Part 1: What Are Mergers And Acquisitions
Part 2: Synergies In M&A Deals
Part 3: Outline Of Business Valuation Techniques
Part 4: Quick Overview Of M&A Process
Part 5: Selling Business To Private Equity
Part 6: Selling Business To Venture Capital
Part 7: Letter Of Intent (or “LOI”) In Mergers And Acquisitions
Part 8: Due Diligence Process
Part 9: Principles Of Negotiating In Mergers And Acquisitions
Part 10: Sale And Purchase Agreement
Part 11: M&A Deal Closing
Private equity refers to the investment in a private company in exchange for controlling interest in the firm. A private equity firm often takes an active role in the management of the companies it invests in. When a private equity firm makes an investment, the money is typically pooled together from all the investors, then used on behalf of the fund. Investors in private equity often include high net worth individuals, insurance companies, pension funds, and endowments.
Venture capital is technically a form of equity financing. Private firms with institutional investors purchase a stake in other companies with the goal of earning a profit. Venture capital firms often specialize in investing in young companies and startups to help them get off the ground and grow.
Often, private equity and venture capital are used interchangeably, but there is a difference between both and the table below summarizes the difference between both.
The typical sale process has six phases: preparation, documentation, marketing, the signing of the letter of intent (or LOI), due diligence, and then close preparation and final sale. While this is process is unfolding, the seller’s advisors prepare their long list of perspective buyers for the business. This involves some careful research to identify the range of potential buyers who may have different strategic reasons for wishing to make the acquisition. Documentation involves the preparation of a sales document, focusing particularly on an information memorandum which should contain enough information to enable a prospective buyer to come to a view about the business without obtaining any sensitive or confidential information too early in the process.
A teaser, or a short no-names marketing document, will be sent out in advance of the sharing of information memorandum which is sent out to a prospective buyer once he has signed a confidentiality agreement.
The marketing phase involves approaching potential buyers, exchanging of information, a confirmation of their interest, and then often site visits and meetings with advisors and or the management team. As this information exchange takes place, buyers often come back with further questions and judgment is required as to which of these questions are answered at this stage or left to the due diligence space. Following this, the seller expects to receive offers to his business from prospective buyers, and as these often come with conditions which must be understood in detail and later negotiated. This negotiation also involves getting the best deal for the seller once the seller has decided on his preferred buyer.
The key terms of the deal are summarized in an essentially non-binding agreement called a letter of intent or often (or the heads or terms). Once this is agreed, the buyer has the opportunity to conduct a detailed review of the business, including all the confidential and commercially sensitive information held back until this point. This is called due diligence. This phase can take six to eight weeks while it’s going on. The lawyers for both sides draw up all the necessary legal agreements, the main one of which is the sale and purchase agreement, providing due diligences completed satisfactory, including the negotiation of the normalized level of working capital. The deal can be closed and money changes hands.
Often minor issues come up in due diligence and these have to be explained and sometimes require a further negotiation. Anything really significant and adverse can kill a deal, so it is better as a seller to be open from the start about any major issues or problems in the business.
In the context of a transaction involving private equity it is important to talk about management buyout. MBO is the acquisition of a business by its management who are employees, and they’re effectively buying the business from the shareholders. The capital to make the acquisition is typically provided by a combination of funds from a private equity firm, and in most cases some bank debt management normally contribute a modest amount to the deal to have skin in the game, i.e. some of their own capital at risk.
The deal is structured so that the funds make a good return and the management team can make many multiples of their original investment if the deal is successful. The structure of a typical deal is as follows, senior debt provided by a bank, normally a five to seven year term loan, the amount of debt is normally decided by the EBITDA of the business.
Selling to private equity often involves a buy-out of the business but its management. While this may not have been the original intention of the owner, it often turns out this way since private equity may insist on having the existing management team stay in place. It may also be that the existing management teams wants to buy out the business on their own initiative in which case they will need to look for funding, and would typically approach a private equity firm which will organize the funding through a combination of debt and equity.
Banks will lend typically between two and four times the EBITDA depending on market conditions. Currently, banks are lending at the lower end of this. If they lend at all, these loans may be unsecured or partially secured on the assets of the business. This is called leverage and why these deals are sometimes referred to as leveraged buyouts.
The next layer of investment is provided by the private equity fund itself. They typically put in up to 90% of their investment in the form of preferred debt so that they can rank immediately behind the banks. This preferred debt also carries an interest rate, which may be paid annually or rolled up into the return the investors are seeking to make from the deal. The remaining investment made by the private equity fund is made in ordinary shares and made alongside the management team.
The management team stake may be a combination of shares they already own and rollover into the deal or purchase for cash.
There is often another element which can be earned by the management team called the sweet equity. The proportion of the equity split depends on the investors and the individual deal circumstances. Most private equity investors prefer to acquire a majority of the ordinary shares i.e. greater than 50%. The sweet equity pot can be up to 20% of the ordinary shares.
