Anatomy of a Letter of Intent

A letter of intent (LOI) is a documented handshake between a potential buyer and a potential seller that sets forth the principal points of the agreement. In this way, an LOI mitigates the risk that prolonged negotiations may not result in a closing. In addition, with transactions requiring financing, the buyer’s lender may require a signed LOI before issuing a commitment to finance the acquisition. An LOI may even enable accelerated compliance with regulatory requirements such as those under the Hart-Scott-Rodino Antitrust Improvements Act.

But to be most effective, it’s critical that an LOI clearly delineate the binding provisions from the nonbinding ones. Briefly: The binding provisions regulate the negotiation process; the nonbinding provisions outline the transaction and its structure. Note that even though they’re nonbinding, there is a “moral commitment” by both sides to abide by the nonbinding provisions.

Binding Provisions

Binding provisions may include buyer access to the target company’s facilities, books and records, and require the target’s cooperation in the due diligence process. They may also contain a “no-shop” or “exclusive-dealing” provision that prohibits the acquisition candidate from directly or indirectly soliciting or entertaining offers from, or negotiating with, third parties in a transaction similar to the one the LOI outlines. Another common binding provision is that the seller must operate the company in the ordinary course of business. A mutual, comprehensive confidentiality provision protecting both parties and encouraging forthright dealings is also customary.

Each party typically bears its own costs and expenses and helps the other prepare and file for any necessary consents or approvals from lenders, landlords or third parties. It’s advisable to include a statement that the binding provisions constitute the entire agreement between the parties, superseding all prior oral or written agreements, and that the LOI may be modified only in writing, signed by both parties.

The binding provisions may also specify jurisdiction and venue for any disputes involving the LOI. It may be wise to include a provision relating to the LOI’s termination, perhaps incorporating a breakup fee. But note that the breakup fee normally isn’t the only remedy in the event of a breach by the seller

Nonbinding Provisions

The nonbinding provisions may be broadly scoped, including a description of the transaction type, a good-faith estimate of the closing date and a summary of the target executives’ employment agreements. They may also incorporate an adjustment to the purchase price based on changes in the consolidated stockholder’s equity following a specified date. In addition, they would address the preparation and approval of definitive documentation that would contain customary and comprehensive representations, warranties, indemnities, terms and conditions. Last, they could set forth escrow provisions for holding back a portion of the purchase price for specified contingencies.

One caveat: The LOI drafter must ensure that the nonbinding provisions cannot morph into binding provisions. The most powerful weapon against this danger is clear and concise draftsmanship. However, the courts have given significant weight to communications and other actions between the parties. For example, a statement such as “We have a deal,” followed by handshakes all around, may persuade a court that the parties intended to be bound.

Safety’s Sake

Nothing guarantees that a deal will close successfully – or at all. But a carefully crafted LOI certainly paves the way to a smoother transaction. In essence, they’re written agreements with the target made before the purchaser incurs full-blown negotiation and due diligence costs. Please call us for assistance with LOIs or any other aspects of an acquisition or merger.

Chart the Best Course

Deciding To Keep or Sell a Family Business

After 20 years at the helm of the family business, Maite is considering selling the company next year. After all, her company has satisfactorily matured, and she believes the time may be right to put it on the market. But questions plague her. How can she be sure it’s the right thing to do – for her, for family members active and inactive in the business, and for loyal non-family employees?

The answer, of course, depends on numerous factors, including the company’s value and current market conditions. Maite has wisely chosen to take her time before divesting. That way, our fictional business owner can properly plan and – in conjunction with M&A experts – assess the most expeditious approach to her goal.

Keeping It in the Family

First she considers keeping the business in the family. Her experienced team of M&A professionals analyzes her company’s financial situation and market position, among other factors. Here are a few highlights:

Valuation. First, Maite obtains a business valuation. The value may well determine Maite’s final decision and certainly drives the plan if she intends to keep the business. Then she must determine whether to transfer the business during her lifetime, on her death or on her husband’s death. Of course, the company’s value and Maite’s plans interest numerous parties, including tax authorities and her family.

Let’s say Maite decides to will the company helm to her spouse. No estate tax will be due then because of the marital deduction, but it will be due on her husband’s death. But Maite and her spouse might want the value minimized for the future estate tax payment on his death. Federal estate tax begins at an effective rate of 41% (on assets greater than the estate tax exemption of $1 million) and moves quickly to 49% (on a taxable estate greater than $2.5 million). Conversely, as you might imagine, the IRS is vigilant in looking for businesses that may have been undervalued in an effort to minimize taxes. This is particularly true for businesses whose fair market value is disputable.

