In our previous post we outlined how using debt in a transaction is often maligned by the media and gave one benefit of leverage. Here we finish off the topic with 3 additional benefits we see with using debt in a transaction.
Benefit #2: Less Equity
At Risk – So Equity Returns Can Be Higher
This is just simple math.
Let’s assume you buy a company for $2 and sell it for $3 in 5
years. (To make this problem simpler,
let’s also assume there are no distributions at all during the 5 year period
and that the debt is not amortized.) If
you financed this transaction with 100% equity, you generated a 50% return over
five years, or an annualized return of about 8.5%.
Now, let’s assume that when you buy the company for $2, you
borrow $1.50 from a bank and invest $0.50 in equity. When you sell the company in 5 years for $3,
you take $1.50 of the proceeds and pay back the bank, leaving $1.50 for the
equity owners. Since you invested $0.50
and the equity is now worth $1.50, this is a 200% return over 5 years, or an
annualized return of about 24.5%.
Obviously a 24.5% annual rate of return is significantly
better than an 8.5% annual rate of return.
Benefit #3: Debt
Reduces Bad Decisions by Management / Governor on Cash
While Hadley Capital provides active oversight of its
portfolio companies, it does not manage any of its companies on a day to day
basis. Day to day management of each
business is the responsibility of each company’s management team.
We implicitly trust our management teams and we believe we
have some of the best operators out there running our companies. However, we also believe that the obligation
to meet a defined principal amortization schedule is an excellent motivational
tool and helps management teams prioritize uses of capital. Projects with a potentially low rate of
return are not funded – only the best uses of capital receive funding.
Benefit #4: Portfolio
Company Lenders Are Our Partners – Deal Confirmation
Hadley Capital has established many excellent and
long-term relationships with debt financing partners. We view these organizations as our partners
in each transaction. If we are excited
about a deal, 9 times out of 10, so are our debt partners. However, occasionally our lending partners
balk at a transaction we find attractive.
We trust our financing partners and we know they have good judgment. If they don’t like a deal it makes us ask
what they see that we don’t. While we
can still complete the transaction without them (either by finding other
lenders or putting in more equity) we have learned over the years that
supportive lenders usually signal a good transaction.
Using debt (borrowing) to finance a leveraged buy-out is
often maligned by the media or politicians and frequently positioned as risky,
destructive, or even dangerous. Others
view the tax deductibility of interest payments to be unfair or bad for
society. (I never hear these same people
saying the taxes paid on interest income to be destructive or bad for society –
but that is a discussion for another post.)
Sayings like: “Neither
a borrower nor a lender be” ring true to many people. Great Americans like Benjamin Franklin and
Andrew Jackson have been quoted as saying “I’d rather go to bed supper-less
than rise in debt” and “when you get in debt you become a slave.”
Hadley Capital believes that debt, when properly used, is an
important and useful tool. If the
capital structure is poorly organized and if the business unexpectedly underperforms,
leverage can compound problems. But if
done right, there are benefits to leverage.
[Note: This post does
not look at the negatives of leverage or how to determine the proper capital
structure. This post simply looks at the
benefits of leverage assuming that it is the right capital structure and that
the business performs to expectations.]
As proponents of leverage, Hadley Capital sees four main
benefits of using term debt to finance a portion of a transaction’s purchase
price. I will talk about the first
benefit in this post and benefits #2 – #4 in a follow up post.
Benefit #1: Interest
Because interest expense is deductible for income tax
purposes, paying interest lowers your income tax liability. Sophisticated financiers can determine the
expected net present value of the income tax shield associated with the
While Hadley Capital’s portfolio company gets to deduct the
interest tax expense, it is important to note that this benefit does not really
accrue to the portfolio company – it generally accrues to the person who sold
the business to Hadley Capital. Why? Because the tax deductibility of interest
payments is universal and available to all buyers. Since all buyers have access to the value of
the interest tax shield, all buyers are willing to increase their purchase
price by a like amount. So the interest
tax shield benefits accrue to the business seller. Don’t believe me? There are many excellent academic studies
confirming this point. Here is an
abstract from an Oxford Business School study for your enjoyment. Following the abstract is a link to the full
savings associated with increased levels of debt are often thought to be an important
source of returns for private equity funds conducting leveraged buyouts
(LBOs). However, as leverage is available to all bidders, the vendors may
appropriate any benefits in the form of the takeover premium. For the 100 largest
U.S. public-to-private LBOs since 2003, we estimate the size of the additional
tax benefits available to private equity purchasers. We find a strong cross-sectional
relationship between tax savings and the size of takeover premia;
and on average the latter are around twice the size of the former. Consequently,
the tax savings from increasing financial leverage essentially accrue
to the previous shareholders rather than the private equity fund that conducts
the LBO. It is, therefore, unlikely that (ex ante predictable) tax savings
are an important source of returns for private equity funds. Furthermore,
policy proposals that aim to restrict leverage or the tax deductibility of
debt are likely to have their impact mainly on existing owners of
Since "list blogs" seem to be
the new fad in blogging, I thought I'd try to mold one of my existing blog
ideas into a list blog. Rather than "7 Ways to Increase
Productivity”, "5 Innovations that are Changing the World" or
"10 Steps to Financial Freedom", I thought I might address a topic
that’s been vexing small business owners over the last couple of years with “3
Ways to Make it Easier to Get a Small Business Loan”.
When we acquire a small business, we
raise debt financing to help cover the purchase price. In most
cases, multiple lenders will compete to lend us money. Small
business owners are often surprised at the ease at which we are able to raise
debt financing, particularly given the difficulty many small businesses have
had in securing debt financing in recent years.
There are three primary reasons why we
are successful at raising debt financing. Small business owners can
easily adopt our Preparation, Pricing and Partnership approach to increase
their chances of getting a small business loan.
- Prepare a detailed package of materials that the banker will require to get
approval for a loan. This package should include an overview of your
business, why you need the loan, how you plan to use it (and pay it back!),
support for loan collateral such as fixed asset appraisals, and
detailed financial history including income statement and balance sheets as
well as a financial forecast. Providing all of this information will
make it easier for your banking contact to do her job.
- Know the "market" for bank debt for small businesses - rates,
terms, etc. As this is a critical part of my job, this one comes
easy for me. It’s less easy for the average small business owner but not
impossible. Before asking for a loan, call
around and talk to bankers about current rates, standard terms and special
programs that may be available to small business (such as SBA
loans). In the current environment, we can typically raise senior
debt financing that represents 1x to 2x the EBITDA of the target company at an
interest rate of 4% - 7%.
– We treat the bank as a true partner. We invite them to regular board meetings
or update meetings and communicate frequently, timely and
honestly. Communicate good news and, more importantly, bad news.
And, when communicating bad news, we have a plan to address the issue and keep
the bank informed on our progress. We also invest hard dollars in
each of our acquisitions in order to provide the bank with additional comfort
that we have skin in the game. Most banks require small business
owners to personally guarantee a loan in order to ensure the small owner also
has a lot of skin in the game.
