Blog

04 Feb
Valuation Accuracy & Adjusting the Financial Statements

Learn From the Past, Value the Future.

The terms recasting, adjusting and normalizing are often used interchangeably and refer to adjusting items on a company’s financial statements that are unrelated or unnecessary to the ongoing operations of the business. Financial reports are generally composed to minimize business tax liability which in turn, results in an inaccurate presentation of a company’s true earnings and profitability. Because the objective of reporting to the IRS is generally in contrast to financial reports composed for company shareholders and perspective investors, financial adjustments made to expose the real performance of a company usually result in higher profits and an increase in the fair market value of the business.

Keep in mind that buyers are paying for the company’s future expected free cash flow, not the historical financial performance.  In fact, one can often hear LockeBridge bankers saying, “Learn from the past, value the future”.  In other words, past performance is only meaningful in so far as it provides insight into the future potential performance of the company.  Ultimately the prospective purchaser is attempting to estimate what the cash flow will be under its ownership.

There are numerous financial items that may need to be adjusted. The process is as much an art as a science. Understanding what the potential purchaser will accept as an adjustment, relevant to both the income statement and the balance sheet, requires significant experience and is a critical component in accurately estimating the value of the company.

There are a handful of categories which define the majority of adjustments. Below is a summary of these items.

 

INCOME STATEMENT ADJUSTMENTS

Owners Compensation
The objective is to account for the cost of all benefits received by Shareholders (passive and active) and their family members which have been expensed to the business.  After accounting for the foregoing, we adjust the total compensation to the fair market rate one would reasonably expect to pay for replacement personnel.

Owner Compensation may include, but is not limited to:

  • Salary
  • Bonus
  • Profit Sharing
  • Health Insurance
  • Life Insurance
  • Club Membership Fees
  • Personal Travel, Meals & Entertainment
  • Personal Vehicle Expenses

One-Time, Non-Recurring Adjustments
Expenses and Income which are not anticipated to reoccur under the new owner’s tenor are called One-Time or Non-Recurring and may include such items as:

  • Legal Expenses (e.g. litigation expense)
  • Broker Fees (e.g. M&A retainer)
  • Consulting/IT Projects (e.g. new web-site development)
  • Non-Performing Employee Expense
  • One-Time Recruiting Expenses
  • Start-Up Expenses (e.g. organizational documents, patent applications, moving costs, hiring costs, etc.)
  • Insurance claim proceeds and lawsuit settlements.
  • Gains or losses from the disposition of assets such as the sale of vehicles.

Note that there are plenty of potential “abnormal” income and expenses which may not be intuitively obvious to business owners. An example of such are:

  • Business interruption costs.
  • Gains or losses from discontinued operations.
  • Abnormal high or low profits (e.g. large one-time orders, inventory clearance event)

Rent Expense
If the property upon which the business operates is owned by the Company or one or more of the company Shareholders often times the rent expense is not in line with the market.  If the Company owns the property only the costs associated with supporting the property such as insurance, property tax, maintenance and utilities, will be expensed without any consideration for arms-length rental rates.   If the purchaser is not acquiring the real estate the property expenses must be adjusted to fair market. Even if the property is being sold along with the operating entity, because the method used to value real property differs from the methods employed to value operating entities, the real property cost must be normalized to fair market so that each of the two assets can be valued independently.

 

BALANCE SHEET ADJUSTMENTS
The profit and loss statement is generally much better understood and garners more attention by business owners than the balance sheet. Consequently, balance sheet adjustments are often overlooked.

Regardless of the depreciation method used assets need to be “marked to market”. Mark-to-market accounting can change values on the balance sheet as market conditions change. For example, your 20 year-old desk may be fully depreciated and show no value on the balance sheet but it works just as good today as it did when it was new. In fact, it may even be valued higher today than the original purchase price. For profitable going concerns the value of the fixed assets generally does not impact the enterprise valuation, however what about the value of the inventory.

Depending on both the inventory accounting method utilized and the type of assets held in inventory, a mark-to-market adjustment can substantially impact the enterprise value.

LockeBridge does a significant amount of business in the metal industry.  Consider a metal processing company using LIFO.  In this case there should be a LIFO reserve footnoted on the financial statements. Depending upon the company’s inventory turn-over and the volatility of metal commodity prices adding back the LIFO reserve can substantially change the value of the current assets.  Even if FIFO is used consider a metal recycler, for example, which may need to accumulate enough inventory to fill a shipping container to be sent to a Chinese buyer. It may take a smaller recycler several months to accumulate this volume. During such accumulation period recent metal prices may differ significantly then the recorded cost of the inventory.

Various factors must be considered in valuing a company. One such factor is how much weight to be placed on a cost-based methodology such as the replacement cost method.  In any event, accurately adjusting the balance sheet may be essential in valuing the company.

 

ENTERPRISE VALUE
After accounting for all of the relevant adjustments, how does one then determine the value of the company? Thorough and credible adjustments are a critical factor in any valuation but even if the job is done perfectly there are many other factors to consider when valuing a company.

For example, most business owners are familiar with the concept of EBITDA “multiples”, and sometimes applying these multiples to a properly adjusted EBITDA can indeed approximate market value, however there are several other variables to consider.

Consider two shipping companies both with the same EBITDA, but one company leases their trucks and the other purchases their trucks. Because the leasing cost is already accounted for as an expense, most likely the company that leases has a higher value.  Even if both companies purchase their trucks the company with the lower capital expenditure, all else equal, will be valued higher. Capital expenditure doesn’t come into play when considering EBITDA. That’s why free cash flow (FCF) is really the relevant number. Most non-professionals, and many professional for that matter, do not fully understand FCF because it takes into account more complex issues such as capex, debt leverage, and tax rates.

