Steps in a Management Buyout

As a friend of Exit Strategies you know us as M&A brokers and appraisers, but you may not know that we advise on management buyouts.

By management buyout (MBO) I mean selling a company or business unit to managers and key employees using a combination of equity and debt. The assets and cash flows of the company are used to finance most of the purchase price, with the equity portion supplied by management or a Private Equity investor, depending on the size, profitability and nature of the company.

Business owners who choose the MBO exit option typically have strong non-financial motivations. Don’t get me wrong, price is important to them. However, factors such as company legacy, employee welfare and local community are often equally and sometimes more important.

MBOs Can Easily Go Awry

Owners and management employees usually lack the time and deal experience to complete successful buyouts on their own. The interdependent owner-employee relationship raises the stakes for all parties and magnifies the consequences of a failed negotiation. Three areas seem to be especially challenging for owners and management:

  1. locking in a fair purchase price (business valuation),
  2. determining the right deal structure, and
  3. financing

Typical MBO Steps

When advising company owners on management buyouts, we start by understanding our client’s short- and long-term goals, needs and circumstances. If an MBO appears to be appropriate, we will:

  1. Prepare an independent business valuation (fair market value) to provide guidance on pricing and feasibility
  2. Work with financial, tax and legal counsel to determine a deal structure that achieves the owner’s liquidity and income goals
  3. Obtain confidentiality agreements from interested parties
  4. Meet with managers to understand their interest level, goals and resources; educate them on the MBO process; confirm feasibility
  5. Develop a transaction roadmap
  6. Collect details on buyer experience, credit, funds and collateral
  7. Prepare a confidential information memorandum, source documents and disclosures to fill management’s knowledge gaps and explain the merits of the transaction to their advisors and lenders
  8. Recommend wealth management, legal and tax professionals (if needed) and coordinate with them
  9. Evaluate debt financing options (including seller note) and the potential of “rollover” equity
  10. Determine if private equity capital is necessary or desired, and available
  11. Recommend and liaise with best-fit debt and equity providers
  12. Propose terms and facilitate sensitive negotiations while buffering emotions
  13. Draft a nonbinding memorandum of understanding on key deal terms, transaction process and timeframes
  14. Facilitate buyer, seller and lender due diligence
  15. Assist buyers with financial models, business plans and shareholder agreements as needed
  16. Work with the parties’ legal teams to finalize definitive agreements
  17. Advise on leadership transition
  18. Coordinate satisfaction of closing conditions, resolve problems that arise, and maintain momentum for a timely deal closing

Every buyout is unique. We add, remove and rearrange steps as needed, and help both sides navigate the process. In some cases, management, not the owner, initiates the buyout.

Most Common MBO Mistake

For a management buyout to succeed, a business usually has to have a solid earnings track record in order to prove it can service the debt. Management must demonstrate the requisite skills, experience and commitment. Putting everything in place can take months or years of preparation. Waiting too long to begin this process is the most common mistake I see owners make.

Have a Backup Plan

Of course, there is always the possibility that the MBO will fall through, and you should be prepared for that possibility. That may involve creating incentives for management to stay on and being ready to market and sell the company to third party strategic and/or financial buyers.

The First Step

If you are considering selling your company to management some day, feel free to call us to discuss your goals and needs, confidentially.

Al Statz is the founder of Exit Strategies Group and a senior M&A advisor in the firm’s Sonoma County California headquarters. Email Al or call him at 707-781-8580.

Financial exit planning, Is your business ready?

I recently had a client looking to sell their medical supply business and retire. I worked with management to pull together all the documentation and financials needed, and conducted conduct a probable selling price analysis. With report in hand I met with our clients to review the results and plan a go-to-market strategy.

Unfortunately, the probable selling price fell slightly short of what the client needed to retire (after taxes). We identified excessive inventory as one of the factors that was limiting enterprise value. How did inventory reduce value and spoil our client’s exit strategy? What can they do resolve this limitation? Read on for the full story.

