Sell-Side Due Diligence

Why Now More Than Ever

by Terry Stidham, President of Target Search Group

Many sellers are told not to worry about doing their own due diligence because the buyer will be doing it instead. This can be a big and costly mistake. The right time to identify problems or issues to be addressed is before going to market.  Sell-side due diligence is best described as a self assessment of a seller’s own financial position plus anything else deemed material to the sale. It enables sellers to proactively identify matters impacting value, negotiating leverage and speed to close, while minimizing uncertainty in the sale process.   Note that sellers should also perform a level of due diligence on potential buyers to confirm their ability to purchase, as well as other items that could affect the purchased business or the seller after the sale.  I have seen many sellers spend a tremendous amount of time and emotional energy in what was thought to be a deal, to only find out that the buyer could not even buy a cup of coffee. There are other times where the "buyer" has no intention of buying but is only there to gather intelligence on the seller's business. At it's simplest level, sell-side due diligence is identical to buy-side due diligence; it’s just performed earlier in the sale process.  None of this is new to the sophisticated investment banking professional, who realizes sell-side due diligence can play a critical role in maximizing value from a deal.   Exit activity is expected to be robust in the near term and private equity groups have a large backlog of portfolio companies that are well past the typical three to five year hold time according to PitchBook.  A look at today’s deal environment emphasizes why sell-side due diligence is more important than ever:  Dry Powder – PitchBook reports that in 2012, 47% of all exits were secondary, private equity to private equity buyouts.  Three years ago, that figure was 25%.  This trend will be exacerbated by the current capital overhang from vintage 2007 and 2008 private equity funds.  These funds are reaching the end of their investment mandate, so investors may lose access to these funds after this year.  The incentive for private equity firms is to put this money (dry powder) to work.   Buyer Due Diligence Intensifies – Serial buyers are putting more capital to work in each deal as valuations are being pushed upward. They are not only accepting potentially lower returns but an equal or higher risk that a problem overlooked could become a much larger one.  An issue viewed as insignificant a year ago can delay or derail a deal today.  Buyer reaction is to intensify their due diligence, focusing harder on historical earnings (searching for negotiating leverage), forecast assumptions, working capital trends and operational drivers of the target company.  Return on Investment – Sell-side due diligence can uncover positive findings that improve the seller's financial results.  An EBITDA adjustment of $100,000 could increase purchase price by $700,000 (assuming a 7x EBITDA multiple as the purchase price). The buyers might discover the adjustment in their discovery but it is up to the seller to let them know that they know. Mutually Beneficial – Historically, a sell-side due diligence project culminates in a written report that can be provided to a select number of prospective buyers. Today, potential buyers are asking for more.  In addition to validating adjusted EBITDA (quality of earnings) and analyzing working capital trends, management teams need a partner to assist them in compiling and presenting data room materials, analyzing historical operating performance, creating/validating assumptions used in a forecast and defending information offered to prospective buyers. Sellers, management teams, investment bankers and buyers all benefit from sell-side due diligence. Contact Us To Discuss Your Next Steps If you have a quality business to sell, now may be the time to sell it.  The general consensus on the street is that there is too much capital chasing too few deals. The easiest way to jeopardize a deal is to raise concerns about the reliability of financial information, operating performance and forecast assumptions presented by the seller. Maximize returns, minimize uncertainty and improve your chances for completing a deal by doing sell-side due diligence.

What Is A Letter Of Intent and Why Do You Need It?

Letter of Intent

In mergers & acquisitions, a Letter of Intent (LOI) is a very vital document because, when it is signed, it spells out the preliminary agreement between a buyer and a seller. Simply stated, a LOI is a nonbinding document that outlines the key business terms the parties have agreed to, which will later become the basis for and part of the Definitive Purchase Agreement and other agreements and documents that memorialize a business sale. Letters of Intent vary in length and specificity. Sometimes they are called term sheets, but no matter what they are called, Letters of Intent should spell out the major deal points, deliverables, timelines and contingencies that become the basis for the legally binding agreements.

