Will appear on Seller pages – RECENT SELLER ARTICLES

M&A Deal Terms: Average Capital Structure

/in , /by Al Statz

The following chart from GF Data shows the average capital structure over the past 5 years for middle market business acquisitions. Equity contributions have varied only slightly over that time, in the range of 46% to 49%. Overall there was a slight rise during COVID, but nothing major. There are two different stories based on deal size however. In the $10-50 million total enterprise value (TEV) bracket, average equity contribution dropped. However, for deals in the $50 to 250 million TEV range, average equity share remained at or reached the mid-50s, suggesting the room for continued valuation increases is greater on sub-$50 million deals.

GF Data collects and publishes proprietary business valuation, volume, leverage and key deal term data on private equity sponsored merger and acquisition transactions with enterprise values of $10 to 250 million. GF Data gives M&A deal participants and advisors more reliable external information to use in valuing companies and negotiating transactions.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com.

 

M&A in 2022: Is this the year to sell?

/in , /by Al Statz

If you’re a business owner, you’ve probably had a rough couple of years – and the challenges aren’t over. While COVID-19 may be weakening its grip, talent shortages, supply chain issues, and inflation are still very much at play.

And yet, the economy is surging. Many of the business owners we talk to have all the work they can handle and strong balance sheets. So on the plus side, performance is good. On the negative, managing the business is really challenging.

If you’re analyzing the pros and cons and wondering if 2022 is the year to sell, here are some things you should know:

Buyers outnumber sellers

The buyer pool is as strong as it’s ever been, and there are significantly more buyers than sellers. Private equity has been driving demand and will continue to do so for the foreseeable future. This group of buyers is exceedingly well capitalized and needs to put their investors’ dollars to work.

Meanwhile, we expect to see corporate buyers ramping up their acquisitions. After a couple of years sitting back and waiting things out, these buyers are feeling a new sense of urgency. With the tight talent market limiting organic growth, companies will be looking to acquisition as a way to expand and evolve.

In terms of making an offer, strategic buyers could offer higher values because of the synergies that can be gained from a merger. And yet, private equity is up against deadlines to place their money in new investments. Pit these active buyer pools against each other and the battle should be pretty good.

Values are at an all-time high

Sellers are realizing record valuations right now. According to GF Data, a company that collects data on privately held M&A transactions, multiples for Q3 2021 hit the highest level they’ve seen in their 16-year history.

Lending is strong

Banks are looking to put their money to work in the same way buyers are. What we’re hearing from lenders is that their traditional clients are flush with cash. So instead of extending lines of credit to their established customer base, they’re out there looking for new loans to make.

Money is cheap. So even though valuations are high, buyers can still meet those prices with a smaller equity stake. According to GF Data, buyers’ total debt as a multiple of EBITDA “surged” by half a percentage point in Q3 2021 – a significant increase by debt standards.

Tax increases are still a danger

We didn’t see an increase in capital gains in 2021, but there’s a sense that it’s still coming. If the Democrats win the mid-term elections, some analysts predict we’ll see an increase in 2023.

The threat of tax increases sent sellers to market in 2021, hoping to get out in time. Now, we’ve basically reset the clock for another year. Business owners who sell today face a 20% tax burden, but if predictions come to pass, we could see capital gains rates increase by an additional 5% or more.

Business inventory will grow

With the uncertainties of the last two years, many sellers have been waiting on the sidelines. That exacerbated supply and demand issues and heightened competition for quality businesses.

But now the economy is going strong, and the market is gaining a new sense of equilibrium as we all learn to live with the lingering specter of COVID-19. As confidence increases, more business owners will enter the market. If you were planning to sell soon, it might be a good idea to act before supply increases.

Deal support teams are stretched

Deal teams are always running full bore in Q4. Between due diligence, financial reports, environmental inspections, contract negotiations, lending, etc., it can take a lot of third-party service providers to move a transition through to closing.

As one buyer’s banker told us, “We’re committed to getting this deal done. But this transaction is twelfth in line.” (And it isn’t a very big bank!) Sellers that don’t move fast enough could run the risk of missing their ‘close-by-year-end’ goals.