Understanding the deal structure debt and equity is critical to understanding who gets what back in what priority is also the key to understanding how the pie is shared out when the business is eventually sold. Often during the term of the deal, the bank debt is repaid by the earnings of the business leaving the private equity firm and the management team to share the sale proceeds. The preferred debt is repaid first with all due interest and then the remainder of the proceeds are divided between the ordinary shareholders in proportion to their equity holdings.
Putting aside all the management school theory, business valuation is all about what a seller wants to receive for his business and what a buyer is prepared to pay.
Public companies have stock market valuations, which give a starting point for valuation and acquisition, but this is not the case for private companies. It is also important to realize that different buyers will attribute different values to the same company depending on what it means to them, what they want to do with the company after the close of the deal and how it fits with their existing business assets, i.e. what additional synergies they can gain in terms of higher revenues, lower costs, or greater profits from a combined entity. Comparative deals statistics are therefore relatively meaningless. Advisors can of course look at deals done by prospective buyers or involving similar companies in a similar sector at a similar point in the cycle, just to revalidate their own calculations.
The variables in such an analysis are such that either side can make a case to support their argument, particularly when discarding anomalous deals, whether high or low.
In essence, the seller will set out his high-value case and normally be prepared to accept a price lower than this, but probably with a fixed minimum. If you are a seller, it’s important for you to have this in your mind.
A buyer will present a low price scenario, particularly for his opening offer, and then move upwards from there in stages, trying to flush out the seller’s minimum price. The buyer will also have a maximum above which he will not or may not be able to go from the seller’s perspective.
Two or more buyers can be used against each other to create a competitive tension with one faced with the threat of not securing the deal.
At the end of all successful negotiations, there must be an overlap between the seller’s minimum price and the buyer’s maximum price and the advisor’s roles are often to help their respective clients close the gap until this agreement is reached.
Private equity buyers of a business are different to trade buyers in that they value a business from both the acquisition perspective and their exit perspective. It is important that private equity invest for a finite horizon, being 3–5 years in most cases hoping to double or triple their initial investment. This makes the process of business valuation more complex.
Firstly, PE buyer will look carefully at EBITDA and take on a view based on comparable deals and other market related information and establish the narrow multiple range they want to pay for the business. Their exit value is based on their desire to make a target hurdle rate of return. In essence, most private equity firms aim to double their capital investment in three years and triple it in five. This equates to an internal rate of return of approximately 30%, but be careful with IRRs as they are very time-dependent and cash multiples are a much safer way of looking at private equity returns.
An analyst at the PE firm will now prepare a detailed financial model of the business so that they can calculate the deal characteristics, evaluates scenarios particularly on the downside and confirm their offer price. This model always includes sources and uses of funds, where the package of finance for the deal is coming from and how it’s being spent, and a returns’ analysis to see how the sales proceeds are ultimately allocated to ensure that the PE firm makes their targeted return.
As mentioned earlier, deals involving PE firms and MBOs will often use some bank debt to fund the deal, provided by an independent bank, by the PE firm itself. It will also involve contribution of equity in exchange for cash paid to the owner of the business, and there may be deferred consideration or an earn-out for the seller. This adds to the complexity of the deal structure and the returns calculations become more difficult.
Private equity firms always assess a deal on a standalone basis, even if they intend to combine the business they’re acquiring with an existing portfolio company.
It is important to mention here that trade buyers, being buyers other than PE firms, will also consider business synergies, revenue and profit enhancement and cost savings more readily. Trade buyers are normally driven by business factors and strategic issues. They are looking to combine the business being sold with their existing business or businesses and to create a stronger and more profitable entity from the combination in pricing the deal. They may be prepared to share some, but rarely all of these benefits with the seller by paying a higher price.
Private equity or financial buyers are driven much more by financial considerations and apply the following criteria when selecting a target business to invest in:
EBITDA is the earnings of a business which most private equity firms use as their preferred measure of profits. It stands for earnings before interest, tax, depreciation and amortization.
It is before interest so that the investors can gauge the true level of business earnings irrespective of the balance sheet structure, particularly whether the business earns interest from cash or pays interest on debt.
Depreciation and amortization are also balance sheet related adjustments to reduce the life of fixed assets or intangible assets respectively. These are in effect non-cash items, and they reduce the profits of the business. This is good from a corporation tax perspective, but it prevents the investors from being able to see the true earnings from a business.
This income stream is also before the company pays any tax due to the tax authorities (IRS, Inland Revenue, et cetera). The EBITDA figure is often presented on an adjusted basis and understanding these adjustments is critical.
Investors will often also add back the salaries of directors who are shareholders, particularly if they’re paying themselves well above the market rate for the job following a deal. These directors may not stay with the business and may be replaced by employees paid at the market rate. Often these directors take their salaries as part of the lifestyle earnings they draw from the business.
