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Glossary of Business Sale, Merger & Acquisition Terms

As with most industries, the M&A industry has its own terminology, which can be confusing to the occasional transaction participant. Here we present many of these terms so that you can have a better understanding and comfort level when we discuss the potential sale of your company. Many of these terms are accounting, finance or legal in nature.

Accrual Method of Accounting:  A method of accounting wherein income and expenses are recognized on the financial statements when the business first acquires the right to receive the income (even though payment may not yet be received) or the obligation to pay the expense (even though payment may not yet be remitted). Most C Corporations are required to use the accrual method of accounting. Investors and lenders will generally want to see accrual statements.

Add-Backs:  Adjustments to the normalized income statement that are made in order to give a more accurate picture of a company’s earnings, which generally include (a) non-recurring expenses, such as the cost of moving the plant, and (b) owner perquisites such as non-business travel and entertainment. Add-backs are some of the adjustments made to arrive at normalized cash flow, EBIT, EBITDA and SDE.  All add-backs should be verifiable, as they will eventually be subject to scrutiny by buyers and their advisors, and lenders.

Allocation of Purchase Price: In an asset sale, the purchase price must be allocated to tangible and intangible assets and goodwill. The buyer and seller agree on and report the same purchase price allocation to tax authorities (IRS form 8594). Different price allocations will have different tax implications for the buyer and seller, and their interests are not always aligned. You must obtain advice from your tax advisor.

Amortization:  The periodic write-off of the cost of an intangible asset over its estimated useful life. The amortization concept is equivalent to depreciation of tangible assets.

Angel Investor:  A high-risk investor who invests in promising early-stage companies. Angels often have valuable business experience and can also serve as advisors and/or board members to the company.

Appraisal:  See Valuation.

Asset Approach to Valuation: A general way of determining a value indication of a business by using one or more methods based on the value of the assets of that business net of liabilities.

Asset-Based Lenders:  Commercial lenders who are willing to take on more risk than commercial banks; lending against fixed assets, accounts receivable and inventory and being subordinate to commercial banks.

Asset Sale:   A sale/purchase of certain (usually most or all) business assets that are both tangible and intangible in nature, and often some liabilities, leaving the seller with the corporate entity and possibly some remaining assets and liabilities. This type of sale significantly reduces the possible liability of a business purchaser, usually has tax benefits to the buyer, and may increase the time it takes to close a deal.  Asset sales account for a majority of business sale/purchase transactions.

Auction Process:  When a business intermediary orchestrates the selling process by encouraging buyers to bid until the best offer is received.

Balance Sheet:  A statement of the financial status of a business on a certain date. Also called the statement of financial condition, it summarizes a company’s assets, liabilities, and owners’ equity.

Blue-Sky:  That portion of a claimed value or requested price that cannot be supported or shown to exist through the application of recognized business valuation methods. (Blue sky is not the same as goodwill)

Book Value:  That figure derived by deducting balance sheet liabilities from assets.

Bridge Loan:  A temporary loan to cover the financing shortfall of the acquisition until permanent funding is available.

Bulk Sale: A law that regulates the transfer of business assets to prevent sellers from receiving sale proceeds before creditors are paid. If a business owner wants to conduct a bulk sale of business assets — that is, sell an unusually large amount of inventory, merchandise or equipment — the business owner must publish a notice of bulk sale and give written notice to creditors. Then, the owner must set up an account to hold the funds from the sale for a brief period during which creditors may make claims against the money. The prohibition against bulk sales is spelled out in the Uniform Commercial Code — and laws modeled on the UCC have been generally adopted throughout the country. The California bulk sale law is contained in division 6 of the Commercial Code and is significantly different from the UCC version.

C Corporation:  A corporation whose profits are taxed separate from its owners under subchapter C of the Internal Revenue Code (versus an S corporation, whose profits are passed through to shareholders and taxed on their personal returns under subchapter S of the Internal Revenue Code).

CapEx:  An abbreviation of Capital Expenditure.

Capital Expenditure:  An amount spent (often during a particular period, say annually) to acquire or improve long-term assets such as property, plant and equipment.

Cash Basis Accounting:  A method of accounting wherein income and expenses are recognized (on the financial statements) when the business receives the income or pays an expense.

Capitalize:  To classify a cost as a long-term investment, rather than expensing it to current operations. A capitalized cost does not appear on the income statement, but instead appears as a credit on the long-term assets account and a debit on the cash account of the balance sheet. However, the depreciation expense related to the capitalized cost will appear as an expense on the income statement. Since the long-term assets account is larger due to the effect of capitalization, the depreciation costs are also proportionately larger. Thus, the timing of expense recognition is changed, but eventually all capitalized expenses do get recognized on the income statement.

