On October 11, 2007 the SEC approved FINRA’s new Rule 2290 regarding the preparation of fairness opinions and the disclosures required in fairness opinions.1 The rule, which began to take form in 2004 and was opened for comments in early 2006, was fast tracked for approval by the SEC. While Rule 2290 is officially applicable only to member firms of FINRA, it is likely to become a market standard by which all fairness opinions are evaluated.
The purpose of the new rule is to address increasing concerns that disclosures provided in fairness opinions may not sufficiently inform shareholders of potential conflicts of interest that may exist among the parties to a deal, those advising on the deal, and those opining to the fairness of the deal. Unfortunately, avoiding the appearance of a conflict is not quite the same as avoiding a conflict. While the new rule provides for added transparency, it does not eliminate potential conflicts of interest.
The portion of the new rule related to disclosures [2290(a)] is applicable if the FINRA member issuing the opinion “knows or has reason to know that the fairness opinion will be provided or described to the company’s public shareholders” and covers the following general topics:
The new rule also contains a section [2290(b)] that delineates certain written procedures an issuing firm must develop (and of course follow) in the preparation of a fairness opinion. The majority of these procedures relate to the use of a fairness committee.
1. The issuing firm must develop written procedures for determining the circumstances under which a fairness committee must approve a fairness opinion. When a committee is deemed to be appropriate, the firm must also have developed and followed procedures concerning the following:
a) The issuing firm must have a written procedure which is used to select the personnel that comprise the fairness committee.
b) Those procedures must specify the qualifications required for persons to sit on the fairness committee.
c) The process must promote a balanced review of the opinion, and the review should involve personnel who are not on the deal team to the transaction. If the firm issuing the opinion is not involved in the transaction as an advisor, then it follows that those persons reviewing, as well as working on, the fairness opinion will not be on the deal team.
2. The issuing firm must also create procedures with which to evaluate the appropriateness of the valuation analyses used in the fairness opinion. The addition of this rule demonstrates that FINRA recognizes the importance of valuation technique in rendering a fairness opinion.
Several conclusions can be drawn from the new FINRA rule. First, FINRA is clearly attempting to provide shareholders with more information and allow them to make their own decisions regarding the existence of conflicts. However, it appears to still be the responsibility of various parties to the transaction and their advisors to ensure that no conflicts exist, or at the very least, are minimized. Despite the new disclosure rules, any time the advisor on a deal prepares the fairness opinion or any time compensation for preparation of the fairness opinion is on a contingent basis, there exists the possibility for real or perceived conflicts of interest.
Further, FINRA pays significant attention to “quality control” issues within the issuing firm. While some of these issues would be rendered moot if FINRA would simply disallow firms with potentially large conflicts of interest from preparing the fairness opinion, the focus does indeed center on what is in the best interest of the shareholder.
Mercer Capital is well equipped to deal with the new FINRA rule for a number of reasons. We do not perform fairness opinions for a contingent fee and in instances where we act as an advisor on a deal, we will not perform the fairness opinion ourselves. In addition, Mercer Capital is very familiar with the concept of “committee review,” having used committees to tackle complex valuation problems for years. It is almost certain that a fairness committee at Mercer Capital would have at least one member with a respected industry credential (CFA, ASA, CPA/ABV, etc.) and possibly several members. Mercer Capital’s experience as an independent business valuation firm means that a client can be certain that any valuation analysis developed in the preparation of a fairness opinion will be both appropriate and objective.
Endnotes
1 FINRA stands for the Financial Industry Regulatory Authority. This organization was formed in July 2007 through the consolidation of the National Association of Securities Dealers (NASD) and the regulation, enforcement and arbitration functions of the New York Stock Exchange.
Reprinted from Mercer Capital’s Value Matters (TM) 2008-03, published March 25, 2008.
Imagine this common scenario for many business owners today…You have spent the better part of your life building your business through hard work, determination, and a little luck. Now, your company has grown into a well-known, highly respected business and a formidable competitor in the industry. You have made a pretty good living for yourself and your family through the success of the business. Now, you are starting to think about the prospects of selling it so that you can spend more time with your grandchildren and just generally have a chance to have fun. You are not sure what the business is worth, but you have an idea at what price you would sell.Then, the call comes. A company in a similar industry calls to inform you that they have been watching your company over the last few years and are impressed with its product mix and brand name recognition. They are interested in buying your business.You think to yourself: “I built this business by myself. I know the industry. I have negotiated with vendors and customers all my life. I should certainly be able to negotiate the sale of my business by myself. It can’t be that hard.”
The above scenario (or some version of it) often occurs with companies considered to be in the lower-tier of the middle-market ($5 million – $200 million revenues). It is common for business owners to get serious about exit strategies only after a potential buyer comes knocking on the door.
At Mercer Capital, we see this frequently, because often times the first thing a business owner does after he gets an offer is call us to obtain an appraisal. Business owners usually tell us that they have an idea what the business is worth or even what they would take for it, but want a professional appraiser to “verify” their assumptions.
Fear is the underlying motivation bringing the business owner into our office — fear of leaving money on the table, or never knowing, with some degree of certainty, if he got the best deal possible. After investing a life’s work growing this valuable asset, which probably comprises the majority of his (and his family’s) net worth, it would be a shame not to realize its maximum value.
Unfortunately for the business owner who takes this route, an appraisal is not the appropriate tool to prevent his fears from becoming a reality. He needs a professional M&A intermediary to help him sell his business. We have seen business owners shortchange themselves by taking the “For Sale by Owner” (FSBO) approach. Sure, they managed to sell their business, but did they get the best price and terms? It’s hard to say without entertaining multiple competing offers. Even if the offer is, in the owner’s mind, a good one; is it the best one?
Objections to using an intermediary usually relate to the fee associated with hiring an investment banker. But is the fee that onerous?
Consider the following analogy:
You are trying to sell your car for $10,000. Someone offers to wash it and tune it up and then do all the work to sell it for you and the only up front cost is to purchase the soap. The individual only wants to be paid after the car is sold and for a percentage of sales price above $10,000.
You don’t have to be a seasoned entrepreneur to know that’s a pretty good deal.
An M&A intermediary is compensated in the same manner. The cost for soap in our scenario is essentially the intermediary’s retainer fee. The intermediary “cleans up” the company by presenting the business in the most favorable way, making necessary adjustments to uncover value. The intermediary will work to convince prospective buyers to pay for that value. The incremental increase in deal price that an intermediary can create is often many times that of the fee charged. It is essentially a “zero-cost” service to the client.
Because Mercer Capital has served both as an intermediary for clients or provided appraisals for clients who chose to go it alone, we have witnessed the outcomes of both strategies. Accordingly, we have compiled a list of warnings for those who venture down the FSBO road:
The disposition of your life’s work is nothing to be taken lightly. You owe it to yourself and the company’s shareholders to consult a professional when considering the sale of your business. Perhaps Mark Twain put it best in his book, Following the Equator, when he remarked:
“There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can”.
If you are contemplating the sale of your business, remember these words and contact an intermediary to help you avoid the perils of FSBO. The professionals of Mercer Capital do more than provide business appraisals. We are regularly engaged to act as intermediaries. If you have been approached by a potential acquirer, give me a call at 800.769.0697 to discuss your situation in confidence. When it counts, count on the experience and expertise of Mercer Capital.
Reprinted from Mercer Capital’s Transaction Advisor Vol. 9, No. 2, 2006.
In July of 2005, Fred Wilson wrote a post on his website, A VC1 on the subject of “back door IPOs.” It was later referenced and augmented in another post on Tom O’Neill’s website, The Buyout Blog2. Their posts provide a backdrop for introducing what may be a new name for another kind of initial offering, the private initial offering (PIO).
An initial private offering (IPO) is an offering of private company stock to the investing public through the regulated, public securities markets. For reasons noted below, the IPO route to shareholder liquidity or growth capital is unavailable to most private companies.
A “back door IPO” is a transaction in which a private company merges into a publicly traded shell company in a process often called a “reverse merger.” It is a reverse merger because the private company brings all the value but the shell company is the surviving entity. Shell companies typically have few, if any assets other than, perhaps, some cash. They may, however, have considerable liabilities, including poor reputations, sleazy owners (who make bad partners), no followings, and no real markets for their shares. The back door IPO tends to be used by companies that cannot or will not go through the usual process of an IPO.
A private initial offering, or PIO, is an offering of private company stock, in whole or in part, to the private equity capital markets. The PIO is available to hundreds of thousands of companies that will never qualify for an IPO and who should not attempt a back door IPO. The concept of the PIO is certainly not new, but the terminology may be. Private equity groups have many billions of dollars, public market disciplines, experience in valuation and growing companies, generally excellent reputations, and few liabilities from the viewpoint of private company owners.
A brief review of back door IPOs and private initial offerings follows:
Initial Public Offerings. What kind of market capitalization does it take to have a successful public company? There are virtually no front door IPOs with market capitalizations less than $100 million. The average market capitalization of successful IPOs is more in the range of $300 million or so.
If your private company is worth less than $100-$200 million, there is little reason to be thinking about the IPO market right now. Does that mean that there are no avenues for owner liquidity and/or growth capital? No, but back door IPOs are probably not the answer.
Back Door IPOs. Fred and Tom mentioned several reasons for private companies not to engage in reverse IPOs, including, as I interpret them:
Private Initial Offerings (PIOs). The new “public markets” for smaller capitalization private companies are the private equity capital markets. There are literally hundreds of private equity groups (PEGs) which have each raised and are in the process of investing anywhere from $20 million to $50 million on the lower end, to many hundreds of millions of dollars or more for the larger groups.
Private equity groups have raised many billions of dollars for investment in private, corporate America. And they have lots of dry powder for future investments. These groups bring public market discipline and public market equity private corporate America.
In years past, the dream of many entrepreneurs was to engage in initial public offerings, or IPOs.
Today, given the breadth and scope of private equity capital markets, it is now possible to engage in another form of initial offering — the private initial offering, or PIO. In a PIO, a company can be presented, in whole or in part, to the private equity capital markets.
While there can be exceptions, the entry point to the private equity capital markets tends to be in the range of $1.0 million in EBITDA on the very small side. This would imply a total capital valuation (equity plus debt) of $4-$6 million or so. As companies increase in size (as measured by sales, earnings and value), the interest levels (and pricing) tend to rise. PEGs, individually or collectively, can engage in transactions into the hundreds of millions or even billions of dollars ranges.
The advantages of PIOs include:
It is well-known that PEGs are a significant source of capital and liquidity for private companies in America. Any time we take qualifying companies to market, we solicit interest from a number of private equity groups, as well as possible strategic buyers.
The point of this discussion of back door IPOs and PIOs is that business owners should consider the private equity capital markets as their primary source of liquidity and growth capital. Back door IPOs are a backwards and disadvantageous way to achieve liquidity. IPOs are not feasible for the great majority of even quite large private companies.
Companies often prepare for many years for their eventual IPOs. Private companies that lack the size to be public companies should also prepare themselves for their PIOs. That preparation can also take many months or even years. However, the PEGs are looking for many of the same characteristics in PIO investments that the markets are looking for in IPOs.
The message is clear: Now is the time for qualifying businesses to begin preparation for their private initial offerings, or PIOs. Once prepared, you don’t have to execute, but once you are ready for sale, you can stay that way. And as we have previously noted you will sell your business. It is not a matter of if, but when. Is Your Business Ready for Sale?™
Endnotes
1 http://avc.blogs.com/a_vc/2005/07/vc_cliche_of_th.html
2 http://www.buyoutblog.com/archives/2005/07/idle_shells_the.html
Reprinted from Mercer Capital’s Value Matters™ 2006-01, January 13, 2006.
From time to time in this space, we have presented articles discussing the various factors that influence the value of a company. In addition, we have stressed to business owners the importance of understanding these value influencing factors especially with both the general economy and the acquisition market currently in the middle of what will hopefully be sustained recoveries. This is certainly necessary for owners who are currently considering the sale of their business or may consider such a transaction in the near future.
Before we begin, we caution business owners to have reasonable valuation expectations. One of the most important roles that we at Mercer Capital play as transaction advisors is to assist owners in the development of pricing expectations. Through this role, we have witnessed the difficulty that many business owners have in taking an objective view of the value of their company. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many business owners have spent most of their adult lives operating and growing their companies. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction. Almost without exception, a lack of reasonable expectations results in a selling process that is frustrating and most often disappointing to the selling party.
The development of pricing expectations should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers can (and do) use various methods of developing a reasonable purchase price. Most fundamentally, an acquirer will utilize historical performance data, along with expectations for the future, to develop a level of cash flow or earnings that is considered sustainable going forward. In most cases, this analysis will focus on earnings before interest, taxes, depreciation and amortization (EBITDA) or some other pre-interest cash flow. A multiple is applied to this sustainable cash flow to provide an indication of value for the company. Multiples are developed based on the underlying risk and growth factors of the subject company.
As mentioned previously, before a multiple can be applied in determining value, a company’s level of sustainable cash flow or earnings must be developed. During the economic boom that ended in 2001, this was typically not difficult because most companies were growing at relatively predictable rates (predictably high rates for most). Sustainable cash flow was either the most recent year’s cash flow or the projected cash flow for the upcoming year. However, recent uncertainties have made this determination substantially more complex in many cases.
Two questions that will likely be asked by an analyst upon initial review of a company’s recent performance are: What is a company’s sustainable cash flow following two or three years of decline from its peak year? What about if the company capitalized on the recent economic improvements and posted a nice turnaround during the most recent year? For many companies, performance during the past few years has been below that of the late 1990s. Some companies have begun the process of turnaround in posting positive earnings growth during 2003. So what does all of this say about a company’s sustainable level of earnings? The answer is, as with most valuation related questions, it depends on the specific operational and financial circumstances of the company. The variables effecting the development of ongoing earning power are obviously too numerous to list in full here, but in general these variables are the same variables that most owners track (or attempt to track) on a regular basis:
Recent fluctuations in performance (especially those trending downward) also affect the multiple applied to the sustainable cash flow. While risk and growth characteristics are the underlying determinants of multiples, various other factors are considered by acquirers. These include:
So, what is the appropriate multiple? Again, the answer depends on the specific characteristics of the subject company.
