Your client spent a lifetime building his company and, now that he's ready to sell, the United States is in the middle of the worst recession in decades.
What do you tell him?
Of course, the first thing you say is: it might be a terrible time to sell a company. (See “Not Now!” p. 48.) If he can hold on for another two or three years, he probably should.
But some clients may be unwilling or unable to wait. If a family business owner suffers from a serious heart illness and has no successor, obviously waiting two or three years is not the best option.
It might even be in a client's best interest to sell now. An entrepreneur who's seen his company's value drop from $200 million to $80 million may feel he can't afford to sell. But selling can make his wealth liquid, freeing him to diversify by spreading the proceeds across a variety of investments. With a balanced portfolio, he can increase his odds of recovering his wealth when the economy rebounds.
And here's the thing: despite the economic crisis, the market for selling a company is not universally bleak. Some companies actually could have a successful sale.
So, know who buys and why. Learn how to assess your client's place in the marketplace, what goes into positioning his company to obtain maximum value, what the general structures of the deals offered to him might be, and how to find someone to help him sell. The ability to do this kind of analysis will stand you in good stead whether your client chooses to sell now in the midst of a severe economic downturn or waits until conditions improve.
As even a quick scan of the business news pages shows, most companies are bought either by financial investors or other companies.1
Financial investors, generally private equity firms, look to buy a company, then sell it for a profit. Usually, they expect to hold a company for three to five years. An unusually successful example of a private equity deal is Caxton-Iseman Capital's buyout of Anteon, a Virginia-based defense contractor. Caxton purchased Anteon for $32.5 million in 1996 and sold it 10 years later for nearly $750 million — a return of nearly 25 times the original investment.2
Companies looking to acquire other companies are known as “strategics,” because there's usually a strategic as well as a financial reason for the acquisition. Most strategics expect to hold on to their acquisitions rather than sell them. AT&T hoped NCR would serve as the basis of its computer business. AT&T certainly didn't expect to have to spin NCR out again six years later after losing billions. Data storage giant EMC was much more successful in its acquisitions of Documentum and VMware in 2003.
It's important to note that financial buyers — even at their peak in 2007 and despite all the press about them — accounted for no more that 20 percent of the M&A market.3 So your odds of selling to a strategic buyer are far greater than to a financial investor. On the other hand, private equity firms have raised well over $600 billion in the last three years,4 and much of that is still sitting on the sideline waiting to be invested.
But whether your client's company is bought by a financial investor or a strategic, many factors will influence the sale. Let's break it down.
It's a Beauty Contest
First, understand your client's company's position relative to other potential investments. In the M&A process, you are competing for investment dollars. Examine both the company's performance relative to its peers and the industry's performance relative to other industries.
Of these two, the company's performance relative to its peers is the most important. The more a company outperforms its rivals, the stronger its negotiating position in a sale and hence the higher its valuation. At its prime, Microsoft's dominant position in its industry gave it an astronomical valuation. As the gap closed, the company's relative valuation suffered.
Clearly the reverse is true as well. While there is some gray area in the middle, generally when your client's company is underperforming it loses nearly all its negotiating strength.
If your client's company is lagging behind its competitors, he should do everything possible to improve its position. Either that, or he must be reconciled to receiving less money from a sale and deferring any additional compensation until the new owner improves his company.
For a client forced to sell, the key to a successful exit from his underperforming company is “sustainable differentiation.” The company has to have something (customers, products, distribution networks, etc.) that a buyer values. If competitors could just run your client out of business rather than buy his company, they'd prefer to do that.
If your client's company is underperforming and undifferentiated (which it might well be as there's a correlation between the two), he should take whatever he can get and move on with his life.
But if your client is confident he can turn his company around himself, he should. Be warned, though: advising such clients is tricky. Generally, if a company is underperforming and particularly if it has unique differentiators, the reason is poor leadership and execution. That is to say, your client is unlikely to be able to turn around the company by himself because he's the one who got it into this mess.
