Trusted Advice On Preparing A Business For Sale
Getting M&A Deals Done
Getting M&A Deals Done in a Challenging Market
By Bill Quish, Mergers and Acquisition Specialist and Certified Exit Planning Advisor
Most business owners we speak with have the impression that fewer sales of businesses are getting done these days because valuation multiples are low and financing is difficult to arrange. Based on our current experience, this is not always the case. What we are seeing is transaction valuation multiples have approached historical norms for companies that are performing above their peers or are being consummated for strategic reasons. While third-party financing is clearly harder to obtain, it is often available at lower leverage multiples and with more restrictive covenants.
This article provides some pragmatic suggestions to bridge gaps in valuation expectations between the buyer and seller, and financing a business sale transaction.
Bridging the Gap Between Seller and Buyer Expectations
When expectation impasses occur, there are three mechanisms that can potentially bridge gaps: earn-outs, seller notes and seller-retained equity. These can be used individually or in combination. For purposes of an example, let’s assume the following: Company X’s trailing twelve months’ earnings before interest, taxes, depreciation and amortization (EBITDA) is $4 million. The seller values the company at $20 million (a valuation multiple of 5 times EBITDA). The buyer believes that the business valuation is $18 million (a valuation multiple of 4.5 times EBITDA). The lower valuation is due to the buyer’s concern that future EBITDA might be less than $4 million. Therefore, the valuation gap between the seller and buyer is $2 million.
Earn out
An earn out is a risk-bridging mechanism whereby a portion of the purchase price is paid after closing if the acquired company meets some predetermined performance targets. The best earn out type will depend on the characteristics and circumstances of the seller’s business and whether the company will remain a stand-alone entity post closing or will become integrated into the buyer’s company. Common types of earn out-based performance targets are revenue, gross margin, operating profits and EBITDA. Earn out periods typically range from one to three years. Structuring an earn out that really works for both parties is tricky. Sellers prefer revenue and gross margin earn outs, because if the earn outs are properly structured, the acquiring company can do little to negatively impact the realization of the earn out. Some earn outs have a minimum earn out (floor) to protect the seller and a maximum earn out (cap) to protect the buyer. Payment of earn outs can be in cash, notes or stock. Clear, specific earn-out language should be included in the Letter of Intent in order to avoid future conflict. Please note that earn outs have a higher probably of being achieved if the company being acquired remains a stand-alone entity and the seller continues in an active senior management role over the earn out period.
In the example above, the earn out might be structured so that the seller receives an earn out payment of $1 million per year for two years, should the adjusted EBITDA exceed $4 million for the year.
Seller Financing
In today’s market, buyers of companies are unable to leverage (e.g., borrow from banks, junior capital sources) the purchase price as aggressively as they could a couple of years ago. This can create a gap between the cash desired by the seller and the amount of equity and leverage some buyers can assemble to complete the transaction. As a result, sellers are being asked to provide more financing now than in the past, often by the buyer offering a promissory note.
Notes are typically payable over a period of three to five years. Payment terms vary significantly. They might be monthly, quarterly, semi-annually or annually. Some notes are structured as interest only for the first year post close, and thereafter principal payments kick-in. Other notes might include a balloon payment. Interest rates are often similar to senior lenders. Payment of the note is typically subordinate to senior and junior lenders. Therefore, the final structure of the buyer note will be subject to the approval of the senior and junior lenders.
These notes are most often unsecured because senior and junior lenders will likely have priority security interests in the assets and stock of the company ahead the buyer note. Sellers should try and get a corporate guarantee or some other form of collateral from the industry or strategic buyer. Financial buyers such as private equity firms typically will not guarantee their notes. That being said, notes are less risky than are earn-outs. Should a downturn occur and cash flow materially decrease, sellers would be in a position to receive payments on the note ahead of the earn-out payment.
Seller Equity Rollover
Another option for bridging the financing gap that is growing in popularity is the seller equity rollover. In this scenario, the seller rolls over (retains) equity in his/her company’s stock or that of a holding company that is formed to acquire the assets or stock of the company. Retaining ownership sends a message to the buyer and the other financing sources that the seller is confident about the future of the company. It is attractive to the buyer because it mutually aligns the interests of all the parties to make the acquired company successful. Over the years we have seen seller-retained equity stakes in the acquired company range from 10% to 40%. Rolling over a significant equity percentage should entitle the original owners to some governance rights (e.g., one or more board seats) and some say as to how the company will operate. Rollover equity usually comes with transfer restrictions. We recommend that the seller consult with a tax advisor to make sure that the rollover qualifies for tax-free treatment. The upside of a seller equity rollover is that the future value of the rollover may become significantly greater than if you elected to receive cash when you sold the company.
In closing, while there are risks to earn-outs, buyer notes and seller rollover equity, if you feel confident in the future direction of your company and have faith in the buyer, these proven tools can position you to sell your company today and potentially provide you with some upside beyond an all-cash deal.
Bill Quish is a Mergers and Acquisition specialist and Certified Exit Planning Advisor (CEPA). He is a senior managing director at Lyons Solutions, LLC. He can be reached at 860-658-1845 or bill@mergermaven.com.
