Will appear on Buy-Side pages – RECENT BUYER ARTICLES

What is an Earn-out?

/in , /by Al Statz

An earn-out is when part of the consideration received for a business is based on future sales or earnings. Earn-outs usually come in to play in business acquisitions when a business has high risk factors, or when non-linear growth is reasonably expected, or when there is a significant gap in the price expectations between the buyer and seller. In all cases the parties share the risk and reward of future performance.

Bridging a Price Gap

An earnout is often the best way to bridge a gap between what a seller will accept and what a buyer will pay. For example,  a seller may think their company is worth $4 million and the buyer thinks it’s worth $3 million. They can agree on a guaranteed price of $3 million, plus an earn-out over a period of 1-2 years, structured to provide the seller with the potential of receiving the extra $1 million, or more if sales or earnings reach a certain level, based on an agreed upon formula.

Devil in the Details

While simple in concept, earn-outs can become contentious during the measurement and payout phase. It is critical that earn-out parameters be carefully thought out and clearly defined in the purchase agreement. There must be no ambiguity in the accounting practices to be used, for example. Even if you continue to manage the business during the earn-out period, don’t assume anything.

At the same time, remember the K.I.S.S. principle. In my experience, the more complicated an earnout gets, the more likely negotiations will fail.  It is usually (though certainly not always) best to base earn-out calculations on top-line sales or gross profit, not net income. Also, be sure to design the earnout formula to completely align the interests of the parties.

For another perspective on the use of earnouts in M&A transactions, see this recent article on Axial Forum.

For more information on M&A transaction structuring strategies, or if you want help selling a business or developing a winning exit strategy, contact me at 707-778-2040 or alstatz@exitstrategiesgroup.com.

Why do business owners hire an M&A broker?

/in , , /by Jim Leonhard

Recent clients “Jane and John Doe” were satisfied with the market value estimate of their manufacturing business, as determined by the independent valuation we prepared.  Armed with this essential piece of information, they were ready to sell the business they had founded and grown with much effort over many years.

John thought they should try to sell the business themselves.  After all, weren’t they the best salespeople for their business? And why should they share a portion of the proceeds with a broker?  Jane was not so sure and began to research whether hiring a business transaction intermediary was warranted.

One article that Jane found contained the results of a poll conducted by Partner On-Call Network LLC in which sellers of small and medium sized businesses were asked why they hire business brokers instead of trying to sell themselves.  The poll identified 62 reasons, including these top eight, in order of frequency cited:

  1. Brokers know how to sell businesses; most sellers don’t
  2. Seller doesn’t want to be distracted from running business
  3. Confidentiality preservation and knowledge of what/when to show buyers
  4. Access broker’s database of potential buyers and investors
  5. Maximize price buyers will pay for the business
  6. Owner does not know how to find buyers
  7. Prepare owner to sell and prepare business for sale
  8. Broker understands and can depersonalize negotiations

After discussing this and other inputs that they had received, the Doe’s decided that hiring an intermediary was the prudent decision if they wanted to maximize proceeds from the sale of their business and reduce the risk of no deal or a flawed deal.

All 62 reasons can be found HERE.

For a certified business valuation or assistance with successfully exiting your California company, you can Email Jim Leonhard or call him at 916-800-2716.

What Sells Businesses? Quality Information.

