 After years of working in M&A and countless conversations with entrepreneurs exploring their exit options, you start to notice patterns.
Recently, I ran into a situation that is common enough to be given a "name" - I call it "The Perpetual Valuation Gap". That's when, after extensive discussions with a potential sell-side client and a detailed review/analysis of their business, you conclude the business is worth "X". In this case, let's say $10 million. But the owner thinks it's worth $20 million. So you part ways amicably and promise to keep in touch. After all, if you can't come to some level of consensus on value, then running a professional, competitive sell-side process on behalf of a client will be a huge waste of everyone's time (and money). Of course, there is always an outside chance for an "above market" deal, and no one can consistently predict the outcome of a sell-side engagement. However, with years of experience, we certainly can judge the probability of a successful outcome. So after a few years, you reconnect with the owner and conclude it is finally worth the $20 million they thought it was worth years before, but now the owner's valuation expectations are $30 million. Sometimes this pattern keeps going and the business never sells and they never engage, because you won't tell them what they want to hear. In some cases, the owner continues to field inbound inquiries from buyers, but the discussions rarely proceed very far. On occasion, they find an M&A Advisor that runs a full sell-side process that usually ends in disappointment. In my humble opinion, the last thing you ever want to do is to put the business out there to test the market and end up in a failed process. Unless the circumstances are easily explainable on why the business failed to sell, or there is sufficient time between the failed process and any new marketing initiatives, it is likely to be considered "poisoned" by some buyers that would otherwise be serious contenders. The adage that "if at first you don't succeed, try, try again" does not apply to the Sell-Side M&A process! Every seller wants potential buyers to understand the future potential of the business, and every M&A Advisor representing them needs to be able to paint a clear picture of the value proposition with potential buyers to drive the competitive process. The best outcomes are when there is consensus on potential value, the business is properly prepared for a sale, it is marketed professionally, and when there are properly structured incentives in place to create alignment between sell-side advisor and client. Eric Bosveld, B&A Corporate Advisors
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 Myths about private company business value abound in the private capital markets. Part of the reason for this is that there is often very little data to make accurate comparisons, or when the information is available, it is either out-of-date and/or there is little contextual information available. Another reason is that business value is not something most business owners think about regularly as they are often not talking to buyers, private equity groups, and other types of investors daily.
While precedent transactional data and non-publicly available deal insight by M&A advisors can be helpful, it is only part of the solution. Most buyers will spend considerable efforts to build out the financial models to carefully assess what a potential business is worth to them, and act/bid accordingly. This blog article addresses some of the common myths business owners often have about how a buyer will value their business when they put it up for sale. Myth #1 - The more valuable the business’s assets, the more valuable the business While quality assets are a component of a business’s value, it is their ability to generate cash flow that drives value. Cash flow can be used to reinvest and grow the business, pay down debt, or be paid out to shareholders. Typically, asset-light businesses trade at higher multiples than asset-heavy businesses, for the simple reason that cash flow is not tied up in replacing assets as they wear out. Owned real estate can be an exception. It can also be a tricky component of the valuation assessment, as sometimes the value of the real estate has appreciated over time, but there have been no corresponding rent or lease expense increases that are based on the market. A highest and best use assessment of the property may indicate that most of the value of the business is in the real estate itself, rather than the operating business. Myth #2 – Industry-standard EBITDA multiples or “rules of thumb” metrics can establish business value Average multiples or “rules of thumb” metrics can, at best, crudely estimate value, and really should only be used as a “check” once a proper valuation assessment is made. By definition, an average means that most businesses are worth more or less than the average. There are dozens of interacting factors that are unique for each business that impacts the future cash flow it can reliably generate, and therefore its value. Two companies with the same sales and the same EBITDA may be worth entirely different amounts based on differences in customer/revenue quality, supplier relations, location, etc. Myth #3 – Enterprise value equals equity value Private company M&A transactions are normally on a cash-free, debt basis, regardless whether it is structured as an asset or share deal. In other words, the buyer will pay the seller what they think the business is worth to them (the enterprise value), but the seller will have to use the proceeds to pay off any debt, including lines of credit, term debt, loans from shareholders or related parties, tax liabilities, etc. On the flip side, if the business has no debt and there are cash or cash equivalents on the balance sheet, the seller normally will keep the cash, or it will be added to the purchase price adjustment at the close. The enterprise value equals equity value myth is most common when the buyer’s offer is to acquire the shares of the business. Of