M&A International™ – the world's leading M&A alliance
Business Valuation, Acquisitions & DivestituresMarch 2014
Howard E. JohnsonMBA, FCPA, FCA, FCMA, CBV, CPA, CFA, ASA, CF, C.DIR
M&A International™ – the world's leading M&A alliance
About Veracap M&A International
Veracap M&A International Inc. is a leading investment bank advising on acquisitions, divestitures, financing and shareholder value initiatives.
As a member of M&A International, Veracap forms part of the world’s leading affiliation of M&A advisors, with over 600 professionals in 41 countries.
Veracap is a sister company of Campbell Valuation Partners, Canada’s longest established independent business valuation firm.
www. veracap.com
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M&A International™ – the world's leading M&A alliance
Speaker
Howard E. JohnsonMBA, FCPA, FCA, FCMA, CBV, CPA, CFA, ASA, C.DirManaging Director, Veracap M&A International Inc.(416) 597-4500; [email protected]
Howard is a Managing Director of Veracap M&A International and its sister firm, Campbell Valuation Partners Limited. Howard has been involved in business valuation, acquisition, divestiture, and shareholder value advisory assignments for corporations throughout North America. He is the author of several books on the subjects of business valuation and corporate finance, and has acted as an expert witness on valuation matters before the courts.
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M&A International™ – the world's leading M&A alliance
Disclaimer
This material is for educational purposes only. It deals with technical matters which have broad application and may not be applicable to a particular set of circumstances and facts. As well, the course material and references contained therein reflect laws and practices which are subject to change. For these reasons, the course material should not be relied upon as a substitute for specialized advice in connection with any particular matter.
Although the course material has been carefully prepared, the author does not accept any legal responsibility for its contents or for any consequences arising from its use.
© Howard E. Johnson, 2014
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M&A International™ – the world's leading M&A alliance
Overview
I. Concepts & PrinciplesII. Valuation MethodologiesIII. Rates of Return and Valuation MultiplesIV. AcquisitionsV. DivestituresVI. Private Equity and MBO’sVII. Wrap-up
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M&A International™ – the world's leading M&A alliance
PART I
CONCEPTS AND PRINCIPLES
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M&A International™ – the world's leading M&A alliance
Principles
• Enterprise value vs. equity value• En bloc value vs. minority interest• Business valuation vs. stock prices• Cash flow and rates of return / multiples• Liquidity
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M&A International™ – the world's leading M&A alliance
Fair Market Value vs. Price
Fair Market Value
• Open & unrestricted market
• Buyer and seller have equal knowledge & negotiating strength
• Parties are prudent and under no compulsion to transact
• Cash transaction
Price
• Market restrictions
• Buyer and seller have different knowledge and negotiating skills
• Parties imprudent or compelled to act
• Non-cash consideration
• Other factors
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M&A International™ – the world's leading M&A alliance
Components of Value & Price
Post-Acquisiti
on Synergie
sIntangible Assets & Goodwill
Tangible Net
Worth Fair
mar
ket
valu
e ra
nge
(‘st
and-
alon
e’)
Inve
stm
ent
Valu
e Ra
nge
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M&A International™ – the world's leading M&A alliance
Goodwill
“Value” of Shares $5,000,000Underlying net tangible assets $3,000,000“Goodwill” $2,000,000
CommercialGoodwill
Transferable
IndividualGoodwill
Transferable w/non-compete
PersonalGoodwill
Non-Transferable
Fair Market Value & Price
Value to Owner
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M&A International™ – the world's leading M&A alliance
Part II
VALUATION METHODOLOGIES
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M&A International™ – the world's leading M&A alliance
70%
32%
22%
2%
12%
0%
10%
20%
30%
40%
50%
60%
70%
% o
f Res
pond
ents
Discounted Cash Flow
Multiple of Earnings
Multiple of EBIT-DAMultiple of EBIT Other/industry-specificMethodology
(Note: many respondents indicated more than one method.Therefore, the percentages do not total 100% )
Valuation Methodologies
M&A International™ – the world's leading M&A alliance
Cash Flow Terms Used in M&A
Income before taxes+ Interest expense= earnings before interest and taxes (EBIT)+/- Normalization adjustments= Normalized EBIT+ Depreciation and amortization= Norm. earnings before interest, taxes, dep’n, amort. (EBITDA)
- Capital expenditures- Cash income taxes- Incremental working capital requirements= Normalized discretionary cash flow (or “free cash flow”)
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M&A International™ – the world's leading M&A alliance
Normalization Adjustments
•Non-active family members•Excess or deficient salaries to owners•Personal expenses•Rents above/below market•Non-recurring items•Unusual items•Etc.