Capitalization:  A conversion of a single period stream of benefits into value.

Capitalization Rate:  A divisor (usually expressed as a percentage) used to convert earnings or cash flows into value as part of the capitalization process.

Cash Flow: Cash that is generated over a period of time by a business enterprise. There are many types of cash flow. When the term is used, it should be supplemented by a qualifier (e.g. “discretionary” or “operating”) and a more specific definition. The definition should state, for example, whether the cash flow calculated is that available to debt and equity holders (pre-debt), or just equity holders (after debt service). See Net Cash Flow.

Certified Business Intermediary (CBI):  A professional designation granted by the International Business Brokers Association (IBBA). CBI’s must complete extensive training, maintain high ethical standards, stay current on industry trends and information, and demonstrate success as business intermediaries. This certification is highly regarded in the M&A community and by transaction professionals.

Closely Held Corporation:  A corporation whose stock is owned by one or a few shareholders and is operated by this person or close knit group.

Collateral:  Property pledged by a borrower to guarantee payment of a debt. Bank loans are usually collateralized or secured by the company’s accounts receivable, inventory and equipment, and frequently by some secondary source of repayment.

Confidential Business Review (CBR):   A document containing a detailed analysis and narrative description of a business and its future prospects. Often called a “Deal Book” or “Offering Memorandum”.

Confidentiality Agreement:  A document signed by potential buyers that requires them to keep the information contained in the CBR and M&A discussions completely confidential. This document is signed BEFORE the CBR is provided.

Contingent Liability:  (a) A possible obligation from past events that will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the business; or (b) A present obligation from past events but is not recognized because (i) it is not probable that an outflow of resources will be required to settle the obligation; or (ii) the obligation cannot be measured reliably. Some examples: in corporate reports are pending lawsuits, judgments under appeal, disputed claims, and the like, representing potential financial liability.

Covenant:  A binding agreement between buyer and seller that restricts each party from taking certain actions, particularly during the Letter of Intent period and closing

Depreciation:  The allocation of the cost of a tangible asset to expenses over the asset’s estimated useful life.

Discount Rate: A rate of return (cost of capital) used to convert a monetary sum, payable or receivable in the future, into present value.

Discounted Cash Flow (DCF):  A valuation model that assigns a value, in today’s dollars, to the discrete cash inflows and outflows that are reasonably expected to occur during future periods. DCF considers risk and the time value of money.

Due Diligence:  The investigation of the business (and buyer) in an attempt to verify information given or uncover previously unknown information.

Earn-Out:  A contract provision stating that the seller is to be paid some amount of consideration based on the business achieving certain financial metrics (usually sales or profit-related) in the future. Two situations in which earn outs are often negotiated are (a) a high percentage of business is with a few customers, and (b) valuation is based on significant sales and earnings growth, for example due to a new product introduction.

EBIT:  Acronym for Earnings Before Interest and Taxes. The earnings remaining after cost of goods sold, and all selling, general, and administrative expenses (SG&A), but before interest and taxes. EBIT is normally calculated and presented on a normalized basis, where one carefully identifies and adjusts for non-operating and nonrecurring income and expense. See also, Seller Discretionary Earnings. Add-Backs and EBITDA.

EBITDA:  Acronym for Earnings Before Interest, Taxes, Depreciation and Amortization.  EBITDA is a very common M&A term, but should always be just a starting point for discussion regarding financial performance. EBIT and cash flow are more realistic metrics than EBITDA because they account for (historical or projected) capital expenditures.

Escrow Holder:  A neutral third-party that prepares routine financial, compliance and legal documents related to the transfer of a business and holds funds until the parties fulfill specified conditions.

Executive Summary:  A 1-page profile of a business that is used to solicit buyer interest. It is usually a “blind” synopsis of the CBR, with all identifying information removed. This is also called a “teaser”.

FIFO:  Acronym for the First In, First Out inventory valuation method. The first inventory units purchased are considered to be the first sold. Therefore the cost of the inventory would be based on the most recent units purchased. The end result of this method (in an inflationary cost environment) is that the ending inventory value is higher, and therefore cost of goods sold is lower, which in turn makes gross profit and net profit greater. The opposite would be true if purchase costs were declining over time. See LIFO.