course, there are situations where a buyer purchases the existing shares of another shareholder and thereby assumes its pro-rata share of any liabilities, including debt. This is more common in minority deals, or when the debt terms are more favourable than what a buyer could obtain on their own. But remember, the pro-rata share value does not equal the pro-rata enterprise value. Myth #4 – Working capital assets such as inventory and receivables are added to the business value The logic here is how can a buyer know the inventory and receivables value if they are changing daily. Therefore, they must be added to the purchase price at close. The truth is that current assets used to operate the business are part of the business value, however, they are offset by current liabilities such as trade payables, prepaid operating expenses, etc. In other words, it takes a certain amount of working capital to operate the business, and the enterprise value includes an appropriate and negotiated amount of working capital, regardless if it is financed by a line of credit or cash on hand. The exception may be for very small “main street” type businesses where the owner sells the business plus the inventory on hand at close at cost. There are lots of other myths out there that we will address in future blog articles.  In a Harvard Business Review article, entitled "The Secrets to Successful Strategy Execution", "information flow" and “clarifying decision rights” are identified as the most important factors in determining whether a business is effective in executing its strategy. In our last blog article, we provided some tools, insights, and ideas that can help improve information flow and ultimately drive business enterprise value as it executes its strategy. In this week’s blog, we address how “clarifying decision rights” inter-relates with “effective information flow” and a business’s strategy implementation effectiveness. The most valuable businesses are those that have a clear strategy that is implemented effectively and where everyone has a good idea of the actions and the decisions for which he or she is responsible.
People make day-to-day decisions based on their level of authority and on the information they have available to them. In every business, there are hundreds of decisions made each day or even every hour that may or may not align clearly with the intended strategic direction of the company. The blurring of decision rights as a company grows is a common problem and can create paralysis where no one decides or when everyone seems to have a say. Even worse than paralysis is when conflicting decisions are made inadvertently. Having well-defined decision rights as part of a detailed job description along with specific goals and objectives for each employee is a critical starting point. This will help identify areas in which there are gaps and/or overlaps in responsibilities and where clarification on decision-making rights may need to be reviewed. This alone, however, will do little to ensure clarity on decision rights across the company. Neither will be making changes to a company’s hierarchy or organizational structure. The way to make progress in clarifying decision-making rights is to proactively, systematically, and deliberately figure out how the decision-making process can be improved in the business. One technique outlined in an article published by Deloitte is to simplify, define, and communicate what, how and who makes decisions by using a Responsible, Accountable, Consulted, and Informed (RCAI) framework. This can be applied to new hires, customer pricing terms, new marketing initiatives, product launches. Of course, the bigger the decision, the more clarity required. It is best to start with the decisions in which there is the greatest ambiguity, and which can have the biggest impact on the company’s strategic goals. First, decide who is Responsible for carrying out the actions tied to the decision. Next, determine who is Accountable. This should also the person (or group) that makes the final decision, and all involved should know who this is. Some people should be Consulted for their input, along with a consultative process to ensure the best decision is made. Finally, there are those in the organization that should be Informed once a decision is made. This could include people in other parts of the business, including those in lateral, senior, and junior roles. A similar framework is outlined in a Harvard Business Review article, called RAPID – Recommend, Agree, Perform, Input, and Decide (although not necessarily in that order). The key is to make sure everyone knows what decisions will be made by who and how they will arrive at those decisions. Without a defined framework, many that are asked for input may become disenfranchised when decisions contrary to their input are made. Often people are confused about the difference between responsibility and accountability. As the company grows and the team gets larger, with more cross-over in responsibilities across functions, the information flow tends to weaken and the clarity on decision rights gets foggier. Ultimately, the best decisions are made by competent people with the right information at the right time, but only when they have a clear understanding of the business strategy and with a well-defined decision-making framework. Always keep in mind that the most strategic companies are often the most valuable companies. How Partnering with the Right Private Equity Partner Can Produce Outsized Results  On November 24, 2020, Private Equity firm L Catterton and McCormick & Company (NYSE: MKC) announced the pending sale of the popular Mexican hot sauce maker, Cholula Food Co. to McCormick for $800 million. With 2020E sales of $96 million and ~$32 million in EBITDA, the deal translates to ~8.3 x revenue and ~25 x EBITDA: an outsized outcome for L Catterton by any standard. L Catterton made 4x its money on the deal since buying the majority of the business in April 2019, according to an article published in Food Processing.