This article clearly does not provide a complete discussion of the various factors that impact value. It is meant primarily as a reminder that thinking about these issues is important for all business owners, regardless of situation. The goal of sellers in all transactions is to maximize the consideration received for that which is given up.
Our experience at Mercer Capital has proven time and again that the most positive outcomes are generally achieved by sellers with reasonable expectations developed through a thorough examination of the specific circumstances and characteristics of the subject company.
If you would like assistance in developing a detailed valuation analysis of your company, or if you are considering a potential transaction, please contact us at 901.685.2120.
Reprinted from Mercer Capital’s Transaction Advisor – No. 1, Volume 7, 2004.
As part of our transaction advisory and consulting services, Mercer Capital is often called upon to provide fairness opinions in transactions. A fairness opinion is usually provided in letter format, and generally provides an opinion concerning whether a proposed transaction is fair, from a financial point of view, to the shareholders (or a specific group of shareholders) of a company. They are generally addressed to a company’s board of directors or to a special committee of the board.
The purpose of a fairness opinion is to assist directors in making decisions concerning the transaction and to protect decision makers from claims that those decision makers violated the business judgment rule. The business judgment rule requires that the board exercises due care in the process of reaching its decision, that the board acts independently and objectively in reaching its decision, that the decision was made in good faith, and that there was no abuse of discretion in making the decision.
There are no hard and fast rules concerning when fairness opinions are required, but they are desirable in a variety of circumstances, the most common being a merger or sale of the company. In these transactions, a fairness opinion is considered a necessary step in the due diligence process of the seller. While the facts and circumstances of the transaction will dictate the areas that are explored in the fairness opinion, some issues are routinely involved.
For most transactions, a number of alternatives exist to the proposed transaction, and certain groups of stakeholders may believe that one or more of those alternatives is preferable to the proposed transaction. Deals that might be in the best interest of all the stakeholders might be delayed or killed by dissenting shareholders, and a fairness opinion can help avoid some of the misunderstandings that might give rise to unpleasant stakeholder relations during a critical time. Fairness opinions can also help to avoid disagreements in situations where there is a perception that corporate insiders might enrich themselves at the expense of the minority shareholders due to the structure of a transaction.
Among the more common situations where a fairness opinion is obtained is in a sale or merger transaction where a number of competing offers representing different exchange rates, different ratios of cash to stock, or different credit quality in terms of debt are received. The fairness opinion letter will typically interpret and compare the competing bids and explain why one alternative is preferable to the others. If a company has recently experienced poor financial performance, a fairness opinion will typically explore the idea of waiting to sell the company at a later date (after a turnaround) rather than selling at what might be perceived as a low valuation.
Unsolicited and/or hostile offers often give rise to fairness concerns, as surprised minority shareholders may perceive that their concerns were not addressed in the process. If the board of directors lacks unanimity in such a situation, it is almost certain that some stakeholders will be dissatisfied with the transaction. When the consideration offered is other than cash, and particularly when the consideration offered is an interest in a closely held company, the financial advisor must investigate not only the interest being sold, but the interest received in return.
In addition to concerns surrounding the total consideration paid in a transaction, issues of fairness can arise concerning the distribution of the consideration. For example, if different classes of stock exist, certain stakeholders may disagree as to the relative value of those classes of stock. Shareholders may also take issue with the noncompete or employment agreements received by managers, or with any other perceived differential treatment of insiders. Regardless of the reason for the fairness opinion on a sale or merger transaction, the opinion serves to memorialize the degree of effort expended by the board in order to reach its decision regarding the adequacy of the consideration received in the transaction and the fairness of the transaction to the stakeholders.
Even when an outright sale or merger is not being considered, fairness opinions are commonly sought on other significant corporate transactions. These include the sale of subsidiary businesses or lines of business, recapitalizations, stock repurchase programs, squeeze-out transactions, spinoffs, and other material corporate events. Particularly when insiders or other affiliated parties are involved in the transaction, a fairness opinion can go a long way toward avoiding disagreements among the stakeholders and between the stakeholders and the board.
Reprinted from Mercer Capital’s Transaction Advisor, Volume 5, No. 3, 2002.
While this article highlights our experience in the banking industry, the strategies presented here are applicable for anyone in any industry engaging in a transaction.
Over the last ten to twenty years in negotiating deals, we have learned that there are many different styles of negotiating when getting a deal done. Some of the most useful and realistic ways to approach various scenarios are fairly simple but they can be easy to overlook while in the line of fire. It is always our objective to achieve our clients’ goals and make them comfortable with the deal. As such, below is a list of things that we know from experience help create value for a deal.
The way to become confident in any transaction is to always be prepared. In being confident we should be able to anticipate issues that could arise in the course of negotiations. We spend many hours reviewing the material that is important to the deal as well as any related information. Thanks to the FDIC, there is a wealth of information available on the purchaser and the industry as a whole. Historical financial information, deposit market share and acquisition history enable us to understand the purchaser’s acquisition rationale and how your bank might fit into the combined organization.
By asking for more than you actually expect to receive, you are establishing a perceived value to the other side that may be beyond actual value. This concept also provides room to compromise later if we need to do so and still helps to achieve a transaction that meets our client’s expectations. This strategy also helps break any deadlocks and keeps the discussions open to move the transaction along.
By asking for more than we expect, it gives the other side the feeling that they have won a point or two when expectations are lowered. The point of any negotiation is to be fair and achieve a win-win situation for all parties involved in the deal. At the end of the process, we are all better off if we actually achieve this. An acquirer’s focus on a specific performance measure often creates an unnecessary and sometimes unrealistic price ceiling. Public acquirers will likely focus on dilution, thereby making price-to-earnings multiples the most important pricing measure. Conversely, a privately held entity may focus on a “build or buy” strategy, which may hinge on a certain return on investment. By catering to an acquirer’s perspective while pointing out other important pricing multiples, return measures and synergistic possibilities it is often possible to justify a higher price than initially offered by the acquirer.
One of the issues that we all have to keep in mind is the timeframe under which we work. Always keep timeframes in mind in doing a deal. Deals usually take time to complete yet by controlling the timetable we should keep logs and try to push the other side as quickly as possible. It is our practice to continually give the other side a timeframe that requires certain conditions be met at specified times. In an industry that depends heavily on personal relationships, every effort needs to be made to retain key employees. The uncertainty created by drawn-out negotiations can possibly lead to employee dissatisfaction and the corresponding loss of customer relationships.
It is helpful in negotiations to let the other side get to know you and also for you to get to know them. This helps to bring things in focus and helps make the negotiations more personal which can create better lines of communication.
Negotiations can be very tense and emotions will enter the picture at various times during the process. Don’t let emotions play a role and always try to leave the door open if and when negotiations stall because there is usually another opportunity to reopen the door later.
We recently worked with a client who was ready to sell a fast-growing, profitable bank to a regional institution. Negotiations stalled due to some unresolved litigation. The buyer was unwilling to consummate the transaction without significant escrow, while the seller did not want the escrow amount to be misinterpreted by the courts as an admission to liability. Buyer and seller agreed to keep the lines of communication open and to pick up negotiations upon termination of the dispute.
It’s not uncommon to deal with others that might test your patience, but learn to hold on for the good of the deal. Be aware that it is important to be careful in your reactions to the way others try to negotiate. If we are flexible and do not take things personally, the process is smoothed.
Know the facts and do not say something or reveal information that may come back to haunt you. If you do not know something, say so. Advise the others side that you will get back to them after you have confirmed the information. This keeps things in perspective and sometimes helps move the deal along. Several years ago, one of our clients purchased a bank that held a significant amount of problem loans. Dishonesty regarding the quality of the loan portfolio resulted in the seller’s loss of the full escrow amount in addition to the primary owner’s substantial consulting agreement.
There are times in any negotiation to draw the line and other times to be flexible. Sometimes others want to draw the line in the sand at an early stage of the negotiation. We always attempt to show them that this is not the time to battle over a certain item and we may want to save this issue for another time. Always keep the end goal in mind and be careful in picking your battles.
In the deal process others may want to take shortcuts in trying to move to the next step. We do not believe in shortcuts. In the banking industry, we know that a high quality loan portfolio is never the result of loan officers’ shortcuts. Clearly, the purchase of an entire bank, with 60% or more of its assets generally represented by loans, will require a significant amount of due diligence.
In all deals there are tense moments that may cause stress to all concerned. We have find that sometimes the use of appropriate humor helps to lighten the mood and move the process along.
If you keep these ten simple but important hints in mind as you go through the negotiation process, you are on your way to a successful negotiation where all parties will win and the deal will get done.
Reprinted from Mercer Capital’s Transaction Advisor, Volume 5, No. 2, 2002.
We talk to a large number of business owners here at Mercer Capital, and in the course of those conversations it has become clear to us that many business owners have not done a great deal of thinking about the value of their businesses. When we talk to these business owners about potential transactions, they often have no (or an unrealistic) notion of the economic benefits associated with their ownership interest in the business.
“Well,” they say as the meeting begins, “I never really thought about selling my business until now, so I never took the time to enumerate the benefits I receive as the owner of the business.” A corollary to Murphy’s Law states that any time the seller is unprepared for a deal, the buyer will require that the deal move along very quickly. The lack of preparation on the part of the seller leads to second-guessing down the road. “Did I pass up a good deal?” ask those who decline the offer. “Did I present my business in the best possible light and maximize the proceeds from the sale?” ask those who accept.
A little time spent thinking about the business without the pressure associated with a deal on the table will provide important perspective when push comes to shove. It is much easier for a seller to walk away from an underpriced deal when that seller is confident that the financial rewards associated with continuing to hold the business interest exceed the offer. By the same token, a seller is less likely to miss a liquidity opportunity by refusing to entertain an offer if the seller recognizes that the offer is within a reasonable range.
For these reasons, we recommend that all of our clients, regardless of whether you are actively pursuing a deal, give some thought to the financial rewards associated with your investment in your business. Mercer Capital offers a complimentary booklet entitled “Is Your Business Ready for Sale?” that will help you establish an intellectual framework for thinking about a transfer of an interest in your business.
Having “done your homework” by researching the shareholder-level benefits associated with an ownership interest in your business will also help you present your business in the best possible light to a potential buyer. A seller who is unprepared to explain the rewards associated with owning the business is leaving money on the table in a sale. And in these days of market consolidation, vertical and horizontal integration, and pursuit of economies of scale and synergy, the group of likely buyers even for small businesses is becoming increasingly financially sophisticated.
All of us have heard about the discussion of features and benefits that takes place during the sales process of a product or service. The most successful salespeople not only explain the features of the product or service, they also explain the benefit to the buyer of those features. Heated car seats are a feature. A warm rear despite the cold morning is a benefit. A good car salesman will explain the benefit of heated car seats, not just mention the features of the car.
A transaction involving a business is certainly more personal and more emotional than the purchase of a car, and a large number of additional factors come into play. But it is still important to frame the discussion of your business not only in terms of the features of your business, but also in terms of the benefits associated with the business. In the case of a financially sophisticated buyer, this means being able to discuss the business in terms of the economic rewards associated with ownership.
For example, the fact that you as a business owner worked long hours for many years for what you consider to be a below-market wage might be considered a feature of your business. On the other hand, if you talk about the loyal customers who pay your company a premium price due to the high level of service you provide, you are illustrating the value to the buyer of the long hours you worked. Similarly, instead of just pointing out the fact that you accepted a low wage in order to help the business grow, show the potential buyer the new equipment that will allow for future growth without additional capital expenditures. In short, look at your business with a buyer focus, much as you look at your product with a customer focus.
The primary message of any communication with a potential buyer has to relate to the value to be received by the buyer as a result of the transaction. Buyers want to know about the expected cash flows associated with the potential investment and the risks associated with those cash flows. They want to understand the most favorable, most likely, and least favorable projection scenarios and the relative likelihood of experiencing each.
Ask yourself right now how you would present your business to a potential buyer. Are you prepared to enumerate the benefits of ownership of your business? If not, you need to begin thinking about this now, before you are faced with transaction decisions. A thorough under-standing of the benefits of ownership of your business will help you determine the minimum consideration you will accept in a transaction, and it will also help you negotiate the maximum possible consideration in an actual deal by communicating effectively to the buyer the financial rewards associated with ownership of your business.
For more information or to discuss a potential transaction, call us at (901) 685-2120.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 1, 2000.
A variety of factors have been working together in the past several years to create opportunities for owners of private businesses to achieve liquidity by selling their businesses to private companies. The mid-to-late 1990s saw a wave of consolidation in various industries that were well received by Wall Street, and the low interest rate environment of most of that period led to low cost financing options for acquirers. While this trend has slowed, there is still a great deal of interest among private company owners in achieving liquidity, and public companies are continuing to evaluate acquisitions.
Several factors have led to decreased acquisition activity by public companies of late. At one time, one needed only to include in one’s proxy the words “rationalization” and “consolidation,” and perhaps the phrase “highly-fragmented industry” in order to be a winner on Wall Street. However, the operational problems experienced by many of the high-flying consolidators after their initial rollups and aggressive acquisition programs have resulted in a fall from grace for many companies whose business plans call for aggressive growth through acquisition.
Another factor limiting deals is, ironically, the strength of the economy. In an effort to slow economic growth and reduce the likelihood of inflation, the Fed has increased interest rates for seven consecutive quarters. The current interest rate environment has increased the cost of financing deals by increasing the cost of debt and increasing the cost of equity for most non-tech sector companies. Uncertainty related to the future of pooling accounting has offset some of this increase in the cost of deals, providing an incentive to consummate deals before poolings go the way of the dinosaurs.
