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.

Is Your Business a Platform or Bolt-On Candidate?

Private Equity Firms Account for a Substantial Amount of Action in the M&A Market

by Terry Stidham

Private equity groups are well known for acquiring large companies. Their deals, measuring in the hundreds of millions and even billions are regularly reported in the local and national business pages.

Less known is the fact private equity groups make a lot more acquisitions of companies with sales under $20 million than of companies with sales over $100 million. The Wall Street Journal seldom reports on PEG's acquisition of $1 or $2 million companies, but they are taking place quietly, on a regular basis. 

If you have a business for sale and are being courted by a private equity firm, it might be helpful to know they make two types of purchases: platform and add-on acquisitions.

Platform Acquisition:

A platform acquisition is going to be larger company within a particular industry for the private equity firm—essentially a foundational operation they will continue to develop through both organic growth and “add-on” or “bolt-on” acquisitions.

Add-On /Bolt-On Acquisition:

An add-on /bolt-on acquisition is when a private equity-backed company acquires another company as a "bolt on" to enhance the private equity-backed company's value.

Generally, for a private equity group to make a platform purchase, the acquisition target ha-s to be doing at least $10 million to $20 million in sales and at least $2 million in EBITDA.

When a private equity group makes an add-on purchase, on the other hand, it’s more of a strategic play because they already own at least one company in that industry. They add smaller companies to the platform in order to expedite top line and bottom line growth, making the company more profitable and more attractive to the next purchaser. 

By growing a company from a $2 million EBITDA to a $6 million EBITDA through both organic growth and acquisition, the private equity firm will typically get a significantly higher multiple for the entire entity than they paid for each company alone.

The M&A Source with support of Pepperdine University has begun tracking private equity platform and add-on purchases as part of its quarterly market pulse report.  In the third quarter of 2012, national members reported that private equity purchases were almost nonexistent until opportunities reached $5 million in value.

In that study, private equity dominated lower middle market purchases of $5 million and above, at 68 percent of deals closed.  Of those, nearly all were add-on acquisitions.

From a seller standpoint, this helps you understand that the private equity firm will be making a more strategic play for your business, rather than looking at it from a financial standpoint.  That impacts both positioning and value.

Also, if you are being purchased as a platform company, you can usually expect a longer transition time.  The private equity buyers will want you to stay around longer to transfer your knowledge and contacts to a new leader or in many cases to leave some equity in the deal and get a second bite at the apple four to five years down the road.  If you want to get out of the business sooner, you’ll have better chances as an add-on acquisition.

Reasons to Deal with Private Equity Buyers

• Higher Valuation
•  In the case of an add-on acquisition, PEGs can often pay more than other buyers, because an add-on acquisition is a synergistic acquisition. That is, by combining the add-on with their existing platform company(s), they can make 2 + 2 = 5. They can take advantage of synergies like economies of scale, market clout, and more to justify a higher valuation.
• PEGs virtually all have an aggressive growth strategy and that strategy typically involves -- add-on acquisitions. Their whole reason for being and their investor mandate is to acquire companies. Simply put, they are under pressure to do what they are in business to do--buy companies.

• Professional Deal Makers
• Because PEGs exist to buy companies, they are run by people who have a lot of acquisition experience. They know how to cut through a lot of the typical red tape and other time wasters involved in buying a business. They know what is and isn't important and how to avoid getting caught up in details that tend to slow a deal down. PEGs will often issue a letter of intent within days of first meeting with a seller.
• To private equity groups, buying companies is their business. Most buyers, including business owners pursuing a strategic acquisition, are not experts in the process and cannot devote full time to getting the deal done. This of course, stretches the time it takes to complete an acquisition. Private equity buyers, on the other hand, know the business buy/sell process and have the resources in place to consummate an acquisition deal. Running their business means making the acquisition.
• Committed Funds
• Private equity groups have committed funds for acquiring businesses. That is, investors have committed to provide funding up to a stated amount upon request. They have made their commitment in advance, in essence agreeing to accept the judgment of the PEG management for any acquisition it wants to make.
• Financing (without committed funds)
• Those groups that are not in the position of having pre-committed funds for acquisitions usually have very solid banking relationships. The banks know them and they know which banks will finance which kinds of acquisition deals. In a nutshell, a private equity acquisition deal, even one that needs bank financing, is likely to get done and get done much more quickly than a non-PEG acquisition.

