Merger Agreements

It all starts with that merger agreement. In this post I discuss the provisions of the agreement that occupy 80% of the space and are irrelevant 95% of the time: Those sections which address when a party has a right not to close.

In the overwhelming majority of deals and in the absence of a global financial crisis, the parties are enthusiastic about closing and these provisions are not relevant. But lawyers are paid to think about things that can go wrong.

To understand how lawyers can take what seems like a simple concept of a purchase of a company and turn it into a monstrous document, you need to understand a bit about how the sausage is made. Merger agreements are not drafted by a lawyer sitting down and dictating to a secretary. They are always based on a precedent transaction or melding several precedent transactions—and the opposing lawyer expands it with even more precedents which favor his side.

If you want to understand the dynamic involved, pull out your mortgage or your will, which you probably have not read carefully either. Their wordiness has three things in common with merger agreements: First, the basic language and structure are based on what similar documents looked like over a century ago. Second, every time a problem arises (for wills, think a secret illegitimate child and, for mortgages, think the fauxclosure scandal) lawyers want to address these contingencies with additional provisions. Third, over time there are more laws and regulations, adding still more provisions in response.

There are other elements that apply to mergers but probably not to your documents. First, when two parties negotiate a provision, the wording almost always gets longer, not shorter. Compromise tends to increase complexity. Second, when you are dealing with billions of dollars, no contingency or risk is too small to merit a section. And finally, word processing has replaced typewriters and carbon paper allowing unlimited rewrites and expansions, which lawyers love. As a result, drafting acquisition agreements is truly a growth industry, even if it is not true that lawyers are paid by the word.

Turning to the substance, there are four “Articles” in every merger agreement that define the rights of a party to avoid closing:

Conditions. The conditions article tends to be quite short– just two or three pages— and relatively straightforward. For example, regulatory requirements need to be satisfied. The representations and warranties (or “reps” as they are shorthanded and which I discuss below) need to be true in all material respects both at signing and closing. And most importantly, there cannot have been a “material adverse change” in the business.

The “MAC” clauses are heavily negotiated. Buyers are concerned by recent court cases making it relatively difficult to invoke these clauses. Sellers try to carve out certain events from the MAC clauses—for example the circumstances under which general industry or economic developments would not give the buyer a right to walk.

Unlike most of the wording of the provisions discussed in this post, this provision always involves input from the most senior lawyers, bankers and client executives. Finally, there can be conditions specific to a deal: for example, a private equity buyer planning to use significant borrowed funds may insist on a financing condition. Obviously a buyer resists this and I will discuss some of the implications of such a condition in my subsequent post.

Representations and Warranties. When you buy a private company, it can be a bit like buying a toaster. You get a series of reps which, if they turn out wrong (like a toaster not working), you can use to get your money back. In public deals, though, it is not realistic to offer the buyer a refund for breaches of the reps. Yet the parties still give reps. Their only function is to trigger the condition discussed above and blow up the deal.

Nevertheless, enormous amounts of time can go into negotiating the reps. For example, extended discussions can be had around whether a particular rep should be qualified by materiality—so that if it is just a little not true, it is not a breach. And similarly lengthy discussions can occur over whether a representation is given to a company’s “knowledge.” Ironically, these qualifications make little or no difference. Remember that the reps only have to be true “in all material respects” to require the other party to close regardless of individual qualifications. And “knowledge” is one of my favorites of the meaningless discussions: since the reps function as conditions and the reps need to true at closing, a buyer can give the seller knowledge by whispering in his ear at closing. So why do lawyers fight over these words in the reps? No one likes to give a flat statement and be wrong—even if it has no contractual consequences—so lawyers spend a lot of time helping their clients hedge the language.

Covenants. A merger agreement generally contains extensive covenants restricting how the business of the target is operated between signing and closing. To some extent this is the mirror image of the reps and warranties—reps and warranties discuss what has happened and covenants discuss what will happen. A breach of a covenant could produce a lawsuit, but once again the primary remedy for a material breach is usually a right to walk away.

Termination. The agreement can be terminated for a number of reasons: breach by the other party, failure to obtain required shareholder or regulatory approval, and if the conditions cannot be satisfied by a specified “drop dead” date. This article contains the right to terminate the deal if a better offer comes along—the so-called “fiduciary out”.