Separate return on effort and return on capital
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M&A International™ – the world's leading M&A alliance
Multiple of EBITDA Approach to Valuation
Normalized EBITDAMultiplied by EBITDA multipleEquals enterprise valueDeduct interest bearing debtEquals equity value
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M&A International™ – the world's leading M&A alliance
Multiple of EBITDA Example
Normalized EBITDA $ 5 millionMultiplied by EBITDA multiple 5xEquals enterprise value $25 millionDeduct interest bearing debt ($5 million)Equals equity value $20 million
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M&A International™ – the world's leading M&A alliance
Issues with the Multiple of EBITDA Approach
•EBITDA vs. discretionary cash flow•Capex considerations•Tax considerations•Working capital requirements•Normalization adjustments•Distorted EBITDA base•Growth assumptions embedded in the selected multiple
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M&A International™ – the world's leading M&A alliance
Capitalized Cash Flow Approach
• Prospective discretionary cash flow• Divided by rate of return• Equals enterprise value• Add redundant assets• Deduct interest bearing debt• Equals equity value
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M&A International™ – the world's leading M&A alliance
Prospective Discretionary Cash Flow
•Cash that can be withdrawn from the business each year in the future without impairing ongoing operations
•Normally determined as:– Earnings before interest expense & taxes (EBIT) of most recent
years ‘normalized’ for non-recurring items and related party remuneration
– Less income taxes – Add back depreciation– Less sustaining capital investment
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Rate of Return
• Capitalization rate (inverse of multiple)• After-tax rate of return applied to after-tax cash flows• Function of risk factors and opportunities• Risk - reward trade-off• Range of 10% to 15% for mid-sized, stable business is
not unusual• Higher rates for small companies, start-ups & high risk
businesses
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M&A International™ – the world's leading M&A alliance
Redundant Assets
• Non-operating assets not required in the operations of the business
• Example: marketable securities, excess land• Must be permanently redundant (i.e. not a seasonal
surplus)• Remove any related income in estimating maintainable
cash flow• Normally withdrawn (on a tax-deferred basis) rather than
sold
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M&A International™ – the world's leading M&A alliance
Interest Bearing Debt
• Financing vs. operations• Includes short term & long term interest bearing debt
(lines of credit, mortgages, capital leases, etc.)• Includes interest bearing debt equivalents (advances
from shareholders, bonuses payable to shareholders, etc.)• Excludes trade debt (accounts payable)• Usually net of cash
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Case Example
• Joe Smith is the sole owner of a small product manufacturing company
• His business has been relatively stable in recent years and is expected to remain so
• Joe’s remuneration consists entirely of a bonus declared at year-end
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Current Balance Sheet$000
Assets LiabilitiesCash 200 Bank loan 1,000Accounts Receivable 1,200 Accounts Payable 700Inventory 800 Bonus Payable 500Due from Shareholder 300 Total liabilities 2,200Total current assets 2,500
EquityShare Capital 1
Fixed assets (net) 1,000 Retained earnings 1,299Total Equity 1,300
Total Assets $3,500 Total Liabilities & Equity $3,500
DECEMBER 31, 2013
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M&A International™ – the world's leading M&A alliance
Historical Income Statements
2011 2012 2013
Revenues 5,530$ 5,950$ 5,710$ Cost of Sales 2,720 3,010 2,860 Gross Profit 2,810 2,940 2,850
Operating Expenses 1,740 2,090 1,770 Depreciation 220 230 240 Interest Expense 100 170 140 Shareholder Bonus 550 250 500
2,610 2,740 2,650
Earnings before tax 200 200 200 Income Taxes 40 40 40
Net Income 160$ 160$ 160$
$000
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M&A International™ – the world's leading M&A alliance
