for a specific industry.
Gross Margin Multiple
The least common and most industry specific multiple is the gross margin multiple. It is used in some specific industries and not useful in most situations. It is often encountered in some low gross margin industries in which the gross margin is frequently a determinant of the viability of the business, the competence of the technical management or the quality of the contracts. The gross margin multiple is calculated as follows:
Gross Margin Multiple = TIC/Gross Margin
In the temporary staffing industry the gross margin multiple is used as an estimate of selling price.
Price to Earnings Multiple
The price to earnings multiple is the index indicating value for most public companies. The price to earnings multiple indicates the implied value of a single share of stock. It is calculated according to:
P/E multiple = Price of stock/Earnings per share of stock
Fortunately, when dealing with a public company, it is very easy to determine the price of a share of its stock since it is printed in the newspaper every day or posted on the Internet every time there is a change in price. The price of the stock is the latest current market price of a single share of the company’s stock and the earnings per share of stock is the company’s net income or net earnings divided by the number of shares outstanding. Knowing the number of shares outstanding and the price of a single share of stock one can imply the value of the entire company if one were to buy all of the outstanding shares of the company. This is known as the market capitalization and it is calculated by:
Market Capitalization = price per common share * number of shares outstanding
However, there is still a problem with using the market capitalization as the indication of the value of the company based upon the ability of the company to generate cash. The market value will include cash that the company has as well as debt that it owes. To obtain a true estimate of the enterprise value of a small company the market value has to be corrected for cash and cash equivalents and for long-term debt except for debt incurred in the ordinary course of business, such as trade payables and accrued employee expenses. The enterprise value of a company can Tango Equity 93 be determined by a metric known as the Aggregate Value. The Aggregate Value can be determined by:
Aggregate Value = market capitalization + (debt + preferred shares) – (cash and cash equivalents)
The enterprise value is the value of the company as an ongoing revenue and income producing entity. It is the market capitalization plus the debt and the amount of redeemable preferred shares less the cash and cash equivalents in the company. The enterprise value can be thought of as the price one would have to pay to become the sole owner of the company. They would have to buy up all of the shares which would be the amount associated with the market capitalization, and they would still have to pay off the debt and the preferred shareholders, which would add to the purchase price. The cash that was left in the company could be used to pay off debt or shareholders so it reduces the enterprise value. There is one other problem in real life with the enterprise value. Since we are now dealing with a public company, we would have to tender for all of the outstanding shares. In a large or medium sized company with hundreds or thousands of shareholders this can be an expensive problem. The shareholders are going to have to be located, prospectuses are going to have to be written and distributed, attorneys are going to have to oversee the process, and companies who provide fairness opinions are going to have to be engaged. On top of all of this, it is unlikely that most shareholders would sell their positions at the then market value. If they wished to do so, they would have done so already on the open market. The buyer should be prepared to add a “control premium” to the price of the shares. The control premium is a price above the market price that will compel the owners of the shares to sell them to the buyer. If the buyer needs to have controlling interest in the company, he or she can stipulate that the transaction will not be completed unless more than 50% of the shares are tendered. There are other complexities in this type of transaction, but suffice it to say, that to obtain control of a public company, it is probably going to be necessary for a buyer to pay something over and above the aggregate value of the company.
The Sun Dixie Company, Inc. Ticker: DIX ANNUAL INCOME STATEMENT (Thousands of U.S. Dollars)
12 12 MONTHS MONTHS ENDING ENDING 12/28/2003 12/28/2003 Net Sales 507,517 Total Revenue 507,517 Interest Expense -16,026 Cost of Sales 387,010 Income Before Taxes 12,461 Gross Margin 120,507 Income Taxes 4,191 Sell/Gen/Admin 92,042 Income After Taxes 8,270 Asset Valuation 0 Pri/Bas EPS Ex. XOrd 0.705 Restructuring 0 Other, Net -22 Total Expenses 479,030 Table 24 – Sun Dixie Income Statement. 94 Tango Equity
The Sun Dixie Company, Inc. Ticker: DIX DETAILED ANNUAL BALANCE SHEET (Thousands of U.S. Dollars)
ASSETS As of 12/28/2003 Cash & Investments 2,440 Accounts Receivable. 0 Receivable., Gross 43,448 Doubtful Accounts -3,290 Inventories 95,113 Held For Sale 14 Other 8,592 Total Current Assets 146,317 Land 5,992 Building 75,665 Machinery/Equipment 211,349 Accumulated Depreciation -149,432 Total Goodwill 109,595 Goodwill/Intangibles -9,103 Other Assets 12,805 L.T. Investments 13,458 Accumulated Amortization 0 Total Assets 416,646 LIABILITIES Accounts Payable 37,458 Accrued Expense 27,993 Disc.Ops-Accrued 0 Cur.Port.LT Debt 1,294 Taxes 0 Other 0 Total Current Liabs 66,745 Long Term Debt 10,145 Subord. Notes 3,952 Total Long Term Debt 14,097 Deferred Taxes 200 Other LT Liabilities. 70 Total Liabilities 81,112 SHAREHOLDER EQUITY Common Stock 45,265 Other Equity -5,967 Paid in Capital 132,724 Retained Earnings. 163,594 Stock Compensation. -82 Total Equity 335,534 Shares Outstanding 11,768.95 Table 25 – Sun Dixie Balance Sheet. Tango Equity 95
To demonstrate we can take an example from the Sun Dixie Company (The Sun Dixie Company is a fictional company used as an example. At the time of this writing the Ticker Symbol “DIX” was not in use on any major US exchange.), a middle market company that had current revenues as of the date of this report of $507 million and operating income of $12,461,000. Sun Dixie’s Income Statement and Balance Sheet is above on Tables 24 and 25. Sun Dixie paid $4.2 million in income taxes and had net earnings before any extraordinary items of $8.27 million. There were 11,723,000 shares outstanding at the time so the earnings per share was 8.270/11.723 = $0.705, or about 71 cents per share. At this time of this report the price of the stock was $11.21 per share so the price to earnings ratio was 16. The multiple on net earnings is 16 and the multiple of operating income (which is a index that is rarely used) is 10.6. This is more akin to the EBITDA multiple that we discussed earlier in this chapter. As we stated earlier, it would probably be necessary for a buyer for the stock of this public company to pay a control premium to get sufficient shareholders to tender their stock in order to assume control of the company. While this varies widely in actual practice, a control premium of 20-30% would not be considered unlikely. If the buyer is offering a 25% premium for the stock it means that he or she is tendering for the stock at $14. Any Shareholders who tendered (sent) their stock certificates to the agent of the buyer within the prescribed time period, would receive $14 for each share tendered, provided however, that the buyer achieves their aggregate target of the shares outstanding. If the shareholders fail to tender sufficient shares to achieve the buyer’s target, the offer will lapse and the shares will be returned to the shareholders. From Sun Dixie’s financial statements we were able to ascertain that the initial market capitalization of the company was approximately $131 million (shares outstanding * share price = 11,723,000 * 11.21 = $131,141,830). When the buyer’s tender offer became public knowledge, it is likely that the price of the stock rose to just under the price of the tender offer of $14. At that point the market capitalization, or the price of all of the stock of the company was 11,723,000*14 = $164,122,000. To arrive at the enterprise value or the aggregate value it is necessary to deduct any cash that the buyer would receive in the transaction and add back the additional debt that is being assumed. In this case, the cash and cash equivalents are $2.4 million and the long-term debt consisted of $10.1 million in long-term debt and $4 million in sub debt. (Sub debt is subordinate notes). The subordinate term describes their position in relation to other creditors indicating how the creditors would get paid off in the event of a foreclosure, bankruptcy, or liquidation. In this case, the long-term debt of $10.1 is probably senior to the sub notes and the holders of the long-term debt would be paid off first, followed by the sub note holders, followed by the unsecured creditors, and down the line to the common shareholders, who would almost always be last in line. Regardless, of the hierarchy of the creditors the aggregate or enterprise value of this transaction is going to be:
Aggregate Value = market capitalization + debt + preferred stock – cash
Aggregate Value = $164 mil + $10.1 mil + $4 mil - $2 mil = $176.1 mil
The aggregated value to net earnings is 176.1/8.27 = 21.3, and the aggregate value to total revenues is 176.1/ 507.5 or .35. But before we can begin to make any comparisons and presumptions about how this transaction might be applied to the valuation of the private company, there is one more factor that needs to be considered. 96 Tango Equity
Shareholders of public companies have the distinct advantage of having some degree of liquidity in their investment. Granted that very large shareholders and founders do not really enjoy this advantage to the fullest extent because if a large shareholder who is also an insider were to sell a large block of stock on the open market it would probably have a negative effect on his or her holdings. But, we are referring here to the average holder with a significant but non-controlling stake, held by a person who is neither an insider nor an affiliate of the company. In such cases, public companies offer excellent liquidity. Private companies, on the other hand, offer very little liquidity. A shareholder’s money except for distributions is, for the most part, locked up in the company. There are regulations that govern the transfer of stock of the private company. In this situation, if the owner retires or otherwise wishes to do something else outside of the business, he or she must develop an exit strategy to not only withdraw him or herself from the business but to withdraw the enterprise value of the business as well. This dilemma is the reason why there is a liquidity premium associated with the equity of public companies. In a public company there is a ready-made market for an investor to withdraw from the investment at any time he or she wishes. It is here where the difficulty arises in applying the comparables method based on comparing P/E multiples of similar companies that have many characteristics in common except that one is public and one is private. It would be easier to compare the multiples of similar companies both of which are private but such data is not easy to find, and when it is found, it is not as reliable as public company data. An option is to apply an adjustment for the lack of liquidity in the private company. This is frequently accomplished by applying a marketability discount. Marketability discounts are estimated by gathering data comparing free-trading stock with certain types of stock called restricted shares. Restricted shares are issued with stated marketability restrictions. They may be identical to the common stock of the company that is free trading in all respects except that there are restrictions on its salability for some period of time. This period of time is usually one or two years depending on who is holding the stock. At the end of this period the stock automatically becomes registered and can be freely traded unless the holder has some other contractual obligations with the company referred to as lock-up provisions. By comparing the price of restricted stock to free-trading stock the marketability discount comes out to somewhere between 25% and 45%. However, this is probably somewhat understated because most restrictive periods, as stated above, are one or two years compared to the indefinite length of the marketability restriction on the privately held shares. As a result, a marketability discount that approaches 50% to 60% may not be regarded as unrealistic.
A Comparison of the Methods
In the discussion on discounted cash flow we used an example of a company that was generating revenues of $1,000 per year and annual cash flow of $100. Its bottom line was increasing at 10% per year and had no debt and had sufficient cash to conduct its ongoing operations. We have already calculated that according to the discounted cash flow method the expected purchase price of the company was placed at $550,000.
Method Estimate Discounted Cash Flow Method $550,000 Tango Equity 97
We said that we have been seeing EBITDA multiples of between 2.5 and 7 and that in many industries the multiples were narrower. In this industry, EBITDA multiples of between four and six would be expected.
Method Low Estimate High Estimate EBITDA Multiple $400,000 $600,000
The next method was the multiple of revenues method. We said that when using the comparable methods, it is necessary to research the specific industry data. The broad industry data indicates that we could expect to experience revenue purchase price multiples of between .35 and .65.
Method Low Estimate High Estimate Revenue Multiple $350,000 $650,000
Then, for the final comparable method it is necessary to make some new assumptions. First, we will use the same company with annual revenues of $1,000,000 and operating income of $100,000. We will make the assumption that the corporate taxes are 40% and that aggregate costs of the public company expenses including legal, accounting, and filing fees add another 10% to the cost of doing business resulting in net earnings of $50,000. Let’s assume that the P/E multiple of comparable companies within this business’s particular industry is 20. Therefore, the market capitalization is $1,000,000. Since there is no debt or excess cash, the market cap is the same as the aggregate value or implied enterprise value. This is the aggregate value that we would expect if the company were a public company. Finally, if we were to apply a 50% marketability discount then the expected value would be $500,000, or:
Method Estimate Comparable P/E $500,000
Valuation is really an art. It takes years of practice and exposure to real life experience to know how and when to apply each method and methodology. The rules presented here cannot be applied like recipes or rote formulas. Each business is different and has its own set of tangible and intangible assets that should be recognized and evaluated.