In most cases, would a buyer walk away from a major merger if the seller refuses to give a separate representation that there are no zoning issues at any of seller’s numerous properties or that all insurance is in place when there is no reason to believe these are critical subjects? Generally no. (After all, buyers always get reps on the accuracy of the public filings and the presentation of financial statements.) Some buyers have more leverage than others and get more of what they want. In many cases, though, the resolution of numerous minor disputes, laid out in thousands of words, is largely an arbitrary process. If anything, each side wants to feel it received a “fair” number of points against its negotiating partner. This, of course, encourages each side’s lawyers to raise lots of points.

Social Issues in M&A

It’s not only deal price that buyers and sellers tussle over. They also negotiate over who will be in charge at the new company, and other “social issues” such as the location of corporate headquarters, treatment of employee stock options, the makeup of the board of directors, maintenance of employee benefit plans after the closing and post-closing indemnities and insurance for target officers and directors.

Indeed, if you were cynical, you might think that sometimes the difference between a “merger of equals”—where neither side’s shareholders receives a premium—and an acquisition in which target shareholders receive a substantial premium, may turn on which individuals will be running the combined companies.  Merger of equal negotiations are more complex than this, but it certainly is a factor.

These social issues are sometimes spelled out in the agreement and in other cases there are more informal arrangements—which should be, and usually are, disclosed in the proxy statement.

There can be, of course, an inherent conflict on some of these issues. Frequently, independent board committees are formed specifically to resolve social issues. Social issues generally don’t involve large financial commitments relative to the size of the transaction. But if you put yourself in the place of the executive officers of a target company—even if they have generous golden parachutes—you can see why the social issues are critical in many deals

Reverse Termination Fees

What happens if a buyer can’t complete a transaction even though nothing has gone wrong at the company to be acquired? And how will management of the target company be treated following the deal?

Reverse Termination Fees. The name says it all: This is the opposite of the typical “breakup fee,” which is paid by a target company to the initial buyer if the target takes another offer.

In a reverse termination fee, it is the prospective buyers who fork over money when an acquisition doesn’t close, if it’s not the target company’s fault. This is a topic that did not come up in merger agreement negotiations until a few years ago, when private equity players started to become prominent buyers.

When a company like Pfizer agrees to buy King Pharmaceuticals for $3.6 billion in cash, there is no need for a reverse termination fee. Even if plans to borrow some money for the deal, Pfizer can easily afford the purchase price, there is no financing condition and the conditions to Pfizer’s obligations to close can be specified in the merger agreement along the lines of my prior post.  If Pfizer refuses to close the deal and the companies’ contract requires it to do so, King Pharmaceutical can run to the courts to force Pfizer to finish what it started.

In short, Pfizer’s entire balance sheet is behind the deal and there is no question that King Pharmaceutical could obtain a remedy if it needed one.

But when a private equity firm buys a public company, like KKR’s recent deal for Del Monte Foods or TPG and Leonard Green’s agreement to acquire J. Crew , it is a bit more complicated. That is because in every private equity acquisition, there is a “deal behind the deal”. The actual buyer is almost always a “shell”—or a company formed just for the purpose of the transaction.  (In the J. Crew deal, for example, the shell company is called “Chinos Acquisition Corp.”)

There is nothing dishonest or unusual about this: the PE sponsor will commit its equity to the deal, but that will not be enough to pay the entire purchase price; much of the money must be borrowed. For confidentiality reasons, and to avoid spending a ton of money on transaction costs for deals that go nowhere, most of the “deal behind the deal” is done after the public announcement of an acquisition.

PE firms don’t generally put their entire balance sheets behind a single acquisition. Frequently their agreements with PE investors don’t permit them to take that risk.

Surprises do happen. And even if there is is no formal financing condition, it is not so easy for the target to run to court to force a deal to close. If the bank financing is not completed and the purchaser is a shell, the PE sponsor might be perfectly willing to put up the equity, but this will not be enough to complete the transaction.

Initially, because of their similarity in structure to breakup fees, the reverse fees were frequently the same amount. But if a PE buyer is left at the altar, it generally pockets the breakup fee and moves on to the next deal with a profit. Targets fare much worse if a corporate marriage falls through. Employees expecting a takeover have moved on or are looking for new jobs.  And when a deal is announced, a target company’s shareholder base tilts literally overnight towards arbitrageurs, who tend to put tremendous pressure on a jilted target to accept a new deal.

What seems to have become standard now is a reverse termination fee that substantially larger than the breakup fee. In the KKR/Del Monte deal, for example, the reverse termination fee is two to four times the breakup fee—or 7% of the total purchase price.  In TPG/J. Crew the reverse termination fee is four to seven times the breakup fee—or again about 7% of the purchase price.