/in , /by Bob Altieri
I recently took on an acquisition client to help them locate and purchase a business here in Northern California.  Over several months we looked at a dozen or so businesses offered by business brokers.  What an eye-opener it was seeing how other brokers present information to prospective buyers! I certainly knew that prior to signing a non-disclosure agreement (NDA); one should only expect to see a 1-2 page blind executive summary with general information about the company offered.  But after signing an NDA, I was expecting to see enough detail to help my buyer client evaluate the offering and decide to proceed or just move on.
What followed in many cases was little more than the initial one-page summary and raw financial statements. I was astonished that most business brokers did not prepare an informative Confidential Business Review (CBR) package, and to my dismay, led my client and me down the path to “wasted time and no deal.” In my client’s case, basic material facts about three businesses were learned during due diligence; after reaching an agreement on terms. These facts were clearly known to the sellers, and known or knowable to the sellers’ brokers, and simply withheld. What an incredible waste of everyone’s time and money.
In my opinion, when brokers offer a business to an open market of buyers, it is essential to do a reasonable amount of pre-offering due diligence and provide detailed information to serious buyers early on. First of all it is the ethical thing to do. Second, in my opinion, it is part of a sell-side broker’s job. Third, from a sales psychology perspective, it is easier to overcome negative aspects while an inquiry is fresh and enthusiasm is highest. And for several other reasons that I may cover in a future blog, it is in the seller’s best interest. Finally, it avoids wasting valuable time for everyone involved, and I mean everyone.
At any given time, there are many businesses for sale. When a business broker asks a prospective acquirer to sign an NDA (and complete a financial qualification questionnaire in our case), the prospect deserves information to make an educated decision to extend an offer to purchase (after meeting the owner) or move on to the next opportunity.  What a time saver!!
Typical CBR Table of Contents
  1. Company History
  2. Ownership, Owner’s objectives
  3. Products and Services
  4. Customer Base
  5. Suppliers
  6. Industry
  7. Competition
  8. Employees & Independent Contractors
  9. Management & Key Individuals
  10. Operations
  11. Tangible Assets
  12. Intangible Assets
  13. Facilities and Lease Terms
  14. Systems & Technology
  15. Sales & Marketing
  16. Relationships
  17. Strengths, Weaknesses, Opportunities and Threats
  18. Financial history, normalized*
  19. Financial forecast, when appropriate
* 3-5 years historical financial statements with appropriate normalization adjustments. A balance sheet and analyses of cash flows, seasonality and working capital history are often included.
The goal of a CBR is to present 80-90% of the information buyers need to size up a business and decide whether or not to proceed. In this business broker’s opinion, it is impossible to run an effective selling process without it. This is one of the reasons that Exit Strategies’ success rate is more than double the industry average.
If we can provide additional information, or advice on your situation, please don’t hesitate to call us.

Reducing Cost of Capital in a Small Business Acquisition

/in /by Bob Altieri

Small Business Administration (SBA) guaranteed loans are widely recognized as one of the only reliable sources of third-party funding for small privately-held business acquisitions (up to $5 million), but do you know how this benefits the borrower’s cost of capital?

Very few small business transactions are completed in which the buyer pays all cash. This is not just because most people don’t have a big pile of cash lying around; it’s also because financial leverage lowers the overall cost of capital in any investment where an income stream is expected. And every business broker knows that it also allows a buyer to purchase a larger, more profitable business.

SBA debt financing for business acquisitions currently “costs” around 6% (interest). The cost of equity financing is much higher — typically 20 to 25% or more — depending upon the risk level of the investment. The risk is much higher for the portion not financed by SBA because if cash flow from operations declines for any reason, it’s the buyer’s cash flow (and return on equity investment) that suffers. The greater the risk, the greater a rational buyer’s expected rate of return will be. In other words, an equity holder’s cash flows are riskier than a bank’s, so they require a higher rate of return. Also, in the event of a liquidation, the debt holder has preference.

How is cost of capital calculated?

If a buyer is able to obtain 6% money from the SBA on 70% of the purchase price of a $1,000,000 business acquisition, and the buyer expects a rate of return of 25% on the remaining 30% (equity portion of capital structure), the weighted average cost of capital is:

Debt               70% x 6%    =   4.2%

Equity            30% x 25%  =   7.5%

Weighted Average Cost of Capital   =  11.7%

This means that by leveraging the business acquisition, the buyer will see greater rates of return from the profits generated; not a bad reason to “leverage the deal.”

By the way, what amount of Fair Market Value will an SBA lender lend?

Subject to the buyer’s qualifications (of course), SBA lenders typically loan 70% (more in certain cases) of an agreed upon asset sale/purchase price plus an amount for working capital (lenders call it “over-funding” the loan). SBA regulations for 7(a) loans require that the sponsoring bank obtain an independent business appraisal from a qualified appraiser for any loan with an intangible (goodwill) value component over $250,000; or for any amount when the business is being sold to a family member. This is a great check and balance for the buyer to be sure the business isn’t over-valued.