The company had thousands of SKUs, colors, shapes, types and sizes of medical supplies in inventory. Fully 78% of its assets were in inventory. Current assets exceeded 99% of total company assets. We compared our client’s financials against 10,000+ companies in the industry. The industry was averaging 35 days of inventory on hand (11 turns per year). By comparison our client turned its inventory less than once per year. Keep these figures in mind as we continue.

Cash Flow is King

It’s no surprise that buyers of going concern businesses buy primarily to get returns on their time and money invested. Tying up cash in inventory means less cash to operate or invest in the business (or pay dividends to investors) and increases the risk that you won’t get your money back out of your inventory. But there’s more to this story about how inventory affects value.

The income approach to valuation is based on the concept that a business is worth the present value of its expected future cash flows to its owners. The other approaches to value (market and asset approaches) are also important, but cash flow is ultimately king.

A common income valuation method involves dividing the forecasted net cash flow by a capitalization rate (Cap Rate). The capitalization rate is a function of the expected growth and risks inherent in a company. There’s a lot that goes into calculating appropriate risk and growth rates, but here’s the basic formula:

Value = Net Cash Flow / (Risk – Growth)

Crunching the Numbers

Working Capital = Current Assets – Current Liabilities

  • With minimal current liabilities and high current assets, the company had high working capital requirements.

Working Capital Turnover (Sales / Working Capital)

  • I previously mentioned that the company turns over inventory less than once a year. This suggests either too much inventory or not enough sales, or both.
  • The working capital turnover for this company was an average of 2 (i.e. sales were 2x working capital cost).
  • Industry data showed an average working capital turnover ratio of 7-8.

Net Cash Flow Calculation

  • Net cash flow to equity (NCFe) measures the cash flow to shareholders in a company (equity interest holders).
  • NCFe = normalized after-tax net income + depreciation – less capital expenses – increases in working capital +/- changes in interest-bearing debt.
  • Notice the NCFe formula subtracts increases in working capital. As a company grows, working capital increases, which means less cash for shareholders. For this client, working capital growth reduced cash flow by 25%.

Enough Numbers – Back to Our Story

Our client’s business has a high risk of not selling through years of inventory before that inventory becomes obsolete, expired, lost, stolen or damaged. Therefore, the value from the income approach came in lower than the market approach and asset approach results. In fact, the cost of inventory was higher than the value of the company on a going concern basis. Even in liquidation, the full value could not be realized after the costs of liquidating.

The moral of this story is that a hard-earned business exit can be busted by excessive inventory and inefficient use of working capital. In this case, we advised our client to put their exit on hold for a few years and work strategically to reduce inventory and increase sales. Not only will the reduction in inventory increase future value, but it will also put more cash in the client’s pocket along the way.

If you’re considering a sale and wondering what financial shape your company is in, Exit Strategies’ team of M&A brokers and business appraisers can help you determine value, evaluate strategic alternatives and maximize results.

Michael Lyman CVA is a certified valuation analyst and M&A broker specializing in health care, technology and education fields. With 15 years’ experience working in and building his knowledge in these markets, Michael understands the needs of sellers, buyer and investors. His background includes university positions, two successful e-commerce startups and president/CEO of a small pediatric health care business.

See our related blog post on Managing Working Capital to Increase Business Value.

Manage Working Capital to Increase Business Value

As you likely know, working capital equals current assets minus current liabilities. Companies that have a high level of cash tied up in current assets (primarily cash, accounts receivable, and inventory) without similar levels of current liabilities are not as attractive as those who tightly manage their working capital. Buyers are often leery of businesses that require high working capital to sales ratios because as sales grow the company must continually invest more cash in working capital. Conversely, companies with low working capital can grow faster and return more cash to shareholders as they grow.

One Recent Example

We were recently retained to do a fair market value business valuation of a multi-state, value-added industrial distribution company for a shareholder buyout. The company was a profitable going concern. While it showed modest EBITDA margins, its working capital requirements were unusually high, primarily due to extraordinarily high accounts receivable and inventory levels.

A prior valuation done not long ago for a different purpose had relied solely on an Asset Approach method. Specifically they used the Adjusted Book Value (ABV) method where all assets and liabilities are marked to market. Thanks to the company’s high current assets combined with almost no current or long-term liabilities, the result was a high valuation number. As part of our analysis, we naturally considered the prior valuation. We wondered how valid its conclusion was from the perspective of a hypothetical buyer of a going concern business who would be concerned with future cash flows.