Other Facts
•Annual capital reinvestment required = $250,000•Market salary for active shareholder = $150,000•2012 expenses includes a one time charge of $300,000
•Prospective income taxes @ 25% (acquirer’s rate)•Assume a 15% rate of return (6.7X multiple)
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Normalized Discretionary Cash Flows
2011 2012 2013
Earnings before tax 200$ 200$ 200$ Add: Unusual expense item 300 Shareholder bonus 550 250 500 Interest Expense 100 170 140 Less: Normal remuneration (150) (150) (150) Normalized EBIT 700 770 690 Less: Income Taxes (175) (193) (173) Normalized income 525 578 518 Add: Depreciation 220 230 240 Deduct: Capital Investment (250) (250) (250) Normalized cash flow 495$ 558$ 508$
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M&A International™ – the world's leading M&A alliance
Estimate of Stand Alone Value
Maintainable discretionary cash flows, say $520Divide by Capitalization rate (6.7x multiple) 15%Equals Enterprise Value (rounded) $3,500Add: Redundant assets (due from s/h) 300Deduct: Debt (bank loan + bonus – cash) (1,300)En Bloc equity value $2,500
Intrinsic Value of Shares
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M&A International™ – the world's leading M&A alliance
Discounted Cash Flow Approach
•Forecast discretionary cash flows – normally 3 - 7 years projected cash flow– Capital expenditure and working capital requirements considered
•Determine “Terminal value”– value beyond forecast period– maintainable discretionary cash flow at that time divided by
capitalization Rate•Discount annual forecast and terminal value
– Discount & cap rates reflect risks in forecast•Equals enterprise value•Deduct interest bearing debt & equivalents•Equals equity value
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M&A International™ – the world's leading M&A alliance
Discounted Cash Flow Example
Current Year 1 Year 2 Year 3 Term.
EBITDA 5,000 5,500 6,050 6,655 6,790 Depreciation (1,500) (1,500) (1,500) (1,530) EBIT 4,000 4,550 5,155 5,260 Income taxes at 25% (1,000) (1,138) (1,289) (1,315) After-tax income 3,000 3,413 3,866 3,945 Add back: dep'n 1,500 1,500 1,500 1,530 Deduct: capex (2,900) (1,000) (1,000) (1,600) Deduct: Working Capital (1,000) (1,000) (1,000) (240) Discretionary cash flow 600 2,913 3,366 3,635
M&A International™ – the world's leading M&A alliance
Discounted Cash Flow Example
Year 1 Year 2 Year 3 Term.
Discretionary cash flow 600 2,913 3,366 3,635
Capitalization rate (net of 2% growth) 13%Terminal Value 27,962
PV at 15% 560 2,362 2,373 19,716(mid-year discounting)
M&A International™ – the world's leading M&A alliance
Discounted Cash Flow Example Cont’d
PV of forecast discretionary cash flows $ 5,300PV of terminal value $19,700Enterprise value $25,000Less - Interest bearing debt $(5,000)Equity Value $20,000
* Note – figures rounded
M&A International™ – the world's leading M&A alliance
What about the Balance Sheet?
•Expectations of buyers as to deliverables – Working capital– Book value
•Normally cash-free, debt free, except as agreed•Redundant assets•Operating asset adjustments
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M&A International™ – the world's leading M&A alliance
Part III
RATES OF RETURN AND VALUATION MULTIPLES
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M&A International™ – the world's leading M&A alliance
Rates of Return
• Discount Rate– Converts a series of cash flows to present value– Used in Discounted Cash Flow calculation– Normally a weighted average cost of capital
• Capitalization Rate– Converts a point estimate of cash flow into value– Equals discount rate less long term growth rate– Capitalized cash flow methodology and terminal value part of DCF
• Valuation Multiple– Inverse of capitalization rate– Often expressed on a pretax basis
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Weighted Average Cost of Capital
Cost ofEquity
WACC
Cost ofDebt
OptimalCapital Structure
Cost%
100%Debt
Debt + Equity
0
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M&A International™ – the world's leading M&A alliance
Simplified WACC Formula
WACC = Ku x {1 - [T x D/(D+E)]}
Debt-free Return on Equity
Tax Rate Debt to Debt Equity (capital structure)
Operating Risk Financial Risk
{ {This is as technical as it gets!!!!