Asset Based Methods
Fair Market Value
Most definitions of fair market value concern themselves with the principal of starting off with a “willing buyer and a willing seller”. Fair market value is defined as the price at which the property would change hands between a willing buyer and a willing seller, when the former is under no compulsion to buy and the latter is under no compulsion to sell, with both parties having full knowledge of the relevant facts. As we have repeatedly emphasized, privately held 98 Tango Equity
companies do not have a readily available market and reliable information on close comparables is difficult to find. For this reason, determining fair market value for privately held companies is a difficult to do. The alternative to fair market value is often called fair value. Fair value is the appraised value of all of the assets in the company. It is important to realize that in public and private companies as well the fair value of the assets is not necessarily the value of the assets that is carried on the balance sheet. In fact, in most cases it would be surprising if it were. For example, some major facilities may be depreciated over 30 or 40 years. An older company with a large manufacturing facility in a desirable location may carry the asset at a very low value, while the actual value may be many times more than it was initially purchased for. Alternatively, software or high tech electronics may be carried on the books with an estimated usable life in excess of the actual useful life. This results in the value of the particular asset being overstated. The fair value appraisal will also assess and value the company’s intangible assets such as intellectual property and patents and assign them a current value. Like the other asset-based methods fair value is often used in contemplating a breakup or wind-down of operations and the sale or liquidation of assets.
Book Value
Book value is considered to be the value of the assets less the liabilities. For the reasons stated above it is not a useful measure of the value of a company.
Liquidation Value
The liquidation value is more akin to the fair value than to the book value. A liquidation value is the estimated value of the company’s assets if the firm was to be liquidated and the assets sold off. In the case of assessing a fair value or a liquidation value all of the assets including the accounts receivable and work in process are considered. Liquidation value can be considerably lower than fair value depending on the circumstances of the liquidation of the assets. If the business is going to discontinue operations, the accounts receivable would likely be more difficult to collect than they would be for going concern. Work in process would be near impossible to collect in a discontinued business because the labor force needed to perform the conversion of the WIP to accounts receivable may no longer be available. In situations where time is of the essence, a lower value may be realized for the tangible and intangible assets than may have been realized if additional time were available. Tango Equity 99
Chapter 6 Transaction Structure
All sale and purchase transactions for middle market businesses will be accomplished by using one of two basic structures. It will either be a stock transaction or an asset transaction. These basic structures refer to what the buyer is buying and what the seller is selling and does not refer to the type of consideration. In an asset transaction the buyer will buy and the seller will sell some or all of the assets of the company. In a stock transaction the buyer is buying the stock of the company from one or more of the shareholders. The type of consideration that is paid makes no difference. A buyer can use stock as payment for assets or can use cash or other assets for the purchase of stock, the discriminating factor that defines the deal structure is what is being bought or sold. Additionally, in a stock transaction, the transaction typically takes place between the buyer and the selling shareholder or shareholders. In an asset transaction the transaction takes place between the buyer and the company. The difference is very important.
The Asset Transaction
As stated above, in an asset deal the transaction takes place between the buyer and the company that owns the assets. The assets that are going to be transferred are going to be scheduled in some fashion in the Asset Sale/Purchase Agreement. In an asset transaction in which substantially all of the assets are being sold, the Asset Sale/Purchase Agreement may simply state that the agreement will convey all of the assets to the buyer and then list a schedule of exempt or excluded assets. Typically, the assets will include all of the goodwill, intellectual property, real estate, furniture and fixtures, customer contract rights, rights to employment agreement and non-competition covenants, and the right to use the name of the company, its telephone numbers, and its trademarks. Remember that in an asset transaction, the selling company will still be in existence. As a result, if all of the assets of International Widget, Inc. (“International”) are purchased by XYZ Corp, International continues to exist even though it has neither operating assets nor operations. XYZ Corp. subsequent to the closing of the transaction now owns all of the assets of International and is going to do business under the name of International Widget with permission granted under the terms of the Asset Sale/Purchase Agreement. However, XYZ Corp. is XYZ Corp. d/b/a International Widget but International is still International.
In the asset transaction the seller, in this case, is International and not the shareholders of International. XYZ Corp. will pay International and International will provide a bill of sale for all of the assets that are being transferred to XYZ Corp. International will receive any compensation for these assets from XYZ Corp. and either pay off the company’s creditors or make distributions to the shareholders.
The Stock Transaction
If this was a stock transaction, and this was a 100% buy out of the stock, the sellers would be the shareholders of International and the buyer would be XZY Corp. XZY Corp. will pay the shareholders of International and for the agreed upon consideration received, the shareholders will transfer their stock to XZY Corp. XZY Corp. will now own all of the stock of International. 100 Tango Equity
International would still continue to exist and have possession of all of its assets; the only difference would be that XZY Corp. now owns all of the stock of International.
The buyer usually prefers to do an asset transaction, mainly for liability reasons. Since the buyer is merely purchasing assets and not the company, the possibility of being held liable for latent or unknown liabilities is greatly reduced. In a stock transaction the buyer has purchased the corporate entity and that includes all of the liabilities for past actions and commitments. This issue can be mitigated to a large extent by the shareholder’s indemnification of the buyer for these latent and unknown liabilities. This is usually a viable solution especially when there are monies that are owed to seller. The buyer can withhold these moniesin the event that a material obligation arises. There are also insurance solutions available for service and other obligations and liabilities. There is usually a greater amount of due diligence required for a buyer to complete a stock deal than an asset deal. However, there are other issues that complicate the asset transaction.
In an asset transaction, as stated above, the corporate entity continues to exist, although without assets or operations. In this case, all of International’s customer contracts, vendor contracts, real estate and operating leases name International Widget Inc. as the party to the contract. In most cases, customer and vendor contracts are not unilaterally assignable. This means that International cannot transfer the benefit of these contracts to XYZ Corp., without the consent of the other parties. To make the problem even more complicated, many of these situations are difficult to address prior to closing since there is never an M&A transaction that is truly imminent. The same problem exists for real estate leases. The real estate lease will need to be assigned to XYZ Corp. or International will have to try to sublet the property to XYZ Corp. If the landlord is unwilling to assign the lease to XYZ Corp. and the property is sublet, then International will retain ultimate responsibility for the payments due under the lease. All of the same issues exist with any operating leases, vehicle or equipment leases, as well as employment contracts and non-competition agreements. The biggest issue arises with the customer contracts. International has performance obligations under these contracts, but has no resources to service the contracts. XYZ Corp. now has all of the resources to service the contracts but has no service agreement with the customer. In reality, the issue is usually not as problematic as it sounds. Most of the time the customer realizes that virtually nothing has changed with regard to the servicing of their account and the customer will either assign the contract, or more typically, make a new contract with XYZ, perhaps on a trial basis initially. One exception to this would be with regard to government contracts. Federal procurement processes are highly regulated and there may be regulatory problems with the assignment of such contracts. In situations in which there is a heavy reliance on federal government contracts a stock transaction may be easier to deal with than an asset transaction. Similar regulatory restrictions may be encountered in many state and municipal government contracts. In either case, problems will arise. However, in cases where the customer is dissatisfied with the company’s performance under the contract, the assignment could give them an opportunity to terminate the agreement. Vendor contracts are usually less troublesome. The vendors are usually anxious to keep the customer, and will typically be willing to make a new contract with the successor company. If there has been a credit problem in the past that issue may have to be addressed, but often the new buyer may be more creditworthy, especially if it is backed by an institutional investor. Tango Equity 101
In establishing the deal, whether the transaction will be structured as a stock deal or an asset deal is the most fundamental vaspect. Once established, the transaction will proceed along one path or the other. The documentation, the agreements, the representations and warranties are much different depending on the basic structure of the transaction. Appendix K is an example from an asset transaction that is contemplated between International and XYZ Corp. Mr. John Doe is the sole owner of International, which is a regular corporation. The consideration consists of cash at closing and a leaseback agreement. Other forms, of consideration may be in the form of notes, contingent or otherwise.
As we can see, as an asset transaction, this agreement is between International and XYZ Corp. Mr. Doe is included as a party to the agreement because he is being asked to enter into a non- competition agreement and because he owns two other companies that are also going to enter into non-competition agreements. He would not otherwise need to be a party to the agreement since it is the company that is selling its assets to the buyer.
Forms of Consideration
The most common forms of consideration in either stock transactions or asset transactions are cash at closing, seller held notes, and seller held contingent notes and earn outs.
Cash at closing is simply cash that is delivered upon the closing of the transaction. It is frequently tied to the delivery of some specific amount of tangible net equity, as it is in the agreement in the example. In the LOI this is defined as the adjusted net tangible equity. In the sale agreement the adjusted net tangible equity has been calculated from the company’s current financial statements and is presented as a specific amount - $2,469,295. However, in this particular agreement rather than the adjustment being made to the cash paid at closing, the adjustment is going to be added to or subtracted from a pooled reserve for third party claims.
The second most frequent form of consideration is a seller note. The seller note is basically a loan from the seller to the buyer to finance the transaction. Seller notes can be either contingent or non-contingent. If there are no contingencies and the note must be paid, it may also be subject to set off and recoupments, concepts that were discussed earlier. Contingent notes are also common. These notes are contingent upon something happening or a certain amount of revenue or earnings being generated by the company post acquisition. Iinitially, this may seem like a good idea, especially to a buyer. Recall when we were talking about the ideal method of valuing a business, the best way to assign a value to an existing business is to perform a present value analysis of the discounted future cash flows. The problem was that it is not possible to know with certainty what these cash flows are. The contingent note can be set up so that the payments fluctuate with the earnings, therefore transaction can be engineered to come very closing to nearly guaranteeing the buyer his or her required rate of return, in the absence of some major disaster. If the note is simply set up as a payout from earnings or as a percentage of revenue the arrangement is sometimes referred to as an earn-out. The seller earns his or her consideration out of the proceeds of the business. This can work when there is a considerable up front cash payment and especially when there is a need for the influx of some capital or other resources that the buyer can bring to the table. If the buyer buys the company and provides additional 102 Tango Equity capitalization to access additional clients, the revenues will increase and operating income will increase, percentage-wise more than revenues in most cases. The larger percentage increase in operating incomes results from the fact that most likely the operating margins will increase more as a percentage than the revenues will. For example, if revenues rise 30% and the gross margin is 50% then the gross profit is going to remain constant and remain at 50% of revenues. However, the indirect costs are probably going to rise very little, perhaps 5%. If the original revenues were $100 and the operating income was $20, then the operating income is going to rise from $20 (20%) to $33.50 (25.8%). Thus, while the revenues only rose 30% the operating income rose 67.5%. If this scenario can be achieved with the application of additional capital then a contingent note may work well for both parties.
There are some problems with contingencies, however, and applying the contingency to the bottom line like the operating margin is probably the most difficult. If the seller is counting on a quick exit strategy then probably a contingency note will not work. In the case in which an owner would like to stay on after the sale and a significant part of the total consideration is going to be in a contingent note, the seller must insist on some level of operational control, and is going to have to be certain that all of the resources that are going to be needed in order to achieve the objectives are going to be made available. There is also the problem with tracking and accounting for the contingency. Is the acquired company going to be assessed any management fees by the new corporate parent? Are the benefit packages going to be the same? How will transaction costs be handled? Questions such as these must be addressed and included as an integral part of the sale documents. The lower the contingent milestone is located in the income statement, the harder the tracking and accounting becomes. For instance, operating income is more difficult to manage and account for than gross margin and gross margin is more difficult to manage and account for than revenues.
Revenues, being the easiest milestone to track, are probably the most frequently used. In this case the note will become a revenue contingent note and its payment will be based on the revenue goals achieved by the business associated with the purchased assets. However, revenue targets are not without their own sets of issues. Problems can arise when a competitor is purchasing the seller or an institutional buyer who already owns a competitive business. Will there be any restrictions on the geography or types of clients or types of services that can be performed or offered within the company’s span of operations? If there are restrictions, how will they affect the achievability of the revenue targets? And also, whenever there are revenue targets established, it is always essential to implement adequate operational controls to make certain that the profitability objectives are not adversely impacted.
The Asset Sale and Purchase Agreement
In Appendix K we have a sample Asset Sale and Purchase Agreement. The agreement begins by naming the parties, which as previously stated are International Widget, XYZ Corp., and Mr. Doe, the principal shareholder of International. The main part of the agreement is being made between the two companies. Mr. Doe is a party because he is being asked to enter into a non- compete agreement. If this were a stock agreement, the transaction would be predominantly between the Shareholder (Mr. Doe) and the buyer XYZ Corp. Tango Equity 103
The first section (1.01) of the agreement stipulates specifically what is being purchased, what the consideration is, and how it is going to be paid. It also stipulates what is not going to be purchased and specifically describes several key assets that are going to remain the property of the seller. The buyer is agreeing to assume all of the liabilities that are scheduled on the Assumption of Liabilities exhibit. In the next section (1.02) the buyer is specifically excluding the liabilities that are not going to be assumed and which will remain with the seller. In the next section the reciprocal indemnification, in which the buyer is indemnifying the seller for actions brought against the seller as a result of actions of the buyer. Likewise, the seller is indemnifying the buyer for actions brought against the buyer as a result of actions of the seller. The section goes on to explain how the indemnification works mechanically and what the limits and conditions of the indemnifications are. The last paragraph of the first section (1.04) gives the buyer rights of set off against money that is owned to the seller. The specific conditions are set forth in the document to describe specifically under what conditions the buyer may assert a set off. In this case, there is a fund available for set offs. If there is any additional money due to the seller from an increase in the amount of the adjusted net tangible equity, then the buyer is going to place this money into the pooled reserves account and any set offs will first be paid from that reserve.