When the appraised fair market value of the business comes in below the agreed upon purchase price, the SBA lender can still lend, but only up to 70% of the appraised Fair Market Value. Here the buyer is usually faced with two choices: (1) pay the incremental amount over the appraised value and increase their cost of capital; or (2) re-negotiate with the seller to lower the price.

“The Importance of a Proper Valuation” is the subject of my next Blog … so stay tuned.

Bob Altieri, CBA (Certified Business Appraiser) appraises businesses for SBA lenders throughout California. For additional information or for advice on a current need, please do not hesitate to call Bob. 

Do Strategic Buyers Share Synergies with Sellers?

/in , , /by Al Statz

In successful M&A deals involving substantial synergies, the deal price usually falls in the range between the standalone fair market value of the target business and that value plus the full value of potential synergies.

Value of potential synergies?
Increased value (over and above fair market value) to a strategic buyer, involves synergies between the acquired and acquiring firm and the additional financial returns and therefore value created by those synergies . There is a “1+1=3” effect in the acquisition process. Synergies come in various forms, including an ability to increase revenues of the target firm, cost savings by eliminating redundancies or achieving economies of scale through combining of business units; and the reduction of risk through, for example, increased size and stability, greater management depth or vertical integration.

How much of this synergistic value component is paid in practice?strategic value_2

Buyers pay, on average, 31% of the average capitalized value of expected synergies to sellers, according to recent research by the Boston Consulting Group. The March 2013 BCG article, titled “How Successful M&A Deals Split the Synergies”, can be viewed here.

From an acquirer perspective, why pay for synergies at all?

Because sellers usually anticipate buyers’ synergies and demand to be paid something for them, particularly when multiple strategic buyers are present. In addition, when the buyer is a public company , markets usually react favorably and boost the value of the acquirer when a strategic acquisition is announced. Of course, this increase in value may vanish if the synergies don’t actually materialize! When paying more than fair market value, strategic acquirers must be certain that there will be synergies in the combination. They do not randomly shell out big bucks. The owners of firms that appeal to strategic buyers have a greater opportunity to maximize value in an M&A sale process.

However, not every firm is a strong candidate for a strategic sale.

Most willing buyers for small companies are financial buyers who will operate the business similarly to the way it is operating now, and are normally willing to acquire a company for fair market value. Individual owner-operators, management employees and private equity buyers are examples of financial buyers.

We are always happy to discuss how buyers would typically value of your company. Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.

– See more at: https://exitstrategiesgroup.com/blog.html?bpid=3676#sthash.rrhDOJwx.dpuf

Goodwill Part II: Goodwill vs. Goodwill Value

/in , , /by Bob Altieri

All businesses have goodwill; however, not all businesses have goodwill value!

Goodwill, which is usually the largest portion of the purchase price of a business, is the sum of intangibles such as having a good location and trade dress, a negotiated lease in place, trained employees, a website, customers, etc. Not all businesses have goodwill value, which is measured by the amount of earnings the business produces adjusted for the risk of earnings continuing to flow into the future, since all value is in anticipation of future economic benefit.

IRS Revenue Ruling 68-6091  defines this very well. The Ruling states that goodwill value is that component of the earnings stream that is in excess of a reasonable rate of return on the investment made in the Tangible Assets (furniture, fixtures, equipment and vehicles) that the business owns, AND after paying the owner a reasonable market wage for his/her services in the business. The latter is often referred to as a “return on labor,” which has nothing to do with the value of the business since a prospective buyer can get a management job in the same industry and obtain a market rate of compensation without investing a dime in a business opportunity. If there are earnings in excess of these two requirements it must be attributable to goodwill value.

[1] During prohibition, this was the formula designed by our government to fairly compensate owners of spirit, wine, or beer producers before closing them down. It might be the only good thing that came out of prohibition!

Personal versus Enterprise Goodwill in a Business Sale

/in , , /by Bob Altieri

Goodwill can exist in two different forms:

  1. Personal Goodwill, which is defined as an intangible asset that is attached to a person; and
  2. Enterprise Goodwill, also an intangible asset that is attached to a business enterprise.

If goodwill is attached to an individual, it is non-severable since the person to which it is attached is not being sold. This also implies that the asset is non-transferable. Of course we often establish contractual arrangements between the parties to lessen the non-transferable portion of personal goodwill to some degree. The ability to pull this off depends on the size and nature of the business being transferred. Smaller businesses tend to have more personal goodwill due to the owner’s personal contact with customers or channel partners, or unique skills (e.g. a chef in a restaurant operation, a surgeon, etc.).

