Over the years, Hadley Capital has developed an age-based rule to help us screen potential deals: if the owner/operator of a small company is less than 45 years old or more than 70 years old, the seller is not sincerely interested in selling at a market valuation.

Owner-Operator:  this rule only applies to an owner who works at their company; it does not apply to absentee owners.

Age:  Younger owners (less than 45 yoa) are only interested in selling if they get a "huge" price for their company.  Otherwise, they prefer to continue running and owning their company.

Older owners (70+ yoa) are often so passionate about their business that they can't see themselves retiring in order to play more golf, spend more time with their grandchildren, etc. Their personal identity is so closely tied to their company that is difficult to separate the two.  

Market Valuation:  Both younger and older owners will sell if the price is way more than the business is worth – both on a market basis and what the owner thinks it's worth. Few buyers, including Hadley Capital, are in the business of over-paying for companies.

Like any rule, there are exceptions and we have seen a few over the years, generally related to severe health issues. The owner-operator is diagnosed with disease X and needs to get his ducks in a row. Of course, this is never an ideal time to sell a business.

If you are an owner-operator who is less than 45 years old or more than 70 we would still like to speak with you but please be prepared to convince us that you are a sincere seller.

SBD 

Hadley Capital's deal flow was up more than 50% in 2011 – a substantial improvement from a 15% increase in the first half of 2011. But, upon further review, the increase is not as impressive as it might seem. 2011 was a tale of bifurcated deal flow:

1) A consistent number of good deals – where we submitted an Indication of Interest or Letter of Intent. These deals received A LOT of attention and many sold at premium valuations.

2) A substantial increase in marginal deals – companies that generally fit our criteria but, after initial review, were not attractive investment opportunities.

Our deal database confirms this divergence, we reviewed more than twice the number of "immediate kill" deals while Indications of Interest and Letters of Intent were about the same as 2010.

I suspect 2012 will be much of the same. Deal flow will remain bifurcated and will increase over 2011: a stabilized economy will allow small businesses that were pulled off the market in 2008 – 2010 to reenter the market and more baby boomers will decide it's time to sell their small companies.

Hadley Capital is off to a good start in 2012 - we have two new small company acquisitions under Letter of Intent and three additional Letters of Intent outstanding.

PDW

I spent an hour on the phone today explaining to a small business owner why it is important to a buyer to receive a period of exclusivity when entering into a Letter of Intent with a seller.

This particular seller thought Hadley Capital should "set up escrow" – place a $50,000 deposit to show our serious intent to acquire his business. I explained that rather than a deposit, I would need a 90 day period of exclusivity in order to 1) confirm the seller's serious intent to close the transaction with Hadley Capital and 2) spend my limited resources (time and money) on working towards closing the transaction.

After Hadley Capital signs a letter of intent with a business owner, we will spend literally hundreds of hours of our time working to close the transaction. As a result, we don't enter into Letters of Intent unless we plan on closing the acquisition (assuming everything checks out in due diligence). And, since Hadley Capital acquires only two or three small companies each year, we can't afford to spend hundreds of hours on an acquisition only to have a seller decide he is going to sell the business to another buyer. Thus our need for exclusivity.

We also spend a substantial amount of money when working to close an acquisition (well in excess of this seller's proposed $50,000 deposit). Hadley Capital hires professional accounting due diligence teams to complete accounting due diligence, we pay for third-party background checks, we may fund independent market analysis or purchase market research, we retain attorneys to draft transaction purchase documents and debt financing documents. These expenses easily exceed $100,000 per acquisition. If an acquisition falls apart because a seller decides to sell the business to another buyer, my partners and I pay these fees out-of-pocket. Again, we need exclusivity.

Any serious small company buyer will require a period of exclusivity when signing a Letter of Intent. The costs associated with closing a transaction are simply too high not to receive exclusivity. If a seller has serious concerns about granting exclusivity to a particular buyer, the seller should conduct a little more due diligence on the buyer before entering into a Letter of Intent.

PDW

Hadley Capital has had a lot of success acquiring small businesses in recapitalization transactions. In a recapitalization, the selling owner receives substantial cash at closing and retains a minority equity position. This minority equity position provides the seller with an opportunity to participate in the future success of the business - the proverbial second bite of the apple.

When we acquired Kelatron back in 1999, the selling shareholders kept a portion of the company so that they could share in the continued success of the business. Last month we sold Kelatron and these shareholders received significant proceeds - more like another entire apple than just a second bite.

Hadley Capital has years of demonstrated success acquiring small businesses, improving them, and creating significant equity value upon exit.

If you are a small business owner who would like some liquidity so that all your eggs are not in one basket, and would also like to share in the continued success of your business, call us to talk about a recapitalization of your business. We didn't just fall off the apple truck yesterday.

SBD

EBITDA is a term that people use all the time but it can't be found on a financial statement. So what is it?

EBITDA = Earnings (net income) + Interest + Taxes + Depreciation + Amortization. Its a shorthand way to determine how much cash a company generates in comparison to other companies.

Interest - The amount of interest a company pays is dependent on how much debt it has. If a business has a lot of debt it will have a lot of interest expense. The identical business without any debt will have zero interest expense. Because the debt structure of a company is not related to how much cash its operations generate (only where that cash goes) interest is added back in EBITDA.

Taxes - Much like debt, the amount of income tax expense a company pays is highly dependent upon such things as corporate form (S Corp v. C Corp), accounting practices, the amount of debt it has, and other factors not related to its operating performance. This is why it too is added back in EBITDA.

Depreciation & Amortization - Depreciation and amortization are non-cash charges against earnings. Depreciation reflects the declining value of a tangible asset (like a piece of equipment) as it wears out or becomes obsolete. Amortization reflects the declining value of an intangible asset (like a patent) as its useful life declines. The accounting treatment of depreciation and amortization rarely reflect the real "costs" associated with acquiring/owning these assets and, since they are non-cash charges, adding back depreciation and amortization better reflects current-period cash flows.

There is one important caveat related to Depreciation and tangible assets: Buying tangible assets (like equipment) is a real cash costs (typically referred to as capital expenditures or 'capex'). Capex shows up on the balance sheet (in the form of additional fixed assets) instead of the income statement (as an expense). So we often refer to a company's 'EBITDA less capex' instead of just its EBITDA.

 PDW

P.S. Check out Warren Buffett's letters to shareholders for an entertaining sidebar on the topic of EBITDA - 2000 letter (page 16) and 2002 letter (page 20).