The second section is a recitation of the representations and warranties of the seller. The seller is representing that everything in this section is true as submitted. There are 18 such representations and if any of them were materially untrue or inaccurate the seller would be in breach of the agreement. These representations range from a statement that the company is in good standing to statements concerning the proper disposal of hazardous waste and exposures to environmental liabilities. A couple of very important representations and warranties of the seller are included insection 2.16 in which the seller states that the books and records are correct and complete and section 2.17 which states that the purchased assets are free and clear of any liens or encumbrances and that the buyer is going to be granted merchantable title to the assets.
Likewise, section 3 is a recitation of the representations and warranties of the buyer. Like the seller representations and warranties, many contained here are standard verbiage stating that the company is in good standing and is authorized to enter into this agreement. The buyer is also stating that prior to the closing, the buyer will disclose to seller any of its findings which would render one or more of the sellers representations or warranties untrue.
Section four contains covenants, which either or both parties agree to perform. The buyer is agreeing to collect the accounts receivable for work that was performed prior to closing. The mechanics of that collection process and provisions for accounts not collected is discussed in (4.03). The seller is agreeing to terminate all of his employees prior to the closing date and there is a specific amount of funding, which is additional to the purchase price, that has been provided by the buyer to provide for severance obligations (4.07). The buyer then is going to rehire as many of the seller’s employees as the buyer feels is necessary to continue the operations going forward (4.08). As we stated earlier, since this is an asset sale the employee contracts and obligations remain with the seller whose company is still a legal entity. The seller will terminate all of the employees and the buyer will offer new employment agreements probably fairly identical to the predecessor agreements to the employees that the buyer is going to rehire. In this 104 Tango Equity case, there were about 850 employees involved in 48 offices. 11 of the offices were closed or consolidated with the buyer’s offices. This consolidation resulted in a reduction in the workforce of about 150. All 700 remaining employees had to be terminated and rehired. Another important point that is needed in an asset agreement is a covenant that the buyer will be allowed to open mail and deliveries that are addressed to International Widget and reasonably believed to be relevant to the purchased assets, and to promptly turn over to the seller any correspondence or deliveries that are not associated with the purchased assets, the Excluded Assets, Mr. Doe or the actual International Widget entity (4.11).
This agreement also addresses the issue discussed earlier with respect to the novation or assignment of the customer contracts (4.15). If it is contemplated that the transaction is going to occur, the “new” entity that is now doing business as International Widget is going to visit all of it customers and request that they agree to assignment of each contract that they had with the “old” and still existing International Widget, Inc. The drafter of this agreement has done something that is very unusual in this section which stresses the importance of having these assignments completed. The covenant to request and consent to the assignment is “absolute and not subject to any right of non-performance for any reason”. The seller simply cannot withhold his consent for any reason - even breach of the contract on the part of the buyer. The reason that this is so important is that after closing the buyer is going to continue to provide goods and services to the customers with whom the buyer technically has no service or sale agreement. The section goes further in stating that if the seller is not able to assign or novate the contract that the seller will take whatever measures he can to see that the buyer receives the benefits of the contract. These measures could include subcontracting the contract to the buyer or rehiring, and performing the services for the benefit of the buyer who would then reimburse the seller for the direct costs associated with the provision of the services.
Basically, this section concludes the areas of the agreement dealing with the structure of the transaction. The remainder has to do with the issues that have to take place prior to closing, to what the buyer and the seller’s obligations are at the closing, and under what conditions the Agreement may be terminated. Tango Equity 105
Chapter 7 The Basics of Financial Statements
The analysis of a business whether it be the business’s return to its investors, its ability to create operating profits, or the efficiency of the utilization of it resources, ultimately comes down to the analysis of financial data. Each industry has its own set of parameters by which a successful operation is judged. In some it is the turnover of the inventory. In others it is the direct labor multiple; and, in others, it is return on assets, etc. The reason is that the numbers create a uniform standard by which we can make a value judgment and establish some characteristics of the business that are not readily determinable by empirical methods or close observation. While specific industries may have different parameters with which to measure some specific but important operating criteria, there are three statements that are used in all businesses from which are derived perhaps the most important valuation and evaluation indices utilized by institutional buyers. These are the Income Statement or Statement of Operations, the Balance Sheet, and the Statement of Cash Flows. Most valuations are made on data contained in these three statements and on what those statements are expected to look like in the future. Transaction parameters are often set up around these statements. In the transaction that we examined in our example involving International Widget, Inc., the transaction was determined by adjusting the net equity that was delivered to the buyer at closing – a balance sheet analysis. In many cases, transactions will involve revenue contingent notes – an income statement analysis. And, most valuations are set up based on the present value of future cash flows which can be a cash flow or an income statement analysis. Therefore, it is important to understand the basics of these three statements.
All of corporate financial accounting is based on a very simplistic concept, which is called the Accounting Equation. It states,
Resources Owned = Source of the Owned Resources
The resources owned are the business’s assets and the sources of the funds for the acquisition of these assets is the combination of the amounts that are borrowed (including credit purchases) and the amount that the owner has put into the business (including the amount that has been reinvested). The amount that has been borrowed and acquired on credit are the liabilities, and the amount that has been invested or reinvested into the business is the shareholder’s equity. Now, the accounting equation can be rewritten as:
Assets = Debts + Shareholder’s Equity
This is also called the Balance Sheet Equation.
Another important concept which is basic to all accounting is the principle of matching and of periodicity. Periodicity simply states that, in order to be meaningful, a business’s life must be segmented into standardized periods, which are typically years, quarters, or months, and; the matching principle states that revenues and expenses much be matched during these periods. This makes up the basis of accrual accounting. The accrual principle states that in order to achieve this matching during any period the revenues from that period must be recognized or recorded when the necessary activities to provide the compensated service or to deliver the 106 Tango Equity purchased goods are provided. This is regardless of when the actual cash is collected from the client or customer. In accrual accounting, cash is the same as an account receivable when determining revenue. These concepts are all that one really needs to know about accounting. Unfortunately, although the concepts sound quite simple in practice they are extremely complicated.
The Income Statement
The Income Statement is also called the statement of operations. It is probably the most useful of the three basic statements. It contains information on the performance of the company over a specific period of time usually a year, a quarter or a month. It is the most useful statement not only for valuing a transaction but it is by far the most useful for managing the business operations. Exhibit 1 is an income statement from our example company International Widget.
Revenues
The Gross Revenues are the total revenues that are earned by the company or its subcontractors or subconsultants during the period from contracts or requests for goods or the performance of services by it clients. Depending on the industry the gross revenues are sometimes misleading and not relevant. When the gross revenues are adjusted for returns, and reduced by the cost to the company of goods or services performed by outside providers, and any pass-through expenses the result is the net revenue. The net revenue represents the earnings by the company for its products or services along with any markups for subcontractors, subconsultants, and pass- through expenses. Depending on the industry the difference between the net revenues and the gross revenues can be large or insignificant. Net revenues are more meaningful than gross revenues in almost all instances because the net revenues represent the actual earnings of the company. Typically, all subsequent calculations such as the gross margin and operating margins are calculated as percentages of net revenues.
Net Revenue = Gross Revenues – Reimbursements, pass-throughs, credits, etc.
Typically, when speaking of revenues it is assumed that one is speaking about net revenues. However, this is an assumption that should never be left unconfirmed. If direct expenses are subtracted from the net revenues, you are left with the gross margin. The gross margin is one of the most important measures of a company’s performance. The gross margin must always be interpreted in relation to other companies within the same industry. Comparing gross margins of companies in two different industries as a gauge of operating performance is meaningless. The gross margin can give an indication of the company’s price positioning, the quality of its contracts, or the effectiveness of its contracts, client or project management. The gross margin involves direct costs and those direct costs are largely variable because they fluctuate directly with the revenues. Direct costs include items such as the cost of the materials needed to manufacture the company’s product, and the labor required to produce it. When the revenues increase, the materials and the labor needed to produce the revenue must also increase. In order Tango Equity 107 to be meaningful and interpreted properly, the gross margin must have two characteristics. First, it must be calculated consistently. Although, the concept that direct costs consist of everything required for the production of the revenue seems to be clear, there are still many grey areas. Even within an industry there are sometimes wide ranges of differences in what is included in direct costs. (Direct Costs are also referred to as the COGS or Cost of Goods Sold, in manufacturing industries, or the COS, or Cost of Services in service industries) In order to make the gross margin a meaningful measure it is important to be certain that the calculations are made consistently and that everything that should be included in the direct costs is included. Secondly, the matching principle of accrual accounting needs to be assiduously applied. It is important that the direct costs included on the income statement represent the direct costs involved in earning the net revenues for that specific period.
Gross Margin (Gross Profit) = Net Revenues – Direct Costs (COGS, COS)
If calculated correctly, the gross margin will reveal a great deal about the company. If the gross margin is low in relation to the industry average, it could mean that the Company is pricing their products lower than the industry or their contracts with their clients or customers have to be renegotiated. Or, it can mean that the products are not being manufactured or the services are not being delivered in an efficient manner. The production, the projects or the accounts are simply not being managed well. This is a question that would need to be answered during the due diligence process. To a buyer, the gross margin may be the most important index in a decision whether or not to pursue and acquisition of a company. If a company has a low operating margin and a healthy gross margin, a buyer may find the Company particularly attractive because it would be perceived that the problems with the operating margin lie in poor management of the indirect costs. Indirect costs are considerably more controllable than the direct costs, and as long as the gross margin is favorable, the operating margin can usually be improved.
All expenses that are not directly attributable to earning the company’s revenues and that are involved in the operations of the company are grouped as operating expenses, or more accurately indirect operating expenses. These expenses include administrative labor, management salaries, rent and other occupancy costs, and depreciation. In the International Widget example we have a high level statement that groups the expenses in three major categories. It is not a detailed statement and is therefore less useful than one that would list the detailed line items individually. G&A, or General and Administrative expenses are usually the majority of the indirect expenses. These are usually indirect expenses that are not included in Sales or Marketing, or Product Development. Frequently sales and marketing expenses are grouped into the G&A bucket and referred to as SG&A, or Sales, General and Administrative Expenses. Product Development expenses are associated with Research and Development of new products or services. They typically are not associated with current revenues and are not even incurred in the support of current revenue such as SG&A costs are. Since there are accounting rules that are specific to R&D and product development expenses, they are usually segregated from other operating expenses and recognized in accordance with these specific accounting rules. Subtracting the operating expenses from the gross margin yields the operating income, or the income from operations. The operating income is often also expressed as a percentage of net revenues. 108 Tango Equity
Operating Income (Operating Profit) = Gross Profit (Gross Margin) - Operating Expenses
The non-operating income or expenses usually follow the operating profit and the calculation of the operating income. Non-operating line items consist of either income or expenses that are incurred outside the ordinary operations of the business. Examples of non-operating income are interest that is earned on bank accounts or income that is earned from non-significant subsidiaries. Examples of non-operating expenses are interest that is paid on bank debt or losses from non-significant subsidiaries. Frequently investors or buyers will ignore non-operating expenses and concern themselves with income actually earned from business operations. As such, it is important to accurately account for non-operating income or expenses. Subtracting the non-operating expenses from the operating income gives the Income or Earnings Before Taxes or the Pretax Income.
Pretax Income = Operating Income (Operating Profit) – Non-Operating Expenses
Finally, if the company is a corporation, it is subject to income tax and there will be a final provision for income taxes. Corporations typically file income taxes annually, and in the intervening periods, the income taxes are estimated and a provision for income taxes is booked.
Net Income = Pretax Income – Provision for Income Tax
The Net Income is the real bottom line. It is what the company is left with after deducting expenses and providing for income taxes. Net income is used when calculating earnings per share for public companies.
EBITDA
Earnings Before Interest Taxes Depreciation and Amortization or EBITDA is an important calculation because it is an indicator of the profitability of a Company. Taxes are calculated on the amount of earnings and interest is less a function of the business operations and more a function of the company’s capitalization. Depreciation and Amortization are non-cash charges. Both depreciation and amortization are expenses that are charged to earnings for the purpose of allocating the cost of a long-term asset, either tangible or intangible over the useful life of the asset. They are not actual cash charges and therefore increase the Company’s cash flow while reducing the earnings. If we take the operating income, which does not include non-operating expenses such as interest and is calculated prior to the provision for income taxes, the EBITDA can be calculated by simply adding back the Depreciation and Amortization. In the case of International Widget the EBITDA is the operating income of $498,737 plus the D&A of $18,915, or $517,652.
