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Weekly UpdatesMany private middle market business owners considering the sale of their company are concerned that they will spend substantial time, energy, and money on the process, only to reach an unsatisfactory conclusion. While the outcome of any sale process is ultimately impossible to foresee, the likelihood of closing a deal on acceptable terms can be significantly increased through an awareness of some of the most common procedural mistakes. The following includes ten habits that can significantly jeopardize the success of private merger and acquisition (M&A) deals and provides advice on how to avoid these pitfalls.
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1) Limiting competition for the business
Many business owners tell their advisors that they already know the most likely buyer for their business. However, in almost every sell-side process, the most likely buyer identified at the onset is not the party that ultimately acquires the business. An owner's willingness to simultaneously explore a diverse range of options is often essential for maximizing shareholder value and increasing the probability of close. Broadly speaking, purchasers will fall into one of three categories, and each presents their own unique opportunities and challenges.
Family members or current employees are often a natural successor to the current ownership. Companies which currently operate in related lines of business (e.g. strategic investors) often have a strong interest in combining the business with their own. Finally, private equity (PE) groups invest in private businesses with the intention of selling at some future date and realizing a return on the investment. These groups are typically funded by institutional investors (e.g. endowments and pension funds), and seek returns which are superior to those realized in public equity markets. In most cases, PE groups use debt to finance a significant portion of the purchase price (e.g. a leveraged buyout, or LBO), thereby increasing the prospective return on the group's equity investment.
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While most business owners know the other players within their industry, they are often unfamiliar with the universe of PE groups. For many business owners, particularly those who have a management team in place that is capable of taking over the business, a PE group may provide an attractive alternative to a sale to a strategic competitor. The past decade has seen a tremendous increase in the number of private equity groups, creating a much greater list of options for business owners.
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One common rationale which owners cite for limiting the number of parties contacted in a sale process is they do not want their employees or customers to know that the business is being shopped. Although these concerns are valid, a well run sale process can help minimize the exposure and the benefits of a competitive auction far outweigh the risks. Competition creates a fear of loss in the minds of potential buyers and is instrumental in keeping interested parties on track and focused.
2) Unrealistic value expectations
Most private business owners will add a significant emotional premium to the market value of their business. Similarly, some owners approach value by first estimating the amount of money they need to retire and then backing into a value for the business. While retirement and estate planning are very important considerations in the decision to sell or not to sell, market values may not align with an owner's long-term financial needs or wants.
Another common phenomenon is for business owners to look exclusively to valuation multiples from other companies or transactions within their industry without objectively analyzing whether the multiples are applicable to their company. Even within the same industry, different companies can trade at dramatically different multiples for a variety of reasons including, but not limited to, size, growth expectations, proprietary products or services, debt capacity, revenue stability, capital reinvestment requirements, and investment liquidity.
Generally speaking, a high growth, publicly-traded company with $50 million of earnings before interest taxes and depreciation (EBITDA) will always trade at a higher multiple than a lower growth, private company with $5 million of EBITDA.
A second common risk is the adoption of a "country club" multiple as a valuation benchmark. Retired business owners will often proclaim to friends at the club that he or she "got 8.0x EBITDA for the business." Owners frequently neglect to mention that the 8.0x multiple was based upon an unadjusted EBITDA number, which included significant personal expenses (e.g. travel, meals, automobile leases, insurance premiums, or pension funding payments), which might bring the multiple effectively paid for the business down to 7.0x. Furthermore, the owner may not mention that 1.0x EBITDA was in the form of a contingent "earn-out" payment based on a forecast that the business has a very low probability of hitting, resulting in what is effectively a 6.0x multiple paid for the business. That is not to say that business owners need to be in the dark regarding value before approaching the market. Trusted advisors can provide helpful insight into the likely value for a business, usually expressed in terms of a range of potential value (e.g. $60 to $70 million, or 6.0x to 7.0x times adjusted EBITDA). However, the only way to ultimately know the market value of a business is to approach potential buyers in a controlled, competitive auction process.
3) Failure to engage qualified advisors
Acknowledging the self-serving nature of this statement, it is almost undoubtedly true that a business owner will be well served by engaging an experienced team of advisors to manage the sale process. Qualified advisors, including corporate finance professionals, lawyers, accountants, and wealth managers, are usually instrumental in the planning and successful execution of a transaction.
One excellent reason for the use of outside advisors is that many owners find it difficult to objectively evaluate their business. Outside advisors can tell business owners what they need to hear and not necessarily what they want to hear. Furthermore, managing a sale process can be extremely time consuming and it will often last between six to 12 months. Most owners who are actively involved in their business already have tremendous demands on their time. Trying to run a comprehensive auction process without a qualified advisor often causes the business to suffer as the owner becomes overwhelmed trying to manage the business and the process at the same time. Finally, selling a business is often a very emotional experience and it is beneficial to have a third-party serve as a buffer between the business owner and prospective investors.
4) Lack of negotiating flexibility
Negotiation is an art, not a science. Aside from the stated purchase price, the form(s) of payment (e.g. cash, shares, earn out, etc.), the deal structure (e.g. a sale of the underlying assets or outstanding shares), and any future consulting or non-compete compensation received will all have an impact on the business owner's net after-tax proceeds. Sellers or buyers that take an inflexible negotiating position on every possible element of a transaction are rarely successful.
From the seller's perspective, a better approach is to identify and prioritize the elements of a transaction which are most important and then leverage the attributes of a competitive auction process to reach a resolution on as many of these points as possible before moving forward with one party on an exclusive basis.
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Even once the seller enters into a period of exclusive discussions with a buyer in order to finalize the deal terms it is unrealistic to expect that the owner will get everything that they want. For instance, compromises relating to the specific language used within the transaction documents are often necessary. Competent legal counsel and corporate finance professionals will help business owners to identify those points where it makes sense to take a firm stance and those points where a compromise may be more appropriate.
Transaction participants sometimes like to draw similarities between negotiations and Texas Hold 'em poker. However, unlike a poker tournament, when the negotiating parties go "all-in" they are not required to show their cards and will take their money (or their business) with them when they leave the negotiating table. Ultimatums and hardball negotiating tactics often create a counter-productive environment.
5) Poor financial performance
Financial performance is an obvious driver of value for any business and will be of critical importance throughout a sale process. There is no quicker way for a seller to lose credibility with buyers than to miss their internal financial forecasts. It's recommended to prepare forecasts that are both reasonable and achievable, especially for the time period during which the sale process takes place. In many ways "hockey stick" growth projections, if not based on sound assumptions, can do more harm than good.
Some private business owners are disadvantaged by the fact that they do not typically prepare a formal annual budget and have never prepared three to five year financial projections. While this type of forecasting is not a requirement to sell a business, it is typically very difficult to monetize the potential of a company when the owner cannot provide buyers with a vision of the future from a financial perspective. Detailed forecasts generated pursuant to a comprehensive, rational planning process will receive the greatest credibility from buyers. If circumstances permit, it is beneficial for business owners to implement a formal budgeting process a few years prior to selling their business, not only from a best practices perspective, but also from the standpoint of refining the budgeting and forecast process.
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