Selling your business is likely the largest financial transaction you’ll make in your life, and there are a lot of variables to consider. It’s a good idea to keep tabs on your business value as the market changes. Talk to advisors who can evaluate your unique business and circumstances. Find out what the numbers look like for a sale in 2022. You may have some big decisions ahead.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Rep and Warranty Insurance Now Available for Deals Under $10 Million

/in , /by Exit Strategies

By Patrick Stroth

In recent years, Representations and Warranty (R&W) insurance has become available to smaller and smaller deals.

The eligible deal size dropped to under $20M… then under $15M. This is already quite a feat when you consider that the average transaction value (TV) for deals with R&W coverage in place is $500M. And to be honest, most insurers won’t go lower than $100M—Underwriters are already backed up on processing policies and insurance companies don’t always want to take the time to work on smaller deals that won’t generate large amounts of fees.

Now, for the first time ever, this unique type of coverage is available for deals with a TV of $250,000 to $10M. This opens up R&W coverage to a whole new universe of deals.

How did this breakthrough come about? As with many business ideas, someone saw a gap in the market and decided to fill it with what is officially called Transaction Liability Private Enterprise (TLPE) insurance.

According to CFC Underwriting, the London-based insurer that innovated this new insurance product, there were 230,000 deals in which the TV was between $250,000 and $10M. They decided to create a product for this vast unserved market and came up with TLPE insurance as the first to market solution.

Here are the basics on this coverage, which is available worldwide:

  1.  It covers deals with TV from $250,000 to $10M.
  2.  The policies are sell-side only. (In standard R&W insurance there are sell-side and buy-side policies, although the vast majority are buy-side.)
  3.  It offers competitive terms at rates lower than traditional R&W coverage.
  4.  A streamlined underwriting process to ensure both timely execution and sustainability.
  5.  A deal can be insured up to 100% of Enterprise Value (EV).
  6.  Policy period: six years.

Covered industries include professional services, technology service and product businesses, transportation and aviation, and insurance brokers. CFC generally declines deals involving businesses in healthcare, financial services, oil and gas, mining, pharmaceuticals and regulated industries (such as telecommunications).

How It Works

Similar to standard R&W insurance, TLPE covers innocent misrepresentations made by the Seller to the Buyer.

This provides the Sellers peace of mind because they know they won’t have to risk some or all of their proceeds from the deal in the event of a breach. On the other side, Buyers enjoy a feeling of confidence because there is a guaranteed source of funds available to cover their loss.

Unlike the vast majority of R&W policies, TLPE is strictly a sell-side product. The policy is “triggered” only by a claim brought by the Buyer against the Seller for a loss caused by a breach of the Seller’s representations in the Purchase and Sale Agreement.

As part of this coverage, the Seller is entitled to have their legal defense to contest the Buyer’s claim paid for by the insurer. Underwriters have full authority on the selection of the Seller’s defense counsel, which enables them to control claims costs. The insurance company will also cover any damages or settlement amounts.

Something not in a standard Buyer-side R&W policy is the exclusion for Seller fraud.

While no insurance policy will cover known fraudulent acts, TLPE will pay the legal fees to defend the Seller against allegations of fraud. However, they will cease providing defense costs if actual fraud is established in court.

Important: if the Buyer sues the Seller for something not related to a breach, the insurer does not provide legal defense.

Quick and Easy

TLPE offers streamlined and cost-effective underwriting:

  • An application is required, but Underwriters depend on the Seller’s knowledge of their own business. Who knows the business better than an owner/founder?
  • There are no underwriting fees, which saves policyholders $30,000 to $50,000.
  • No underwriting call is required.
  • The turnaround time is just three days after transaction documentation is submitted and responses to any underwriting questions are provided.

This quick and easy process is possible because the Underwriters are not viewing the reps. They’re not looking at the due diligence collected. They are simply underwriting the application that the Seller provided.

TLPE in Action

TrenData is a Dallas-based SaaS company that offers various human resources services. A larger human resources technology firm was planning to acquire them. The TV was about $5M.

What held up the deal was the Buyer insisted that in the event of a breach of the intellectual property (IP) rep, that the target company would be responsible for any legal expenses or loss. At the same time, the Buyer would retain the sole authority for selecting their own legal counsel and determining the legal strategy.

As the target company noted, this is like essentially writing a blank check. The Buyer could easily hire high-priced attorneys and/or drag the case on and on. They would not go for it.