So, what made the deal so attractive to McCormick that they agreed to anti-up such a big multiple? Even more interesting, what was L Catterton able to accomplish in such a short time that would drive the value of Cholula to such stratospheric multiples? According to the deal press release, the value-creation program over their nineteen-month ownership period was multi-faceted and included recruitment of industry-leading talent, operational improvements, and heavy investments in the brand and its marketing by increasing awareness and loyalty. L Catterton was able to increase household penetration by over 50% during their short ownership period. According to Cholula CEO, Maura Mottolese, “L Catterton… vastly improved our commercial execution efforts, and pivoted our foodservice strategy to position Cholula for long-term growth and success. L Catterton was well-positioned to acquire and grow the Cholula business by virtue of its global footprint, including its presence and local team in Mexico…” According to an interview with CNN, Mottolese outlined that forty percent of consumers learn about Cholula through their in-dining experience at restaurants. At the onset of the pandemic, foodservice sales dropped dramatically, so the company needed a new strategy. It chose to focus on the co-branding of new menu items and new packaging. It also pivoted its retail grocery strategy with the introduction of a new 2-ounce bottle for consumers to sample, as they began cooking more at home. L Catterton is no stranger to effectively growing middle-market CPG companies. With $20 billion of invested equity, L Catterton claims to be the largest and most experienced CPG-focused Private Equity Group in the world. Although Cholula’s hot sauce recipe has been marketed and sold in Mexico for years, it was first introduced in the U.S. in 1989 and is now sold in over 20 countries. The product line is made with a unique blend of peppers combined with a secret blend of signature spices. Since the brand was first introduced into the U.S., it has been effectively marketed as “The Flavorful Fire” through sporting events such as snowboarding, football, baseball, and joint promos with restaurant chains such as Papa John's. In 2019, it launched “Tacopedia”, a series of interactive exhibits described as “an Instagrammable Amusement Park Disguised as a Pop-up Museum”. According to Lawrence Kurzius, McCormick Chairman, President, and CEO, “McCormick has a history of creating value through acquisitions. We have a proven track record for achieving our plans and accelerating the performance of acquired brands. We plan to grow Cholula by optimizing category management and brand marketing, while also expanding channel penetration…” In an investor presentation, McCormick outlined the following as the key drivers behind the acquisition:
McCormick became intimately familiar with the trends impacting the hot sauce market through its acquisition of Frank’s RedHot Hot Sauce in 2017, as part of a $4.5 billion deal with RB Foods. According to Statista, the hot sauce market in the U.S. is currently a $1.5 - $1.55 billion market and expected to grow to about $1.65 billion by 2022. Nielsen estimates that the hot sauce category has been growing by 9.7% over the last four years. Here’s the first take-home message! High-quality distinctive product line with growing sales and high margins + rising tide for product category + brand marketing and management expertise + smart capital + strong fit with well-capitalized industry leader = outsized exit multiple. And here’s the second take-home message! While it is unclear how much scale was driven by L Catterton’s investment during its ownership, this deal is an outstanding illustration of how private company owners can partner with Private Equity to become highly attractive, middle-market companies when they choose the right firm. And even more importantly, when owners roll equity through a PE recap, the rewards for a two-step exit plan can be truly outstanding! Prepared by Eric Bosveld and Vijay Malhotra, B&A Corporate Advisors  In a Harvard Business Review article, entitled "The Secrets to Successful Strategy Execution", "information flow" and “clarifying decision rights” are identified as the most important factors in determining whether a business is effective in executing its strategy. Also important were "aligning motivators" and "organizational structure." All four factors are highly inter-related and of course, executing a well-thought-out strategic plan usually leads to an increase in enterprise value.