When evaluating a potential small company acquisition we are
most interested in the sustainable cash flow produced by the target business on
a historical basis (see our post on how we use EBITDA as a proxy for cash
However, in many small businesses and family
businesses there are a variety of expenses that are not related to day-to-day
operations but rather exist to benefit the owner(s). To determine sustainable
cash flow under our ownership we need to "add back" these expenses,
commonly referred to as "owners' benefits", to EBITDA because they
will not exist under our ownership.
We ask a simple question to determine if
expenses are legitimate add backs: will eliminating these expenses (or not
incurring them) have any impact on the performance of the business?
Many owners' benefits are easy to identify:
- Personal automobiles, boats, planes,
etc. won't have any impact on the future of the business if they are
- Same goes for personal travel, season
ticket packages and donations to favorite charities.
- Excess salaries and salaries paid to
family members not active in the business are also clearly legitimate add
- Above-market rents on real estate
(usually held by the owner in a separate entity) and whole life insurance
policies on key owners won't impact future results because they can be
There are a host of expenses that are often passed off as owners'
benefits that don't qualify:
- The salary of the owner manager - we
are going to need someone to run the business if the owner/manager wants leave
the business annual.
- Performance bonuses paid to management
- we are going to need these managers to be motivated going forward and if the
bonuses are important part of their compensation then they need to remain.
- Costs associated with improvements to
the business - an ERP implementation, costs associated with turning around an
underperforming business unit, costs to hire (or fire) key managers
While every situation is unique, the need to identify
legitimate owners' benefits is universal in small company acquisitions. Be
prepared to legitimize these expenses in a small company sale process. Don't
forget to ask the question: will eliminating these expense (or not incurring
them) have any impact on the performance of the business?
Inc.com blogger, David Lonsdale, recently
wrote a blog with the provocative title of “Why Your Deal is Taking Forever to
This is a topic worth some exploration and
discussion in small company M&A. Unfortunately,
Lonsdale’s core explanation is bunk – excess capital is causing private equity
buyers to be “scared to actually put it to work”.
A basic understanding of the incentives of
private equity fund managers suggests the exact opposite is more likely. That is, the excess capital (called
“overhang” in the industry) should increase the pace at which deals get
done. Here’s why: the
overhang must be invested within a proscribed time period or the private
equity fund manager loses the opportunity to invest the funds (and receive the
management fees for investing the money).
In my experience, there are more acute
reasons “Why Your Deal is Taking Forever to Close”:
1. The buyer is window shopping – Some
private equity buyers will issue a letter of intent after completing minimal
investigation of a target company (often with an attractive purchase price for
the seller). These
unscrupulous buyers will then renegotiate the terms of the transaction after
the company has been off the market for a while and the seller feels
“pregnant”. (See #4 below). Sellers
should be wary of buyers that don’t commit the time to understand the target
before issuing a letter of intent. Sellers can head off this type of buyer by
asking buyers about their track record of closing deals in a timely manner,
under the terms of their original letter of intent (and ask for references to
back it up!).
Hadley Capital takes a letter of intent
very seriously. We don’t
issue a letter of intent unless we have a high level of confidence that, after
due diligence, we will acquire the target company under the terms of our letter
of intent. It takes a lot of time and a lot of work to develop this
confidence. Check out our
overview of letters of intent.
2. The seller is not prepared: I can agree with Lonsdale on his
conclusion: “prepare well ahead of time and start the process early. Get your financial statements in order
and put together a good group of people on your selling team.” Well said. Nothing will slow down a deal more
quickly than an unprepared buyer. The due diligence involved in selling (and
buying) a small business is rigorous and developing a strong “selling team” –
attorney, accountant, intermediary – will help a seller prepare, set
expectations and move along a closing process. See one of our previous posts on
“Preparing to Raise Capital or Sell a Small Business”.
3. Target hits a bump: Buyers value
businesses based on earnings history and prospects. Any material changes in a
target’s earnings, or potential earnings, will often slow down a deal. For
example, losing a key customer or a key employee between signing a letter of
intent and closing will require both buyer and seller to sort through the
issue to determine the impact on the target’s prospects, earnings, and
4. Buyer or Seller reneges on a key deal
term: The last stage of
selling a small business is negotiating a definitive purchase agreement. The definitive purchase agreement is
drafted from the key deal terms contained in a letter of intent. Nothing can delay a deal longer than
an attempt by buyer or seller to “retrade” a key deal term. For example, a seller decides they no
longer will enter into a non-compete agreement or a buyer decides they need to
increase the size of the escrow or holdback by 100%. Besides the goodwill damage created by
such a move, the result can be weeks (or months!) of negotiation, not to
mention attorney fees.
Yesterday I got the email below
from a good friend who is considering selling his small business and is
concerned about the potential tax liability that will be created by
depreciation recapture at the time of sale.
Paul - Hope all is well. Have you
ever dealt with depreciation recapture issues during a transaction? For
example, does a seller get worried about the potential tax consequences of a
sale if they've depreciated assets in their business for years?
Here was my response:
Yes. We see it both in depreciation and
Depreciation recapture happens because
a seller has used accelerated depreciation (particularly section 179
deductions) in order to reduce income taxes. However, the recapture is only a
make-whole for the IRS. That is, the seller is not harmed by the recapture
because it simply brings the tax bill back to what the seller would have paid
had they not taken accelerated depreciation.
Same happens with inventory when a
seller has aggressively marked down inventory in order to depress earnings and
save on taxes. When a buyer puts the inventory on its balance sheet at fair
market value, the seller faces recapture. However, just like depreciation, the
taxes due by the seller are simply a catch-up or make-whole for the IRS. The
seller is no worse off than if they had correctly accounted for the inventory
in the first place.
So, that's a long way of saying that we
don't make special considerations for sellers in these scenarios. We try to spend
some time educating sellers on why the recaptures is not a "loss" to
them in the transaction.
you are considering selling your business and have questions about depreciation
recapture, please contact us. We have experienced this
situation many times and can walk you through the financial impacts of
Brent Earles, an advisor for small company M&A at Allegiance Capital recently wrote an article in President & CEO Magazine about selling a small company to a private equity firm. He encourages small company owners to evaluate a few key factors when evaluating a private equity buyer:
1. Genuine chemistry and shared vision of growth - Is there "chemistry between buyer and seller"? At Hadley Capital we have another test: would you want to have a beer/dinner with the seller? This is obviously a two way street. It is even more critical when the seller retains equity.
2. Clear and effective funding of the transaction - Earles summarizes, "when the owners makes more of a commitment to funding the deal (i.e. seller financing) than the buyer" then maybe the alleged buyer is not the best buyer. Couldn't agree more on this point, Hadley Capital is a committed capital fund with the money required to get transactions done quickly.