Following standard business valuation practice, we considered the three approaches to valuation: asset, market and income. The asset approach using ABV gave results marginally higher than the prior valuation while the market approach (comparable asset transactions method) values were slightly lower. However, when we analyzed the income approach using a single period capitalization method (SPCM), our result was substantially lower than the asset approach. Why? Because the SPC method is based on capitalization of net cash flow to equity holders, which considers changes in working capital that are largely ignored by the asset and market approach.

We were compelled to give some weight to the income approach results as we believe knowledgeable buyers of shares in the company would have a strong  interest in their expected return on investment. The result was a valuation conclusion somewhat lower than adjusted book value.

Theory Holds True in Practice

I want to point out that this affect of working capital on enterprise value isn’t just abstract financial theory. We regularly see it play out in actual M&A transactions where buyers have no interest in paying more for companies with higher working capital. And we often see sellers rewarded (sell for higher earnings multiples than their industry peers) for having proven that they can operate effectively with less working capital.

It is also interesting to note that in this case, should the owners of the company have tried to liquidate the company’s assets to generate cash, the net amount yielded would have been substantially less than adjusted book value. Given that the company had no plans to liquidate, we didn’t consider using a liquidation value.

What Companies Should Be Doing in this Area

Company owners and management should constantly reevaluate and consider modifying their accounts payable and borrowing practices, as well as focus on ways to reduce accounts receivable and inventory requirements. All of which will reduce working capital, generate cash, enable faster growth, and increase shareholder value. Sometimes this even means making tough decisions like firing a customer or replacing a key vendor.

For further information on how working capital affects enterprise value, or to have a business analyzed for sale, acquisition or exit planning purposes, contact Jim Leonhard, CVA MBA  at 916-800-2716 or jhleonhard@exitstrategiesgroup.com. 

Business sale planning: Three lessons from Shark Tank

As an M&A advisor having participated in the sale of businesses ranging in price from $500 thousand to $100 million, I enjoy watching ABC’s Shark Tank. On the show, entrepreneurs pitch their businesses to a panel of five investors (“sharks”) who then decide whether or not to invest. Today I want to pass along three key takeaways from Shark Tank for every business owner who plans to sell their business some day.

1. The business valuation has to be realistic and defensible

Many times on Shark Tank, the valuation of a company is way too high. The asking price is not based on sound valuation principles and is not defensible. The Sharks opt out because the owner is unrealistic. This is an important lesson for business owners looking to sell their company. A realistic and well-supported valuation invites serious and capable buyers who seek a reasonable return on their investment, and an unrealistic valuation chases away buyers.

2. Presentation is fundamentally important

The Sharks don’t know anything about the companies prior to the pitch, and the sellers get one shot at presenting their information in the Tank. This is the same in a business sale process. Potential buyers don’t know much about the seller’s business, and if they are familiar it, they don’t know the details of the financials, operations, personnel, markets, customer base, systems, etc. Brokers know the kind of information buyers want and need, and how to position a company for sale or investment. They prepare a Confidential Information Memorandum for use in the sale process to give qualified buyers the information they need to make their best offer, and an offer that will survive due diligence.

3. Deal negotiations – competition is key

Sharks, like all buyers, hate competing for a deal. Sellers love competition because they get to choose the best terms available in the market. Having a broker in a deal creates competition among potential investors (buyers) because brokers promote the acquisition opportunity to a broad and targeted audience. Envision a shark feeding frenzy! Even if only one buyer prospect comes along and begins the negotiation process, they know that low-balling a fairly priced business will likely not fly in a competitive open market of buyers being orchestrated by an experienced broker. In the absence of a broker, it’s anyone’s guess where things will end up, but not likely as good of a deal in the absence of a competitive environment.

Keeping these three lessons from Shark Tank in mind as you go through the exit planning and business sale process will likely lead to a better outcome for you and your stakeholders.