A LOI serves many purposes besides documenting the business deal, including the following:

• Serving as a record of the progress of the initial negotiations
• Identifying items that need resolution in order to reach a preliminary agreement prior to due diligence
• Defining (often) a “no shop” provision or standstill period during which the seller is precluded from negotiating with other parties
• Minimizing the waste of time and money by both parties, because if they cannot reach agreement on the key terms and conditions of the transaction in the letter, there is almost zero probability of negotiating the other definitive documents
• Acting as the basis for the buyer obtaining financing from a lender
• Defining time frames and deadlines so that the transaction can move toward a closing in a predictable manner, even though delays and extensions are common in merger & acquisition transactions due to the need for third-party consents, renegotiation of terms, the magnitude of work involved in gathering due diligence materials and supporting schedule information for the definitive agreement, or for other reasons

At a minimum, a LOI should address the following three items so that there is no misunderstanding between the buyer and seller at a later date:

  1. The Parties to and the Type of Transaction

These should be spelled out clearly. Who is the buyer? Who is the seller? What is the form of purchase (Asset, Stock, Recapitalization, Merger, etc.)? What is being purchased and what is being excluded (are all assets, liabilities and debts part of the purchase, or are specific assets, liabilities and debts part of the purchase)? How are these assets, liabilities and debts defined (cash; accounts receivable; inventory; furniture; machinery; customer and employee lists; seller's right, title and interest in the office lease and other contracts; trade names and trademarks; accounts payable; accrued payroll and payroll taxes; and capital lease obligations)? Which party is responsible for paying off bank loans?

What is the total purchase price? How much will be paid at closing? What is the method of payment (cash, the buyer’s stock, note, stock options, earn-out)? If other than cash or stock payable at closing, when and how will the other payments be made? Will part of the purchase price be retained by the buyer to secure representations, warranties and indemnifications? If so, how much and for how long? If the purchase price is adjustable based on finalized earnings or balance sheet deliverables (e.g., working capital peg), how will any adjustment be calculated?

  2. Employment

What is the agreement between the parties as to if and how long the seller will be employed by the buyer? What will be the initial salary, bonus, benefits, vacation days, etc.? If there is to be a bonus, how will it be determined? Will the salary be guaranteed? Are there termination obligations as far as salary continuation and benefits? What are the terms of the noncompete agreement?

  3. Transaction Contingencies and Conditions

Must the seller meet any thresholds to receive the purchase price? Is the transaction subject to the satisfactory completion of due diligence? How will due diligence be scheduled? Is there an “adverse change in the business condition” clause? What is the outside date for execution of the Purchase Agreement and closing? What information is to be considered confidential? Is the transaction subject to board of directors or lender approval? Is approval required by a legislative body? Is there an exclusivity period? If there is to be a press release, when will it be issued, and will what is said be subject to mutual agreement? Who will be responsible for the various costs of completing the transaction, including any audit, brokerage or consulting fees? How will the purchase price be allocated so that each party can understand the tax ramifications of the transaction? Is there an exclusivity period? Can the LOI be extended if deadlines are not met?

It is important to address all the above-mentioned issues so that there is true understanding between the parties prior to initiation of due diligence and the drafting of the Definitive Agreements, and so that the transaction has the maximum probability of being successfully completed with the minimum of misunderstanding and renegotiation between the parties.

Is There An Angel In Your Future?

Angel Investors: For Startups

by Terry Stidham

There are currently between 5-7.2 million people in the United States who are accepted as accredited investors. This group of people, which represents as little as 1% of the U.S. population, is made up of wealthy individuals that make $200,000 or more in base salary every year, or maintain a net worth of over $1,000,000.

A common investing trend where the wealthy commit part of their portfolio in startups is called angel investing. According to the recent Reynolds survey, there are currently 756,000 angel investors in the U.S. who have made an angel investment or participated in a friends and family round of financing.

Angel Investors

The term angel investor originally comes from Broadway, where it was used when describing the people that provided financing for theatrical productions.

Angel investors invest their own money, where the typical amount raised ranges from $150,000 to $2,000,000. Since angel investors are very often individuals that have held executive positions at large corporations, they can often provide fantastic advice and introductions to the entrepreneur, in addition to the funds. A Harvard report provided information on how angel funded startups had a higher chance of survival.