Effective information flow throughout the organization allows for quicker and better strategic decisions, whether it is information flow from the front office to the back office, from corporate headquarters to the locations, from the plant floor to the office, from one business unit or department to another, etc. As an organization grows, effective information flow becomes more complex and naturally gravitates to become increasingly ineffective. So how do you resolve this challenge? We believe there are three primary ways to improve information flow and hence dramatically improve a business’s ability to effectively act on its strategic plan. 1) Strategy Communication. The business's strategy must be clearly communicated throughout the organization regularly to be understood and thereby acted upon. Everyone in the business must also understand how their role contributes to the strategic plan. Management must commit to effective information flow on how the business is progressing towards its strategic goals to maintain momentum and employee engagement levels. 2) Strategy Review Meetings. Many people think they already participate in too many meetings. To effectively implement your strategy, strategy review meetings need to be separated from operational meetings. They also need to be scheduled regularly. The optimal interval between meetings depends on the business growth rate and how quickly the market landscape is changing. For very fast-growing companies the interval needs to be very short, however, in all cases, they should never be less frequent than once per quarter. Each strategy review meeting has three primary purposes: 1) to repeat, reiterate, and reinforce your business strategy to gain deeper team insight, input and clarity, 2) to review progress towards your strategic goals and identify the key barriers/challenges that need to be resolved, and 3) to set your top strategic priorities and the action plans that need to be implemented before the next strategy review meeting. Regular strategy review meetings build and maintain momentum by keeping the team focused on what's important. They also facilitate effective information flow which is essential to bring the strategy to life. 3) Information Technology. Information flows up, down and across the organization has never been easier with today’s communication technology. However, at the same time, it has become more difficult to separate the important and critical data/information that is needed to drive the organization’s strategy, from the everyday noise about operations, the market, your competitors, etc. Strategy-focused organizations have systems in place to collect, analyze, and share critical data, such as key performance indicators on important strategic initiatives, in real-time. Each strategic goal needs to have an “owner” i.e. the person that is responsible for the collection, analysis, and updating of the data used to assess progress or when key milestones are completed. If it is a high priority, highly important, stretch goal, it normally will only be accomplished if the team can stay intensely focused on implementing the action plan. It must then remain “top of mind” through effective information flow. It is amazing what a team can accomplish when focused and given clear insight with real-time feedback on the team’s progress towards a shared goal. And when a team is energized, rewarded, and focused on important strategic goals, it inevitably drives enterprise value and creates more and better exit options for shareholders. In our next blog article, we will address how “clarifying decision rights” inter-relates with “effective information flow” to drive an effective strategic plan implementation.  Sellers routinely underestimate what it takes to convince a buyer to close on a deal. They also often tend to mistakenly withhold information that they deem to be immaterial, only to find that when it emerges during due diligence, it threatens the deal or the potential buyer tries to renegotiate the initial offer.