Active and inactive heirs also may have different views of the business’s proper value, especially if they don’t hold interests in the business or if their inheritance is to be “equalized” from other assets (that is, compensated for their share of the business through assets other than the business itself). So make sure your valuator clearly understands the valuation’s purpose.

Transition. Maite will turn 64 next year. Therefore, retirement is another option she must consider. If she chooses to keep the company, she must decide whether everyone now involved in the business should stay involved. That means assessing personnel’s aptitude, ability and temperament. Then she must determine if only those children who are active in the business retain current, or have future, ownership of it. Finally, she must decide what inactive heirs should receive.

Without considering these issues, Maite would be less inclined to make an ownership transition during her lifetime. And that might not be in her (or her family’s) best interests.

Decision-making authority. Presume at this point that Maite has decided to leave the business to her heirs. She must then determine who will take the helm when she leaves. If she’s not done so already, she should empower those running daily operations to make important decisions. She should consider whether the decision-makers should report to a formal or informal board of directors, or an institutional executor or trustee. With her M&A team of experts, Maite should examine whether her company can meet its capital and borrowing needs and how it can maximize its intellectual capital. If a solid management team already exists, it should have an incentive to stay on when the next generation of Maite’s family assumes ownership and control.

Full benefits. Many business owners don’t take into account the value and extent to which they are receiving benefits from the company in addition to salary. In our example, Maite must recognize medical benefits, perquisites, pensions and employment opportunities for herself, family members and others before deciding to retain or divest the business.

Estate plan. Contrary to popular belief, having the correct legal documents doesn’t constitute a business continuity plan, nor should that plan remain static. Changing tax law and values require a periodic estate plan review, as do changing children’s (and grandchildren’s) ages, maturity and marital status. Health concerns also affect planning. If Maite wants to keep the business in the family, an estate plan is a key component.

Letting It Go
Let’s say Maite decides to sell the business to outsiders. Here’s a look at the salient issues from the seller’s side.

Value. A buyer bases a business’s value on strategic benefit and fit with other businesses, earnings and cash flow, and the management team. For the seller (Maite in our example), the gross value most often determines whether to sell. Note that consideration paid can take several forms and should be carefully structured and negotiated.

Getting at net value. The extent, timing and payment of taxes (be they capital gains tax, income tax or estate tax) on the proceeds can and should be planned. Total purchase price should not be as important as the net value to the seller and his or her family. The buyer can be convinced to deliver more to the seller if it is more tax efficient for him or her.

Presale planning. A great deal of planning should take place before any sale transaction. The more time that elapses between the implementation of a strategy and the sale transaction, the better the potential to preserve wealth and structure a deal that is beneficial to all parties.

Transaction strategy. Before a business goes on the market, have your expert examine its financial status and state it in the best possible light. In other words, balance sheets and income statements may need to be re-evaluated. Fortunately, Maite’s M&A experts helped her identify an appropriate buyer (from a field of strategic, financial, institutional and management candidates) and communicated with that company’s representatives throughout the process.

Implementation and positioning. Before negotiations began, Maite and her M&A team defined her role and others. By doing so, the sale process moved smoothly and she was on track to the best possible results. Experienced advisors helped her determine the most effective offer process.

Post-sale planning. Coordinating a change in the assets’ makeup (for example, from stock in a closely held business to liquid assets) requires an income and security analysis and a review of any existing estate plan.

Smooth Sailing

Chances are, you wouldn’t drive to an unfamiliar destination without a map. Neither should an owner even contemplate selling a business without a plan. That plan will reveal the best course of action and chart how to get you there. Please call us to help you navigate your way to the successful sale of your business or with any other M&A issues you may have.

Sidebar: Pertinent Considerations

There’s no one-size-fits-all answer to a businessperson’s keep-or-sell conundrum. Fortunately, there are several constants. The decision to retain or sell a company includes considerations such as:

  • The owner’s desire to work or retire,
  • Family dynamics,
  • Financial security for working family members and shareholders,
  • The current business environment as it relates to the business’s market value,
  • What will and should happen to loyal executive and employee groups,
  • The extent of the owner’s assets, and
  • The tax impact.

These are a just a few of the many items to review before making a decision. Call us for more detailed information.