In this environment, public acquirers are more selective than ever in their acquisitions. A large number of deals are getting done, however, and it is the private companies who are best able to position their businesses as acquisition targets which will continue to find liquidity opportunities among public companies.
The key to maximizing the likelihood of potential proceeds from a transaction with a public business lies in recognizing why public companies buy private companies. The reasons all boil down to maximizing the value of the public company. Public acquirers are not a form of welfare for small business owners. If a public company buys your company, chances are the managers of the public company believe that whatever consideration they paid in the deal will be more than offset by the future benefits of owning your business; i.e., no earning dilution per share to the public company.
Public companies buy private companies to meet a variety of financial and strategic needs. It would be impossible to list all of the potential needs that an acquisition might meet, but some of the more common motivating factors include:
Many consolidators need an extensive geographic presence. Your business will likely be more valuable to an acquirer if it allows the acquirer to fill a gap in its current service area.
Does your business market a unique product or service to the same customer base as a public company? If so, the public company might purchase your business in order to increase the diversity of products it can offer to its current customers.
If you have a customer base that is appealing to a public company, the public company might be interested in marketing its products/services to your customers by bundling them with the ones you are already selling. For example, the retail financial services business is likely to see an increasing number of this type of transaction, as banks, brokerages, insurance agencies and underwriters buy each other in order to market additional products to the combined customer base.
In industries where economies of scale are possible, the realization of significant post-deal expense saves makes acquisitions attractive. The promise of significant expense savings was part of the appeal of the consolidation craze of the mid-1990s, but the consolidators had widely varying degrees of success in realizing the savings.
Do you provide a unique and necessary input to a public company? If so, that public company might be interested in purchasing your business in order to guarantee itself a source of supply.
In order to maximize the value of your business in a sale to a public company, it is important for you to understand the particular strategic and/or financial needs of the potential buyers. If you are active in industry trade associations or read industry periodicals, you will no doubt have a good idea which public companies are buying businesses similar to your own. Once those public companies are identified, you can start researching the public company to determine its strategic and financial goals so that you can emphasize how your business can help to achieve those goals.
Corporate culture is also a key issue in the success of many transactions. An assessment of the compatibility of the target’s culture with that of the purchaser is becoming an increasingly important part of the evaluation and due diligence process. If you have managed to foster a professional, cooperative culture in your business and have a dedicated staff and competent managers, this can be a real selling point. Many experienced public acquirers have done at least one deal where the attitude of the employees did not “feel” right and it resulted in double-digit monthly turnover rates. Those experienced public acquirers are likely to look very carefully at whether your employees display a professional attitude. If you want to maximize the consideration paid in the deal, make sure that your employees carry themselves with a professional demeanor and that your corporate culture is consistent with that of the potential acquiror.
When public companies acquire private companies, they typically perform at least a rudimentary “build vs. buy” analysis. When you talk to a public acquirer, do not emphasize what your business could do if you replaced all the equipment, rebuilt the building, and changed the name. It would be irrational for a company to buy your business only to be faced with the cost of building a new business from scratch immediately after the deal. If you believe that the full potential of your business cannot be realized without making fundamental changes to the business, then go ahead and make those changes. If they do indeed maximize the value of the business to a public acquirer, then they maximize the value to you, as well.
Regardless of whether a private company manager is considering a sale of the business in the immediate future, it is an important shareholder value maximization tool to position a private company for sale to a public acquirer. Once liquidity opportunities arise, they either move forward quickly or wither away. The lesson here is to manage the business today to maximize its potential sale value so that when a sale opportunity arises, the private company will be in a position to maximize the proceeds to shareholders from the deal.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 2, 2000.
You have recently been approached by ABC, Inc., a public company within your industry that wants to acquire your business. After a review of the business, ABC’s representatives indicate that they would be willing to pay $40 million for your company – in the form of ABC common stock. While considering this offer you are approached by XYZ Company, a private company in your industry. Following limited due diligence XYZ offers $30 million for your company – in the form of cash. Which offer is more attractive? The example is a simple demonstration of the proposition: “Price vs. Terms.”
This article addresses some of the issues that a seller of a company must consider when evaluating and negotiating the sale of a business. It is by no means an exhaustive analysis of the subject.
In terms of the example, several questions come to mind when evaluating the two offers. When examining the offer from ABC (public company), questions would include: “What is the track record of the company and how has its stock performed?” “What are the future prospects?” “Is there adequate liquidity in the company’s common stock?” “Are there any restrictions on the sale of the stock (e.g. lock up provisions, affiliate issues, registration, etc.)?” “Is the proposal for a fixed price or a fixed exchange ratio?” “What are the tax implications (e.g. triggering of Alternative Minimum Tax, holding period for capital gains treatment, etc.)?”
When examining the offer from XYZ (private company) fewer questions arise. If you are receiving all cash at closing, most questions center around the tax treatment of the consideration.
The decision to accept the stock of an acquirer is not insignificant. You share the same risk in the ability of management to effectively integrate the acquisition as the shareholders of the acquiring company. More times than not, the selling shareholder(s) will have a reduced role in the operations of the combined company. The seller should consider whether or not they are willing to be a shareholder in a company that they have little or no control over. If the acquiring company has a successful track record of integrating acquisitions and is significantly large relative to the seller, this risk is somewhat mitigated. If, however, the acquirer was formed for the purpose of consolidating a group of companies in a fragmented market, the execution risk can be significantly high. Most industry “roll ups” have failed to produce the expense leverage and revenue enhancement promised to the market. These shortfalls have resulted in stock prices that have tumbled from their highs to well below their IPO price. Many sellers saw the fruits of their labors evaporate as the share prices fell. Any company considering weighing an offer that includes stock in the consideration should do a great deal of due diligence on the acquirer. Remember that when accepting stock, you are buying as well as selling.
When accepting stock, the seller needs to understand any limitations on the ability to monetize this investment. Some restrictions may be market-based and others shareholder specific. An indicator of liquidity is the average weekly volume in the acquirer’s stock. If selling the company for $50 million in stock and the average volume in the stock is a few hundred shares, liquidity is likely limited. This limitation applies to anyone investing in the acquirer’s common stock. Other restrictions may relate specifically to the shares received by the seller’s shareholders. Sometimes an acquirer will require that key shareholders of the seller’s company enter into a lock-up arrangement that prohibits the sale of the stock received for a period of time. During this intervening period, there is no guarantee that the price of the acquirer’s shares will not decline, thereby reducing the value of the deal. If, by virtue of this transaction, the selling shareholder becomes a beneficial owner of 10%, or more, of the acquiring company, Securities and Exchange Commission (SEC) rules limit the amount of stock that can be sold for a period of one year from the closing date of the transaction. Again, value can be greatly diminished during this forced holding period.
Another issue of equal importance to the seller is whether or not the proposed offer is for a fixed price or a fixed exchange ratio. If the offer is for a fixed price, then regardless of the price of the acquirer’s stock, the seller will receive a number of shares equal to the price divided by the market value of the acquirer’s stock as of a pre-determined date. If the deal is for a fixed exchange ratio, then the seller will receive a fixed number of shares for each of its outstanding shares. In this case, if the price of the acquirer’s stock goes down from the date that a definitive agreement is entered into to the closing date, then the value of the consideration to the seller declines. Conversely, if the price of the acquirer’s stock goes up, then the value to the seller also increases. A tool often used to mitigate the price risk between the definitive agreement and the close is to place a floor and ceiling on the total consideration. The floor protects the seller from a free falling stock and the ceiling protects the buyer from paying excessively based on its fast rising stock.
These are but a few of the issues that a seller must deal with when considering an offer for their business. So, which offer is better – $40 million in stock or $30 million in cash. It depends.
For answers to this and other questions, or to discuss a potential transaction, please contact us at (901) 685-2120. We would be happy to discuss your particular requirements in confidence.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 3, 2000.
Corporate mergers and acquisitions are typically announced in a press release that expresses the enthusiasm of both the purchaser and the target. Like any wedding, a deal is an event that results in a great deal of excitement on the part of both participants, as well as a great deal of speculation on the part of those familiar with the union about whether or not it is a wise decision. And, like many marriages between a man and a woman, a significant number of corporate marriages result in disappointment for all involved.
It is this disappointment to which we are referring when we talk about “bad deals”. A bad deal is a deal that does not meet the expectations of the parties due to an avoidable failure of pre-closing due diligence. While there are some deals that go bad due to some unavoidable or unforeseeable event, these are not the situations that this article will addresses.
So why do deals fail to meet the expectations of the parties? One of the big reasons is that in many cases, neither party goes into a deal with clear expectations about how it will work. This is an important but often overlooked aspect of the decision to buy or sell a business. While the parties to the transaction invariably have some expectations about what will happen after the deal, it is more rare for either party to have spent some time writing down a detailed list of post-deal expectations.
Formulating a detailed list of post-closing expectations allows the parties to the deal to expand the due diligence phase to test the likelihood that those expectations will be met. An example will help illustrate this point.
Suppose that Company P and Company T are distributors of competing products. Company T decides to buy Company P in order to expand its geographic coverage, increase its customer base, and realize cost synergies associated with a reduction in the size of T’s sales force and the elimination of T’s warehouse facility. While just this sentence gives us some idea of P’s expectations in the deal, it is best if the management of P specifically quantifies the anticipated benefits of the deal and tests those expectations in due diligence.
If P does not quantify those expectations and test them in due diligence, there is a great deal of room for things to go wrong. T’s customers, for example, might have a strong preference for the products that T currently distributes and might be unwilling to purchase the products that P distributes. T might be in a long-term lease on the warehouse facility that will result in significant cost should P wish to break the lease after the deal. T’s customers might be closely tied to T’s salespeople, some of whom P expects to eliminate, and others of whom might leave, taking customers with them. In addition, it could be the case that part of T’s competitive advantage came by offering quick delivery times, and the elimination of the T facility and the larger delivery area serviced by P results in those customers finding an alternate vendor.
So in just this very simple example, we see that there are several areas where our hypothetical merger might go bad. The key to a good deal here is for P to determine, to the extent possible, whether its post-deal expectations are realizable before closing the deal. This would include expanding the traditional due diligence process to include talking to salespeople and possibly customers in an attempt to determine realistically what will happen after the deal.
While the example above focused on the buyer, it is just as important for the seller to form concrete expectations about how the deal will work. If a seller receives an offer of $10.0 million for the business, that seller might think that the offer means that he will walk away from the deal with $10.0 million in cash in his pocket. That expectation needs to be tested very carefully by hiring experienced legal, accounting and tax advisors. The $10.0 million offer may well have been an offer for substantially all of the assets of the business and none of the liabilities of the business. Paying off the liabilities that are left behind, paying the corporate tax on any gains realized in the asset sale, and paying any income taxes that result from moving the cash from the deal from the corporate balance sheet to the personal balance sheet of the owner could take a significant bite out of the deal proceeds. Clearly, a seller who expects to walk away with $10.0 million only to find that the actual net proceeds from the deal are less than half that amount will be disappointed.
Too often, the parties to a deal press forward with a transaction without having formulated or discussed a clear picture of how things will work after the deal. If both sides just fill in any blanks with favorable assumptions, and this starts the deal down the road to failure. When we assist our clients in a transaction, we try to pin down their expectations, and we encourage them to test those expectations to the extent possible in due diligence. It is dangerous to assume that certain expenses will go away or that a selling shareholder will have a certain amount of influence over the operations of the combined company. These types of issues must be explored well before the closing in order to avoid post-closing disappointment.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 3, 2000.
Convertible securities, comprising convertible debt and convertible preferred stock, represent a hybrid ownership interest combining features of both “straight” debt and common equity. Like fixed income securities, convertibles typically have periodic interest or preferred dividend payments, stated par values/liquidation preference amounts, maturity dates, and call dates. At the same time, convertible securities are exchangeable at some price or conversion ratio into the common shares of the issuing company.
Convertibles provide current income through scheduled interest or preferred dividend payments and a floor value through the par value or liquidation preference as well as additional appreciation potential through the common share conversion feature. For companies needing cash, convertibles offer a means to reduce current borrowing costs by “buying down” the interest or preferred dividend rate by offering the security holders the ability to profit from future appreciation in the issuer’s common stock. For classes of investors (such as leveraged employee stock ownership plans and owners of acquired companies) requiring downside protection and/or current cash flow exceeding whatever dividend the issuer is paying on its common shares, convertibles offer a means of meeting those objectives while still retaining a stake in any appreciation in the company’s common equity.
Given their hybrid nature, convertible debt and convertible preferred stocks are typically issued with coupon or dividend rates below the market yields for comparable “straight” bonds and preferred stocks. At the same time, convertibles are also commonly issued with “out of the money” exchange ratios; that is, the conversion price is set at a premium to the current market price of a common share.
For example, if the prevailing yield on medium grade corporate bonds is 8.0%, a convertible issue of comparable credit quality, maturity, and callability might be issued with a 5.0% coupon. If the issuer’s common stock was trading at $20.00 per share, the exchange ratio might be set at 40 shares per $1,000 par bond, or $25.00 per share. The investor thus trades coupon income for upside potential in the event of enhanced corporate performance or higher stock market multiples while the issuer trades potential future dilution of its common share values (in the event of conversion) for lower current financing costs.
Under current financial theory, in general, the minimum value of a convertible security should be the greater of its value as a pure fixed income security or its value as a common share equivalent. Thus, if the net present value of the coupon income and par value exceed the value to be realized by immediately converting the security to common stock and selling the shares at the current market price, the security would be expected to trade at a price not less than its value as a “straight” bond or preferred stock. Alternately, if immediately converting the security into common shares yields a value exceeding the present value of the scheduled cash flows, the security would be expected to trade at a price not less than that implied by the conversion ratio multiplied by the current common share price. Because of the hybrid nature of convertibles, they typically trade at some premium to the prices implied by their pure bond values or their conversion values.