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M&A International™ – the world's leading M&A alliance
Determining the Buyer’s Debt-Free Return on Equity (KU)
•Function of operating risk (business risk)– reflects industry and company-specific risks & opportunities
•Normally relatively stable given investment horizon•Often based on a ‘build-up’ methodology
– LT Gov’t bond rate + equity risk premium +/- Adjustments
•Possibly a corporate hurdle rate
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M&A International™ – the world's leading M&A alliance
Determination of Buyer’s Capital Structure
• Optimal vs. ‘appropriate’• Long term target range• Target vs. acquirer• Determinants
cost of debt industry practice stability of cash flows underlying assets covenants tax rate
• Subjective
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Buyer’s After-Tax Capitalization Rate
Nominal WACC discount rate (including inflation)
Deduct: inflation
Deduct: perpetual real growth rate(reasonableness issue)
Equals Capitalization Rate
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Discount & Capitalization Rate Example
Facts:Cost of equity (pre-debt) 14%Inflation 2%Debt to total capital 33%Tax rate 25%Perpetual real growth 1%
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M&A International™ – the world's leading M&A alliance
Discount & Capitalization Rate Example Cont’d
Discount rate (nominal WACC)
= 14% x [1 - (25% x 33%)] = 13% (rounded)
Capitalization rate (real WACC)= 13%
deduct: 2% inflation 1% growth= 10%
Equivalent multiple of after-tax free cash flows (before interest expense):= 1 / 10% = 10X
Equivalent multiple of EBIT = 10 x (1-25%) = 7.5X
Multiple of EBITDA: 7.5 x (1-20%) = 6x (assuming dep’n is 20% of EBITDA)42
M&A International™ – the world's leading M&A alliance
Buyer’s Corporate Hurdle Rate
• Another name for discount or capitalization rates• Set at board level• Must understand what it represents (WACC or ROE, discount or capitalization rate, etc.)• Fact specific adjustments• Implicit assumptions re: inflation, financial leverage, industry risk, etc.
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M&A International™ – the world's leading M&A alliance
Target Nominal WACC Rates of Return Used by Corporate Acquirers
Less than 10%
10% - 11%
12% - 13%
14% -15% 16% -17% 18% - 19%
20% & Over
9%
25%
20%
30%
3%5%
8%
0%
5%
10%
15%
20%
25%
30%
% o
f Res
pond
ents
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M&A International™ – the world's leading M&A alliance
Valuation Multiples
Mirror Side of the Capitalization Rate•Often converted to a pretax basis, and expressed as a multiple of EBIT or EBITDA
• 5x EBITDA a popular ‘starting point’ for mid-sized mature businesses
•Adjustments for risk, growth, perceived importance of acquisition target, etc.
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M&A International™ – the world's leading M&A alliance
Determinants of Valuation Multiples
•Company size•Revenue stability and concentration•Proprietary products and services•Management and employees•Growth potential•Capital expenditure requirements•Buyer synergy expectations•Terms of the transaction•Comparable transactions
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M&A International™ – the world's leading M&A alliance
Rates of Return & Multiples
Return Multiple
EBITDA $5,000 20% 5.0XDepreciation 1,300EBIT $3,700 15% 6.7XIncome taxes 1,200After-tax cash flow $2,500 10% 10.0X
All results lead to $25 million (enterprise value)
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M&A International™ – the world's leading M&A alliance
PART IV
ACQUISITIONS
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M&A International™ – the world's leading M&A alliance
Objectives Driving Deals for Buyers
•Access to new markets ...76%•Growth in market share ...74%•Access to new products ...54%•Access to talent …47%•Enhanced reputation …46%•Reduction in operating expenses …46%•Access to distribution channels …38%•Access to new technologies …26% •Reduction in # of competitors …26%•Access to new brands ...25%( source: PWC)
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M&A International™ – the world's leading M&A alliance
M&A Valuation Dynamics
Buyers
Detailed Calculations1. DCF / Cap. Cash flows
2. Comparable transactions
Sellers
Preliminary Calculations1. Comparable Transactions
2. DCF / Cap cash flows
DynamicInvestment value
Market influences
Negotiations
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Overview of the Acquisition Process
1. Pre-acquisition Planning 2. Search for targets3. Target company analysis4. Internal valuation & pricing5. Negotiations and the LOI6. Detailed due diligence7. Purchase agreement & closing8. Integration
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Pre-acquisition Planning
•Fit with strategic plan•Build vs. buy•Policies and procedures in place•Resources•Search criteria•Active vs. passive search
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M&A International™ – the world's leading M&A alliance
Confidentiality Agreements / NDA’s
• Usually will be asked to sign prior to receiving confidential info and sometimes prior to knowing the identity of the seller
• Be careful re: provisions governing restrictions on contacting customers, suppliers etc. (especially for competitors)
• Best to ask that your own ‘2-way’ NDA be signed• Establish internal protocol for NDA approvals