Adjusted or Recast EBITDA
Notwithstanding the recent accounting scandals and restatements of earnings by many major corporations, public companies are under a great deal more scrutiny than private companies with Tango Equity 109 regard to their accounting policies and procedures. The owner of a closely held private business does not need to justify his or her salary to a board of directors. As long as the salary is properly accounted for, and taxes are paid, they can pay themselves anything that they want. Also, owners of closely held companies do not have to answer to boards when making capital expenditure decisions with regard to items that may not be otherwise regarded as the efficient use of capital resources such as company boats or seminars at golf resorts. The seller’s financial consultant will adjust for these differences by recasting or normalizing the income statements usually for the current year and possibly several years’ back. Since every business has its own set of financial circumstances it is not possible to itemize all of the items possibly requiring recasting. Some of them may include:
x Owner’s salary – To the extent that the owner is paying him or herself in excess of what the market would pay an executive in a comparable business. x Prepaid expenses – to the extent that they are not booked on the balance sheet x Additional perks and benefits to the owner or to key employees – any additional compensation that is not normally provided to key personnel in similarly-sized companies. In making a recast such as this, it would be important to determine whether or not the additional “better than market” compensation can be discontinued. If the additional compensation is to owners or family members, it is likely that it will be possible to discontinue the perks and maintain the business. However, if the additional compensation is being paid to key personnel who will receive no direct benefit from the change in control, it is likely that this is a legitimate business expense that will need to be continued. x Extraordinary or one-time charges – many times a business will experience some extraordinary expense that is unusual or unique. These can be expenses such as settlement charges from litigation or charges from a prior period that have not been matched up correctly. In the former case, it is important to determine that this charge is, in fact, an extraordinary charge and that is likely to be a one-time event. In the latter, it would be necessary to match up the expenses, and this may require restating a previous accounting period. x Extraordinary or one time revenues – on the other hand, there can be extraordinary windfall projects that for one reason or another are unlikely to be repeated. In this case it would be necessary to make adjustments and to restate the earnings for the period. x Non-capitalized capital expenditures – oftentimes, privately held companies are more liberal in their application of accounting rules when it comes to capital expenditures. A capital expenditure consists of funds that are used to acquire or improve physical assets that are long term in nature, and these expenditures should be charged to earnings over the expected useful life of the asset. This has the effect of increasing earnings, increasing income taxes, and thereby reducing cash flow for the current accounting period. As a result, there is a temptation to charge capital items to earnings to reduce taxable income. It is necessary for a buyer to look for items that perhaps should have been capitalized rather than expensed and to make the necessary adjustments. 110 Tango Equity
Balance Sheet
Unlike the Income Statement, which reports the operating results of a company during a specific period of time, the balance sheet reports certain aspects of the financial condition of the company at a specific point in time. Thus, the balance sheet is more like a photograph whereas the income statement is more akin to a movie.
The balance sheet equation was mentioned earlier as being,
Assets = Liabilities + Shareholder’s Equity
As an equation, both sides must be equal, or balance. Broadly speaking, the assets are the resources that the company owns. The liabilities are the debts that the Company owes, and the Shareholder’s Equity is the amounts that the owner’s have either contributed or reinvested. A reinvestment can also be simply money that is left in the business and not distributed to the shareholders.
Assets
Assets are typically segregated into at least tangible assets and intangible assets. The Tangible assets are assets that have some type of physical form such as cash, accounts receivable, furniture, fixtures, and machinery. Intangible assets are resources of value that do not have physical form. These are items such as intellectual property rights, patents and copyrights, and goodwill. Tangible assets are further divided at least into current assets and fixed or long-term assets. Current assets are physical assets that can be converted into cash within a year. Examples of these types of assets are accounts receivable, cash, work in progress, and inventory. The major current assets are usually the accounts receivable and work in process (unbilled receivables), and depending on the industry, inventory. Work in process (“WIP”) is revenue that has been earned and not yet billed. It is money that is actually earned (for the most part). It is also commonly referred to as unbilled receivables or amounts earned, and not billed. There are numerous reasons why revenue may be earned and not yet billed. The most common situation is where there are contractual requirements that the Company, as a vendor bills the customer once a month or goods delivered for services provided during the period. In this case, the WIP will steadily increase during the course of the month as more work is completed or more goods are delivered and not billed. At the end of the month, when the customer is billed the WIP is converted into an account receivable. Accounts receivable (“AR”) are revenues that have been fully earned and billed by the company and for which the company has not yet been paid. At the end of the month when WIP is converted into AR, the WIP will decrease and the AR will increase by the same amount provided that all of the WIP is billable. Finally, when the receivable is collected, the AR is converted into cash, the AR will decrease and the cash will increase by the same amount. Inventory, like work in progress is a current asset. Inventory consists of raw materials, products that are in the process of being manufactured and finished products that are available for delivery to fulfill customers’ orders. Both work in process and accounts receivable are earned revenues and will be treated equally on the income statement. However, an important difference between these accounts is that a company can usually finance Tango Equity 111 or borrow against its billed accounts receivable whereas conventional lenders will often not lend against work in process, or if they will, they will lend only within more stringent guidelines than the accounts receivable.
The accounts receivable and the WIP can also provide important information regarding the operations of the company, including information on the efficiency of both the credit and collection department. The days sales outstanding, or DSO, is the number of day’s sales that are tied up in accounts receivable. If the number is 30 it means that the company, on the average, takes 30 days to collect its credit sales. If the DSO is 90, then it takes 90 days for the company to collect its average credit sale. The DSO varies within industries but serves as a good index of how good a job the company does on its collections and some indication of the quality and nature of its customers. The DSO is calculated as follows:
DSO = Accounts Receivable / (Sales for period / number of days in period)
In our example, International Widget’s outstanding accounts receivables are $316,025 and its total sales for the year were $7,193,848. The daily sales are $19,709 ($7,193,848/365) and the DSO is 16 days ($316,025/$19,709).
The long term or non-current assets usually consist of fixed assets. Fixed assets are tangible resources that the company owns that are not expected to be turned into cash. Most fixed assets have a determinable period of useful life. The expense associated with the cost of the long term fixed asset is usually amortized over that expected useful life rather than being expensed or charged to earnings in the period in which it was acquired. This principle is consistent with the matching principle discussed earlier. As such, fixed assets are reported at the cost of the asset less the accumulated amortization (or depreciation). Accordingly, at the end of the useful life of the asset, the asset has a net valuation of zero. When the asset is removed from service, sold, or discarded, the asset is removed from the schedule of fixed assets and is no longer included as an asset of the company. Typically, especially in privately held companies, fixed assets may be depreciated on an accelerated basis, similar to the rates of depreciation allowed income tax purposes. Because depreciation is a charge to earnings it has the effect of lowering reported earnings and thus income tax obligations. Since the actual cash has already been expended, the business owner would prefer to depreciate the assets as quickly as possible. Therefore, the actual value of the fixed assets, in most cases will be higher than the net fixed asset value reported on the balance sheet.
Intangible assets, as stated above, are resources of value that have no physical form. One of the most common intangible assets is referred to as goodwill. Goodwill can arise in several ways. Most often it is as a result of a previous acquisition transaction. In this case, the goodwill is the difference between the amount paid for the business and the net value of the assets received in the transaction. The net asset value of the transaction is the value of the assets received less the value of the liabilities assumed. As we have seen in the section on valuation, the net asset value of a company has little to do with the expected purchase price of the business. In our example, International Widget has a net asset value of $1,029,016, which is determined by taking the total assets of $2,036,155 and subtracting the booked liabilities of $1,007,139 (Current liabilities of 112 Tango Equity
$781,132 and long-term liabilities of $226,007). Because, the purchase price is going to be $4 million, there is going to be goodwill of $2,970,984. Another way of looking at this is that the buyer is paying $4 million in consideration for the business and is assuming another $1,007,130 in liabilities, so the total purchase can be thought of as $5,007,130 and the total value of the assets is $2,036,155. The excess purchase price, or goodwill, is the difference of $2,970,984. Goodwill typically remains on the balance sheet of the buyer and the purchased assets are periodically assessed to determine if the value has been impaired. If the value of the assets has been impaired, and are currently worth less, then the amount of goodwill should be reduced and a charge to earnings taken.
Liabilities
On the other side of the balance sheet are the liabilities and shareholder’s equity. The liabilities are the amounts owed by the company. Similar to the assets, they are typically divided up into current liabilities and long-term liabilities. The current liabilities are obligations that are going to have to be paid by the company within one year and the long-term liabilities are obligations that are due in more than one year. Also, they are recorded as they are incurred. Just as the balance sheet considers a current asset the same whether it be a billed account receivable or an unbilled receivable (WIP), liabilities are also recorded as they are incurred regardless of whether the obligation is actually due at the time the statement was prepared. The current liabilities are typically comprised of trade accounts payable, amounts owed for interest, accrued (or owed) liabilities, and accrued employee expenses, as well as short-term obligations from creditors such as lines of credit. Also included as a current liability would be the portion of any term loans that are due and payable in the next twelve months.
Shareholder’s Equity
As stated earlier, the shareholder’s equity includes the amount that the owners of the company have contributed for the capitalization of the business as well as earnings retained in the business or amounts that have been reinvested. Shareholder’s equity is equal to the total assets less the total liabilities. The shareholder’s equity may be comprised of several line items. It consists of the amounts that shareholders have paid for stock in the company, which is the capital stock, the paid in capital and the retained earnings. The retained earnings are the net earnings of the company to date that have not been distributed to shareholders. In this sense, these can be thought of as amounts that the shareholders have reinvested. Often the current earnings are separated from retained earnings and recorded on a separate line as net income for the period. More often the current period’s net income is combined with the cumulative retained earnings and recorded together.
If the company has lost money to date, then it is likely that the retained earnings are going to be negative in the aggregate. If the cumulative losses exceed the amount of capital that has been invested by the shareholders then the shareholder equity is going to be negative as well. A Tango Equity 113 company with negative retained earnings has had cumulative losses and a buyer will need to examine the income statements to obtain a history of those losses. A negative retained earnings (or deficit) or even negative shareholder’s equity is not necessarily a deterrent, since most companies lose money in their early years of existence. The company may be in a stage in its lifecycle in which it is now becoming profitable.
Statements of Cash Flow
We have stated that the financial statements we have been examining thus far, the income statement and the balance sheet, have been developed on the accrual basis of accounting. The accrual basis employs a matching principle that attempts to match revenues in the period in which they are earned with expenses in the period in which they were incurred regardless of when the cash from the revenues is received or when the cash for the expenses is disbursed. This enables the owner to manage their business effectively. However, it is also necessary to manage cash flow and for that purpose another statement is necessary which converts the accrual statements to cash statements.
Similar to the income statement, the statement of cash flows records the performance of a company over a specific period of time rather than at a particular period of time. Fast growing companies and companies with lengthy DSOs may have some issues with cash flow even if they are profitable. The statement of cash flow will reveal the working capital requirements and any potential cash flow problems.
The statement of cash flows usually consists of at least four sections. The first three are the respective cash that is being generated from operating activities, investing activities and financial activities. The last section is the change in the cash position derived from these sources.
Cash Flows from Operating Activities
This section adjusts the results from the income statement for amounts actually paid to vendors, employees and others as well as for cash that has actually been collected from customers. It also adjusts for cash that has been paid out for operating expenses and taxes as well as interest that has been received or paid out.
Cash Flows for/from Investment Activities
This section takes into consideration the payments made for investments typically for capital equipment. Recall that on the income statement, only the portion of a capital expenditure that has been depreciated is accounted for in the income statement and that the depreciation takes place over the useful life of the asset. Nevertheless, the company probably paid cash for this 114 Tango Equity asset, often when it was acquired. This section adjusts for such accounting. Conversely, if equipment is sold for cash, the accounting adjustment is made to account for the cash received.
Cash Flows for/from Financing Activities
This section takes into consideration the financing activities from external parties, that is, not from the company’s operations. This may include cash proceeds from loans from banks or other creditors, or from the sale of the company’s stock. Also, if any dividends or distributions were made during the period they would be recorded in this section.
