Posts Categorized: Sellers

Lower Middle Market Too Hot to Touch

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Article written by Danielle Fugazy | May 17, 2018 and provided courtesy of Axial.net

The M&A market as a whole remains white hot and the lower middle market is no exception. Sellers are undoubtedly benefiting from today’s strong market conditions. “The market is as robust as it’s ever been. We are seeing high valuations. Average purchase price multiples are at at an all-time high in mid seven times EBITDA,” says Graeme Frazier, president of Private Capital Research LLC and a founder of GF Data, a data provider that tracks companies with enterprise values of  $10 million to $250 million. “Even rising interest rates are not quelling demand.”

There are multiple factors leading to the frenzied deal pace in the lower middle market. First, there’s a tremendous amount of capital in the market. The abundance of dry powder has been well documented over the years. Second, the lending markets are feeding the frenzy. According to GF Data, debt multiples have reached a total of 4.2 times EBITDA and on the senior side they have inched up to 3.4 times EBITDA in the lower middle market. “It’s not a record, but there is sustained strength in the lending market for sure,” says Frazier.

Robin Engleson, a managing partner with Sapphire Financial, which provides debt and equity to middle and lower middle market companies, says it’s the combination of both the dry powder and equity available fueling activity. “You have an abundance of debt, and buyers are willing to over equitize these transactions today. Today, lower middle market companies that have a reasonable story have a good shot of getting the highest valuations they could ever get,” she says.

Additionally, some of the frothiness in the lower middle market can be attributed to larger buyout firms and strategic acquirers—perhaps priced out of their own markets—coming down market to find good deals. One of the main reasons private equity firms look down market is to average out their cost of capital. After buying a platform company at a high valuation they more frequently move down market to find add-on opportunities at a better price to average down their costs. According to Pitchbook, as of Q2 2018 roughly half of all buyouts globally and more than two-thirds of all buyouts in the U.S. are add-ons. In the first quarter alone add-ons accounted for 70 percent of all buyout activity.

“You are seeing a lot of traditional middle market sponsors compete in the lower middle market.  Valuations are high for good middle market platform companies and so they’ve entered the lower middle market to find a company that can serve as a buy-and-build platform,” says Dan Lipson, a partner with Rotunda Capital, a Washington, DC-based private equity firm. “With more resources dedicated towards business development, either through internal staff or external buyside firms, traditional middle market sponsors feel comfortable they can deploy an adequate amount of equity capital through an add-on acquisition strategy even when starting with a lower middle market platform. It’s given growth to companies like Axial and the role of the business development professional.”

Moving  away from financial engineering and organic growth, it’s clear that the buy and build strategy have become one of the most common value creation tactics today. According to Pitchbook, it’s most frequently used in sectors that are highly fragmented like healthcare and education.

As a result of the strong market dynamics at play even less attractive deals are starting to get more attention. “The higher quality deals get done at a premium. Even deals that aren’t above average are starting to get bid up. The quality premium is narrowing. This is when things can start to get ugly. During a downturn your higher quality assets will weather the storm. Assets that are of lesser quality will have difficulty,” warns Frazier. “We see the IRRs they are modeling and unless they are able to grow these assets fast, it’s going to be challenge to make the return on capital with the high valuations that were paid or make it through lean times.”

Waiting for things to turn

Many typical lower middle market investors continue to wait on the sidelines for valuations to come down. “It’s a competitive market. Everyone’s look-to-bid and bid-to-close ratio is lower. We look at a lot of attractive companies, but we constantly push ourselves to remain disciplined. Unfortunately that means we are sometimes passing on companies in auction simply because we know the market clearing price is beyond what we’re willing pay,” says Lipson. “It’s not an easy market to be a buyer. When you’re paying full value, you have to have to be very focused and confident that you can execute your value creation strategy.”

Jeff Kadlic, a founder of Evolution Capital Partners, a lower middle market private equity firm, agrees that it is hard to compete in today’s market. “The larger funds are just so well capitalized that they don’t even need financing contingencies to close acquisitions in the lower end of the market, so it’s an attractive offer as a seller. The valuations for growth have become eye popping,” he says.