Fair Market Value:  The amount that a hypothetical willing buyer would pay a willing seller acting at arm’s length in an open and unrestricted market, when neither is under any compulsion to buy or sell, and when both have reasonable knowledge of the relevant facts.

Financial Buyer:  A buyer that values a business based on the expected future economic performance of that business if operated on a standalone basis (without additional synergistic benefits). Financial buyers are typically willing to pay fair market value. Individual owner/operators, management employees and most private equity buyers are examples of financial buyers.

Floor Price:  The lowest preconceived price a seller will or should accept.

Form 4506:  A form often required by an acquisition financing lender to obtain copies of federal tax returns (of the seller and buyer) from the IRS for verification purposes.

Free Cash Flow:  Free cash flow is usually calculated as net operating income plus depreciation and amortization (non-cash charges), less capital expenditures, plus/minus changes in net working capital. Free cash flow, in essence, is the amount of cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is what allows a company to pay dividends, reduce debt and pursue opportunities that enhance shareholder value, such as develop new products or make acquisitions.

GAAP:  Acronym for Generally Accepted Accounting Principles. GAAP includes the standards, conventions, and rules accountants follow in recording financial transactions and preparing financial statements. GAAP comes from the Financial Accounting Standards Board (FASB), a non-profit organization created by the accounting profession to develop and maintain standards.  GAAP is slowly being phased out in favor of the International Financial Reporting Standards (IFRS).

Going Concern Value:  The value of a business enterprise that is expected to continue operating in the future.  The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, a customer base and suppliers, and the necessary products, systems and procedures in place.

Goodwill:  Generally means the difference between the purchase price and the value of the assets of an acquired business.

Holdback Provision:  As written into a purchase agreement, this provides for an amount to be held in escrow for a period of time after closing, often to pay any liabilities that the seller may not have disclosed, or to provide incentive for a seller to complete a promised act after the closing and change-of-possession.

Income Approach:  A way of determining a value indication of a business using one or more methods that convert anticipated economic benefits into a present single amount.

Installment Method:  A method of accounting under which gains are recognized as payments are received.

Indemnification:  Usually the exemption for the buyer from incurred penalties or liabilities after the closing from incomplete representations and warranties of the seller.

Intangible Assets:  Non-physical assets (such as franchises, trademarks, patents, copyrights, goodwill, mineral rights, securities and contracts), as distinguished from physical assets, that grant rights, privileges, and have economic benefits for the owner.

Investment Banker:  A business intermediary for Middle-Market companies who sometimes provides additional services such as bridge loans or underwritings. For Main Street and lower Middle Market transactions this person is usually known as a business intermediary, M&A advisor, or business broker.

Lease Assignment:  When selling a business that occupies leased premises, a buyer typically “assumes” the lease.  Commercial leases are personal property and belong to the business or its owner, who is the tenant. A tenant (seller) may assign his “right, title and interest” in that lease to an “assignee” (buyer).  The act of assignment does not relieve the original tenant, or “assignor” from his obligations under the lease unless the landlord specifically releases him.  It is unusual for a landlord to release an assignor, but the tradeoff is that it makes it easier for a landlord to consent to an assignment. Typical lease language states that the lease is assignable with landlord’s consent, sometimes “not to be unreasonably withheld”.  Some leases can not be assigned.  Some require the tenant to pay the landlord a fee to consider an assignment of the lease.

Lehman Formula:  An industry standard commission rate, which is a sliding scale percent on successive million dollar purchase price brackets.

Letter of Intent:  A written offer to purchase a business, usually non-binding, which if accepted by the seller leads to due diligence and the drafting of a definitive Purchase and Sale Agreement.

Leveraged Buyout:  A transaction in which a company’s capital stock or its assets are purchased with borrowed money, causing the company’s new capital structure to be primarily debt. Management Buyouts are generally leveraged buyouts.

Lien:  A charge or hold on assets usually by a creditor until the indebtedness is satisfied.

LIFO:  Acronym for the Last In, First Out inventory valuation method. The last inventory units purchased are considered to be the first sold. Therefore the cost of the inventory would be based on the earliest purchased cost. The end result of this inventory method (in an inflationary cost environment) is that the ending inventory value is lower, and therefore cost of goods sold is higher, which in turn makes gross profit and net profit lower. The opposite would be true if purchase costs were declining over time. See FIFO.

Main Street Businesses:  Generally defines firms with revenues below $5 million. See Middle Market. Our firm generally sells Main Street and lower Middle Market companies, with revenues from $1 million to about $30 million.