Neither side would budge on this issue, and it seemed like the deal was lost.

However, less than a week later, the Seller reached out to my firm, Rubicon Insurance Services. We discussed TLPE coverage and how it could work in this deal. The Seller contacted the Buyer, and once they found out that the Seller would pay for the policy, that legal costs would be covered in the event of a loss, and that the deal could be insured up to the full $5M in TV…the gap between the two sides was bridged and the deal closed within a week.

What to Do If You’re Interested in Coverage

TLPE seems simple enough. However, there are key conditions and limitations with this new product. So it’s essential you have an insurance broker experienced in M&A handle the process of securing this coverage.

Something to keep in mind: TLPE policies can be placed post-closing, so if you were unable to get protection for a previous deal, it can actually be revisited.

If you’re interested in seeing if TLPE coverage could be a fit for an upcoming – or past – deal, you can contact Patrick Stroth, at pstroth@rubiconins.com.

Tracking your Business Perks

/in , /by Al Statz

Perks is an abbreviation of perquisite, which means a benefit, incidental payment, or advantage over and above regular income, salary, or wages.

Business owners take any number of perks from their business, from the standards like auto expenses, memberships, and insurance plans to extras like entertainment, vacations, or an additional family member on the books.

Perks are a way for owners to be further compensated for their hard work. However, they can complicate valuing a business. When you go to sell your business, make sure you do one of two things: 1) reduce perks to drop money to the bottom line, or 2) maintain an excellent paper trail so you can clearly delineate which expenses are needed for operations and which are done for you as a tax write off.

Be aware that doing a job for “cash” – or perks that can’t be tracked and proven – can diminish the value of your business. When preparing your business for sale, your advisors will “normalize” your financials to account for these extras. When perks are adequately documented, we can usually get the majority of that value accepted.

While valuing a business is not a straight calculation, buyers will use SDE (seller’s discretionary earnings) or normalized EBITDA (earnings before interest, taxes, depreciation, and amortization) as a tool when arriving at their offer.

For example, a small Main Street business with an SDE of $200,000 USD will typically sell at a 2.0 multiple: $200,000 x 2.0 = $400,000 in value. A lower middle market business with EBITDA of $1.2 million might sell at a 5.0 multiple, or $6 million.

These are very general guidelines that can be influenced by any number of business factors or market conditions, but it helps to show the importance of driving cash to the bottom line in the last couple of years before you sell. Your discretionary cash is multiplied in a sale, so talk to your advisors about the tax benefits / value tradeoff of certain perks.

Think about how perks impact your total compensation and retirement needs, too. For example, if you’re pulling $200,000 as salary, you might think you can comfortably live off that amount in retirement income. But under closer examination, your perks may actually provide an income closer to $275,000. It’s important to know how much you’re truly taking out of the business.

Consider family perks as well. For example, maybe your child works for the company as part-time social media support but receives a salary equivalent to a full-time marketing manager. Adjustments will need to be made there, too.

Perks are a common way for owners to pull additional value from their business. However, when it’s time to sell, your advisors need to be able to account for these perks in detail.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

M&A Advisor Tip: Avoid key-man risk

/in , /by Al Statz

Business owners should ask themselves, if I became incapacitated, could my business run without me? If the answer is no, buyers will be concerned about the business’s ability to operate when you’re gone.

If you can’t get away for at least a week of vacation at a time… if you hold key customer relationships… if you’re solely responsible for an essential business function… buyers will see risk, and rightly so.

To get the most value in a sale, you need to build a business that can operate without you. Better yet, try to eliminate key-man risk throughout the organization so that business operations can continue no matter who gets sick or quits unexpectedly.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

How Supply Chain Issues are Complicating M&A Dealmaking

/in , , /by Al Statz

Many businesses are struggling with supply chain issues right now. After vaccine programs and government stimulus monies kicked in and economies roared back to life this past year, global supply chains came under immense strain as weaknesses were exposed. Though conditions have improved slightly in just the past few months, experts in most industries are forecasting that supply chain troubles will persist well into 2023.

This article discusses some of the ways that supply chain problems are complicating M&A transactions for business owners looking to sell in 2022.