Seven percent of the purchase price may still not make a jilted target whole, but it certainly is a tidy sum of cash to nurse its wounds.

Anil Kumar’s cheap betrayal of McKinsey’s soul

On the front of the McKinsey & Co website is a link to a McKinsey Quarterly article titled Motivating People: Getting Beyond Money.

It is a good topic, for the biggest question about the involvement of Anil Kumar, a McKinsey director, in an insider trading ring allegedly headed by Raj Rajaratnam of the Galleon hedge fund, is why he put his own reputation – and that of the firm – at risk for $2.6m.

Mr Kumar has agreed to forfeit this money, which is said to have been paid to him in return for providing inside information on companies he gleaned through his work at McKinsey, and apologised in a New York court for the “shame and embarassment” he caused his colleagues.

It is a shocking incident for McKinsey, like other blue chip advisory firms such as Goldman Sachs, depends on being trusted with its corporate clients with confidential information.

So far, McKinsey appears to have escaped lightly enough from the affair, although that would change if any other cases of its directors leaking information came to light.

But why on earth did one of McKinsey’s most senior employees break the rules so egregiously simply for material gain? Are McKinsey partners not paid enough as it is?

Perhaps not, is the answer. The annual distribution per partner at McKinsey has fallen from its peak as a result of the financial crisis and, although we do not know the figure since McKinsey is a private firm, is much less than the annual bonus of a senior investment banker.

The case of Mr Kumar shows that at least one McKinsey partner could be bribed for a fraction of what Wall Street’s elite earns.

What would Marvin Bower, the partner who built the modern McKinsey – and who passed on his stock to his partners at book value on his retirement rather than put it into debt – have thought?

Bower, dubbed “the soul of McKinsey”, would not have been impressed, it is safe to say. Rajat Gupta, a former McKinsey managing director, says of Bower:

“Convinced that behaviour and conduct are every bit as important as skills and expertise, Marvin sought to build the firm into an enduring, values-based institution.”

Among the five principles laid out on its website is:

“Keep our client information confidential. We don’t reveal sensitive information. We don’t promote our own good work. We focus on making our clients successful.”


No wonder Mr Kumar was so emotional in a New York court about what he did.

Ten reasons to work in private equity :)

Here is a list of 10 tongue-in-cheek reasons given by David Rubenstein, a co-founder of the Carlyle Group, for why private equity is still a great career.

Mr Rubenstein included his list in a recent presentation on the industry. The public controversy surrounding private equity has clearly not made him lose his sense of humour.

His reasons are:

1. There is no educational requirement – anyone can get into the business, no barrier to entry.

2. You don’t have to keep time sheets or fill out insurance reimbursement forms.

3. Lack of clear skills or a high IQ is not a handicap – it may be a plus.

4. You get to hire lawyers and economists, the people who were smarter than you in college.

5. Your ability to make charitable contributions will get you invited to much higher class parties (and get your children into higher class colleges).

6. Someone pays you 20 per cent (if not 25 per cent or more) of the profits on their money.

7. You will have every reason not to forget to negotiate a pre-nuptual agreement.

8. Private equity and hedge fund professionals live to 90 – no reported heart attacks.

9. There is no random steroid testing.

10. You can afford better grade assisted living arrangements.

New Social Investment Model

When entrepreneurs start a social venture, they are immediately in conflict: A social venture develops social connectedness, intellectual resources and skills, creative expression, personal health, a safer and cleaner environment.

But most equity investors measure their own success by financial returns, thus the social enterprise must also meet financial expectations. When setting course, social entrepreneurs may be immediately caught between a rock and a hard place.

Microfinance has emerged as a solution by providing debt, which changes the expectation of risk, thus of returns.  Microfinance manages risk through its small scale and other methods. Yet social enterprises, particularly in developed countries, often require an investment scale that microfinance can't address.

But a hybrid is possible.

An example of such hybridizing is what Marc Dangeard is building with the Entrepreneur Commons, which is explained on his blog as follows:

"A not-for-profit social network of entrepreneurs providing financing for early stage companies through debt guaranteed by a mutual guarantee fund. The financial risk is mitigated by the mutual guarantee fund. The risk on the 'management' side is mitigated by the social network: loans are by invitation only, so you will have to be approved by your peers to get in. ..."