Market Approach:  A way of determining a value indication of a business using one or more methods that compare relevant characteristics of the subject firm to similar businesses that have sold.

Market Cap:  Abbreviation of “market capitalization” that applies to a public company’s worth in the stock market by multiplying the total number of shares outstanding by the current stock price.

Mezzanine Capital:  Subordinated to senior debt, it is like a second mortgage, with higher interest rates and often with common stock purchase warrants.

Net Cash Flow: A form of cash flow. When the term is used, it should be supplemented by a qualifier (for example, “Equity” or “Invested Capital”) and a definition of exactly what it means in the given context.

Net Cash Flow to Equity: Those cash flows available to pay out to equity holders (in the form of dividends) after funding operations of the business enterprise, making necessary capital investments, and reflecting increases or decreases in debt financing.

Net Cash Flow to Invested Capital:  Those cash flows available to pay out to equity holders (in the form of dividends) and debt investors (in the form of principal and interest) after funding operations of the business enterprise and making necessary capital investments.

Net Worth:  See book value.  Net worth in M&A is often based on the value of assets and liabilities at their true (market) value, not necessarily as expressed on the balance sheet, and may include the value of intangibles and goodwill not shown on the balance sheet.

Niche:  Uniqueness in the marketplace in which the company has a product or service, which has a competitive advantage because there are few competitors.

Non-Operating Assets: Assets not necessary to ongoing operations of the business enterprise.

Normalization:  Business valuation usually requires adjusting or “normalizing” financial statements to remove the influence of decisions made by the owners to minimize taxes; and to recast or restate them in such a way as to depict the economic performance and condition of the company from the perspective of an investor who would consider purchasing the company. Normalizing usually involves marking assets and liabilities to market and adjusting financial statements for non-operating assets/liabilities; discretionary, related-party, non-market, nonrecurring and non-operating income and expenses; and accounting irregularities, to depict true business economics and facilitate buyer analysis. Business intermediaries and appraisers normalize income statements using standard methodologies.

Normalized Earnings:  Company earnings after the normalization process described above. Normalized earnings are commonly stated at the SDE, EBITDA and EBIT levels.

Off Balance Sheet Liabilities:  Unrecorded obligations, such as repurchase agreements, pending lawsuits, and unfunded pensions.

PEG:  Acronym for Private Equity Group.

Perquisites (Perks):  Owner benefits incidental to a regular salary or dividends, such as personal use of a company automobile, country club membership, and personal entertainment.

Preferred Lender: A lending institution that has met the Small Business Administration’s necessary experience and quality requirements is given “preferred” status, and is allowed to make lending decisions on behalf of the SBA. Working with a Preferred lender can save 30 days in closing a deal.

Price Multiple:  The inverse of a capitalization rate.

Recasting:  See normalization.

Representations and Warranties:  Statements made in a contract by either party that refer to past or present facts or matters that are important to the contract. The contract may then go on to provide that if a party is wrong about a representation or warranty, that the other party has certain remedies available to him or her. Each party must stand behind its representations or pay the price for breaching them.

ROI / ROE:  Acronyms for Return on Investment and Return on Equity. Must be greater than the cost of capital in order to create shareholder value.

S Corporation:  Common business slang to distinguish a corporation whose profits are passed through to shareholders (without a corporate level tax imposed) and taxed on their personal returns under subchapter S of the Internal Revenue Code. An S corporation has restrictions with respect to stock ownership, such as it must be owned by thirty-five or fewer individuals.

SBA (Small Business Administration): A federal agency, created in 1953, that grants or guarantees long-term loans to small businesses.

SBA Loan:  Loans made to buyers of small businesses by banks or other qualified financial institutions and guaranteed by the Small Business Administration of the U.S. Government.  These loans usually have terms of 7 to 10 years, variable interest rates, and monthly payments starting 1 month after closing.  SBA Lenders require sufficient earnings from the business to cover a buyer’s normal living expenses, principal and interest payment on the loan and future capital expenditures, plus a comfortable (for the lender) margin of safety. The strength and accuracy of the business tax returns will be the primary basis for the lending decision. The buyer will need to have sufficient down payment, strong credit and relevant management experience.

SDE:  Acronym for Seller’s Discretionary Earnings.

Scalability:  A scalable company can maintain or improve profit margins while sales volume increases.  A firm (or plant) is said to achieve “scale” when it reaches the smallest output that it can produce such that its long run average costs are minimized. A business model that scales well will be able to increase efficiency and gross margin performance and/or operating profit as sales volume increases.