As previously mentioned, purchasers value the future expected FCF. To do this they project the entity’s adjusted earnings into the future and then “discount” or “present-value” them back into today’s dollars using a discount rate which accounts for their cost of both debt and equity, the weighted average cost of capital (WACC). One critical job of the valuation professional is to estimate the prospective purchasers WACC.  The methodology used for such estimation varies widely and is often the determining factor in the valuation accuracy.  A discussion of the various methodologies used to determine WACC is beyond the scope of this paper but suffice it to say that the WACC is based on numerous factors including, but not limited to:

  • The Risk Free Rate of Return
  • Small Company Risk
  • Industry Specific Risk
  • Company Specific Risk
  • Availability and Cost of Debt (i.e. leverage)
  • Forecast Credibility

This article has mentioned only two valuation methodologies, the replacement cost method under the cost approach and the discounted cash flow method using the income approach,   however a number of methods should be considered to accurately value a company. Each method has its strengths and weaknesses.  Refer to below Appendix for LockeBridge Valuation Accuracy.

 

THE BOTTOM LINE
No owner one should enter into the merger and acquisition (M&A) process prior to obtaining a very credible estimate of value.  It is critical that selling Shareholders have reasonable and relatively accurate expectations, which reflect how the market perceives the value of the company. Additionally, if not credibly performed Shareholder’s can be subject to a material conflict of interest with their M&A Advisors, whose compensation is usually substantially based upon the value and structure achieved.  Refer to www.lockebridge.com/engaging-an-investment-banker  for a brief discussion of potentially advisor conflicts.

Both offer prices and valuations can range substantially. Refer to www.lockebridge.com/case-studies to see numerous sell-side transactions, bid prices and composition. Here you can see that it is not uncommon for offers to range +/-30% or even more.

The M&A process is not to be taken lightly.  It should be done effectively and optimally, the first time around. Obviously, unanticipated circumstances out of the control of both the Advisor and Owner can and do occur, however a failed process requiring the business to be placed back on the market a second or even third time is rarely a good thing.  An offensive position the first time around can easily morph into a defensive posture. An accurate estimate of value and an effective selling process should minimize the time, energy and potential defocus and exposure which can all result in substantial costs to both the Shareholders and the Advisor.

APPENDIX

Valuation Accuracy
Valuation accuracy is critical to sellers in order to properly assess alternatives. Over the last 10 years LockeBridge’s understanding of key value drivers has resulted in extremely accurate estimates.

  • LockeBridge’s average valuation is 93.3% of the average offer price.
  • LockeBridge’s valuation ranges within +/-13.05% of the average offer price.

07 Dec
Increasing Economic Uncertainty & Valuation Volatility

Warning Signs Abound. Business Valuation Volatility is High.

December 2018Dear Colleagues and Business Owners:

We are concerned that mid-market valuations may soon be compromised and many business owners do not have the time to ride out a potential downturn.

The purpose of this memo is to share LockeBridge’s current perspective on the potential shift in economic trends and the impact such may have on middle-market business valuations

LockeBridge Economic Forecasting – Highly Accurate Track Record
In 2006 and 2007 LockeBridge published numerous articles, sent thousands of emails  and advised dozens of business owners of the impending economic crisis and resulting business devaluation, which subsequently put thousands of companies out of business.

Refer to Appendix below for select articles.

While we do not believe that we are heading into a major down cycle, we do believe that volatility is the highest it has been since the 2008 downturn and such volatility can cause significant buyer hesitation.  Over the past couple of years we again authored many articles and have advised small business owners, who do not have at least 5 years to sustain a cyclical downturn, to consider the sale of their business sooner rather than later.  One such LockeBridge authored article, which has received material attention, is titled “Business Value Decreases With Fed Rate Increases” and can be viewed at:
https://www.lockebridge.com/bus-value-decreases-with-fed-rate-increases.

BACKGROUND
The economy is starting to tilt. In fact, current macro-economic uncertainly is already repressing valuation multiples and creating buyer hesitation. J. Powell just this week announced that the Fed is on edge and closely watching leading economic indicators.  Powell indicated the Fed is now closer to a neutral interest rate policy and Jame Bullard, CEO of the  Federal Reserve Bank of St. Louis, stated that the Federal Reserve should consider pausing hiking interest rates at its December meeting to give itself more time to understand why financial markets have become so volatile.

This foregoing represents a dramatic change in tone from the Federal Reserve.  Mr. Powell noted the slow-down in forecasted car sales, which was evidenced by GM’s announced plant closings, as well as the dramatic slow-down in housing sales. The point is that after an unprecedented nine years of economic growth we are now facing signficant economic uncertainty. This uncertainty is further exacerbated by the tenuous Chinese/US trade issues.

To add further fuel to the file The U.S. Treasury yield curve just inverted for the first time in more than a decade. An inverted yield curve occurs when long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. The inverted yield curve has preceded the last seven recessions going back to the late 1960’s.

Curent Volatility Drivers
-Inverted Yield Curve
-China/U.S. Political Uncertainty
-Fed Policy Uncertainty
-Slow- Down in Housing Sales
-Slow-Down in Auto Sales

SHOULD I SELL OR SHOULD I HOLD
While we do not pretend to have a crystal ball regarding the future of the economy, one thing that most economists agree upon is that economic uncertainty is currently the highest it has been during this exceptionally long nine-year cycle. Considering this current economic volatility and warning signs it seems only prudent for business owners who have been contemplating a near term exit to seriously consider at least preparing for such a sale now.   

Stock Price Recovery Time (S&P 500)

As can be seen in the chart above, from 1950 – 2018 there have been 11 periods when the S&P 500 dropped from its previous all-time high. On average it took 2.7 years for stock prices to recover. That stated, it took an average of 7 years for stock prices to recover from the previous two drops.

The Take-Away
Those business owners that continue to postpone a potential sale should be prepared to hold the business through a potential downturn and/or period of cyclical volatility. History shows downturns can last as short as one-year, on average approximately three-years and as long as eight-years.

 

Note
To execute an effective selling process generally takes nine months to a year. Therefore, owners considering a sale need to project what their company will look like a year from the date one begins the exit process.


