Mid Market Staircase Photograph

“Seems like a good offer, so let’s take a closer look.”

Cartoonized photo of PH and PaulThere is a shortage of supply of middle market businesses available for acquisition. That is why prices are high and private equity firms are selling their best portfolio companies. As an owner/operator, there are some days when you have to wonder about what price would tempt you to sell the business. Your readiness depends on your specific circumstances. You may have family shareholders or other partners to consider, and they may or may not be able to understand how you (as boss) gauge the competitive landscape, but there comes a time when cashing-in has great appeal. Once you decide to listen to that strategic partner who has asked you repeatedly or the private equity firm that assures you that they are different (special), it is essential to know what you could actually achieve and how it would work if you choose to pursue a deal. We help business owners know what is possible and how to negotiate the best deal. That begins with a focus on valuation and purchase price in the context of the proceeds to the seller. Here is how you can avoid surprises.

There are plenty of sources that quote acquisition purchase price multiples for middle market businesses and there is usually at least some meaningful intelligence on deal valuation for relevant companies. What isn’t so easy to find is what really matters for determining net proceeds to the seller. You may ask, “multiple of what, exactly?… trailing adjusted earnings or a current full year?… and what balance sheet adjustments might apply?… how are working capital and capital expenditures factored into cash flow? … what strings are attached to a buyout offer?”

The most straightforward deal is the purchase and sale of the assets and business of a company on a cash-free and debt free basis. That may seem simple enough, but somehow it usually becomes less simple before all is said and done. It is generally assumed that the seller is an S-Corp or LLC or that the C-Corp will elect 338(h)(10) constructive liquidation so that the seller is essentially a pass-through entity for tax purposes. Delivering a debt-free business in an asset sale structure leaves the seller responsible for repayment of all interest-bearing debt and allows the buyer to record acquired assets at fair value (including intangibles and goodwill) for tax benefits to cushion the purchase price. We think any analysis of price should be in the context of what balance sheet reference point accompanies the price and what price adjustment mechanism will apply.

The usual focus for what a purchase price multiple is applied to is normalized EBITDA (that is trailing 12 month pretax earnings with depreciation and amortization expense added back plus other expenses such as owner’s compensation in excess of market cost and one-time items not necessary going forward). Adjustments to “normalize” earnings range from the fairly obvious to the quite creative. Sellers seek to maximize the EBITDA (the cash flow proxy) and maximize the multiple of EBITDA (purchase price multiple) so that the whole company valuation is as high as possible. The high end of a range is the reward for consistency, growth potential, the depth of continuing management and critical mass which also translates into market position and size. Bigger is always better when it comes to multiples in M&A. The reason is that the relatively bigger middle market company attracts a broader range of suitors and debt financing options.

Understanding the determination of purchase price multiple is tricky because each of the parties has different needs to rationalize the price as a good deal. Buyers tend to look at the multiple in terms of what they expect to earn and they do whatever they can to have the seller appreciate that the focus has to be on what the seller has produced, not what the buyer might earn. Few sellers actually realize that the buyer has incremental expenses as well as potential savings. Private business owners tend to look at the amount of money they receive rather than the multiple of earnings. The offer is a price and the multiple is a relative value indication in evaluating price. Lenders tend to look at the cash flow and the fixed charge coverage based on the specific capital structure of the buyer. The bottom line is always a measure of how much money the seller takes home.

Deal problems usually arise in the purchase price adjustments which become the focus of negotiations during the definitive agreement stage. That is why the evaluation of bids in auctions includes consideration of the mark-up to the seller-drafted asset purchase agreement. The two most unpopular culprits are balance sheet liabilities not accepted by the buyer and adjustments which always seem to reduce price. It is fairly easy to accept that the buyer will not become responsible for any funded debt (bank debt, capital leases, shareholder loans). Those liabilities must be repaid by the seller from the proceeds paid to the seller by the buyer. It is the contingent liabilities and other exposure such as third-party claims of intellectual property infringement which can eat into the sale proceeds post-closing that can be particularly troubling.

Balance sheet adjustments (price reductions) resulting from working capital requirements and previously unbooked liabilities identified by the buyer during due diligence after exclusivity has been granted (reserves for product warranty, litigation, pension obligations) are usually more straight forward (but not less painful) than likely indemnification claims over one to two years post-closing. The former type of balance sheet adjustments occur at closing or soon after. Holdbacks vary up to 15% of the purchase price and can be stepped down based on specific terms. Responsibility post-closing for excluded items such as discontinued business units and employee obligations can further reduce the value of a transaction to the seller. What matters most are the net proceeds to the seller after all deductions from the purchase price. That’s not always as straightforward as conversations early in the process might suggest and it may be quite sometime after closing before you really know.

Purchase price frequently involves deferred components such as seller notes, continuing ownership and/or earn-out based on post-closing performance. These further complicate matters. Subtleties such as the capital structure of the buyer are very important in determining the financial risk of deferred payout and equity upside. The second bite at the apple can be sweet as long as the terms are well understood. Owners/operators are increasingly asked to roll over a portion of the purchase price into a continuing equity stake in the company with its new owners. That can usually be accomplished with pretax proceeds. What sometimes makes it hard to evaluate the potential upside is the capital structure which may include junior debt capital and preferred equity which have priority claims on the future value.

None of these items should discourage owner/operators from entertaining offers to buy their business. Midmarket is here to help you evaluate alternatives and make the most of what can be achieved. We have the expertise to arm you with the relevant knowledge, to anticipate issues specific to your company and to avoid surprises. We bring what you need to be comfortable that you are fully informed and able to make the best deal possible. We further distinguish ourselves by being easier to do business with than our competitors. Our terms and the cost for our services are based on an independent consulting model with flexibility not available elsewhere. Call us to learn more about how we can serve you.