Seller Discretionary Earnings (SDE):  EBITDA + a replacement general manager’s compensation. This is the most common level of earnings presented for owner-operated Main Street businesses, by business intermediaries, appraisers and sellers.  Comparable sale data often includes SDE and Price/SDE multiples.

Seller Financing:  The seller extends his or her own notes to the buyer in lieu of all cash at closing or other debt financing, such as bank loans.

Senior Debt:  The most secure bank debt and the first in line with primary collateral.  Often senior debt is a short-term revolving loan that is paid down completely within a year.

Stepped-up Basis:  In most asset transactions, the basis of the assets of the target corporation is stepped up in value to the purchaser’s cost. For the buyer this shelters future income from taxes.

Statement of Cash Flows:   A financial statement showing a firm’s cash receipts and cash payments over a specified period.

Stock Sale:  A form of acquisition whereby all or a portion of the stock in a corporation is sold to the purchaser. There are advantages and disadvantages to the parties in a stock sale compared to an asset sale, which vary with the nature of the business and the specific circumstances of the parties.

Strategic Buyer:  A strategic (or synergistic) buyer is one that is willing to pay a premium over the fair market value of a business based on the added economic benefits attributable to synergies between the target business and the acquiring business.

Subordinated Debt:  Refers to non-bank debt, which is less secure than bank (senior) debt.  To attract lenders, borrowers often give subordinated lenders rights to convert their debt to equity.

Synergy:  Interaction among two or more acquired parts of a corporation that creates a combined economic contribution greater than the sum of the individual parts.

Term Sheet:  A preliminary, non-binding agreement setting forth very basic terms under which an investment will be made. The term sheet usually precedes the Letter of Intent.

Tight Money:  When banks hold back on making loans, it restricts acquisitions.

UCC Filing: A security interest in most types of business personal property (promissory note, corporate stock certificate, equipment lease, etc.) is “perfected” by filing a UCC-1 financing statement with the Secretary of State office.

Valuation: The act or process of determining the value of a business, business ownership interest, security or intangible asset. A valuation report is often referred to as a valuation or appraisal.

Working Capital:  The excess value of all current assets over all current liabilities on the balance sheet; represents the liquid funds available to operate and grow a business in the short-term.

Obviously, this list is not comprehensive and contains only a small part of the M&A lexicon. Selling your business may be the most important financial transaction of your life, so learn as much as you can — you’ll only get one chance to get it right. If you would like to learn more about the process of selling your company, I invite you to attend one of our M&A workshops or call to request a confidential consultation.

Why 2012 May be the Year to Sell Your Business

Article Published January 3, 2012 — North Bay Business Journal

Historically, business transactions escalate when taxes are expected to change, as sellers and buyers try to capitalize on favorable rates. It is safe to assume that the U.S. will soon have to raise taxes on businesses and individuals, so retirement-age business owners looking to maximize value should look closely at selling in 2012. Since it typically takes a year to prepare, find a buyer, negotiate, work through due diligence and close a deal, now is the time to get started.  This article outlines a handful of the expected tax changes and how they will affect sellers.

Capital Gains Tax Rate Increase

Given our massive federal budget deficit, most experts believe that the Bush tax cuts will not be extended again at the end of 2012. The current maximum Federal long-term capital gains income tax rate is 15%. The top long-term capital gains tax rate is expected to revert to the pre Bush tax cuts rate of 20% on January 1, 2013.  The 20% rate was effective from 1997 to 2003, and some expect it to could go even higher.  Note that from 1987 to 1997 the maximum capital gains tax rate was 28%.

Ordinary Income Tax Rate Increase

The current top individual ordinary income tax rate is 35%.  This rate applies through 2012 due to the Bush tax cut extension. Again, expectations are that the Bush tax cuts will not be extended beyond 2012.  What will the new maximum tax rate be?  Consider our tax rate history:

PeriodTop Tax Rates
1944 to 196382% to 94%
1964 to 198269% to 77%
1982 to 198650%
1986 to 199231% to 38.5%
1993 to 200238.6% to 39.6%
2003 to 201235%

Special 15% Qualified Dividend Tax Rate may be Eliminated

The qualified dividend maximum tax rate remains at 15% through the end of 2012. Before the Bush tax cuts, dividends were taxed at ordinary income tax rates. C corporation business owners could be faced with a 100% or more increase in this tax if they don’t distribute dividends before the end of 2012.