Also, any one off costs such as a bad debt or a major item of operational expenditure if expensed to the profit and loss account rather than capitalized on the balance sheet might well be written back from EBITDA (adjusting it upwards).
When selling a business, the seller needs to decide what he will include in the sale. The simple way to address this is that he should include all the assets required to continue to support the future generations of revenues and profits from the business at the level he is projecting.
These include all appropriate fixed and intangible assets such as intellectual property where the office and other property is involved. If the basis of ownership is to change, such as when the seller owns the office and decides to keep the freehold and lease it back to the company after the sale, this should be reflected in the adjustments to the EBITDA discussed earlier (reducing EBITDA for future rent cost).
Much more critical is the amount of capital left in the business, the oil in the engine if you like.
Before we get into a detailed discussion of working capital and more importantly normalized working capital, it’s important to cover off a clear understanding of what is meant by cash free, debt free.
This important phrase tells the buyer that the company is being sold without any surplus cash, but also without any outstanding debt. To the extent that either of these subsequently turns out to exist, the purchase price can be adjusted up or down on a dollar for dollar basis.
From the buyer’s perspective, he will want to know that the business has sufficient capital, working capital for the business to continue to run.
Working capital is the capital in the business which enables it to trade on a day-to-day basis i.e. it can pay people to whom it owes money, normally suppliers, whilst waiting to be paid by the people who owe it money, normally customers.
If the buyer acquires a business without sufficient working capital, he will have to put more cash into the business to make up the shortfall, thereby increasing his acquisition cost. For this reason it is essential when negotiating the price of the business to look at working capital and normalize it so that the buyer and seller can agree on the required level of working capital for the business, and adjust the selling price accordingly.
To ensure that the business is sold and purchased with sufficient working capital, any potentially surplus cash is calculated with reference to the normalized working capital calculation. As mentioned previously, this reflects the ability of the business to fund its working capital and to pay its suppliers and debtors while waiting to be paid by its customers and creditors as well as have sufficient capital to afford its inventory or to fund its work in progress. This is often referred to as the working capital cycle and will be explained in the next section.
Normalized working capital differs for every business and in some exceptional cases, when the business is paid in advance for its goods or services, the company may be able to trade with negative working capital, which is a sweet spot to be in. Its operations are funded by payments from its customers, and it doesn’t need any working capital, in which case the normal working capital calculation is a relatively simple one.
The working capital cycle may be long (meaning that revenue-to-asset ratio is low) or short (meaning that revenue-to-asset ratio is high), or it may be seasonal (meaning that it fluctuates during the year).
It is therefore important to look at normalized working capital over a period of 12 months, not just the last three or six. Equally, if payments are received regularly at particular points in a month, this timing may be significant and looking at the level of working capital at the beginning of a month instead of in the middle or at the end may make a significant difference to the calculation of normalized working capital.
Understanding the working capital of the business and the balance between the money the company owes its creditors is owed by its debtors, has tied up in stock or work in progress, and the cash or debt on the balance sheet is important to get right from both the seller’s and the buyer’s perspective.
If the company has low stock, has not paid its creditors but has been paid by all its debtors, it will have a high level of cash, which the seller might try to argue is surplus cash and belongs to him and thus should be paid out of the business before the sale completes. If this occurs, the buyers will be in a difficult position with not enough money to pay creditors or to pay for new stock.
When the converse is the case the company has paid its creditors, has not been paid by customers and debtors, and has high stock levels, it is likely that the company will have low levels of cash.
Because of this dichotomy it is a critical area of negotiation in an M&A deal and due diligence, and it is important that your advisors understand this area of the deal properly. Winning this argument has a direct impact on the cash that changes hands between the seller and the buyer at the close of the deal. This cash can amount to millions.
When calculating the normalized level of working capital, one must look at the last 12 months and must be clear about how many data points is taking (it could be 12 months, if the business is not seasonal and cash flows are linear, but it may be twice this level if there are major fluctuations in the level of working capital as reflected in cash balances).
You must be clear about the significance of the timing of these data points with reference to the business payments and receipt cycle. Look for any seasonality. Ensure that any proposed CapEx or Opex, which the seller is proposing is fully funded and if this is needed to support the future level of EBIT that the seller is projecting.
Once agreed at the close of the deal, the actual level of working capital in the business on that day will be calculated in the closing balance sheet. If net cash is below what is expected for the normal running of the business, the seller will have to leave more money in the business and the price of the deal will be adjusted down. If the net cash position is higher, the seller will receive an additional consideration as the price of the deal will go up.
This argument normally starts once the due diligence team gets into the business and gets its hands on the management’s financial information. The negotiation can go right to the wire if not handled properly, and in some cases can destroy the deal if one side or other feels they are not getting a fair, honest, or true account.
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