Hunter Street Partners, a firm that provides opportunistic debt and equity to the lower middle market, is looking to target areas where they feel there are pockets of dislocation. “We are looking for good companies with stressed balance sheets. There is not a lot of distress yet, but frothiness leads to dislocation. Although tough to predict when dislocations will increase, we are positioned to further take advantage of them as they occur,” says Neal Johnson, CEO and founder of the firm.

Despite feeling like the market is at the top or close to it, market professionals don’t see anything on the horizon that will change market conditions anytime soon. “There’s no sign of a slow down. We are seeing a lack of good target companies, but there’s nothing to make us believe that demand for lower middle market companies will slow. It’s certainly a compelling market to be a seller,” says Frazier.

Frazier also suggests that the growth of the private lending industry in the lower middle market could be a red flag, but says even that is only fueling demand. “After traditional banks had their wings clipped finance companies came in to fill the void. The underwriting standards can become relaxed, just like they did in the last cycle, but still we have no reason to believe things won’t continue as they are. There’s no fundamental reason for them to stop.”

Sapphire’s Engleson says she is seeing creative lending structures put in place to help boost returns from lower middle market companies. “As soon as lower middle market companies reach a certain threshold, their valuation multiples go up. This has always been true, but the increase is more significant now. Buyers are entertaining the purchase of smaller and smaller companies as combining them and bringing them to that next level today can mean increasing their value from five to six times EBITDA to 10 times EBITDA. This scenario is happening a lot more frequently. It’s a great time to be a seller.”

 

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How To Use EBITDA For The Valuation Of Your Small Business

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Article written by Jeffrey Kadlic Evolution Capital Partners and provided courtesy of Axial

Selling a business can be a difficult decision for entrepreneurs to make, both on an emotional and financial level. There are a number of factors that come into play when determining an appropriate asking price, including competitive advantages, growth opportunities, and historic financial performance.

However, one valuation metric in particular — EBITDA — can be a great starting point in measuring a company’s potential value in a sale. Before sitting down with prospective buyers or investors, small business owners should understand how this valuation metric will be used to calculate the worth of their company.

What is EBITDA?
EBITDA — or earnings before interest, tax, depreciation, and amortization — is an indicator commonly used by prospective buyers or investors to measure a company’s financial performance.

In its simplest form, EBITDA is calculated by adding the non-cash expenses of depreciation and amortization back to a company’s operating income. Below is the basic formula:

EBITDA = Operating Profit (EBIT) + Depreciation (D) + Amortization (A)

By eliminating the non-operating effects that are unique to each business, EBITDA can help balance the scales by focusing on operating profitability as a singular measure of performance. This is particularly important when comparing similar companies across a variety of industries or different tax brackets.

EBITDA as a Valuation Metric
As a key factor of a successful sale, small-business owners should have a clear understanding of how prospective buyers or investors will determine the value of their business. More often than not, that valuation comes down to a multiple of the company’s earnings.

On its own, EBITDA makes for a relatively futile statistic. After all, there is good reason behind the depreciation and amortization of assets. Simply adding those non-cash expenses back to a company’s net income can paint a misleading picture of its financial performance.

That’s where the need for adjustments comes in. Because EBITDA is a non-GAAP figure, prospective buyers or investors are at the discretion of a business to decide what is, and is not, included in the calculation. For instance, one might devalue tangible assets such as old equipment and add intangible assets like management and employees. As such, companies tend to adjust the included items from one reporting period to the next.

However, it’s important to understand the limitations of EBITDA. Although it’s often used as a proxy for evaluating the earning potential of a business, EBITDA cannot measure cash flow — it strips out the cash required to fund working capital and equipment upgrades.

Because EBITDA is almost always higher than reported net income, it is often used by businesses as an accounting gimmick to “window dress” their profitability. It also doesn’t take into account a company’s growth potential and customer base.

Therefore, small-business owners should be sure to analyze EBITDA in conjunction with other important factors, such as capital expenditures, changes in working capital requirements, debt payments, and net income.

Using EBITDA to Strike a Deal
If a company is in a high-growth market, it can expect a significant acquisition premium — a buyout offer that is several times more than its most recent EBITDA. Generally, the multiple used is about four to six times EBITDA.

However, prospective buyers and investors will push for a lower valuation — for instance, by using an average of the company’s EBITDA over the past few years as a base number.

