Nicholas J. Heinz

This is the sixth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. In middle market transactions, some of the most crucial points of negotiation are the net working capital targets agreed upon by the buyer and seller. Net working capital targets set a defined minimum amount of working capital that the buyer requires the seller to leave in the business at the close of a transaction. Given that net working capital targets can have a direct effect on the final purchase price of a transaction, understanding the how and why of these types of negotiations is crucial for buyers looking to negotiate deals that not only look good at closing but also pass the test as the buyer takes over the operation of the newly acquired business. Defining Net Working Capital Before negotiating working capital targets and benchmarks, it is important that the buyers, sellers, and their advisors in a deal setting have a clear understanding of what will and won’t be included in net working capital for the purposes of closing the deal. By the book, net working capital is defined as current assets less current liabilities. While this definition is acceptable for financial statement analysis and other accounting-adjacent applications, in the M&A universe, the most commonly used measure of net working capital is cash-free, debt-free net working capital. This is the standard definition of net working capital in a deal setting because it assumes that a seller will retain the cash in the business after paying off any short-term debts that the business owes. These debts could potentially include related party notes and lines of credit with banks. In an M&A transaction, net working capital and net working capital targets are often defined terms in both the letter of intent and the purchase agreement. For buyers, it is crucial to understand these definitions because the basis of the net working capital calculation could directly affect the final purchase price. Why Are Net Working Capital Negotiations Necessary in a Deal? Net working capital targets are necessary in deal settings because the amount of net working capital in a business often fluctuates from month-to-month and even week-to-week. Therefore, it is important that a benchmark or base level of net working capital to be left in the business at closing is agreed upon by both the buyer and the seller. For example, a seller could aggressively collect accounts receivable in the months leading to closing in an effort to convert these receivables into cash. Conversely, a seller could let accounts payable inflate in the months leading to closing and theoretically retain a higher amount of cash. Even absent any sort of concentrated effort to impact the working capital, most companies have some level of fluctuation in their various balance sheet accounts. Setting a net working capital target negates the impact of these fluctuations and prevents the seller from “gaming” cash and working capital levels in anticipation of a transaction. If net working capital levels at closing are not in line with the targets established in the negotiation process, an adjustment to the purchase price can be triggered. The purchase price adjustment related to net working capital is typically applied after the close of the transaction – based on a final accounting as of the closing date. Usually, a defined amount of the purchase price is set aside in a short-term escrow specifically for any negative adjustment related to the final net working capital balance. If the final determination of net working capital comes in below the established threshold, then the buyer retains funds from the escrow to make up for this shortfall. If the final net working capital figure is above the threshold, the buyer makes an additional payment to the seller for the excess amount. From the buyer’s perspective, it is important to negotiate an escrow amount that is large enough to cover any potential swings in net working capital that could result at closing. Negotiating Net Working Capital Targets The most practical and commonly used method of setting net working capital targets and benchmarks is to calculate a historical average amount of net working capital needed to fund a company’s operations. This is most often done by calculating the average net working capital on a monthly basis over the twelve months preceding the valuation date used in the transaction. Calculating an average over a historical period removes any seasonality effects and reveals a “normalized” level of net working capital needed to support the company’s ongoing operations with no capital disruption. Since valuations are typically predicated on trailing twelve months EBITDA (or some other measure of earnings), it is typical that the lookback period for the net working capital target calculation coincides with the twelve-month period in which EBITDA is calculated. In other words, the calculation of a net working capital target should be on the same historical basis as that of the measure of earnings used to support the transaction value. In situations where EBITDA from the most recent period is deemed to be unsustainable or if there is significant short-term growth underlying the transaction value, it might be necessary to calculate the net working capital benchmark by applying a percentage (based on historical averages) to an ongoing revenue figure in order to consider that net working capital needs will change as revenue either declines or increases post-closing. While conducting due diligence, buyers may find potential adjustments to certain balance sheet items that comprise net working capital, which can affect the calculation of the net working capital target. Buyers will want to confirm that the seller has properly accrued (both historically and at closing) for certain items such as accrued vacation, payroll, bonuses, warranty obligations, etc. These potential adjustments can add another layer of complexity to the negotiation of net working capital targets, as buyers may find that there is an excess or deficiency of net