Interestingly enough this hybrid model may also help angels and other investors improve their return on capital: Marc relays that a study of over 1,300 VC and PE firms worldwide shows that the returns they bring on average is 3% below the S&P 500 (after fees; 3% above, before fees). So market rates are actually competitive returns, and investors receive steady revenue stream of debt repayments for the lifetime of Entrepreneur Commons, instead of the feast-or-famine of funding rounds and exits.

So this model is an insightful way to solve the problems of
•    providing seed capital for social ventures that facilitates non-financial asset building
•    providing financially competitive market returns for investors
•    providing liquidity for investors. 

Do we really need more money??

Ask any entrepreneur, social or otherwise, and the answer is always an emphatic “yes”. 

We are all keen to get our hands on more capital, convinced this will solve all our problems.

We seek it everywhere and demand governments to “do more” for the sector. When Barack Obama recently requested $50 million for a Social Innovation Fund, I queried the amount, suggesting it was trivial. After all, in Britain the government has invested hundreds of millions of pounds into social enterprise and is currently considering at least another £300 million to support a Social Investment Wholesale Bank.

But the question arises—is all this government money a good thing? I challenge the notion and point out that the social business sector, especially in the UK, was in danger of being flooded by too much government funding.  Does this not crowd out private investment? Are the criteria for decision-making apolitical, or are they heavily influenced by partisan calculations or “cronyism”? In such times of burgeoning fiscal debt and individual hardship, is such government largesse appropriate?

There is a more fundamental question. Are we focusing too much attention on the supply of investment to the sector? Funds for investment can be organised quickly—overnight if you're Bill Gates. But to build a successful social venture can take at least 5 to 10 years. By focusing excessively on the investment side, are we not missing an opportunity to invest more into building great businesses?  Won’t this imbalance harm the earliest investors, who will realise poor financial returns as too much capital will be chasing too few good deals? Won’t the longer-term future of Impact Investment suffer as a consequence?

I understand the importance of bringing more capital into the sector. But we must ask ourselves what is the best use of incremental funding at this time—more investment or building more great social ventures? The companies need professional non-executives, sound financial control, well-conceived marketing and sales strategies, etc

Debt Relief for Social Entrepreneurs

In the business world, it’s par for the course to move on when a project has proven financially unviable. Those who identify as social entrepreneurs can be more stubborn, at their own expense. They don’t necessarily move on when our projects have proven financially unviable.

They keep going, at first turning to philanthropic capital(where available, and it seldom is) and then, too often, to their credit cards. Some of them move on only when the money’s gone, passion muted, and monthly minimum payment so high that they have no choice but to abandon the work they love.

 

I fear that cash-strapped social entrepreneurs are becoming too dependent on the only reliable source of funding for social innovation, Mastercard and Visa. They have few alternatives. Large-scale funds created to advance the sector are bureaucratic and risk-averse by design. One-off funding sources for socially innovative organizations are too few in number and rarely come with deep enough pockets to stabilize a social venture.

 

A perfect storm has formed around the failure of philanthropic capital to address the needs of social entrepreneurs, the ease with which personal debt can be accessed, and the stubborn enthusiasm that social innovators often bring to their projects.

 

The damage this storm can cause is tremendous. The cost is nothing short of social entrepreneurship losing its brightest and most passionate to more stable if less socially-minded careers.

 

We would all be well-served to think of cash-strapped social entrepreneurs as too small to fail. Despite their small size today, many carry the blueprint for a program that could significantly advance a social issue or improve society in 5, 10, or 20 years. The field of social entrepreneurship shouldn’t be putting social innovators in situations where they need to choose between selling equity in themselves, paying the credit card companies’ exuberant fees, or leaving the work they love.

 

How do we build debt relief into the social entrepreneurship eco-system to ensure the growth and development of world-changing innovations, and the innovators behind them?

Crowdfunding: A new concept

Derek Lomas doesn’t see business as evil; he sees it as a tool to fund and distribute interactive games for children in Latin America. Jesse Gossett doesn’t use hisengineering degree to build bigger buildings; he is using it to democratize investments in renewable energy. Rosey Sambilli doesn’t just buy music to relax or dance to; she is using it as a platform to fund hundreds of undiscovered artists in Africa.

The convening power of the Internet, rapid advances in technology, and the reduced costs of launching a social enterprise in today's wired world are driving the race to create business models brimming with purpose. In this environment, social entrepreneurs like these are developing new solutions to take advantage of these advances and recreate yesterday's broken business models.

