Another statistic of the aforementioned Thomas Reuters study is the median amount of synergies captured by the selling company and reflected in the transaction price is 31%. When we multiply this 31% by the approximate 50% of incremental value created by the synergies, we can estimate that the average amount of transaction premium captured by Sellers from synergies is approximately 15%. This infers that a 5X EBITDA mutiple (a typical small company multiple paid for companies which have an anticipated 10% CAGR) would increase to 5.75X when sold to a strategic buyer with average synergies. It is important to note that the 31% statistic is based upon transactions values in excess of $300 million. Sellers of such transactions generally employ seasoned transaction advisory professionals where Sellers of lower mid-market (< $50M) transactions, and especially those executing transaction less than $20M generally do not have such transaction expertise.

While working with business owners one of the issues most often pondered is “When Should I Sell My Business?” On a personal level the answer may be:

• when your heart is no longer into it
• when you decide it will take new blood or capital to get to the next level
• when you reach an age when you are ready to retire
• or any of a host of personal reasons

While any of the above may be good answers, one principal objective of the investment banker should be to help business owners time an exit so as to maximize their value in a transaction. Since the last recession officially ended in June 2009, we are now talking to many business owners who have two or three years of double digit earnings growth. Many of these people are baby boomers thinking about an exit strategy and believe their business has at least one more year of solid growth. They also do not want to get stuck fighting their way through another downturn. So, the real question is:

“Do I sell today or bet on another year of growth?”

The short answer is that buyer expectations drive value and one slow year deflates expectations very quickly. Buyers are investing in expected future earnings and historical earnings and growth rates are the baseline for creating the expectations. Discounted Cash Flow (“DCF”) valuation models are the tool most frequently used to quantify future value. The following example illustrates the importance of selling when expectations are high.

Assumptions – Company for Sale:

1. Revenues and earnings have been growing by 10% annually, outlook is good.
2. A buyer can borrow 30% of the purchase price based on the company’s cash flow and balance sheet. Weighted average cost of capital is approximately 16.8%.
3. The fiscal year just completed produced operating income of $1,000,000.

Scenario 1 – Sell Today

1. Buyer’s DCF model assumes growth will continue at 10% for the next 5 years and then 5% in perpetuity.
2. The discounted cash flow valuation is $6.2 M.

Scenario 2 – Grow for 1 more year, then sell

1. The economy slows and operating income grows by 5% to $1,050,000.
2. Buyer’s DCF model assumes growth continues at 5% for 5 years and then 3% in perpetuity.

The discounted cash flow valuation is $4.9 M.

Selling with a strong growth outlook (scenario 1), versus selling later with a larger profit but a weaker growth outlook (scenario 2), almost always results in a higher transaction value. In the example, the Seller would have achieved a $1.3M higher valuation had he sold today with $1.0M of profit and growth rates of 10% (scenario 1), versus selling a year later with the higher profit of $1.05M but a lower growth rate of 5%. (scenario 2).

Both scenarios involve buyers with reasonable expectations based on recent operating histories, but higher earnings are almost never an adequate substitute for faster and/or more predictable sustainable growth.

There are many factors that are considered when a buyer values a company. Return on investment as quantified in a Discounted Cash Flow analysis, which discounts future expected earnings, is often a major consideration. That stated, our answer to the question of “when to sell,” is the following:

Sell when you have strong growth. Do not underestimate the risks of trying to add another dollar of profit. If you sincerely believe that there will be strong growth for a few more years, negotiate an earn-out or retain some equity so that you can participate in the upside, after you have put some money in the bank and mitigated the potential risk of a slow down.

As a final consideration, we like to remind clients to plan on one to three years from the time you decide to sell until the time you are free to sit on a beach. This includes six to 12 months to complete a transaction and one to three years for a typical employment transition and/or earn-out.

Note: There are many factors that are considered when an investment banker or a prospective buyer estimates the value of a company. Discounted cash flow models are a frequently used tool and involve more variables than could be reasonably factored into the above illustration. Buyers who are seeking to satisfy strategic objectives through an acquisition will frequently offer valuations that are above what could be justified by DCF modeling. Only the market can determine what a company is truly worth.

1. Be sure to get a valuation from the prospective banker prior to engaging. Make sure that the Banker justifies the valuation to you with high credibility.
2. Some bankers may try to charge you for the valuation. In my opinion, this is an investment that the banker needs to make in order to “quote the job”. Would you pay a builder to quote you price to build a home, or a real estate agent to give you an estimate on the value of your house?
3. Ask the banker what he/she thinks is the probability of closing the transaction at the valuation provided.
4. Don’t even consider selling your Company if the probability is less the 70% – 80%. There’s just too much work and exposure risk to enter into this arduous process for any less than a 70% probability of success.
5. Assuming that the banker is quite confident of meeting your objective then ask him/her “If you are so confident of selling my company, why then do you need a retainer?”

1. Because it typically takes 6 – 12 months to sell a company and in the meantime we have significant overhead.
2. Because we need to know you’re serious before we invest our substantial resources to sell your company.

1. I would not want to engage with an advisor that is going to assist me to sell one of the largest, if not the largest, transaction of my life if that advisor needed my retainer to pay his overhead.
2. If the advisor cannot tell if you, the Prospective Seller, is serious then how on earth will he/she be able to determine if the potential buyer is serious? After stating the foregoing to the advisor perhaps he responds with; “With no skin in the game what is stopping you from just changing your mind after we expend a substantial amount of our resources to sell your Company?” There are many ways to deal with this, such as the implementation of a break fee in the event that the advisor brings bonafide offers which meet some predetermined criteria. The advisor is supposedly an expert in deal structuring, surely he can structure a deal with you that will meet both of your needs!