With enterprise goodwill being attached to the enterprise, this asset is indeed transferable because it is a part of the business being sold. So it may be obvious that enterprise goodwill usually transfers to the buyer without special arrangements. Personal goodwill, on the other hand, requires much deeper analysis to determine how and how much of this intangible asset is reasonably transferrable to a willing buyer.

Enterprise goodwill has transferable value, whereas personal goodwill may or may not have transferable value.

Without proper analysis of goodwill value, whether or not it is related to an individual (usually the owner), and thoughtful strategies for the transfer of the personal goodwill component, the value of a business can be significantly distorted (diminished).

Should we use a business sale escrow? What does an escrow holder do?

/in /by Al Statz

A client recently asked me these questions, and I thought the answers would make a good blog post …

A business sale/purchase escrow holder protects the interests of buyers and sellers of small businesses by acting as a neutral independent fiduciary, communications link and closing facilitator. Escrows are used extensively by business transaction attorneys and intermediaries throughout California since regulatory compliance, routine closing documents and administrative details are handled in an efficient, cost-effective manner.  Business escrows are used in both asset and stock sale/purchase transactions.

These are the typical duties of an escrow holder in an asset transaction:

  1. Preparing escrow instructions reflecting the terms of the purchase agreement and describing the duties of the escrow holder
  2. Obtaining and holding purchase funds from the buyer
  3. Complying with Bulk Sale statutes (public notice to creditors), when applicable
  4. Obtaining UCC lien searches for state and county
  5. Notifying the county tax collector
  6. Requesting a beneficiary’s statement if debt or financial obligations are to be taken over by the Buyer
  7. Requesting pay off demands from existing lien holders, receiving claims
  8. Notifying and obtaining clearances from county, state and federal agencies as required
  9. Routine consultation regarding questions and problems that arise
  10. Complying with lender requirements, securing loan documents, signing and receiving funds
  11. Prorating expenses and income (taxes, interest, rents, security deposits, etc.), as instructed
  12. Preparing/filing fictitious business name statements
  13. Preparing routine transaction documents and amendments
  14. Preparing estimated closing statements prior to close of escrow
  15. Securing releases of all contingencies and conditions imposed on the particular escrow
  16. Obtaining appropriate signatures on all documents
  17. Preparing final closing statements for the parties, accounting for the disposition of all funds deposited in escrow
  18. Closing escrow when all instructions of the buyer and seller have been carried out
  19. Disbursing funds as authorized by instructions
  20. Recording UCC-1, UCC-3 and deeds of trust, as needed
  21. Securing tax clearances
  22. Distributing final transaction documents to all parties

This list is generic. Escrow duties in an actual business asset sale / acquisition in California depend on circumstances and are spelled out in instructions prepared by the escrow holder. The duties performed in stock transfers are quite different.

•    •    •

Al Statz is President of Exit Strategies Group, Inc., a business brokerage, mergers, acquisitions and valuation firm serving closely-held businesses in California. He can be reached at 707-781-8580. EXIT STRATEGIES GROUP DOES NOT PROVIDE ESCROW SERVICES.

See You on the Other Side

/in , , /by Al Statz

Is a smooth transition possible when acquiring a business? I was was recently interviewed on this subject for the May 2011 issue of Entrepreneur Magazine …
Entrepreneur_1

Q:    I’ve started talks with a company’s owner to acquire her business. How do I make sure my first days as the new owner go … well, is smoothly asking too much?

A:    Ah, the first-time buyer. After talks get going, there’s always that day when you wake up and say, “Oh yeah, I’ll need to run this place.” A smooth transition isn’t too much to ask for–as long as you start working toward it early in the acquisition process. Your most important tools for a better Day One? A strong transition plan and the wisdom of the company’s original owner.

“In successful transactions, the principals have time, after the negotiating is done, to sit on the same side of the table and focus on the transition plan,” says Al Statz, president of Exit Strategies Group, a business brokerage, merger and acquisitions and valuation firm in Petaluma, Calif.

…

 Click here to see the full Entrepreneur Magazine article.