working capital at certain points in the historical lookback period. Sellers will often make the argument that they have historically operated with excess working capital based on comparisons to industry averages. Buyers should always approach any “excess” adjustment of this type with caution. It can be difficult to understand why the selling company would have operated with this “excess” when the capital could have been paid out to shareholders or invested in another way. With further analysis, there is often an explanation as to why the “excess” working capital has historically been carried on the company’s balance sheet. As an example, the “excess” could have historically resulted from a quick turnover of payables such that the company has lower current liabilities than the industry average. The quick payments may have earned the company discounts from its vendors, which likely equated to higher profit margins. If the cash flow figures underlying the transaction value include the benefit of these discounts, then it could be double counting to adjust the net working capital to a “normalized” level. One question that will arise in the negotiations is whether a specific dollar amount or a range should be utilized as the net working capital target. The logic of applying a range is straightforward – it prevents minor variances from creating a post-closing adjustment and reduces the likelihood of disagreements between the buyer and seller regarding the calculation of net working capital to the specific dollar. A word of caution on ranges: if the range is left too wide, it invites the same type of balance sheet “gaming” from the seller that the setting of a target was meant to prevent in the first place. Our experience has been that, if a range is preferred, it should be tight enough that any amount that would be potentially gained from the closing working capital figure falling at the bottom or top of the range should be immaterial to both the buyer and the seller. Concluding ThoughtsHaving a team of seasoned advisors to assist with the acquisition and due diligence process can ensure buyers that the net working capital targets, and thus the purchase price, are set at levels that are appropriate and fair to the buyer. Mercer Capital has acted in this capacity in hundreds of transactions over our 30+ years of existence. If you are looking for an experienced team of professionals to assist in the due diligence and negotiation process, please reach out to one of our Transaction Advisory Group professionals to assist.

This is the third article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here. When given the choice between paying more or less for a good or service, it only makes sense that people prefer to pay less. Following this, a rational person would be expected to pay no more than the minimum available price for an item. Many modern business acquisitions appear to defy this logic – at least at first glance. According to Bloomberg, acquirers paid an average premium of 25.86% when making transactions in 2021. In other words, the average acquirer was willing to pay almost 26% above the intrinsic market value of a target business to successfully bid on an acquisition. Theory holds that the value of any corporation, especially a controlling interest in such corporation, should have a value equal to the present value of the cash flows expected to benefit shareholders. This is called a financial control value and represents the intrinsic value of the company on a stand-alone basis. As evidenced by the premium data noted above, many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium.What Is a Strategic Premium?A strategic premium exists when a buyer expects that two plus two equals five, or possibly even some figure above five. In less abstract terms, acquirers pay a strategic premium when they expect that the combination of their business with another will generate more cash flow than both businesses on a standalone basis. A strategic premium reflects the portion of this added benefit that the buyer is willing pay to the seller to secure a deal.To give an example, let’s say that Company A and Company B both generate $2 in EBITDA each year. Both companies may have an intrinsic stand-alone value of $12 (6x EBITDA). When Company A acquires B, they might pay 7.5x EBITDA ($15) because they expect that by combining into Company AB, the Company will generate a total of $5 of EBITDA per year (2+2=5) – providing for a combined intrinsic value of $30 (6x EBITDA). The difference between Company B’s stand-alone value of $12 and the $15 that Company A is willing to pay for it is $3, a 25% strategic premium. Company A spends $15 to increase their value from $12 to $30 – a deal that is accretive to shareholder value.What Justifies a Strategic Premium?The framework we provided for the strategic premium begs a larger question: what justifies a strategic premium? Ultimately, there are several possible explanations. Acquirers pay a strategic premium when they expect to gain some sort of efficiency through a business combination. As outlined in our previous example, they expect that these efficiencies will generate more cash flows than both companies can produce on a standalone basis. There are many efficiencies that companies could expect from a transaction, but three are most common.Cost SavingsCost savings are the most common justification for strategic premiums, often because they are comparatively easy to forecast.Let’s go back to our two companies from earlier. Let’s say that Companies A and B both need to purchase the same raw material to create widgets. Once the companies combine, they still need the same amount of raw materials, but they will likely place a smaller number of larger orders. Since each order that comes in will now be larger, their suppliers may give them a bulk discount, which lowers the overall cost. By combining, Companies A and B are spending less money to bring in the same amount of revenue-generating raw materials, leading to larger amounts of profit and free cash flow.Cost savings