Bias Toward Overvaluing the Business

How do you think a real estate agent might persuade you to engage them to sell your house? Their number one tactic would most likely be to convince you that they can fetch a higher price then the next guy. They might tell you that they can get $1 million, for example, when they know that the value of the house is really in the range of $900 thousand to $950 thousand. You then execute a six month exclusive agreement, and now they own you. The agent then brings multiple offers that are all in the $900 thousand to $950 thousand range and gives you all sorts of reasons why you house is not fetching the $1 million price tag. In broker lingo, they call this “bringing you to school”. The broker knows that if you are motivated to sell you will eventually lower your price to meet the market’s valuation. So, the broker misled you in order to convince you to hire him, and he was not even asking for any upfront fee. Now imagine how he might mislead you if he were asking for a $50 thousand upfront engagement fee!

Accepting Low Probability Engagements

According to a information published by the International Business Brokers Association, the average closing rate among US intermediaries representing transactions valued in the range of $10 million is approximately 30%. This just does not make any sense to me. Why would someone pay a $50 thousand engagement fee for a 30% chance of success? Not to mention that there is generally significant work required by the Owner in any exit process, as well as a risk of a confidentiality breach which can harm the business. Wouldn’t one just be better off to put their $50 thousand on red at the roulette table! When the business broker or investment banker can make a living from the engagement fee it’s not hard to imagine that they may not be very selective. Our experience at LockeBridge, a registered Boston based Investment Banker, is that about half of the businesses for sale are not saleable; with the reason often being that the typical sell-side broker will take any engagement in which they can earn a $50 thousand upfront fee.

In addition to the above, large upfront fees can also result in several other potential conflicts such as a low commitment to success and low investment in resources devoted to the engagement. So what’s the alternative? Unfortunately the de facto standard among seasoned investment bankers is to charge a significant engagement fee. Contrary to the legal profession, which has been around for thousands of years, mid-market investment banking has only been around in any formal way for less than 50 years, and the demand for seasoned, unbiased representation has simply not been met with an adequate supply of investment banking services in the lower end of the mid-market. In fact, at the sub $20 million transaction size it is difficult to find truly seasoned expertise even if you are willing to pay a hefty upfront fee. If one is seeking both seasoned expertise and an engagement agreement without potential built-in conflicts (i.e. no substantial upfront fee) then be prepared to look for a long time. In our experience the combination of high expertise and no engagement fee in the lower end of the mid-market is practically non-existent. This situation is not an issue in the legal profession, which seems to have worked out the demand and supply gaps over the last thousand years. In the legal profession, everyone knows that the standard contingent agreement, with no upfront engagement fee, is accompanied by a success fee of 30%. Hopefully it won’t take hundreds of years to meet the demand for high level, uncompromising mid-market investment banking representation.

The major issue for the Purchaser to consider will be:

Is it worth a savings of five hundred thousand dollars to expose their $200 million business to all the potential liabilities of the target acquisition?

Imagine that the ski manufacturer made a defective binding a year prior to the acquisition? Subsequent to the acquisition the binding failed and the skier fell and seriously injured himself. The Purchaser will be liable for the damages!

Product and environmental liabilities are two of the most concerning issues to potential Purchasers of corporate stock.

While a strong intermediary may be able to overcome such liability issues and subsequently structure a sale of corporate stock that will work for both parties, corporations should review the current pros and cons of the “C” corporation status and consider converting to an LLC or S corporation well in advance of the sale of the business. If converting to an S corporation is not possible, don’t lose sleep yet. It may be possible to structure a transaction that will allocate the purchase price so not to be exposed to double taxation. For example, professional service businesses may be able to allocate a substantial portion of the price to personal goodwill, which bypasses the corporate level tax. Additionally, retainers and non-compete agreements may be negotiated which will also bypass the corporate tax.

It is critically important to hire a strong transaction team (accountant, attorney and intermediary) that has substantial negotiation and structuring experience. When it comes to selling a “C” corporation the transaction can become much more complex and the team’s structuring tactics even more crucial. An effective deal structure will maximize the amount the Seller will have to show for a lifetime of sweat equity. Note: A strong intermediary will advise you on required skill se of the team members and coordinate the team member’s activities.

Conversion from a Subchapter S to a “C” corporation is not a problem from a tax perspective. However, going from a “C” corporation to an S can be a taxable event if the value of the corporation has appreciated since its formation. Note that generally, you cannot convert a corporation to an LLC. You will need to dissolve your corporation. Once having done this, generally one may form a new LLC using the same name.

When an existing “C” corporation converts to an S corporation, only the post-conversion appreciation in the corporation’s assets will qualify for single level tax treatment, unless the corporation’s assets are sold more than 10 years after the date of conversion. This 10-year “look back” period prevents a “C” corporation with appreciated assets (and subject to double taxation on the sale of those assets and subsequent distribution of proceeds to its shareholders) from converting to an S corporation in order to achieve a single level of taxation.

If your company is a “C” corporation seriously consider a conversion that will lower the taxable impact on your business. If you plan to sell the business prior to ten years from the time of conversion then hire a strong team that will be able to assist in structuring a tax efficient transaction.