Net Change in Cash
The addition of the net changes in cash flow from each of these three categories would result in a change in the company’s cash position, either up or down depending on the activities. The net change in cash will be added to the cash at the beginning of the period and will result in the cash at the end of the period. The cash at the end of the period should correspond to the cash or cash equivalents accounts on the balance sheet at the end of the period.. Tango Equity 115
Chapter 8 Summary of Tango’s Approach
Tango’s approach is significantly different from most other business intermediaries and business brokerages. Tango’s principals have spent most of their careers on the buy-side of middle market M&A transactions. This experience has given Tango a unique and valuable perspective from which we can advise our sell-side client on how an institutional business buyer would look at their company. In addition, our network and familiarity with the community of institutional business buyers has enabled us to determine what businesses and industries are most attractive to business buyers and what characteristics of those businesses are necessary to make a successful transaction likely.
Start with the Buyers
Tango’s initial approach has been somewhat contrary to the approach of most other business intermediaries. However, the approach has solved one of the most common issues facing the business owner and the intermediary. That is, the question of how to distinguish between a qualified buyer and an unqualified buyer. Qualifying a buyer is not an easy process. Most business intermediaries request statements of financial condition from non-institutional business buyers. The problem is that the buyer prepares these statements and often the information is not always reliable. Spending time and effort on a non-qualified buyer is a waste of time for the intermediary as well as for the owner, and has the potential to compromise confidentiality. To avoid this problem, Tango started by soliciting only qualified buyers. 95% of Tango’s buyers are institutional buyers, and most of them are private equity groups. We have explained earlier what private equity groups are and how they operate. We have also explained why they are the ideal buyer as they usually represent the hybrid of the strategic buy and the financial buyer. The advantage of dealing with private equity groups is that they are easily qualified and financially capable. Private equity funds usually have capital or committed capital and typically do not need to secure the financing prior to concluding the transaction. In addition, they are sophisticated with the concepts of corporate finance and can assess the proposed details of the transaction quickly and professionally. They usually have internal legal resources or access to legal resources that are familiar with business transactions and this helps the speed and efficiency of the process. In most cases, the private equity group is closely familiar with the industry in which the target company operates and often has holdings in their portfolio in that particular industry. This accelerates the process and avoids the need for the seller to spend a great deal of time educating the buyer on the industry. Tango, as of this writing, represents 250 buyers consisting of some of the most active and sophisticated dealmakers in the world. These buyers are interested in sell-side opportunities across North America and their interests include a broad range of industries.
The Tango Index.
Tango Equity keeps very close track of the preferences and acquisition criteria of their institutional buyers, and as a service to its sell-side clientele periodically publishes the Tango Index. The Tango Index is a barometer of the industry preferences of Tango buy-side clientele. The higher the Tango Index the more interest there is in a particular industry. A Tango Index 116 Tango Equity around zero indicates that there is an average interest in the industry. A Tango Index above 1 indicates that the sector is relatively attractive and a Tango Index of below -1 indicates that there is relatively little interest on the part of the institutional buyers. Since the Tango Index is an indication of preferences in acquisition criteria, it is actually a forecast of what industries are going to see the completed deals over the next few quarters and an indication of what sectors are likely to command the highest purchase price multiples.
THE TANGO INDEX Industry Subcategory Score Tango Index Life Sci/Health Care General 997 2.1 Life Sci/Health Care Health Care Technology 987 2.0 Manufacturing Tools and Measuring Equipment 972 2.0 Communications Infrastructure 930 1.8 Technology IT Infrastructure 915 1.7 Life Sci/Health Care Health Care Services 754 1.1 Communications Telecomm Wireless 709 0.9 Manufacturing Chemicals and Plastics 658 0.7 Manufacturing Packaging 655 0.6 Manufacturing Basic Manufacturing 635 0.6 Technology Hardware 633 0.6 Manufacturing Electronics and Equipment 583 0.4 Manufacturing General 581 0.3 Manufacturing Consumer Products 577 0.3 Transportation General 571 0.3 Life Sci/Health Care Biotech and Pharmaceuticals 550 0.2 Services General 520 0.1 Finance General 510 0.1 Finance Financial Services 507 0.0 Manufacturing Food Products 455 --0.2 Services Environmental Services 453 -0.2 Services Environmental Services 452 -0.2 Finance Real Estate 450 -0.2 Technology Software 445 -0.2 Wholesale General 425 -0.3 Communications General 422 -0.3 Services Automotive 410 -0.4 Construction General 355 -0.6 Technology Information Technology 351 -0.6 Technology General 326 -0.7 Mining Power Industry 322 -0.7 Services Engineering 320 -0.7 Mining Oil and Gas 285 -0.9 Finance Insurance 270 -0.9 Technology eCommerce 250 -1.0 Construction Special Trades 175 -1.3 Agriculture Forestry and Fisheries 169 -1.4 Construction Heavy 160 -1.4 Retail General 125 -1.5 Agriculture General 28 -1.9 Table Tango Equity 117
Relevant Offering Memoranda
The principals of Tango Equity have been involved with middle market transactions on the buy side for fifteen years and as such have an intimate familiarity with the data set required by institutional buyers. Financial buyers look at hundreds of potential transactions per year and execute only a few of them. They rely on being supplied with information that is concise and relevant. Tango’s offering documents contain a succinct description of the company with relevant financial data. The description contains an overview of the company’s products or services, operations, facilities, management, sales and marketing, and financial and legal issues followed by an investment summary and a complete set of financial statements and a recasting of the latest income statement with notes and explanations. The document does not contain pages of industry research and data. It does not contain any demographic information on the geographical areas of operation unless the data is unique and relevant to the valuation of the company. The reason is that the buyers that Tango deals with are sophisticated and quite familiar with the industry in which they are seeking to make acquisitions. They do not require a repetitive discourse on an industry that they know quite well. They would much prefer to receive information on the relevant issues. Many competing M&A intermediaries produce very large presentations for offering memoranda containing a lot of boilerplate industry statistics. They also charge fees of between $10,000 and up to $40,000 for the production of these documents and, when presenting the company to institutional buyers, this information is at best unnecessary and at worst, will dissuade a prospective buyer from reviewing a transaction due to the preponderance of “fluff” or cause them to miss substantive facts that would persuade them to pursue the transaction.
Selective Engagements
By soliciting business opportunities only from sell-side businesses that fit the acquisition criteria of registered buyers we are able to increase the probability of successfully completing a transaction. Tango charges only a small retainer to cover the cost of putting the transaction documentation together, and to administer the process of getting the business out in front of the most likely institutional prospects. The company does not survive on fees from retainers or the production of Offering Memoranda but on success fees from completed transactions. Consequently, there is a great incentive to actually complete transactions. We also do not charge additional fees for putting the documentation together. We are not financial publishers; we strive to complete transactions. If we have contacted a business owner to determine his or her interest in selling their company, it is because we have a registered buyer who is interested in that industry and the business has the general characteristics required by the buyer.
Shift Some of the Financial Burden from the Seller to the Buyer
As already stated, Tango deals almost exclusively with institutional buyers. Since these buyers are engaged in a broader strategy for a business acquisition they tend to be less price sensitive not only with dealing with the purchase price for a business but also in dealing with transaction- 118 Tango Equity related fees. For this reason we have shifted some of the burden from the traditional sell-side fees to the buyer’s side. Sellers are, in many cases, business owners who have dedicated their lives to their businesses. In most circumstances, they are only going to sell their business once in their lifetime. As a result they are very sensitive to the consideration that they are going to receive from the transaction. What Tango has done is to shift a portion of our fees from the seller to the buyer.
The Tango Advantage – The 2% Solution
Advantages to Sellers
A. Cost Since Tango is engaged as a Finder by its Registered Buyers, Tango receives a fee from the buyer upon the successful completion of a transaction. This enables Tango to charge the Sell-Side client a significantly lower fee than any national competitor in the middle market range. As explained earlier, most national competitors charge success fees based on a standard or modified Lehman formula. Tango’s innovative fee structure is a flat 2% of purchase price or Total Invested Capital, which is significantly below any of its competitors. There is an explanation of this unique fee structure in Chapter 2 as well as a description of how most other intermediaries assess their fees. Below is an example of Tango’s fees relative to two of its national competitors:
Total Invested Capital 2,000,000 3,000,000 5,000,000 10,000,000 Standard Lehman 90,000 120,000 150,000 210,000 Double Lehman 180,000 240,000 280,000 380,000 Tango Flat 2% 40,000 60,000 100,000 200,000 Table 27 – Comparison of Success Fees Owed Under Various Cost Structures and Transaction Sizes
Total invested capital (“TIC”) is the aggregate of all of the consideration in a transaction whether it is cash, notes, contingent payments, or assumed liabilities. It is similar to purchase price as determined by GAAP under purchase accounting. As can be seen from the table above, at $3 million in TIC, Tango’s fees are 25% of the largest national provider who assesses charges based on a double Lehman formula and the competitor who charges based on a standard Lehman formula. However, since in this transaction Tango would also be entitled to a Buy-Side fee, Tango’s aggregate fees are quite in line with the competition. At $3 million in TIC, Tango’s buy side fees would be $100,000, so Tango’s aggregate fees would be $160,000. Similarly, at $5 million in TIC, Tango’s Buy-Side fee would be $150,000, thus bringing the aggregate fee to $250,000, again right in the middle of the range. Therefore, Tango’s revenue model does not significantly alter the pricing algorithm but merely spreads the charges more evenly over the transaction with both buyer and seller paying a portion and the more price insensitive buy-side client paying the majority of the fee. This creates a favorable economic benefit for the seller and therefore augments the overall deal flow. Tango Equity 119
B. Low Retainer
Tango charges a one-time $5,000 engagement fee, which covers the costs of the development of the marketing materials, offering memoranda, and other documentation. There are no other charges except for success fees. If your company is not sold to a party introduced to you by Tango, no success fees are owed.
C. Short Term Exclusive Contract
Tango’s sell-side agreement contains a 90-day period of exclusivity. This is significantly shorter than most other intermediaries. The reason that we are able to do this is because we believe that we have identified qualified and capable buyers and have the personnel and structure to get the process underway quickly. By offering to work on a very short term exclusive basis there is very little downside for our Sell-Side clients. If we do not sell the business, the seller owes us nothing and can extend our agreement another 90 days (without any additional fees), sell the property him or herself, or hire another intermediary. If we do sell their business the seller saves a great deal of money on the sale of their life’s work. The Sell-Side client is entitled to keep the offering memorandum and other marketing material.
D. Limited Marketing to Protect Confidentiality
In any M&A transaction the protection of the sell-side client’s confidentiality is of paramount importance. A business owner who is contemplating a sale typically does not wish employees, competitors, creditors, landlords, clients or colleagues to be made aware that a transaction is contemplated. One of our large national competitors sends blind business summaries to 17,000 of what they describe as potential buyers. The problem is that no business in existence has 17,000 potential buyers. This type of broad shotgun approach very likely can cause a compromise to the client’s confidentiality. Financial buyers who only have a concise business summary, usually cannot identify middle market companies, but competitors and employees would have little difficulty in identifying that company. Another problem with such a shotgun marketing strategy is the introduction of numerous unqualified buyers who are financially incapable of completing the contemplated transaction but typically very capable to wasting the time of the intermediary and the business owner. As previously stated, Tango’s approach is to begin by selecting the most active business buyers in the industry. Next, Tango selects only those buyers that have affirmatively stated that they have an interest in the specific types of properties with characteristics closely akin to those of the seller. Confidentiality 120 Tango Equity
is protected by limited distribution to qualified buyers who have indicated their interest in the specific business property.
E. Higher Anticipated Success Rate
Since Tango’s competitors do not publish data regarding the number of their sell-side engagements, or the number of successful ones, it is not possible to definitively determine any comparison with regard to relative success rates. However, given the approach to our sell-side engagements, we anticipate that in each case Tango’s success rates, that is, the percentage of transactions actually successfully completed, would be higher relative to the less structured shotgun approach of some of the Company’s national competition.
Summary of Advantages to Sellers
1. Cost a. Lower Success Fees b. Low Engagement Fee 2. Short-Term Exclusive Contract a. No long-term engagement 3. Targeted Marketing to Protect Confidentiality a. No broad Internet Advertising 4. Higher Success Rates from Pre-qualified Buyers a. All buyers are large institutional buyers who are well-qualified and well- capitalized b. Faster time to completion since the buyers are already identified and familiar with the industry
Advantages to Buyers
A. Access to Deal Flow
The biggest advantage to a very active business buyer in working with Tango is access to Tango’s deal flow. Tango aggregates sell-side inventory from all over North America and presents transactions that will not be found elsewhere. In addition, the deal flow generated by Tango’s internal sales and marketing initiatives are shown to no one outside of the Tango Registered Buyer network until the buy-side clients have had a chance to review the businesses. Management believes that Tango has the largest sell-side inventory in the world and our Registered Buyers are the only business buyers with priority access to these properties. Tango Equity 121
B. Freshness
Tango’s largest competitor publishes its sell-side inventory each quarter and sends it off to 17,000 in its extensive network. Much of the inventory is well shopped around before it makes its way to the buy side network and many deals are sometimes six months at distribution. When Tango receives notice of a sell-side business, either through its network of Cooperating Intermediaries or its internal research department, it examines the characteristics of the business and contacts the most likely buyers according to their position in the retention hierarchy sometimes within hours of a business coming onto the market.
