Category: Mergers & Acquisitions
Who Wants to Go Public Anymore?
Not long ago it was the dream of many a private company CEO to take their company public someday. During most of our lifetime, an initial public offering (IPO) was the preferred exit strategy for the successful entrepreneur. It not only provided liquidity for their shares but also demonstrated to customers, employees and suppliers that they had “arrived.” Being able to open the Wall Street Journal over a cup of coffee and see your company’s stock price listed in black and white was the equivalent of admission to an exclusive country club.
However, today most successful entrepreneurial businesses shun IPOs. The few initial public offerings that are coming to market are generally spin-offs of divisions of larger public companies seeking to become more focused or they are liquidity events for private equity firms who want to demonstrate that they have had a success in their portfolio. But it is rare for a high-growth business still owned by the founders to seek public status anymore.
Why is this? There are several downsides to being a public company that have always been there, plus a host of new ones that have cropped up since Enron, Tyco and WorldCom thumbed their noses at the regulators, triggering an avalanche of corporate governance reforms that have made running a public company much more challenging.
One of the most frequently mentioned downsides that deter business owners from offering their shares to the public is the need to disclose the compensation of senior executives to the world. But today, the SEC is considering rules that would allow shareholders to do a lot more than peek under the skirts of corporate executives; institutional investors will have real power. For the first time, the term “shareholder democracy” will not be an oxymoron.
The new rules under consideration would bestow true clout upon shareholders. Long-term shareholders, defined as a group that collectively has owned 5 percent of the shares for at least two years, could nominate up to three board candidates, depending on the size of the board. This represents a revolution in how companies are governed. Today, the options are to vote for the slate that is presented to the shareholders or to not vote for the internally chosen slate, comparable to the system Sadaam used.
The ability to propose shareholder nominees would be triggered in the future if 35 percent of the voting shareholders cast “withhold” votes for a company-nominated director. (The board at Disney must be quaking following this year’s vote, knowing this proposal may be enacted by next proxy season.) Alternatively, if a majority of the shareholders voted for a resolution authorizing an election contest, it would trigger the opportunity for shareholders to propose their own candidates.
What scares so many corporate executives about giving institutional investors direct access to the proxy statement is that the individuals who run these large funds are not members of the same fraternity of MBAs that run corporate America. In many cases, they represent the interests of a public pension fund or a labor union fund and they may have all sorts of agendas. After this year’s contentious proxy fight at Disney, six major pension funds arranged to meet with the board. Most of these funds were represented by a trustee whose day job is state controller, i.e., they are political officials who control millions of Disney votes.
Another knock on going public is that there has always been a considerable expense associated with not only executing the initial stock sale, but maintaining all the quarterly and annual filings with the SEC. When new SEC rules take effect August 23, 2004, public companies will have to report a lot more information, and report it sooner to the regulators. The are10 new events that will have to be reported to the SEC on form 8-K, all generally within four business days, as opposed to the five- to 15-day grace period that exists today.
Some of these events include the following:
- changes in the boardroom, bylaws or fiscal year end,
- any restatement of financial results,
- exiting a business line, or
- off-the-books deals that involve significant debt.
Most observers would agree that corporate abuses in recent years have given the SEC a mandate to act. But the legal and administrative expenses of keeping up with these new reporting requirements add up to real money. Just complying with Sarbanes-Oxley regulations can cost a small fortune. Audit fees are up 20 percent to 30 percent for most companies. The average large company spent $5 million in audit fees last year. And officers and directors’ liability insurance premiums have shot through the roof since Sarbanes-Oxley was enacted. Peachtree City-based Crown Anderson recently announced it had enough of being a publicly traded company. The company is going private, largely to save what it estimates to be $250,000 to $400,000 a year.
One of the most compelling reasons to take a growth company public in the past was so the founders could share the wealth with the key executives who contributed to the success of the company. They could offer a cornucopia of stock options that were essentially free rewards to insiders. Now it appears those stock options are going to have to be reflected as an expense on the company’s income statement.
While the high-tech community is regurgitating over the expensing of options, in my view past practices are one gravy train for which there is no logical defense. If giving an employee a paycheck is an expense that reduces the earnings available to distribute to the owners, then giving them a stock option that dilutes the shareholders’ stake in the profits of the business also should be recorded on the books.
Ever since I was in charge of corporate governance policy for a previous president named Bush, I have supported most of the above governance changes, as they promote true accountability for public companies. In fact, I even proposed several similar reforms more than a decade ago. The recent push by the New York Stock Exchange to separate the role of chairman and CEO (how can you hold yourself accountable?); having only independent directors on the nominating and compensation committees and having a majority of directors that are not affiliated with the company are all ideas that were well debated in the 1980s and whose time have come. But it took the crises of Enron and others to inspire policy makers to act.