APPENDIX

 LOCKEBRIDGE ARTICLES PUBLISHED PRE-2008 CRASH

  1.  For What its Worth”,
    Walls & Ceilings Magazine, May 2006,
    https://www.wconline.com/articles/84852-for-what-it-s-worth

Article Synopsys
In this article LockeBridge is warning all business owners whose businesses are sensitive to the health of the housing market to seriously consider selling their business if they do not have an appetitive to ride out a potential down cycle in the industry, which can easily last for five years.

Article Extract
“Timing is everything.   A significant decline in the National Association of Home Builders’ Housing Market Index over the last five months indicates a continued slowing in the housing market.  There does seem to be a relatively high level of uncertainty in the industry, so if your time horizon is relatively short, less than five years, you may want to consider selling in the near future while merger and acquisition activity is still relatively strong and there is an abundance of money searching for good companies.”

 

  1. “Should I Sell or Should I Grow. How Will the Slowing Housing Market
    Effect the Value of Your Company?”, Walls & Ceiling Magazine, June 2006.

Article Synopsys
This article explains how macro-economic trends occurring in 2006 can dramatically negatively impact the enterprise value. Additionally, the article discusses common value deflators and how to minimize their impact on the business value.

Article Extract
“As I write this article on the 31st day of March, the Chairman of the Federal Reserve Board, Mr. Bernanke, presides over his first meeting of the Federal Open Market Committee, the group that sets interest rates. Today they announced that they are continuing the gradual interest rate-raising campaign. It was the 15th such increase since the Fed started tightening credit in June 2004. The prudent building supply company owner has to ask himself “at what point will rates hurt my business?

 The prime rate is at its highest since the spring of 2001. The National Association of Home Builders Market Index, a measure of builder sentiment, fell to 55 yesterday (see graph), the lowest figure since April 2003. At the same time, mortgage applications as measured by the Mortgage Bankers Association have fallen five out of the past seven weeks. These figures indicate a market slowdown. What does this mean to the value of your company?”

 

  1. Metal Industry Owners Face a Difficult Decision, Should I Sell or Should I Grow?”,
    Recycling Today Magazine, June 2006

Article Synopsys
This article explains how industry specific variables, relevant to the metal industry, such metal commodity prices, overseas shipments, etc., lead one to believe that valuations may have peaked and industry risk is high.  The article also provides pointers on how to mitigate such risk and ways to optimize valuation.

Article Extract
“As previously stated, the metals industry is at an all-time high. Where we go from here is anyone’s guess.  There does seem to be a relatively high level of uncertainty in the industry, so if your time horizon is relatively short, less than five years, you may want to consider selling in the near future while the industry dynamics are extremely positive and merger and acquisition activity is strong with an abundance of money searching for good companies.”

 

  1. “For Sale?  How have unprecedented metals prices affected the value of your company?”
    Recycling Today, August 2006, https://www.recyclingtoday.com/article/for-sale-/

Article Synopsys
This article emphasized that there is a high level of uncertainty in both the macro-economy and within the metal industry.  It urges Business Owners that are not prepared to own their company in a potentially highly volatile business environment to seriously consider selling. The article further discusses how best to prepare for a sale of their company.

Article Extract
The objective of this article is to ensure that readers understand that several considerations will affect their businesses’ values and to encourage prospective sellers to put as much effort into the selling process as they have into their companies’ operations. After all, the average selling process lasts about one year, but when executed correctly, it can yield as much as the total cumulative earnings that the owner has made over the life of his or her company.

  

  1. “Metal Industry Valuations”
    Recycling Today Magazine, October 2007

Article Synopsys
The author, Scott Waxler, is extremely sensitive to the historically high run up in metal prices and the implication on enterprise value for companies participating in the metal industry.  The article discusses valuation methods and how to account for metal price variability.

Article Extract
The unprecedented run up in base metal prices has necessitated the creation of alternate valuation techniques. Dynamically changing metal prices have resulted in a widening of valuation ranges for companies dealing with these commodities. Profit increases resulting from the increases in the underlying commodity price are not viewed as sustainable or controllable and therefore must be normalized.

02 Nov
Raising Capital & Equity Retention

We created the Value Plateau Model© (VPM), to better explain
the importance of timing the capital raise and tranched financing.

Today’s highly variable and unpredictable economy creates a large discrepancy in opinions about the future. As a result, valuation ranges are much wider than normal. It is not unusual for a company to attract a range of bids of plus or minus fifty percent as compared to a more typical plus or minus thirty percent range experienced during a more stable economy. No matter how strong your company’s performance or outlook, no company is totally insulated from macro- economic forces. In fact, the performance of most companies is highly dependent on the state of the economy including external factors such as Gross Domestic Output, Interest Rates, Balance of Trade, Consumer Sentiment and Consumer and Government Spending. This uncertainty has a significant impact on the capital raise process. Whether the raise is in the form of equity or debt or to fund early stage or mature company growth; capital’s worst enemy is the fear of uncertainty. So what can you as a business owner do? Don’t add unnecessary risk on top of the inordinate risk already existing in the  economy and your industry. Focus on tactics which reduce risk such as substantial proof of efficacy, well defined business plans and milestones, and limit the amount of capital per raise while increasing the frequency.

Startup Equity Capital
For early stage companies seeking to raise equity capital, the principal variables are: Timing, Amount of the Raise and Credibility/Validity of the Business Plan. Each of these variables are highly inter-related. The primary objective of the early-stage entrepreneur/founder during the capital raise process is to manage these issues effectively, in order to retain as much equity as possible. This is especially critical during the early stages where risk is high, value is low and many entrepreneurs are scrambling to raise much needed capital,  and in many instances even “survival” funding.

Timing, Credibility, Amount of Capital
No doubt that that timing of the capital raise, the amount of the raise and the credibility of the business plan are critical variables for both mature and early stage companies alike, however; for early stage companies that properly manage these variables it can mean the difference between retaining a majority of ownership versus next to nothing. Too many startup entrepreneurs have failed to manage the capital raise process effectively, only to be left with a small fraction of ownership by the time the company actually turns cash flow positive.