Earnings Performance

One of our M&A clients, a durable goods distribution company, currently has a record order backlog of 11 months, as customers place large orders to combat long lead times. Normal backlog before COVID was around 1-2 months. Lead times on popular SKUs that were once 2-3 weeks are now 5-6 months, and scheduled deliveries on some products are a full year out! Meanwhile many vendors are missing promised delivery dates, and the order backlog keeps climbing, for now. Sales (shipments) are totally dependent on the supply chain.

EBITDA is the most talked about, relied upon, and argued over earnings metric in the world of mergers and acquisitions. When a business has solid orders but is struggling to ship products, it becomes difficult to establish an earnings run rate and to forecast earnings. That in turn makes it difficult for acquirers and sellers to see eye to eye on EBITDA and therefore enterprise valuation. And how well correlated is trailing twelve-month (TTM) performance with expected future performance anyway under these conditions? Often not well at all.

And this is part of a broader question―where will growth stabilize after COVID restrictions and government stimulus ends, and inflation and GDP growth are back to normal? Since different buyers will have different views of TTM and expected future EBITDA performance (not to mention working capital and capital spending needs) the best way for sellers to optimize value in today’s market is to run a structured sale process where multiple buyers come to the table.

Supplier Due Diligence

As acquirers seek greater supply chain resilience, we’re seeing them do more due diligence in this area than ever before. In the past, buyers were relatively relaxed about supply vulnerabilities, focusing more in other areas. But now we’re seeing more scrutiny of supplier quality and on time performance, length of supplier relationships, supplier concentration, location of supplier operations, supplier commitment to the target, capacity for growth, strategic plans, recent or potential change of ownership, contracts, proprietary content, history of price increases, long lead time items, economic order quantities, sole sourced items and alternative sources of supply, and other potential areas of risk.

We brought an electronics business to market recently that had backups or workarounds for nearly every component in their products. Frankly, we’d never seen a company put so much time and energy into supplier redundancies. Yet, they had one essential PCB with no alternate supplier.

Buyer concern was so significant, we took the business off the market until a reliable second source was identified and qualified.

Working Capital

Another aspect of M&A dealmaking that is being complicated by supply chain issues has to do with working capital negotiations. Working capital is like gas in a car – you need it to run a business. When selling a business, the buyer and seller agree on a “sufficient” amount of working capital (usually on a cash-free debt-free basis) to be left in the business to support ongoing operations. In a typical economy, unless a business is growing or declining rapidly, this “target” working capital level is based on a TTM average calculation.

But right now, many businesses are holding onto bloated levels of inventory to compensate for parts shortages and long lead times. Manufacturers that used to buy inventory on a just-in-time basis are now overstocking. Not only are inventories much higher than normal, but in many cases the price-per-unit has skyrocketed as well. Companies are paying whatever they have to in order to keep critical parts in stock and keep customers happy. The same goes for shipping costs.

So, businesses selling now based on a TTM average working capital target will be including more working capital than if they had sold 12 or 24 months ago. This is one of the areas that can really upset sellers – no one likes to leave money on the table. Fortunately, with all the competition in the market today, many buyers are willing to throw out the book on working capital to win the deal. The key is to negotiate the target earlier in the process when there are still multiple buyers at the table. In the past we often negotiated the working capital target during due diligence. Today we almost always negotiate it in the LOI.

What to do

Owners looking to sell in a world reshaped by the pandemic should select an M&A advisor who anticipates issues like these and has strategies for addressing them. Owners planning to remain independent may want to consider protecting their supply chain by vertically integrating upstream through a strategic acquisition.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

M&A Advisor Tip: Perks & business value

/in , , /by Al Statz

Business owners take a number of perks from their business, from the standards like auto expenses, memberships, and insurance plans to extras like entertainment, vacations, or an additional family member on the books.

Perks are a way for owners to be further compensated for their hard work. However, they can complicate valuing a business. When preparing your business for sale, your advisors will “normalize” your financials to account for these extras.

Be aware of providing products or services for cash – or perks that can’t be adequately tracked and proven in your books – can diminish the value of your business. When planning to sell, talk to your advisor about the tax benefits / value tradeoff of certain perks and consider where it would be better to drive cash to the bottom line.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Creative deal structures and deal terms move to lower middle market

/in , /by Al Statz

When selling your business, price is not the only important factor you’ll negotiate with a buyer. The deal structure includes a wide range of considerations from transaction type, ownership and payment structures, working capital, assurances, timelines, and more.