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The 3 Classic Deal Contexts
1. The single buyer
2. The controlled auction
3. The effective auction
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Preliminary Due Diligence
• Assessment of confidential information memorandum• Publicly available data• Meetings with owners and management• Review data room• Assessment of other potential bidders
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Preliminary Due Diligence
• Strategic Fit assessment• Likelihood of integration• Revenue base and growth prospects• Sales and marketing• Management and employees• Operations• Financial performance• Synergies
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Integration and Transition Risks•Loss of customers•Non-transferability of key contracts•Loss of key employees•Change in culture•Additional costs / lost revenue during integration•Damage to brand names and other intangibles acquired
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Transition Risks
M&A International™ – the world's leading M&A alliance
Synergistic Objectives (& Results) Driving M&A Deals
•Access to new markets …76%... (74%)•Growth in market share …74%... (60%)•Access to new products …54%... (72%)•Access to talent …47%... (51%)•Enhanced reputation …46%... (48%)•Reduction in operating expenses …46%... (39%)•Access to distribution channels …38%... (60%)•Access to new technologies …26%... (63%)•Reduction in # of competitors …26%... (80%)•Access to new brands …25%... (92%)
Source: PWC
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Synergies
• A premium over ‘stand-alone’ value due to:– increase in free cash flows due to higher revenues or reduced costs– reduced risk in achieving free cash flows– additional growth opportunities and ‘strategic value’
• Should be separately assessed• Unique to every acquirer• Buyer is in a better position to quantify • Apply probability factor to reflect risk• Synergies not ‘paid for’ act as buffer • Can be a key negotiating point
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Up to 25% of synergies
16%
Synergies not considered
18%
More than 75% of synergies
30%
51% to 75% of synergies
7%
26% to 50% of synergies
29%
Proportion of Synergies Incorporated by Acquirers in Valuing Acquisition Targets
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M&A Negotiation
• Importance of negotiating strategy often underestimated • Posture, style, and other tactics• Price and terms are important• The need and desire to transact
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M&A Negotiation Team
Internal –Division Executives (finance, marketing, operations, etc.)–Corporate development officer– In-house General Counsel
External- Transaction / Valuation Advisors- Legal / Tax / Accounting- Non-M&A Technical Advisors
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Who Should be Involved in Negotiations
• Agree up front• Fewer is better (directly)• External advisors act as buffer
–subsequent relationship–emotional deal killers–shadow negotiator
• Authority/competence to recommend deal
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Financing Alternatives
• Vendor financing (e.g. promissory note)• Senior debt
– Normally secured against A/R, inventory, real property– Rate is prime +– Usually up to about 2x to 3x EBITDA
• Subordinated debt– Usually a coupon of 10% to 15%, plus upside ‘kicker’– Considerable interest in ‘acquisition financing’– Usually 1x to 2x EBITDA
• Equity – New vs. existing
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Debt Financing Considerations
• Restrictive covenants
• Security offered
• Long term capital structure
• Future financing requirements
• Degree of flexibility
• Matching principle
• Principal repayment options
• Renewal options
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Final Due Diligence
•Legal and audit due diligence•Verification of facts and assumptions•Details not previously reviewed
–Employee details–Contracts and agreements–Detailed operational issues–Customer / supplier details–Financial details– Insurance and related claims–Legal issues, minute books, etc.
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Hidden Liabilities
•Overvalued assets–Slow-moving inventories– Receivables– Fixed assets (repairs, maintenance)
•Undervalued Liabilities–Pensions and post-employment obligations–Warranties–Contracts and commitments
•Revenue / expense recognition
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Due Diligence Renegotiation
•Buyer’s side –significant issues discovered or interim business issues– Lower price vs. change terms– When to walk away
•Seller’s side– ‘unsolicited’ alternative offer– Interim business performance–Holding out for more
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Purchase Agreement
•Definitive binding agreement•Contains all aspects of the deal•Drafted by the buyer’s legal counsel•Normally prepared concurrent with due diligence•Representations and warranties•Arbitration clauses
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Representations & Warranties
•Best of knowledge vs. Absolute knowledge•Time period•Minimums / maximums (baskets and caps)•Seller covenants
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Management Contracts
•Individual shareholders•Eases transition issues for buyers•Usually 6 months to 3 years•Level of involvement to be determined•May effectively represent a portion of price•Transition issue for seller?