One example of their approach is crowdfunding -- the collective cooperation by people who network and pool their money together. And the implications, from technology to community-powered renewable energy to political campaigns or to financing the next wave of social enterprises, are immense. Think about how the Obama campaign flipped the standard campaign fundraising model on its head through harnessing small repeatable donations from the crowd.

It's an opportunity that has the potential to transform the business, political, and charitable landscapes. And it's already happening.

On this current trend there are some questions to consider:

1. What business model for social impact does your organization use?


2. Does an opportunity exist for crowdfunding to scale your impact?

3. Besides the examples noted above, can you think of other possibilities to harness crowdfunding for good? 

4. What isn't sustainable about your business model? Why? Could "tapping the crowd" for funds enhance your sustainability?

Impact Investing In Asia

The Capgemini/Merril Lynch “State of the World’s Wealth” 2011 reports that for the first time, there are as many high net-worth individuals (HNWIs) in Asia Pacific as in Europe with HNWI assets invested in the region growing to US $8.6 trillion. Despite this shifting of assets, Asia’s impact investment market still lags significantly behind Europe and the US.

 

Currently philanthropic giving – which we are correlating with social engagement – in China is around 0.35% of GDP as compared to 2.1% in the US, according to the Hudson Institute.

 

Should impact investing be positioned as an opportunity to show faith in a social entrepreneur in a frontier market, as an opportunity to tap bottom of the pyramid consumers as highlighted in the Next 4 Billion report, or be seen to provide underserved populations with increased access to key goods and services?

 

Early findings of the impact investment market in Asia, suggests that total invested capital of between US $90 to 250 billion, or 1-3% of the total assets currently being invested in the Asia Pacific region, could be deployed across key sectors to capture annual revenues of between US $100 and 350 billion by 2020.

 

Discussion questions:

·         Does the level of philanthropic giving reflect impact investing?

·         What is the best way to encourage private HNWI investors to allocate investments intosocial enterprises, especially small and growing businesses?

·         Do we need the multi-laterals and/or institutional impact investors to lead this charge or will private impact investments be sufficient to shift economic power down the pyramid?

·         What are the tipping points which will drive local governments to recognize the power ofsocial enterprises and create favourable regulations? Will it ever happen? Will it matter if it doesn’t?

Corporate Capital for Social Enterprises

For a social economy to take hold, financial resources are essential. Yet the conversation then turns to whether the funds should come from financial institutions, individual or high new worth investors (HNWIs). Rarely does the corporate sector get a mention.

The world’s largest corporations are awash with cash. Let’s consider Apple Inc., which earlier this year became the world’s top company by market capitalisation. It earned $7.3 billion after tax in the quarter ended 25 June, 2011 and reported cash of over $12 billion, with another $16 billion in marketable short term securities and no debt. While Apple may be unique, it is not alone. Many large companies have been paying down debt, issuing equity and harvesting cash. Whereas governments are struggling, banks are wobbling again and individuals continue to feel the pinch, large corporations all over the world are in rude financial health.

Could they be the answer? Like HNWIs, they are able to contribute expertise and human capital in addition to their financial might. But unlike angel investors they move very slowly before making financial investments. How can this be accelerated?

Corporations have another powerful way of helping the social enterprise (SE) sector: they can engage with SEs in a commercial relationship, providing contracts which generate revenues. Unlike capital investments, social enterprises must provide goods and services in order to fulfil these contracts, but this commerce can be continuous, as opposed to “one-off”. In this way they help SEs professionalize.

But what of the downsides?

• Is securing corporate capital a dangerous step down a slippery slope, imperiling social and ethical missions?
• If social enterprises trade with corporates, should this commerce be on normal terms, or should SEs expect to be favoured? If the latter, does this undermine the goal of making the sector properly sustainable?
• And what about corporate objectives? How much should social enterprises know about their corporate partners? Are some companies simply inappropriate to engage with (e.g. armaments manufacturers)?

Irrespective of the risks, I think this is a source we cannot ignore.

Early Stage Investment: Africa

It's difficult to predict the future when innovation is the name of the game, says successful technology entrepreneur and venture capitalist Vinod Khosla.  And it is.

But what does this have to do with early stage investing -- the state of play in Africa – and the whole wide world?

"Imagine what happens when the intelligence of 900 million people is unlocked, and the untapped reserves of a continent's innovation flow freely. Building the developed world as we know it required linking speculative capital to people with brilliant, unproven ideas. Africa is home to untold numbers of people harboring spectacular ideas, yet the continent and indeed, the world, reap far too little of what African innovation could produce due to a lack of investment in its entrepreneurs."