Is your Business Right for Private Equity Acquisition?

Some companies are good candidates for sale to private equity and some are not. We at Target Search Group know the language of the Sellers and the Buyers and we know what Private Equity Groups look for.  Contact Us today to discuss your situation and to find out if your business meets their criteria.

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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One Chance to Get it Right

Most Business Owners go Through the Sale of a Business Only Once in a Lifetime

by Terry Stidham

Most successful entrepreneurs and business owners are great at negotiations and sales, but few are well equipped when it comes to selling their business. They easily become overwhelmed by the process, or else they make some very costly mistakes. While it’s somewhat daunting, selling a business can be managed with the right amount of preparation and guidance.
 

Selling a business can take 1500-2000 man hours and can easily be drawn out to over a year or longer.

Where to Begin - The first step is to ask yourself the question, “Why do you want to sell?” Before you get too far into the process, examine your reason for selling. You don’t want to make a decision that you will later regret. There are many reasons to sell a business, including:

• Retirement - one of the best reasons to sell a business
• Lack of Operating Capital - usually results in selling the business in a hurry and at a “discount”
• Lack of Growth Capital - can be a good reason if  business is profitable and you can still dictate sales terms
• Burnout - might want to consider taking some time away first (even a four- or five-day getaway trip) to think of ways to reduce stress before selling simply because you are “burned out
• Boredom - business is no longer a challenge or exciting
• Partnership Issues - irreconcilable differences
• Divorce - a very difficult situation if the husband and wife have been working together
• Declining Business - identify the reason why...new owner can possibly fix
• Too Many Assets Tied up in Business - might be ready to diversify risk
• Lack of Time for Family and Friends - "No one ever said on their deathbed, 'I wish I'd spent more time at the office'"
• Health - usually not a good time to sell, but all too often this is the reason
• Regulations - Business does not have the critical resources to manage

You should have a well-thought-out reason to sell your business. Selling for the wrong reason hurts the seller on multiple counts. For one, you are subject to receiving a below-market sale price for your business. Frequently this also means that your future options are limited by your age and financial position. So you might wind up selling without getting enough money to retire on and then need to seek employment where you’d be making a lot less than if you had simply kept the business! In any case, if you become convinced that your reason to sell is viable, the next key step is to get started.

The timing of a business sale is critical and planning ahead is key. Too many business owners fail to plan for the day when they will want or have to  to sell.

Why Buyers Buy

Think like a buyer once you have decided to sell your business. In so doing, you will take steps to make your business more attractive to prospective suitors. From a financial perspective, the buyer will be looking for three key results on the other side of the purchase.

• Cash Flow
• ROI
• Market Penetration/Expansion

7 Categories of Buyers

1. Competitors/suppliers/customers
2. Individual Investors
3. Investment Groups
4. Public Companies
5. Foreign Buyers
6. Employees
7. Family Members

All buyer types will focus on  return on investment (ROI). In simple terms, the ROI is calculated by dividing the net annual return by the dollars invested. But this calculation is anything but simple when it comes to the sale of a business. The buyer wants the highest ROI (implying a low purchase price), while the seller wants to maximize the sales price.         

    

Key Components of ROI: cost of money, degree of risk, greed, liquidity and future expectations of profits.