Not familiar with Shark Tank? Shark Tank is an Emmy Award-winning structured reality television series on ABC, now in its tenth season.  Watch Shark Tank on ABC.com

For more information on buying or selling a business, Email Louis Cionci at LCionci@exitstrategiesgroup.com or call him at 707-781-8582.

How to Build a Sellable Construction Business

With the San Francisco Bay Area building industry booming I am regularly approached by the owners of construction companies with requests to help them to sell their companies. As interest rates are low (but creeping up) and investors are still in the market for solid businesses, some construction company owners with strong financial histories and future growth prospects are looking to cash out.

However, even in the best of times construction companies are notoriously difficult to sell. Any business that requires a professional accreditation (like a California contractor’s license) to operate will logically attract fewer buyer prospects. Buyers with the requisite licenses and financial resources often prefer to start their own companies rather than buy someone else’s. Many construction companies even large ones depend heavily on their owner’s experience and contacts to attract business. When it comes to selling, the personal goodwill of the owner is tough to transfer to a new owner.

If that weren’t enough, many construction businesses have high capital equipment costs, high labor costs and because of retention are slow to receive payment for their services. Furthermore, the industry is cyclical which increases the need to maintain cash reserves. These factors increase overall working capital requirements for construction businesses and make them difficult to finance and expensive to manage.

So, what qualities in a construction company are attractive to buyers? This list is a good start:

Experienced and Dedicated Labor

Unemployment in the Bay Area hovered at just under 3% in October. The market for construction-related jobs is even tighter. For many Bay Area construction companies growth is constrained not by demand for their services but by their ability to complete the work. Some of these companies are resorting to acquisitions of other companies simply to secure talent. Owners of companies with trained and dedicated employees are well positioned to benefit from this industry wide challenge.

Committed Management Team

Businesses with multiple owners that compose the management team and want to retire at the same time are particularly challenging to sell. Business partners or spouses that both play vital roles and want to leave a business together are difficult for buyer prospects to replace. Buyers like to know that the owner can take time away from the business without it impacting performance. Ideally, a company will have a committed non-owner management team that will embrace an incoming buyer and continue to run the business after its sold.

Low Working Capital Requirements

Not all construction companies require a large working capital investment. For example, companies that provide services directly to building owners rather than general contractors often have more control over when and how they get paid. Also, companies that have regular service contracts with clients often have shorter cash flow cycles.

Qualifier Flexibility

The buyer of a construction company that is in the same business will have the required licenses to operate. But many buyer prospects for small construction companies won’t and they will have to figure out how to run the business until they are able to qualify for the requisite licenses. A business in which the seller or one of the company employees is willing and able to serve as the license qualifier during the transition will make the business easier to sell.

Construction companies with these attributes will be more attractive to buyers.

Exit Strategies Group regularly appraises and brokers the sale of companies in the construction industry. For further information or if you own a California construction company that you’d like to sell or have appraised please contact Adam Wiskind at awiskind@exitstrategiesgroup.com or (707) 781-8744.

Inside the Mind of a CEO

Of course it’s in a CEO’s DNA to think big, challenge the status quo, set stretch goals and inspire teams to perform to their full potential. So, why did this recent CNN Business article on How power changes the CEO brain catch my attention?  Because my wife pointed it out to me

Seriously, according to this article, neuroscience researchers have found that those who feel powerful become:

  1. more goal-oriented and think more abstractly
  2. more optimistic about risky decisions
  3. less likely to see the world from others’ perspective

I would add, from 30+ years of working closely with founder-CEO’s as a business executive and valuation and M&A advisor, that most successful founder-CEO’s are also surprisingly humble and know how and when to throttle back that power. These traits help them assemble extraordinarily dedicated groups of managers, employees, clients and investors.  Helpful when it’s their time to sell!

CLICK HERE for more insight on how power affects the brain of a CEO.

Business Sale Planning – How CPA’s Can Help

Exiting right requires early planning and help from a team of advisors that is often formed by a company’s CPA.

In our work as M&A brokers, business owners often come to us emotionally ready to sell but unrealistic about the value and condition of their business. And frequently they are out of time or unwilling to re-position the business for a more lucrative sale.  Misconceptions, clouded judgement and lack of planning are all too common. Fortunately, a growing number of business owners are turning to their CPA’s for early exit planning assistance.