A consultant might be able to provide fresh insight. But your client should look for a consultant with experience improving underperforming companies. Also, the client needs to listen. For many self-made business owners, it's not easy to take outsiders' advice, no matter how expert. You may be able to help by making it clear that the cost of failure is huge. The longer it takes for him to turn his company around, the more value it will lose.
As important as the company's relative position is, its industry's performance also is critical. Just as investments migrate toward successful companies, so too they tend to flow toward industries with compelling prospects. That makes it harder to sell even successful companies in suffering industries. These days, for example, there are not a lot of investors interested in buying a U.S. auto manufacturer; they'd probably prefer to invest in health care.
Most industries' relative position is cyclical; things will get better over time (just think of the boom and bust cycles of home building and oil). But sometimes, a whole industry is threatened with extinction, or at least a dramatic downsizing transition. In the 1980s, an owner of a typewriter manufacturer unable to transition into a new business would not have done well waiting for things to get better. The “Big Three” U.S. auto manufacturers may well be a contemporary example of this phenomenon.
These two dimensions — a company's position relative to its peers and an industry's position relative to others — create four possible categories into which your client's company may fall: (See “How Desirable Is the Company?,” this page.)
Stars — The Stars are companies that are out-performing their competitors in a market that is strong. If your client is lucky and/or talented enough to have such a company, finding suitors won't be a problem. Even now, it's a fine time to sell. But remember, always, to solicit multiple bids for star companies, no matter how juicy an initial offer might seem.5
Imagine, for example, that your client owns a high-flying company in the green technology market; his company has built a successful floating wind turbine. Despite the poor economy, the tight credit market and all the other challenges, investors still would want to pay a premium for such a company, because it's seen as a relatively safe bet with lots of growth potential.
Because of the current economic crisis, the private equity market is in full-scale “flight to quality”: Many firms have become very conservative and are only willing to consider seemingly safe investments. If your client's business is sound and so is his industry, financial investors will flock (if they can). For example, the Blackstone Group, one of the largest private equity firms, recently invested $1.6 billion in a German off-shore wind farm.
Strategics also will be interested in star companies. The interest may come from within the same industry. For instance, Vestas, the largest manufacturer of wind turbines, might want to buy your client's wind turbine company to help maintain its competitive position.
Interest also may come from neighboring industries. An oil company may be attracted by the opportunity to expand into a new growing market with a differentiated product. StatoilHydro, Norway's largest oil and gas producer, is currently trying to develop its own floating wind turbine; but, historically, large companies have an easier time buying into new markets than trying to develop their own solutions. Before AT&T failed to buy its way into the computer market with its NCR acquisition, it failed nearly as spectacularly in trying to develop its own computer company internally.
One thing to note about these strategic examples (Vestas and StatoilHydro) is that they are both very large companies. A strategic sale usually depends upon finding an acquirer who's much larger than your client's company. A smaller or even equivalently sized firm probably can't afford the premium your client can demand.
Consolidators — If your client's company is outperforming its competitors in an industry that's suffering, now is a great time for him to consolidate his position in that market. The best choice in today's economic environment is for him to buckle down for a few more years and really grow his firm — either organically by winning competitors' customers, or by acquiring underperforming competitors with valuable assets. Taking this approach will pay off exponentially once his industry (and the M&A market) recovers.
Right now, an excellent example of a potential Consolidator is a top performer in the specialty metals market (high-end steel, nickel and titanium alloys). Many of the public companies in this space have seen their stock prices drop 70 to 85 percent in the last year. Thus, they're prime acquisition Targets for a competitor wishing to create a dominant position in specialty metals.
If, however, your client can't or won't wait to sell, he should position his company as a platform for someone else's growth. In that scenario, he'll be looking for either a financial investor who's pursuing its own consolidation strategy, or a much larger strategic from his own industry willing to pay a premium for the growth opportunity. Because his industry isn't that attractive, strategics from other markets are unlikely to be interested.
Despite the fact that his industry is out of favor, his company's relative strength should enable it to be sold successfully, albeit not at the same valuation it would have gotten just last year.