For startups there are several value plateaus during the lifecycle of the company. Obviously, the value of the startup increases as risk decreases and the business starts to achieve its major milestones or “value plateaus”. During the early stages, it is critical to identify these value plateaus. Each value plateau represents an increase in efficacy; an achievement which enhances the company’s probability of success. Timing the capital raise to be in concert with the value time line (see diagram below) is essential. This requires an extremely well thought out plan with crisp execution. It is essential to understand when and how much to raise at each plateau, and factor time-to-market into the equation. Since most early stage entrepreneurs view the capital raise process as a total defocus and “necessary evil” they want capital on the balance sheet as soon as possible. Therefore, the decision of delaying a capital raise until the next value plateau is always a sensitive trade off.

Timing the Raise
The Value Plateau Model (VPM)©.  When speaking with early stage entrepreneurs, I often refer to the Value Plateau Model© (VPM), which LockeBridge created to better explain the importance of timing the capital raise and tranched financing. The word tranche is derived from the French, meaning slice or portion. In the world of investing, it is used to describe a security, either debt or equity, that can be divided into smaller pieces and subsequently sold to investors.

Tranched financings, historically used in life science companies, has expanded into other industries.  Simply stated, for the entreprenuer, the principal benefit of tranching is a reduction in dilution or preservation of equity. Tranching is not for everybody, however.  This type of financing requires careful structuring and is unique to every company. More conservative entreprenuers, or those that may not have the highest level of confidence in achieving their interim milestones may opt to take the full amount of required capital upfront.  Word of caution; be very careful that you dont get caught in a corner by presenting an adversion to tranching.  Experienced investors can easily interpret such an adversion as a material weakness in your confidence.

To best illustrate the stages of the Value Plateau Model © (“VPM”), we will use terminology which generally relates to the lifecycle of a technology-based product, however; the same concept can be applied to any product or service.

 The Value Plateaus

A.  Idea Inception (Seed Financing)

The first activity which generates value is the inception of an idea. Financing at this level is made to support the founder’s exploration of the idea and is referred to as seed financing. Value at this stage depends upon several factors which include the incremental benefit the idea provides to the consumer, the amount of required investment, time-to-market, barriers to entry, total available market size, etc.  At idea inception, there is little or no proof of efficacy, therefore value is very low.  As such, unless the idea is superior, you can count on funding coming from your own pocket or those of family and/or friends (thus the term “family & friends money”).   Typical seed capital ranges between $50,000 – $250,000

B.  Alpha – Proof of Efficacy in the Lab

For newly developed products, the first test of efficacy is generally conducted in a laboratory setting and referred to as alpha testing.  Since there is a huge gap between lab testing and actual application of the idea in a real world environment, risk is still very high.  As with the prior step, unless the idea is a blockbuster, value will still be low.  The name of the game in this stage is to have highly documented, controlled testing.  At the end of this stage, a prototype may be developed.  The typical value for companies operating between the Proof of Efficacy and Beta stages,  which have product with attractive characteristics (i.e. relatively large total available market, defensible position, growing market, good projected ROI, etc.) falls in the $2 million range.  This $2M is just a general rule of thumb and can vary signficantly.   A  more accurate valuation methodology may be achieved by present valuing the expected free cash flow over the life of the company.  Of course, the forecast itself is generally the largest variable. So, to the extent the forecast lacks credibility the present value discounted cash flow method will not be favorable.  Typical discounts rates at this stage can be in excess of 70%. 1

C.  Beta

Beta generally involves controlled use of the product in a third party, real-world environment.  At each plateau there are varying levels of efficacy.  At the Beta stage the highest level of efficacy typically occurs when an operator, working in a production environment, is operating the product without assistance from the product engineering team. When this occurs, the product is typically running effectively enough for the Company to enter into production,  producing and shipping multiple systemsor componets to be used in the customers production environment.  At this point, efficacy is very high. The investors’ focus now shifts more to operating and marketing issues such as customers’ perceived value and the costs of manufacturing and pricing.  Although still pre-revenue, if milestones are being achieved on-time and on-budget the company’s enterprise value will have increased significantly.  Typical discounts rates applied at this stage are between 50% and 70% 1

D.  Production Stage (Series – A Financing)

At this stage, the company is filling orders for the product to be used in a production environment.   The company is not profitable but has an organization, a working product and some revenue.  At this stage, the investor is very focused on issues such as product reliability and perceived customer benefits.  Typical discounts rates applied at this stage range from 40% – 60%.1

 E.  Repeat Orders (Series – B Financing)

One might argue that Repeat Orders really belongs in the Production Stage, however; I believe that when a customer, especially a well recognized and respected industry player, places a follow-on order it represents substantial validation of both the product benefits and the economics.  After receiving several repeat orders from well-respected customers, product/technology efficacy begins to fade into the background.  The focus changes from “Does the product work?” to “Does the company work?”   Can the management of the company scale its operations while retaining its competitive advantage, servicing the customer needs, retaining its employees and maintain the critical operations required to be successful in the long run? Discount rates for Series – B financings typically range between 30% – 50%.1 

In an effort to add some persective to the discount rate guidance, investors or buyers of mature “nano-cap” (<$50M revenue) privately held companies with solid historical performance typically seek a return on their equity in the range of 20% – 25%, depending upon such factors as the current risk-free rate of return (typically measured by the 20-year treasury bill), industry risk and perceived company specific risk.

 

Final Words of Advice

As I compose this article, a few years after the crash of 2008, the idiom “cash is king” has rarely ever carried more weight.  There are a plethora of bargains out there if you’re the king.  With cash being so valuable, the competition vying for their share of the green, is tougher than ever.  So how is a startup going to get a piece of the action?  The onus is on the entrepreneur to drill down and focus on the validity of the idea, the timing of the raise and the required amount of capital.  Presentations that lack credibility, products which lack efficacy and companies which seem to require excess capital will be immediately rejected.