C. Targeted Properties
Tango has a very active research department that focuses on the exact types of businesses that our Registered Buyers are seeking. The Company has over 200 Registered Buyers, each with a specific roster of criteria for platform companies for new industries and for tuck-in for consolidation in existing portfolio companies. Although for each client, each set of criteria is unique, there is nevertheless, considerable overlap within individual industries. Tango purchases or otherwise acquires lists of relevant companies that match these criteria. Tango’s research department contacts these target companies using a specific sequence of direct mail, email, and telephone contacts. Each company is followed up with additional material depending on their level of interest. When a sell- side company is engaged by Tango a short blind business summary is produced and sent to those clients whose acquisition criteria match the business property’s characteristics. Thus, the buyer is assured of only receiving information on businesses that are likely to be of interest to him or her.
D. Focused Approach
Each Registered Buyer is interviewed extensively to determine their specific acquisition criteria. The Registered Buyer receives only businesses that fit their criteria and does not have to waste time reviewing business properties that do not interest them. Tango functions as an extension of the buyer’s own research department.
E. Large Sourcing Network
Tango presently has a network of over 1,500 M&A consultants who cooperate with us (the “Cooperating Intermediaries”) and provide us with sell-side properties to present to our clients. The application of the Tango Equity business model results in a technology augmented large independent supplier of M&A and banking services that will be able to capture a significant portion of the transaction-related financial services market. The application of this business model has resulted in the development of one of the largest sell-side inventories in the world and the exploitation of this network with technological enhancements have enabled the Company to be more responsive to its buy-side clients 122 Tango Equity
than any other national middle market M&A service organization. We have created a system which brings business buyers and seller together in a fashion that was not previously possible and a turnaround time of hours rather than weeks or months.
Conclusion
We at Tango Equity have enjoyed presenting this information to you and hope that it has been helpful. We would like to extend an invitation to all of our readers to call us at any time to discuss anything related to middle market M&A. We will be glad to extend our expertise and to be of assistance in any way we can. There is no charge and no obligation, whether you are a client or not. We look forward to speaking with you and extend our best wishes for continued success. Tango Equity 123
Appendices and Exhibits 124 Tango Equity
Exhibit A-1 – Due Diligence Documentation
This a part of an initial Seller’s package. The Initial Business Overview is a questionnaire that the owner or management completes to begin the production of the marketing documentation, primarily the Blind Short Summary
DUE DILIGENCE CHECKLIST
Please submit copies of these documents with your Initial Business Overview: 1. Accrual-based income statements for the last three completed fiscal years and the most current interim statements 2. Most current balance sheet Please prepare or have available the following documents prior to due diligence: 3. Federal income tax returns for the last three years 4. Accounts receivable aging report 5. Accounts payable aging report 6. Schedule of Current Inventory 7. Work in process report 8. Sales Pipeline report 9. Schedule of all obligations to long term debt 10. Schedule of unbooked assets or liabilities 11. List of excluded assets (items that you would wish excluded from the sale) 12. Copies of any material capital leases 13. Copies of material operating leases 14. Legal description of any real property to be included in the transaction 15. Description of intellectual property, patents or trademarks 16. Current appraisals of business real estate, machinery, IP or other material assets 17. Copies of employment contracts 18. Copies of insurance policies 19. List of any customer contracts for services 20. Description of all pending, ongoing and threatened litigation 21. Copies of collective bargaining agreements Tango Equity 125
Exhibit A-2 - Buyer’s Detailed Due Diligence Checklist
Due Diligence Program
General Background Yes No Notes
1. Have you obtained information or made a judgement about: a. The image of the company compared to competitors? b. The reputation of the current owners, directors and management? c. The trend of market share? d. Recent major developments among competitors? e. The extent of government regulation? f. Other external factors affecting the company? g. New developments planned or in progress including: x The relationship of programs to the company’s position in the industry? x Capital equipment commitments? h. Special skills and advantages such as: x Technical position? x Established position? x New product success? x Survival from major setbacks x Well-developed internal communications? i. Major litigation, pending or potential? j. Cyclical factors affecting the industry? k. Credit rating? l. Major operations discontinued in recent years or planned in near future? m. Contracts and leases nearing expiration? n. Labor negotiations pending? o. Trade association membership? 2. Have the company’s officers or directors been involved in criminal proceedings, regulatory commission violations or significant civil court litigation? 3. Do you know the real reason the company is raising capital or being sold? 4. How long has the company been seeking investors and if other transactions have fallen through? 126 Tango Equity
5. Have you considered whether management has done anything to make the company appear more attractive to a buyer such as: a. Reducing discretionary expenditures for advertising, maintenance, research and development, new product introductions, capital improvements? b. Deferring raises or bonuses? 6. Are you aware of the aspects of the business that appear to be dominant in the industry? 7. Do you know what factors make the company more attractive than other companies in the industry? How can the company maintain its advantage, identify developments that could cause the company to lose that advantage and assess the likelihood of their occurring? 8. Would the company provide a bridgehead to other desirable industry segments? Identify and evaluate the possibilities?
9. Do you have the basic information you need about the company including: a. History of business, any predecessor companies and changes in capital structure, capitalization or insolvency proceedings? b. Description of products, markets, principal customers, any subsidiaries and other lines of business? c. List of officers and directors, with their affiliations, ages and number of years in office? d. Number of people employed and their major areas of activity? e. Capitalization and stock distribution, including the number of shareholders and names of principal shareholders, rights of each class of stock and stockholders’ agreements? f. Terms of outstanding warrants, options and convertible securities? g. If the stock is publicly traded, the exchanges on which it is traded or, if over the counter, the dealer making markets, the extent of public float, institutional holdings, trading volume and total market capitalization,? Obtain and SEC filings and a shareholder list, if available. h. Organizational chart? i. Names, addresses and contacts of company’s Tango Equity 127
professional advisers, including attorneys, auditors, principal bankers and investment bankers? j. Locations of company’s financial and legal records? k. State of incorporation and date of incorporation? 10. Will a drastic change in the company’s management or business approaches be necessary to meet your expectations? Determine if present employees or customers would be able to adjust to achieve your goals. 11. Do you have general date on the transaction: a. Terms of the acquisition? b. Accounting treatment? c. Arrangements that have been made with any brokers or finders representing either side of the transaction? d. If any subsidiaries are not wholly owned, the details of outside ownership? Consider completing a separate checklist for any major subsidiaries with significant minority interests. e. If any subsidiaries are not wholly owned, the details of outside ownership? Consider completing a separate checklist for any major subsidiaries with significant minority interests. f. Other companies the company has a significant investment in, carried on the equity method? g. Details of recent acquisitions or divestitures?
PRODUCT LINES, MARKETS, INDUSTRY CONDITIONS AND COMPETITION
Product Lines 1. Do you know how many customers use the company’s products? 2. Are you aware of these basic buying considerations: a. Price? b. Quality? c. Service? d. Availability? e. Sales? f. Engineering? g. Credit terms? h. Right of return or consignment? 3. Have you examined the past and prospective pattern of product changes in the industry? 128 Tango Equity
4. Do there appear to be new uses for the product? 5. Are there related products or industry segments the company is not now servicing? 6. Have you looked into the warranty terms that are customarily offered and their cost? 7. Does the product expose the company to significant product liability concerns? 8. Is Patent and trademark protection adequate?
Markets
1. Do you know if demand is: a. Basic? b. Created? 2. What type of customer buys these products: a. Individual customers? b. Industrial companies? c. Commercial or financial businesses? d. Federal, state or local governments? e. Service businesses? 3. Does the company operate in a “mature” market? 4. Do you know the importance of domestic and export demand? 5. Are you aware of factors that affect demand: a. General business conditions? b. Population changes? c. New products, product changes or technological innovation? d. Advertising or promotional pressure? e. Governmental factors (i.e. fiscal policy, import- export controls, defense) f. Customer growth? g. Ecological considerations? 6. Can the market be expanded by efforts of the company? 7. Is the market segmented by: a. Type of customer? b. Geographic locations? c. Product? d. Channel of distribution? e. Pricing policy? f. Degree of integration? 8. Do you know how the company has responded to market segmentation? 9. Are there any seasonal sales patterns and shifts in Tango Equity 129
established patterns? 10. Do you have a 10-year record of product sales performance? Indicate the date the product was introduced and note any significant modifications. Relate trends to both external factors and company actions. Note the stages in the products’ life cycle. 11. Do you have a reasoned projection of growth or contraction trends for the product lines’ industry or industries? 12. Do you have a forecast of sales expectations and estimated share of market? Compare it to industry projections. 13. Have you obtained an estimate of the industry’s ability to supply present and anticipated demand? 14. Have you reviewed sales backlog, accounts receivable, sales correspondence and customer continuity? 15. Have you analyzed present and probable pricing policies for the product lines, considering: a. The sensitivity of both the industry and company to price changes? b. Whether there is a price leader? c. Whether there is a good price discipline? d. Any excess capacity in the industry that might tend to depress prices? e. Whether the company has been able to pass along recent cost increases to customers? 16. Have you analyzed present and potential domestic and export customers, including: a. The total number and major types of customers and the percentages of sales to each type? b. Geographical locations and percentage of sales by location? c. Names of principal customers, annual volume and sales and buying habits? d. Any contractual relationships with customers? e. The extent of government contracting subject to cost regulations or price determination? f. A summary of special discounts and credit terms offered to significant customers? g. Possible loss of customers as a result of this acquisition? 17. Do you know the methods this and other companies in industry use to distribute and sell, including: a. The channels of distribution and their relative importance? 130 Tango Equity
b. If the company does not see directly to end users, conditions in the customers’ markets? c. The nature and importance of the field sales effort? d. The manner of compensating sales personnel? e. Advertising and sales promotion practices in the industry? f. Any changing patterns in the distribution process? g. Any trend among major customers toward integrating, purchasing substitute products or otherwise deviating from purchasing from the company? 18. Have you reviewed advertising appeals, media and other sales promotion programs for cost and effectiveness? 19. Have you analyzed distribution and selling costs for the past few years to determine possible shifts in profitable customers and products? Describe any unusual marketing methods relating to foreign sales, including licensing arrangements and joint ventures. 20. Have you analyzed the trend of bidding success and costs, including: a. Invitations received? b. Bids submitted? c. Contracts awarded? d. Average contract size? e. Cost per contract award? 21. Have you reviewed trends in the major elements of marketing, including: a. Market forecasts compared to actuals? b. Sales cancellations and returns and the reason for them? c. Departmental costs compared to budget? d. Sales and expenses per salesman? e. Customer service costs? f. Shift in product mix profitability? g. Order processing costs? h. Customer’s complaints and lost customers? i. Discount pattern by customer groupings? j. New accounts opened? 22. Do you know to what extent the company is over dependent on one or a few customers?
Industry conditions and competition Tango Equity 131
1. Have you analyzed the industry’s composition and, in particular, recent changes in that composition? a. Have you determined how many companies operate in this industry and whether that number has been declining or increasing? b. Have you reviewed the recent merger, acquisition and divestiture deals that have occurred in the industry? c. Have you analyzed the trends in the prices paid for these deals? d. Have there been recent plant closings or openings, or announcement of such? e. Have you examined the degree to which foreign companies are entering this market, possibly through joint ventures? f. Are the market leaders’ specialists in this industry or are they diversified into other businesses? 2. Have you determined which factors are critical to success in this industry? a. Have you determined who the industry leaders are and why? b. What are the principal bases of competition? Price, quality, service or innovation? c. Does the market leader have a unique strategy? d. Does this industry have a high rate of business failure? e. Have you determined how important high production volume is to low cost? f. Who holds the power in this industry and how did they get it? Do suppliers have more power than buyers or vice versa? g. How reliant is the industry on exports and how vulnerable is it to imports? 3. Have you obtained growth projections and other industry analyses? 4. Have you obtained growth projections and other industry analyses from hard-copy and electronic information sources? a. What growth trends is the industry, including its companies and trade organizations, projecting? b. What trends are industry outsiders, including consultants, economists and security analysts, projecting? c. Has financial, investment or industry analysts reported adverse conditions? 5. Have you determined the extent to which external 132 Tango Equity
factors influence the industry’s health: a. Will existing or pending litigation affect the production of or demand for the industry’s products? b. Do governmental regulations affect the industry? c. Do any environmental issues affect the industry? Have any new studies been released that would increase the industry’s liability? d. Are there any potentially adverse political, social or economic conditions (e.g. trade restrictions, high interest rates, probability of nationalization or expropriation, currency revaluations)? e. Is the industry vulnerable to any external forces cutting off supply?