Targets — Let's say your client's company is underperforming its competitors in an industry that is strong. That makes his company a Target. It's not a pretty picture, but he does have options.
If he prefers simply to sell, the good news is that his company is part of an industry in which investors are interested. Strategics from the same industry could be interested in gaining share, gaining access to new customers or geographies, or gaining access to new products and capabilities. Wyeth Pharmaceuticals, for example, recently sold to Pfizer Inc.
High-performing strategics also can generate a return by improving the performance of your client's company with their superior operating skills. But they won't pay a premium to do so.
Beware, if competitors can achieve similar results by forcing your client's company out of business, they will.
Strategics from other industries are less likely to go after a Target, as they'd be trying to enter a new market with a weak hand. One could argue that the AT&T/NCR merger falls into this category. Before AT&T got into the picture, even though NCR was doing well, it wasn't a particularly strong player in the computer industry. Of course, AT&T probably could have ruined the best computer company.
Most financial investors are looking for successful companies with growth opportunities. But relatively few private equity firms possess the strategic and operating skill sets to pursue “value” investments similar to these. For such firms to be interested in your client's company, they'd have to believe they can improve its performance and that the company possesses some unique value that makes the effort worthwhile. This is not an easy proposition. Going back to the wind turbine market example, if your client's floating wind turbine company was actually underperforming its peers (most likely due to your client's mismanagement), a financial investor still might be interested. The unique value associated with the differentiated, highly desirable product might outweigh the cost and risk associated with cleaning up the company.
Remember, though, no matter how unique the value proposition, target companies are unlikely to justify a high valuation. And your client's payout is apt to be spread out over time.
The Distressed — Pity the distressed company. It's a firm that is doing poorly in an industry that investors want to avoid. Right now, any underperforming homebuilder fits into this unfortunate category. Ditto for suppliers to the big three U.S. auto manufacturers.
What can you advise such a client?
Tell him that if there's anything he can do to keep his company afloat and improve its performance, he should do it.
If he must sell, he should expect nothing more than to get out from under his obligations. At best, he'll receive a deferred value for his equity — if the buyer can turn the company around.
He's entered the domain of a work-out or turn-around financial investor. Very few firms have the skills necessary to deal with these sickest of the sick companies. Traditionally, this is a niche, specialty market filled with old men in cheap, gravy-stained suits who haven't been home in six months. This space has recently received more attention from larger private equity firms.
Unless your client's company possesses some “diamond” in the middle of all its rough, strategics will not be interested. Even if such a diamond exists, they'll just carve it out and leave the rest to rot.
Ultimately, the company's value will be determined, at the high end, by the amount of the company's truly unique differentiators (diamonds), and at the low end by the liquidation value of the company's hard assets. These days, used factory equipment in the United States is often sold as scrap metal. And the value of scrap metal has plummeted. It's sad.
Best Foot Forward
This may be obvious, but companies are valued, not based on their revenues, but on their profits and the potential to grow those profits. There are two components to this: the absolute amount of profits and the value multiple applied to those profits. All other things being equal, a company with $1 million in profits would be worth less than a company with $10 million in profits6 — even if it has twice the revenue (or especially if it had twice the revenue.)
The value multiple applied to a company can range from “not meaningful” (if the profits are negative) to 10 times or even greater. To use a simple example: an attractive company with $5 million in profits might be valued at eight times, or at $40 million, whereas an unattractive company with $5 million in profits might be valued at four times, or $20 million.7
What separates an “attractive” from an “unattractive” company? The buyer's perception of value.
Regardless of the category into which your client's company falls, there are measures he can take to maximize its perceived value at selling time. So, when advising your client, you've got to know what acquirers want. Understanding what they value and how they value it can help your client determine who the best acquirer might be. It also will help him position his company. Knowing the “hot buttons” will help him downplay potential concerns and highlight core values. There are also several quick fixes your client can pursue, even if he can't make major strategic changes in his company.