In order to ensure the highest valuation, small-business owners will need to boost their company’s overall financial performance. As a starting point, the focus should be on preparing high-quality financial statements.

If a company’s financials are poorly done, it sends the signal that there is a lack of competency and/or knowledge of the business. From a value perspective, thorough numbers also greatly reduce the risk of missing an item that might work in favor of the buyer and, thus, lower the company’s valuation.

In addition, making the right changes — such as cutting unprofitable costs, increasing sales, or reaching new markets — can also have a significant impact on a company’s EBITDA.

That said, it can still be difficult for a company and the prospective buyer to reach an agreement on a purchase price — otherwise known as a “valuation gap.” In this case, a small-business owner will need to prove that its ROI and growth potential justifies a higher EBITDA multiple.

This can be achieved by developing a solid strategic plan that will help showcase the background and performance of a company. In turn, small-business owners will need to find facts or data that support the story they are trying to communicate to prospective buyers or investors.

 

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2018 Trends in Middle Market Restaurant and Food Franchise Capital Markets

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By Nora Zhou Author, Axial

2017 saw a lot of activity in the middle market restaurant and food franchise industry. We spoke with two experts from BBVA Compass about market forces impacting the space and expectations for 2018.  “Refranchising [editor’s note: the sale by brand owner of corporate-owned units to franchisees] by the big franchisors has been a primary driver of M&A activity in the restaurant sector for the past seven or eight years,” said James Short, Director of Food Franchise Finance at BBVA Compass. “Jack In The Box Corp was probably the first that did it. Taco Bell, Burger King, Wendy’s, many different large brands have sold company stores to franchisees.”

By doing this, franchisors have created what’s dubbed as an “asset-light” model. Short said, “They are able to cut out of a lot of expenses, and their capital expenditures go down substantially because they’re no longer running the restaurants.  This almost always results in improved cash flow margins for the franchisor”

An inflow of private equity investors into the space has also boosted M&A volume in the space, said Kevin Fretz, Senior Vice President at BBVA Compass. He said private equity investors often find better returns within the restaurant sector because there is a perceived risk premium relative to similar-sized general industry companies. Short noted that an average private equity group seeks to make approximately a 20% equity return in the restaurant sector. The larger private equity firms tend to acquire the entire brand and hold on their books for their prescribed investment horizon, often five to seven years, Fretz added. Family offices are also an active group in the food and franchise sector. According to Fretz, unlike larger PE firms, family offices often hold such assets longer. And instead of acquiring a brand, they frequently acquire mid-sized franchisees, often driven by investment size limitations.

Speaking of what incentivizes family offices to invest in this sector, “The answer is often the same as for the larger firms,” Fretz said. “They’ve got a pool of money they have to invest, and the investors expect a certain return, and the commercial & industrial market generally isn’t generating those returns for a similar-sized investment, so they look to that next higher riskhigher reward sector, and find food franchise.”

One thing family office and PE investors have in common is that they both are often targeting large, national brands and they are focusing on the ability to scale, said Short.

“I think most [PE firms and family offices] are looking to acquire, at a minimum, 20 units at a time versus trying to do one-offs. They’re looking to pick up a whole market and gain some economy to scale,” said Short.

Due to confidentiality, Fretz and Short weren’t able to share specifics of deals done by family offices, but they said JAB Holding’s $7.5bn acquisition of Panera Bread in April 2017 was one of the most notable deals of the year. JAB Holdings is a German private equity investor and also the owner of Caribou Coffee and Peet’s Coffee & Tea.

In terms of the predictions for 2018, Short said that the M&A deals that may happen in 2018 will likely be more geared toward franchisee to franchisee, versus a refranchising event, and the overall M&A level will likely moderate somewhat, due to expected multiple incremental interest rate hikes.

“There were three interest rate increases in 2017 by the Fed and we’re expecting three or four in 2018. So as the cost to capital continues to increase, it’s very likely that lending is going to slow down a bit,” Short said. “In addition, a lot of brands are wrapping up their refranchising efforts. Burger King is completely done, Wendy’s is basically done refranchising, and most of these large brands are now at their desired ratio of company-run stores to franchise stores.”