Company Acquisitions: Why They Can Be Important

According to PricewaterhouseCoopers’ 10th Annual Global CEO Survey, more than 70 percent of CEOs expect to acquire all or part of another company in the United States within the next 2 years.  So, why are so many companies buying other companies? And should you be one of them?

Barriers To Organic Growth

In many cases, acquisitions are a way to overcome barriers to organic growth, or growth from your existing assets. In other words, if your existing business isn’t growing, buying another business is a common strategy to grow and benefit through increased cash flow, higher business value, greater ability to attract capital and talented management, and business sustainability.

The following barriers can keep a company from growing:

  • Changes in knowledge, belief and behavior that affect purchasing decisions
  • Changes in interest rates, inflation and unemployment that affect economic growth
  • Technological changes that make your machinery and equipment less competitive or obsolete
  • New products or services that make yours less competitive or obsolete
  • Low barriers to market entry that make it easier for new competitors at home and abroad to take away your market share
  • Many small companies selling to a few large companies, putting the bargaining power in the hands of the buyers.
  • Many small companies buying from a few suppliers, giving the supplier more leverage
  • Slow industry growth and overcapacity shrinking the pie and increasing rivalry among competing firms.

Strength From Within

If you find yourself faced with these barriers, an acquisition is one alternative that may help you overcome them. In addition to addressing these external forces, acquisitions enable your company to bolster its competitive advantage by acquiring resources like strong management or skilled labor, complementary or proprietary products or services, and production capacity or new technology to meet demand.

In other cases, acquisition can be a way to expand your company geographically or manage your business risk through market or customer diversification. These are ways to avoid relying on one large customer or a single market for the majority of your sales. If you lose that customer, or the economy in your region slows down, having exposure to other markets and customer diversification can help you buffer the blow while you work to replace lost business.

Companies Searching For Acquisitions

Here are a few examples of why companies pursue acquisitions.

Earnings and sales growth. A large precision machined products manufacturer decided to boost its organic growth with acquisitions. In addition, the management team wanted to fill existing capacity, acquire new products in new markets and establish operations in new locations close to certain customers. The company is owned by two private equity groups and, therefore, has the experience and capital to purchase businesses. However, it doesn’t have the human resources to manage the entire process. As a result, they outsourced part of the process and engaged a financial advisor to identify, contact and negotiate with acquisition targets.

Business model change. Another company interested in making acquisitions wanted to transform its business. The company’s management team acquired a troubled company in an out-of-favor industry a few years ago and completed a dramatic turnaround. In the meantime, the company grew quickly and accumulated significant cash on its balance sheet. Through its strategic planning process, the company decided to change its business model and enter a related industry with better long-term prospects. To do so, they engaged a firm to advise them through the entire acquisition process—from strategy development to closing transactions.

Vertical integration. Another reason for acquisition is to become more vertically integrated. What is the benefit? In this case, the management and the board of directors of this consumer health care products manufacturer decided that vertical integration would help them gain more control over the supply of certain raw materials. They considered building these capabilities themselves. However, they concluded it would be faster and more cost effective to acquire these capabilities instead and worked with a firm to identify, contact and negotiate with acquisition targets.

How To Get Started

You might have decided to explore an acquisition and know some likely targets, which is a good start.

What’s next? You can begin contact on your own, or if you don’t have this type of business experience, you can engage the services of an investment-banking firm. The biggest benefit to outside help is that you can tap into their expertise in making acquisitions while you focus on your expertise: running your business. The right advisor will help in other ways as well:

  • Creating or refining your acquisition strategy and criteria
  • Determining whether or not you have the capital, human and other resources to make an acquisition
  • Providing advice on current market valuations and valuation methods
  • Identifying and weeding out acquisition targets
  • Analyzing and valuing interested targets
  • Developing transaction structure alternatives, draft term sheets or letters of intent, and presenting them to interested targets
  • Arranging the financing to complete transactions
  • Helping you and your legal advisor and CPA conduct due diligence and close transactions.

Looking Forward

Many of the variables that affect the way deals are priced and structured are currently favorable to buyers. Interest rates are likely to remain steady or go down, and commercial bankers are aggressively pursuing good business deals. After increasing for several years, purchase price multiples decreased at the end of 2007, suggesting that multiples may have stabilized or may continue to decrease. In the meantime, debt to EBITDA multiples have remained steady.

What does that mean to you? It’s a good time to buy if your cash position is strong and your strategic plan calls for customer or market diversification, or you want to eliminate your competitors by buying them out. Talk to your investment banking firm to see what your options are and the most appropriate way to begin the process.