Potential buyers of a business view investment risk and opportunities from a completely different frame of reference than the seller. They worry that they will pay too much, or even more so, that the business may not perform as expected once they become the owners (and hence, they paid too much). The seller, on the other hand, is already intimately familiar with the business and understands its customers, its suppliers, employee matters, etc. and the business risk and opportunities associated with each. Transferring that deeper understanding of the real risk and opportunities from the seller to the buyer is ultimately the overriding purpose of the due diligence process. Sellers must look at the business from the viewpoint of a buyer and try to anticipate how buyers will perceive risk and opportunities with a healthy dose of skepticism. Simply put, buyers will believe what the seller can prove and be skeptical of what they can’t. Undertaking a comprehensive “Pre-Sale” due diligence process will go a long way in preparing the business for a smooth sale when it is time to sell. By “Pre-Sale” due diligence, we mean a comprehensive investigation or review of all aspects of the business, either through the utilization of internal resources or by an outside advisor, to identify, document, and ultimately correct issues that will be inevitably uncovered by a potential buyer. So how do you begin the process? The first step is to compile a due diligence list and populate it. Buyers expect to review almost everything today electronically, so start by building a directory on your server or online. It should be organized by major sections, such as “Financial”, “Operations”, “Sales and Marketing”, “Legal” etc. with subdirectories for each major section. Once the information readily available has been uploaded, gaps and shortcomings will start to emerge. Are your operating procedures up to date and documented properly? Have changes been made to your performance management program that is not fully reflected in your latest employee manual? Employee matters are a critical part of the due diligence process by buyers. Are there restrictions to assignment clauses in important supplier agreements? Are there inter-company or related-party transactions and relationships that are not documented with formal contracts and are they at market rates? Revenue quality (sales that are, profitable, sustainable, and predictable) is one of the most important aspects explored extensively by potential buyers early in the due diligence process. Sellers should be able to aggregate and segregate sales and margins by customer, customer type, region, salesperson, location, product, product line, etc. Sophisticated business analytics capabilities will go a long way in helping a buyer assess risks and opportunities, as will a comprehensive, up-to-date, written business plan, complete with embedded strategic planning and implementation processes. Having audited statements will help ensure that the firm’s accounting practices are up to date and the internal controls are up to industry standards. An audit will help build a buyer’s level of confidence in the financials, but some may require a “Quality of Earnings” (QofE) review. A QofE will help a buyer determine maintainable earnings by adjusting for one-time/non-recurring expenses and sales, owner-benefits, inter-company and related-shareholder transactions, etc. For companies that have a lot of potential adjustments, undertaking a QofE by the seller before going to market may be advisable. Organizing and compiling the information a buyer will need to review will give you a “running start” when you hire an advisor to assist you in the sale, or when you begin discussions with potential buyer candidates. It will also get your potential buyer to “yes” or “no” a lot faster if you’re prepared. Drawn-out extensive discussions and “bit by bit” information flow usually leads to a monumental waste of time for all involved. The reality is that buyers will eventually uncover any “skeletons in the closet”, so it is always best to identify and correct them on your terms and well before you get into detailed negotiations with a potential buyer.  Any owner-operator that has read even a single article on transition planning will know that the key starting point is to make the business less reliant on any single person, or more importantly, yourself. For owners that are looking to sell, any risk (real or perceived) to future cash flows related to its reliance on any key person, can dramatically affect its transferable value (i.e. what it’s worth to someone else without you). Even if the business is sold to management, employees, or transferred within the family, it must have transferable value or it may be doomed to fail. However, simply knowing the path you must take is only the starting point: taking concrete steps as part of an actionable plan is what matters.