can come from supply costs, staff eliminations, or any number of other areas. These savings are usually both the most obvious and quickly achieved strategic enhancements following an acquisition.Revenue EnhancementsRevenue enhancements are another common justification for strategic premiums but are harder to model.There are many ways in which revenue enhancements can occur, but we focus on a simple example for the sake of this article. If Company A has a large distribution network, they can use that network to sell Company B’s products to a larger group of people than Company B had been able to previously. Bringing in this additional should increase profits and create more free cash flow.Process ImprovementsProcess improvements come about when the companies involved in a transaction absorb each other’s core competencies or assets. Mixing these competencies or assets can create revenue enhancements and/or operational efficiencies.Continuing our examination of Companies A and B, Company A might pay a premium for Company B if they see that Company B has some sort of proprietary efficient process for creating widgets that Company A could learn and take advantage of. In today’s world, such considerations often focus on technology – be it software of some other form of technology. If the target company’s technology can be utilized by an acquirer to enhance the acquirer’s own cash flow, a strategic premium may be in the offing.Should You Pay a Strategic Premium?Now that we have reviewed the theory behind strategic premiums, we discuss how they can be advantageous or detrimental to acquirers.Perhaps the most obvious benefit of paying a strategic premium is that it can prevent other firms from purchasing the acquiree first. Sellers in a transaction are incentivized to maximize price. By paying a higher premium, strategic acquirers can entice sellers away from financial buyers or other seemingly “less strategic” buyers. On the other hand, paying a strategic premium is a potential risk. A higher acquisition price increases the amount of cash flows necessary to recoup the acquirer’s investment. If the premium is too high, even an acquisition with compelling strategic benefits can become unprofitable.Ultimately the reasonable price to pay for a target depends on the buyer. Different suitors will expect different efficiencies from the acquisition. To avoid paying too large of a premium, acquirers must have a realistic notion of what they can pay for a target before entering negotiations. Even then, buyers need to exercise discipline and know when to walk away from a bidding war that has gotten too heated.Acquirers are most likely to be successful when they have an organized process for ensuring that the rationale behind the acquisition justifies the transaction price. Such a process usually includes the analysis (and scrutiny) of the specific enhancements anticipated from a transaction. Strategic enhancements often seem reasonable when considered generally but may fall apart (or at least shrink in magnitude) when under the light of detailed financial inspection. Premiums paid on the basis of only a general consideration of strategic enhancements could be doomed for failure. The success of such deals is often based more on luck than anything else.Concluding ThoughtsTo mitigate the risk of overpaying for an acquisition (and to reduce the impact of pure luck), we recommend a detailed financial inspection of both the target company and the potential strategic value of any transaction. As part of this analysis, it will likely benefit an acquirer to retain a transaction advisory team that possesses financial and valuation expertise.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company. Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition. In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position. Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.

This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company. Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition. In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position. Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.

This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well.A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company.Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition.In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position.Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.

Real Expertise Is an Investment, and the Benefits in Return Should Well Exceed the Costs In the previous article, we highlighted the various benefits of hiring a financial advisor when investigating the potential sale of a business. In a transaction with an outside party, the buyer will almost always be far more experienced in “deal-making” relative to the seller, who often will be undertaking the process for the first (and likely only) time. With such an imbalance, it is important for sellers to level the playing field by securing competent legal, tax and financial expertise. A qualified sell-side advisor will help ensure an efficient process while also pushing to optimize the terms and proceeds of the transaction for the sellers. As with anything in this world, favorable transaction processes and outcomes require an investment. Fee structures for transaction advisory services can vary widely based on the type and/or size of the business, the specific transaction situation, and the varying roles and responsibilities of the advisor in the transaction process. Even with this variance, most fee structures fall within a common general framework and include two primary components: 1) Project Fees and 2) Success Fees. Project Fees Project fees are paid to advisors throughout an engagement for the various activities performed on the project. Such activities include the initial valuation assessment, development of the Confidential Information Memorandum, development of the potential buyer list, and other activities. These fees generally include an upfront “retainer” fee paid at the beginning of the engagement. Retainer