3. Diligent cadence and a commitment to the process - Earles: "deals that drag...often turn into relationships that...end badly" and "a good private equity buyer will get the deal done within a well-cadenced timeline." Couldn't agree more. Hadley Capital is slow to enter into LOIs. We take an LOI very seriously and we only sign LOIs when we plan to commit a lot of our firm's limited resources to closing the deal within 90 days.
4. Fundamental grasp of the company's industry and business model - Earles asks, "when a PE firm starts asking basic questions about your industry", maybe its time to be wary. Hadley Capital is not an expert in any of the industries that our companies operate in but our management teams are often industry leaders. We rely on talented management teams to run our companies but we don't spend a lot of time on any acquisition unless we feel it has good long term potential, as determined by our own research and due diligence.
The only thing I would add to Earle's list is that sellers should complete due diligence on the private equity buyer. Any competent buyer will turn your business inside out during due diligence. Why not do a little of your own due diligence on the buyer? I am amazed at how few sellers do legitimate diligence on buyers. Ask to talk to other business owners that have sold businesses to the private equity firm, ask to talk to Presidents of their companies. Ask these references if the private equity firm is trust worthy, do they do what they say, how do they treat people, have they helped grow your company, etc. It's common sense but rarely executed.
Maybe business owners are blinded by LOIs with big prices and forget that if it's too good to be true, it probably is. Get good advisors, heed the advice of Earles (his firm has represented many quality companies that Hadley Capital has reviewed over the past 10 years), and do your own due diligence on private equity buyers!
We recently got an email from a business broker asking us what type of finders fee structure we typically use. Our standard finder's fee structure is based on the Lehman structure. We outlined the Lehman structure in a previous post. Since that post has gotten a nice response from the business broker community we thought it might be helpful to walk through a detailed example of how the Lehman structure works. For this example let's assume we have a finder's fee agreement with a lehman structure with a business broker, and we end up buying a business that they introduced to us for $10 million. This is is how the agreement would pay out:
$1 million x 5% = $50,000
$1 million x 4% = $40,000
$1 million x 3% = $30,000
$1 million x 2% = $20,000
$6 million x 1% = $60,000
The total fee for this transaction would be $200,000 (or 2% of the sale price) and it would be payable at closing.This fee structure was created in the early 1970's by Lehman Brothers and it is a very common fee structure for small business acquisitions. We have used this structure with many of our existing portfolio companies. If you are a business broker and you have a business that meets our criteria, please contact us.
Small business owners are often apprehensive about the changes that may occur when their business is acquired by a private equity firm. When Hadley Capital acquires a company we do not look to make immediate changes to the business. However, financial reporting is something that does change after the deal closes. This typically means two changes for a business: 1) monthly reporting is completed in a more timely manner and 2) additional financial reporting is required.
Timely Monthly Reporting.
Hadley Capital receives monthly financials (income statement and balance sheet) from our portfolio companies within 30 days after month end. Most small businesses are not used to producing monthly financials this quickly. While this can be adjustment our portfolio companies eventually see the benefits of timely reporting. It is much easier to manage a business when you have timely data.
Additional Financial Reporting.
Borrowing Base Certificate. All of our portfolio companies have a revolving line of credit to manage working capital. A line of credit is supported by a borrowing base certificate. A borrowing base lists a company’s eligible accounts receivable and inventory and dictates how much the company can borrow. Many small businesses are not accustomed to providing monthly accounts receivable aging reports and monthly inventory reports. However, the benefits of access to additional capital (via a line of credit) are greater than the administrative burden of creating these reports.
Financial Covenant Calculations. Banks and mezzanine lenders use financial covenants to monitor the performance of a borrower. These lenders receive quarterly financial covenants calculations from the borrower. Financial Covenants give the lenders a heads up if the financial standing of the borrower has changed over a given period of time. For example, one common financial covenant is Total Leverage. The Total Leverage covenant measures the Total Debt (senior debt + mezzanine debt) in relation to the trailing twelve months (TTM) of EBITDA. So if the Total Leverage covenant is Total Debt must be less than 4.0x TTM EBITDA, the borrower has to perform this calculation each quarter and send the results to the lender in a covenant compliance certificate. If the Total Leverage is less than 4.0x then the borrower is in compliance with the covenant. However, if Total Leverage goes above 4.0x, the borrower is not in compliance and the lender will want to sit down with borrower and understand why things have changed. Covenant calculations are not difficult, but most small businesses are not used to completing them so it can take some time getting used to.
Individually none of these financial reporting requirements are a big deal, but collectively they can seem like a lot to a small business. However, we have been through the process many times and we work with our portfolio companies to make it a smooth transition. The lenders that work with our portfolio companies typically require our companies to submit a monthly borrowing base certificate and quarterly financial covenant certificates.
My last post on acquisition financing covered senior debt. This post will cover Mezzanine debt. Specifically, I would like to talk about how mezzanine debt is structured and what the implications are for small businesses that use it.
The word mezzanine is defined as the "partial story between two main stories of a building". In this case the two main "finance stories" of a company are senior debt and equity. Mezzanine debt then is the middle level or "mezzanine" between senior debt and equity. From a borrower's perspective, mezzanine finance is more expensive than senior debt and less expensive than equity. Mezzanine debt is more expensive than senior debt because 1) it is subordinate to senior debt (meaning in a liquidation the senior debt lender will be paid in full before the mezzanine lenders sees a dollar) and 2) it typically does not require any principal payment until the end of the term loan. This structure obviously creates more risk for the mezzanine lenders and as a result they charge higher interest rates.
Mezzanine loans are typically priced anywhere between 15% and 20%. There are three main components off mezzanine debt: 1) current interest 2) PIK Interest and 3) Warrants. As mentioned, Mezzanine loans are typically interest only with the principal due at the end of a five or seven year term. Current interest payments are typically due monthly or quarterly. For example a $3 million 15% current pay interest mezzanine loan with a 5 year term would look something like this:
Current Cash Interest
In some cases mezzanine lenders will PIK (Payment-in-Kind) a portion of the interest payment and add it to the principal payment of the loan. In this case, there will be two buckets of interest: current cash interest and PIK interest. Here is what it would look like if a mezzanine lender offered a $3 million with 14% current cash interest and 2% PIK interest:
Current Cash Interest
Mezzanine debt can also frequently include warrants, which are very similar to equity options. Warrants give lenders equity upside when the borrower performs well. Warrants typically represent 1% to 5% of the fully diluted ownership of the company.
Due to the high interest rates associated with mezzanine debt, we work with management to pay it off sooner rather than later. If a company is performing well and has plenty of cash, we will some cash to pay down the mezzanine debt. We typically use 1x - 1.5X EBITDA (or cash flow) of mezzanine debt in an acquisition. So if we buy a company for 5x EBITDA, a typical capital structure might be 2x senior debt, 1x mezzanine debt and 2x equity. We feel 3x total leverage (2x senior + 1x mezzanine) is an appropriate amount of debt for a small company.