From a valuation perspective, convertibles can be modeled in two ways: first, as a “straight” bond or preferred stock with an embedded option or warrant to purchase the issuer’s common stock at the conversion price; and, second, as a bundle of common shares carrying the right to additional current income over some time horizon. Thus, the bond value is enhanced by the value of the embedded warrant while the common share equivalent value is enhanced by additional current income.
If we add the assumptions of a seven year maturity and semi-annual coupon payments to the hypothetical 5%, $1,000 par bond convertible into 40 common shares currently trading at $20.00 per share, we can infer a market value under the model of a bond with attached call options. Discounting the coupon income and the par value at a market yield to maturity of 8.0% implies a bond value of $841.55. The embedded warrant can be valued using a standard option pricing model such as a variant of the Black-Scholes or Binomial models. Let us assume that the option pricing model calculates a value of $4.00 per warrant share, or $160.00 for the 40 common shares under option. The resulting total value of the convertible security is thus $1,001.55 per bond, approximating par.
The same hypothetical security can be valued as a bundle of common share equivalents with additional investor cash flows attached. Multiplying the 40 common shares per bond by the $20.00 per share market price implies a conversion value of $800.00. The present value of the right to receive semi-annual payments of $25.00 for seven years discounted at 8.00% annually is $264.08. The total value implied is thus $1,064.08, a modest premium to par. This example assumes no common dividend. If the common stock paid a dividend, then only then only the present value of the cash flows on the convertible in excess of the common dividend would be added to the current conversion value.
This hypothetical security would be expected to trade somewhere between par and 106% of par; that is, between the indicated value as a bond with attached warrants on common stock and the indicated value as a bundle of common share equivalents with additional current income.
The preceding example incorporated simple terms and assumptions. Most convertible issues include call features allowing the issuer to redeem the shares prior to maturity, thereby forcing the holders either to be cashed out or to exercise their conversion rights early. In theory to maximize the value of its common stock, the issuer should redeem the convertible as soon as the conversion price is “in the money” relative to the market price of the common stock; otherwise, common shareholders are diluted by the existence of a group of equityholders having both the right to extra cash flows and the right to require the company to issue to them common shares for consideration (i.e. the conversion price) at or below the current market price. The presence of a call or redemption feature complicates the modeling of the embedded warrant on the issuer’s common shares as well as the modeling of the scheduled cash flows of the convertible security.
Where the issuer’s common stock is closely held or the shares to be received in conversion are not to be registered and/or the convertible security is unregistered or otherwise not readily marketable, valuation becomes further complicated. It will likely be appropriate to apply a marketability discount to the common stock and to add an increment for illiquidity to the pricing yield for the fixed income component of the convertible. In valuing the embedded warrants, adjustments must be considered to reflect any lack of marketability in the common shares, non-transferability of the embedded warrants, the inability to separate the warrants from the fixed income component of the security (that is, the right to call the shares cannot be exercised without terminating the scheduled cash flows), and the potential dilution of common share values due to the issuance of new shares upon conversion.
If you wish to discuss an appraisal or structuring of convertible debt or convertible preferred stock please contact us at (901) 685-2120.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 2, No. 2, 1999.
The terms “Financial Buyer” and/or “Strategic Buyer” frequently arise in discussions about investment banking activities, particularly when discussing the sale of a business. This article describes some of the characteristics of each type of buyer, and briefly discusses potential situations in which one might be more appropriate than the other.
Financial buyers can generally be classified as investors interested in the return they can achieve by buying a business. They are interested in the cash flow generated by a business and the future exit opportunities from the business. They are typically individuals or companies with money to invest, and who are willing to look at many different types of businesses or industries. Their goals may include growing cash flow through revenue enhancement, expense reductions, or creating economies of scale by acquiring other similar companies. Their exit plans may include an IPO (initial public offering), where the business is “taken public” (hopefully at a higher multiple of earnings than paid at acquisitions), or selling the company at a future date.
Financial buyers will carefully scrutinize the financial statements of the company. Most are looking for a well-managed company with a history of consistent earnings, and preferably, earnings growth. The transactions of financial buyers are often leveraged. It is common to see financial buyers use as much as 80% or more debt to finance an acquisition. By using high leverage, the financial buyer is effectively partnering with someone who is willing to accept a level of return (a lending rate, perhaps augmented by “kickers” to augment returns) that is generally lower than that required by financial buyers.
In layman’s terms, financial buyers are buying exactly what the company has to offer. They are buying the expected future earnings of the company as they are perceived to exist at the time of the acquisition. While financial buyers may see the potential for expanding cash flow beyond what the company has achieved on its own, they are generally not willing to pay for that potential. They are much more likely to keep the current personnel in place than strategic buyers. However, if their intent is to grow the business and eventually sell to a strategic buyer, the retention of personnel may be temporary.
Strategic buyers are interested in a company’s fit into their own long-term business plans. Their interest in acquiring a company may include vertical expansion (toward the customer or supplier), horizontal expansion (into new geographic markets or product lines), eliminating competition, or enhancing some of its own key weaknesses (technology, marketing, distribution, research and development, etc.).
Strategic buyers are often willing and able to pay more for a company than financial buyers. There are two main reasons for this. First, strategic buyers may be able to realize synergistic benefits almost immediately due to economies of scale that may exist through the combined purchasing power of the new entity and the elimination of duplicate functions. The better the fit (i.e., the more realizable the synergies are), the more they will want the business and the greater the premium they will pay. Second, strategic buyers are generally larger companies with better access to capital. They often have another currency available to them in the form of stock. Strategic buyers often offer stock, cash, or a combination of the two in payment of the purchase price.
In short, the strategic buyer is buying the company in light of how it will enhance their existing operations. They are often willing to pay for readily realizable synergies, and many times will pay for speculative synergies, particularly if the target company is being marketed to other competitors (through some type of “auction”). Strategic buyers are much less likely to retain all of the current personnel.
Believe it, or not, the answer to the question “which is right?” is not always as cut and dry as it might seem. Whether a strategic buyer or a financial buyer is right for a specific company depends largely on the seller’s goals in selling the business. Listed below are different scenarios discussing the seller’s goal and the type of buyer most appropriate.
This brief discussion is in no way intended to try to address all of the circumstances that may need to be considered in the prospective sale of a business. If you are a business owner who is considering the sale of your business please contact us at Mercer Capital to confidentially discuss your specific situation.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 2, No. 2, 1999.
Acquirers of non-financial services companies tend to focus on various definitions of cash flow and value. Because acquirers typically employ a different capital structure than the seller, value generally refers to the value of total invested capital (“TIC”), or the value of the firm’s operations before considering the capital structure. Value for equity holders is derived by subtracting the target’s capital structure debt (note: short-term working capital borrowings would not be considered capital; however, to the extent such borrowings exist, operating cash flow should be reduced for interest expense on revolver loans.)
Cash flow measures including earnings before interest, taxes, and depreciation/amortization (“EBITDA”), which is sometimes referred to as gross cash flow, represent a proxy for cash earnings before capital expenditures and debt service. Operating cash flow is generally defined as EBITDA less capital expenditures (in effect “cash EBIT”). Pricing multiples which are based upon cash flow (or earnings) measures before consideration of the capital structure, such as EBITDA and EBIT, refer to overall firm value, not the value of the residual equity. Net free cash flow represents residual cash flow available to common shareholders after capital expenditures, debt service requirements, and net working capital requirements have been met. While cash flow is an important consideration for any security analysts, LBO sponsors, private equity investors and other investors who typically use a large amount of debt to finance transactions are highly focused on these cash flow concepts rather than reported GAAP net income.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 1, No. 2, 1998.
Companies often use contingent consideration when structuring M&A transactions to bridge differing perceptions of value between a buyer and seller, to create an incentive for sellers who will remain active in the business post-acquisition, and other reasons. In the medical device industry, contingent consideration is most often used to manage risks related to the uncertainty of the future performance of development-stage technologies. Starting when SFAS 141R (now ASC 805) became effective in 2009, acquiring entities are now required to record the fair value of earn-outs and other contingent payments as part of the total purchase price at the acquisition date. This rule came into effect in the aftermath of the financial crisis when M&A activity slowed to a stand-still. Given the recent experience and continued expectation of increases in M&A activity in the medical device industry, a refresher on the new rules may be helpful for CFOs and controllers of companies contemplating acquisitions in 2011.
The Rules
ASC 805, the section of the FASB codification that addresses business combinations, requires that:
What is Fair Value?
In the case of contingent consideration, fair value represents the amount the reporting entity would have to pay a hypothetical counter-party to transfer responsibility for paying the contingent liability. This amount is basically the present value of the probability-weighted expected amount of the future payment.
Valuation Procedures
The complexity of the procedures necessary to estimate the future payment ultimately depends on the structure of the earn-out.
Valuation Inputs
For earn-out structures including milestone payments or tiered schedules, the fair value of the contingent payment is generally most sensitive to the estimate of the probability-weighted expected payment (rather than other inputs such as duration of contingency or discount rate). Developing reasonable estimates of the probability of future events is inherently difficult, but the use of decomposition and cross-checks will help improve the quality of these estimates. Decomposition is the process of breaking down a big event (such as FDA approval) into a series of smaller, more familiar pieces to make the probability estimate process easier. Cross-checks using aggregate industry information (such as the average length of time to receive PMA-path approval from the FDA) can be helpful to validate assumptions that by nature rely on judgment. Industry expertise can be extremely valuable when selecting a valuation specialist to help with estimating the fair value of contingent consideration. An expert will be able to decompose common pathways into a series of managable steps to estimate, will have familiarity with available industry data that can be used to help support assumptions, and will be able to effectively explain and defend the assumptions.
Role of a Valuation Specialist
In most cases, you or someone else in your company will likely be the individual most knowledgeable of the potential outcomes. The role of the valuation specialist is to integrate this information into the appropriate valuation model, test it for reasonableness, and to articulate the nuances of the inputs and valuation model in such a way that is clear for auditors and other third-party reviewers to understand. For simple situations it may not be necessary to bring in the outside help of a valuation specialist. For more complicated situations requiring multiple scenarios or Monte Carlo analysis, however, outside support may be necessary. If you have any questions regarding the valuation of contingent consideration or the impact of particular structures on financial reporting procedures, feel free to call or e-mail us to discuss in confidence.
Leverage – the favorite son of an efficient capital structure has become the bane of those who relied too heavily on easy flowing, low cost financing. As it turns out in this new economy, the malt flavored punch is proving just as toxic as that served to investors in real estate and virtually every other asset class on the planet. Now, with an almost unprecedented deleveraging of the economy, malt beverage distributors find themselves in a world where financial uncertainty is higher and growth is less visible than at anytime in living memory. Consequently, there have been fewer transactions, less available credit, and ultimately lower valuations for the entire distributor space.
We are not surprised given our wealth of transaction and valuation knowledge amassed from thousands of engagements across hundreds industry platforms and niches during decades of service to business owners and their advisors. The valuations implied by many transactions in the past decade simply never reconciled to the financial realities of the broader marketplace. Much of the guiding information communicated to distributors appeared, from a valuation perspective, to stretch the bounds of reasonable and sustainable expectation. Yet, these transactions helped establish unrealistic valuation norms through a dangerous cocktail of rules-of-thumb and excessive debt. Yes, there have been voices calling for a better understanding, but like the rest of the business world, times were just too busy and the perceived needs and opportunities too great to stand still long enough to hear the encroaching tidal roar. Now we find ourselves in the wake of that great flood with a house whose foundation may be compromised.
What can beer distributors learn from the postmortem? Lots. We submit that a more thorough and comprehensive understanding of business valuation concepts and vocabulary is required to better appreciate the lessons of this recent past, as well as to anticipate the future that will likely unfold for many beer distributors. Therefore, we respectfully offer (from a valuation perspective) the following valuation framework and observations for deciphering the past and anticipating the future.
Regardless of the industry space or business model one may own or manage, the talk at industry trade functions and the casual exchanges with colleagues and pundits often includes rumors about who recently sold their business and for what sum. Drink the malt industry brew and you are likely to witness at least one small fish morph into Moby Dick via a mistaken rule of thumb. This is not a unique phenomenon. Ask the car dealers, the bankers, the internet service providers (among others) about their former rules of thumb. Thankfully, the misfortune that engulfed those industries does not appear absolute for beer distributors, but the lessons are loud and clear. No business model is immune from the forces of market and financial evolution. Just when and who first described a transaction value of a malt beverage distributor using rules of thumb is difficult to pinpoint. But the first misuse of these rules surely occurred at the exact same moment.
What is a rule of thumb? WIKIPEDIA offers the following definition:
A rule of thumb is a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.
Those familiar with WIKIPEDIA know that it is a collaborative, web-based amalgam of its users’ and contributors’ collective wisdom. Consequently, anything found there is subject to constant review, revision and qualification. Too bad the same principle has not been true of the rules of thumbs for transacting a beer distributorship. From a business valuation perspective, we offer the following addendum to the definition of a rule of rule of thumb:
A business valuation rule of thumb is a simplified metric that converts a financial or operational measure of performance to a value for the subject business. Unless specifically qualified otherwise, a business valuation rule of thumb expresses the value of 100% of the tangible and intangible assets of the enterprise as such would be normally included in a transaction.
If you have a pulse, let alone a multi-million asset at stake, you should have many questions about the origin of any rule of thumb and the specific application of that rule to your business. Let us take this moment to introduce the basic representative equation of business value:
V = P x M
V= Value
P = A Measure of Profitability
M = Multiple (or Capitalization Factor)
Value is the product of some measure of profit times some multiplier of that profit. This formula appears relatively simple. However, the first mistake is taking this formula for granted. There are numerous underlying definitions and qualifications that must be understood for the results of this equation to be properly framed for the specific question being posed.
The most common rules of thumb for beer distributors use gross profit and/or case volume. Substituting these measures into the basic value equation results in the following equations:
Value = Case Volume x Multiplier
or
Value = Gross Profit x Multiplier
Simple enough, right? But wait. As beer distributors, don’t countless questions immediately spring to mind?