For small companies, the first step is to grow the business beyond your capabilities. Most often, very small lifestyle businesses have no transferable value. Even businesses with 5-10 employees can be difficult to transfer successfully if the owner-operator makes the key decisions and the rest of the staff are sales, administration, and operational assistants. Many owner-operator entrepreneurs are so focused on keeping costs low that they get stuck in a rut, and the business never makes breakthrough performance. Being the first one in the office and the last one to leave may be a great way to set an example, but it may also be a sign that business will never grow beyond what it is doing today. Breaking through a size plateau is no easy task. One way to start is by focusing on the critical tasks that play to your strengths and then slowly delegating everything else. This is going to take some time and most importantly, it will take patience. Unique knowledge and skills, as well as relationships with vendors and/or key customers, are transferable when the right people are patiently mentored and supported by the boss. Most importantly, it will free up time to work “on” the business rather than “in” the business. Building next-level management also requires the right incentives, support, and the ability of the boss to get out of the way by not second-guessing every decision or critiquing the process. Instead, the owner-operator's energy needs to be spent nurturing next-level managements’ capabilities and focusing on the many other drivers that will increase enterprise value. According to a Mckinsey report, between 25% and 50% of leadership transitions fail or were deemed as a disappointment after 2 years. The main reason cited was organization politics and a lack of support. Ultimately, the goal is to transition from General Manager to Chief Strategy Officer. The key is to focus on ensuring the business is well-run rather than running the company well. It is important to understand what it takes to evolve from a manager to a leader. So how do you get there? Every situation is unique however an interesting tip worth considering for small companies is to take an extended vacation, or perhaps shorter vacations more frequently. Employees and next-level management naturally step up to the challenge when the boss is away because they will not want to bother you with every little decision. Soon the “wheat will separate from the chaff” and the real leadership skills of key employees will begin to emerge. For companies that already have a quality “next-level” management team in place, driving transferable value often involves more formal HR practices to recruit, nurture, and retain talent. Best practices around your onboarding program, incentive programs, performance reviews, etc. will be necessary. Building the skills and talent of the entire team drives transferable value regardless of the stage or size of any business. And building transferable value is the only viable way to successfully exit regardless if the business is sold to a third party, transferred to the next generation, or kept as an investment in a family trust for future generations.  Many experienced business owners and management teams have lived through both good times and bad and have the scars to prove it. Entrepreneurs late in their career may have experienced the exorbitant interest rates and high inflation in the 1980s, 911, the financial crisis in 2007/08, and the subsequent recession in 2008/09, amongst others. Like every crisis, the COVID-19 pandemic has created challenges that require solutions that are unique to each business and industry.
For private business owners planning their exit, the pandemic can present some additional challenges. Depending on the situation, it may mean that any exit plan that includes a sale is best delayed. Perhaps there has been a drop in earnings and the business’s anticipated enterprise value, or there are fewer buyers with the financial wherewithal or interest in actively pursuing acquisitions. Perhaps it simply creates challenges for buyers undertaking their due diligence as not everyone is able or comfortable with traveling or participating in face to face meetings. Nevertheless, the demonstration of resiliency during adverse or unusual business circumstances, such as a pandemic, can enhance long-term business value and interest from multiple buyers. Managing during difficult times usually means getting back to basics. That is, watching and/or reducing expenses, freezing new hires, deferring non-essential capital expenditures, and perhaps even shutting down non-core parts of your business or selling off/discontinuing unprofitable product lines, etc. In the current pandemic, it also means implementing safety protocols that keep employees healthy and limits absenteeism. Presuming any downturn is not fundamentally permanent, the tough times can also create special opportunities as well; such as buying out a competitor or securing a “rock-star” employee or manager that has been laid off or downsized. A business’s ability to survive a severe market down-turn boils down to two key items: 1) its capital structure, and 2) its management team and their problem-solving skills. A well-financed business with a strong balance sheet and a talented management team that emerges from a downturn “leaner and meaner” is in a better position to withstand the next downturn and is fundamentally worth more to a buyer. In some cases, when times are good and access to debt financing is easy and cheap, business owners are lured into investments that may impair their ability to weather the inevitable or unforeseen downturns. Many businesses do very well during the good times simply because they have a “strong wind in their back”. Sometimes this can lead to aggressive decisions on pricing to capture market share or recruitment of talent with “out of this world” salaries or incentives. In good times, customer objections may be easy to handle with profitable solutions. Even the poor performing salespeople, seem to hit their targets each month. The key to management in the good times is to ensure that you don’t get complacent or sloppy. A highly disciplined approach to investments and growth is critical. It is also critical to build resilience into your balance sheet to withstand the inevitable turn for the worse that is down the road. So regardless of where your business stands under the current circumstances…regardless if the times are good or bad, entrepreneurs and management teams need to be keenly focused on continually improving performance across all functional aspects of the business and building resiliency into their capital structure. As the adage goes, “Good times become memories and bad times become lessons!”  