Patient Protection Act

Starting in 2013, there is an additional 3.8% Medicare tax for individuals with adjusted gross income (AGI) above $200,000, joint filers with AGI above $250,000 and married taxpayers filing separate with AGI above $125,000.  This tax is generally levied on interest, dividends, annuities, royalties, rents and capital gains.

Also beginning in 2013, the Patient Protection Act imposes a 0.9% additional Medicare tax on earned income in excess of $200,000 for individuals, $250,000 for joint returns and $125,000 for married taxpayers filing separate.

Section 179 Deductions

Decreases in Section 179 deduction limits from $500,000 in 2011 to $25,000 in 2013 and the elimination of bonus depreciation in 2013 will result in higher taxes as well as lower business valuations from buyers. Businesses with recurring capital equipment needs will be especially hard hit.

Cumulative Effect

Business owners who are approaching retirement are encouraged to consult with their tax advisor immediately to understand what the cumulative tax effect will be if they exit in 2012, set against waiting another year or two. The savings could be substantial. Because tax practitioners are so inundated at tax time, these exit planning conversations often don’t happen. Be proactive here to maximize proceeds and avoid surprises.

Al Statz, CBA, CBI, is President of Exit Strategies Group, Inc., a business brokerage, merger, acquisition and valuation firm serving private businesses in Northern California. Al can be reached at 707-778-2040 or alstatz@exitstrategiesgroup.com. Dave Fisher also contributed to this article. Dave is a Bay Area CPA who focuses on business, personal, trust and estate taxes. Dave can be reached at 707-588-9700 or dave@dfishercpa.com.

The  North Bay Business Journal, a publication of the New York Times, is a weekly business newspaper that covers the North Bay area of San Francisco – from the Golden Gate bridge north, including Marin, Sonoma and Napa Counties.

Small Business Acquisition Financing: What Lenders Want

In ten years of selling private businesses, financial leverage has consistently been one of the key success factors in expanding the pool of buyers and closing deals. Fortunately for business owners, the SBA loan guaranty program is an excellent funding source for deals up to $5MM. And, lenders are lending now. A lender analyzes both the buyer (borrower) and the business being purchased.  Here are 10 things lenders look for when evaluating a loan request for a small business sale/acquisition:

1. Down Payment.  Lenders want a buyer to inject 15%-25% of the total project in cash, depending on several factors including whether real estate is included in the sale. Common down payment sources are retained earnings, savings, retirement plan funds and gifts from family members. Your cash injection cannot be borrowed.

2. Creditworthiness.  Lenders investigate a buyer’s credit at the outset of the approval process. A bankruptcy, foreclosure or judgment usually nullifies their chances, no matter how good other criteria look. Remove blemishes from your credit history before you apply.

3. Track Record.  Individual buyers must have experience in the type of business and/or industry they are buying into. Lenders look for management experience, and they prefer to see prior business ownership. Tailor your resume to highlight your management and applicable industry experience.

4. Cash Flow is King.  Business cash flows must service the loan and provide adequate income for the owners. Lenders analyze the historical tax returns of the business—allowing reasonable adjustments for owner perquisites and non-recurring costs. The quality of financial records comes into play here. Your business plan also comes into play. Synergistic benefits, increases in working capital and capital expenditure needs are considered in the cash flow calculation.

5. Collateral.  Buyers with real property to pledge as collateral may compensate for weaknesses in debt service coverage, business assets, experience, credit, or liquidity. Generally, if you have equity in real property, the SBA requires that it be used to secure your business acquisition loan.

6. Positive Trend.  Nothing scares lenders more than negative sales and earnings trends in a business or its industry. Conversely, a pronounced positive trend is a thing of beauty to a lender. They often look back several years to see how the business performed through past economic cycles.

7. Business Plan.  Buyers have to submit a basic business plan for the business they are acquiring. Lenders want to see an intimate understanding of the business and industry. In most cases a plan calling for modest growth and incremental change is your safest bet.

8. Continuity.  Commitments by existing managers, key personnel, suppliers and customers to continue with the new owner represents reduced risk to a lender.

9. Seller Training.  Lenders want to see a well thought-out management transition plan. The training/transition period can be anywhere from 1-12 months, depending on circumstances. Be sure you negotiate this point up front and clearly spell it out in the purchase agreement.

10. Seller Financing.  When a seller finances even 10-15% of a deal, subordinated to the bank note, it shows the lender that the seller is confident in the business under the buyer’s leadership. This deal point is commonly imposed by lenders.