The combination of answers can result in a far more complicated assessment than the simplicity of the equation suggests. Referring back to the basic value equation, the same questions apply – the vocabulary is simply different and the interaction of the volume/profit measure and the multiplier are highly dynamic because each element of the equation can influence the appropriateness of the other. For example, the use of an adjusted or forward looking measure of case volume or gross profit (assuming growth is occurring) might require a modestly conservative view of the multiplier. Conversely, the use of a conservative volume or profit measure from an unfavorable year might suggest a slightly higher multiplier to capture the upside potential to right-size distributor performance in the market.
Given the prevalence of rules of thumb and reliance on a relatively small universe of advisors and brewery resources, it seems many beer distributors have had little interest in understanding the language and concepts of business valuation. Now that beer distributors are becoming less immune and less differentiated from other distribution platforms (economically that is), they are more curious about the basics of the valuation discipline than ever before. Let’s use the basic valuation equation and pose an abbreviated list of similar questions as noted above but use the vocabulary of a business valuation practitioner. The scope of possible questions and the responses to them include some potentially unfamiliar concepts to distributors and their shareholders but they are critical in order to understand the valuation placed on a given distributorship as a whole or for an ownership interest therein.
Regardless of the rules of thumb used to describe a transaction, these metrics (i.e. case volume or gross profit) can be translated into more meaningful financial expressions. These translations are useful because they can reveal important variables and identify potential sources for common valuation mistakes. Judging from the legacy of transactions represented on the balance sheets of a great many distributors, there has been rampant misunderstanding in determining how much to pay and what the consequent return on investment would be.
The most common (and most crude) distributor valuation rule of thumb is value per case. A common rule of thumb for the value of total assets for a domestic brew house distributor has been approximately ten times annual case equivalent volume (historically speaking). Referring to regularly compiled data reported by Risk Management Associates (“RMA”) and the National Beer Wholesaler Association (“NBWA”), we can make some basic assumptions about a “typical” beer distributor. Such a distributor (statistically) might have an annual case volume of 2.5 million, with net sales of $30-$35 million and a gross profit margin of approximately 25%. Many have a reported earning before interest, taxes, depreciation, and amortization (EBITDA) margin of approximately 5%, but in our experience, this can vary greatly. Often, the transactions between distributors are premised on adjustments to EBITDA on the order of 2%-5% of sales (shareholder compensation) increasing the adjusted EBITDA margin to approximately 8% (if not more). At this level of cash flow, a typical distributor would be expected to deliver $1.00 of EBITDA per case (+/- 8% EBITDA margin 0n net sales per case of approximately $13.50).
Based on the financial profile of a typical distributor, $10 per case translates to a total transaction value of $25 million. Based on an 8% EBITDA margin, the typical distributor would be producing on the order of $2.6 million in adjusted EBITDA. Based on a 25% gross margin, the same distributor reports $8.1 million in gross profit, corresponding to the other commonly used rule of thumb: three to four times gross profit. However, the gross profit rule of thumb implies multiples of EBITDA (10x in this example) that are higher than similar-sized transactions across numerous small-to-middle market sized companies in various industries (typically 5x EBITDA). There may be sound reasons to explain somewhat higher multiples than often exist for many other small-to-mid-market sized businesses, but such reasons should be compelling.
From a valuation perspective, only two underlying characteristics can explain a value at 10 or more times EBITDA: 1) exceptionally low risk, and/or 2) significant growth potential. In the malt beverage world, growth rates in volume and profit are typically limited to inflationary pricing growth and 1%+/- for population growth and other territory factors. Given the rarity of high growth as a supporting rationale for such high multiples, the only value attribute remaining is risk, uncommonly low risk. The assessment and quantification of risk is beyond the scope of this article. However, it should be obvious that the economics commonly applicable to a broad range of industries, some with attractive risk and growth attributes, simply do not correlate to the valuations often paid in beer distributor transactions, either for brand rights or for total assets. Accordingly, a rule thumb at 10 or 12 or higher times case volume seems questionable without unique circumstances. There are always exceptions, but they are few and far between. Ultimately, it is no surprise that recent transaction activity reflects lower valuation multiples than those of the last many years. What is surprising is that it took the worst financial crisis in 75 years to alter valuations in the malt distributor space.
Unfortunately, rules of thumb are not just the folly of the industry but can become habitual in the financial valuation arena as well. It is relatively easy for financial assumptions to become bogged down through the use of near universal assumptions regarding rates of return, capital structure assumptions, and growth rates. Through the years we have had the benefit of reviewing numerous appraisals. As with all analytical works, particularly those requiring elements of judgment, some of these reports have been sound and some, in our view, have been lacking in documentation, clarity, and/or reasonableness. Often, valuation issues emerge from a combination of almost ubiquitous assumptions concerning rates of return and growth rates that often do not reconcile to the transactions and realities of the market place.
A brief example involves the assessment of a near universal cost of capital on the order of 10% and extremely low growth rates. True, growth at the top line of the malt beverage industry is not sexy. That’s why the call of the day for brewers and distributors is consolidation, because defense of margin and prospective growth are largely reliant on increasing efficiencies. It’s true that margin pressures for distributors have been acute in recent years reflecting periods of unusual fuel costs, price competition, declining volumes, and other factors. Ultimately though, a 1%-2% growth rate for cash flow falls short of reconciling to the gross profit and case multiples of even some of the most conservative valuations. Yet in many valuations, 10% seems to be the universally adopted total cost of capital and low growth rates are predominant. The low growth treatments are not so troubling but there are exceptions based on the level of cash flow being used and the nature of the individual distributor being valued.
For example, low-volume growth in a highly leveraged distributor does not automatically equate to low-earnings growth since earnings can increase as debt is retired. Even flat to low growth in cash flow (EBITDA) can facilitate a healthy pace of loan repayment. Based on the realities of present value math, near term earnings growth via the amortization of debt can have a meaningful effect on value which under many valuation methods may best be captured through an appropriately higher growth rate in earnings than might be reasonable for revenue or cash flow.
The capitalization rate resulting from a 10% cost of capital and a 1% growth rate is 9% (10% less 1%% = 9%). The reciprocal of that capitalization rate is a cash flow multiplier of 11.1. Assuming a hypothetical norm of annual net cash flow (after taxes) on the order of $1 million (based on “normal” margins and normal cash flow sources and uses for a typical 2.5 million case house) the 11.1 multiplier explains only half of the valuation such a distributor’s total assets (warehouse, fleet, inventory, brand rights, etc.) would receive. In our example, that’s less than two times gross profit and less than five dollars per case. The primary financial reconciliation of historical deals and historical valuation norms includes a lower cost of capital or a higher growth rate for cash flow, or some combination of both. We’re not suggesting that a 25 multiplier of cash flow is typical, but in relation to $25 million valuation for a 2.5 million case wholesaler, that’s what it would take. Often net cash flow is somewhat higher than our example (via adjustments), and the use of a much higher debt structure in the deal provides the underpinning for the historical financings and valuations we have witnessed for brand and territory acquisitions. Tweaking the cash flow up by 20%, adjusting the capital structure to include more low-cost debt, and using a higher growth rate for net cash flow will collectively explain many of the historical deals. Ultimately, paying more to get a deal done equates to compromising the buyer’s rate of return on the investment.
The additional value push under many historical valuations came from buyers giving their sellers most, if not all, of the synergies of the deal. In the eyes of many strategic buyers are operational and financial enhancements that can increase value. Many of these synergies are limited for financial buyers. Additionally, and perhaps questionable, is the assumption that the IRS will help buyers pay for part of their bite at the apple. The booking of a transaction facilitates a purchase price allocation that provides for favorable tax treatment, namely the amortization of distribution rights over a 15 year period. The most valuable asset for most beer distributors is distribution rights. Using our $25 million example deal, it might not be unusual to see $15 to $20 million in booked distribution rights. Over a 15 year period this can shelter upwards of $1.3 million in annual earnings from income tax. Using typical tax rates, this equates to $500,000 annually in saved taxes for 15 years that can be used to service debt. Until recently, lenders were too happy to oblige and distributors seemingly used this source of cash flow to over-borrow and thus to overpay. However, the notion of a 40% break on the rights portion of the deal and the reality of the time value of money simply don’t reconcile. In truth, the present value of this tax benefit is only about half of the perceived $7 million benefit implied by common observation (40% of the rights). So, not only were buyers dealing away an inflated perception of the tax benefit, perhaps they were giving it all away. Based on our $25 million deal, we would estimate this misunderstanding to explain a portion of the over-valuation in many deals, albeit, a strategic buyer’s compulsions often result in making compromises to get a deal done.
It is important to understand that our perspectives on value are steeped in the concept of fair market value. Fair market value is a concept of financial value in a rational and hypothetical world without unique compulsions for either buyers or sellers and where both are imbued with equal knowledge and negotiating power. In the strategic world, there is often an exception to the fair market value concept. People do things because they are uniquely inclined to do.
While the observations in this piece may seem adverse to the interests of distributors who are seeking to maximize their valuations – fear not. The world has simply changed, and while valuation expectations should be reined in a bit, understanding the financial and financing realities of this market are key to positioning your business for its best result in the market. There are still many valuable franchises in this space. In addition to optimizing your distributorship’s sales and operations, you should seek feedback on the state of your valuation so that expectations may be better aligned with emerging market conditions. Feel free to contact me with your questions and/or comments.
Originally published September 2009.
In recent years, valuation issues have become increasingly important for start-up companies due to changing IRS and financial reporting rules, as well as increasing regulatory and shareholder scrutiny, which together compound potential troubles for start-up companies. In the past, industry specific start-up “rules of thumb” may have been sufficient to serve as reasonable basis for any valuation concern (e.g. the “Silicon Valley Rule” that the value of a common share is equal to 1/10 of the value of the preferred share pricing in most recent capital round). While the simplicity of such rules can be appealing, the scrutiny of the IRS, SEC, and your auditors in combination with the potential liability associated with misreporting make it critical that value be determined and articulated in a credible fashion.
Valuation for start-up enterprises can be a tricky proposition. Regardless of industry, start-ups generally share a common set of operational characteristics and valuation needs that are distinct from mature firms. Because both the subject enterprise and valuation purpose are misfits within the context of typical valuation work, typical valuation practices are generally not applicable for start-up companies. Combined with the unique market dynamics and regulatory environment associated with the medical device industry, medical device start-ups present a unique set of valuation considerations.
Below, we will discuss common circumstances that give rise to the need for a valuation, basic valuation concepts, and specific valuation considerations relevant to medical device start-up companies.
The day-to-day activities of start-up companies, being in a formative phase, require significantly more attention from senior management than mature firms. As a result, many start-up company founder/managers can overlook pending valuation issues for more immediate operational concerns.
For start-ups, valuations are most often needed for employee stock option or equity compensation compliance purposes. For financial reporting purposes, SFAS 123R requires that employee stock option compensation be recorded as an expense at the fair value of the option grant as of the grant date. The issuance of IRS 409A has created tax implications for non-qualified deferred compensation plans, which includes the issuance of stock options and stock appreciation rights to employees at a discount. Given the severity of the tax implications, the rule effectively requires non-public companies that issue stock options or other forms of equity as compensation to obtain an independent, contemporaneous valuation of the relevant securities.
Other common valuation circumstances for start-ups involve advisory services and fairness opinions related to additional fundraising or exit events on behalf of company management for both planning purposes and to fulfill a fiduciary duty to shareholders. There is also a growing trend in venture capital funds obtaining independent valuation opinions or reviews of internal valuations related to compliance in reporting fund investments at fair value.
Through casual observation, the value of an enterprise seems like an easy concept with a single definition. In reality, the appropriate definition of value varies depending on the circumstances surrounding each valuation engagement. The actual analytical framework for determining value is only developed once these aspects are defined. The following concepts are vital to understanding what is meant by “value” and are essential in defining an engagement with a valuation specialist.
The standard of value establishes the particular definition of value used in a specific engagement. Identification of the appropriate standard of value is the first step of every valuation. So, what are the most common standards of value for start-up companies?
Fair Market Value is the most common standard of value used in business appraisals and is the standard used for 409A compliance related to equity compensation. Fair market value is defined by Revenue Ruling 59-60 as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” A significant body of application guidance has been generated over the years through a variety of professional standards, government regulations, and court cases.
Fair Value can have one of two distinct meanings, depending on the situation. For start-up company valuation, fair value most commonly refers to the standard defined by FASB in SFAS 157 for financial statement reporting purposes. Here, fair value is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition of fair value is the relevant standard of value for valuations involved in SFAS 123R compliance for employee stock option compensation reporting.
In other circumstances, fair value can refer to the statutory standard of value applicable to cases involving dissenting minority shareholders with respect to corporate reorganizations or recapitalizations covered by the various state statutes. It may also have a specific meaning for divorce or under the securities laws for a given state. These statutory definitions of fair value (which are unrelated to the definition of fair value for financial statement reporting), however, are not commonly relevant in start-up company valuation.
Many start-up managers and venture fund managers often pragmatically observe that fair market value and fair value are different than the real world where buyers and sellers are very specific people who are individually motivated, uniquely informed, and are using something other than 100% cash to transact.
Investment Value is the value to a specific investor based on their particular investment requirements and opportunities. This value reflects the knowledge, expectations, synergies, and economies of scale of the particular investor. Investment value is generally used when valuation or investment banking professionals are advising their clients as to the merits of executing a specific transaction such as raising additional equity capital, selling the business, or completing an IPO. Investment value answers the questions – what’s it worth to them? Or what’s it worth to me?
A word of advice concerning who you choose to value your medical device start-up: associated with nearly every industry are niche consultants who sometimes practice valuation without the requisite command of how value is defined for a given circumstance and correspondingly how such value should be developed. Likewise, there are many valuation specialists without specific experience with the unique dynamics of the medical device industry. Given the incremental valuation complexities particular to medical start-up enterprises, it is important to remember that industry knowledge and valuation knowledge are not synonymous—and both are important.
