Are You Attractive For An Equity Investment?

Equity Investment Candidate

by Terry Stidham, President of Target Search Group

Equity capital generally is composed of funds that are raised by a business in exchange for an ownership interest in the company. This interest can be in the form of ownership of common or preferred stock or instruments that convert into stock.

In addition to taking an ownership interest in your company, equity investors may also participate as a member of the company’s board of directors and take an active role in managing your company.

However, in comparison to debt financing, or loans, which must be repaid over time, equity financing does not have to be repaid.

While equity investing can come from family and friends, it’s often raised from high net-worth individuals or from venture capital or private equity firms. Investors are looking for early stage companies that can’t yet obtain traditional financing; a return on their investment of at least 30-40 percent and a clear strategy to realize their investment within 3-7 years.

What Makes a Company Attractive for 

Equity Investment?

• Industry – Typical companies that receive equity investment are high-growth companies, with the potential for a high rate of return.  These high growth industries include the energy sector, technology and media and entertainment to name a few. The companies receiving investment generally have the ability to be a market leader and often capitalize on "first mover advantage" in other words,  being first in a growing marketplace or industry sector.
• Clear Exit Strategy – Angel investors and venture capitalists are attracted to companies that have a clear exit strategy, allowing them to obtain the return on their investment. Often known as a "liquidity event", this includes an initial public offering; private placement, acquisition or merger with another company or management-led buyout. In general, investors are looking to exit an investment within 3-7 years.
• Financial Return – Equity investors are attracted to companies that clearly demonstrate the likelihood of significant financial returns. In general, these investors would like to see profit margins of more than 50 percent.

Requirements for Obtaining Equity

If your business is a likely candidate for venture capital, you must prepare certain information to sell your idea. This includes a very short oral presentation; an investor-oriented business plan and executive summary; and documentation for any due diligence analysis.

Oral Presentation - In searching for venture capital, you will have to pitch your idea to potential investors, often in informal settings. To do this, you must present your business concept and reasons for a high return in a short, concise (no more than two minute) presentation. If you are then invited to make a formal presentation to a venture capitalists or group of angel investors, these presentations generally last between 5-10 minutes.

Business Plan - You must prepare an investor-focused business plan that remains current based on market or business model changes. This business plan must include the following: .

• Executive Summary
• Description of the Company
• Analysis of the Marketplace
• Discussion of Products and Services
• Marketing and Sales Activities
• Discussion of Management and Ownership
• Organization and Personnel
• Funds Required and their Use
• Financial Data
• Exit Strategy

Due Diligence - Any company looking for venture capital should anticipate and prepare for the due diligence analysis that will be undertaken by any investor. In general, investors will want to see support for the assumptions and projections that are made in your business plan and presentation and to assess any liabilities. They will review financial statements, tax liabilities and any other potential legal liabilities. They will also want to test any technology and review any licenses, patents or documentation required to operate your business.

If you are ready for an Equity Investment then contact the Deal Sourcing Professionals at Target Search Group today.

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.

Eye of the Beholder

How Your Company is Valued Depends on the Buyer                                  

Tom Gledhill wrote a blog last week that took a look at different valuation methods that buyers use. He points out that different types of acquirers use different valuation methods. Knowing what buyers are looking for gives sellers guidance on how to prepare and present a business when ready to go to market.

Based on analysis one have a good idea of what buyer type will be interested in acquiring their company. But how will that buyer type value the business? Before considering that, let’s review the valuation methodologies. The following is a brief overview of the valuation process. A complete understanding of business valuation would require a college course at the MBA level!

Tom says, "You should note that valuing a business is not an exact science. Even the best appraisers need to make subjective decisions in the valuation process. Consequently, business valuations for the same company can vary from appraiser to appraiser.

3 Basic Valuation Approaches

Market Approach - This works best in real estate because there are so few parameters to consider, and they are fairly consistent by region and price range. Businesses, on the other hand, have an almost infinite number of moving parts, so that comparable sales have to be used in conjunction with other valuation methods. The problem with employing this approach to private SMBs (Small and Medium sized Businesses) is that there’s not enough data to compare apples to apples. The market approach is probably better suited to valuing public companies where a large amount of data can be gleaned.

Income Approach - The income approach may be the most common for valuing private SMBs. As expected, it is based on company revenues and earnings. One method is called Multiple of Discretionary Earnings Method (SDE), where the SDE is defined as the net operating income plus adjustments plus the owner’s salary. The multiple is the inverse of the capitalization rate (cap rate) which is determined from an analysis of the company. Another method, the discounted cash flows (DCF), is based on reasonable projections (usually 5 years), and uses a discount rate (usually the cap rate plus rate of growth) to calculate the present value of the future cash flows.

Asset Approach - The asset approach is used when the fair market value replacement cost of assets represents most, if not all, of the value of the business. Obviously, it is based on the net tangible assets of the business, the machinery, equipment, furniture and fixtures, etc. It’s typically used when the business is no longer a going concern, or if the business has been losing money for the last few years.

Valuation Method Depends on Buyer Type·

Strategic Buyer -These are typically large private or public companies. By their very nature Strategic buyers are interested in how the acquisition of your company can benefit them in the future, and they are not so concerned about what your company has done in the past. Consequently, the most likely valuation method will be the discounted cash flow approach.

Sophisticated Financial Buyer - These buyers are typically small investment groups, private equity groups (PEGs), and small companies interested in growth by acquisition. These buyers are interested in what your company has done in the past, as well as opportunities for growth in the future. Consequently, the most likely valuation methods will be the various multiples of earnings (using EBIT and EBITDA) and the discounted cash flow approach.

Lifestyle Buyer - The lifestyle buyers are looking for an income, the ability to build equity, and the ability to service their debt from future cash flows. There is a saying about this buyer type they will buy the future but they will only pay for the past. If they are looking at three companies and everything else is equal except for the future prospects, they will buy the company that presents the best opportunities. Consequently, the valuation method of choice for this buyer type is the multiple of seller discretionary earnings. For larger companies still within this buyer type segment, they may use the multiple of EBITDA method. The only difference between the two is that seller discretionary earnings includes the owner's normalized salary and multiple of EBITDA does not.

Industry Buyer - don't confuse the industry buyer with the strategic buyer. The industry buyer is usually somebody in your niche that you know and considers your company inferior to his company. He's typically a bottom feeder and is trolling for a company that he can buy on the cheap for certain assets that your company may have. If he uses a valuation method it will be the asset approach - probably a book value method. If there's any possibility that this particular buyer may be interested in buying your company (total assets plus goodwill), then you must seek professional help to even the playing field.

The valuation methods used by the buyer types presented above are certainly not cast in stone. In any given situation any buyer type may use several different valuation methods. If a buyer uses several different valuation methods, each method is typically weighted and the valuation methods by buyer type suggested above usually receive a higher weighting."

Terry Stidham is the President and founder of Target Search Group. He is a 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.

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