These reforms should accomplish their objective of enhancing corporate accountability. But while it is one thing to accept real accountability when stepping up to the helm of a public company that is already owned by public shareholders, it is quite another level of shock therapy to go from being private to becoming public in today’s environment. The days of issuing the public a different class of shares with little or no voting rights, stacking the board with your buddies from Augusta National and the Business Roundtable and burying all the bad news in a 10-K report, while blasting the good news around the world in press releases, are over.
Today, if you want access to the funds of the public to expand your business, you need to be prepared to accept your new owners as true partners rather than viewing them simply as a cookie jar. And since cookie jars are a lot more attractive than partners to many entrepreneurs, I wouldn’t expect to see a revitalization of the IPO market any time soon.
Buyer Beware
Studies consistently show that in about two-thirds of corporate acquisitions shareholder value is destroyed, which means that companies either paid too much or what they bought did not perform as planned. This is not because the concept of putting two businesses together is flawed; it is a result of user error. In other words, most bad deals can be avoided.
Despite the high failure rate, a recent study conducted by the Boston Consulting Group concluded that companies growing through acquisitions generated greater shareholder returns than those expanding via organic growth. When you combine these two observations, the conclusion is that it makes sense to pursue acquisitions, but only if you do it right.
What makes for a successful acquisition? Obviously, the first screen when contemplating an acquisition should be whether the target company has strategic merit for the buyer. The era of conglomerates in the 1950s and 1960s taught us that, unless you are Jack Welch or Warren Buffet, simply owning a portfolio of disparate businesses that operate autonomously with no operating synergies is not an effective corporate strategy. Before acquiring a company a business owner should ask whether the target has strategic qualities that could be more economically purchased than organically grown. Simply put, does your company lack the capability or the time to build what you are attempting to acquire or can you buy it cheaper than you can build it?
As an example, last year I sold Lawrenceville-based Inter-American Data to Agilysys (NASDAQ: AGYS). IAD was the leading provider of software to casinos and highend resorts. IAD software operated on an IBM platform because of the requirements for reliability demanded by the multi-million dollar enterprises running its products. Agilysys was a $1.5 billion dollar reseller of hardware, much of it IBM. With the commoditization of hardware and resultant shrinking margins, Agilysys felt it needed to provide software applications that were sold in the same markets where it was the leading provider of hardware in order to remain relevant to its customers. Agilysys had neither the skills nor the time to build a software company from scratch. Acquisitions were the only logical way to go.
Some of the strategic reasons why an acquisition might make more sense than organic growth include the following:
- Geographic expansion
- Economies of scale
- Complementary products that can be sold through the same distribution channel
- Vertical integration to reduce production cost
- Access to technology or intellectual property
- Movement up the value chain
A good example of the last item on this list was Oxford Industries’ purchase of Tommy Bahama. Oxford was a stodgy manufacturer of mostly private label and other commodity apparel products. The company had strong production and sourcing skills, but it was not known for its fashion prowess, which is where the money is made in the apparel world. Tommy Bahama, on the other hand, was a strong brand selling apparel in the categories that Oxford knew best. The Tommy Bahama acquisition transformed Oxford, and the shareholders reaped a huge reward.
Most businesses get the “strategy” part right. The deal makes sense on paper. But there is a lot more to a successful acquisition than strategic merit.
Studies show that the number one reason deals fail is poor cultural fit. As America’s economy shifts to knowledge based industries, most companies’ key asset is their people. If the acquirer assimilates the target into a culture that is anathema to the leaders and workers of the company they are buying, the good people will leave or, at a minimum, they will not be fully productive. Then the acquired company will have difficulty achieving the performance the buyer anticipated.
Sellers who are reticent to introduce their key executives to a prospective buyer prior to closing the deal out of a fear that employees might leave if they know the company is for sale make evaluating cultural fit nearly impossible. Consequently, a buyer should insist on interviewing key executives prior to consummating the transaction. Ask them about the firm’s culture, how it evolved, and what actions are needed to preserve it. While it is important to use employment agreements, bonus programs or non-competes to influence future employee behavior, these legalistic approaches do not compensate for a poor cultural fit.
Another major challenge for the acquiring company is to integrate the new business effectively. A formal plan should be in place prior to closing the deal that addresses key organizational changes, system integrations and customer announcements. The plan may call for a gradual integration, but it needs to be in place nonetheless.
If the acquired business will continue to be run by the prior owner, failure to properly integrate that individual is tantamount to failure. Most entrepreneurs are entrepreneurs for a reason: they don’t like working for someone else. Figure out how they are wired emotionally before you structure the deal. An all-cash offer that makes the CEO independently wealthy is not a good idea if you expect the same motivation going forward that got the company to where it is. In many cases putting a meaningful portion of the purchase price into an earn-out preserves the entrepreneurial bent of the prior owner. If you use an earn-out, just be sure to establish a formula that motivates behavior that is consistent with your integration plan, or you will have fits trying to assimilate the new business.