There are three general approaches to determining business value – asset, income, and market. Under each approach there are specific ways to determine value that are commonly referred to as methods. As a general rule every valuation should consider each of these approaches. Ultimately, the conclusion of value will reflect consideration of one or more of these approaches (and perhaps various underlying methods) as being most indicative of value for the subject ownership interest.
The Asset Approach
The asset approach determines the value of the subject business by examining the cost that would be incurred by the relevant party to reassemble the company’s assets and liabilities. For start-up companies, the asset approach is generally inappropriate to apply unless the start-up is in a very early stage of operational development such that there has been no intellectual property or other intangible value developed internally. The asset approach can provide meaningful valuation benchmarks for start-ups that have recently completed fund-raising rounds.
The Income Approach
The income approach is based on the idea that the value for a given enterprise is created by the expectation of future cash flows and thus focuses on the capacity of a start-up company to generate future economic benefits. The mechanics of an income method require an estimate of future cash flows and an appropriate discount rate with which to determine the present value of future cash flows.
Methods under the income approach are wide ranging but typically fall into one of two categories: 1) single period capitalization of income; or 2) discounted future benefits. By nature, income expectations for medical device start-up companies are often characterized by a period of anticipated operating losses and increasing capital needs, followed by an expected payoff in the form of proceeds from an IPO, strategic acquisition, or other exit event. Accordingly, single-period capitalization of income methods and conventional applications of discounted future benefits methods are rarely appropriate to use.
The Market Approach
The market approach compares the subject to similar businesses, business ownership interests, or other assets that have been recently transacted. Market methods include comparison of the subject interest with valuation metrics implied by investments in publicly traded companies and those implied by transactions involving controlling interests in similar companies. Consideration of prior completed financing rounds or other transactions in interests of a start-up is also a method under the market approach.
Guidance in SFAS 157 suggests that the market approach is the preferred approach when appropriate data is available in sufficient quantity and quality. Most start-ups are not near IPO or acquisition, however, so there is generally not sufficient information to implement the market approach to determine the enterprise value for start-up enterprises with the exception of the occasional very late stage start-up.
Prior financing rounds can provide meaningful indications of value for a particular equity class in a start-up, but differences in rights and preferences between various classes of equity create difficulties in translating value of one equity class (e.g., preferred stock) to another (e.g., common stock). Generally, medical device start-ups are funded by one or more financing rounds subsequent to the company’s initial formation, and thus are capitalized by several classes of equity—which complicates the determination of enterprise value based on a given share value. However, such per share pricing information from capital rounds provides helpful valuation anchors in the form of upper or lower boundaries for enterprise value, and can credibly substantiate the reasonableness of valuation conclusions.
Ultimately, the value of a start-up company is a function of:
For medical device start-ups, exit events generally take the form of a strategic acquisition or an IPO. In either case, exit value will be driven by the relevant market characteristics combined with the expected impact the company will have on that market. At any given point in time, the probability of achieving successful exit and the expected time period necessary to achieve a successful exit will be a function of the development stage of the company as well as certain key indicators such as management quality.
Market Characteristics. All companies operate within a given market and this context is perhaps the most significant factor in the exit valuation of a medical device start-up. Even if a start-up has everything else in place, 100% market share of nothing is still nothing.
Market dynamics within the various medical device segments tends to share the same broad contours. The most significant market factor to consider for a medical device start-up is the absolute size and growth prospects for the pertinent market. Relevant measures in evaluating a particular medical device market often include the number of physicians performing procedures, the number of procedures performed in a given year, and the reimbursement rate per procedure.
Most new medical devices tend to be improvements on devices used in existing procedures, and thus have a readily-defined market at the start of the device development process. Less frequently, new devices offer revolutionary solutions for which there are no existing markets. Developing expectations of market characteristics in this situation is more difficult, but such products typically command far greater market impact.
Market Impact. Market impact can be defined as the market share that, if development efforts succeed, a medical start-up would likely command. Market impact is driven by the disruptive potential of the new technology and management’s ability to develop the technology, execute the business plan, and fully realize the new technology’s disruptive potential.
Other than the disruptive potential of the new technology itself, strategic acquirers in the medical device space commonly consider a variety of factors in evaluating the potential market impact of a new device:
Stages of Development. The value of a given start-up is largely related to its level of operational development. Most medical device start-ups tend to follow similar patterns in operational development regardless of industry segment. Loosely speaking, medical device start-ups often follow the following development pattern:
Since the development of start-up enterprises is measured by the passing of various milestones, the meeting of milestones (or the lack thereof) contributes significantly to the valuation of a start-up. Passing certain milestones create a bigger impact on value than others; examples of such milestones include the completion of the initial round of financing, proof of concept, regulatory approval, delivery of product to customers, and profitability.
With the passing of each milestone, the level of uncertainty associated with the start-up decreases and thus drives value upwards. Generally, meeting later-stage milestones generates greater increases in value than that of earlier-stage milestones.
Key Indicators. Compared to mature enterprises, financial information for start-up companies is less frequently available and typically of lower quality. Due to this relative lack of information, qualitative factors such as the quality of the management team, clinical advisory team, and venture capital investor group become an important consideration, especially in the valuation of early-stage start-ups.
Mercer Capital has valued a number of start-up enterprises in the medical device space over the years and we have witnessed many of the hardships and successes of such companies. We hope this introductory primer helps you better shop for business valuation services and understand valuation mechanics. We encourage you to extend your business dialogue to include valuation – sooner or later circumstances requiring independent valuation will arise, and early awareness will minimize the likelihood of potentially unpleasant surprises.
Over the last decade there have been hundreds of transactions in the beer distribution space. The impetus for consolidation has come from the top-down strategy of the breweries and the bottom-up ambition of distributors. Like a great many things before the onset of the financial crisis, the underlying strategies compelling distributor consolidation and deal pricing made better sense then.
During the last 10 years, major changes have occurred in the financial reporting process. The movement of financial reporting from a system of almost purely historical cost to one more focused on market value is now well established. In 2001 and 2002, the Financial Accounting Standards Board (FASB) enacted new rules concerning the manner in which business combinations must be accounted for. At that time, the use of the “pooling-of-interests” method was abandoned in favor of the “purchase method.” The purpose for the change was multi-faceted, but the overriding goal was to promote a more relevant accounting representation of the economics of a given transaction and its composition, namely the value of the intangible assets acquired in a transaction. To the degree a buyer in a merger paid consideration in excess of the net tangible asset value of the seller (inventory, fleet, and warehouse), such excess is required to be booked as specific intangible assets, whether definite-lived or indefinite-lived in nature, with the residual amount recorded as goodwill. For beer distributors, the value of “brand distribution rights” generally falls into the category of an indefinite-lived intangible asset. The exercise of assigning fair value to the assets acquired in an acquisition is referred to as purchase price allocation, the process for which is defined under Statement of Financial Accounting Standard (SFAS) 141R. Based on surveys of financial data published by the National Beer Wholesalers Association and Risk Management Associates, the average beer distributor has approximately one-quarter to one-third of its total assets booked as a “distribution rights” intangible.
Prompted by tightening credit and compounded by disconnects between buyers and sellers on deal valuations, consolidation has slowed and deal flow will likely remain modest as distributors digest emerging news concerning brewery strategies on distribution. Given the gloomy economic outlook and increased uncertainty in the market today, the carrying value of “distribution rights” could require restatement. Under SFAS 142, the carrying value of an indefinite-lived intangible asset or goodwill cannot exceed its “fair value.” Carrying values must be subjected to periodic tests for impairment. Should such distribution rights fall short of fair value as defined under SFAS 142, then the asset is considered impaired and must be written down to its fair value. Just as fair market value has a specific meaning under the tax code, fair value has specific meaning for financial reporting purposes and is defined in SFAS 157, Fair Value Measurements. The nuances of the numerous FASB pronouncements applicable to beer distributors is beyond the scope of this article; however, since distribution rights often represent the majority of value acquired in a transaction, SFAS 142 is a particularly relevant and timely pronouncement.
Auditors are increasingly requiring their clients to obtain an independent valuation analysis to determine if the carrying values of intangible assets are free of impairment. Keep in mind that SFAS 142 does not require the restatement of the carrying value unless the asset is determined to be impaired (again, worth less to a market participant than reflected in the financial statements). For beer distributors, fair value accounting procedures have become compulsory and likely represent an opportunity for distributors to reform their thinking about the valuations that should govern future strategic decisions, as well as influence shareholder expectations.
If your distributorship has grown via acquisition and the legacy of those deals resides on your balance sheet as a large distribution rights asset, the value of that asset may be impaired. The reality is that numerous advisors in the deal market are on the record proclaiming that the rules of thumb have changed and the financial realities of the market represent lower cash flow multiples. Lenders echo this new reality with less favorable credit terms and with requirements that buyers bring equity to their deals. Those distributors paying big multiples for territory and brand rights who have not markedly improved the margins, market share, and/or operations of their predecessors likely face the challenge of testing these assets for impairment. Beer distributors are main street players in their regional economies and communities. However, Wall Street realities and accounting requirements are knocking at the door.
This is not to say that most transactions in the beer distribution space were bad deals or lacked a sound economic rationale. Most beer distributors are savvy operators and who relied upon the financial feedback of their breweries concerning territory and brand acquisitions. Like many business platforms in the world today, the rules are simply different, or least more stringent, than before. The nature of change in so many markets is exactly the purpose behind enhanced financial disclosure and reporting rules. Many distributors could care less what the financial statements say, particularly as a result of accounting rules that may lack a certain operative and intuitive sense. However, auditors have a keen interest in compliance with the pronouncements that govern the accounting function, not to mention the financial opinions that lenders rely on. Shareholders also need to understand and reconcile the economics of past transactions.
Mercer Capital has a combination of industry, valuation, and financial reporting expertise that is uncommon in the beer distribution space today. Distributors face rising scrutiny with lenders and auditors because historical valuation metrics simply do not translate to today’s transaction environment. Last, but certainly not least, is a challenging world of expectations for many distributors and owners who could face strategic attrition and/or outright termination as brewery strategies surface and evolve. In this environment, what is the fair value today of yesterday’s transactions and how can this new reality be turned into the power of information for better reasoned decisions tomorrow? For a confidential assessment of your strategic and financial reporting needs, call me at 901.685.2120.
The market downturn of 2008 left a myriad of battered stocks in its wake. In such a difficult investment environment many investors flocked to the safe haven of so-called “recession proof” stocks. Historically, beverage stocks have been thought of as recession proof stocks.
In the case of soft drink manufacturers and distributors, the thinking is that despite hard times consumers can’t give up drinking (although they do have the option of cheaper alternatives, such as water). However, changes in consumer behavior within the soft drink segment often occur at the margin, according to Pepsi CEO, Indra Nooyi. For example, consumers may be more deliberate to stock up on soft drinks at the supermarket, where prices are lower, in order to avoid impulse purchases at convenience stores and other on-premise consumption outlets, where prices are higher. Additionally, in an economic downturn consumers become much more conscious of the products already in their pantry, using every last item before making a trip to the store to re-stock. Nevertheless, households in budget mode generally look to first cut bigger ticket items, such as vacations, furniture, and even cell phones, offering soft drink manufacturers at least some reprieve.
Along a different line, the alcoholic beverage industry is often thought of as recession proof for more somber reasons. It is commonly thought that drinking offers an outlet or escape from the stresses of tough economic times, which might include unemployment, foreclosure, precipitously declining retirement accounts, etc. The beer industry in particular is often viewed in this light, while some portions of the wine and liquor segments are considered (and priced) more as luxury goods, making them somewhat more optional in the household budget.
Unfortunately, in a severe market downturn, such as the one experienced in 2008 and continuing on into 2009, it seems no stock is immune, and beverage companies were no exception, with stocks across segments of the industry falling to multi-year low valuation multiples. All three segments (as tracked by Mercer Capital’s indices) reported median P/E valuation multiples representing double digit percentage declines from 2005 levels. Wineries and distillers saw the largest decline in P/E ratios, followed by soft drinks and then brewers. Perhaps it was best put by Peter Cressy, CEO of The Distilled Spirits Council of the United States (DISCUS), when he stated that “Contrary to popular belief, the entire beverage alcohol sector is recession-resistant, not recession-proof.”
So, is it possible to spin any of this in a positive light? In fact, there is a silver lining to plummeting valuation multiples (and these days a silver lining is about all you can hope for). No owner of a privately held business wants the value of their company to decline, especially not at the pace or to the levels experienced in the past 18 months. However, owners of wineries, beverage manufacturers, beverage distributors, distilleries, or any other company within the beverage industry could actually benefit from the current level of valuation multiples.
Over the life of a business, any number of transactions in the stock will, and eventually must, take place. For example, the gifting of shares to younger generations, contributions to charitable or family trusts, the granting of employee stock options, and others are all more efficient to the tax payer if done at lower stock valuations (i.e., lower valuation multiples). As an added bonus, any transfers done now help to ease a shareholder’s estate tax burden later. Estate planning, succession planning, and operational requirements within the distribution world are linked together making the execution of any one plan a multi-faceted exercise. As with any transaction or transfer, finding mutually agreeable and financially credible solutions can be challenging. Figure One provides a comprehensive list of conditions and circumstances for which a valuation may be required or is advisable.
Perhaps it is proverbially chaste to remind oneself that tomorrow is not a better day to do something that could better be done today. From the perspective of strategic and ownership planning, the insult on top of the injury of today’s markets and valuations will occur in the future when many look back at this time and realize they did not take advantage of a life time opportunity (at least the best so far in living memory). One could argue that it is a buyer’s market – possibly so, if your business is not well positioned and operationally optimized to receive its highest value. We would argue that the current economic climate has more likely given rise to a paradigm of more rational pricing for both buyers and sellers, one that looks more like that of other distribution platforms we have seen in our practice over many years. This new reality is a big part of the current discussion in early 2009, particularly in malt beverage distribution.