We often talk with small business owners who are struggling with the decision of selling their business. It is a very difficult and emotional decision to make and as a result business owners spend a lot of time thinking it through. We see people who sell for all different kinds of reasons, but certain patterns have developed over the years. Here are a few reasons that we have seen:
This is never a good one to see, but it is fairly common. As people get older, health problems tend to pop up. Health problems usually result in an exit when a business is really dependent on the owner for its success.
As business owners get older, the passion for the day to day management often fades. This may mean they are ready for retirement or they are just burnt out from leading the business for 20+ years.
Some serial type entrepreneurs will want to move on to another venture. Once the business is built and is stable, we have seen business owners sell in order to build new businesses or start new projects.
Holding it Back
The skills you need to start a business and get it to $10 million in sales are not necessarily the same skills you need to get it to $20 million in sales. Some owners realize they don't have the necessary skills to get the company to the next level. They feel like they are holding the business back and look to sell.
No Transition Plan
Mom was working under the assumption that her son would want to run the business some day. When mom finally asks her son, she realizes he wants to be a baker and has no interest in running the business.
Spouse Says So
Here the spouse has usually seen their husband or wife obsessed with the business for 20+ years. The business owner promised that one day they would quit and spend more time with the family. That day has come.
Need to Diversify
Business owners often put all their money back into the business. When it comes time for retirement, any financial planner will tell you it is never good to have all your net worth tied up in one asset.
In this example there are usually two owners with significant ownership in a business and one is ready to retire. When the owner who is retiring wants to sell his shares that means the business needs to be valued. After the business is valued the business is more likely to be sold.
These are just some of the reasons we have seen over the years. Sometimes it can be a combination of the above reasons. When considering whether to sell a business, a business owner should do what is best for them. If you are business owner facing one of the challenges above, please let us know. We would love to talk to you.
We recently read Stage2Planning’s post “Is Private Equity For You?” The post points out some things that companies should consider before selling to a private equity firm. While we agree that business owners should think about what they want before selling their business, we don’t agree with some of the points the author makes about private equity. Below are the points we disagree with and why:
“These stakeholders might be your employees, suppliers, the community, or the customers of your company. Your job moves from only keeping stakeholders happy to maximizing the financial return of the company.”
These two things are not mutually exclusive. The majority of business owners work to keep employees, suppliers, customers, etc. happy AND they maximize the financial return of the company. This is not an either or situation. At Hadley Capital we think the company should do both.
“A private equity firm wants to usually hold your company for five to eight years and then find another buyer to cash them out with a very handsome return. This means you will have to grow your business very rapidly. While growing the business you’ll have to understand that you will need to do this with little cash because the private equity people will not want to put more money than their original investment into your company.”
At Hadley Capital our first order of business after acquiring a company is to “Do No Harm”. We make little to no changes to the business in the first year. We are not looking to make quick changes and then “flip” the company. Instead, we look to make a couple small changes each year. We also disagree that a company will have “little cash” to grow. When acquiring a company we make sure the company is well capitalized to support growth. We also often put additional capital into the company when making acquisitions.
“Are you aware of the capital structure of your company after you do a deal? A typical private equity deal will have five dollars in debt for every dollar in capital the new investors put into your company. Your company is now on the hook for this new debt.”
We would never do a deal with a 5:1 debt/equity ratio. Our typical structure is 2 parts debt to 1 part equity. It is also disingenuous to suggest that “the company is on the hook for this new debt”. In most of our companies, we own the business in partnership with management - we are all in this together.
"If you have a bad year the private equity firm you thought was in your corner may quickly move to being an adversary.Your agreement with the private equity firm is likely to have a take over clause. This means that if you don’t hit pre-arranged financial performance numbers you will be asked to leave and someone will take your place. Many private equity firms will tell you that everything will stay the same after they make the investment in your company. They will also say that their takeover clause is only reasonable since they have put so much money in your company. Private equity firms have learned that for them to get the financial returns they expect, they will often have to change senior management, including and especially the founder of the company."
We determine who is going to run the company before the acquisition closes and we support management in running the company. We don’t put in a “take out clause” and the business owner goes into this process “eyes wide open”. For selling a majority stake in their business, they receive millions of dollars. In exchange for the millions of dollars the business owner gives up absolute control of the company but frequently retains a minority share in the business in order to get a proverbial “second bite of the apple”.
"Private equity might be the perfect thing for you. Before you take the plunge, spend some time running your company maximizing the return and economic value of your company. If you enjoy doing this, then private equity could work out well for you. If not, choose another path to having a liquidity event in your company."
We think it is condescending to tell business owners to “spend some time running your company maximizing the return and economic value of your company”. The majority of businesses are already doing that (or at least trying!). Profit is not a bad word. Most business owners like to make one and we like to help them.
At the end of the day we always tell business owners to do research and due diligence on the buyer (private equity or strategic). It is the only way to get evidence that a buyer does what they say they do.
Over the years we have evaluated a number of small company acquisitions where the target company was deciding between doing an ESOP or selling the business to a financial sponsor like Hadley Capital.
ESOP promoters are quick to point out the significant economic benefits to ESOPs, mostly related to preferential tax treatment of ESOP contributions and distributions. However, there are a number of problems with ESOPs that are not immediately transparent to small businesses. We have developed a list of problems with ESOPs based, in some cases, on first hand accounts of companies that we were evaluating. Here are a few:
1. ESOPs are complex and expensive - ESOP is an acronym for Employee Stock Ownership Plan. ESOPs are qualified, defined contribution, employee benefit plans that are regulated by the Employment Retirement Security Act of 1974 (better known as ERISA) and, thus, subject to byzantine rules. The ESOP Association itself suggests that "plan sponsors consider the following":
- Seek professional help in designing the ESOP documents including the Plan Document.
- Strictly adhere to fiduciary structure and document all governance steps and decisions.
- Continually review the investment of employer stock and develop a list of factors to be reviewed. Follow and update that list as appropriate.
- Communicate accurately when discussing employer stock with employees and make sure they are clearly advised of the risks inherent with an employer stock investment.
- Consider engaging in an independent trustee to serve participant interests, or a qualified outside firm for plan administration and record keeping. Request indemnification from outsiders for any errors they may make and obtain evidence of their errors and omissions insurance policy.
- Purchase adequate Fiduciary Liability Insurance.
Sound simple enough? It's not. That's why promoters of ESOPs are paid handsome fees to establish ESOPs and to manage ERISA compliance on a going forward basis.
2. ESOPs have repurchase obligations - Employees can require ESOPs to repurchase their stock when they leave the company. These repurchase obligations must be completed at the company's current ESOP valuation, may put pressure on the company's cash flow, and are out of control of company management. This can limit a company's operating flexibility and balance sheet capacity - rather than investing in attractive growth opportunities a company may be required to maintain balance sheet capacity to fund repurchase obligations.