Potential CPA Exit Planning Services

  • 3-5 years before exit.  A top business CPA can help assemble a team of advisors that typically includes an M&A advisor, a personal financial planner, a business attorney, and perhaps an estate planning attorney. The CPA can recommend a business valuation or a sale readiness assessment by the M&A advisor and run tax calculations under likely deal terms. They can help the client select their best exit option, and if gaps exist, the team can assist with developing a comprehensive exit plan, which typically includes a business growth plan.
  • 2-3 years before exit.  Top business CPA’s can provide finance and accounting advice and services.  They can recommend that a client stop co-mingling personal expenses and adjust related-party transactions to market, help clean up the balance sheet, shore up accounting systems, staff, policies and practices, help organize all financial records, and create important management reports — all things that buyers and their CPA’s and lenders expect to be in place.
  • 1-2 years before exit.  The CPA can perform a sell-side Quality of Earnings (Q of E) analysis of historical reporting. Q of E often covers revenue recognition procedures including rebates, discounts, allowances, credits and collections, analysis of accruals and contingent liabilities, identification of non-recurring revenue and expenses, working capital level analysis, adequacy of capital expenditures to sustain performance and operational plans, changes in personnel and compensation, and stratification of revenue and gross margin by customer and product. Basically, whatever it take to understand and verify the underlying economics of a particular business.
  • During the sale process.  The CPA can provide tax / deal structuring advice, financial and tax due diligence support, and financing support for lender(s). They can also provide or recommend post-closing investment support.

What Business Owners Should Do

Early involvement in exit planning by a seasoned business CPA can help company leaders increase shareholder value, improve marketability, and ensure that owners are able to exit on their own terms and time frame.  When selecting a CPA for your business, ask about their experience and track record in helping other clients achieve more successful exits. Then choose accordingly.

Loui Cionci, ABV, CPA, is a senior M&A advisor and business appraiser with Exit Strategies Group.  For more information on exit planning services, help finding an experienced business CPA, or selling a California business, contact Louis at LCionci@exitstrategiesgroup.com or call 707-781-8582.

Business Valuations Can Create Value, Not Just Report It!

I recently completed a valuation engagement for two shareholders of a California manufacturing company who were going through a buy-sell transaction. After the sale, the buying shareholder called to tell me how my valuation report gave him the confidence he needed to complete the purchase, take on debt, and revamp the company’s business plan. Besides making my day, his call made me think about why almost every business owner can benefit from a valuation.

When all aspects of a business are objectively analyzed by an independent, experienced business valuation professional who then considers each detail (after all, valuation is both art and science), applies real-world valuation approaches, and produces a well-documented report, you receive invaluable information for making important business and investment decisions.

If you’ve had your business professionally appraised, you know what I mean. If you haven’t, you are missing out on more valuable and actionable insights than you probably realize.

Why do business owners and others have businesses valued?

Some of the most common reasons include:

  1. To get an idea of how the market would value a business
  2. To create a process to increase a company’s marketability
  3. Click here for 50 Reasons for a Business Appraisal

For further information on buying, selling or increasing the value of a business, or business valuation or appraisal, you can contact Jim Leonhard, CVA MBA at 916-800-2716 or jhleonhard@exitstrategiesgroup.com.

A Lease Can Make or Break a Business Deal

The transferability of a commercial property lease can have a direct impact on the potential sale of a brick and mortar business enterprise.

Most commercial leases contain restrictions on the tenant’s power to freely transfer or assign the interest in a lease. These restrictions are necessary for the protection of the landlord, providing assurance that any successor of the business and the lease has the financial and legal wherewithal to pay the rent.

In rare cases, the lease may expressly prohibit a tenant’s right to transfer. See California Civil Code 1995.230.

Where the lease does not include any language prohibiting or restricting a tenant’s right to transfer, the tenant retains an unrestricted right to transfer. See California Civil Code 1995.210.