Angel investments are high-risk, which is why this strategy normally doesn't represent over 10% of the investment portfolio of any given individual. What angel investors look for is a great team with a good market that could potentially return 10 times their initial investment in a period of 5 years. The exits, or liquidity events, are for the most part via an initial public offering or an acquisition.

According to the Halo Report, angel investors particularly like startups and early stage businesses operating in the following industries: internet (37.4%), healthcare (23.5%), mobile & telecom (10.4%), energy & utilities (4.3%), electronics (4.3%), consumer products & services(3.5%), and other industries (16.5%).

In today’s competitive business world, there are times when a business runs out of capital funds. The easiest and most convenient source of funding during such times, are often the angel investors. This however doesn't mean that they should accept cash from any angel investor. Choosing the right kind of angel investor is an important consideration.

While there are several kinds of angel investors, they can widely be categorized as –

7 Types of Angel Investors

1. Return on Investment (ROI) Angels - One thing about ROI angels is that, they invest only when the market is doing well. This is because; such investors are mainly concerned with the financial rewards they will be able to reap given the high-risk investments they make. For the ROI angels each investment is like another significant addition to their already diversified portfolio.
2. Corporate Angels - These angels are most often former business executives who have either been replaced from large corporations downsized or taken voluntary retirement. While these investors seem to be making investments only for the sake of profitability, they are actually looking for a paid & secured position in the company they are investing in.
3. High -Tech Angels - Though these investors are less in experience, the investments made by them in modern technology is quite significant. These investors value profitability as much as they value the exhilaration of introducing a novel technology in the market.
4. Entrepreneurial Angels - These are successful investors who have their own brilliant businesses, which provide them with a steady flow of income for making high-risk investments in start-up companies. While they make all efforts to help entrepreneurs launch their start-ups, they do not actively get involved in the operations of the company.
5. Core Angels - These are investors with extensive business experience, who have accumulated enormous amount of wealth over extended period of time. One important fact about these investors is that, they usually tend to make high-risk investments in spite of their losses, which adds-up to their diversified portfolio. Core Angels not just make capital investments but also useful knowledge investments.
6. Professional Angels - Being professionally employed as lawyers, physicians, etc, these angels make investments into companies of their fields. At times, they may invest in several companies simultaneously. Professional angels are extremely valuable for initial capital investments.
7. Micromanagement Angels - These are considered to be the most serious types of investors. While some of them are born with a silver spoon, others acquire their wealth through sheer hard work. These investors usually seek a board position & tend to implicate the business strategies they have incorporated in their own companies into the companies they are investing in.

Angel Investment Returns

Data collected by the Kauffman Foundation shows that the best estimate for angel investor returns is 2.5 times their investment even though the odds of a positive return are less than 50%, which is absolutely competitive with the venture capital returns.

The secret recipe for getting a good ROI is to diversify your investments into multiple startups and hedge your bet. Angel investors should look to position themselves as investors in at least 10 startups in order to play the startup game right. However, carefully selecting your picks and knowing who you are getting into bed with, so to speak, is very important. The due diligence process should be taken very seriously before making any type of decisions.

Angel Groups

During the last 15 years, angel investors have joined different angel groups in order to get access to quality deals. According to the Angel Capital Association, there are over 330 groups in the United States and Canada that are active within the startup community.

One disadvantage of joining an angel group is the time commitment of having to go to their events and networking with the group. In addition, most of the angel groups require member attendance to the screening process, which takes hours out of your schedule. Another requirement is that members need to invest a certain amount every year. For example, the New York Angels require every member to invest at least $50,000 during a 12-month period.

Investment Crowdfunding

Times are changing, and the new way to access deals is via investment crowdfunding. With investment crowdfunding, angel investors are able to navigate quality deals from home without any limitations and requirements, being able to invest lower minimums, allowing angels to hedge their bets with more startups.