Mercer Capital has a combination of industry, valuation, and financial reporting experts that are uncommon among the pre-existing expertise in the beverage industry. For a confidential assessment of your strategic, valuation, and financial reporting needs, contact myself or Tim Lee by calling 901.685.2120.
Prepared by an independent financial advisor, a fairness opinion is just that – an opinion that a proposed transaction is fair (or not) from a financial point of view, to shareholders of a company (either all or a certain specific group of shareholders). A fairness opinion can assist corporate directors and/or ESOP trustees in making or approving decisions concerning strategic and financial events. A fairness opinion can also instill confidence among stakeholders that an action has been thoroughly vetted for its effects on the ESOP and/or the sponsoring company. These opinions can aid in substantiating that decision makers have adhered to the business judgment rule.
The prudent answer is yes. Despite out belief that transactions affecting or potentially affecting an ESOP should include a fairness opinion, such opinions are rare. Some business owners and trustees believe that fairness opinions are time-consuming, costly, uncommon, unnecessary, or excessive for many transactions. Perhaps, in some circumstances, a fairness opinion could be viewed as nonessential. However, every ESOP installation and every ESOP termination, and virtually every significant corporate (or strategic) event in an ESOP sponsoring company would be better served to include a fairness opinion rendered from the financial perspective of the ESOP and its trustee.
That an ESOP transaction or significant corporate event that affects the shareholders or participants of an ESOP company requires a fairness opinion is not specifically codified. Nonetheless, obtaining the service can be a vital, virtually obligatory exercise for any prudent decision-maker, particularly one carrying the burden of a fiduciary obligation to ESOP participants.
No. A valuation of the transacting interests may be an essential underpinning for a fairness opinion but it is not the only substance of a fairness opinion. Fairness opinions frequently contain additional disclosures, observations, and assessments concerning the circumstances of, alternatives to, and other key factors surrounding a transaction.
In many cases a fairness opinion reaches beyond the instant economics of a transaction to examine the specific terms and context of a transaction. Valuations are often based on the standard of “fair market value” and are constructed using reasonable assumptions and reflections of a hypothetical and rational universe. When an actual transaction arises between specific parties, the situation often includes attributes specific to the parties and the circumstances – in other words, the real world versus the hypothetical world. A well-crafted fairness opinion reaches beyond the hypothetical to examine and document these real world considerations.
The following is a list (non-comprehensive) of the types of events that could give rise to the need for a fairness opinion. A good rule for decision makers concerning the assessment of need for a fairness opinion is if you suspect that any aspect of a transaction is potentially controversial, then an assessment of fairness to the party in question should be considered. The responsibilities and obligations inherent in the ESOP trustee role is serious business.
Absolutely. Based on Mercer Capital’s experience, events that are potentially controversial, involve a conflict of interest, or involve decisions and actions other than in the ordinary course and timing of business may require a fairness opinion. As with the previous list of events, the following is not all-inclusive. Additionally, most of the following conditions relate to the sale of an ESOP company or the installation of an ESOP.
Despite the breadth of the above events circumstances, there are many other situations which likely accompany ESOP transactions and transactions of ESOP owned companies. Your transactions should be thoroughly reviewed from the financial perspective of the ESOP. The transaction process, evolution, negotiations, and other factors that comprise the event (and any circumstances) should be systematically analyzed and documented within the fairness opinion.
The fairness opinion is a brief document, typically in letter form. However, the supporting work behind the fairness opinion letter can be substantial. This supporting work is often reported and documented in the form of a fairness memorandum that incorporates all material factors, conditions, circumstances, and other considerations which were analyzed, assessed, and disclosed in the development of the opinion. The fairness opinion letter typically makes the affirmative statement that the proposed transaction is fair from the financial perspective of the ESOP.
In the case of a new ESOP or the sale of an ESOP owned company, the fairness exercise virtually always includes a valuation to determine if the ESOP is paying or receiving adequate consideration for the interests it is buying or selling. Generally, the purpose of the valuation is to develop the fair market value of the ownership interest to be transacted. The fairness memorandum also includes all relevant disclosures concerning the transaction, alternatives and potential consequences related to action or inaction regarding the pending transaction, and other assessments that may be specifically requested by the trustee.
In our experience as financial advisors to ESOP trustee, and as an ESOP-owned company, every ESOP situation usually has unique circumstances that require specific assessment. For a confidential discussion about your specific ESOP situation, please contact a Mercer Capital valuation professional.
The establishment of an Employee Stock Ownership Plan (“ESOP”) is a complex process that involves a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan. The process of a business valuation is often new and challenging to first-time clients, so we thought it would be helpful to provide elaboration on Mercer Capital’s valuation process to make the experience less intimidating.
Part of the establishment process is a feasibility analysis to determine whether the company is a good and appropriate candidate for an ESOP. Typically the company engages a number of advisors who coordinate to assist the company and its shareholders in making this determination. A firm that specializes in ESOP implementation is generally hired, as well legal counsel (if the ESOP service firm does not have internal legal resources), an accounting firm, a banker (if there are plans to leverage the ESOP), and an independent Trustee.
An appraisal firm is hired and works with the company and its team of professional advisors to determine the characteristics of the stock held by the Plan and to place a value on the shares. If the company is undecided about whether a plan will actually be implemented and is in the discovery phase of the process, the valuation firm may initially be retained to provide a limited appraisal or valuation calculations and at a later time prepare an appraisal in accordance with the Employee Retirement Income Security Act, the Department of Labor and the Internal Revenue Service guidelines as well as Uniform Standards of Professional Appraisal Practice (“USPAP”).
However, whether the initial estimate of value is a limited appraisal, valuation calculations or a stand-alone appraisal, if the ESOP is eventually implemented there are certain procedures and requirements necessary to develop and prepare a fully documented appraisal that is in compliance with USPAP. The following discussion will provide an overview of the steps necessary to prepare an appraisal.
During the initial introduction, professionals of Mercer Capital will request certain descriptive and financial information (usually recent audits and marketing brochures) to help define the scope of the business in the context of an ESOP appraisal. Defining the project is a critical phase of the valuation, and can be accomplished with telephone and personal visits with the company and its professional advisors, as required.
Once the valuation project has been defined, an Engagement Letter is issued setting forth the key elements of the appraisal assignment. Typical elements included in the letter are the name of the client (usually the Trustee of the Plan), the official name of the entity to be appraised, its state of incorporation or organization, its principal business location and the specific business interests to be appraised. Additionally, the letter will indicate the appropriate standard of value (fair market value), the premise of value (controlling or nonmarketable minority interest), the effective date of the appraisal, and the type of report to be produced. There are three scopes of work, including appraisals, limited appraisals and calculations as defined by the Business Valuation Standards of the American Society of Appraisers.
The Engagement Letter will provide a descriptive project overview, outline the qualifications of the appraiser and set forth the timetable and fee agreement. Accompanying the Engagement Letter is a comprehensive checklist request for information which is forwarded to the company. The information requested includes the company’s historical financial statements and detailed operating and structural information about the business, and the market in which it operates.
Upon execution of the Engagement Letter by the responsible party, including a response to the checklist request for information, Mercer Capital will begin its preliminary analysis of the company, including research and review of appropriate industry data and information sources. As securities analysts, we recognize that an appraisal of common stock represents an assessment of the future at a current point in time. Yet, most of the information available to the analyst is historical information. The future will likely change relative to the past, and we know that management will be largely responsible for making that future happen.
Accordingly, upon review of the checklist and industry information, we will schedule an on-site appointment with management to discuss the operations of the business. Normally, one or two business valuation professionals will visit with management at the headquarters location to:
The Company visit provides an important perspective to the business valuation, since it puts the analyst in direct contact with the individuals responsible for shaping the future performance of the Company. In a very real sense, management’s input will shape the investment decisions to be made by the appraiser in reaching a conclusion of value.
Following the Company visit, the analysis is completed, making specific documented adjustments discussed with management, in context with more subjective conclusions involving the weighting of some factors more than others. Prior to sending a draft report, the valuation analysis and report will be thoroughly reviewed by other in-house analysts to ensure that the initial conclusions are well- reasoned and supportable.
The client’s review of our draft report is an important element in the process. We believe it is important to discuss the appraisal in draft form with management and the Trustee of the ESOP (if one has been appointed at the time of our analysis) to assure factual correctness and to clarify any possible misunderstanding from our company interview.
Upon final review, the valuation report is signed by the major contributing appraiser, and is reproduced in sufficient number for the Plan’s distribution or documentation requirements.
If you are considering an ESOP, or have one already in place, and would like to discuss any valuation issue in confidence, please give us a call. We know that most companies do not run their businesses to be able to immediately respond to an appraiser’s inquiries, but our depth of experience will lead you easily through the valuation process.
ESOP valuation is an increasing concern for Trustees and sponsor companies as many ESOPs have matured financially (ESOP debt retired and shares allocated), demographically (aging participants), and strategically (achieved 100% ownership of the stock).
Given these and other evolving complexities (including the proposed DOL regulation which would designate ESOP appraisers as fiduciaries of the plans they value), it is sometimes necessary or advisable for ESOP Trustees and the Boards of ESOP companies to change their business valuation advisor.
This article addresses why a Trustee or sponsoring company might or should opt for a new appraisal provider, as well as what criteria, questions, and qualities drive the process of selecting a new appraiser.
There are potentially many circumstances and/or motivations that can compel an ESOP Trustee to seek a new valuation advisor.
Some appraisals may subtly (or unintentionally) rely on the upper end of the range of valuation assumptions, thereby compounding a series of seemingly reasonable control treatments or adjustments into an unsupportable valuation conclusion.
Over-valuation can also result from a failure to reasonably modify or abandon control-style treatments over time due to changes in market evidence, economic/financial cycles, or changes in company performance and/or outlook. Has the company’s management and/or non-ESOP shareholders lived up to their end of the bargain by modifying their compensation to comply with valuation treatments applied to develop transaction pricing? If not, how has the appraisal treated the issue?
When the decision has been made to select a new qualified appraiser, it is appropriate for the Trustee to begin an orderly process of interviewing more than one potential valuation expert in order to make an informed decision.
Therefore, Trustees and/or sponsoring companies should consider the following:
The Trustee has a role to play in providing pertinent information to the prospective appraisal firms such that they can understand the proposed project and provide a comprehensive proposal of services. As such, the Trustee should provide the following information to the appraiser candidates:
The Trustee’s selection decision should be based on the overall qualifications of the business appraisal firm. Discussion of the probable valuation outcome during the selection phase could be misleading or taint the process. In cases where a new appraiser serves as a review resource to the Trustee, there could be situations when differences of treatments and methodologies are discussed, as well as the impact that valuation modifications or additions would have on an appraisal issued by the previous appraiser. In such cases, the new appraiser has the burden of independence and credibility and Trustees have the obligation of obtaining the best information and not a predetermined outcome from a change in the appraisal firm. As stated previously, shopping the valuation for a targeted treatment or result is a dangerous endeavor.
The selection process should also be reasonably documented so that the questions of “why was a change necessary?” and “how was the selection process undertaken?” can be answered by the Trustee.
There are risks involved when making the decision to select a new appraiser, including a change in valuation methodology, a possible meaningful change in share value, and the perceived independence of the Trustee (and appraiser) from the perspective of regulators and/or plan participants. Some Trustees are simply averse to the potential backlash or complications that can arise from changing appraisers. However, in many situations, a change is needed and prudent and a lack of change can be viewed as creating or worsening a valuation issue.
The selection process should serve to ensure that the change in appraisers minimizes or mitigates the negative impact on the ESOP, and the ESOP participants (or that a change is accompanied by necessary, long-term considerations, even if a change in the valuation provider results in a meaningful near-term impact on the ESOP) and should be rigorous enough to withstand scrutiny from government regulators and plan participants.
Given the economic uncertainties in recent years, the continuing globalization of markets, the evolution of valuation science, and the growing concern for DOL compliance, Trustees must retain the right and conviction to source valuations from providers that can properly develop and defend their appraisal results.
Originally published in Mercer Capital’s Value Matters(TM) 2011-01, released March 2011
For many business owners, the investment in their company is their most significant asset. Shareholders of closely held businesses, particularly those on the crest of the baby boom wave, are rigorously searching for exit plans to diversify their portfolios and to plan for the next stage of life. It certainly helps if the exit plan is aligned with a compelling estate and tax strategy. In this era of challenging credit conditions and economic uncertainty, interest in Employee Stock Ownership Plans (“ESOPs”) is rising as sellers come to understand the varying opportunities related to transaction financing and to potential tax benefits accorded qualified sellers to ESOPs. One such potential benefit for selling shareholders is the 1042 rollover.
Internal Revenue Code Section 1042 provides beneficial tax treatment on shareholder gains when selling stock to an ESOP. Given certain conditions, capital gains tax can be deferred allowing the full transaction proceeds to be invested in Qualified Replacement Property (“QRP”). Long-term capital gains are recognized upon the liquidation of QRP securities at a future date after a required minimal holding period. If the QRP is not liquidated and becomes an asset of the seller’s estate, it enjoys a stepped up basis and avoids capital gains completely.
In order for the sale of stock to qualify for a 1042 rollover, several requirements must be met:
Qualified replacement property is defined as stocks and bonds of United States operating companies. Government securities do not qualify as replacement properties for ESOPs. The seller must invest in these properties within a 15 month period beginning three months prior to the sale and ending 12 months after the sale. The money that is invested can come from sources other than the sale, as long as that amount does not exceed the proceeds. However, not all of the proceeds have to be reinvested. If the seller chooses to invest less than the sale price, then he or she will have to pay taxes on the amount not invested in QRP. In order to meet the 30% requirement, two or more sellers may combine their sales, provided that the sales are part of a single transaction. The sponsor Company must be a C Corporation for selling the shareholder to qualify for a 1042 rollover.