ESOP’s Fables: Fiduciary Concerns in Change-of-Control Transactions

Fiduciary Concerns in Change-of-Control Transactions

Several years ago, corporate transactions involving employee stock ownership plans (ESOPs) grew tremendously. Yet, just as ESOPs became an integral part of the leveraging of corporate America, they got slammed by the same forces as domestic companies. Some ESOP companies prospered while others faded away, starved for more capital.

Fiduciaries of many ESOPs that have some acquisition debt outstanding now need to consider new transactions. Each of these situations presents a host of questions about the nature of the ESOP’s financial interest and ways it can or should be viewed under the Employee Retirement Income Security Act of 1974 (ERISA).

5 Issues To Be Seen and Heard Fiduciaries should address several matters when an existing ESOP is involved in a corporate change-of-control, whether to ensure survival or just capitalize on good fortune. These include:

  1. Transaction participation.The ESOP may be holding the same class of stock as the other shareholders (common stock) or another stock class that is convertible into common stock (convertible preferred stock). In either case, the ESOP may be offered a financial opportunity different from that offered to other shareholders. If the ESOP wants different treatment than other shareholders, the fiduciary should determine whether such treatment serves the participants’ best interests. Although no established guidelines exist for resolving this, a prudent ESOP fiduciary course of action would be to treat transaction participation the same as any other investment decision, as the following example suggests.In the case of a tender offer to other shareholders, the fiduciary may be requested to exchange its shares for those of the acquirer’s similar stock class rather than to tender them. When this option is compared with that offered to other shareholders who are receiving cash consideration for their stock, the fiduciary should evaluate it from the standpoint of two investment decisions: first, selling the stock; and second, reinvesting the proceeds in the acquirer’s stock. If both investments meet the “adequate consideration” requirement under ERISA, the decision to exchange the shares may be a justifiable course of action. In other words, the investment makes sense if reinvesting the proceeds allows the ESOP to continue providing a potentially greater return than would otherwise be earned.
  2. Evaluating a transaction’s total consideration. Consideration paid in a tender offer may be in cash, notes, other securities or retention of certain assets. Merger consideration typically takes the form of the acquirer’s stock. Consideration may also include value attributed to employment contracts, non-compete agreements or other compensation arrangements. These usually are provided only to management shareholders but, in essence, represent a portion of the purchase price the acquirer is willing to pay.
    Standard valuation principles should apply when one assesses the fairness of the total consideration to be received. Important factors would include, but not be limited to, the:

    • Company’s and industry’s outlook,
    • Company’s cash-generating ability
    • Securities market pricing for comparable public companies’ stock, and
    • Actual prices paid in comparable change-of-control transactions.
  3. Evaluating what the ESOP will receive as consideration addresses the transaction’s absolute fairness. This analysis enables the fiduciary to ensure the ESOP is receiving adequate stock consideration.
  4. Allocating total consideration among all equity holders.To ensure the ESOP is being treated fairly, it’s important to examine the terms of the securities each type of equity holder owns. Different classes of stock may be assessed differently depending on their rights and preferences. For example, if an ESOP holds convertible preferred stock and the acquirer intends to terminate the ESOP when the transaction is completed, then the ESOP may be entitled to the greater of its redemption or fair market value. The value to the ESOP should never be less than what it would have received had it held only common stock; the fiduciary can always convert the preferred stock and receive the same value provided to all common shareholders.It’s also important to determine whether a disproportionate amount of the total consideration is being paid to shareholders other than the ESOP. Some practitioners believe that if the ESOP holds a minority interest in the company, the plan is entitled to less than its pro rata share of the total enterprise value realized in a change-of-control transaction. But all common shareholders, including the ESOP, ordinarily have a right to receive their share of the total value proportionate to their percentage of stock ownership, regardless of whether they hold a minority or controlling interest.Even if the value to be received by the ESOP is fair on an absolute basis, allocating any excess value may be unfair. For example, no guidelines exist about how much value one should attribute to management shareholder agreements. The fiduciary’s financial advisor could consider whether employment and non-compete agreements were in place before negotiations, whether they conform to industry market standards and whether the proportion of the total purchase price these agreements represent is reasonable.Evaluating allocation of total consideration addresses the transaction’s relative fairness. The fiduciary’s objective? Ensure the ESOP is treated fairly financially – in terms of absolute and relative fairness.
  5. Treatment of remaining ESOP debt.In a leveraged ESOP, the company commits to repaying the ESOP indebtedness through contributions or dividends. Effectively, the commitment becomes a corporate liability and, as such, affects all shareholders alike. This issue can cause controversy during subsequent transactions.If the ESOP debt is treated as a corporate liability when the sale takes place, shares held by non-ESOP shareholders and shares allocated to ESOP participants will be valued (all else being equal) similarly to the annual valuations; that is, all shares will reflect a value after payment of the ESOP debt. Alternatively, if the ESOP’s unallocated shares are used to satisfy the ESOP’s indebtedness, the percentage of the total value flowing to the ESOP (after the debt repayment) is reduced; the shares held by the non-ESOP shareholders and the ESOP’s allocated shares (that is, all shares unencumbered by debt) increase in value.Because projected contributions or dividends used to repay the ESOP’s debt represent future benefits to the participants, some have argued that any sharing of the ESOP’s debt in a subsequent transaction would result in a benefits windfall to participants – effectively, participants would receive all future benefits at once. This windfall occurs because all unallocated shares would be released from the suspense account when the corporation repays the debt. Others have argued that the commitment to repay the ESOP debt always has been a corporate liability, and any transaction that alters this design merely transfers value away from the ESOP.
  6. Continuing ESOP or other employee benefit plans.Whether the ESOP remains in place after a merger or tender offer may have value implications for ESOP shareholders. If the ESOP benefit is considered favorable relative to standard industry benefits, continuing future contributions or dividends to the ESOP may represent real value.If a substantial amount of ESOP debt is outstanding with corresponding unallocated shares to be released as the debt is repaid, the fiduciary and its advisors should consider these questions:
    • Has the merger partner or acquirer made a legal commitment to make future contributions or dividends sufficient to repay the ESOP indebtedness?
    • Are current ESOP participant interests likely to be diluted through a substantial addition of new employees to the plan?
    • If the ESOP is to be terminated, are replacement benefits contemplated, and how do they compare with the existing benefits?
    • The answers to these questions will help the fiduciary and its advisors more accurately assess valuation considerations of retaining the ESOP.

The Moral of the Story

The ESOP’s involvement in a change-of-control transaction raises a host of new issues that must be appropriately addressed by ESOP fiduciaries, legal and financial advisors, and company management. While each situation is unique, the fiduciary’s knowledge of the original structure of the ESOP’s equity purchase, securityholders’ rights and preferences, and the surviving company’s post-transaction intentions toward benefit plans and remaining ESOP debt repayment will help the fiduciary ensure fair treatment of the ESOP. As a great Greek philosopher once said, “Prepare today for the wants of tomorrow.” Please call us.

Five Early Warning Signs

Is your bank’s lending officer asking you to invest more equity in your business, reduce your outstand­ing balance, or worse, find a new bank?

If you answered “yes,” and it’s your first indication of trouble, you probably missed a few warning signs along the way. If you answered “no,” now is the time to learn about and look for these financial red flags. The sooner you recognize them, the more options you’ll have and the greater your ability to address them effectively.

What are some of these early warning signs? They include slow or no growth, customer or market con­centration, competing on price alone, shrinking gross margins and difficulty funding capital expenditures.

Slow or no growth: Not all growth is good, but slow or no growth in your business can be dangerous. Sure, many compa­nies do just fine for years with limited growth. But what are the real underly­ing problems causing your business to slow down that sooner or later could cause a significant problem? For example, slow or no growth could be a sign of emerging threats or underlying weaknesses such as inferior products or services. It could be as basic as too few new or innovative products or services. It could also point to the presence of new substitutes—products or services that your previous customers find to be a better solution. Poor quality, late delivery, high prices, ineffective sales and mar­keting or weak economic or industry conditions also can be the root cause of your company’s slow decline.

There is no hard, fast rule, but companies should at least grow at a rate equal to the rate of inflation or their primary industry’s growth. Robust growth sig­nals that your business is strong in terms of products and services, competition or competitive advantage, pricing power, sales and marketing, and customer loyalty or satisfaction.

Customer or market concentration: Many small businesses were founded with the help of one large customer. In some cases, the customer prohibits its suppliers from doing business with its competitors. Most small businesses work hard to develop new customers over time, but find it difficult to grow their way out of a concentrated situation. Diversification helps to spread risk while concentration intensifies it. If one customer or market generates more than 15 to 20 percent of your sales, you need to start diversify­ing now.