Another reason deals do not work out as planned is a failure on the part of the buyer to thoroughly do their homework. The process of differentiating what the seller has told you from reality is called due diligence. Companies that do not have the requisite skills in house should hire a good lawyer and CPA to perform the legal and financial due diligence. Hire specialists with extensive deal experience! Do not use your divorce lawyer or the person who completes your tax return just because you trust them.
Unfortunately, many companies never go beyond legal and financial due diligence. Effective due diligence includes speaking with key customers and suppliers, performing background checks on key employees and possibly having consultants examine industry trends and the competitive landscape if the company being acquired is in a business sector with which the buyer is not intimately familiar.
Yet another frequent reason deals fail is that the buyer pays too much. Ironically, it is not uncommon for the buyer to overpay because they tried to minimize transaction expenses and they cut corners on doing the deal properly — the proverbial “penny wise, pound foolish” syndrome. Inexperienced buyers who refuse to hire professionals to help them value the company, structure the deal and assist with due diligence are asking for trouble.
Many first-time acquirers do not have a firm grasp on value when they make their offer. If you are using an industry “rule of thumb,” such as X times sales or so much per customer, you also are likely to get into trouble. At the end of the day, the only metric that matters is cash. A discounted cash flow analysis must be performed to make sure the target’s cash flow covers the buyer’s cost of capital.
Even when the proper analysis is performed, often the assumptions are too aggressive. And even if they are realistic, it is possible to overpay if you lack fiscal discipline. There are two concepts in business valuation that are relevant when making an acquisition. The first is fair market value, which is the value of a business on a standalone basis. The second is investment value, which is what the target company is worth to the buyer given all the synergies between the two companies. Most successful deals are priced somewhere between these two measures of value. Bottom fishers who are unwilling to pay at least fair market value often lose out to other bidders. And buyers who pay at or near investment value have absolutely no upside. If they integrate the two businesses perfectly and achieve all of the projected financial benefits, they simply break even on the deal because they have already paid a price assuming that would occur. The reason to do the deal in the first place is to acquire capabilities at less than investment value so that the buyer can create shareholder value by doing the deal.
Finally, buyers have a tendency to fall in love with their deals. Don’t be afraid to walk away—at any point in the process! The bride who turns and runs from the church is better off than the one who walks down the aisle with serious reservations. You may get stuck with the bill for the reception, but that is a lot cheaper than a failed marriage.
Along the same vein, the sooner you figure out whether you really have a deal the better. When the buyer and seller go too far down the road without a common understanding of the terms of the transaction, it opens up the door for a lot of wasted time and energy. I generally encourage a buyer to lay out the agreed upon deal terms in writing in the form of a letter of intent (subject to due diligence) as soon as they have a handle on the value of the company. State in the letter what assumptions the offer is predicated upon and that there will be adjustments made if those assumptions prove to be inaccurate. When contemplating an acquisition, proceed with caution, but don’t analyze the deal to death before discussing and agreeing on major deal points. Otherwise, you may discover in five minutes that you have wasted five months.
A lot of business owners fear acquisitions, often because they have never taken on a management task in which they weren’t fully in control of the outcome, and rightfully so. Consummating a successful acquisition is not easy. That is why two-thirds of them fail. But very few companies achieve great success without making prudent acquisitions. So it is worth it to pursue transactions that add capabilities more effectively or efficiently than you could create them in-house.
Improve Your Chances for a Successful Acquisition
- Before acquiring a company, ask yourself whether the target has strategic qualities that could be more economically purchased than organically grown.
- To determine if there is a cultural fit, insist on interviewing key executives prior to consummating the transaction.
- Prior to closing the deal, put a formal plan in place that addresses key organizational changes, system integrations and customer announcements.
- If the acquired business will continue to be run by the prior owner, structure the deal to motivate him or her to support and implement your integration plan.
- Hire a good lawyer and CPA to perform the legal and financial due diligence.
- Complete the due diligence process by speaking with key customers and suppliers and by performing background checks on key employees. If the company being acquired is in a business sector with which you are not intimately familiar, have consultants examine industry trends and the competitive landscape.
- Perform a discounted cash flow analysis to ensure the target’s cash flow covers your cost of capital.
- And finally, don’t be afraid to walk away — at any point in the process! The bride who turns and runs from the church is better off than the one who walks down the aisle with serious reservations.
The Art of Negotiation
Over the years I have witnessed deals that should have been made that blew up because of poor negotiating and others that could easily have failed but made it to the closing table because they were artfully negotiated.
The first rule of negotiating a deal is to figure out what you want. It sounds obvious, but far too often we lose sight of what we are truly trying to accomplish and the deal falls apart over matters that should not be deal breakers. In any business deal there are many aspects of the deal, some of which are more important than others. Yet being the competitive spirits that we are, we can become obsessed with “winning” a negotiation and focus too much attention on getting our way on matters that really are not that important.