Leases that contain restrictions on tenant transfer may require the landlord’s consent subject to express conditions or standards. These conditions could include:

  1. Does transferee have an acceptable business reputation?
  2. Will transferee use the space in a manner that is consistent with landlord’s expectations and local zoning/use laws?
  3. Is the transferee in good financial standing?

Should the lease contain restrictions on tenant transfer but provide no standard or condition for withholding consent, the transferability is subject to the implied standard that the landlord’s consent may not be unreasonably withheld. Where the landlord withholds consent but upon written request from tenant, provides no grounds for reasonable objection to the transfer, the transfer may be allowed. See California Civ. Code 1995.260.

A well drafted lease balances the interests of landlord and tenant and protects the interests of all parties from the onset, during the transition of ownership, and beyond. A diligent review by your attorney of a new or existing lease is money well invested.

Don Ross is a business broker in Exit Strategies Group’s North San Francisco Bay Area office. For further information or help selling a business contact Don at 707-778-0210 or donross@exitstrategiesgroup.com

August 21st Seminar: How and When to Exit Your Business for Maximum Value

Are you considering retirement or exiting ownership and wondering if you’re going about it the best way? Will your business sell for maximum value? Please join us for an exclusive, limited-seating breakfast seminar in Roseville on Tuesday August 21, 2018 for business owners contemplating their exit. Learn the ins and outs of successful exit strategies and how to maximize value when you sell. This free, educational seminar is sponsored by Exit Strategies Group and Exchange Bank, a local community bank serving northern California since 1890.

You’ve spent years creating value in your business and you deserve to make a full-value exit on your terms and time frame. You’ve heard about hugely successful deals and horror stories of deals gone wrong. But what separates them? Not just luck.

What is the value of your business today? Is that enough to retire or fund my next endeavor? Is the timing right to maximize value? What are my exit options and how do I select the right option? What should I be doing to prepare for an exit? How far in the future should I plan? What can I do to make my company more attractive to buyers? How can I position it to attract strategic buyers? How do I present my financials properly? How do I avoid financing a sale? How do I get more value for all my years of hard work and ensure a successful sale when I’m ready to sell?

If you’ve asked yourself any of these questions, this seminar is for you. This fast-paced 2-1/2 hour live session will provide practical answers regarding:

1) How companies are valued and what factors influence the price buyers pay
2) How to prepare yourself and your company for a better sale outcome
3) The current state of the market for business sales
4) Pros and cons of different types of buyers for your company
5) Steps and important tools in an M&A sale process, and mistakes to avoid
6) How experienced professionals level the playing field with sophisticated buyers
7) The criteria banks will use to qualify your business for buyer financing
8) How to maximize proceeds and reduce financial risk in a sale

SEMINAR DETAILS

• Date: Tuesday, August 21, 2018
• Time: 7:30am – 10:00am (check-in and continental breakfast start at 7:00am)
• Location: Exchange Bank, 1420 Rocky Ridge Dr. Suite 190, Roseville, CA 95661
• Presenters: Senior advisors from Exit Strategies Group and Exchange Bank
RSVP Required:  CLICK HERE TO REGISTER ONLINE  Or, contact Mike Lyman at 916-476-2611 or mlyman@exitstrategiesgroup.com. We will call you to confirm your reservation. For privacy, we allow only one company per business type. Register early. The seminar is free and seating is limited.

We hope to see you on August 21st. If you cannot attend but would like to be notified of future seminar dates, receive our monthly newsletter, or discuss a business sale or valuation need, please contact Mike Lyman at 916-476-2611 or mlyman@exitstrategiesgroup.com.

About the Sponsors:

Founded in 2002, Exit Strategies Group, Inc. is a full-service Northern California-based merger and acquisition brokerage firm serving $1-50 million revenue company owners.  Exit Strategies also appraises businesses for MBO, buy-sell transactions, ESOP, estate and gift tax, litigation support and other uses.  With 12 seasoned professionals and 4 California offices, Exit Strategies combines the expertise and resources of a large firm with the close senior-level attention of a boutique M&A practice.

Founded in 1890, Exchange Bank consists of 18 branches.  Exchange Bank is an SBA PLP lender with decades of experience.  Dedicated SBA M&A lending professionals committed to outstanding customer service and fast turnaround.