Angel groups on average review around 80 deals per month. Another positive ingredient that investment crowdfunding platforms provide is the fact that they’ve done most of the due diligence process for you. Typically the venture follows this process:

• The entrepreneur submits all the business information (business plan, executive summary, financial information, investor presentation, etc.)
• The application is reviewed and the business analyst team decides whether or not it makes sense to move forward. This step is all about the compelling story, the uniqueness, and the traction that the business has been able to accomplish.
• The deals that pass the above filters are forwarded to the investment committee comprised of individuals with vast experience in acquisitions. All of them are active angel investors. The main focus during this process is to review the financials, legal structure, and deal terms.
• If the company passes the investment committee’s due diligence process, then the investment committee would schedule a conference call with the entrepreneur for additional questions and a full walk through of the pitch.
• If the call and additional background checks are passed the deal is posted on the platform and the interaction with the registered accredited investors begins.

Conclusion

One of the positive factors about investing in startups is not only the potential of getting a return, but also being able to be a part of something great. As opposed to investing in the public markets, investing in startup companies gives the investor the chance to be in communication with the team and opens the opportunity to be part of the growth.

Angel investing is positive all around. Not only because it could provide gains, but also because every single investment contributes to the US economy thanks to the jobs that these ventures create. It is important to note that during the past 17 years, startups were accountable for creating 65% of the net new jobs. Providing them with access to capital is without a doubt something that is needed in this country.

Angel investing is becoming the new venture capital. 50,000 companies were started by seed capital last year while venture capital firms financed only 600.

About the author Terry Stidham

Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

1st Quarter 2013 Closed Transactions for SMBs

Sales of Small to Medium Business are Up

by Terry Stidham, President of Target Search Group

In total, 1,897 closed transactions were reported in the first quarter of 2013, a dramatic bump over the 1,218 recorded in the same period of 2012. The number represents the highest number of businesses sold in a quarter since the second quarter of 2008. The 56% year-over-year jump is also the largest such increase since small to medium sized business (SMB) sales bottomed out in mid-2008.

Across the board for all industries, the average selling price was 2.2 times the company’s discretionary cash flow or approximately 60 percent of gross annual revenue.

The spike in SMB sales can be attributed to a couple of factors:

• For a few years now, SMB's financials have been improving as the economy slowly recovers. Business owners who have been looking to exit their business, particularly baby boomers ready to retire, finally have their businesses in sellable shape and are more confident that they will receive an appropriate financial return on their sale. This proved true in the first quarter of 2013 as the median sale price of a sold business was the highest level since 2009.
• Business transaction fundamentals are strong with a latent supply of owners ready to sell and improving buyer demand due to ongoing unemployment, recovering stock portfolios and the slowly improving lending situation. Just last month a survey of national business intermediaries found that 75.2 percent of respondents said they are seeing the same or more deals getting done as compared to 2012.

Top 2 factors driving increased valuations and sale prices are:

1. Increased number of buyers
2. Low cost of capital

As the stock market and overall economy improve, so do the financials of SMBs across the country. According to the data, the median cash flow of a SMB sold in the first quarter of 2013 increased 20.45% from the same quarter in 2012. Median revenue also improved by 11.45% from the same quarter last year.

Quick Pitch Business Plan Components

Business Plan Basics by Terry Stidham

Congratulations, you have a winning business idea. You’re excited, inspired, and ready to raise capital. Now you need to write a business plan. You Only Have Seconds to Generate Interest

The 3 goals of a marketed business plan should be to: Have it Read Generate Sufficient Interest  Set up Face-to-Face Meetings Investors have numerous business plans to review. Consequently, your business plan needs to stand out by delivering a succinct and well thought-through message. Components of Your Plan Your executive summary should: Be no more than three to five pages Answer the basic "who, what, why, and how" questions Who is on the team  What do you sell and to whom? Why do your customers buy your products or services? How much money is required? Your Business Plan Should Include: Executive summary Brief history of the company Description of products or services (including detailed value proposition) Market overview (including trends and competitive analysis) Business model (including evidence to support critical assumptions) Operations overview and strategy Product development and delivery Distribution channels Organizational charts and management resumes Historical and projected financial statements (including cash flows) Description of short and long-term financing requirements You will have to write a solid, formal business plan. Business owners who want to borrow money or attract investors will be successful only if they have well-written, well-researched business plans. All of your potential lenders or investors will want a crisp and clean overview of your business and a solid idea on how it will work before ever deciding to take a closer look and giving you that important face-to-face meeting.