3. ESOPs can fail and create legal exposure for trustees - Many ESOPs are formed so small business owners can realize cash proceeds from an ESOP "sale". The tax advantages of ESOPs (tax deductibility of principal payments on debt) often result in ESOP "sales" that utilize a substantial amount of deb. Debt can restrict operating flexibility and, in conjunction with a recession or loss of a major customer, can lead to the failure of a company. In this outcome, the trustees of the ESOP (often the business owner that set up the ESOP) can face substantial legal exposure from members of the ESOP.
4. ESOPs are difficult to unwind - The unique structure of ESOPs make it incredibly complex to unwind or sell an ESOP company and/or to raise outside capital for an ESOP company.
Unlike selling a closely-held small company, selling an ESOP company can be like selling a quasi-public company. ESOP participants have broad voting and information rights and trustees of an ESOP are required to "maximize shareholder value" - a difficult concept to prove in the sale of small business. If a single ESOP participant feels like any of the above requirements are violated, even a well conceived transaction can be derailed or squashed. A more detailed outline of these problems is available here. http://www.faegrebd.com/2646
5. Raising equity capital for an ESOP company can also be very problematic - ESOP companies must be valued on a regular basis in order to establish a value of the ESOP stock. These valuations establish a baseline that must be considered when evaluating an equity capital raise. If the valuation is too high (from the perspective of capital sources), it will be difficult to raise outside capital. If the valuation is too low, the ESOP trustees may face disgruntled ESOP shareholders, who face dilution from the new equity capital, opening up the trustees for risks described in #3 above.
ESOPs can be a nice exit strategy for some small business owners but they are not perfect for every situation. Small business owners should complete their own due diligence prior to entering into an ESOP arrangement - including talking to successful and unsuccessful ESOP companies. We'd also be willing to share our own experiences with ESOP companies and discuss other ways of addressing the exit goals of a small business owner.
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.
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.
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.
Before Hadley Capital invests in a company we conduct due diligence. We seek to learn as much as we can about the business to avoid surprises and be ready for the future, whatever that may bring. The due diligence process can be rather exhaustive, especially on a business owner who hasn't been through it before.
But the shoe is often on the other foot. Hadley Capital is not only a buyer of companies, but also a seller. We know what a good due diligence process looks like – one that is complete but not unreasonable. When we are buying, we do not ask any business owner to do things in due diligence that we ourselves are not willing to do.
I have spent the past month selling one of our companies. In this case the buyer was a public company, and I can safely say that its due diligence makes Hadley Capital's seem like the minor leagues!
Non-compete agreements are a standard part of the small company sale process. Buyers need to be assured that sellers (and their key managers) are not going to turn around and use their unique skills, relationships and know-how to set up competing businesses.
Hadley Capital seeks five year non-competes with broad restrictions. In most cases, these terms are not a problem. The sellers are selling precisely because they want to exit and pursue other passions, not to get back into the business. However, we have had a few occasions where the terms of a non-compete have become an issue. This is a major red flag for us: Unless a seller has designs on competing he really shouldn't should be concerned with the terms of the non-compete.
This issue is so important to Hadley Capital that we actually walked away from an acquisition because of it. It happened right at the end of an acquisition process. The seller told us that he wouldn't sign a non-compete despite the fact that the terms had been outlined in our letter of intent. We had already spent a lot of time and money working to close the deal, but we decided that our sunk costs paled in comparison to the risk of the seller opening a competing business and so we moved on.
Hadley Capital relies on various service providers to help us do our jobs – attorneys, accountants, environmental consultants, etc. We have long relationships with a number of fine firms. These people are experts in their fields and we value their input.
We look to our service providers to give advice and make recommendations, but at the end of the day 'the buck stops here.' Hadley Capital is the decision maker. We don't let our service providers make decisions for us, especially on key issues.
Unfortunately, we've seen instances where sellers have let their advisors take over the sale process. They say things to us like "I know you're right, but I have to defer to my lawyer on this – he's the expert." This is frustrating, especially since service providers can have different motivations from their clients (increased billings, the loss of a good client on sale, etc.). Or the advisor might just be trying to be a 'fierce advocate.' Regardless, if the decision maker is not the seller this often leads to trouble. We're working on a transaction right now where the seller's attorney fancies himself the business person/decision maker and it's a mess because he and his client don't necessarily see eye to eye.
It's essential to use good service providers. They help business people make good, informed decisions. But at the end of the day it's the business owner's responsibility to make the key decisions, not the other way around.
I spent today in Minneapolis talking to a couple of business partners in their late-50's. They had two competing goals: (1) decreasing personal risk, while (2) growing their business.
This situation is pretty common. The partners spent 25 years building their business, it is their primary financial asset and they don't want to threaten the golden goose. However, they also have several growth opportunities they want to pursue (unfinished business...) and these require investment & financial expertise.
A recapitalization with Hadley Capital would help them achieve their objectives. They would reduce their personal risk by selling a portion of the business for cash. And by remaining meaningful owners they would benefit substantially from any future growth. They would also benefit from Hadley Capital's experience helping business owners just like them further grow and develop their businesses. We've seen that 1 + 1 can equal a lot more than 2 in these situations.
In light of Steve Job's resignation from Apple, I thought it would be a good time to write about how Hadley Capital evaluates leadership transition in a small business.
We typically buy businesses from owner/managers who want to retire, either immediately or over the next few years. If the owner is the most valuable person in the businesses, which is often the case, our transition risk is higher. This has a negative impact on value. If, on the other hand, the owner/manager is not the most important person, and there are lots of other important people working in the business, then our transition risk is lower. This has a positive impact on value.
Here are some questions we seek to answer when evaluating the transition risk associated with a target company:
1. If the owner were absent, is there someone that could run the day-to-day operations of the business? If so, who? And what are that person's strengths and weaknesses?
2. Do all the employees in the company report to the owner or are there other key managers?
3. Did the owner create all the intellectual property in the business or did other key employees play a role?
4. Does the owner make all the important business decisions?
5. How difficult would it be to hire someone from outside the company to replace the owner?
Just because an owner/manager who wants to retire is important to a business doesn't mean that Hadley Capital can't buy it, only that we need to first think through how we might most successfully transition it to another manager or team of managers.
Barbara Taylor, a business broker and NY Times blogger, wrote a good post yesterday that describes how a well structured earnout can be a good thing – for both the buyer and the seller.
What is an earnout? An earnout is a form of contingent purchase price that gets paid to a seller over time based on achieving certain agreed upon milestones. Earnouts can be tied to revenue, customer retention, gross profit, EBITDA or any other metric that is agreeable to both a buyer and seller. Earnouts help protect a buyer from "over paying" for a business because, in the event that a milestone is missed, the additional consideration is not paid. On the other hand, earnouts also protect a seller from selling "too cheaply" because, if the company continues to perform well and the milestones are achieved, the seller gets paid additional purchase price over time.
