Middle market transactions are defined as deals valued between $2-$250 million. There is very little information available on these deals to enable a potential selling owner to know what is involved in the sale process. Correspondingly, prospective sellers are often under numerous misconceptions that can be harmful. During my many years in acquisitions, I have talked to thousands of owners/entrepreneurs. From these conversations I have determined that the following seven pitfalls are the most common erroneous beliefs of middle market owners.
The answers to the following questions should correct these misconceptions.
1.Is a valuation basically a "numbers crunching" process? Nothing could be further from the truth. A properly conducted valuation involves the complete investigation of a company's business foundation. It includes defining the company's future opportunities and major risks along with their projected impact. The following factors must be evaluated during this process:
A. The strength of the company's marketing program, including the diversity and control of its customer base.
B. For manufacturing companies, the ability to produce a high-quality, low-cost product, and the caliber and productivity of its research and development function.
C. For distribution or service businesses, the demographics of its trading area, the quality of its product and/or service line, the attractiveness of its locations and the ability to run its operation on a cost-effective basis.
D. The quality of the management team and the presence of a reasonably-paid, well-motivated work force.
These factors become a prime determinant of the multiple to apply to the company's expected future earnings.
2. Will planning and timing the sale of a company increase the transaction price?
Prudence dictates that a selling owner plans and times the sale to maximize the transaction price. As part of the planning process, all factors defined in Question 1 are evaluated and suggestions are made to strengthen the business foundation. The solidifying of the business foundation will increase the transaction price. In addition, the planning of the sale will enable a company to be prepared to "go to market" at the appropriate time to generate the maximum price. It also enables an owner to be capable of responding intelligently to the unsolicited interest of a prospective acquirer.
3. Is the deal fundamentally completed when a preliminary price is established at the letter of intent (LOI)?
In fact, the execution of an LOI is merely the start of the negotiating process. Unless you have a sophisticated, experienced advisory firm that has a strong personality and the ability to control the deal, it is not unusual for an acquirer to demand a price reduction between the LOI and the closing. You must make sure that an acquirer knows that will never be productive. The negotiation of the Definitive Purchase Agreement (DPA) is a difficult, confrontational and time-consuming process. The DPA includes all the critical representations, warranties and indemnifications that are of potentially equal financial importance to the deal price itself. If they are not negotiated to provide the seller maximum protection, it can give the acquirer a post-closing opportunity to recover a considerable portion of a seller's deal proceeds.
4. Should owners only sell their company when they are at or near the end of their business career?
The answer is definitely no. Most owners don't understand many of the benefits that can arise from a sale. Usually owners of closely-held corporations have a vast majority of their personal wealth concentrated in the business. In and of itself, this is poor financial planning, but it is a typical by-product of owning a closely-held corporation. By selling all or part of the company, owners can reduce their concentration of wealth in the business. In addition, it puts their estate in more liquid condition. I have advised many younger owners recently in the sale of their business, who have wanted to put their financial condition in that shape. They also wanted to enjoy the finer points of life for a few years, while still in prime health. After their covenant-not-to-compete expires, which could occur after a five-year period, they can get back in business. However, they will commit only a small portion of their sale proceeds to the new business endeavor. This will assure that they have lifetime financial security. They will be refreshed and might be eager to pursue a new business endeavor. From a personal standpoint, this is a very attractive alternative for a number of owners.
Where owners merely want to reduce their concentration of wealth in the business, but still want to run the company, a recapitalization with a private equity firm might be the answer. In this type of situation, a selling owner can get approximately 90% of the deal value while still retaining a 30% interest in the recapitalized company. As most private equity firms strongly prefer management to stay, the selling owner should be able to continue to run his business in basically an unfettered manner. The only thing likely to change is that the owner will now report to a Board of Directors. However the owner will still determine the company's strategic course. For an owner that wants to pursue this alternative, it is essential that he finds the right private equity firm. Only a few private equity firms are price-aggressive and pay a price comparable to a strategic acquirer. Certain of these firms might have companies in their portfolio that are a strategic fit with the seller. This should enable them to pay a price comparable to a strategic acquirer. An experienced advisory firm will know if a recapitalization makes sense for the owner. The advisory firm also should know which private equity firms historically pay a strong price.
5. Do private equity firms usually pay a fair price for a company?
Most, but not all, private equity firms pay substandard prices for companies. These firms typically pay a price 15-30% below a strategic acquirer's. Therefore your advisor should only deal with the few private equity firms that have historically paid prices comparable to a strategic acquirer. In general, if an owner wants to primarily sell the company to get out of the business, the most logical buyer is the pure strategic acquirer.
6. Should a selling owner have to accept notes as part of the transaction proceeds?
Many unsophisticated people and advisory firms, which are not overly concerned about maximizing their client's interests, believe that acquirers will always want a seller to take back a significant portion of the purchase price in notes. They rationalize that an acquirer needs this as protection against legitimate hidden problems that might be uncovered after the business is sold, and because growth-oriented companies must use all available leverage to fund future expansion. However, this is nonsense. When an individual sells their company, they have the right to receive their proceeds in cash except for the equity portion retained in a recapitalization.
7. Should a selling owner employ special legal counsel to handle their transaction?
It all depends on the sophistication of the seller's present law firm. If it is a large firm that has specialists in the critical areas of environmental law, human resources, intellectual property, corporate finance, and certain other areas, it might be appropriate to retain the current counsel for the transaction. However if the seller presently utilizes a smaller law firm of fundamentally generalist attorneys, they want to employ new counsel that has specialists in the numerous functional areas to advise them in the transaction. If the seller employs a sophisticated advisory firm that will direct the deal negotiations, it is often advisable to allow the advisory firm to bring in a large, experienced law firm with whom they are familiar. This will ensure a blending of compatible negotiating styles with people that are familiar with each other's negotiating style and skills. This will be a significant asset to the seller during negotiations.
Owners that avoid these pitfalls should be able to sell their company at an aggressive premium price with only limited, if any, exposure to post-closing issues.
George Spilka is president of George Spilka and Associates, a Pittsburgh-based merger and acquisition consulting firm that specializes in middle market, closely-held corporations. This is his second article on sales and acquisitions in ID Access. Visit his website at http://www.georgespilka.com
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