Finally, for loans over $350,000, or whenever a buyer and seller have a close (non-arm’s length) relationship, SBA lenders require a fair market value appraisal from an accredited business appraiser to validate the borrower’s purchase price. The deal can’t exceed the appraised value. Sellers are advised to prepare months or years in advance, to increase their odds of cashing out when they are ready to exit. Ask yourself, does my business qualify?

•   •   •

Al Statz, CBA, CBI, is President of Exit Strategies Group, Inc., a business brokerage, merger, acquisition and valuation firm serving owners of closely-held businesses in Northern California. He can be reached at 707-778-2040 or alstatz@exitstrategiesgroup.com.

The North Bay Business Journal, a publication of the New York Times, is a weekly business newspaper which covers the North Bay area of San Francisco – from the Golden Gate bridge north, including Marin and the wine country of Sonoma and Napa counties.

October 27th “Maximize the Value of Your Business” Seminar Announced

Exit Strategies announces the next in its series of executive briefings for business owners. At this candid, fast-paced workshop, business owners will learn …

  1. Valuation basics & 20 ways to build enterprise value
  2. Preparing a successful exit strategy
  3. Market conditions and trends
  4. Tax advantages of selling in the next 15 months
  5. Steps in a successful M&A sale process
  6. Answers to common questions

When:    Thursday, October 27th, 5:00 to 7:30 pm

Where:   Petaluma, California

Cost:      Free of charge to private business owners

Presenters:   Al Statz, President, Exit Strategies Group, Inc., and David Fisher CPA

Registration Required:  Call 707-778-2040, or Email info@exitstrategiesgroup.com. Space is limited. We will confirm attendance.

This is essential information for private business owners who intend to sell in the next 3-5 years.  It is never too early to plan ahead to achieve the successful exit that you, your family and partners deserve, and avoid unnecessary surprises.

•    •    •

Exit Strategies’ executive briefings are free or nearly free workshops on essential topics for private business owners. These topics originate from years spent guiding clients through successful exits, mergers and acquisitions. The sessions are presented by our knowledgeable staff and subject matter experts within our professional network, in a private, small group setting. For confidentiality, we strictly limit attendance to one business owner per business type and pre-register all participants.

See You on the Other Side

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 …

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.

Famed Investor: References to EBITDA make us shudder …

… does management think the tooth fairy pays for capital expenditures?

Article Published December 6, 2010 — North Bay Business Journal

This title is a quote from Warren Buffett’s letter to shareholders in Berkshire Hathaway’s 2000 annual report. EBITDA (earnings before interest, taxes, depreciation and amortization) is a good financial metric to use in analyzing, comparing and valuing companies, but, as business owners and investors, we need to understand its limitations.

EBITDA is one of several measures of economic benefit to which a multiple can be applied to estimate value for a company. A multiple is the inverse of a capitalization or ‘cap’ rate. When used properly, multiples are applied to an investor’s forward looking cash flows and adjusted for risk.

EBITDA is a popular proxy for Cash Flow because we can easily calculate it from the P&L — no balance sheet required. However, EBITDA ignores capital investment, working capital changes, taxes, borrowing, debt repayment and financing costs, which all affect a company’s cash flow and ability to pay dividends to its owners. The focus of this article is the “D” in EBITDA, or Depreciation, which results from owning capital assets.

Depreciation Matters

Don’t let anyone tell you depreciation doesn’t matter because it is a non-cash item. I have yet to sell or appraise a company that owns fixed assets that never need replacement. Not only do capital assets deteriorate, they are also subject to functional obsolescence caused by technology advancements (faster, cheaper, better) and sometimes new environmental regulations.

Here’s how Warren Buffet put it in his 2002 letter to shareholders, “Trumpeting EBITDA is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?”

Let’s imagine we’re in the drilling business, looking to grow through acquisition, and there are two companies in equally desirable markets available to us. Both companies operate the same number and type of drill rigs. Both generate $5 million in sales and $1 million EBITDA annually. Same EBITDA, same value, right? It’s a trick question. Company A’s rigs are 4 years old on average, while B’s rigs average 13 years old. We estimate that B will need $300,000 more in annual capital outlays to maintain its fleet and revenues going forward. Even though EBITDA is the same, Company A will generate substantially higher cash flows for us, and is more valuable to us.

Now say there’s a Company C available. It also shows $1 million EBITDA and is equivalent to A and B in all other respects except that it sub-contracts drilling to several independent operators. It owns no rigs and has no capital expenditures or depreciation. (Since there are no assets to depreciate or replace, EBITDA is a better approximation of free cash flow.) From a cash flow perspective, C tops A and B.