By and large, financial investors and strategic acquirers are looking for the same things: growth potential, strong brands, defendable positions, etc. But these two types of buyers value these assets very differently. (See “What They're Looking At,” p. 46.)
For example, while financial buyers obviously prefer that a target company have loyal customers, for strategics, loyal customers are a “must have.” If your client's company's customers aren't particularly loyal to his products, competing strategics will just woo them away.
On the reverse side, a financial buyer will be scared away by too much customer concentration: companies for whom one or two key customers make up a large percentage of their sales. They'll see it as too many eggs in one basket. By contrast, customer concentration is less likely to worry a strategic buyer, because they are adding the Target's customers to an existing customer base. Buying the company presumably will diversify their own customer base. (Obviously, a financial buyer looking to add on to an existing portfolio company will think more like a strategic.)
Because of strategic buyers' ability to achieve synergies, they're often willing to pay more for a company than financial investors. For example, I recently worked with a private equity firm that was interested in buying a chain of high-end retail stores. This firm was able to structure a deal that appealed to it because the investor planned to keep the top performing stores but shrink the size of the corporate organization overseeing those stores. Ultimately, this financial investor was out-bid by a strategic buyer who was able to eliminate the Target's corporate structure entirely because it could manage the stores with minimal additions to its own corporate overhead.
As an advisor to the owner, you should ensure that your client has done everything he can to promote the attributes that potential suitors value, while minimizing those that'll tend to scare them away. The company's inherent characteristics may help determine whether a financial or a strategic investor makes more sense. Be sure your client is not relying too heavily on synergies between his company and a potential suitor's. While synergies have value, most sophisticated acquirers discount synergies heavily, because experience has shown that actually achieving those cost savings can be elusive.
Fortunately, the things potential acquirers value are the hallmarks of a well-run company. What a business owner should be doing to build the value of his company is make the right strategic choices that allow him to grow his company over time. For example, a “professionally managed” company will both outperform and be valued higher than a firm run like a “Mom and Pop.” A chain of retail stores may have each store manager doing his own accounting (possibly using individual instances of QuickBooks). Putting in an enterprise system that can track all the stores from one place will increase both the performance and the value of the company. It will give more confidence in the results and allow for better explanations of trends.
Professional management is easier for a prospective buyer to understand, helps everyone avoid surprises that scare away acquirers or lower valuations, and enables the new owner to come in and run it without the seller's help. Hallmarks of a professionally managed company include: audited financial statements, few excessive perks, and professional outside (that is to say, non-family) managers.
Business owners should work to address other issues that buyers pay attention to. For example, if a company relies too heavily upon a single material supplier, they should work to develop a second or even third source for critical components.
Another, less obvious, way to add value to a company is to pay taxes. One tightly held family business kept significant amounts of cash off their books to avoid paying taxes. When it came time to sell the company, the owners were not able to find a company willing to pay them what they thought (knew?) their company was worth. What they should have done is to introduce the extra cash slowly over a period of three to five years. A sudden, unexplained significant jump in profitability might have looked a little suspicious. The payoff from the sale of the company would have far outweighed the incremental taxes. Using representative numbers: reintroducing $1 million in profits over a three year period would have cost the owners roughly $1 million in incremental taxes (assuming a 50 percent tax rate). Valuing that additional $1 million of profits at a reasonable six times would have increased the value of the company by $6 million, or a net gain of roughly $5 million.
Deal Structure Trade-Offs
So you have a potential buyer. Now what?
There are actually two components of a company sale: the valuation and the deal structure, or how that value is paid out to your client over time.8 So far, we have been focused on only the first aspect, how to maximize the value. But your client's ultimate perspective on the success of his company's sale may depend as much or more on how the deal was structured as on how it was valued.
Owners have two primary goals: to maximize the value of their company and to get as much of that value up front.
Acquirers' goals are usually the exact opposite: to minimize the value and to defer as much of that payment for as long as possible. Minimizing the up-front value increases an acquirer's expected return on the investment; deferring the payment helps reduce the risk associated with the acquisition.