I had one client abruptly break off discussions with, perhaps, the most logical buyer for his company (and the one who was in a position to offer the highest price) because he didn’t want the buyer to do business with a customer with whom he had had a bad relationship in the past.
Once you are sailing in the Bahamas, what difference does it make who the new owner does business with? The best way to avoid getting side tracked in a negotiation is to make three lists, write them down on paper, and regularly review the lists:
- Must Haves
- Nice to Haves
- Icing
The key is to keep the first two categories as short as possible, then stay focused on achieving the first one while obtaining as many of the second and third as possible.
My second rule of negotiating is a corollary to the first: figure out what the other party wants. Again, this seems obvious, but it rarely happens. A deal occurs only when both parties’ objectives are met. In any negotiation, there are tradeoffs. If you can understand the goals — and constraints — of the other party, it is a lot easier to structure a deal that works. When I begin a negotiation, I make a list of what is more important to my client than to the other party and vice versa. Then I know which areas I can give ground on in order to obtain the desired result.
In a meeting between one of my clients, who was selling his company, and a prospective buyer, who ran a public company with a thin management team, my client stridently stated that he wanted to be free to walk out the door the day of the closing. I knew he had nowhere to go and he knew he had nowhere to go and he was certainly young enough to stick around for a year or two to help a new owner integrate the two businesses. He communicated a “Nice to Have” as a “Must Have.” The buyer, not surprisingly, walked away from the table convinced the deal would not happen. Because he had no internal candidate to immediately replace the owner as CEO, having the owner remain for a transition period was a “Must Have” for him.
Another tenant for a successful deal is to be creative. Deals can be structured in an infinite number of ways. A successful deal structure is one that achieves the objectives of both parties, given their respective interests and constraints. The structure is the pathway to work around the constraints to get to each others’ respective interests.
I had a client who was convinced his company was poised to experience phenomenal growth, but wanted to sell it anyway for personal reasons. He valued his company at $35 million. The buyer, who was much more sophisticated than the seller, knew that my client’s historical results did not justify a price close to what was being asked and instead valued the company at $20 million. In most cases this deal would never have happened because of price.
However, we devised a structure that got them both comfortable with the price. The buyer offered $20 million in cash at closing, plus an “earn-out.” The earn-out contract would pay my client an additional $15 million over the three-year period following the closing if certain financial milestones (which my client had reflected in his projections) were met. In effect, the buyer said, “Put your money where your mouth is.”
My client met the milestones and was paid the additional $15 million. He was happy, and the buyer was happy to pay it because they achieved the results they were after.
In another case, a buyer wishing to purchase a company could not borrow enough money to come up with the entire purchase price. The banks would lend only a fraction of the value of certain assets being acquired, as is common. So the buyer offered to let the seller retain ownership to the real estate and lease it back to the buyer, thereby reducing the cash portion of the offer by the fair market value of the real estate. At the end of the lease, my client could sell the real estate to the buyer or find another buyer for it at fair market value. In the meantime, the seller would have an income stream from leasing the property which was much more attractive than what he would have earned in a money market account. The seller got his price and the buyer was able to finance the acquisition.
One obvious rule of negotiating that is broken far too often is to never say something that is not true. It is often prudent to keep some cards close to the vest. But if you profess to have an ace in your hand, you better have one when the cards are laid down. Before a deal closes, extensive due diligence is conducted, which, if done properly, uncovers all the skeletons. If you are ever caught being dishonest or misrepresenting the facts, you will lose all credibility with the other party. They will then discount everything you have said and you will have sub-optimized your deal.
Another typical mistake made by parties in a negotiation is to mislead their agents. Often a party to a negotiation will represent to their advisor that their bottom line in a matter is X, when in fact it is Y. They assume that if they set the bar for their agent above where it really is, they will get a better result. In reality, many deals never happen because the agent has an unworkable mandate.
Select advisors you trust. Tell them the truth about what you are trying to accomplish. Incentivize them to exceed your expectations. Then they will have all the tools to negotiate the best outcome on your behalf. I recently represented a seller who felt his business was worth $22 million. Rather than structuring my fee as a flat percentage of the sale price, he paid me a below-market fee up to $22 million, then doubled the percentage for any amount over $22 million. That way I was able to get more parties interested in the deal by representing to them that the seller was reasonable in his expected value. And by having more parties interested, it was possible to ratchet up their initial offers well above $22 million. Because I had every incentive to push the price as high as possible, my client never second guessed me and achieved an outcome much better than expected.
Although negotiating styles can vary dramatically from person to person, keeping the above principals in mind should help to achieve a more favorable outcome when negotiating a deal.
Using Advisors Wisely
Most business owners and executives rely on professional advisors for outside counsel. It is crucial to not just select the right individuals to be your advisors, but to seek their advice on the appropriate matters and to manage your advisors properly.