Redundant assets, or non-operating assets, are those assets that are not specifically required to generate cash flow and earnings of a company’s core business. They can be either fixed assets such as real estate or working capital assets such as inventory. When valuing a business, the net realizable value of the redundant assets is added to the value of the operating business to give an enterprise value. In circumstances where redundant assets make up a significant part of the enterprise value and the owner is planning to sell the business, some prudent pre-sale preparation can go a long way to help ensure an acceptable outcome.
Often buyers will not pay full market value for a business that has significant redundant assets as they are only interested in the core business and its future cash flow. Sometimes a seller can easily carve out the redundant assets to retain post-sale, but it can also complicate the deal and the negotiation process. The best option may be to divest redundant assets before marketing the business for a sale. Strictly speaking, real estate can be considered redundant, when the company does not engage in real estate as part of its core operations. Pre-sale divestiture of non-operating real estate can be to an outside party, to a shareholder, or a related entity. Selling to a shareholder or setting up a related entity to acquire the company’s non-operating real estate allows the seller to take a disciplined approach to obtain its fair market value when it is time to sell or retain it for long-term appreciation. While the carve-out for retention or pre-sale divestiture of real estate holdings not used in the operating business can be straightforward, owned real estate used by the business can be a little trickier, particularly if its book value is substantially less than its market value. In this situation, it may be best to explore a sale-leaseback in advance of a sale of the business. A sale-leaseback is where a company sells an asset, such as its real estate, to either a related entity or a third party, then leases it back at market rates on an arms-length basis. The cash it generates can be distributed to shareholders through a special dividend or used for operations. This approach could have significant tax implications and therefore obtaining expert advice from a tax specialist familiar with sale-leasebacks is critical. It will also undoubtedly impact the business’s earnings, as a new lease payment based on the market value of the property may be higher than the depreciation it replaces. This may mean the business is worth less but the combined value, net of taxes, should be higher. Separating the real estate through a sale lease-back to a related entity or shareholder can also unlock more value in a couple of other ways. First, it may generate more interest by a larger set of potential buyers, when there is flexibility on the part of the seller. Some buyers may want to acquire both the real property and the business, while others may be interested in the business only. More potential buyers can mean higher values in a well-run competitive process. Second, asset-light businesses can attract higher multiples, as they are in higher demand. A study by Ernst and Young found that companies that transitioned to asset-light models were more likely to generate higher Total Shareholder Return (TSR) than their asset-intensive competitors and 17% more likely to exceed shareholders' expectations of value when sold. Taking this concept further, there may be instances where the pre-sale divestiture of a division or product line can unlock further value. According to a Harvard Business Review article, a disciplined approach to divestiture can not only sharpen a business’s focus on its core strengths and strategy, it can also create almost twice as much shareholder value (based on a twenty-year study by Bain and Company). Finally, almost every business has a list of assets that are fully depreciated and underutilized. Perhaps there is production equipment that is used as a backup or only used periodically that can be sold. Selling these types of assets before a sale will likely be advantageous for the seller as buyers would normally expect all operating equipment on the books to be included in the purchase price. The same principle could be applied to any excess, written-down, or non-core inventory. There also may be receivables that a buyer will not want to assume or will use to negotiate a late-stage purchase price adjustment. Selling receivables to a factoring company beforehand may be a more disciplined way to generate maximum value. The key to maximizing the value when it is time to sell the business is to plan and to think through the best options for your specific situation; which among other things, may mean the pre-sale divestiture of redundant assets, or even a product line or business unit.  The use of an earnout is one mechanism buyers and sellers of private businesses can use to simultaneously satisfy both parties differing viewpoints on business value during an M&A negotiation. While most sellers would prefer an “all-cash” deal, buyers often remain skeptical of the sellers’ projections, particularly when there are a lot of market uncertainties. The earnout can help mitigate those concerns but can also raise other issues that sellers need to be cognizant of, and as such, requires careful consideration.