Some tips to consider

Think about what motivates the investor.  Lower his risk (derisk the offering) and raise his perceived return.   Consider creating a checklist that includes the most important capital raise criteria. The following may be included on your list:

    1. Large total available market
    2. High barriers to entry
    3. Growing market
    4. Razor – Razor blade (i.e. annuity component)
    5. Exceptional documentation and testing controls
    6. Substantial proof of  prduct and technology efficacy
    7. Well defined milestones
    8. Tranched capital raises
    9. Credible business plan

 

A Side Note

The other night, I happened to catch a movie based on the life of Robert Kearns, the professor turned inventor who masterminded the intermittent windshield wiper.  I squirmed in my chair as his invention was blatantly stolen out from under him.  Although his story had a somewhat satisfying ending, the point that stayed with me was that from the very beginning, he did not have the proper support structure in place to safeguard his interests.  Understanding how to maximize ownership of your ideas throughout the process of raising capital will ensure that as your invention gains traction and your company grows, so will your bank account.

 

 

  1. Sahlman, William A.,  A Method for Valuing High-Risk, Long-Term Investments, Harvard Business School, August 12, 2003
01 Nov
lockebridge sagacity inc
Private Company Recapitalization
lockebridge sagacity inc

Business owners can have the opportunity to sell a portion of their company
while still maintaining a significant, or even a majority, ownership stake.

A recapitalization is the process of exchanging one form of financing for another. For business owners wishing to take something off the table a recapitalization represents an alternative to the complete sale of a company. A recapitalization can provide the necessary capital for growth, achieve personal liquidity and diversify risk for owners wishing to sell less than 100% of their business.  It gives a business owner the opportunity to sell a portion of their company while still maintaining a significant, or even a majority, ownership stake. In essence the owner is able to create liquidity and diversify risk today, while setting the stage for a second “payday” down the road. These transactions enable our clients to partially cash out of their investment in the business and capitalize on the enormous amount of sweat equity they have put into their business over the years.

The original owner can continue as a partner and/or manager of the company, while the new partner and capital provider shares the business owner’s culture and vision for the future. Unlike some strategic acquirers who purchase with a view towards eliminating overhead redundancies, private equity firms prefer a more passive or board level involvement and a collaborative relationship with the existing owner and management. As partners, private equity firms are often able to introduce opportunities to the company that were not previously available and can provide significant experience in order to assist the company in growing to its next level.

For owners wishing to partially cashout the actual mechanics could be that the company issues stock to buy back debt, which had previously been provided by the owner for funding. In its simplest form the company may merely sell stock to a third-party investor.

Less common and understood is a leveraged recapitalization. If the owner desires to pass the business on to his/her children a leveraged recapitalization can be a very effective strategy to enable the owner to both take cash out of the business while at the same time making it affordable for children to obtain ownership. With a leveraged recapitalization, instead of issuing stock, the company may take on additional debt. The amount of debt available to the company depends upon both the assets available to collateralize the loan as well as the cash flow available to service it.

ADVANTAGES

Conventional Recapitalization

  • Can provide the capital for growth and achieve personal liquidity and risk diversification for the shareholders through a partial sale of the company’s equity to a passive institutional investor, while simultaneously refinancing (or “recapitalizing”) the company’s capital structure.
  • Represents an alternative to a complete sale, thereby enabling the shareholders to capitalize on future growth potential while utilizing third party investment capital.

 

 Leveraged Recapitalization

  • Enables retention of 100 percent of the company ownership.
  • Financing source is typically a conventional commercial bank which can act faster than a third-party equity investor.
  • Risk of a breach of confidentiality is much lower.

DISADVANTAGES

Conventional Recapitalization

  • There can be adverse tax consequences if preferred stocks are distributed through recapitalization. The company’s cash might get drained by preferred stock dividends.
  • If a business has been classified as an S corporation, it becomes difficult to do a recapitalization because such corporations cannot have more than one class of stock.

 

Leveraged Recapitalization

  • Personal guarantees will likely be required by the bank as security for the additional debt obtained. So, even though the business owner has taken cash out of the business, risk still remains with the personal guarantees.
  • There will be increased financial reporting required by mezzanine and senior debt providers.
  • Additional debt on a business will increase the stress on cash flows, since lenders will require sufficient cash to cover the debt servicing requirements. This can affect a company’s ability to grow.

 

IDEAL CANDIDATES

  • Privately owned companies which have solid management teams, healthy margins and stable cash flows, strong market and competitive positions, and attractive growth opportunities.
  • Owners willing to remain as the operating partner until executing a secondary sale of the owner’s remaining equity (typical 2 – 3 years, coterminous with employment agreement) to the financial partner or a sale, along with the financial partner, to a third-party purchaser.

“In essence the owner is able to create liquidity and risk diversification today,

while setting the stage for a second “payday” down the road.”

SUMMARY – MORE THAN SIMPLY SELLING YOUR BUSINESS

Liquidity
Business owners can realize significant personal and family liquidity by selling part of the business to a financial partner and extracting 70% – 80% or more of their company’s current value.

Diversification
Avoids the risks of having personal and family wealth tied to a single business enterprise and allows for prudent wealth diversification .

Upside
Entrepreneurs can participate in a “second bite of the apple” in 3 to 5 years by maintaining a meaningful ownership stake and aggressively growing the business, using the capital from the financial partner, thereby creating an opportunity for  significant additional wealth.

Management
Owners and existing management maintain operational control of the business. With new financial partners owners can focus on accelerating growth without exposing themselves to additional financial risk.

Partner
A well-capitalized partner with deep pockets and extensive business connections sets the stage for strong growth organically and/or through acquisitions.

* Note:
LockeBridge advises its clients on all exit options. Recapitalizations is just one of numerous potenial exit strategies.  It is critically important that the business owner(s) meet with the banker to discuss options which compliment their each shareholder’s personal objectives.