Fretz added that a higher cost of debt will not only slow down the rate of capital expenditures, it will also likely suppress purchase multiples, “because it will not be possible to layer as much debt against a given amount of equity and maintain a certain WACC, or the debt-to-equity equation will shift because that cost to capital will be higher. This  equation should ultimately drive a commensurate decrease in purchase multiples absent more investable equity for a given transaction”

Short noted that the multiples on the acquisition of an entire brand have generally ranged between 6 times and 20 times, while the multiples for acquisitions between franchisees generally range from 4.5 times to 8 times, dependent on concept and size of operator. As for the difference in numbers, Fretz explained that “as a franchisee you are somewhat constrained as to what efficiencies can possibly be squeezed out of that operation from a cash flow margin perspective. You’re ultimately bound by the limitations of the brand itself. Whereas, if you own the brand, I think your opportunity for growth and improvements in efficiencies is perceived as almost limitless.”

Both Fretz and Short think 2018 will be another busy year for the food franchise sector with continued robust transaction volume, although likely focused more within franchisees and local and regional-size brands, and likely at multiples somewhat moderated from what have been seen the past couple years for reasons mentioned previously.

 

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How To Lure A Giant Like Facebook Into Buying Your Company

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A great business is bought, not sold, so, if you look too eager to sell your business, you’ll be negotiating on the back foot and look desperate—a recipe for a bad exit.

But, what if you really want to sell? Maybe you’ve got a new idea for a business you want to start or your health is suffering. Then what?

As with many things in life, the secret may be a simple tweak in your vocabulary. Instead of approaching an acquirer to see if they would be interested in buying your business, approach the same company with an offer to partner with them.

Entering into a partnership discussion with a would-be acquirer is a great way for them to discover your strategic assets, because most partnership discussions start with a summary of each company’s strengths and future objectives. As you reveal your aspirations to one another, a savvy buyer will often realize there is more to be gained from simply buying your business than partnering with it.

Facebook Buys Ozlo

For example, look at how Charles Jolley played the sale of Ozlo, the company he created to make a better digital assistant. The market for digital assistants is booming. Apple has Siri, Amazon has Alexa and the Google Home device now has Google Assistant built right in.

Jolley started Ozlo with the vision of building a better digital assistant. By 2016, he believed Ozlo had technology superior to that of Apple, Amazon or Google. Realizing his technology needed a big company to distribute it, he started to think about potential acquirers. He developed a long list, but instead of approaching them to buy Ozlo, he suggested they consider partnering with him to distribute Ozlo.

He met with many of the brand-name technology companies in Silicon Valley, including Facebook, which wanted a better digital assistant embedded within its messaging platform. They took a meeting with Jolley under the guise of a potential partnership, but the conversation quickly moved from “partnering with” to “acquiring” Ozlo.

Jolley then approached his other potential partners indicating his conversations with Facebook had moved in a different direction and that he would be entering acquisition talks with Facebook. Hearing Facebook wanted the technology for themselves, some of Jolley’s other potential “partners” also joined the bidding war to acquire Ozlo.

After a competitive process, Facebook offered Jolley a deal he couldn’t refuse, and they closed on a deal in July 2017. Jolley got the deal he wanted in part because he was negotiating from the position of a strong potential partner, rather than a desperate owner just looking to sell.

 

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What Do Buyers Look for in the Lower Middle Market?

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For owners looking to sell their businesses, it can be hard to know what buyers find attractive. This is particularly true in the lower middle market.

In my work in the exit planning industry, I’ve seen countless owners struggle to pin down what will make their business valuable to potential acquirers.

I asked two experienced investment bankers for their thoughts. Tom Majcher of Majcher Group, LLC focuses on sell-side representation in the $5 million to $25 million range — i.e., the lower end of the lower middle market. Kevin Short of Clayton Capital Partners works with businesses with $2 million to $10 million of EBITDA, most with value exceeding $25 million.

Who are the buyers in this market?

Tom: In this lower range of business value, there are a lot of financial buyers, private money, and search fund advisors. The latter are (often young) entrepreneurs with limited experience but adequate financial backing from investors. There are few strategic buyers for companies in this value range.