According to data supplied by SRS Acquiom on more than 1200 private company transactions between 2016 and 2019, 27% of the deals included an earn-out provision, when the deal size was less than $50 million. When the technology and life-science industries were excluded, it drops to 19%. Almost all earnouts had a cap (97%), and 80% were for three years or less. More than half (53%) were based on revenue, while 33% were based on EBITDA or some other earnings metric. Forty percent were based on some other milestone metric or a combination of financial and milestone metrics. The earnout is inherently risky for the seller for the simple fact that they have given up control of the business, and therefore may or may not be involved in key decisions that could impact the payout of the earnout. The buyer’s priorities often change as they begin to operate the new business and decisions on funding new hires, marketing, new product development, capital expenditures, etc. also change. While many “resource provisions” can be included in the earnout agreement, market conditions, such as a global pandemic, may require a business to pivot from its plan, and force a business to re-think its allocation of resources. It is doubtful that pre-2020 deals with existing earnouts included provisions for a pandemic, yet it is reasonable to assume that many may not be paid out as a result. It will be interesting to see whether the pandemic leads to an increase in disputes that need to be settled through arbitration or worse, litigation. There are generally two broad categories of earnout payout provisions: Those based on financial metrics and those that are based on non-financial metrics. Financial metrics include items such as EBITDA, revenue or some combination of financial metrics. Generally, sellers prefer revenue as they can have little control over operating expenses. Buyers are often concerned about using revenue as a metric, as new sales may not be very profitable, and therefore prefer some type of earnings metric. There can also be disputes on how financial metrics are calculated so it is critical to have this clearly defined upfront. An adjusted EBITDA metric is one option often used, whereby the line items used to make the adjustments are defined beforehand, or it is based on a baseline EBITDA amount or percentage. One best practice is to include an example calculation in the agreement itself. Complex earnouts that rely on accounting standards, assumption on expense exclusions/inclusions etc. can be a dispute waiting to happen. Non-financial metrics can sometimes be simpler to use and less subject to dispute. For example, a business may be worth a lot more to the buyer, if a contract with a large customer is renewed. Perhaps the seller can have a significant influence on whether it is renewed, after the business has been sold, and can mitigate concerns a customer may have with management under new ownership. On the flip side, the buyer may be concerned that conditions of the renewal may not be acceptable, while the seller may be concerned that the new owner is not aggressive enough on pricing. While good data on the probability of a payout is hard to find, there are certainly lots of anecdotal stories of where the full earnout was not paid. The key for both parties is have the provisions clearly defined, ensure that dispute mechanisms are fair and specific to the earnout and to keep them simple and easy to calculate wherever possible. Given the current M&A environment from the pandemic, earnout provisions are likely to be for longer terms and likely to become a larger part of the total consideration. The use of an earnout to bridge a valuation gap can benefit both the seller and the buyer when structured properly. The buyer reduces the risk they will be paying for results that never materialize, and the seller can potentially find a path to meet their full valuation expectations. Undoubtedly, both the legal and tax implications can be complicated and material to both the seller and the buyer, so caution and thoughtfulness are a prerequisite for both parties. |
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December 2024
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