• Creativity and innovation – are they such a big deal?
• And if their results are hard to predict, how will they get funded?

It looks as though early stage investment may hold a key.

But let's get back to Khosla. Khosla can back up his assertion about predicting the future with a delicious array of remarks, including "The telephone has too many shortcomings to be seriously considered as a means of communication" (Western Union Internal Memo, 1876), Lord Kelvin's "Heavier-than-air flying machines are impossible" (1895), Thomas Watson Sr.'s idea that "five or six computers" would be enough to satisfy world need, or DEC founder Ken Olsen's inability to see why anyone would want a computer in their home…

No wonder Khosla quotes Karl Marx to the effect that "when the train of history hits a curve, the intellectuals fall off " – and it's not just scholars he's talking about, it's pundits, analysts, advisers, consultants…

He also quotes Alan Kay, "to predict the future, invent it" – George Bernard Shaw, "All progress depends on the unreasonable man" -- and Martin Luther King, "Human salvation lies in the hands of the creatively maladjusted" – so what have we learned?

Forget Brett Shere's 900 million people for a moment, and think of one sub-population among them -- the fraction of 900 million people who are "creatively maladjusted"...

• what does it take to empower them?
• and where are we falling short?

"The existence of a major gap in the financial markets of the world's second most populous continent is a serious problem: seed and early stage investment are major drivers of any robust entrepreneurial economy, and entrepreneurship is the most important force for sustainable job creation in the world," Shere writes – and "while Africa has an active microfinance space and emerging mid-size private equity sector, there is a gaping 'missing middle' in Africa's capital markets that includes seed stage angel investment and early stage venture capital."

• Why is early stage investment so crucial?
• Why is it so easily overlooked?
• Do you have to be "creatively maladjusted" to make early stage investments?
  • foolish?
  • courageous?
  • a creative risk taker?
• Is there even a difference?

The Japanese came up with 17-character messaging – haiku – in the mid seventeenth century, and over the years it became hugely popular as an art form. But social networking with 140 characters, on the scale of Twitter? Matsuo Basho, the 17^th Century Japanese haiku master, didn't see it coming! 200 million users in five short years! 200 million tweets a day!

Khosla asks, "Could McKinsey or an analyst have predicted Twitter?" -- or for that matter, the fall of the Berlin wall, or the Arab Spring?  Here are my questions:

• What are we missing?
• How important will that be, a short five years from now?
• Will you do something about that?
• Who are we missing?
• Are you talking with them?
• Why not?
• What tools do you have?
• Who else will do this, if you don't?
• OK --what will you do?

When is it a right time to sell a company

A financial consulting company recently had a client who had intentions of selling his business for a long time but was unable to decide when to start. His big dilemma was that he was expecting to be rewarded a government contract and believed that his business would be worth substantially more once that happened. The seller did not want to put the business in the market until the contract came through. Sounds like the right thing to do, doesn’t it? 

The firm's advice in this and similar situations is for the business owner to consider the trade-offs of starting the business sale immediately as opposed to waiting until the “big sale” closes.

First, let’s look at this type of contract from a potential acquirer’s perspective:

Ø  If the company that is being acquired has recently landed a big contract, how desirable is it and how much life is left in the contract? 

Ø  If the company has not gotten the contract but is likely to get it, what could it be worth?

Ø  Is this contract potentially a large percent of the company’s revenues and does the contract pose a material risk to rest of the company if something were to go wrong?

Ø  What is the economic benefit of it going forward? Is this contract a sustainable one or is it more of an aberration? 

Now, let’s look at the contract from the business owner’s perspective:

Ø  What is the lead time for the contract? Assuming delays or disruptions, which are common for big contracts, does the business owner have the time?

Ø  What if the business owner does not get the contract or, worse yet, the process drags on? How will it affect the company’s operations? How long can the seller wait to recover?

Ø  What are the chances that this contract will materialize or that there will be another bigger deal on the horizon after this deal? What does history say about how the company grows?

Ø  Between now and the anticipated close date of the business sale, is the competition getting stronger? Is there new competition?

Ø  How about the market? Are there any fundamental changes that are likely to happen over the next few years? Are there big investments needed to continue growing?

Ø  Is there any potential upside an acquirer can bring to the deal? Is it more likely that the company will get the contract with the current management or with the acquirer? 