02 Mar
Asset Protection and Estate Taxes for Business Owners

Asset Protection and Estate Taxes for Business Owners

Most Mid-Size Businesses Owners Needlessly Pay Huge Estate Taxes & Unnecessarily Expose Business & Personal Assets to Creditors.

Business Owners seem to be relatively savvy in reducing income taxes however, we rarely see owners implement effective estate plans or prudently protect personal and business assets. Unfortunately less than 1 out of 5 business owners we speak with have an appropriate succession or estate plan, and most of these owners will lose 50% or more of the value of their business if the plan is not amended. Additionally, most business owners leave their personal assets exposed to business creditors. Perhaps even worse is that most are not even aware that they can lose their personal assets to any number of potential creditors.

For Business Owners Preparing for a Sale
The Potential to Materially Reduce or Eliminate
Taxes can be Quite Substantial and Time Sensitive.

The Interview – Asset Protection & Estate Tax
We have interviewed dozens of Business Owners regarding their estate plans. Of those Owners that do have a plan the most frequent set of responses are:

LockeBridge: What kind of trust do you have?
Bus. Owner: I’m not sure.

LockeBridge: There are many different types of trusts. Can you call your lawyer to find out what you have!
Bus. Owner: My lawyer tells me that I have a revocable trust that will protect me.

LockeBridge: Did you know that currently your revocable trust will only shelter $5.45M from federal estate taxes for each of you and your wife and there is a good change that you will have to pay state and federal estate taxes of more than 50% of your net worth.
Bus. Owner: Are you kidding! I expect my Company to grow significantly so the taxes are going to be huge. Why didn’t my lawyer tell me about this?

LockeBridge: Well, did your estate attorney speak with you about the eventual disposition of your Company.
Bus. Owner: No, when I was speaking with him I was not considering the sale of my Company. Now that I have decided to sell it these issues are more tangible to me

LockeBridge: I assume that your also not aware that you can also shelter substantially more of your Company from estate taxes by valuing the Company utilizing an IRS acceptable Lack of Marketability and/or a Minority Interest Discount prior to gifting or selling it to a irrevocable trust. I would be happy to illustrate for you how much you can save by doing this. I would also be happy to refer you to another estate attorney.

If you are contemplating the sale of your business
in the foreseeable future, it is even more important to act now

or you will most likely lose much of the opportunity to reduce estate taxes.

More Than Estate Tax Protection – Protection From Creditors
In addition to estate taxes a proper trust vehicle can keep both the business owner’s personal and business assets safe from creditors such as:

  • Divorcees
  • Tax Collectors
  • Accident victims
  • Health-care providers
  • Credit card issuers
  • Business creditors

Select Client Experience – Estate Planning and Asset Protection

“LockeBridge gained a clear understanding of our objectives which went well beyond the transaction itself. They gave us invaluable guidance on estate planning and wealth management. This was a part of the process we had given very little thought to but turned out to be a very important step in completing the deal and preserving our wealth”

Joe Montesano
President and CEO – Something Sweet, Inc.

“Not only did LockeBridge structure a very favorable deal and manage all the steps to closing, they provided services far beyond the transactional requirements focusing on the personal interests, tax minimization, and wealth creation of the owners. Winning Proposals was actually a subsidiary holding of a pension fund with multiple layers. The objective was to create a transfer that would result in deferring materially all taxes while at the same time meeting the Owners’ post-closing income needs.”

David Claiborne
President -Winning Proposals, Inc.

“LockeBridge gave us invaluable advice on how to both minimize and defer the taxes which resulted from the transaction. Because the buyer was a foreign public company, on the Stockholm exchange, the financial considerations were even more complex. In the end we made a very favorable transaction and protected our assets from creditors which were exposed to certain potentially adverse foreign policies.”

Matthew Nekoroski
President -Surgical Tables, Inc.

* LockeBridge advises its clients on strategies to minimize estate and income taxes. When appropriate LockeBridge refers its clients to attorneys and accountants which are pre-approved via an arduous screening process which seeks both excellence in performance and uncompromising client commitment. LockeBridge does not charge retainers and we do not accept compromising referral fees. Mission Statement / No Conflict of Interest.

23 May
Bus Value Decreases With Fed Rate Increases

PRELUDE

This article has been specifically written for the small business owner.

On May 22nd 2015 the Labor Department announced that the core CPI increased 0.3 percent, which represents the largest gain since January 2013. As a result of the CPI report, the Fed Fund Futures is now pricing in a 100% chance of a rate hike before year end.

All else being equal, the value of small businesses will decrease when the Federal Reserve increases interest rates. Presumably all else will not be equal at the time the Fed raises rates. The Fed has stated that it will only raise rates when the economy is on a solid footing, as measured by key economic indicators. Hopefully the economic improvement has resulted in an increase in your company’s value sufficient to offset decline in value due to interest rate increases. That stated, the U.S. economy has seen upward momentum for six years and most businesses have now exceeded their 2007 earnings.

Articles with titles such as “The Biggest Threat to Stocks are a Fed Rate Hike” seem to be one of most popular topics these days. So why is Wall Street so nervous over a rate hike and why should you, the Business Owner, also take note? One of the drivers of the bull market has been the Fed’s policy of near zero rates since 2008.

Factoid: Since World War II there have been 16 cycles during which interest rates were raised and over 80% of the time, the stock market suffered a blow when the Fed raised rates. But, more importantly;

Low interest rates have also been one of the principal drivers behind favorable valuation multiples and these low interest rates are soon to rise causing downward pressure on valuations.

# # #

INCREASED INTEREST RATES EQUAL LOWER VALUE

All else being equal, when interest rates go up the value of businesses go down. This includes the value of lower mid-market businesses (generally classified between $5M – $100M in value). How much the value will go down in part depends upon the amount of debt available to the buyer in a potential transaction (i.e. the leverage amount) as well as the the buyer’s required return on equity. Commenting on the increase in the CPI, Todd Hedtke, Vice President for Investment Management at Allianz Investment Management, states, “I think it’s a decent sign for the economy. I don’t think it’s a good sign for capital markets.”