Kevin: Strategic buyers are usually not interested in companies in Tom’s market because they want to acquire companies that “move the needle” for them. Depending on the characteristics of an owner’s business, strategic buyers, financial buyers and private equity firms will all be potential buyers.

What are buyers looking for?

Tom: To owners who want sell their companies to third parties, I review with them the attributes of camera- or transaction-ready companies that buyers expect. These attributes include:

  • A strong management team (apart from the owner) that is properly incented and is prevented, via employment agreements, from competing against the company should they terminate employment.
  • Stability and predictability of revenue and cash flow
  • Low customer concentration
  • Other value drivers such as state-of-the-art operating systems

Kevin: I agree with Tom, but in the $2MM to $10MM EBITDA range, buyers are also looking for a high level of preparedness. Buyers are laser-focused on the quality of the management team and level of customer concentration.

What’s the biggest obstacle for owners in this segment of the market?

Tom: That’s easy: the owners themselves. Too often they negotiate directly with potential buyers who are much more sophisticated and knowledgeable about the sale process, and who use experienced deal attorneys and investment bankers. To overcome this obstacle, it is critical that these owners level the playing field by retaining experienced deal attorneys and investment bankers before they talk to any buyer.

The second biggest obstacle is the business. Most are not camera-ready because it takes time, talent, and commitment to prepare a business for sale. Before a company goes to market, owners and their advisor teams must have executed their plans to enhance all value drivers. When advisor teams include a transaction advisor (business broker or investment banker), that person not only shares knowledge of the sale process, but contributes real world knowledge of what buyers are looking for.

Kevin: Most private equity firms do not have a management team waiting in the wings. If an owner’s team is not top-notch both professionally and personally, a private equity/financial buyer will either pass or subject management to a rigorous professional assessment and background check. Clearly, it behooves owners to run background checks on all their important employees long before going to market.

When a company in the $10MM to $100M+ range lacks a stellar management team or has a customer concentration issue, a strategic buyer may be a solution. Often, strategic buyers are not as concerned with high customer concentration because their existing customer base spreads the risk. Similarly, they may already have experienced, proven management poised to fill any void caused by the seller’s departure.

How does an owner attract a strategic buyer?

Kevin: The most effective, least time-consuming way of doing so is to work with an experienced investment banking firm to conduct a controlled auction sale process. By bringing multiple competing buyers to the table simultaneously, the controlled (or competitive) auction maximizes a seller’s chances of receiving top dollar and closing the deal. An experienced investment banker will know how to attract the best strategic buyers without disclosing the identity of the seller.

How are buyers behaving in the marketplace today?

Kevin: Buyers are offering companies with $2 million to $10 million in EBITDA increased EBITDA multiples over historical norms. This not only means more money for sellers, but also significantly more scrutiny in the form of due diligence. The reason for the greater scrutiny is the greater risk financial buyers/private equity incur when they have to pay more and invest more of their own capital. I’m seeing financial buyers/private equity groups spending more than $1 million on due diligence alone.

This article written by John Brown, Founder of BEI and provided courtesy of Axial.net

 

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One Tweak That Can (Instantly) Add Millions To The Value Of Your Business

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If you’re trying to figure out what your business might be worth, it’s helpful to consider what acquirers are paying for companies like yours these days.

A little internet research will probably reveal that a business like yours trades for a multiple of your pre-tax profit, which is Sellers Discretionary Earnings (SDE) for a small business and Earnings Before Interest Taxes, Depreciation and Amortization (EBITDA) for a slightly larger business.

Obsessing Over Your Multiple

This multiple can transfix entrepreneurs. Many owners want to know their multiple and how they can jack it up. After all, if your business has $500,000 in profit, and it trades for four times profit, it’s worth $2 million; if the same business trades for eight times profit, it’s worth $4 million.

Obviously, your multiple will have a profound impact on the haul you take from the sale of your business, but there is another number worthy of your consideration as well: the number your multiple is multiplying.

How Profitability Is Open To Interpretation

Most entrepreneurs think of profit as an objective measure, calculated by an accountant, but when it comes to the sale of your business, profit is far from objective. Your profit will go through a set of “adjustments” designed to estimate how profitable your business will be under a new owner.

This process of adjusting—and how you defend these adjustments to an acquirer—is where you can dramatically spike your company’s value.