Human nature teaches us to surround ourselves with people we trust. Listening to your instinct and selecting advisors you trust is a good start. But when it comes to using those advisors wisely, many business owners get into trouble.
Here are a couple guidelines to help you consistently receive quality, objective advice from your advisors and avoid the common mistakes business owners make when seeking professional guidance:
1. Understand your advisor’s distinctive competence.
Perhaps the most common trap business owners fall into when seeking guidance is to go back to the same trusted advisor for counsel regardless of the issue, sometimes when the matter is outside that advisor’s competence.
As an example, few entrepreneurs have financial backgrounds, so they are forced to rely on their CPA to guide them through the numerous tax, financial reporting and regulatory quagmires faced by businesses. In the process, they learn to rely on the expertise of their CPA – for everything.
Business owners should have a team of professionals, each with their own distinctive competence. No one individual can be an expert in everything.
While your CPA may be a guru when it comes to preparing financial statements or doing your taxes, in most cases there are professionals who are better versed in estate planning or managing your investments.
This principal applies to all professional advisors, not just CPAs. I have dealt with numerous business owners who have a trusted lawyer whom they turn to no matter what the legal matter. Just because a lawyer helped incorporate your business, defend an employee lawsuit or handled your divorce proficiently does not mean they are the right person to represent you if you are selling your business. There is a minefield of risks that arise if the purchase agreement you sign to sell your company does not contain the right representations, warrantees and indemnities.
For special circumstances, you need special counsel. You would never allow your general medicine practitioner, no matter how much you trust them and no matter how many years they took care of your mother, to perform open-heart surgery on you. Why would you let a GP lawyer who does not have a background in securities and transactions represent you in the most important financial transaction of your life?
2. Understand the bias of your advisor.
Everyone in business has an agenda. There is nothing wrong with this; it is human nature. It is also what makes us successful at what we do. But if a business owner overlooks this fact, they can be led down the wrong path by their advisors.
Even if you are confident in the integrity of your advisors, it is wise to first consider what makes that individual successful in their practice when soliciting their advice. By understanding your advisor’s agenda, you can filter their advice so that your interests remain paramount.
A good place to start is to consider how they get paid. If a professional is paid on an hourly basis, they are going to have partners beating on them weekly to bill more hours. If you assume this has no impact on their psyche, you are probably vulnerable to being sold services you don’t need or having matters drawn out longer than necessary.
Most CPAs and lawyers I know are too ethical to milk their clients. Yet we all know a story of someone who has had their brokerage account churned to run up commissions or who had worked out the terms of their divorce amicably until the lawyers got involved.
Typically, though, the bias is much more subtle. For example, there are some financial planners who offer services to help business owners get their estates in order whose principal source of revenue is driven by commissions derived from selling insurance. You can bet that in 99 percent of the estate plans they draft there will be a major purchase of insurance involved. Their services may sound very affordable compared to a fee-only planning firm. But in many cases it is because fees are hidden in the products they sell you.
One of the most pervasive biases that is difficult to detect occurs when the advisor’s services are either dependent upon or disappear in the event of a certain outcome. Since my primary business is selling companies, I will pick on my profession. Most people in the M&A business derive 100 percent of their income from selling companies. So rarely do they advise a client to wait three years until their company’s performance has improved or the market is more favorable to sell their business.
If you are thinking about hiring an M&A advisor, ask them for a list of clients they have counseled to not sell their company, or to wait until a better time. To avoid the above temptation, my firm operates a business valuation practice, which pays the overhead in down markets and allows us to diversify our revenue stream, so we don’t live or die based on when our clients sell their companies.
On the flip side, if your banker, financial planner or CPA has never sat you down to develop a plan for transitioning the ownership of your business, they are not looking out for your best interest. To these individuals, your account is an annuity. If you sell your company, your CPA or banker is unlikely to retain you as a client.Consequently, they have a strong bias to either persuade you to hold on to your business for as long as possible or to transition the ownership to children or management, where they have a shot at retaining the account. Yet only 30 percent of companies are successfully transitioned to the next generation of management. And in almost all cases an internal sale yields lower proceeds than a sale to a third party.
Sadly, I have witnessed cases where a CPA or banker overtly tried to convince a business owner to not sell their company when it was in their client’s best interest to sell. In one case, the CPA, who the business owner trusted implicitly, egregiously understated his estimate of the after-tax proceeds the owner would receive if he accepted an offer and talked the seller into walking away from a deal that he may never see again.
More common is denial. I recently had a business owner call me who had been referred by her banker. She and her partner were both approaching retirement age and neither had children in the business. They had been approached by a major, national trucking company that was interested in buying their business, and they felt they needed professional advice.