In some cases, a negative event associated with one or a few customers or markets can reflect negatively on your business, too. For example, industry reces­sion, labor strikes or business failure can hit at any time. A change in corporate policy, such as minimum vendor size, may lead a dominant customer to take its business elsewhere. A customer or distributor might decide to become a competitor and take away valu­able business.

In other cases, the event may be less traumatic, and the damage may unfold over time. Your top customers might naturally soak up most of your company’s sales and marketing, engineer­ing, and capital—leaving fewer resources for you to develop new markets, customers and products. In addition, large customers tend to continuously pressure suppliers to lower prices and make greater concessions. Over time, that shrinks your business margins.

Competing on price alone: In his groundbreak­ing book “Competitive Advantage,” Michael Porter says above average performance in the long run is not based on price, but on sustainable competitive advantage. There are three basic types of competitive advantage: low cost, differentiation and focus. Many companies confuse low price with low cost or com­pete on price without an actual cost advantage. The sources of cost advantage include economies of scale, proprietary technology and preferential access to raw materials. Low prices without a cost advantage lead to low profit margins. Companies with exceptionally low margins are threatened by volume swings and tend to carry more debt than their peers.

Cost cannot be your only form of differentiation for long. Although cost leadership creates a competitive advantage, cost leaders must differentiate their compa­nies in other ways to be above average or build a sus­tainable business. If they don’t, their competitors will.

Shrinking gross margins: Margin problems often start as pricing problems. Lack of a good cost accounting system and flawed pricing policies, strate­gies or enforcement are common contributors. But the failures to control costs or raise prices as costs increase can be devastating over time. This can happen when a customer changes product specifications or order quantities, when labor costs increase or when mate­rial costs increase.

Difficulty funding capital expenditures: High-per­formance companies reinvest profits in research and development as well as new equipment and technol­ogy. Some of this spending supports the development of new products or business opportunities. However, much of it is used to replace aging equipment with improved technology. At a minimum, companies should spend an amount equal to their depreciation.

Companies that do not generate enough cash flow from operations to cover required capital expendi­tures either defer expenditures or take on more debt. In some cases, the bank will not lend more, which is a huge warning sign. At that point, the company is digging a hole that becomes difficult to climb out of.

Don’t wait for your lender or another stakeholder to tell you your financial condition is sending any of these five warning signs. Take the time to listen to, and analyze, your business’s condition. Make the tough decisions to change as needed. The sooner you start, the sooner you begin assuring a sustainable future for your business.

Institutional Capital: Money to Grow On

Small- and middle-market companies have many promising growth opportunities, despite the clouds hovering over today’s economy. Organizations can still find financing to fund expansion, a capital investment or an acquisition. But what’s a business owner to do once his or her company’s credit lines have run out?

Institutional capital, which includes subordinated debt and preferred equity, could be the answer. It can be used for making acquisitions, buying out partners or obtaining working capital. Let’s look at this financing option for companies whose spirits are willing but whose bank lines are exhausted.

What’s Institutional Capital and How Does It Work?

Institutional capital is an unsecured debt that is subordinated to a company’s senior bank debt. It can be supplied by numerous institutions, including insurance companies and pension fund providers, and is generally used to fulfill long-term capital needs. Also, redemption or amortization usually doesn’t happen until five years after the debt is issued. In exchange for taking a bigger risk than secured lenders, institutional investors assume minority ownership positions and become investment partners with business owners.

Institutional capital has some important long-term implications. For example, it’s only cost-effective if it helps your company significantly improve profitability. It should also help drive the value of your stake above what it would be if you hadn’t taken on a new investment partner.

Who Qualifies for Institutional Capital?

The best candidates for institutional capital need at least $3 million in funding, have annual sales of at least $10 million and earnings before interest, taxes and depreciation (EBITDA) of at least $2 million.

On the other side of the table, institutional investors are looking for companies with a diversified customer base, favorable industry growth trends and barriers to entry – or more simply put, a solid infrastructure. They will require audited financial statements that show a stable earnings record, and they will want to monitor progress. So their potential clients should have information systems that can generate timely, accurate financial statements. Finally, investors plumb for evidence of managerial depth, including a succession plan that ensures smooth operational continuity.

Matchmakers Can Make It Happen

Because institutional investors – like the companies that seek institutional capital – can be located anywhere, an intermediary usually brings the two parties together. It’s much like an arranged marriage in which the parties meet beforehand to see whether they get along before a union is finalized. Many intermediaries have access to myriad investor groups, allowing them to determine the best fit.