In general, projected cash flow should be our metric for evaluating companies. Cash flow assumes adequate reinvestment in the business, as opposed to the unsustainable reinvestment shortfall represented by EBITDA.

EBITDA is a good starting point for sale, merger and acquisition discussions. Just don’t rely on it for making a major decision; unless you would buy a car knowing only the model and year, or propose marriage on the first date. There are more EBITDA hazards to avoid, but the depreciation trap is a key one. When one of Warren Buffet protégés comes calling, we’ll be ready.

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Al Statz is President of Exit Strategies Group, Inc., a business brokerage, mergers, acquisitions and valuation firm serving closely-held businesses in Northern California. He can be reached confidentially at 707-778-2040 or alstatz@exitstrategiesgroup.com.

The  North Bay Business Journal, a publication of the New York Times, is a weekly business newspaper which covers the North Bay area of San Francisco – from the Golden Gate bridge north, including Marin County and the wine country of Sonoma and Napa Counties.

Five Phases of the Business Sale Process

Article originally published on August 21, 2010 — North Bay Business Journal

Remember the story about the chicken and pig that walk past a diner advertising “bacon and eggs” for breakfast? The chicken enthusiastically endorses the menu. The pig replies, “For you it’s all in a day’s work. For me it’s total commitment!”

Most company owners already understand that selling a business on their terms requires commitment to a cohesive process. Others try and fail to sell, and learn the hard way that selling is more complex and fraught with pitfalls than they realized. A systematic business sale process improves your price, terms and probability of sale, and reduces your time, stress and financial risk. Here is a brief outline:

Phase 1. Evaluation & Planning

Commit to having the business objectively evaluated by a valuation expert. A reliable opinion requires significant due diligence, research and analysis of financials, assets, markets, relationships, contracts, systems, and more. The expert acts in concert with your legal and financial advisors to provide essential answers that allow you make the best decisions. This phase is critical to deciding the right time to sell — whether today or 1-5 years from now.

You’ll have answers regarding:
1. Most probable selling price
2. Likely deal structures
3. Target buyers
4. Marketability and potential obstacles
5. Strengths and weaknesses, value drivers and detractors
6. Financial gaps, wealth preservation and maximizing after-tax yield
7. Specific ways to build value, short and long term

Phase 2. Marketing Preparation

When the time is right to sell, commit to presenting your business to prospective buyers convincingly, in writing, with supportable facts. Since confused minds always say “no”, a thorough deal book allows buyers to grasp your business opportunity, affirm their interest and make strong offers. A “blind” summary will be extracted for initial contact with target buyers. While your M&A Advisor produces the book and develops a list of buyers with strong potential synergies, you’ll wrap up recommended business preparations that enhance value, marketability and transferability.

Phase 3. Confidential, Strategic Marketing

A direct marketing campaign is aimed at target buyers, using multiple communication methods. A net is cast deep and/or wide to produce buyers, based on for your business type and circumstances. Deal books are released to candidates that demonstrate financial ability and sign a confidentiality agreement. Your Advisor schedules site visits for a short list of finalists, where you get to know each other and ask in-depth questions.

Phase 4. Negotiations & Deal Structuring

Now comes the interesting part, and this is not a one-size-fits all process. Every transaction is unique. Your Advisor endeavors to obtain multiple offers, possibly through a controlled auction process, discusses their pros and cons with you and helps you select the lead horse. The Advisor guides you through negotiations, in concert with your tax and legal advisors. Experience is critical.

Phase 5. Due Diligence & Closing

With the deal points are settled, buyer and seller due diligence commence, while financing and third-party consents are arranged, and definitive agreements and closing documents are prepared. This is where phases 1 and 2 pay off. In today’s business environment, expect a financial audit, and expect the buyer’s experts to investigate government compliance, environmental issues, insurance claims, key relationships, contracts, equipment, intellectual property rights, and more. Your Advisor coordinates work flow and keeps the deal on track.
Selling a business is often a business owner’s largest financial transaction. To realize the reward you deserve for your years of hard work and sacrifice, be prepared, commit to a cohesive selling process and engage professionals that allow you to focus on business performance at a time when it matters most.

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Al Statz is President of Exit Strategies Group, Inc., a business brokerage and valuation firm based in Sonoma County. He can be reached at 707-781-8580 or alstatz@exitstrategiesgroup.com.

The North Bay Business Journal, a publication of the New York Times, is a weekly business newspaper which covers the North Bay area of San Francisco – from the Golden Gate bridge north, including Marin and the wine country of Sonoma and Napa counties.