The required return on equity goes up with interest rates because equity investments compete with debt investments. The higher the interest rate on debt, the higher the required return on equity needs to be in order to attract investors. Stated another way, as interest rates rise investors are more attracted to fixed income investments, which in turn reduces the amount of capital available for equity investments. In order for a company to attract equity investment the company’s perceived future prospects must increase and/or perceived risk must decrease. The combined costs of equity and debt, called the Weighted Average Cost of Capital (WACC), are used to discount the company’s future expected cash flow and establish on measure of a company’s value.

When WACC increases 1%, what happens to the value of a small business? A typical company with $30M of Revenue and $3M of Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA) growing at a compound annual growth rate of 5% (the “Model Company”) will lose $945,000 (6.7%) of its value, from $14,038,000 to $13,093,000, with the EBITDA multiple decreasing from 4.91 to 4.5 (refer to below chart).

Impact of 1% rise in interest rates on typical company
with $30M Revenue, $3M EBITDA and 5% CAGR (the “Model Company”)
($ thousands)

Before 1% Increase in Rates
4% cost of debt, 23% cost of equity
After 1% Increase in Rates
5% cost of debt, 24% cost of equity
Difference% Difference
Enterprise Value1$14,038$13,093-$945-6.7%
Debt$5,615$5,237-$378-6.7%
WACC214.76%15.60%0.8%5.7%
TTM EBITDA Multiple34.914.58-33.0%-6.7%
  1. Enterprise Value: Equity + Debt
  2. WACC: Weighted Average Cost of Capital
  3. TTM EBITDA Multiple: Trailing Twelve Month EBITDA Multiple

As illustrated in the chart above, the $30M Model Company will lose $945,000 (6.7%) of its value as a result of a 1% increase in interest rates.

CONCLUSION

The Federal Reserve has made it clear that they will raise interest rates only when it is confident that the economic recovery is robust and companies have regained the ability to raise prices.

Per our analysis, if the Fed were to raise interest rates by 1%, from the current .13% to 1.13%, in order to maintain the current value of the business, the modeled $30M company will need to increase its operating profit by approximately 7.2% to compensate for a 1% rate increase.

Don’t panic quite yet. Interest rates are not going up overnight. U.S. Federal Reserve Vice Chairman Stanley Fischer said the process of returning to a more normal level of interest rates will take a few years. Last week the Federal Funds Rate closed at .13 percent. Fed economists expect the rate will reach from 3.25 percent to 4 percent in three to four years. Will that mean that our Model Company will go down in value proportionally more? Probably not, for two reasons:

  1. Although the interest rate at which businesses borrow moves with the Fed Funds Rate, they do not necessarily move proportionately and
  2. As previously stated, the Federal Reserve is expected to raise rates with a growing economy. A growing economy generally translates into an increase in the value of small business.

Take note, there can be and most likely will be a lag between an increase in rates and an increase in valuations. This means that Business Owners who do not have a longer term time horizon, at least five years to outlast a cycle, should consider the impact of a rate hike on the value of their business and the timing of an exit. Keep in mind that even after you decide to start the exit process, between getting valuations, choosing an investment banker and executing the selling process, you are easily looking at 1 to 2 years.

01 Mar
Negotiating a Premium for the Sale of Your Business

Negotiating a Premium for the Sale of Your Business can take substantial preparation well beyond practicing your presentation. Most Buyers are significantly larger then the Seller, have executed numerous deals and have a team that is well coordinated and trained in all relevant areas of merger and acquisitions. Knowing that most Sellers of small businesses have never sold a business before you can be easy prey for the Buyer if you are not well prepared.

The key to achieving a premium for the sale of your business is not necessarily your ability to make a credible presentation of the valuable assets and opportunities in your business, which are rarely presented in an optimal fashion. When selling your business to a strategic buyer the most critical aspect of the negotiation is dependent upon your understanding of the Buyer’s operations and the determination of the value of the synergies which would be created by the merge of the two companies. Most people relate to the term 1+1=3. What is implied by this term is that the sum of the parts, when combined together, exceeds the total of the individual components when they remain separate. The amount by which the former exceeds the latter is referred to as the value of the synergies.

Synergies can come from either or both the cost side or revenue side of the equation. On the cost side, the consolidation of the operations generally presents a significant opportunity to cut costs. Examples of typical cost cutting are: Closing of duplicative locations, elimination of redundant jobs, an increase in buying power and reduction of part numbers. On the revenue side there may be an opportunity to raise prices or sell more product due to cross selling opportunities, reduced competitive pricing pressure and increased brand marketing.

The general rule of thumb is that the greater the amount of synergies the more the value and the more the Buyer can afford to pay. However, extracting the value of those synergies is quite another story. The savvy Buyer will never disclose the source of the synergies, let alone the value of such synergies. So how are you, the Seller, going to estimate the value of such synergies, which is the first step in executing a negotiating strategy which will reflect the value of the synergies in the price of your business.

As seen in the illustration below, the Normalized or Recasted EBITDA (i.e. adjusted for such items as owner’s excesses and one time events) of the Seller’s business is $2,000,000. Applying a 4X EBITDA multiple, a typical multiple for small businesses with little to no growth which are purchased by financial buyers, yields a price of $8 million. On the other hand, Strategic Buyers often pay multiples of 5 to 8 times EBITDA, depending on the magnitude of the synergies. Because of the synergies, the Strategic Buyer can justify paying a much higher price while still achieving their required return on equity (ROE). Let’s be clear, the required ROE for the Strategic Buyer is the exact same as that of the Financial Buyer. The only difference is that the Strategic Buyer, because of the value of the synergies, can afford to pay a higher price while still achieving the required ROE. Of course just because he can afford to pay a higher price does not mean that you, the Seller, will be able to negotiate such a premium price for your company.