The intermediary visits the capital-seeking company, observes its business operations and prepares a comprehensive operations memorandum, which becomes a marketing tool for prospective investors. Then, the intermediary contacts investors it believes best suit the company’s circumstances. They all meet and decide whether a business relationship is viable. When the match is made, the intermediary helps negotiate agreement terms and conditions.

Proceed With Caution

Institutional capital can be an excellent way for your company to expand or make an acquisition. But before pursuing this financing route, thoughtful analysis is necessary. Taking on an investment partner will affect your company’s operations and goals, so institutional capital isn’t simply “about the money.” Before taking this leap, give us a call; we’ll help you map out the best route between your company and the capital it needs.

Sidebar: Good Intermediaries Attract Excellent Capital

Institutional capital can help you create significant long-term value you might not have achieved otherwise. Getting the best deal means putting your company’s investment considerations in the best possible light. A key step in securing institutional capital is a high-quality offering memorandum that lists your pertinent assets. An intermediary can help you prepare your documentation and contact investors best suited to your company’s circumstances – so choose this consultant wisely. To do so, ask questions, such as:

  • What’s your track record on prior offering memoranda?
  • How frequently have you raised capital for a project like the one we’re pursuing?
  • Have you previously worked with our investor candidates?
  • Do you have direct access to the decision-makers?

The answers to these questions should help you choose the right intermediary.

Is an Equity Recapitalization Right for You?

Change continues to be a natural part of business. Does one or more of your partners want to exit, but you want to stay (or vice versa)? Do you want to unlock some of the value in your business, but continue to own a significant portion of it and enjoy the future upside? Or, do you need a retirement or succession plan? If so, an equity recapitalization might be an attractive alternative to consider. Simply put, it can enable you to take some chips off the table now, maximize the value of your business over time and sell the balance of your equity at a higher valuation in 3 to 7 years. Other benefits include:

Net worth diversification. For too many small business owners, the majority of their net worth is locked in their business, and privately held middle market businesses are considered to be riskier than many other assets.

Fresh capital and contacts. Your new partner might help fund capital expenditures to support organic growth or acquisitions to bolster management, growth, profitability or competitive advantage. They also could introduce you to new customers or suppliers who can help increase sales, decrease expenses or launch a new strategy.

Financial and operational expertise. Your new partner will want to add value by sharing his or her general management experience and skills by implementing new procedures or processes. For example, a more robust cost accounting system or business planning process might help improve profits or take your business to the next level.

Most equity recapitalizations are funded by private equity groups (PEGs) that raise and invest money from institutional investors like banks, insurance companies and pension funds. PEGs tend to invest in companies with strong management, growth, profitability and competitive advantage. However, some are interested in distressed or underperforming companies.

In the typical equity recapitalization, the PEG or its fund:

  • acquires 51 percent or more of the target company (some will acquire a non-control equity interest);
  • takes a seat or two on the board of directors and works with management to grow and improve the business;
  • seeks liquidity (in 3 to 7 years) through an initial public offering, recapitalization or sale.

To illustrate the potential financial benefits to you (the selling shareholder), here is an over-simplified example. If today your company generates $2.5 million in earnings before interest, tax, depreciation and amortization (EBITDA) on $25 million sales, we value it using an enterprise value multiple of 5 times EBITDA, and the balance sheet includes no interest bearing debt or excess cash, then the equity value would equal $12.5 million. If you agree to sell 51 percent of the equity to a PEG, you would realize $6.375 million pre-tax.

Then, in 5 years, if your company generates $5 million in EBITDA on $50 million sales, we value it using an enterprise value multiple of 5 times EBITDA, and the balance sheet includes no interest-bearing debt or excess cash, then the equity value would equal $25.0 million. If you agree to sell the remaining 49 percent of the equity to a strategic buyer, you would realize $12.25 million pre-tax.

You and your management team maintain control of day-to-day decision-making, leadership and operations, and your new partner provides advice or guidance as a board member. However, in most cases, you will lose control of the voting rights associated with equity and, if not accustomed to it, you will need to learn how to work with a board of directors.

To many, the benefits of diversification, liquidity and succession outweigh any shortcomings associated with a recap. It can help you mitigate risk and put you on the path to retirement. One never knows when the economy or a customer will upset your prospects, or when you will get the itch to find your blue water—whether it’s a personal mission in life or a lakeside cottage with beautiful sunsets.

