Economic Value Add: The Best Financial Metric to Measure Long-Term Shareholder Value Creation4/20/2023 Economic Value Add (EVA) is a financial metric that is becoming increasingly popular among companies looking to create long-term enterprise value for their owners. It measures the “economic profit or loss” of a company rather than its “monetary profit or loss” and is considered by many to be the best financial metric to focus on because it considers both the costs and benefits of invested capital. A business that focuses on increasing EVA over the long term, becomes meticulous at managing the capital entrusted to it by its shareholders. Many entrepreneurs instinctively focus on EVA when they have limited access to capital, however, it is easy to lose sight of the importance of the cost of capital as the business grows and gains increased access to capital. In this blog article, we explore the concept of EVA and why it is the best financial metric to focus on to create long-term enterprise value. Economic Value Add is a calculation that subtracts the cost of capital from the net operating profit after taxes (NOPAT). The cost of capital is the amount of money the company must pay to access the funds it needs to operate and grow, such as interest on loans and the return required by its owners. By subtracting the cost of capital, EVA provides a clear picture of the value a company is creating for its owners. Sometimes a business can increase its earnings while not necessarily increasing its enterprise value; which on the surface seems counterintuitive. If increasing the value of the business for shareholders is the goal, then all earnings growth is not good growth. So how can business enterprise value stall despite demonstrated earnings growth? The simple answer is that the incremental earnings were not enough to cover all the operating costs plus the cost of capital (including the opportunity cost of the equity in the business). EVA provides a clear picture of the return on investment for a company’s shareholders and allows companies to make informed decisions about investment opportunities and prioritize initiatives that will maximize long-term value for shareholders. It also reflects the time value of money. Unlike other financial metrics, such as revenue or profit margins, EVA is not influenced by accounting practices or one-time events. It can be used to guide spending/investments in R&D, advertising, new hires, incentive programs, M&A, etc. It encourages judicious investment in long-term value-creation strategies and measures progress on initiatives that most accounting metrics miss. It also provides discipline on capital expenditures as the cost of capital changes over time. It is a reliable and consistent measure of a company’s performance over time, which is essential for creating long-term value. Here are some practical ways to improve your company’s EVA. 1) Increase profits without tying up any more capital. This can be in the form of improving margins and/or lowering operating costs or both if the total capital does not increase. It encourages streamlining operations and investing in growth initiatives whenever the benefits exceed the cost of capital 2) Decrease capital without losing earnings. Some possible options include: - Lowering inventory levels or increasing inventory turns - Shortening selling terms or improving collection practices - Negotiating better supplier terms or taking advantage of supplier incentives - Divesting redundant assets 3) Divest, liquidate or discontinue parts of the business, where the lost earnings are more than offset by the savings in the cost of capital. 4) Only invest (increase capital – capital expenditures PLUS working capital) in projects that provide a return that exceeds the cost of capital. 5) Reorganize the capital structure of the business to lower the overall cost of capital. In conclusion, Economic Value Add is the best financial metric to focus on to create long-term value. By focusing on EVA, companies can make informed decisions about investment opportunities, prioritize initiatives that will maximize long-term value, and create sustainable and profitable growth for their shareholders.
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In previous blog articles, we have written extensively about many of the drivers that impact the value of a private business when it is sold to a third party. Business owners that enter into direct negotiations with a potential buyer based on an attractive, but very preliminary offer, often find out that their business is not ready for a sale. The earnings, sales, growth, products, markets, and facilities may be attractive, but there are underlying issues that are uncovered during the buyer’s due diligence process that sends them running or they attempt to “re-trade” the deal at a lower value. Marketability drivers are aspects of the business that don’t necessarily add value but can dramatically improve the probability of closing a successful transaction. They also increase the probability of receiving multiple offers when a well-run, competitive sale process is deployed, and therefore can indirectly enhance value. That is, more offers mean more choices, which equals a better negotiating position and possibly a higher enterprise value. So, what are some of the drivers that impact marketability? Outside audits and/or Quality of Earnings review A business is much more marketable when it has clean financials without a host of “adjustments” or “add-backs” to normalize earnings. Having at least a couple of years of audited statements can be important for some buyers and therefore increases its marketability, while reviewed statements are sufficient for others. Audited statements will help ensure that the firm’s accounting practices are up to date and that the internal controls are up to industry standards. In some cases, it may be advisable to hire an outside firm to conduct a “Quality of Earnings (QofE)” review. A QofE will help a buyer determine maintainable earnings by adjusting for one-time/non-recurring expenses and sales, owner-benefits, inter-company, and related shareholder transactions, etc. Many buyers will require their own QofE to be completed during due diligence, however, if much of the work has been completed, it can make the business more marketable, the transaction process easier, and less likely to be derailed as items are uncovered. Conflicts of Interest Minimizing conflicts of interest in advance of a sale will help with its marketability, but business entrepreneurs often fail to recognize what might constitute a conflict of interest in the buyers’ mind. Intercompany relationships are one area that should be reviewed and adjusted to market where necessary in advance of a sale. Accounting and Enterprise Resource Planning (ERP) It is critical buyers can understand the nuances of the business and how it operates. An ERP system can offer several benefits to businesses, including improved efficiency, streamlined processes, better data management, and increased visibility on sales, customers, markets, etc. It can help management exercise more control over operations. It can also help organizations integrate and automate various business functions, such as finance, accounting, supply chain management, and human resources, leading to cost savings and improved decision-making. A robust ERP program with up-to-date and professional accounting processes is essential in ensuring that the business is marketable. Some buyers will just walk if they can’t get the answers, they think are essential. HR Practices A company that utilizes best practices