Let’s take a simple example to illustrate. Imagine you run a company with $3 million in revenue and you pay yourself a salary of $200,000 a year. Further, let’s assume you could get a competent manager to run your business as a division of an acquirer for $100,000 per year. You could safely make the case to an acquirer that under their ownership, your business would generate an extra $100,000 in profit. If they are paying you five times profit for your business, that one adjustment has the potential to earn you an extra $500,000.

You should be able to make a case for several adjustments that will boost your profit and, by extension, the value of your business. This is more art than science, and you need to be prepared to defend your case for each adjustment. It is important that you make a good case for how profitable your business will be in the hands of an acquirer.

Some of the most common adjustments relate to rent (common if you own the building your company operates from and your company is paying higher-than-market rent), start–up costs, one-off lawsuits or insurance claims and one-time professional services fees.

Your multiple is important, but the subjective art of adjusting your EBITDA is where a lot of extra money can be made when selling your business.

 

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How Third-Party Due Diligence Can Help You Uncover Future Earnings Potential

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By Kay Cruse Strategex | January 31, 2018

In due diligence for earnings and legal issues, best practice dictates the use of a highly qualified, third-party assessment.  So, why not take the same path when it comes to validating the qualitative elements that support the earnings history?

More importantly, if you had the opportunity to provide an assessment of future earnings in the same diligence exercise, how much more value could that provide to your deal assessment?

QofE looks at past financial performance.  Many times, we’re asked if there’s a way to document future earnings potential.  The short answer:  absolutely there is.

With few exceptions, in a third-party-assisted, detailed customer due diligence initiative, we are able to not only identify the potential for future spendbut importantly how customers believe the company ranks as their preferred supplier.  By extrapolating rank and future spend and comparing it to the target’s company’s share of wallet at the customer – something that QofE can’t find – one can build a pretty detailed picture of the future financials of a potential acquisition.

Coupled with how the company compares competitively – do they lead or lag competition – you’re on your way to identify future earnings, and also create a reasonable roadmap of potential hurdles that the newly acquired company will have.

What additional value does a third party bring?

Firstly, a professional research-interviewer is able to have an engaging and non-threatening conversation about the target company without ever having to mention that a deal is pending.   They can dig into key questions, such as:

  • What are the company’s top strengths?
  • What are its top areas of improvement?
  • Why does the customer buy from the company?
  • How does the company perform across a wide variety of customer-valued measures?
  • What would the customer most like to see the company provide or innovate to solve underserved or unmet customer or market needs?

As important as the interviews themselves are, the most important element of a third-party’s customer diligence is the ability to pull together a complete analysis of both qualitative and quantitative findings.  This enables you to construct a strategy that is more fact-based and unencumbered by conjecture and preconceived theses.

In short, the value of third-party research is to have thorough conversations where there is no preconceived agenda. This helps you build a deep and clear understanding of what the company needs to do in order to have a more satisfied and loyal customer and what actions need to be taken to expand on growth and opportunity.

Who wins in this approach? Everyone: the target company learns from the Voice of the Customer what they need to do to accelerate growth and opportunity; the acquirer begins to have an intimate and detailed understanding of not only the target company but also of its customers in order to prioritize a 100-day integration strategy upon close; and lastly, the customer whose voice was heard and whose needs will be met.  We have found this approach often takes the sting and fear of a shift in ownership off the table.  It’s a great way to turn the page on a new beginning for both the acquired and the acquirer.

 

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Deriving Normalized EBITDA for Your Business

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We recently wrote an article about the dangers of failing to properly document business meal and other entertainment expenses. The piece raised quite a few concerns among business owners.

The question we most often heard usually went something like this, “Wait, I thought personal expenses like meals, travel, and entertainment could be normalized…what gives?” Answers to questions such as these, unfortunately, are never straightforward and true standards for deriving normalized EBITDA calculations don’t exist.

First, a quick refresher on EBITDA for anyone who reads it: EBITDA is a basic and widely accepted normalizing adjustment for businesses that tends to serve as a proxy for cash flow when deriving a value for the business. This measure adds expenses from the income statement like interest, corporate income taxes, and depreciation and amortization back into the value of net income to derive the firm’s cash flow.