Making An Acquisition The Smart Way

According to Bank of America Business Capital’s2008 CFO Outlook, among those companies expecting merger and acquisition activity, 86 percent report that they will be making the acquisition, while only 7 percent plan to be acquired by another firm. In other words, many buyers will be chasing few sellers. That means if you are a would-be buyer, you need to develop a well thought-out process that generates proprietary deal flow, minimizes your risk and maximizes your return on investment (ROI). The right approach will also enable management to continue focusing on its existing business; increase your probability of acquiring the right company at the right price, terms and conditions; compress the time frame to complete a transaction; and ensure successful post-merger integration.

How To Get Started:

Should you wait for investment bankers or business brokers to call you with deals? That might result in missed opportunities, competitive bidding situations such as auctions, or a stream of companies that do not fit your criteria. The acquisition process includes a number of steps and requires considerable preparation and careful execution. It also calls for experience and specialized skills in accounting, due diligence, finance, law, strategy and valuation. So let’s start at the beginning.

Step 1: Acquisition strategy and criteria.

Your first step is to clearly define your acquisition strategy and set of criteria. Some common strategies are to:

  • Overcome barriers to organic growth.
  • Bolster a company’s competitive advantage by acquiring key resources like strong management, skilled labor, complementary or proprietary products or services, production capacity or new technology.
  • Expand geographically or manage business risk through market or customer diversification.

Once the strategy has been vetted, set specific criteria for the business you want to buy. Type of business (or industry), size of business (in terms of sales or cash flows), location, size of transaction and equity investment and other qualitative factors are commonly used criteria. If your strategy is off-target or your criteria are too loose, you’ll waste time and other resources or, worse, fail at attaining your goal

Step 2: Valuation methods and assumptions.

It is also important to use valuation methods and assumptions that fit your requirements as well as those of a reasonable seller (for example, market-based). Most financial advisors use the discounted cash flow (DCF) method to estimate the value of companies with positive, predictable cash flows. Purchase price multiples should be used carefully as a rule of thumb to check a DCF valuation or to provide a quick estimate. As part of the valuation process, you must make assumptions about variables like future sales growth, capital expenditures, cash flows, financing and return on equity. Using generally accepted, reasonable valuation methods and assumptions greatly increases your probability of completing acquisitions of companies that satisfy your strategy and criteria.

Step 3: Acquisition funding.

Before reaching out to acquisition targets, as a buyer you should identify sources of debt and equity and determine how much capital you can invest. Some buyers need to look no further than their own balance sheet, since excess cash and existing revolving lines of credit are common funding sources. Other sources include private placements, sale-leasebacks, bridge or term loans, and mezzanine or subordinated debt. Another alternative is to raise equity from a professional investor such as a private equity group (PEG). PEGs are not only a source of capital, but also provide board-level advice, management and deal-making expertise, and industry experience and contacts. Clearly, the source and amount of capital will influence the size of transaction you can consider as well as the valuation and structure of any proposed transaction.

Step 4: Preparing for a broad search.

When you target a large group of companies such as an industry rather than one or a few specific targets, you need to prepare a few more items:

  • Have a list of prospective targets based on your acquisition criteria, such as type of business (or industry), size of business (in terms of employees or sales) and location
  • Write a brief description of your business and acquisition criteria. Prospective sellers want to know who is courting them and why. This can be presented to prospective sellers verbally, but many will ask for something in writing.
  • Prepare a Confidentiality or Non-Disclosure Agreement. Confidentiality is critical to sellers especially privately held middle-market businesses. A few prospective sellers will want buyers to sign their own, but many will not be prepared to sell their company and, therefore, will not be ready with an agreement.
  • Complete a standard information request. Again, since many prospective sellers will not be marketing their companies for sale, you need to be ready to request pertinent information. An initial screen of about five items is a good place to start.

Step 5: Finding the right fit.

Once you have completed the necessary preparations, contacted several prospective sellers and identified an interested party who may be a good fit, the heavy lifting begins. You will need to analyze detailed target company information to understand the target company and determine whether or not it fits your strategy, culture and ROI parameters. Valuation models and transaction structure alternatives need to be developed. If you decide to pursue a transaction, a letter of intent or term sheet needs to be presented, negotiated and finalized. Funding needs to be arranged. Due diligence needs to be conducted, the transaction needs to be closed and post-merger integration needs to be completed. The right approach will increase your likelihood of finding the right acquisition. It requires considerable preparation, careful execution, experience and specialized skills. While this process may seem time consuming and a bit intimidating, you can get help. The right team of professional advisors includes your investment banker, attorney, CPA and other experts who will show you the way.