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Non-competition Agreements
•Individual shareholders•Individual goodwill•Specifies scope of work, territory and time period•2 to 5 years is not uncommon•Purchase price allocation
–Tax rules
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Closing
•Usually at a lawyers office•Concurrent with or shortly after execution of purchase agreement
•Exchange of cash, shares, notes, etc.•Last-minute negotiations•Post-closing audit
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Keys to Successful Integration
•Communication•Plan with milestones•Execution / managing the process•Champion with authority and business savvy•Plan in advance – during assessment stage•Identify and deal with issues early•Getting employee buy-in
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Classic Buyer Mistakes
•Overpaying for expected synergies / unrealized synergies•Compulsion to act / falling in love with ‘the deal’•Inadequate due diligence•Technical errors in financial analysis & calculations•Poor integration•Bitter post-acquisition sentiment•Management philosophy / cultural differences•Failure to identify hidden costs•Failure to anticipate or avoid key personnel turnover
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Acquisition Opportunities in the Current Environment
• Active search for proprietary deals• Turnaround situations – equity investment• Debt acquisitions • Small cap public companies• Private equity portfolio orphans
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PART V
DIVESTITURES
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Transition Trade-offs
Family Mgmt. 3rd Party
Usual time requirements 2-4 months 3-6 months 6-12 mo.’s
Complexity Low-med Med-high High
Valuation & Pricing Low-med Medium Med.-High
Cost Lowest Moderate Highest
Risk (deal failure, info. leak, etc.) Lowest Moderate Highest
Deal structuring flexibility Good Fair – good Fair - good
Tax efficiency opportunities Very good Good Fair - good
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VALUE RECEIVED BY THE
BUSINESS OWNER
ECONOMIC TERMS OF THE DEAL
INTANGIBLE ASPECTS
OF THE DEAL
STATED PURCHASE PRICE
Elements of Value to the Business Owner
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The Private Company Sale Process
1. Deciding When to Sell2. Preparing for the Sale3. Estimating Value & Price4. Search for Buyers5. Preliminary Due Diligence6. Deal Structuring7. Negotiations8. Closing
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Timing of the Sale Process
Time Req’dPlanning Phase
Deciding when to sell It dependsPreparation 1-3 years (ideally)Valuation 1-2 months
Execution Phase Search for buyers 1-2 monthsPreliminary due diligence 2-4 monthsDeal structuring & negotiations 1-2 monthsClosing 2-4 months
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Building Deal Momentum
Deciding When To Sell
PreparingFor the Sale
The SearchFor Buyers
Estimating Value and Price
PreliminaryDue Diligence
PLA
NN
ING
PH
AS
E
EX
EC
UTI
ON
PH
AS
E
NegotiationsDeal Structuring Closing
V A
L U
E
E N
H A
N C
E M
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T
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Deciding When to Sell
The owner’s personal situationEconomic and industry conditions
Company performance and prospects
Key = Time the sale to coincide with favourable personal and business conditions
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Circumstances Leading to Sale
•Compulsion to sell– An undesirable situation
•The growing company dilemma•Voluntary retirement / change of interests
– Management contract considerations•Unsolicited offer
– Seller must stay in control of the process
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Considerations Prior to Sale
•Personal impact on owner and family–Family members active in the company
•Who to sell to–Family, management or third party
•Plans following the sale–Management contract / non-compete considerations
•Personal financial situation–Acceptable forms of consideration
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Company Performance and Prospects
•Recent historical operating results–Easier to sell a growth story–Revenue and cash flow growth
•Budgets and projections–Tangible support where possible (e.g. contracts)–Beware of unfounded optimism
•Influence on valuation multiples
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Timing of the Sale
Profit Level
Time
Historical Forecast
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Preparing for the Sale
Operational and financial structuringIncome tax and estate planning
Transaction advisors
Key = Structure the affairs of the company toincrease its attractiveness to buyers
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Operational Matters
•Customer and market analysis– Revenue stability and concentration– Competitive analysis
•Management and employees– Ability to transition the business– Key employee issues
•General operational matters– Facilities, equipment, inventories, etc.– Company website– Caution re: new commitments
•Administrative matters– Minute books, banking agreements, contracts, etc.