Strategics often use their own stock to buy another company. If that strategic is a public company, its stock is fairly liquid and therefore similar to a cash offer, although obviously not identical. Your client will need to determine how attractive he finds the acquirer's stock as opposed to cash. Complicating matters: a stock sale may be subject to a “lock-up period” during which the seller cannot sell his newly acquired stock. Private company stock obviously locks up the value indefinitely because it's significantly more difficult for your client to sell those shares.
Of course, your client's base position in this negotiation is determined by his company's relative strength and the differentiators the company possesses that the acquirer values. The stronger his position, the more of the value he is apt to get up front and vice versa.
In the likely event (particularly in a financial deal or a management buyout) that some portion of his proceeds will be deferred, there are a range of options he should consider:9
The seller's note — On one end of the spectrum is a seller's note. For a conservative client, this is the best option.
A seller's note is the least risky but therefore has the lowest reward. It is a note that commits the acquirer to pay the seller a set amount at a set interest rate over a set period of time. The seller's risk is that the company goes out of business, in which case the seller's position would be subordinated to that of the bank and other creditors. In the event of a bankruptcy, a seller's note would be the last thing paid before the equity holders. Hopefully that is a relatively small risk. On the other hand, a seller's note has no additional upside.
Stock — At the other end of the spectrum is retaining stock in the ongoing company. This option is for those clients with the greatest faith in the future growth in the company and no short-term needs to cash out. If your client plans to remain very actively involved in the company, this is often an attractive option.
Deals heavy on payment in stock are the riskiest option, but have the greatest potential reward. If the new acquirers succeed in growing the company dramatically, when they exit, your client will receive far more for those shares than he would have at the time of his sale. On the other hand, he'll have to wait until the company has a liquidity event (gets sold or goes public) to get his money out. If your client isn't willing to defer some of his value indefinitely (even for a potentially large return), this is not the best option.
Earnouts — In the middle are a wide array of “earnouts.” This is a good option if your client believes in the future of his company, but is willing to sacrifice potential return for getting more of his money out quicker than he would by simply maintaining an equity position.
At the most simplistic level, earnouts look somewhat like a seller's note in that they spell out a certain amount the seller can expect to receive over time. But earnouts have two potential significant distinctions.
On the negative side, they are usually tied to company performance: The seller gets paid only if the company achieves certain profitability targets. For example, earnouts are generally conditional on the company remaining within the bank's covenants; if paying the earnout would cause the company to trip a covenant, it doesn't get paid. If the seller is no longer in a senior management position, he bears the risk of being compensated based upon a metric he no longer controls. As a business owner, it would be incredibly frustrating to not receive the full value for your company because the new owners mismanaged your “baby.”
On the positive side, many earnouts aren't capped. That is to say, if the company exceeds the profitability targets, the seller can share in that upside. For example, if the profitability target for Year Three was $5 million and the company actually had $10 million in profits, the seller might split that incremental $5 million in addition to whatever earnout was associated with hitting the $5 million profit target.
Similar to stock, an earnout is a bet on the future of the company. The primary distinctions being that the payout will occur over a defined period of time and is directly tied to company performance.
A Word About Selling
Finding the best buyer for a closely held company is like finding the best customer for any product or service; the more demand, the higher the valuation. It's obviously in your client's best interest to have as many potential bidders as possible. There are two factors that mitigate this basic truth:
Time — speed can be more important than a few more dollars; and
Exposure — the more people who know about the sales process, the more bidders you are apt to get, but also the more customers, suppliers, and employees are apt to find out. This obviously represents a significant threat to the company.
For these reasons, professionals whose primary job is to sell companies can be useful. For smaller companies, there are firms known as business brokers. For mid-sized firms there are “middle market” specialty investment banks like Houlihan Lokey, Robert W. Baird, etc. For larger companies there are the “blue blood” investment banks such as Goldman Sachs and Morgan Stanley. But there are no clear delineations between these three groups. For example, I've seen $100 million companies being sold by brokers and $50 million companies being sold by small investment bankers. Unless your client's revenues are greater than $500 million, he is unlikely to attract the attention of the top-tier investment banks.