If a buyer and seller want to do a deal, but the proposed transaction value is too far apart, an earnout helps close the gap. We use earnouts in about half of our acquisitions and the typical earnout consideration represents about 20% of the total transaction value – which is frequently the gap between our value and the seller's value.
About 79 million Americans make up the Baby Boom generation. This generation has presided over a period of tremendous economic growth, so perhaps its no surprise that they also own tens of thousands of smaller companies.
As Baby Boomers enter retirement age, we agree with the many experts who expect a proverbial title wave of companies coming to market. According to a Cornell University research study, over $10 trillion in assets will change hands due to this generational trend. Other experts talk in terms of 7-9 million such businesses coming up for sale in the next 10-12 years.
It is hard to know what impact this will have on the small business M&A marketplace, but it might mean that, due to the sheer volume of companies for sale, purchase prices will decline. If so, Baby Boomers who are otherwise already motivated to sell or otherwise transition their businesses should probably consider acting sooner rather than later, particularly with tax rates near historically low levels. Alan Brind, a business broker, wrote a good blog on this topic and provides recommendations on how to start building an exit plan.
In the legal documents for a small business acquisition, a seller will make certain representations and warranties (defined on our website) regarding the business. For instance, he might represent that the business's inventory is of merchantable and usable condition. If it turns out that some of the inventory is obsolete, the buyer might have a claim against the seller. Baskets and caps establish limits on the amount a buyer can claim against a seller for certain claims of indemnification.
An indemnification 'cap' limits the overall liability of the seller to some dollar amount. Typically, small market transactions have caps equal to 50% of the purchase price. These caps also usually exclude certain key representations and warranties (i.e. the cap does not apply) such as ownership, authority to enter into the sale transaction, etc.
A 'basket' establishes a threshold under which the buyer cannot make a claim against the seller. In small market transactions the basket amount is usually 0.5% of the purchase price and the basket is a 'first-dollar' basket. In the case of a transaction with $5 million purchase price this means the basket would be $25,000. In this case, if there were claims totaling $20,000, the buyer could not make a claim against the seller because the $25,000 threshold had not yet been reached. But if the claims totaled $30,000 the buyer could make a claim from the 'first-dollar:' that is for the entire $30,000.
Baskets and caps are just one part of the definitive legal agreements that formally document a transaction, but they're useful to understand.
I spent some time today explaining to an entrepreneur why inventory is not sold separately in the sale of a small business. His proposal involved selling his business for $4.0 million and selling his inventory for an additional $2.0 million – a total of $6.0 million.
For Hadley Capital, and most buyers, the value of a business is determined by its ability to produce sustainable, operating cash flow. A business produces cash flow by converting tangible assets like inventory and intangible assets like intellectual property into salable products and services.
In this case, the business was using $2.0 million in inventory (and other assets) to produce $1.0 million +/- in annual cash flow. I valued the business, based on its cash flow, at around $4.5 - $5.0 million.
Alternatively, I offered to value the business based on its assets. The business had a net book value of around $3.0 million, which includes the inventory and all other assets less certain liabilities.
The business owner obviously liked $4.5 - $5.0 million better than $3.0 million but still had a hard time appreciating why we wouldn't buy the inventory assets separately.
I gave him an extreme example to try to drive home my point regarding assets not being sold separately:
Suppose you operate a consulting firm instead of a manufacturing business. Your consulting practice has intangible assets including its workforce (consultants) and intellectual property (consulting models). You spent money to develop these assets and these assets generate cash flow - just like inventory in a manufacturing business. Are the consultants sold separately?
P.S. We have a pretty vanilla overview of how Hadley Capital values small businesses on our website.
If you are considering raising capital or selling your company, here are a few of the items you should consider having on hand; they will be among the first things requested:
- Summary of the need for capital or reason for a sale or recapitalization
- Financial statements for the prior 3 years and current year-to-date
- List of sales by major customer for the prior 3 yrs and current year-to-date
- List of sales and gross profit by product or service type (assuming the business has multiple lines) for the prior 3 yrs and current year-to-date
- List of major suppliers and the % of total cost of sales each represents
- Basic organizational chart
- Summary of any excess owners excess compensation, rental expense above or below market rates, and/or excess owners benefits for the prior 3 yrs and current year-to-date
This list expands on the list on our website.
Having this information ready will help a potential capital source, be it a bank, private equity firm, etc., more quickly determine whether there's a fit, and if so, how they would structure the deal. It also gives the impression that you are serious about doing a transaction, which is helpful.
The same intermediary who introduced the box game I described in my last post also referred me Jason Cohen's blog on the topic. Cohen sold his company back in 2007 and described his keep-it-versus-sell-it thought process in Rich vs. King in the Real World: Why I Sold My Company. If you are considering selling your company, but are just not sure as to when, you'll enjoy Cohen's post.
If you're not up for reading the entire blog and want a Cliff Notes primer, check out the chart below. It plainly and simply illustrates the benefits of cashing in now versus holding on for more. Locking in your gain by selling all or a portion of your company can be a life-changing event and, depending on where you fall on the $? Mil scale, holding out for more may not be worth the risk.
A few weeks ago I blogged about a business owner who said he'd prefer to keep his company another 5 years rather than sell it today. Well, it happened again today. Except this time the intermediary (who was on the call and undoubtedly has heard this refrain countless times) had a very logical reply. The conversation went something like this:
Intermediary: Let's play a game. Inside one box is $10,000,000. Inside the other box is $0. You don't know which is which and you get to pick one. The expected value of the choice is $5,000,000. Right? OK, now, let's play the game again. You have a choice of choosing either of the boxes OR you could just ask for the $5,000,000 and the game show host would give it to you. What would you do?
Owner: I'd take the $5,000,000. It has the same expected value and it's a sure thing.
Intermediary: Yes, I agree, that is the logical answer. Keeping your company is the equivalent of playing the game instead of taking the sure thing.
Owner: Well it might be worth $10,000,000 in five years.
Intermediary: Yes it might. It might also be worth $0. Just look at what happened to lots of business owners in 2008 and 2009.
Post script: See Part III of this series on keeping versus selling a small business.
A business owner recently asked me, "Why do you need to meet with my accountant and review the tax returns?" It's a good question. Why review both the financial statements and the tax returns? Isn't this a duplication of effort?
The answer is that the reconciliation between the two is a material aspect of due diligence. Tax returns are often more reliable than internal financial statements. They are prepared with an eye towards being audited by the IRS instead of just for internal use. The exercise sometime brings to light useful information.