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Financial Matters
•Financial statement review / audit•The income statement
– Revenue recognition– Expense management– Profit trends
•The balance sheet– Working capital management– Capital expenditure management– Redundant assets
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Tax and Estate Planning
•Holding companies•Crystallizing the capital gains exemption–Family trusts, discretionary trusts, etc.
•Redundant / non-operating assets–Real property issue
•Capital dividend account•Refundable dividend tax on hand account
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Search for Buyers
Identifying prospective buyersQualifying prospective buyers
Initial buyer contact
Key = Establish a sufficient number of qualified buyers to establish the platform for the effective
auction
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Types of Prospective Buyers
•Strategic•Non-strategic•Small corporate / individuals•Financial•Management and employees
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Where to Find Buyers
•Previous solicitations•Competitors•Industry transactions•Public company disclosures•Industry associations•Customers / suppliers (value chain analysis)•Financial buyers – websites
Importance of thinking outside of the box
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Qualifying Prospective Buyers
•Research and analysis•Public company disclosures•Websites•Prior transactions•Financial buyers
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Initial Buyer Contact
•Approaching the right person(s)•Method of solicitation•The acquisition profile–The disclosure / obfuscation trade-off
•The non-disclosure agreement–Beware of its limits
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Preliminary Due Diligence
The Confidential Information MemorandumInitial buyer meetings
Other information and procedures
Key = Control the flow of information to increase the perceived value of the company among
buyers
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Confidential Information Memorandum
•Purpose–Sales document–Establishes the ground rules (e.g. type of auction)
•Nature and amount of disclosure–Sufficient to allow a buyer to understand the company and decide whether they are interested in proceeding further
–Extent of disclosure of weaknesses and threats
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Initial Buyer Meetings
•Meeting protocol–Who attends–Where held–What is discussed–Setting the agenda
•Preparing for meetings•Conveying information to the buyer•Obtaining information from the buyer
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Other Information and Procedures
•Additional documentation•Plant tours•Discussions with key employees / customers / suppliers
•Product demonstrations
Issue – how much information to disclose prior to the LOI
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Transaction Structuring
Assets vs. sharesForms and terms of paymentThe Management Contract
Key = Evaluate each proposal based on its risk-rewardparameters and income tax efficiency
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Assets vs. Shares
•Buyers normally want to buy assets –Income tax advantages–Reduced liability
•Sellers normally prefer to sell shares –Tax free share exchange –Capital gains exemption - individuals
•Therefore, proceeds for assets normally higher, but consider tax consequences to seller
•Seller of assets either can wind up company following sale or retain it as a holding company
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Asset Purchases vs. Share Purchases
Always or usually shares
49%
Always or usually assets34%
Mix of assets & shares17%
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Forms of Consideration
•Cash at closing•Holdback•Seller take-back / Promissory Notes•Share exchange•Earn-out
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Holdbacks
•Protects buyer against undisclosed liabilities•5% to 15% of purchase price not uncommon•6 to 18 months not uncommon•Specify
– Interest bearing or not– Buyer’s payment covenant and seller’s recourse for non-payment– Conditions for non-payment
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Seller Take-Back
•Usually a promissory note– Generally 1 to 5 years– Sometimes redeemable preference shares
•Specify – Stated interest rate (or dividend rate)– Buyer’s payment covenant and seller’s recourse for non-payment– Conditions for non-payment
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Share Exchange
•Normally tax-free if made between Canadian companies and seller does not receive other consideration–Foreign tax free structures possible, but more complex
•Liquidity issue– Private companies– Public companies – restrictions & floats– Forward sale
•Often highly risky (e.g. Dot.coms)
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Earn-out
•Transfers risk from buyer to seller•Five principal items negotiated
– Duration– Control (Who has?)– Unit of measurement (top, bottom or middle lines?)– Cumulative ? (A second chance?)– Collar and cuff? (Cliff payments and maximums)
•Tax issues
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Forms of Consideration
Cash Only60%
Share Exchange 26%
Vendor Take Back 2%
Earnouts 2%
Combination of Above10%
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Negotiations
Preparing for negotiationsNegotiating strategies and tactics
The Letter of Intent
Key = Secure a comprehensive letter of intent that offers the best value to the business owner
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Preparing for Negotiations