Let’s look at an example. In our example, the synergies which can come from various areas such as cost savings, increase in sales from cross selling, technology benefits, etc., are estimated to be $1.0 million, which results in an adjusted “Synergistic EBITDA” of $3.0 million. Applying the same 4X multiple now results in a value to the Strategic Buyer of $12 million, the “Synergistic Value”, a 50% premium over the “Financial Value” of $8 million. Your ability to get the entire value of the synergies depends upon your negotiating skills. Chances are that the Negotiated Price will end up somewhere between the Financial Value and Synergistic Value. Your ability to negotiate a premium for the sale of you business will depend on several factors including your confidence in the estimated synergistic value.

Financial Buyer

Value of SynergiesN/A
Normalized EBITDA$2,000K
Mutliple4.0X
Financial Value$8,000
Buyer’s Initial Offer$7,000
Negotiated Price$8,000K
(+/- 10%)

Strategic Buyer

Value of Synergies$1,000K
Normalized EBITDA$3,000K
Mutliple4.0X
Synergistic Value12,000K
Buyer’s Initial Offer$7,000K
Negotiated Price$10,000K
(+/- 20%)

So how are you, the Seller, going to determine the value of the synergies and once determined how are you going to extract the entire Synergistic Value of $12 million, $4 million more than the Financial Value? As stated in the prior article, Selling Your Business to a Multi- Billion Dollar Acquirer, the prudent Buyer will not disclose the nature of their anticipated synergies to the Seller. The Buyer’s mentality is that they are enabling the resultant increase in value. As such, it is their objective to keep all of the incremental value emanating from those synergies. In the next articles we will explore how to obtain a premium price for your business by extracting the value of the synergies.

01 Dec
Selling Your Business to a Strategic Buyer

When selling your business to a strategic buyer, a principal objective should be to identify the incremental value of the synergies created by the merge of the two entities and capture as much of that value as possible. The first step in extracting the value of the synergies is to estimate the dollar amount of value created from the synergies. As stated in the last article, synergies can come from various places such as Cost & Risk Reductions, Process Improvements, Revenue Augmentation and Economies of Scale. According to The Boston Consulting Group, 94 percent of merger announcements which disclose the value of synergies mention only cost synergies or don’t mention the specific nature of the synergies at all. 1 The principal reason for the foregoing is that cost based synergies are the easiest to quantify. For example, estimating savings from eliminating administrative redundancy, consolidating operations and increased purchasing power are relatively straight forward.

With the above stated, bolt-on acquisitions completed by larger companies often result in substantial revenue synergies. Many larger companies acquire smaller “bolt-on” companies in order to add complimentary products to their offerings, which their sales people sell to the existing customer base. Furthermore, cross selling opportunities, the potential to sell both company’s products to the other company, can materially increase the Buyer’s revenue.

According to a 2012 study performed by Thompson Reuters, transaction synergies from a sample of 365 deals with values of more than $300 million that took place from 2000 – 2011 range from 2 to 10 percent (depending on the industry) of the target company’s latest annual sales, with a median of 4.8 percent (refer to chart below). If we assume that a similar level of synergies exist with lower mid-market transactions (i.e. transaction values less than $100M) we can infer that the synergies contribute an additional 50% or so to a typical small company’s EBITDA.2 But what if the Buyer generates billions of dollars of revenues in your market. Simply dropping your products into the hands of their salespeople can result in increasing your Company’s sales by a magnitude!

Source: Thomson Reuters Data Stream

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.

Accordingly, it is our observation that most Sellers of smaller transactions (< $20M) see little to no increase in value due to synergies resulting from a sale to a strategic buyer. From our perspective, this is unacceptable.

There are a magnitude more potential financial buyers then strategic buyers, so why search for a strategic buyer if the Seller is not going to benefit from the synergies! In fact, the 31% of the total synergies which are captured by the Seller is also unacceptable to us. By effectively preparing the company for a transaction, studying the Buyer’s operations to enable a reasonable estimate of the value of the potential synergies and by applying seasoned negotiating skills one should be able to grab much more than the reported 31% of the synergistic value.

Don’t settle for little to no share of the synergies, let alone the average 31%. Sign up to receive the LockeBridge Newsletter to get the next articles in which we will discuss, how you (the Seller) can grab more than your fair share of the synergies created.

  1. March 27, 2013; Jens Kengelbach, Dennis Utzerath, Christoph Kaserer, and Sebastian Schatt; How Successful M&A Deals Split the Synergies.
  2. Assumes that a typical EBITDA margin of a well run company is 10%.
01 Jun
When Should I Sell My Business?

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.

Conclusion

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.

01 Jun
Engaging an Investment Banker: What You Should Know

In the prior article titled Investment Banking Retainer Fees – Beware of Conflicts I mentioned that the average closing rate among US intermediaries representing transactions valued in the range of $5 million to $30 million range is approximately 30%. I also stated that the average engagement fee for such transactions is around $50 thousand. Needless to say, I never met a business owner who wanted to pay an engagement fee or retainer, especially with a success rate of only 30%. So what are you going to do about this issue when it is time to sell your business? My suggestion when choosing an investment banker is as follows:

  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?”

Several common answers to this question are:

  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.

My thought on these answers are as follows:

  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!

OK, down to brass tacks. The above is all well and good but the fact of the matter is that most advisors in the lower middle market just cannot afford to do enough diligence to provide them with the confidence they need to waive the retainer. Let’s, for a moment, put aside the potential conflicts of interest that a large engagement fee can cause. If the advisor does not have confidence that they will succeed, at least a 70% confidence level as previously stated, then I don’t believe that the business owner should hire such advisor. The worst thing that can possibly happen is that you execute the selling process more than once. This is one process that you want to do the right way the first time. The implications of going to market a second time can be disastrous, but this is a topic for another article.

With the above stated, if you find that you cannot avoid paying the retainer and still want to engage the Advisor, at least you should have gotten a warm and cozy from the answers the Advisor provided to the above questions. I think you will be surprised by the type of answers you get. The worst that happens, as a result of these questions, is that you will learn allot about the thinking of the advisors which may represent one of the most important transactions of your life.