The shares sold to the ESOP can not be allocated to the ESOP accounts of the seller, the relatives of the seller (except for linear decedents receiving 5% of the stock and who are not treated as more-than-25% shareholder by attribution), or any more-than-25% shareholders.
The current federal capital gains tax is 15%, but if no legislative action is taken, on January 1, 2011, the federal (long-term) capital gains tax will revert to 20%, making the 1042 rollover option more attractive and beneficial to business owners. If an owner with a $2,000,000 basis sells his or her shares for $5,000,000 and realizes a capital gain of $3,000,000, he or she would defer or save $450,000 in capital gains taxes under today’s tax structure. Given no legislative action and a 2011 reversion to previous capital gains rates of 20%, a seller would defer or save $600,000 in federal capital gains tax on the sale as shown below.
If legislative action is taken that results in an even higher capital gains tax rate, a 1042 rollover becomes even more attractive.
Leveraging the sale of stock to the ESOP can provide further financial benefit to the company and its shareholders. Sellers often use all or part of their replacement property as collateral for loans used to finance ESOP purchases. Financing costs are significantly lower for corporations that borrow to purchase owner’s stock for ESOPs than for conventional stock redemption because the corporations are able to deduct the principal and interest payments on the loan when used to purchase ESOP stock. If a corporation is in the 34% tax bracket and borrows $5,000,000 to purchase the ESOP stock, it would save $1,700,000 in federal income taxes. Combined with the $450,000 in savings with the current capital gains tax rate, the federal tax savings would be $2,150,000 or 43% of the selling price. If capital gains tax rates revert to the previous rate of 20%, the total federal tax savings would be $2,300,000 or 46% of the selling price.
Although S Corporations are allowed to have ESOPs, the 1042 rollover option is not available to the shareholders. In most cases, there is a 25% limit on tax-deductible contributions made by employers to ESOPs. C Corporations do not have to count interest payments on ESOP loans as part of the 25% limit, but S Corporations do. There is no required length of time during which a corporation must have C status to receive the benefits of the 1042 rollover, which means that an S Corporation can change its status and receive the differed tax benefits without delay. However, this change in status can have negative tax effects that would cancel out any benefits gained from the 1042 rollover status due to different accounting methods, so a change in status may not always be the best option.
Given the corporate development criterion of most strategic and financial buyers in the markets today, relatively few small-to-medium sized business owners can achieve an exit via a transaction with an external buyer. Throw in the difficulties of financing acquisitions and many shareholders of successful and sustainable businesses may be locked out of certain exit strategies. Increasingly, sellers to ESOPs are financing their own transactions. Before the financial crisis struck, many ESOPs sellers found that continuing business involvement and loan guarantees were required by ESOP lenders. The realization: seller financing in today’s market represents little incremental risk and time than in previous more favorable markets. True, many valuations may be lower than a few years back, but most good ESOP candidates have likely fared better than the markets as a whole. Absent the need for lump sum liquidity, and given a strong and early start to longer-term exit planning, seller-financed ESOPs may be a viable and preferable path for many closely held business owners.
Confused? We’re alluding to taxes – in the context of a nation whose thirst for government spending had been both red and blue in the past ten years and shows little sign of being quenched. The likely result, relentless tax pressures even if significant belt tightening occurs. For those business owners committed to the long-term success of their businesses, concerned about the fate of their employees, and who have a desire for favorable tax treatment in the course of achieving succession and exit planning, the ESOP is a viable alternative. As taxes went down in previous years, so it seems they are going up. As ESOP formation waned in a previous market where external exit opportunities abound and have now collapsed, ESOP formation appears primed to go up. ESOPs represent one of the few exit plans that can be timed and entered into without a change of control. In an increasingly uncertain world, throw in a healthy dose of tax advantages for qualified sellers and it is hard not to view the ESOP with increased interest.
Mercer Capital has over 35 years of experience providing ESOP valuation services and is employee-owned, giving us a unique perspective. For more information or to discuss a valuation issue in confidence, give us a call at 901.685.2120.
Article originally appeared in the September/October 2010 issue of Value Matters(TM).
ESOPs are a recognized exit planning tool for business owners, as well as a vehicle for employees to own stock in their employer company. However, most business owners and their advisors are unfamiliar with how an ESOP works. The mechanics of an ESOP can vary somewhat, but there is a basic common functionality to all ESOPs. Below, we discuss the mechanics of leveraged and non-leveraged ESOPs.
Most ESOPs are leveraged and involve bank financed purchases of either newly issued shares, or more often, the stock of a selling shareholder. The Company funds its ESOP via annual contributions as a qualified retirement plan and the plan effectively uses those funds to repay the debt used for the purchase.
Leveraged ESOPs tend to be more complicated than non-leveraged ESOPs. A leveraged ESOP can be used to inject capital into the Company through the acquisition of newly issued shares of stock. Figure 1 illustrates how the initial leveraged ESOP transaction typically works.
Subsequent to the initial transaction, the Company makes annual tax deductible contributions to the ESOP, which in turn repays the loan. Stock is allocated to the participants’ accounts — just as it is in a non-leveraged ESOP — enabling employees to collect stock or cash when they retire or leave the Company. ESOP participants have accounts within the ESOP to which stock is allocated. Typically, the participant’s stock is acquired by contributions from the Company — the employees do not buy the stock with payroll deductions or make any personal contribution to acquire the stock. An exception to this norm could involve roll-overs of participant’s funds from alternative qualified plans sponsored by the Company. Plan participants generally accumulate account balances and begin a vesting process as defined in the plan. Contributions, either in cash or stock, accumulate in the ESOP until an employee quits, dies, is terminated, or retires. Distributions may be made in a lump sum or installments and may be immediate or deferred. The typical annual flow of funds for a leveraged ESOP is illustrated in Figure 2.
Although non-leveraged ESOPs have certain tax advantages to selling shareholders, they generally tend to be an employee benefit, a vehicle to create new equity, or a way for management to acquire existing shares. The Company establishes an ESOP and either makes annual contributions of cash, which are used to acquire shares of the Company’s stock, or makes annual contributions in stock. These contributions are tax deductible for the Company. As in a leveraged ESOP, the employee/participant vests according to a schedule defined in the plan document, and stock accumulates in the account until the employee/participant leaves the Company or retires. At that time the participant has the right to receive stock equivalent in value of his or her vested interest. Typically, ESOP documents contain a provision called a “put” option, which requires the plan or the Company to purchase the stock from the employee after distribution if there is no public market for it, thus enhancing the liquidity of the shares. Figure 3 illustrates a non-leveraged ESOP.
As ESOP participants roll out of the plan at termination or retirement, the ESOP or the Company purchases the employee’s plan shares based on the terms specified in the plan document. Plan design and administration are crucial to a successful ESOP experience and require the participation of specialized financial and legal advisors.
As with all qualified retirement plans, there are rules and requirements pertaining to annual contribution limits, vesting, share allocation, plan administration, and other functional aspects which are beyond the scope of this overview.
Sellers of stock to an ESOP may enjoy certain tax benefits related to their sale proceeds, and the Company (the sponsor) may enjoy tax benefits related to its contributions to the ESOP. Thus, ESOPs are often postured by business advisors as a tax advantaged exit strategy. Please refer to other articles on Mercer Capital’s website or contact me or Tim Lee for more information.
Mercer Capital is itself an employee-owned firm. We value scores of ESOPs annually and provide fairness opinions and other valuation services on a regular basis to many other plans. To discuss a valuation issues in confidence, give me a call at 901.322.9716.
Reprinted from Mercer Capital’s Value Matters (TM) 2009-03, published March 31, 2009.
The Employee Stock Ownership (ESOP) appraisal utilizes the same tools and techniques of any fair market value appraisal assignment, but with an added emphasis on analyst expertise in understanding the market, the economy, and the underlying business model for the subject company. The ESOP appraisal has the added sensitivity of the Plan participants and trustees who don’t like to see the value of allocated shares reflect a decline on the annual plan account statements, especially if it’s at redemption time.
We all recognize that in the real world, stocks frequently do decline in value, and closely held ESOP shares should be no exception. However, the appraiser of ESOP shares is in a unique position to interpret market, industry, and company performance in the context of a fair market value appraisal. This analysis is even more important for a cyclical company, where sales and earnings declines are expected but seldom forecast. As appraisers, we frequently utilize the tool of average or weighted average earnings in context with a specific company risk premium and earnings growth rate to develop a capitalization rate, or multiple of ongoing earnings. For an annual ESOP appraisal update, the use of average or weighted average earnings can work against the reality of the situation, and it is here that the analyst must have a firm grasp on the underlying trajectory of earnings as the subject company
navigates through the down cycle, in anticipation of the expected, but unknown, upside.
Consider the case of Cyclical Growth Company, Inc., (“CGC or the “Company”), a large manufacturer of industrial products, subject to normal business cycle fluctuations. The eight year summary of operations shown in Figure One reflects the peak of the last cycle and the recovery to date in 2006.
During the period 1999 – 2001, earnings are advancing but not at an accelerating rate, and appear in line with management’s expectation of a long term growth rate approximating 5%. With the benefit of hindsight, we know that 2001 was the peak of the cycle, we just don’t know that for the 2001 appraisal.
Accordingly, a reasonable derivation of the capitalization factor by means of the Adjusted Capital Asset Pricing Model during this time period may include using a 3% specific company risk premium and a 5% sustainable growth rate in earning power. As shown in Figure Two, this results in a multiple of earnings at 7.90x for 2001, applicable to ongoing earnings power.
When applied to the ongoing earning power of CGC, based on 5-year average earnings, a value of $21.75 per share is indicated. Again, this was the peak of the cycle, we just don’t know that yet.
By 2002, it is evident that this is the first year of the downturn. As shown in Figure One, earnings approximate one-third of prior levels and sales are down substantially. The Company is able to maintain about the same gross margin as in the prior year, but the cut in SG&A expenses is not enough to avoid an operating margin at about half of the peak (2001) year, although profitability is maintained. Specific company risk has not changed, although interest rates are now lower in the recession. Since the length and depth of the downturn are unknown, and the average earnings analysis has produced ongoing earnings of $2.5 million (versus reported earnings of $1.2 million), it may still be reasonable to expect a long term growth rate of earnings at 5%, resulting in only a modest decline in value compared to 2001.
By 2003, it is clear that the recession and decline in sales and earnings are for real. Reported earnings are now about half of 2002 and approximate about 16% of the peak (2001) year, although still profitable. The length and depth of the recession are still unknown, but recent history tells us that recessions are shorter than expansionary phases. The 5-year average earnings analysis still provides some moderation to ongoing earnings (now assuming a reasonable recovery). With the specific company risk premium unchanged, and given the underlying growth rate of earnings approximating 5%, it may now be feasible to assume that with earnings acceleration upon the recovery, the long term growth rate of earnings for the determination of a single-point capitalization rate may be 7%. This results in a higher multiple on lower earnings, which is exactly what the market would typically do if the Company were publicly traded.
By 2004, the sales decline has now ended, but profitability has not fully recovered, as the Company has maintained sales with lower margin products, and boosted SG&A expenses back to the 2002 – 2001 level. The operating margin at 3.6% is the lowest in the last six years, and earnings at $620,000 matches 2003’s performance, Management may have a feel for a prospective, but undefined recovery at this point, but we will not know that this is the nadir of the cycle until we can look back on it. Given the relatively low ongoing earnings based on the 5-year average earnings analysis, in context with a prospective, but undefined recovery, it may be reasonable to boost the growth rate of earnings to 8% for 2004, anticipating a recovery by 2005.
By 2006, the recovery is clearly in place, with sales and earnings greater than expected. The gross margin has improved to its highest level, exceeding the peak in 2002 – 2001. Operating expenses have increased too, with additional catch-up bonuses to employees who sought to maintain market share in the recession. The operating margin now approximates the peak in 2001. Earnings are at the highest level ever, at $4.3 million. With the Company clearly beyond the recession, it may be time to modify the average earnings analysis to a 3-year average, which picks up the two recovery years, but tempers that with the last diminutive year of the recession. From this recovery earnings level, the earnings growth rate as a component of the capitalization rate is no longer 8%, but can reasonably be expected to achieve the 5% projected by management.
During the economic cycle described, the Company has experienced significant changes in financial performance. While consistency is important in an ESOP appraisal, the analyst need not be crucified on the cross of consistency. Given the modest changes in interest rates, and a constant specific company risk premium, the key variables here involve the growth rate of earnings and the average earnings base (ongoing earnings) to which the capitalization multiple is applied. It is at this decisive analytical juncture that the seasoned analyst has an edge: experience counts. Experience with the variance of market cycles and the nature of equipment manufacturers during different phases of the economic cycle, in context with the legacy experience in the analysis of the Company and its management all comes together to provide an analytical perspective allowing the adjustment (and defense!) of key benchmarks in the multiple and the ongoing earnings to which it is applied. A summary of the capitalization of earnings approach since the peak in 2001 is shown in Figure Two.
In the case of Cyclical Growth Company, Inc., the analysis has reflected the reality of the marketplace at key junctures in the economic cycle. While the future is uncertain during the freefall part of the cycle, the averaging of earnings provides some moderation to the decline (assuming, of course, that earnings actually will recover). Moderating the growth rate at the proper time, based on experience, assigns a higher multiple to lower earnings, which is exactly what the public market does. Finally, with the recovery in place, a re-adjustment of the growth rate of earnings and the averaging process results in a reasonable assessment of the future at the valuation date. From the ESOP participant’s point of view, the per share value declined only modestly over three years, but not nearly as severely as the decline in earnings for those years, and the value upon recovery exceeds the prior peak in 2001.
If you need the experience of a seasoned analytical team to define and defend the appraisal of your ESOP, or for other business valuation resources, please give us a call at Mercer Capital to discuss your specific requirements in confidence.
Reprinted from Mercer Capital’s Transaction Advisor, Vol. 10, No. 2, September 2007.