•Who should be directly involved–Understanding of seller’s needs and interests
•Location where negotiations are held•Parameters re: price range and deal structure•Research on buyer
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Negotiating Principles
•Information is key•Credibility–Information provided–Changes in stated positions
•Alternatives–Number and quality of buyers
•Price and terms are important–When / how paid–Conditions for payment–Tax issues
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The Letter of Intent
•Non-binding except for certain provisions–Confidentiality–Exclusivity
•A key document in negotiations•The apex of negotiations•Dangers of ambiguity •LOI vs. Expression of Interest
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Usual Contents of an LOI
•Offer price or range•Specify shares or net assets•Forms and terms of payment•Salient terms of a management contract & non-compete
•Conditions of offer•Exclusivity time period•Balance sheet requirements•Income statement / cash flow requirements•Unusual representations and warranties
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The Buyer/Seller Advantage Curve
ManagementPresentation
Multiple Offers
LOI Negotiations Exclusivity to Buyer Closing
Seller
Buyer
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Closing
Detailed due diligenceThe purchase agreement
Final closing
Key = Maintain negotiating position to crystallize the value enhancement created throughout the
sale process
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Why Deals Fail to Close
• Buyer and seller have different expectations– Secure a comprehensive, unambiguous LOI / term
sheet• New issues uncovered in detailed due diligence
– Ensure full disclosure of major issues prior to the LOI / term sheet
• Material adverse change in the company’s operations– Adopt a ‘business as usual’ attitude during closing
• External circumstances– Negotiate a relatively short exclusivity period
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Divestiture Opportunities in the Current Environment
• Public companies with cash on hand• Private equity overhang about $500 billion• “Bolt-on” opportunities for small and mid-size companies• Management buyouts• 2-Stage deals, earnouts, etc.
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PART VI
PRIVATE EQUITY ANDMANAGEMENT BUYOUTS
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The Traditional Private Equity Mentality
Leverage x Growth x Multiple Expansion = Huge ROI
Today
EBITDA $5 MMultiple 5 xEnterprise Value $25 MDebt $15 MEquity $10 M
ROI = 500%
Sale
$10 M 6 x
$60 M$ 0 M
$60 M
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The MBO Opportunity
•Availability of capital from financial investors coupled with a lack of quality opportunities for investment–Financial investors becoming more aggressive
•Quicker and more confidential than a 3rd party sale•Deal structuring opportunities–Tax efficient transaction and availability of cash
•Possible lucrative upside for owner and management
•Personal sentiment of the owner–Management has “earned” the opportunity
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The MBO Process
1. Discussions between owners and management2. Initial valuation3. Business plan / information memorandum4. Soliciting and meeting with financial investors5. Negotiating the terms of the deal6. The term sheet7. Due diligence and finalizing the valuation8. Closing
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MBO Example
•Company generates $5 million EBITDA and has no debt
•Multiple of 5x considered appropriate•Management can raise $1 million•Debt of $10 million can be raised, at an average cost of 10%
•Expected exit multiple of 6x EBITDA
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Financial Investor Economics
Current Year 1 Year 2 Year 3 Exit
EBITDA 5,000 5,500 6,050 6,655 6,655Cash flow after tax, before debt 950 1,369 1,852Debt repayment (950) (1,369) (1,852)Residual 0 0 0
Effective transaction multiple 5x 6xTransaction value 25,000 39,930
Financed by:Debt 10,000 9,050 7,681 5,829 5,829Equity 15,000 34,101Total 25,000 39,930
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Financial Investor Economics (cont’d)
Current Exit
OwnershipManagement team 6.7% 16.7%Financial investor 93.3% 83.3%Total 100.0% 100.0%
Equity InvestmentManagement team 1,000 5,684Financial investor 14,000 28,418Total 15,000 34,101
Return on EquityManagement team 78%Financial investor 27%Blended 31%
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What are Private Equity Investors Looking for?
•Strong business fundamentals•Differentiation•Strong management team•Alignment of interests•Exit strategy alternatives
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Classic Mistakes – MBO’s
• Not recognizing management’s conflict of interest
• Insufficient financial buy-in by management• Not managing debt constraints and covenants• Choosing the wrong financial partner(s)• Being too stringent on terms
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Part IX
WRAP UP
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Review
I. Concepts & PrinciplesII. Valuation MethodologiesIII. Rates of Return and Valuation MultiplesIV. AcquisitionsV. DivestituresVI. Private Equity and MBO’sVII. Wrap-up
M&A International™ – the world's leading M&A alliance
Final Words
•Understand the components of value•Internal consistency •Importance of price and terms•Negotiations are key•Manage the acquisition & divestiture process
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