In the course of the conversation, as I shared with her my philosophy of assembling the right team of advisors when confronting such a major decision — that included a CPA and a lawyer — I asked her the name of her CPA firm. When she told me, knowing that this firm had a formal alliance with my company to refer clients who were contemplating the sale of their business, I asked her if her CPA had ever discussed with her how she planned to transition the ownership of her business. She laughed, and replied, “Are you kidding?”
Regardless of the professionalism and integrity of your advisors, they are human. That means they are not all-knowing. They have limited areas of expertise. They also provide for their families. That means certain outcomes benefit them more than others. Your best bet is to assemble a team of professional advisors and manage them wisely so you receive the right advice on the right subject.
The Small Print in Selling a Company
After what is often a lengthy, drawn out negotiation with a purchaser of their company, business owners typically sign a document that spells out the major terms that have been hammered out. This document, known as a letter of intent, describes the basic deal price and structure. However, the letter of intent is nothing more than a written handshake. It is not a legally binding document. The transaction is far from a “done deal” until a legally-binding purchase agreement is executed by both parties.
Frequently, the terms that are customary in a purchase agreement come as a shock to the seller. Consequently, many deals fall apart over the “small print” issues. And the primary reason is not that the buyer is asking for anything egregious or unusual; it is because the seller is unfamiliar with the standard provisions in a purchase agreement.
There are certain provisions included in every deal of consequence that business owners should be aware of before negotiating to sell their business. Unfortunately, many lawyers do not educate their clients who are sellers before forwarding the voluminous purchase documents to them. And worse yet, some sellers are too cheap to hire a lawyer who specializes in M&A, and the lawyer who represented them in their divorce or other personal matters makes a federal case out of provisions they should have expected to see, often killing the deal. A good M&A lawyer can negotiate these points to the extent possible, but they can’t make them go away.
In the purchase agreement, the seller will be asked to make certain “representations and warranties” which is where the business owner, if he or she is smart, attempts to make sure there are no undisclosed landmines. The reason to come forward with all your dirty laundry before the closing is because you will be asked to indemnify the buyer against matters that are not disclosed. And because you will be liable for these claims anyway, you may as well negotiate them before the closing so you can walk away from the deal if an acceptable resolution is not found.
According to Stuart Johnson, cochairman of the corporate practice at Arnall Golden Gregory, typical reps and warrantees might include the following, among others:
- The company is not subject to any undisclosed litigation
- The company owns all of the assets that are used in the business, i.e., they are not titled in the name of shareholders or third parties
- There are no contracts (including verbal) binding on the company with a value greater than a certain amount other than those listed
- The company has complied with all employment laws, including paying overtime when required
- Financial statements have been prepared consistent with generally accepted accounting principles (GAAP)
- All payroll and state sales taxes have been paid
The seller will then be asked to indemnify the buyer against any losses they incur as a result of the above statements not being fully accurate. In order to provide some meat to the indemnification, the buyer will insist that a certain portion of the purchase consideration be set aside in an escrow account. So, if you were expecting to walk away from the closing table with the total sale proceeds, you are in for a rude awakening.
The customary amount that is escrowed is in the range of 10 percent of the purchase price.
For example, if you sell products that are subject to warrantee claims, and the new owner would need to honor any claims that resulted from sales that occurred prior to the closing, there needs to be a way for the buyer to honor those claims without chasing the seller down and asking for money back, which is never an easy task.
No matter how much due diligence is performed, a buyer cannot be expected to uncover undisclosed liabilities or verbal contracts you made that were never written down. It takes time for these matters to rise to the surface. And the buyer wants to know that all the money they paid for the business is not in the Cayman Islands if they do discover something.
In a recent case, a key salesperson appeared in the office of the new owner demanding his end-of-year bonus. The new owner, befuddled, asked where the salesman got the idea that he was due the bonus. He responded that the prior owner promised it to him. After significant quibbling and not insignificant legal fees, the court found that the bonus was owed to the salesman, and that the seller was primarily responsible, as he had entered into a verbal contract that was not disclosed to the buyer.
The typical time period the escrow is held is at least through the completion of the first audit cycle and maybe longer. The average timeframe is 12 months, according to Scott Smith, an M&A partner with Powell Goldstein.
While these funds are escrowed, they can be invested in relatively safe investments, with the income accruing to the seller. Many sellers fear that the buyer will make up claims and that they will never see their escrowed money. However, there is typically a provision included in the purchase agreement providing for arbitration if the seller and buyer cannot agree on the legitimacy or amount of a claim.
If you hide the skeletons, or simply forget to disclose something that has an economic impact on the buyer, that money in the escrow account should never have been yours in the first place. Buying a company is not as simple as buying a house, where you can rely on the principle of “buyer beware.”
Often the buyer will allow a “basket” or deductible, so if claims are not material, say not more than $25,000 or $50,000, they will not reach into the escrowed funds. However, the ultimate protection for your escrowed funds is to deliver a clean business, with the value of all assets and liabilities accurately and fully disclosed in the purchase agreement. If there are no skeletons, your money is safe, and you will eventually get it, with interest.