So, what should the business owner do once the trade-offs are understood? The critical element to consider in this situation is the reason why the business owner wants to sell the business in the first place. Does the business owner not have the energy to continue driving the business aggressively? Is he/she under any time pressure for health, personal, or other reasons? Whatever else the reason may be, is it still valid? If the answer to any of these questions is “yes”, now is the time to put the business sale process in motion.

When it comes to waiting for a big sales contract before you sell your business, consider the trade-offs before you make a decision.

What do PE firms look for in a Company

To understand what Private Equity Groups (PEGs) look for in a company, one needs to understand the meaning of Private Equity.

Private Equity is long-term, committed capital provided in the form of equity to help private companies grow and succeed.

Unlike debt financiers who require capital repayment plus interest on a set schedule, irrespective of your cash flow situation, Private Equity is invested in exchange for a stake in your company. After the equity infusion, you will have a smaller piece of the pie. However, within a few years, your piece of the pie could be worth considerably more than what you had before.

Private Equity investors’ returns are dependent on the growth and profitability of your business. If you succeed, they succeed. If you fail, they fail.

Assuming the company is suitable for Private Equity investment, investors look at several criteria before providing the equity for your business.

Strong Management team

Unless the intended purpose of the equity transaction is management transition, the quality of the management team is by far the most important criterion for many Private Equity investors. Most investors do not invest in a company unless they are satisfied with the management team.

Growing Market Segment

The value added by Private Equity in many cases is their ability to grow the “pie” and in that context the growth potential in the target market segment is a very critical factor.

Realistic Growth/Expense Plan

Unrealistic planning will create a doubt in investors’ minds about the management’s business skills. Similarly, under budgeting for material, labor and equipment costs will reflect poorly on the management team.

Exit Route

The PEGs are in the deal for the long term but they need a workable exit to get their money back. The exit could be business sale, management buyout, IPO or something else.

Security

Unlike debt, equity investment does not come with any overt security collateral. To mitigate risk, PEGs typically require a seat on the company’s board and a codified management plan to protect the PEG’s interest.

Contingency Planning

No business grows without hiccups. Understanding what could go wrong and putting contingency plans in place to deal with specific situations can go a long way in gaining a PEG’s trust.

Reputation

The best business ideas are not worth much without good people and PEG’s want to make sure that they are getting a strong, positive team with good marketplace reputation.

Good Rate of Return

The return a PEG is willing to accept is a direct function of how desirable your deal is and how much competition exists for your deal.

In summary, PEG investors must be assured that the capital being deployed by them will yield the returns they are seeking. If the investment is considered worthwhile then there will be competition to do your deal. Competition often means you get a higher valuation, better deal terms for your company and more cash proceeds for you

Fair Business Valuation: A Myth

So, how can Bear Stearns be worth about $20 billion dollars in January 2007 and be worth only $238M in 16^th March 2008 – just 14 months later? And how can it be worth about $1B within days after JP Morgan announced the $238M deal? What is the fair valuation?

The answer is simple and holds a message that every business owner should be keenly aware of: There is NO fair value for illiquid assets.

While the 100:1 valuation swing that Bear Stearns saw within a span of about an year is uncommon for public sector companies, it is not at all uncommon for mid-market businesses. We routinely see business owners who have suffered enormously from dramatic valuation compression due to poor planning and/or picking wrong advisory teams. Let’s look at what “fair valuation” of illiquid assets means in the context of mid-market business owners and shareholders who are getting ready to sell or recapitalize their businesses.

Professional valuation specialists charge thousands or tens of thousands of dollars to come up with a fancy report that narrows the value of the business to a precise number or a narrow range of values. This type of report is typically tens of pages long and addresses valuation factors such as financials, industry sector, strength of management team, value of the assets, the purpose of the sale, etc. A typical report also uses various valuation methodologies to arrive at a weighted average number that is given out as value of the business.

So, what does it mean to have a “professional valuation report” or a “fair value report”? Does this mean that the seller will know the exact selling price of the business? Not really!

Professional valuations and fair value opinions aim to provide a “fair business valuation” but they are all contingent on multiple assumptions. The valuations are as good as the assumptions upon which they are based. Two of the key factors in valuations – future growth rate and operational synergies – are highly subjective and no two views on these topics are likely to be identical. Unfortunately for business owners, the exact conditions laid out by valuation professionals never occur in real life!