fees serve to ensure that a seller is serious about considering the sale of their business. For lower middle market transactions, the upfront retainer fee is typically in the $10,000 to $20,000 range. Often times, a fixed monthly project fee will be charged throughout the term of the engagement. These fees are meant to cover some, but not all, of an advisor’s costs associated with the project. For lower middle market transactions, monthly fees are typically $5,000 to $10,000. In certain situations, the engagement will include hourly fees paid throughout the engagement for the hourly time billed by the advisor. Such hourly fees are billed in place of a fixed monthly project fee. Hourly fees are typically appropriate when the project is more advisory-oriented versus being focused on turn-key transaction execution. Hourly fees serve to emphasize the objective needs of the client by counter-balancing the incentive for an advisor to “push a deal through” that may not be in the best long-term interests of the client. An hourly fee structure typically front loads the fees paid throughout the transaction process and is paired with a reduced success fee structure at closing which brings total fees back in line with market norms. Mercer Capital has had favorable outcomes with numerous clients when fee structures are well-tailored to the facts and circumstances of the seller and the seller’s options in the marketplace. Success Fee A success fee is paid to a transaction advisor upon the successful closing of a transaction. Typically, success fees are paid as part of the disbursement of funds on the day of closing. As with project fees, success fees can be structured in a number of different ways. A simple approach is to apply a flat percentage to the aggregate purchase price to calculate the success fee. The use of a flat percentage fee seems to have increased in recent years, and makes a fair bit of sense as it allows the client to clearly understand what the fees will look like on the back-end of a transaction. Traditionally, the most used success fee structure employs a waterfall of rates and deal valuation referred to as the Lehman Formula. This formula calculates the success fee based on declining fee percentages applied to set increments (“tranches”) of the total transaction purchase price. For lower middle market transactions, the simplest Lehman approach is a 5-4-3-2-1 structure: 5% on the first million dollars, 4% on the next million, and so on down to 1% on any amount above $4 million. The Lehman Formula, which can be applied using different percentages and varying tranche amounts, pays lower percentages in fee as the purchase price gets higher. Smaller deals may include a modified rate structure (for example 6-5-4-3-2) or may alter the tranche increments from $1 million to $2 million. The Lehman Formula, in its varying forms, has been utilized to calculate transaction advisory fees for decades. While the formula may add some unnecessary complexities to the calculation (versus say a flat percentage), it has proven over time to provide reasonable fee levels from the perspective of both sell-side advisors and their clients. A success fee can also be structured on a tiered basis, with a higher percentage being paid on transaction consideration above a certain benchmark. If base-level pricing expectations on a transaction are $15 million, the success fee might be set at 2.5% of the consideration up to $15 million and 5% of the transaction consideration above this level. If the business were sold for $18 million, the fee would be 2.5% of $15 million plus 5% of $3 million. The blended fee in this case would total $525,000, a little under 3% of the total consideration. Escalating success fees are often favored by clients because they provide an incentive for advisors to push for maximized deal pricing rather than settling for an easier deal at a lower price. Typical Total Fees Transaction advisory fees, on a percentage basis, tend to be higher for smaller transactions and decline as the dollars of transaction consideration increases. Various surveys of transaction advisors are available online that suggest typical fee ranges. Consensus figures from these sources are outlined below. Based on our experience, these “typical” ranges (or at least the upper end of each range) appear to be somewhat inflated relative to what most business owners should expect in an actual transaction advisory engagement. Mercer Capital’s View on Fees At Mercer Capital, we tailor fees in every transaction engagement to fit both the transaction situation at hand and our client’s objectives and alternatives. In situations where a client has an identified buyer, we understand that our role will likely be focused on valuation and negotiation. Many sellers are unaware that price is only one aspect of the deal, and terms are another. Altering the terms of a definitive agreement can move the needle by 5%-10% and can potentially accelerate end-game liquidity by 6 to 12 months. Accordingly, we design each fee structure to recognize what we are bringing to the process, typically utilizing some combination of hourly billings and a tiered success fee structure on the portions of the deal where our services are making a difference in the total outcome. If we are assisting a client through a full auction process, it may be appropriate to utilize a more traditional Lehman Formula or a flat percentage calculation. A primary focus of our initial conversations with a potential client is to understand the situation in detail so that we can develop a fee structure that ensures that the client receives a favorable return from their investment in our services. Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate critical transactions, providing timely, accurate, and reliable results. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients. We recommend to clients to accept the right deal or no deal at all. Our dedicated and responsive team is available to manage your transaction process. To discuss your situation in confidence, give us a call.