To those who are experienced in corporate transactions, none of the above will come as a surprise. To those who have never been through the process, it is useful to know what lies ahead so you don’t overreact the first time you sell your business.
Two Bites of the Apple
Sometimes in business, like in poker, it’s wise to take some chips off the table, even when you’re not ready to get out of the game. There is a very effective, and often prudent way to do this that I call “double dipping.” In effect, you have the opportunity to sell your company more than once.
The strategy is to sell a significant interest in the company to a private equity fund, roll over a meaningful ownership interest on a tax-free basis — which allows you to continue to own a sizeable piece of the business and to run the company — and invest the proceeds to diversify your net worth and establish liquidity.
The executive/owner’s daily management role does not change dramatically. Plus, you still have tremendous upside if you continue to grow the business, and you can sleep much better at night knowing most of your net worth is no longer tied up in the value of your company. Does this sound too good to be true? Actually, it happens every day.
Over the past few decades, an increasing percentage of corporate America has become owned by private equity funds. These funds aggregate money from large institutions such as pension funds and insurance companies with the express purpose of investing in the ownership of private companies, as opposed to the stocks of public companies. Some of these funds are household names such as KKR and Carlyle Group, while others are much smaller and typically do deals below the radar screen of the Wall Street Journal.
In Atlanta there are a few such firms including CGW Partners, Crescent Capital and Peachtree Equity Partners that primarily invest in mature, privately-owned businesses. The reason that the private equity funds have grown so much is that the returns they provide investors are thought to be higher than they are for the money managers who invest in public markets.
The way the transaction works is that the “Equity Sponsor,” i.e. the private equity fund, and the owner agree on the value of the business (much easier said than done.) The private equity firm then purchases a controlling stake in the company; for illustration purposes, assume 80 percent. The owner now has cash (at least what is left over after capital gains taxes, which is a lot more today than it might be after November) to invest in whatever beach homes, hedge funds or Treasury Bills he or she wishes. Because the equity sponsor pays for its shares partly with borrowed money (assume 50 percent for simplicity) the business owner’s piece of the pie going forward is actually 40 percent, although they just “sold” 80 percent of their company for cash.
Private equity funds are always looking for “platform companies,” which are businesses that they can use as a platform to do additional acquisitions of related businesses. If a private equity fund can purchase businesses that are synergistic with existing portfolio companies, they can achieve superior returns (at least in theory). Because the MBAs who operate private equity funds are not in the business of running businesses, they need the management team of the companies they acquire to stay on to run the business afterward to help them cash in.
As a business owner/CEO this presents a tremendous opportunity to build an empire using someone else’s money with significant upside — you still own a chunk of the company — and minimal downside; most of the value of your company is now in the bank.
For an owner/CEO who is at least five to seven years away from hanging up their spurs, selling to a private equity fund can be a compelling option. In addition to the estate planning benefits previously mentioned, there are several other advantages. For instance, if you have key managers who have helped you build your company who are not involved in the ownership of the company, the equity sponsor will typically allow, if not encourage, them to become shareholders through the transaction. Most private equity funds respect the value that your key managers bring to the table and will also establish incentive stock option plans or some other form of equity incentive to keep everyone rowing in the direction of shareholder value.
And if the senior managers are already shareholders, as they were in the case of Jaymar Furniture, then they can have two bites of the apple as well. In 2000 River Associates, a Chattanooga, TN-based private equity group, cashed out the principal owner of Jaymar and allowed a key executive (Guy Patenaude) to sell some of his shares. Patenaude stayed on to run the company, built it nicely, and in March 2003 sold his remaining shares along with River Associates to a public company at a much higher price than the 2000 deal.
If you manage the deal properly, selling to a private equity fund typically leads to a greater value than attempting to parcel out shares to employees or selling outright to management without the participation of an equity sponsor. If you simply went to the bank to borrow money for the company to re-purchase your shares, you would likely receive a much chillier reception. Banks that would not lend you the money to retire shares in your company in a typical leveraged re-capitalization are often willing to support an equity sponsor with a proven track record of successfully managing leveraged enterprises, particularly because they are coming to the table with a substantial pile of cash.
However, there are downsides to this strategy. Once you sell a controlling stake in your company, you are no longer in control. While this is patently obvious, many business owners seem to overlook this fact. It is problematic for some to sit in the same office running the daily operations of a business that may bear their name, and no longer be the potentate.
Using company resources to pay for that family vacation, or the leased jet service, are no longer standard operating procedure once a private equity group is involved. If the son-in-law is on the payroll because he was essentially unemployable elsewhere, he will need to find a new job. And if performance fails to meet or exceed projections, the board meetings will be a lot more intense.