On top of variability in key valuation factors, sale terms such as the type of sale, the payment schedule, consulting clauses, earn-outs, and the reps and warranties can easily cause a 20-40% swing in what the seller gets to take home. Setting aside sale terms, which are typically not covered by a valuation report, the seller will be lucky if the real sales price comes within 10% to 20% of the professional valuation. In several of our most recent deals, the initial valuation report was off at least 30% from the final sales price.

The reality of business sales process is that the value of a business is determined by the acquirer much more than any other factor. The same business could be viewed completely differently by two different acquirers depending on their strategic needs and their perceptions of future cash flows.

The business sale process also plays a big role. Acquirers tend to pay much more for a deal that they believe is competitive. While negotiating in a recent deal, one buyer, after realizing the seller needed to sell for medical reasons and thinking that there was no competition on the deal, said: “I know I got a price reduction but if I wait long enough wouldn’t the seller have to pretty much give the business away?” 

From our experience, the type of buyer and the type of sale skew the valuation to such an extent that it is unwise for a business owner to be not familiar with these variables and their impact before the beginning of the sales process. Business owners should be aware that these two factors play a disproportionately large role and consequently any “professional valuation” has only limited applicability in the business sale process.

The key messages for business owners looking to sell or recapitalize their businesses are:

-      There is no fair value for illiquid assets. It all boils down to what a willing buyer can pay and what the business owner is willing to accept.

-      To maximize valuation, working with the right acquirer is extremely important.

-      Be prepared for a drawn out sale process. Competitive bid process, an important tool used by M&A specialists to maximize exit valuation, can take time.

-      Plan early and never sell in desperation.

10 Factors that reduce the value of your Business Sale Deal

If you are like most mid-market business owners, your business is your single largest asset. To get the most value for this asset it behooves you to understand what reduces the value of your business and minimize or eliminate these value killers. The purpose of this article is to help you identify the value killers in a typical business sale and help you take steps to get a higher value for your business.

Here are the key value destroyers in a typical business sale:

1.    Unplanned Sale: The most expensive mistake that sellers make is not taking the time to plan a sale. Planning for the sale should begin a minimum of one year and preferably three years before you need to sell.

2.    Lone Acquirer: The second most expensive mistake that sellers make is that they get themselves into a single buyer auction. This typically happens when the seller got an unsolicited bid from an industry player. Regardless of the reason, if there is just a single player determining the value of your business, you are very likely to get an offer that is well below the market price.

3.    Surprises: Any negative surprises can dramatically alter the deal as the acquirer starts questioning the surprise and begins wondering if there are any other issues with the deal and redoubles his/her due diligence. Negative surprises can lead to changes in price and terms of the deal and in many cases end up becoming deal killers.

4.    Losing Focus: One of the most expensive mistakes that sellers make is taking their eye off the ball during the business sale process.Loss of focus tends to be not only expensive but traumatic as the buyer renegotiates price and terms of a deal that you think is done.

5.    Customer Concentration & Lack Of Recurring Revenue Streams: Ideally, no single customer should contribute to more than 10% of your revenues or profits. The best solution for this problem is to diversify the customer base. If that is not feasible, see if you can get the customers to commit to you with long term contracts. Lack of long term contracts, annual service/licensing fees, and other recurring revenue streams make business less desirable and results in a lower EBITDA multiple.

6.    Lack Of Management Depth: Acquirers buy a business that they hope will be fully functional and growing after the sale. It is tough for the acquirer to place a high value on your business if you are the sole decision maker in the company and the business depends largely on your skill set.

7.    Poor Financial Records: To many acquirers, poor bookkeeping indicates increased risk and also says a lot about how the business was run. Having a set of clean, easily auditable books inspires confidence and helps during the due diligence and negotiation process.

8.    Poor Legal Records & Weak Contracts: Having poor legal records and having contracts without teeth is a sign of weakness. How well is your intellectual property protected? Are all your independent contractor agreements signed and readily available? Can your suppliers stop servicing you at the drop of the hat? Can your customers drop your line at their whim and fancy?

9.    Lack Of Confidentiality: Lack of confidentiality about the sale may mean that your competitors may use the uncertainty to their advantage. Loss of a key employee or a key customer can be devastating to the company’s value.

10. Inexperienced Deal Making Team: Lack of a good team that can balance the experience of the acquirer can be very expensive. Can your transaction management team get a good deal on your price and terms for you? Can your team overcome the aggressive steps taken by the acquirers during due diligence to drive down the value?

The most important take away from this article should be that while EBITDA matters, the process and approach to deal making also has considerable impact on the perceived value. Avoiding the value killers mentioned above will give you an upper hand during the negotiation process.