Normalizing EBITDA before a transaction can help sellers present their business in the best light possible. However, we typically advise clients to be cautious with the level of “owner’s perks,” and corresponding normalizing adjustments, they charge to the business. Below are four of the most common adjustment categories for deriving normalized EBITDA, as well as a few words of caution where appropriate.

1. Non-Recurring Expenses– These are expenses (or benefits) incurred by a business that wouldn’t normally affect the business’ profitability. Adjustments to this category might include (but certainly aren’t limited to) insurance payouts, moving expenses, and losses from discontinuing operations. However, other typical non-recurring expenses like lawsuits may be questioned by a potential acquirer if the business is in an industry known for frivolous lawsuits. In cases such as these, an acquirer may deem lawsuits a normal, and recurring, business expense that needs to be accounted for in the financial statements and should not be normalized.

2. Personal Expenses– A broad category to say the least. Expenses like travel, meals, entertainment, personal insurance policies (e.g., key man), and discretionary bonuses tend to get lumped into this section. Although all of these expenses can be normalized, that doesn’t mean they should be. A good rule of thumb is that expenses not related to business activities shouldn’t be charged to the business.

Here are a few examples:

  • Travel expenses: Recognizing that some may bill travel expenses not associated with the business activities through the business, owners can typically normalize these expenses.
  • Auto leases: These are a typical and acceptable normalizing adjustment, since some executives receive compensation or reimbursement for automobiles. The idea here is that an executive shouldn’t drive a car that would make them embarrassed to meet a client.
  • Meals: In most instances, meals should not be eligible for normalization. However, exceptions do apply. For example, meal expenses related to selling the business, which are non-recurring in nature and are not related to normal business operations, but are related to the ongoing nature of the business can be normalized.
  • Entertainment: Entertainment can be vague, which makes it a popular area for owner perks like sport or event tickets. Like other categories, entertainment should be related to business activities, but when exceptions do take place, they can be normalized.
  • Personal insurance policies, cell phones, and other related perks: These are generally acceptable since they are usually related to the business owner’s involvement in the business, and will not be present following its sale.

3. Excess Family Member Salaries – Similar to personal expenses, some owners provide family members with compensation in excess of what they would pay someone else to do the same job. Considering expenses like these would go away following a sale – presumably the acquirer would only pay fair market wages – excess family member salaries can be normalized.

4. Charitable Contributions – Charitable contributions may be good for your karma and can be normalized in most instances. However, if, for example, a business works with healthcare operations like hospitals, then normalizing charitable contributions to an existing or prospective client’s golf tournament may be considered a sales and marketing expense. Alternatively, charitable contributions not related to the ongoing nature of the business should be normalized.

We hope this brief explanation on normalizing adjustments provides some clarity on what is (and is not) generally accepted as reasonable expense adjustments. Also keep in mind that from an ethical and transactional point of view, improperly charging expenses to the business may save some money now, but it could cost you more in the long run during a sale if an acquirer doesn’t like what they see. We recommend reaching out to your personal accountant or M&A advisor to address any lingering questions or concerns.

This article written by Michael Thomas of Topline Valuation and provided courtesy of www.Axial.net

 

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Why Startups Stall

Posted by & filed under Sellers.

Have you ever wondered why startup companies stop growing? Sometimes they run out of potential customers to sell to or their product starts losing market share to a competitor, but there is often a more fundamental reason: the founder(s) lose the stomach for it.

When you start a business, the assets you have outside of your business likely exceed those you have in it, because in the early days, your business is worthless. As your company grows, it starts to have value and becomes a more significant part of your wealth—especially if you’re pouring your profits back into funding your growth.

For most business owners, their company is their largest asset.

Eventually, your business may become such a large proportion of your wealth that you realize you are taking a giant risk every day that you decide to hold on to it just a little bit longer.

95% Of His Wealth In One Business

In 2000, Etienne Borgeat and Olivier Letard co-founded PCO innovation, an IT consulting firm. The company took off and, by 2016, PCO had 600 full-time employees and offices around the world.

As the business grew, Borgeat and Letard started to become uneasy about how much of their wealth was tied up in their business. By 2015, the shares Borgeat held in PCO represented 95% of his wealth.