1. a. b. c. d. e. f. g. h. i. 2. a. b. c. d. 3. a. b. c. 4. a. b. c. d. e. f. g.
Plant and Facilities Tango Equity 133
1. Have you obtained information on: a. Location and description of plant or plants and property? b. Proximity to transportation facilities, materials sources and labor supply? c. Description of the area, including climate and natural hazards? d. Restrictions imposed by building codes and zoning laws? e. Utilities, including availability, usage and rates? f. Real estate taxes and other fixed costs? g. Title to realty and title insurance policy? h. The adequacy of insurance coverage? i. Any liens or actual or potential condemnation proceedings? 2. Have you obtained land information, including: a. Acreage? b. Cost? c. Assessed value and fair market (appraised) value? d. Current and possible future use and value? 3. Do you have adequate building information, including: a. Description, pictures and current use? b. Cost, accumulated depreciation and depreciation rates and policies (or lease terms)? c. Assessed and fair market (appraised) value? 4. Do you have all machinery and equipment information needed, including: a. A list of principal machinery and equipment showing cost, age and condition, accumulated depreciation, location and departmental use? b. Depreciation rates and policies (or lease terms)? c. Additions during last five years, by categories? d. Fair market (appraised) value? e. Technological obsolescence? f. Health and safety considerations? Find out if the plant complies with OSHA and EPA regulations? g. What level of maintenance has been performed? Review maintenance program, if any. Review what major repairs or betterments will be required. 5. Do you have a list of any surplus and idle buildings and equipment? 6. Have you analyzed estimated future plant, machinery and equipment requirements? 7. Have you evaluated maintenance and “housekeeping” controls? 134 Tango Equity
8. Have you determined capitalization vs. expense policies for repairs and maintenance? 9. Have you made an industrial engineering assessment of the adequacy of auxiliary equipment – tools, patterns, material handling equipment?
Production
1. Do you know the nature of the manufacturing process (e.g., assembly, machine shop, extraction, metal forming)?
2. Have you identified the important elements in the manufacturing process (e.g., capital investment, know- how, design of plant, skilled labor, pool of available labor)? 3. Have you evaluated: a. The organization and departmentalization of manufacturing? b. The basis for and adherence to the production schedule? c. The use of economic production order quantities, bills of material, time and motion studies, formal machine scheduling routines based on capacities and speed and similar techniques? d. Production methods, efficiency and layouts? e. Safety and security measures? f. Storage and inventory requirements and warehousing facilities? g. Major and critical raw materials, their availability and price prospects? h. Make or buy practices, purchasing and inventory controls and subcontracting done by others? i. Critical lead times for materials or tooling and significant current problems? j. Materials handling methods employed – pallets, conveyors, vacuum pipe, magnetic lifts, forklifts, trucks? k. Quality control? l. Industrial engineering? 4. Do you know the general elements of production costs (materials, direct labor, indirect labor, manufacturing expenses) and the proportion of each to the whole? Relate these to industry norms. 5. Have you determined the relationship between fixed Tango Equity 135
and variable costs, the break-even point and the relation of volume to the break-even level? What are the effects of non-cash costs and cost accounting for idle capacity and volume variances on analysis of production costs? 6. Do you have a recent schedule of manufacturing overhead? Review it for any significant trends. 7. Have you reviewed the trend over the past three years in these elements of manufacturing: a. Defective production? b. Idle time – stoppage, delays, improper materials, etc.? c. Labor efficiency? d. Waste and scrap? e. Absenteeism, accidents, grievances and overtime? f. Coordination of production planning with sales forecasts – partial or short runs, peaks and lulls? g. Goods manufactured for others whose needs may change? h. Labor turnover? i. Excess production times and the reason for them? j. Delays in delivery time? k. Returned goods? l. Downtimes and the reasons for them? m. Preventive and emergency maintenance costs? n. Engineering change notices? 8. Have you reviewed the trend in the number of days it takes a customer’s order to go through the plant? 9. Could possible changes in production methods make the manufacturing process obsolete? 10. Have you evaluated the efficiency of the company’s production process in relation to the industry? 11. Have you determined what factors might lead to an increase in production costs? Purchasing
1. In the purchasing function, have you looked into: a. The relationship of raw materials to goods bought for resale? b. The percentage relation of material costs to sales over the last five years? 2. Have you identified principal raw materials or products required, commenting on future price trends, market conditions, raw materials supply, competitors’ activity and general economic conditions in suppliers’ 136 Tango Equity
industries? 3. Have you evaluated all principal suppliers, locations and materials or products supplied? 4. Are there multiple sources of supply for critical materials? Note any monopoly suppliers. 5. Have you determined the extent of reciprocal buying, if any? 6. Do you know the company’s policy on carrying inventories of regularly used materials or supplies? Determine the existence of inventory limits such as min-max levels and number of month’s supply. 7. Have you considered the effect on the purchasing function of technological or product-line changes? 8. Have you determined the degree of centralization/decentralization and autonomy of the procurement function? 9. Do you know how the department is organized (e.g., by commodity, division, function)? 10. Do you understand the relationship between production and procurement functions for short- and long-term planning? 11. Have you studied the procurement procedures that are followed – authorized requisitions, inquiry, priced purchase orders, receiving and supplier payment? 12. Do you know which of these preferred practices are used: a. A formal purchasing manual? b. Formal use of economic order quantities? c. Up-to-date vendor evaluation files (containing delivery and performance reliability records)? d. A formal program of reviewing purchased materials (value analysis)? e. A program to standardize materials and supplies throughout the company? f. Competitive bidding procedures? g. Minimal use of vendors “suggested” by operating (as opposed to procurement) personnel? h. Lead times established by product and vendor? Determine the extent to which operating personnel consider these lead times in requisitioning materials and the percentage of “Rush,” “Emergency” and “As Soon As Possible” orders placed. i. Formalized make-or-buy analyses? j. A small purchase system? k. Commodity specifications? Tango Equity 137
l. Price standards and variance accounting? m. Use of inventory and usage records as purchasing guides? 13. Do you know how much vendors are relied on for unit prices? 14. Is there undue concentration of purchases of any items from individual vendors? 15. Have you reviewed operating information and trends for the purchasing department, including: a. Trend of cash discounts earned? b. Operating costs compared to budget? c. Waste, scrap and salvage disposals? d. Rejection of material on incoming inspection? Inventories and Costing
1. Do you have information on: a. Trends in inventory levels by reporting category (e.g., raw materials, work in process, finished goods)? b. Satisfaction into value by fast-moving, slow- moving, excess and obsolete inventory? c. Seasonal inventory fluctuations? d. Inventory turnover (ratio of average inventory to cost of sales) by product line, line of business, division or subsidiary? e. Basis of valuation (FIFO, LIFO, average costs), any recent changes to it and their effect on reported performance? f. Trends in customer service levels-stockouts, substitutes back orders? g. Sales and write-offs of obsolete stock over the past few years? h. Maintenance and plant equipment parts inventories? i. Returnable packages, sacks, containers? j. Arrangements for and experience with inventory held by others, whether under consignment or otherwise? k. Extent of any “field warehousing” financing activity? 2. For cost accounting procedures, have you determined? a. Whether the cost system is job cost or process cost? b. What costs are included in overhead? 138 Tango Equity
c. Whether idle plant costs offset inventory unit costs? d. How overhead is distributed? e. If standard costs are used, how under-and over absorbed costs are allocated to inventory and cost of sales? f. If ascertaining lower of cost or market, how market is determined (i.e., on a unit basis, by class or product or on the inventory as a whole)? g. If LIFO is used, what the approximate difference between LIFO and current cost is? h. The treatment of intercompany profit in inventory and its effect on ratio analysis by line of business? 3. Do you have enough information on long-term contracts, including: a. Contracts entered into, noting products, types of customer, price terms, payment schedules, extent of sub-contracting and dollar volume? b. The method of recording income and provision for losses?
c. Cost-estimating procedures and an analysis of cost overruns or underruns? d. Bidding procedures and strategy? e. If contracts are with the U.S. government, adherence to its cost accounting requirements? f. Any disputes or litigation with customers or subcontractors? 4. Have you reviewed trends of important controllable elements, including: a. The frequency and adequacy of physical counts and extent of adjustments required? b. The accuracy and quality of perpetual inventory records? c. Management reports – turnover, discontinued lines, asset percentage? d. Inventory security and insurance coverage?
LEGAL MATTERS
1. Are any charges pending against the company by any federal or state agency? 2. Would this acquisition raise any antitrust problems? 3. Does the company have in-house counsel? Assess Tango Equity 139
whether it would be more effective to use outside attorneys. 4. Have you obtained a copy of the most recent legal representation letters sent to the company’s auditors? 5. Is the company in compliance with environmental, equal opportunity employment and OSHA requirements? If not, find out what compliance will cost. 6. Have you obtained legal opinions that stock is validly issued, fully paid and nonassessable and that the corporation is in good standing in the state of its incorporation and all states in which it is doing business? 7. What outstanding legal matters should be dealt with in the acquisition agreement? 8. What legal problems have competitors experienced? Find out if they will eventually confront the company.
MANAGEMENT STYLES AND PRACTICES
Management Approach
1. Do you know what the basic approach of management is – entrepreneurial, authoritative, management-by- objectives? Determine the extent of centralization or decentralization of authority. 2. Have you assessed how the company’s management approach will fit with that of the buyer? 3. Have you reviewed to what extent existing management would be integrated or permitted to operate autonomously? Decide if there are any areas in which functions of the company could be fully integrated. Then figure the cost savings that would result and weigh these against the advantages of allowing the company to be fully autonomous (preserving entrepreneurial spirit, integration costs). 4. Have you considered to what extent existing management will stay on? Consider whether the buyer will need to provide management expertise in any areas. 5. Does the company have management or operating expertise that complements any weaknesses in the buyer? 140 Tango Equity
6. Have you considered the record of the management team as a whole, including: a. The success of the company relative to the industry? b. Whether the success of the company can be attributed to good management or a good market and industry? c. The strategies management is using to increase market share and profitability? d. The intelligence demonstrated in taking advantage of anticipated changes in the marketplace and the environment? e. The work environment management has created in the company? Determine if people are working together. f. Whether the management is as small in scale and as low in cost as possible? See if the company makes any effort to measure the ratio of administrative managers to total personnel and otherwise reduce administrative overhead. g. Whether management seems to work as a smooth integrated whole or is constantly dealing with crises and emergencies? The problem-solving and decision-making process? Are the right decisions being made at the right level of management? Find out if executives are spending most of their time preventing problems from arising, or if they are using their time to solve the same problems over and over. 7. Have you determined the extent and effectiveness of basic concepts and tools of good management, including: a. Documented objectives? b. Strategic and tactical plans? c. Responsive organizational structure and controls? d. Effective policies and procedures? e. Adequate management information systems? f. Budgetary control and responsibility accounting? g. Standards of performance and control? h. Management and manpower of development?
Planning
1. Do you know: Tango Equity 141
a. What the company’s attitude is toward the planning process, long-range as well as annual? a. If plan are well thought out? b. If the plans and budget are real management tools? 2. Have you determined who in the organization is responsible for long-range plans? 3. Are the plans documented and communicated to the people responsible for implementing them? 4. In the budgeting process, are sales forecasts based on real assessments of the market, rather than on percentage increases? Find out how costs are estimated and how far down into the company the budgeting process extends. 5. Do budgets embody realistic assumptions of the availability of manpower, productive capacity and working capital? 6. Are long-range plans integrated with capital budgeting and financial planning? 7. Do long-range plans reflect competitive reactions? 8. Do plans include alternative strategies? Determine if they are sufficiently flexible in relation to the operating environment. 9. Are objectives described so achievement can be monitored? 10. Does senior management judge whether operating personnel are working toward and achieving specified objectives? 11. Has the company a history of meeting its goals? 12. Are the budgeting and internal accounting functions integrated so that actual performance is reported on the same basis and under the same assumptions as budgets were prepared? 13. Is actual compared to budget, and is there a formal procedure for documenting variances? 14. Is the budget regularly updated? 15. Do you know what procedures are used to monitor the marketplace, such as: a. Market share? b. Activities of competition? c. Attitudes of customers?
Internal Controls
1. Do you know the company’s attitude toward controls? 2. Have you found out to what extent these basic elements of control operate: 142 Tango Equity
a. Are the duties and responsibilities within the company organized to provide segregation of duties? b. If the company is too small for adequate segregation of duties, are other elements of control substituted? c. Are the authority and responsibility of each function and person clearly defined and understood? d. Is there an adequate accounting system that provides control over all assets and transactions? e. Are there documented statements of policies and procedures? 3. Are there any cost reduction or profit improvements programs?