I'll give you a recent example. During negotiations, the owner of a business said his salary was $100,000 and that he wanted to continue that going forward as an employee of Newco. This made sense to us and we agreed. We entered into a letter of intent based upon the company's income statements which we assumed included the $100,000 salary. But what we learned after reviewing the tax returns was that the owner's $100,000 salary was in fact a distribution and as a result the $100,000 cost was not included in the income statements. So our understanding of the cash flow of this business was overstated by $100,000. Said another way, the $100,000 salary lowers EBITDA by $100,000. Using a 5X multiple, this equates to $500,000 of enterprise value. Not a small number. The owner wasn't intentionally trying to mislead us, but without digging in and comparing the income statements to the tax returns this may have slipped through.
I recently heard these words from a business owner in his early 70's. This is not unusual. Of the 25 – 30 business we seriously pursue in any year, better than half of the businesses are not sold because the business owner decides to "just keep the company."
In this particular case, the business owner's rationale was as follows: Why would I sell today for X when I can continue to own the company and pay myself X over the next several years and still own the company at the end?
Fair enough: By keeping the business he is entitled to collect the future profits available to ownership, and a few years down the road he may have, in fact, earned X. Yet in the meantime he will also have had all of the risks and headaches associated with ownership.
I think some business owners aren't particularly concerned about the time value of money and, being confident in their abilities, they are making a clear economic choice to pursue the potential future payments instead of receiving a lump sum today.
But in other cases I think there's another explanation: Some business owners are just not willing to let go. Their business has been such a big part of their life for so long that they would rather "die with their boots on" than move on, even if selling is the right economic decision given their age, the condition of the business, its need for reinvestment, etc.
One of our biggest challenges is to separate true sellers from those that just can't bring themselves to sell (see a previous blog post on this topic). Keeping the company is always a strategy, but it is not guaranteed to be the best strategy. The last few years has confirmed this lesson.
Post script: see Part II and Part III of this series on keeping versus selling a small business.
In a Part II of the Anatomy of a Letter Intent post, I introduced Working Capital Adjustments as purchase price adjustments in small business acquisitions. Working Capital Adjustment are often a source of confusion in the sale of a small business.
A properly structured Working Capital Adjustment captures the performance (good or bad) of a business between executing a Letter of Intent (LOI) and closing an acquisition; it is not meant to benefit or penalize the seller or the buyer.
The most important component of a Working Capital Adjustment is the Working Capital Target. The Target is negotiated between buyer and seller as part of the LOI. It determines the 'appropriate' level of working capital to be delivered at closing - 'appropriate' meaning the amount of working capital required to operate the business. An 'appropriate' amount will be specific to each company and must take into consideration seasonality, growth, and a host of other factors.
If the Working Capital at Closing is more than the Target, more cash is due the seller. If the Working Capital at Closing is less than the Target, the cash due to the seller is decreased. But the net impact to buyer and seller will be zero.
A simple example will be help illustrate:
In the negotiation of an LOI a buyer and seller agree to set the Working Capital Target at $10 and the Working Capital is as follows:
||Less Accounts Payable
||Working Capital Target
At closing, the actual working capital of the seller's business is as follows:
|Less Accounts Payable
|Working Capital at Closing
Working Capital at Closing ($13) exceeds the Working Capital Target ($10) by $3 so the Seller receives an additional $3 at closing.
From LOI to closing, the seller's business grew and, as a result, the balance sheet of the business grew. Accounts receivable increased from $20 to $25, requiring the seller to fund $5 of cash into the business. The accounts payable also increased from $10 to $12, a source of $2 cash to the seller. The net impact of the increase in accounts receivable (fund $5) and accounts payable (get $2) was $3 in cash funded by the seller into the business to support working capital growth.
The Working Capital Adjustment 'worked'. The net impact to the seller was $0 because the seller recaptures the $3 funded into working capital. The net impact to the buyer was $0 because the buyer paid an additional $3 for a balance sheet that was $3 larger than at LOI.
This example can obviously work in both directions but the outcome will be the same – neither buyer or seller will benefit or be penalized by the Working Capital Adjustment.
In Part I of the Anatomy of a Letter of Intent post I suggested that a buyer benefits from buying assets versus buying stock in the acquisition of an S Corporation (or other flow through entities like LLCs).
Before I start, a disclaimer is probably in order. In business school I took tax accounting (FNCE 447) as a pass/fail class and, as I remember, barely passed. So consider the source and I’ll try to dig up the transcript to prove it…
This is going to be a very high level overview of asset versus stock sales. If you want a crazy detailed version check out this book from my tax accounting course (it's actually a great reference book, and priced like one!).
It may be easiest and most instructive to understand how C Corporation acquisitions are treated because they tend to be a little more straightforward. When selling a C Corporation, the seller has a strong tax incentive to sell stock versus assets. Why? Because if assets are sold, the C Corporation that sold the assets can only distribute the proceeds of the asset sale to its shareholders through dividends. This results in double taxation – once when the assets are sold and once when the dividends are distributed to shareholders. Painful.
In an S Corporation, the seller is generally neutral to selling stock versus selling assets because the tax treatment of the sale is often similar and the S Corp form avoids double taxation because everything flows through to the shareholders’ personal returns.
However, a buyer receives two primary benefits from buying assets:
1. Asset Write Up – the buyer can write up the value of the assets to fair market value. This is beneficial because the buyer can then depreciate the assets, lowering taxable income and, thus, cash taxes.
2. Liability Shield – the buyer of the assets is only buying the indentified assets. All liabilities (except usually working capital liabilities like accounts payable) stay with the seller. Liabilities can range from outstanding debt to environmental liabilities to unknown liabilities. The benefits to the buyer of leaving behind these liabilities is obvious.
Of course, like anything that involves the IRS, there are lots and lots of exceptions - like 338(h)(10) elections in stock sales to get asset sale benefits. I have presented a plain-vanilla scenario, we’ll leave the complex stuff for the accountants and attorneys.
Recently, we’ve come across several companies for sale with substantial fixed assets – generally in the form of manufacturing equipment. A large asset base is normally a positive in the sale of a small business because it provides a buyer with the collateral necessary to obtain debt financing from a bank. Generally, banks feel more confident that they can get their money back if things go poorly and thus are more willing to lend money to a buyer (this is asset based lending 101).
A little aside on asset valuations is required here: replacement value is what it would cost to replace the assets in hand. The appraised fair market value (FMV) of assets is often a better proxy for true asset value because FMV generally reflects the earning potential of the assets. Also, banks do not lend on replacement value but rather orderly liquidation value (a reduction to FMV).
In the particular cases we were evaluating, each company’s large fixed asset base actually prevented a transaction from occurring. Why? Because these businesses did not generate enough free cash flow to support a purchase price equal to the replacement value of assets. Some sellers find it difficult to understand why their company is not worth at least the replacement value of assets.
It comes down to the old saying, cash is king…free cash flow in this case. There is a limit to the amount of debt a company can support and that limit is based on free cash flow, not the size of the asset base. In a buyout involving debt, a company must generate enough consistent free cash flow to support its future debt payments, taxes and capital investment needs (plus a cushion to protect the business in a downside case). Thus, there’s only so much debt we can, or will, put on a company. The rest of the purchase price must be funded by equity (or by the seller in the form of an earn-out, etc.). More equity equals less expected investment return, all other things being equal.