Copyright 2010 By Bill Quish. All Rights Reserved.
By Bill Quish, Mergers and Acquisition Specialist and Certified Exit Planning Advisor
Most business owners we speak with have the impression that fewer sales of businesses are getting done these days because valuation multiples are low and financing is difficult to arrange. Based on our current experience, this is not always the case. What we are seeing is transaction valuation multiples have approached historical norms for companies that are performing above their peers or are being consummated for strategic reasons. While third-party financing is clearly harder to obtain, it is often available at lower leverage multiples and with more restrictive covenants.
This article provides some pragmatic suggestions to bridge gaps in valuation expectations between the buyer and seller, and financing a business sale transaction.
Bridging the Gap Between Seller and Buyer Expectations
When expectation impasses occur, there are three mechanisms that can potentially bridge gaps: earn-outs, seller notes and seller-retained equity. These can be used individually or in combination. For purposes of an example, let’s assume the following: Company X’s trailing twelve months’ earnings before interest, taxes, depreciation and amortization (EBITDA) is $4 million. The seller values the company at $20 million (a valuation multiple of 5 times EBITDA). The buyer believes that the business valuation is $18 million (a valuation multiple of 4.5 times EBITDA). The lower valuation is due to the buyer’s concern that future EBITDA might be less than $4 million. Therefore, the valuation gap between the seller and buyer is $2 million.
Earn out
An earn out is a risk-bridging mechanism whereby a portion of the purchase price is paid after closing if the acquired company meets some predetermined performance targets. The best earn out type will depend on the characteristics and circumstances of the seller’s business and whether the company will remain a stand-alone entity post closing or will become integrated into the buyer’s company. Common types of earn out-based performance targets are revenue, gross margin, operating profits and EBITDA. Earn out periods typically range from one to three years. Structuring an earn out that really works for both parties is tricky. Sellers prefer revenue and gross margin earn outs, because if the earn outs are properly structured, the acquiring company can do little to negatively impact the realization of the earn out. Some earn outs have a minimum earn out (floor) to protect the seller and a maximum earn out (cap) to protect the buyer. Payment of earn outs can be in cash, notes or stock. Clear, specific earn-out language should be included in the Letter of Intent in order to avoid future conflict. Please note that earn outs have a higher probably of being achieved if the company being acquired remains a stand-alone entity and the seller continues in an active senior management role over the earn out period.
In the example above, the earn out might be structured so that the seller receives an earn out payment of $1 million per year for two years, should the adjusted EBITDA exceed $4 million for the year.
Seller Financing
In today’s market, buyers of companies are unable to leverage (e.g., borrow from banks, junior capital sources) the purchase price as aggressively as they could a couple of years ago. This can create a gap between the cash desired by the seller and the amount of equity and leverage some buyers can assemble to complete the transaction. As a result, sellers are being asked to provide more financing now than in the past, often by the buyer offering a promissory note.
Notes are typically payable over a period of three to five years. Payment terms vary significantly. They might be monthly, quarterly, semi-annually or annually. Some notes are structured as interest only for the first year post close, and thereafter principal payments kick-in. Other notes might include a balloon payment. Interest rates are often similar to senior lenders. Payment of the note is typically subordinate to senior and junior lenders. Therefore, the final structure of the buyer note will be subject to the approval of the senior and junior lenders.
These notes are most often unsecured because senior and junior lenders will likely have priority security interests in the assets and stock of the company ahead the buyer note. Sellers should try and get a corporate guarantee or some other form of collateral from the industry or strategic buyer. Financial buyers such as private equity firms typically will not guarantee their notes. That being said, notes are less risky than are earn-outs. Should a downturn occur and cash flow materially decrease, sellers would be in a position to receive payments on the note ahead of the earn-out payment.
Seller Equity Rollover
Another option for bridging the financing gap that is growing in popularity is the seller equity rollover. In this scenario, the seller rolls over (retains) equity in his/her company’s stock or that of a holding company that is formed to acquire the assets or stock of the company. Retaining ownership sends a message to the buyer and the other financing sources that the seller is confident about the future of the company. It is attractive to the buyer because it mutually aligns the interests of all the parties to make the acquired company successful. Over the years we have seen seller-retained equity stakes in the acquired company range from 10% to 40%. Rolling over a significant equity percentage should entitle the original owners to some governance rights (e.g., one or more board seats) and some say as to how the company will operate. Rollover equity usually comes with transfer restrictions. We recommend that the seller consult with a tax advisor to make sure that the rollover qualifies for tax-free treatment. The upside of a seller equity rollover is that the future value of the rollover may become significantly greater than if you elected to receive cash when you sold the company.
In closing, while there are risks to earn-outs, buyer notes and seller rollover equity, if you feel confident in the future direction of your company and have faith in the buyer, these proven tools can position you to sell your company today and potentially provide you with some upside beyond an all-cash deal.
Bill Quish is a Mergers and Acquisition specialist and Certified Exit Planning Advisor (CEPA). He is a senior managing director at Lyons Solutions, LLC. He can be reached at 860-658-1845 or bill@mergermaven.com.
Copyright 2010 By Bill Quish. All Rights Reserved.