Fundamentally, both brokers and investment bankers do the same thing: connect companies with potential acquirers.
Finding a firm that'll help you sell a company is easy. Figuring out if the firm is any good is tougher. It's just like finding a real estate broker. There are a lot of them, but the best way to find a good broker or investment bank is through your friends and peers. A referral from people who've used the firm to sell their own company means far more than a slick marketing presentation. As with most things, larger firms with stronger brands are able to provide value that smaller, lesser known firms can't. But your client will need to carefully consider whether that incremental benefit is worth the premium those firms charge.
As with real estate agents, brokers and investment banks receive a percentage of the sale price as their payment. Again, there are no hard and fast rules of thumb. Percentages are often tied to the amount of work the investment bank thinks will be required and the potential size of the deal. These rates are highly negotiable and are often success-based. If the company doesn't sell, the broker doesn't get anything. Because fewer deals are getting done now, brokers are probably increasingly flexible on terms.
While it's possible for an owner to sell his own company, unless there is an obvious potential suitor whom he knows well and who knows his business well, the risks far out-weigh the cost savings.
Clearly, selling a company is far more complicated than selling a house.
Other, less common options include passing a company to a family member or selling it to a current management team. The later is known as a Management Buy Out (MBO). Before you get a client excited about an MBO, warn him that such sales often mean he won't get much, if any, cash upfront.
Telis Demos, “Private Equity: Remember the Little Guys” Fortune Magazine, May 12, 2007.
Antonio Capaldo, David Cogman and Hannu Suonio, “What's Different About M&A in this Downturn?” The McKinsey Quarterly, January 2009, McKinsey & Company.
Venture Economics, 2008, Thomson Financial database, password-protected at www.venturexperts.com.
The terms, “stars,” “consolidators,” “targets“ and “the distressed“ are mine, not industry jargon.
The principal profit metric used in acquisitions is earnings before interest, taxes, depreciation and amortization (EBITDA).
Valuation multiples are an industry shorthand to compare different deals — a benchmark. Ultimate company valuations are based on more complex methods such as a discounted cash flow analysis, or other industry comparables.
While these are the two primary components, there are many other factors, including tax and estate issues involved in a deal structure that should be reviewed with a professional advisor (for example, the tax implications of a stock versus an asset sale for an S corporation.)
I've been intentionally simplistic in this review of deal structures. There are a myriad of alternatives that fall between these options or combine aspects of each.
Robert M. Held is a partner at The Watermill Group — a private equity and consulting firm based in Lexington, Mass.
It's hard to sort through all the doom-and-gloom headlines to figure out what truly impacts the potential sale of a company. But this recession makes for a challenging environment because it packs a triple whammy:
COMPANY VALUATIONS ARE SUFFERING — The primary driver of company valuation is future growth prospects. Most companies are underperforming their past performance, meaning they are worth less now than they were last year. Even if your client's firm is still doing well, buyers will discount its future prospects heavily. That is, if you can find a buyer.
BUYERS HAVE DISAPPEARED — Typically the value of mergers and acquisitions activity is cut in half in the first year of a recession. This year is shaping up to be no exception. Strategic buyers (other operating companies) are worried about keeping themselves afloat. Financial buyers (private equity firms) are conserving their cash to protect the companies that are already in their portfolios. Already the volume of private equity deals has fallen 72 percent from its peak in 2007.1
THE CREDIT MARKET IS FROZEN — Banks are so over-extended at this point that, despite receiving hundreds of billions in government bailout funds, they're not lending money to customers. Currently, the total U.S. debt is 3.5 times the gross domestic product (GDP), whereas the long-term average is about 2 times GDP. Even in the Great Depression, U.S. debt peaked at around 2.7 times GDP.2 This means that even if you can find a buyer, they'll have a hard time finding the debt necessary to complete the deal.
“McKinsey on Finance,” Number 30, Winter 2009, McKinsey & Company.
Ned Davis Research, 2008.