• Cost of Money -The cost of money has an inverse relationship with the denominator in ROI. As the cost of money rises, profits fall and earnings multiples also decline. Lower cost of money leads to higher profits and higher earnings multiples. Interest rates for the cost of money are set by government and market forces. A recent example of these forces at work has been U.S. Federal Reserve Chairman Alan Greenspan’s lowering of short-term interest rates an unprecedented 400 basis points from January to October 2001.
• Degree of Risk - The more risk perceived by the buyer, the higher the expected return will be. If your revenue and earnings have been erratic in recent years, the buyer may perceive the purchase of your business to be a higher risk than it would be to buy one with stable sales and profits. If so, he will demand a higher return (which means a lower price).
• Greed  - Pure greed may motivate the buyer to try to drive the price down.
• Liquidity - The easier it is to convert an investment into cash, the lower the expected ROI and the higher the earnings multiple. In other words, a potential buyer is going to expect a much higher return buying your business than he could get putting the same amount of money into Treasury Bonds.
• Future Expectations of Growth and Profit — The buyer will be more likely to pay a higher multiple of earnings for a company that has a believable forecast for growth in the future.

Calculating Value

Earnings Multiple x Earnings before Interest Depreciation Taxes and Amortization (EBIDTA) = Business Value is the most common method for calculating value.
Rules of thumb are valuation methods that should be used as guidelines only. Valuations vary greatly from business to business. The true value of a business lies in the future as seen by the buyer.         

Book Value of a business is computed by adding retained earnings, paid in capital, common stock and shareholder loans. However, book value multiples are rarely used in computing business sale calculations, because the buyer will be dependent on the earnings capacity of the business to earn a living, pay back debt and generate an acceptable return on investment.

One  will not be able to compute the potential sales value of a business just from reading this article. Depending on many factors (business age, location, market potential, financial trends, potential financial adjustments, gross margin level relative to the recognition and identification industry, and condition of business assets, to name a few), the earnings multiple could vary widely.

There are a number of different financial earnings measurements that can be used to value a business. The five most commonly used are:

• Shareholder Discretionary Earnings
• Adjusted Earnings before Interest and Taxes (EBIT)
• Net Profit Before Tax
• Net Profit After Tax
• Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA)

Earnings multiples are generally established as the result of a transaction. They shouldn't be used to drive a transaction, because there are so many extraneous factors that affect the value.

            

Importance Of Recasting

The historical financial statements alone seldom portray the true financial picture of a business. It is virtually impossible to value a privately held company without careful analysis and recasting to determine the true level of profits.

Recasting is the process of adjusting the out “extra” expenses that are typically run through a closely held business. These expenses are designed to reduce the tax liability of the owner, but they understate the earnings power of the business. It is up to the seller to provide to potential buyers the detail on these expenses.

Here is an example of some of these expenses. The income statement of an engraving business shows a pre-tax net profit of $100,000 for a given year. However, included in the expenses are the following:

• A $30,000 salary for a family member who works part time and could be replaced by a part-time employee earning $10,000 per year
• $15,000 per year for the owner’s leased vehicle
• $30,000 in overly conservative inventory write-down        
• $8,000 per year in country club dues

This could have a substantial impact on the potential sales price of the business. There are many expenses that can be adjusted out of the recast income statement to maximize the reported earning power of a business. Some of the most common are:

• Excessive owner compensation
• Family compensation to spouse, siblings or children
• Owner expenses such as vehicles • Owner perks such as club dues and travel
• Accelerated depreciation or amortization
• Use of nonconforming accounting principles
• Conservative inventory write-downs         
• Conservative bad debt write-offs
• Unusual expenses such as legal expenses associated with a lawsuit        
• Excessive maintenance that appears in one year
• New product or division start-up costs
• Capital items expensed (such as a new computer system) that could be depreciated        
• “Toys” such as boats, airplanes and hunting camps        
• Charitable contributions

Deal Structure

The structure of the deal is often more important than the actual sales price of a business. For instance, if it is important for you to cash all the way out now, you might take $1,000,000 less for a cash offer rather than take another offer that requires owner financing. In fact, there are numerous ways for you to be paid in the sale of your business:

• Cash — The most certain way to collect the entire sales price, but has immediate tax consequences.
• Secured notes — Seller is paid over time out of the cash flow of the business and has the right to foreclose as a secondary repayment source if the buyer defaults.
• Unsecured notes — Riskier than secured because the claim is unsecured; limited secondary repayment source if the buyer default
• Shares in purchasing company — Typically only included as part of the package when selling to a publicly traded company
• Consulting agreement — Seller required to stay involved for a fairly short period of time (usually from six months to two years) in exchange for part of the purchase price.
• Employment contract — Seller required to stay involved on a longer-term basis (usually three to five years) to help with transition to new owner.
• Lease on assets retained by seller — Most common with real estate or equipment; if you agree to this, you should require the buyer to sign a long-term lease (five years or more).
• Non-compete agreement — Seller receives payments over a period of time (usually three to five years) in consideration for agreeing not to open up a competing shop down the street.
• Royalty program — Seller receives part of sales price based on future sales generated by the business.
• Earnout — Seller receives part of sales price based on future earnings generated by the business; can be problematic if profits decline after the sale.
• Selling shares vs. selling assets — Buyer purchases the shares of the business directly from the owner(s) of the stock. While some businesses are sold on an all-cash basis, most sales include seller financing in the form of a secured or unsecured promissory note or some other form of future payout to the seller (such as a consulting agreement and a non-compete agreement). This can prove beneficial to the seller from a tax-planning standpoint. However, the seller becomes a creditor and takes some risk that the business will continue to perform well enough to generate sufficient cash flow to meet future obligations to all creditors.

Don’t Fail To Plan

“Business owners never plan to fail, but they do sometimes fail to plan, giving the buyer an added advantage. Be prepared for a process that will require a great deal of time and effort that should pay off in maximizing the sales price of your business in the long run.

Feel free to contact me if you have any question about your next steps or need any recommendations for additional help.

Top 10 Reasons Why Most Small to Medium Sized Businesses Don't Sell

Business Owners Can be Their Worst Enemy in Selling Their Business

by Terry Stidham

 Statistics show that less than 28% of businesses sell when they are marketed for sale. This means that more than 70% of businesses aren't sold. A survey of merger and acquisition (M&A) advisors and business brokers showed some very interesting insights. The advisors and brokers were asked to identify top issues that were problematic in the ability of a business to sell successfully. The top response was seller valuation expectations; 69% of the advisors and brokers indicated this issue as being the most problematic in selling a business.

 

Top 10 Reasons Why Many Businesses Don't Sell or Realize Fair Market Value (FMV) * 
1.    Unrealistic expectation as to value of business
2.    Legacy issues 
3.    Business is too dependent upon the owner who is unwilling to transition
4.    Customer concentration
5.    Outlook for future growth is bleak
6.    Declining revenues due to owner’s age or enthusiasm for the business
7.    No exit or succession planning
8.    Numerous financial rewards and perks of the businesses not added back into EBIDTA
9.    Uneducated seller especially on the due diligence process by the buyer and their advisor
10.  Lack of representation to aid in the sale of what is most likely the sellers largest asset

Without properly preparing the business for sale and arming oneself with a proven mergers and acquisitions process, there will be a huge business valuation gap between what the business seller expects to receive and what a reasonable buyer sees as fair market price. Selling a business takes preparation and the use of a proven process.

For owners of B2B businesses and larger businesses, your better buyers will most likely not be an individual, but rather a corporation or a private equity group. If the potential buyer has revenues up to $100 million, the mergers and acquisitions contact is usually the president. If the company is larger, the contact is typically the head of strategy, business development or merger and acquisition services. The first task is to recognize that reaching these corporate buyers is a very difficult and a labor intensive process. In these situations, it is wise to enlist the services of a merger & acquisition advisory firm that specializes in reaching these targeted buyers.

In summary:
I cannot stress enough that there needs to be proper preparation of a business for sale. The process to properly prepare a business for sale is not very costly and it does not have to take much time, but the results will bring about realistic expectations as to terms and value along with an increased likelihood of a successful sale. 

* Fair Market Value (FMV)

Under a section of the Internal Revenue Code, this is defined as: “…the price at which the property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge or relevant facts.”

In 1959 the IRS issued a revenue ruling that identified specific factors that can influence fair market value. They include the nature of the business, the economic outlook, book value, earnings, dividends, goodwill and recent prices paid for similar businesses.

About 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.