RESEARCH, DEVELOPMENT AND ENGINEERING
1. Do you know the quality of product, process and market research in the company? Compare it to that in the industry as a whole. 2. Are you familiar with the industry’s basic source of effective research? 3. Have you reviewed industry expenditures for research and how the company’s research expenditures compare? 4. Do you know what the company’s policy has been on research and development? Review the percentage of sales it has been spending on research and development, any significant new products under development and the known R&D activities of competitors. 5. Have you evaluated the company’s technical activities and services by classification (e.g. contract, services, customer services, company R&D, manufacturing engineering, tool design, product engineering)? 6. Have you reviewed the current and proposed staffing and personnel requirements for each activity? 7. Do you know the methods of authorization, funding and reporting for product engineering and company R&D, related to overall research plans and market requirements? Tango Equity 143
8. Have you assessed the caliber of the research staff? Find out if the staff has dealt with long-term research as well as day-to-day product engineering. 9. Has the research program actually produced any new products during the past five years? 10. For contract engineering, are you familiar with the programs, their tie-in to products and their follow up on prospects? 11. Do you know the relationship of customer services to market activity, product sales and profitability? 12. Have you assessed the type, condition and adequacy of engineering space and laboratories? 13. Are proprietary rights on all products under development adequately secured by the company? 14. Are you aware of any patents and trademarks held or that have been applied for? 15. Is the company protected in foreign as well as U.S. markets? 16. Do agreements exist under which the company is licensee or licensor? Find out what the estimated royalties are. 17. Are any key patents held by shareholders, management or other individuals? Find out if the company’s rights to these patents are satisfactory. 18. Are any infringement suits or claims outstanding?
HUMAN RESOURCES
1. Do you know the number of employees by sex and age, grouped into production, sales, purchasing, engineering and administration and approximate total wage or salary cost of each category? 2. Have you examined all union affiliations and contracts for significant agreements? 3. Have you determined the average pay scale and fringe benefits for production employees? 4. Have you reviewed strike history for the past five years – dates, duration, issues and settlement terms? 5. Are there any formal charges pending before federal or state labor agencies? Determine how similar cases have been resolved in the past. 6. Do you know what labor unions are represented in the industry and the general area? Find out if there is any special organizing effort going on in the area? 144 Tango Equity
7. Have you looked into the incentive system, average rates incentive and hourly), date they were established and date of the last updating of standards? 8. Have you reviewed: a. Labor morale and the handling of labor relations? b. Working conditions, statistics on turnover and reasons for it? c. Employment, recruiting and personnel policies and procedures? d. Accident frequency and safety inspection reports? e. Medical problems and sick leave frequency? f. The wage and salary administration system? g. Training programs and apprenticeship systems – their effectiveness and costs? h. The productivity of the labor force? i. Any unfilled positions? j. The cost and effectiveness of the personnel department? 9. Have you looked into the general labor market, including: a. The types of skills available in the area? b. Current pay rates and personnel practices, of the industry and of other companies operating in the immediate area? c. Area transportation, community recreation facilities, housing and schools? d. The overall labor situation? e. What union demands were made in the last bargaining process and what demands will likely be made in the next? 10. Do you have this information on management personnel? a. The organization of management functions and responsibilities? b. Management and key employees, including position, career path, age, compensation, retention outlook and management training received? c. Any employment agreements or unwritten understandings? d. Any replacement candidates for present management? e. Recent key personnel losses to competitors? f. The character and attitude of key personnel? Tango Equity 145
11. In evaluation of employee benefit programs, have you reviewed: a. The details and costs of pensions, profit sharing, life insurance, disability insurance, medical benefits, travel, accident, bonus, deferred compensation and severance plans?
b. The funding status of plans and the performance of fund managers? c. Benefits and salary levels compared to those of the acquirer? Determine if either company would need to upgrade its benefit programs or salaries as a result of the acquisition. If so, estimate the cost. d. Vacation and sick pay policies? e. The number of company-provided cars? f. Any stock option or stock bonus plans and the number of outstanding options? Look into how the plans would integrate with the buyer’s plans or otherwise be treated. Estimate the resulting costs.
FINANCIAL CONSIDERATIONS
Financial Data
1. Have you obtained: a. Audited financial statements, preferably on Form 10-K if the company is publicly held? b. Recent registration statements? c. Comparative financial results by major division? d. The most recent unaudited financial statements? e. Tax returns for the last five years, IRS reports, schedule of unused loss and investment credit carryforwards? f. Projected operating and financial statements? g. The chart of accounts and a description of accounting practices? h. Sales backlog information? 2. Have you examined operating results, analyzing: a. Trends in sales, net income, earnings per share, dividends and return on stockholders’ equity? Determine compound growth rates. b. The effects of acquisitions, dispositions and changes in accounting presentation (either discretionary or from changes in generally accepted 146 Tango Equity
accounting principles)? c. The cost of goods sold, selling expenses and general and administrative expenses? Review these for significant trends, especially in controllable costs such as advertising, travel and entertainment and repairs. d. All extraordinary and nonrecurring expenses for the period reviewed? Schedule significant items in other income and expenses. e. Annual interest expense and other fixed charges? f. Compensation paid to officers and key personnel? g. Legal retainers, consultants’ fees and similar arrangements? h. The terms of the following agreements, where applicable, and of any other pertinent contracts or agreements affecting income (excerpting if possible): x Bonus or profit-sharing plans? x Royalty agreements? x Union contracts and employment contracts? x Long-term leases? x Sales contracts and dealership agreements? 3. For financial ratios, have you compared: a. Current assets to current debt? b. Net profits to net sales, tangible net worth and net working capital? c. Net sales to tangible net worth, net working capital and inventory? d. Collection period (number of days’ sales in accounts receivable)? e. Fixed assets, current debt and total debt to tangible net worth? f. Inventory to net working capital? 4. For cost of doing business percentages, have you compared sales or revenue to: a. Costs of goods sold? b. Selected operating expenses: x Compensation of officers? x Rent paid on business property? x Repairs? x Bad debts? x Interest paid? x Taxes paid? x Amortization, depreciation and depletion? x Advertising? Tango Equity 147
x Pension and other employee benefit plans? 5. Have you checked industry sources for pertinent data on: a. Market trends? b. Economics of the industry? c. Accounting and auditing implications? d. Taxes? e. Management technology? f. Employment benefit plans?
Balance Sheet Review
1. Have you reviewed cash position, present and projected, including: a. Listing banks where the company maintains accounts and related balances at balance sheet date? b. Analyzing total cash by function of account? c. Reviewing monthly cash balances and inquiring about unusual fluctuations? d. Determining whether idle cash balances are promptly invested? e. Determining whether seasonal bank borrowings are required? f. Evaluating the company’s cash management techniques? 2. For accounts receivable, have you: a. Obtained an analysis of the total receivable balance for amounts due from customers, officers, employees and others? b. Obtained “aged” trial balances of the receivable accounts above? Compare them to aging percentages for previous years and note any trends. c. Inquired about customer receivables, including: x Terms of sales? x The number of customers? x The names of large customers and volume of annual sales to each by product line? Find out if there are any unusual arrangements with any of these customers. x Turnover? x Credit policies? x The amount of unfilled orders? x The effectiveness of the credit department? x The real significance of credit limits? d. Scheduled the ratio of returns and allowances to 148 Tango Equity
sales by month for the last six months of the year and inquired about fluctuations? Indicate any evidence of dissatisfaction with the company’s products. e. Determined whether customers’ receivables are discounted to finance operations? The amount, if any, should be noted. f. Ascertained the purpose and repayment terms of loans (other than minor amounts) to officers and employees? g. Inquired about the collectibility of receivables and adequacy of reserves? h. Determined how the company establishes credit terms? i. Evaluated the collection efforts? 3. For prepaid expenses, deferred charges and other assets, have you: a. Obtained a listing of securities and investments held by the company, showing the cost, carrying value and market value of each item? b. If the company carries any investments on the equity method, obtained details of the origin of the investments, their cost, market value (if available) and earnings and dividend history? c. Obtained details of patents owned by the company? d. Determined the amortization policy for any prepaid expenses or deferred charges? e. Determined how any goodwill or other intangibles arose and how they are being amortized? f. Investigated the nature of any other assets? 4. For accounts payable and accrued expenses, have you: a. Obtained an analysis of the type (vendors, taxes, payroll, payables on reimbursable contracts, etc.) and described payment practices for each? b. Compared the balances in the various accounts with those at the end of the previous month, quarter and year? c. Determined whether the company takes appropriate advantage of discounts for prompt payment? d. Obtained a list of the company’s principal suppliers, together with the approximate annual amounts purchased? Note all delinquencies in settlement of vendors’ and suppliers’ accounts. e. Asked about the amounts of outstanding purchase commitments? Tango Equity 149
f. Asked about any other nonfinancial current liabilities? g. Described the company’s policy on vacation and sick pay accruals? 5. For contingent liabilities, have you inquired about: a. Contracts and agreements to which the company is a party? b. Price redetermination or renegotiation? c. Sales subject to warranty and service guarantee? d. Product liability? e. Unfunded past service costs of pension plans? f. Antitrust matters? g. Any possible equal opportunity employment problems? 6. Concerning environmental regulations, do you know: a. Whether the facility has received a waste treatment, storage and disposal permit under Sections 3004 and 3005 of the Resource Conservation and Recovery Act (RCRA)? If so: x The financial liability of the site? x Whether there have been any notices of violations or warnings? Make sure you have two copies. b. Whether the facility discharges wastewater into something other than a public owned treatment works (POTW)? If so: x Have you obtained a copy of the discharge permit? x Have there been any notices of violation? x Are there any “treatment facility changes” required? Note any costs involved. c. If the facility does use a POTW: x Whether “pretreatment” is required by the POTW? x If so, its estimated costs? d. Whether the plant has generated hazardous wastes, as defined in Section 3002 of RCRA? If so: x Where these wastes have been stored or disposed? x What volume of waste was/is generated in a year? x The plant’s EPA/ID number (from 150 Tango Equity
manifest form)? e. Where there have been environmental disclosures in the 10-K? Make sure you have copies. 7. Have you determined the purpose of any reserves, obtained an analysis of activity and determined the extent to which reserves are discretionary? 8. Have you inquired about any other liabilities?
Financing and Capital Structure
1. For borrowings (short-and long-term), have you: a. Listed the amounts of all financial liabilities and determined the general terms of notes, bonds and mortgages payable (e.g., lender, payment schedules, interest rates, seniority, personal guarantees and other pertinent information)? b. Noted the nature and exact amount of assets pledged as collateral? c. Noted aggregate payments due? d. If any amounts are due to officers or stockholders, discovered the nature of the advances and repayment terms? e. Determined the terms of indentures and ascertained that all covenants have been complied with? f. Determined whether there are any restrictions in the indentures that would interfere with the acquisition? g. Obtained credit reports from Dun & Bradstreet? h. If debt is publicly held, obtained bond ratings? i. Obtained the terms of capitalized leases and long- term noncapitalized leases? Determine the nature of property subject to the leases and what renewal or purchase rights exist. j. Injured into any quasi-financing agreements (take or pay contracts, etc.) and guarantees of debt of other entities? k. Obtained information on any established lines of credit, terms and unused amounts available? 2. Have you obtained details of any preferred stock outstanding and determined if the terms of the stock specify treatment in an acquisition or merger?
3. For common stockholders’ equity, have you: a. Obtained a shareholder’s list? Tango Equity 151
b. If there is more than one class of common stock, determined the rights of each class? c. Reviewed any treasury stock acquisitions, determined whether any treasury stock is “tainted” for purposes of pooling interests and ascertained that none is carried as an asset? d. Determined whether the company has any obligations to issue or repurchase shares? e. Inquired about the company’s past dividend policy? f. Inquired about any unusual capital accounts (donated capital, appraisal surplus, etc.)? 4. Have you determined the percentages of the company’s capitalization represented by the various types of long- and short-term obligations? 5. Have you determined interest and fixed charge coverages for the last five years? 6. Have you received the source and use of funds statements for the last few years? 7. Have you determined the extent to which the company’s growth has been (or could have been, ignoring nonrecurring transactions) financed by internally generated cash? Analyze the implications for the combined enterprise. 8. Have you inquired about the company’s policy on financial needs? 9. Have you inquired about capital budgeting procedures? 10 Have you evaluated the company’s relationship with . banks, lenders and the financial community in general? 11 Have you reviewed the capital budget and planned . sources of funds? 12 Have you determined whether the existing debt . repayment schedule can be met from operating cash flow? If refinancing will be necessary, determine the effect of current interest rates. 152 Tango Equity
Forecasts