In these recent cases where the companies’ assets were very large relative to their free cash flows, we were not able to meet the sellers’ valuation expectations. The amount of debt was fixed by the cash flow, and the amount of equity required to pay the replacement value of assets resulted in equity returns that were too low to meet our investment needs.
In the first post on the Anatomy of a Letter of Intent we covered the form of the transaction, how a seller is paid and what a buyer buys and doesn’t buy. In this post, we will cover common purchase price adjustments, the sources of financing used by buyers and how a deal gets done.
We will continue to use this generic letter of intent as a template.
Purchase Price Adjustments: Let’s start with the easy one first…This asset transaction is structured as a debt-free/cash-free transaction so the Net Debt adjustment is meant to clarify what is considered debt and, therefore, remains an obligation of the seller not to be acquired by the buyer. If the buyer has to settle any debts, the purchase price would be reduced by these amounts.
Working capital adjustmentsare used in nearly all transactions to adjust the purchase price for movements in the working capital accounts (usually accounts receivable, inventory and accounts payable) between the execution of the letter of intent and closing. A working capital adjustment is designed to ensure that a business is sold with an appropriate level of working capital (usually defined as the working capital target). It is not designed to benefit or penalize either the buyer or seller. This is another tricky topic that I will cover in a future post.
Sources of Financing: This section is intended to provide the seller with comfort that Hadley Capital has the expertise and resources required to finance the acquisition. If a buyer will not or cannot provide specifics regarding their proposed sources of financing, a seller should question that buyer’s ability to complete the acquisition.
Conditions to Closing: This portion of the letter of intent highlights the expectations and obligations of both the buyer and seller and are often specific to the circumstances of the individual business. The conditions also outline important procedural items from due diligence to financing to negotiating legal documents (like a definitive purchase agreement).
Exclusivity: Buyers and sellers agree to a 90 – 120 days of exclusivity in order to focus their efforts on the steps required to get from a letter of intent to a closing. Generally, these steps include due diligence, financing and legal documentation. Hadley Capital typically closes a transaction 90 days after signing a letter of intent.
Miscellaneous Terms: This is pretty straight forward.
Hopefully Part I and Part II of this post are helpful to business owners contemplating a sale of their business or actively negotiating a letter of intent. It's obviously not a replacement for good legal counsel in a sale transaction...a topic probably worth yet another post.
Most small business owners only sell a company once so the process of selling a company can be opaque - to put it kindly. One of the most difficult steps can be understanding and negotiating a letter of intent – the document that outlines the terms and conditions of an offer from a buyer and to a seller.
Over two blog posts, I am going to attempt to explain, in plain English, the components of a Hadley Capital letter of intent. I’ll use this generic letter of intent as a template.
The first post will cover:
- the structure of the transaction (asset sale or stock sale)
- the form of consideration paid to the seller (cash, seller debt, consulting payments, earn-outs)
- what the buyer is purchasing (everything) and not purchasing (everything else).
The second post will cover:
- adjustments to the purchase price (working capital adjustments and net debt)
- sources of buyer financing (equity/cash and borrowed money)
- how the deal gets done (conditions to closing and exclusivity)
Structure of Transaction: right up front this letter of intent states that Hadley Capital is buying the target company’s assets. I will cover asset sales versus stock sales in another post but, quickly, the vast majority of businesses in the U.S. are S corporations, and the seller of an S Corp is generally neutral (in terms of taxes) regarding a sale of assets or a sale of stock. However, a buyer benefits from buying assets instead of stock…again, more in a future post.
Total Consideration: Hadley Capital is offering the seller total sale proceeds of $5.0 million: $4.0 million in cash plus a seller note of $500,000 and a consulting and non-compete agreement of $500,000. A large percentage of small business sales include some form of seller financing – in this case a seller note and a consulting and non-compete agreement. While overall market estimates vary, nearly all Hadley Capital acquisitions include a small portion of seller financing.
Assets being Purchased: All of the assets required to operate the business are sold including hard assets like machinery to operating assets like inventory to intellectual property assets like customer lists. Certain assets may not be included in a sale, such as buildings and land (a buyer may elect to rent the existing facility from the seller) and personal assets like cars and boats. In most asset transactions, the sale is structured as a debt-free/cash-free transaction where the seller keeps all debt and all cash. This concept can be a little tricky, I will cover this topic in a future post…
Liabilities being Assumed: Again, like most asset purchases, the only liabilities acquired by the buyer are accounts payable. All other liabilities, whether known or unknown, stay with the seller. For example, a seller would be required to repay all debt, settle all accrued vacation and paid-time-off pay, etc.
That's a lot for one sitting (for you and for me). I'll pick up Part II in another post...
My partners and I are frequently asked this question by small business owners and their advisors. In most cases, they are looking for a list of specific characteristics to determine if their company is ‘desirable’. But there is actually a much more important question that needs to be answered to determine if a company is a good acquisition candidate: is the company actually for sale?
Hadley Capital has a standard list of ideal characteristics that we look for in an acquisition target – proven management team, proprietary product line, etc. – and consider these as table stakes.
But ask any good business broker or investment banker and they will agree that the most important criteria is whether the company is actually for sale. That’s because it’s hard to buy or sell something that isn’t actually for sale (and most intermediaries don’t get paid unless there is a transaction). The most common reasons a business isn’t actually for sale is because an owner has unrealistic expectations about value, is not emotionally committed to a sale or hasn’t prepared the company for sale.
Valuation – According to many small company intermediaries, the #1 reason most businesses don’t sell is because they are over priced – owners do not have realistic expectations about value. One business broker, Toby Tatum, even wrote a book about it. Valuations can vary widely based on industry, growth rate, customer concentration, etc. but a good advisor can help a seller develop a realistic range of valuations for his or her company. NYTimes author and blogger Barbara Taylor (herself a business broker) covers it pretty well in a post on NYT's Your the Boss blog. Hadley Capital has an overview of small company valuations on its website.
Emotions – The sale of a small company can be a highly emotional affair. There is a reason owners consider their business to be 'their baby'. A buyer needs to get comfort that there is a compelling reason for a sale and confirm a sellers’ honest appraisal of their commitment to sell. When a buyer asks a business owner, “What are you going to do after you sell your company?”, the buyer is not just making small talk, she is trying to better understand a seller's emotional commitment to sell.
Prepared – Poor preparation can create a number of problems in completing a sale. If financial and tax records are not in order, the due diligence process can become drawn out, ‘deal fatigue’ can set in, a buyer may get cold feet or require a purchase price reduction, all of which can jeopardize a deal. Barbara Taylor wrote another good post on preparing a small company for sale.
So, is the company actually for sale?