That’s about the point that aerospace giant Boeing came calling. Boeing wanted PCO to take on a very large project and Borgeat and Letard turned down the opportunity reasoning that the project was so large it could risk their entire company if it went wrong. In the early days, the partners would never have turned down a chance to work with Boeing, but the partners had changed.

That’s when Borgeat and Letard realized the time had come to sell. They agreed to an acquisition offer from Accenture of over one times revenue.

The success of your startup is probably driven by your willingness to put all your eggs in one basket. You’re all in. However, at some point, you may find yourself starting to play it safe, which is about the time your business may be better off in someone else’s hands.

 

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What is EBITDA, and Why Do Investors Care About It?

Posted by & filed under Buyers, Sellers.

By Karen Sibayan | January 13, 2016 – courtesy of www.axial.net

During negotiations in an M&A deal, buyers and sellers look closely at several factors in order to agree on a price that properly captures a company’s value.

One of the closely examined metrics in this process is EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization.  EBITDA is used as a way to measure company performance. EBITDA indicates whether a business is profitable by revealing the amount of its normal operational earnings.

EBITDA has many uses in addition to the M&A sales process. For traders, analysts, portfolio managers, and others, it is an indicator of whether companies are properly valued. It is also a gauge for lenders to know if companies will be able to pay their future debt obligations. However, while EBITDA provides a valuable snapshot of a point in time in a firm’s cycle, it does not necessarily provide a complete picture of a business’ true value or performance.

What is EBITDA? If you’re considering selling your company, understanding how EBITDA is calculated can help you present your company’s financials in a way that makes your firm’s post-sale cash flow attractive to buyers.

Investors use EBITDA to measure the enterprise value of the company.

“In a sale process, generally what a buyer pays for a company is a multiple of EBITDA,” says James Cassel, chairman of Cassel Salpeter & Co. (an Axial member).

Is EBITDA the Same as Cash Flow?

Many think of EBITDA as synonymous to a company’s cash flow, but is this really the case?

Adams Price, a managing director at The Forbes M&A Group (an Axial member) says that EBITDA serves as “a proxy for pre-tax operational cash flow. It gives a sense of what cash flows might be expected to come out of the business after an M&A transaction.” Since a company’s depreciation, amortization, debt, and tax profile can change as a result of a deal, EBITDA removes those components from the picture. EBITDA is also a more standardized way for buyers to compare companies within their respective sectors.

What EBITDA effectively does, according to Cassel, is take the earnings of a company while not accounting for capital expenditures (capex) and the interest on a company’s debt.

EBITDA removes the factors that distort a company’s profit from the equation. This is why even though EBITDA is not precisely cash flow, it can be considered the best proxy.

Read more about Why EBITDA Is Not Cash Flow here.

How is EBITDA Calculated?

What goes into calculating EBITDA? Kenneth Eades, a professor of business administration at the Darden School of Business, explains how EBITDA is calculated to arrive at this standardized number. “The metric starts with EBIT,” a company’s profit before interest and taxes, “which is a nice number because it indicates how much profit a company produces before it pays debt holders and the government,” Eades says.

After taking EBIT and adding back the depreciation and amortization expenses for the period, we get EBITDA. EBITDA has the benefit of being a number that is not affected by how much debt a company carries. However, “this comparison is ideally used within the same industry because the depreciation and amortization part of EBITDA will differ across industries,” Eades says.

Depreciation expense is created when the cost of a long-term asset is divided and reported as an expense over a period of time. For instance, companies that are in capital intensive industries often have a lot of equipment on the books that creates a significant depreciation expense. When this depreciation expense is added to EBIT, the resulting figure is significantly larger. By contrast, other industries will have little or no depreciation to add back, which means the two figures will be approximately the same value.

While depreciation relates to “real” assets such as equipment, amortization involves adding back expenses tied with intangible assets such as intellectual property or patents. An amortization expense is created when a cost of a patent, for instance, is divided over the length of the patent’s life.

There are differences in companies’ multiples and earnings. When buying the assets of a company, the transactions are mostly on a cash-free and debt-free basis, with the debt being paid off at closing. In terms of cash flow, buyers look at non-cash items such as depreciation. From these, many private equity firms come up with a range of multiples of EBITDA depending on the industry and business characteristics.

 

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