In other words, some business owners are very uncomfortable with the accountability that goes along with ownership by a private equity fund. If you are not wired to deal effectively with accountability, do not do it. You will be very frustrated, particularly if the equity sponsor assigns a staffer two years out of B-school to be your new director and primary contact.
But the greatest shortcoming of this strategy is simply that it is not available to most companies. You have to have a real plum business to be a candidate for a private equity fund. This typically includes owning a business in a growing market sector, with consistent cash flows, limited debt, and a strong management team willing to stick around for a few years. If your company does meet this profile, it would be well worth it to at least consider taking two bites of the apple.
Reprinted with Permission from Catalyst Magazine March 2004
Is Now the Right Time to Sell My Business?
Today it is possible to sell a portion of the company to take advantage of favorable market conditions and diversify your net worth, yet continue to run your company. So let’s consider whether now is a good time to seek liquidity—either partial or full liquidity.
The three considerations for evaluating the timing of an exit are:
Is the overall market for selling companies favorable?
Is my company’s recent performance strong enough to attract a favorable price?
Am I emotionally ready to either exit my company or willing to bring a partner on board to help me take the business to the next level?
It is not likely that you will experience the perfect storm where all three of these considerations flash a bright green signal simultaneously. Rarely do all the stars line up perfectly. Those who wait for that perfect moment typically wait too long to exit; they are forced to continue in the business longer than they desire or to accept a sub-optimal price.
But the answer to all three questions needs to be acceptable, or the timing is not right.
In 2011, the answer to the first question is that the market for selling most private companies is very favorable. The prices being paid today are not quite as aggressive as they were during the peak of the bubble in 2007 and early 2008. But they are close, and as good as we can expect to see in this new era of limited leverage for the foreseeable future.
Today U.S. corporations have more cash on hand than any time in history. They are anxious to put it to work, and acquisitions are the most expedient way for many of them to do so. Additionally, private equity firms have an unprecedented level of cash burning a hole in their pockets. There are over 5000 firms that have to invest in private businesses to justify their existence. During the financial crisis, private equity firms were focused on supporting or salvaging the investments they had already made. And they could not borrow money to finance new deals anyway. So we went about two years with very few transactions being done. A private equity firm cannot survive unless it invests all of its capital because its investors will ask for their money back—with a return—in either 8 or 10 years from the commencement of the fund. Today there is a significant pent up demand among both the strategic (corporate) buyers and financial (private equity) buyers.
Moreover, when selling a business, the concern should not be: How much do I get? Rather, it should be: How much do I keep? And that is a function of the tax code. Late last year Congress extended the Bush tax cuts. That means capital gains rates will remain at 15% until the end of 2012. These rates are the lowest in history, and guaranteed to increase when they expire in less than two years. As a former U.S. Treasury official, I would bank on it. Our current budget deficit is unsustainable, and tax rates will go up after 2012 and probably never be this low again in our lifetime.
So that leads us to the next question: How is your company performing? A surprising number of my clients did well in 2010. If you are in that boat, 2011 should be a superb time from a market standpoint. The field will get very crowded next year. But some businesses did not fared as last year. If you are in that boat, look at 2011 as a time to maximize your bottom line so you can cash in next year before tax rates escalate.
The final question is whether you are mentally, emotionally and financially ready to exit. I could write a book on that topic, but let me just summarize some key considerations.
First of all, give up the notion that you can sell your business and invest all the proceeds in Treasury securities with no risk and maintain the same income. If that is your criteria (I hear that all the time) you will never sell your company, because that is not possible. A low risk diversified portfolio of liquid securities will never yield the same return as a private company. You may think your company is low risk because you are in control. But from a pure finance perspective, it is not.
If you are not financially or emotionally ready to fully cash out today, you should consider selling part of your business to a private equity firm now, continuing to own a meaningful percentage and operating the business. Then you can set aside enough cash to take care of most or all of your family’s financial needs and sleep a little better the next time we have a financial or political crisis. It is not a question of if, but when. And you can have access to the expertise of professional investors who are trained in how to build business value. Out of over 5000 funds, surely there are one or two which you could get along with. Perhaps not. But to take your company to the next level, having some outside counsel usually helps. Then in 3, 4 or 5 years you can exit fully—have your second bite at the apple—and provide a nice return to your investors and yourself (and not have all your eggs in one basket in the meantime.)
If you are the type that does not think you could function with another owner in the mix, and you know you want to retire in the next few years, you should target the end of 2012 as the time to be safely out of the business to avoid sharing too much of your sweat equity with Uncle Sam. And since it generally takes up to 12 months to complete a sale transaction, you need to get busy looking for the right team of advisors to assist you in the process now. Maybe someone will ring your doorbell and make you an offer you can’t refuse. But that only happens in rare cases and fairy tales. To get the best deal, you need to have an advisor who will pro-actively approach every logical buyer out there and make sure you have several parties to negotiate with. A competitive process is the only way to assure a successful outcome.