By mid-2020, traditional brick and mortar retailers, including well-known brands such as J.C. Penny, J. Crew, and Pier One, were christening what many believed to be the first wave of post COVID-19 bankruptcies.  At the time, our view was that companies impacted by the COVID-19 pandemic might look for relief via M&A while opportunistic buyers might look to take advantage of lower valuations in the market.  While some industries have fared worse than others, the unprecedented fiscal aid pumped into the economy seems to have warded off a wave of bankruptcies in the middle and upper market, or at least prevented a surge at the scale many were predicting.  M&A deal volume recovered in the second half of 2020 after coming to a near halt in the initial months of the pandemic.  Deal volume, while increasing, does generally remain below levels seen in 2018 and 2019.  All the while, capital has flooded the market, with a good amount of it ending up parked in banks, resulting in bank deposits increasing over 20% in 2020.Data per Epic Aacer, Available online at: https://www.aacer.com/blog/january-2021-bankruptcy-filings-continue-historic-slideWhile nothing is for certain, it appears that the worst of the economic risks tied to the pandemic could be behind us.  Estimates range widely, from as early as July 2021 to as late as 2022, but the U.S. now has a path to reaching herd immunity through the administration of multiple vaccines.  As it stands in March 2021, over a quarter of the U.S. population has received at least one dose of a vaccine.  The public markets have viewed the rollout favorably, and while one explanation for the market’s strong 2020 performance might be summed up by a blend of a low-risk free rate amidst asset inflation, it is undeniable that valuations in the public markets are pricing in some level of a continued post-pandemic recovery.As the public health crisis continues to improve, one would expect deal volume to increase in tandem.  Prior to the pandemic, many market observers had concluded that small to middle market M&A activity was poised for an uptick, as a generation of baby boomers was expected to retire and in turn monetize their stake of private company ownership.  That generational trend remains in-tact post COVID.  The Biden administrations’ efforts to increase the capital gains tax rate may also accelerate some M&A activity in the immediate short-term, as sellers seek to position transactions to be taxed at current tax rates.While the middle market M&A environment has not witnessed the downward shift in values that one might have expected following the economic shutdown of the early pandemic period; neither has it seen the run-up in values that was exhibited in the public markets throughout the second half of 2020 and into early 2021.  If the public markets provide a meaningful measure for general economic expectations, then how long until these higher expectations are priced into middle market M&A values?  At a minimum, the downside pandemic-related risks that were initially so prevalent appear to have diminished.  As with most things in this environment, risks are very industry specific and there are many industries that have exhibited (and will likely continue to exhibit) dramatic negative shifts in valuations.  Overall, however, transaction multiples appear to have declined only a small amount from pre-pandemic levels. As my colleague Jeff Davis concluded in a recent piece for this blog, the availability of debt financing for most family businesses in 2021 should be favorable, likely with a low cost of credit and lenient terms by historical standards.  Jeff noted some exceptions, such as hotels, retail CRE, restaurants, and tourism-related businesses, but on the whole banks are eager to invest.  Loans in the commercial banking system declined for the first time in a decade in 2020 and for only the second time in 28 years while deposits remain historically high.  In the current low-rate environment, revenue pressures are high for banks as cash and bonds yield little to nothing.  Without a competitive alternative, banks and investors flush with capital are under pressure to compete for lending opportunities to produce a return while loan demand is weak as the U.S. market rounds what many believe to be the very beginnings of a new economic cycle. For family business directors, 2021 should be an opportune time to consider making an acquisition.  General indications on valuation suggest that the private company M&A market has not been priced-up at anywhere near what has been seen in the public markets.  While this difference may be caused by a public market over-valuation issue that is “corrected” in the short-term, it suggests that there could be positive momentum in private company valuations as the economy continues to move through subsequent stages of the post-pandemic recovery.  A good M&A deal can be made even better with favorable financing, which should be available to many borrowers in the current environment. We can’t predict the future, but those who take a buyer’s view of the M&A market now might be rewarded with enhanced returns.  With pent up demand and a high availability of capital, we anticipate a rise in M&A activity over the next year with the best valuations and financing deals likely favoring the early bidders.

This whitepaper is structured to provide further details outlining the factors contributing to the proliferation of the urgent care services industry, the key players and their activities, and considerations for current and prospective owners of these facilities related to the valuation of urgent care centers. This whitepaper is part of Mercer Capital’s expertise in providing valuation and transaction advisory services to a diversity of businesses and for a wide range of purposes, including those operating in the healthcare service sector, such as urgent care centers and similar businesses.