What we’re seeing in the market right now is a rise in creative deal structures. These are non-typical solutions that help dealmakers bridge some sort of gap between the buyer and seller. If properly negotiated, these structures can make a lot of sense for both sides, but it’s critical for a seller to have an experienced M&A advisor and transaction attorney on their side to ensure they understand these more complex provisions.

An earnout is, perhaps, the classic example of a creative deal structure. Under these agreements, the seller receives additional payments provided the business hits certain targets down the road. Earnouts can be a great way to bridge valuation gaps, such as when the business is expecting a big performance boost in the near future – and the seller wants to be paid for those as-yet-unrealized gains.

Some creative deal structures are more common in the middle market M&A (transactions with values over $50 million). But as private equity buyers continue to shift into the lower middle market (business values of $2 million to $50 million), they’re bringing deal structures like these with them:

Reps and warranties insurance. When selling your business, typically you’re going to “represent and warrant” certain things about the business (e.g., you’ve provided accurate info, no known legal or customer issues pending). If something turns out to be not wholly accurate, the buyer can come back to you for a certain percentage of the purchase price.

In smaller deals, the seller will simply agree to a guarantee. But as transactions get larger, buyers may ask sellers to put that money in escrow. That money is then tied up for a certain period of time, not earning any returns.

As an alternative to escrow, the deal can include reps and warranties insurance. In this case, the insurance company does their own due diligence and agrees to take on that risk. The advantage for sellers is that they don’t have to hold that money in escrow anymore and shed the risk of covering a reps and warranty claim during the warranty period.

Premiums for reps and warranties insurance often start at around $250,000. Because of the cost and additional diligence required by the insurer, it was only common in larger transactions over $50 million. Now we’re seeing that move down into deals as small as $10 million in enterprise value.

In some cases, buyers are using reps and warranties insurance as a tool to win the deal. If competition is strong (and these days it often is), buyers may offer to pay for reps and warranties insurance. As sellers evaluate multiple offers, they might consider the opportunity to bypass escrow as a factor that tips them in a buyer’s favor.

338(h)(10). In these transactions, the deal is treated as a stock sale from a legal standpoint but as an asset sale from a tax standpoint. From a legal standpoint, this structure can eliminate the need to comply with time consuming and sometimes challenging customer contract “change in control provisions.” For the buyer, that means they can get a step-up in basis and re-depreciate the assets they just acquired.

F reorganization. An F-reorg is a tax efficient method to allow the seller to rollover equity into the new business (i.e. retain a small portion of the business ownership) without paying taxes on the rollover amount.

Without using an F-reorg, for example, the seller might sell 100% of the company and get taxed on that full amount before reinvesting some of their proceeds in the buyer’s new entity.

Deal makers predict an increase in these and other creative deal structures in the year ahead. The pandemic is one factor behind that. Businesses saw their operations disrupted, and that has created some business opportunities and some risks. Alternative deal structures are one way for buyers to mitigate valuation gaps, reduce seller’s taxes, and create win-win agreements between buyers and sellers.

Deal competition and private equity activity are also driving creative structures. According to a Mergermarket survey, private equity respondents indicated they were more likely to consider creative deal structures than corporate dealmakers (75% to 37%).

That may be because private equity firms simply have more experience with these structures. Or it could be that they have a stronger imperative to win deals, and creative structures provide more flexibility to do that. Regardless of the reason, by utilizing an experienced M&A advisor sellers have an opportunity to embrace these more complex deal terms leading to increased enhanced upside.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Market Pulse Survey – Quarter 3, 2021

/in , /by Al Statz

Presented by IBBA & M&A Source

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

 

M&A Advisor Tip: Value = Risk vs. Reward

/in , , /by Al Statz

Buyers value your business based on risk (real or perceived) and future cash flow. Consider potential business risks. What could prevent your company from realizing your forecasted earnings? Think talent, customers, suppliers, competition, cash flow.

Strategize ways to reduce risk in each area, e.g. cross training, outsourcing, succession planning, customer diversification, backup suppliers, etc. The more you do to take away potential pain points, the more attractive your business will be.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.