in HR across the organization is more marketable than a business that has limited capabilities in managing a growing workforce. Best practices in recruiting, onboarding, training, development, compensation, performance management, cross-training, etc., with opportunities for promotions and personal development lead to high retention rates and a high intrinsic value of the business. Processes/Systems/SOPs/Third-Party Certifications Every industry has a litany of processes, internal and external audits, certifications, etc. that seem at times to add little value to the business but may be a necessary evil. Many of these, however, give buyers an elevated level of assurance that the business is being operated professionally, and therefore many of these processes can increase a business's marketability. Leadership, Succession, and Transition Plans The leadership and management of a business are critically important to a buyer, however, providing more insight to a buyer on the business's succession plan at multiple levels within the organization helps build confidence in its long-term sustainability. Environmental, Social, and Governance Factors Businesses focused on reducing their carbon footprint, improving waste management practices, and resource usage are more marketable than those that make every attempt to skirt the rules and save costs. Likewise, a company's impact on society, including its labour practices, community engagement, and relationships with stakeholders is important to many buyers. In recent years, ESG factors have become increasingly important to investors as they seek to invest in companies that align with their values and promote sustainable growth. Many investors believe that companies that prioritize ESG factors are more likely to achieve long-term success and generate positive returns. A Written Strategic Business Plan Buyers want to know where the business is headed and how the management team plans on getting it there. Too many lower-middle market businesses rely on an unorganized, unwritten, let’s “see what we can do” type business plan, that works fine until you need to scale and need investment (either externally funded or funded from internal cash flows). Taking key team members off-site for a couple of days of “deep strategic thinking and planning” and formalizing the outcome into a written business plan with key stakeholder buy-in, helps more potential buyers see the opportunity and therefore increase the marketability of the business. Cross-border M&A deals between US and Canadian-based companies add complexity to the M&A process as well as the post-acquisition operation and integration of the target. Yet, with the right advisors, both US and Canadian-based companies can expand their growth prospects through acquisitions, widen their markets, and diversify risk by exploring cross-border M&A. But before you start here are some items to consider: 1. Understand the tax implications: Tax rules on cross-border profit distributions via dividends, royalties, or interest payments are regulated by the Canada-US Tax Treaty which outlines the rules for determining any requirement for withholding taxes. Generally, the treaty provides for a zero withholding tax rate on dividends paid by a Canadian subsidiary to its US parent if the US parent directly or indirectly owns at least 80% of the voting power and value of the shares of the Canadian subsidiary for a specified period. On the other hand, the general withholding tax rate on dividends paid by a US subsidiary to a Canadian parent is 15%. However, if the Canadian parent owns at least 10% of the voting shares of the US subsidiary, the withholding tax rate may be reduced to 5%. The specific rate and conditions may vary depending on the specific provisions of the tax treaty and the circumstances of the payment. The tax treaty between Canada and the US, as well as the domestic tax laws of both countries, treat outbound and inbound dividends and other income distributions differently. There are also significant differences in corporate income tax rates. Canadian Controlled Private Corporations (CCPC) are taxed at much lower rates than non-CCPC companies and this lower tax rate status is lost if more than 50% of the company is US owned. Companies need to consult with tax professionals to ensure there is a clear understanding of the countries’ tax laws and regulations, before pursuing a cross-border M&A strategy. 2. Regulatory and Legal Differences: The US and Canada have different regulatory and legal frameworks, but often operate under similar principles. Nevertheless, cross-border M&A deals must navigate these differences, including antitrust laws, securities laws, and labour laws. These can vary by State or Province as well as at the Federal level. For example, the acquisition vehicle options for M&A in Canada and the US are somewhat similar, but there are some key differences. It's important to note that the choice of acquisition vehicle will depend on various factors, including tax considerations, the nature of the transaction, and the goals of the parties involved. While Canada does not have LLCs and S-Corps, in some cases they can own Canadian subsidiaries but there may be many legal and tax considerations that need to be taken into account. Often, US-based acquirers set up Canadian ULCs (Unlimited Liability Company) for their Canadian acquisitions as flow-through entities, however, there may be important differences in liability protection that needs to be considered. Like the tax implications, it's important to consult with a lawyer and an accountant who has expertise in cross-border business transactions before proceeding. 3. Employee benefits and healthcare: The main differences between employee benefits costs to companies in Canada versus the US may vary depending on the specific benefits, but some general differences are: a) Healthcare: In Canada, healthcare is largely publicly funded and administered by the government, while in the US, healthcare is largely private and employer-sponsored. This can result in higher healthcare costs for US companies. Canadian companies often also offer health and benefit insurance that is either cost-shared with employees or paid by the employer to cover extended health care (dental, drug coverage, etc.) and other non-publicly funded health care costs. b) Retirement benefits: In Canada, employers are required to contribute to the Canada Pension Plan (CPP) or other retirement plans (such as the QPP in Quebec), while in both the US and Canada, employer-sponsored retirement plans such as 401(k)s, or group pension plans are common, but not required. c) Paid time off: Canadian employees are generally entitled to a minimum of two weeks of paid vacation per year (however paid time off rules vary by Province), while in the US, there is no federal requirement for paid vacation. d) Parental leave: Canadian employees are entitled to a longer period of paid parental leave compared to the US, with up to 18 months of leave in some Provinces, while in the US, the Family and Medical Leave Act (FMLA) provides up to 12 weeks of unpaid leave. e) Taxes: Canadian companies may face higher payroll taxes and employment insurance costs, while US companies may have higher healthcare and insurance costs. It's important to note that these differences may not apply to all companies and industries and that regulations and benefits can vary by province and state within each country. 4. Currency Fluctuations: Currency exchange rates can significantly impact the value of cross-border M&A deals. Changes in exchange rates can create significant financial risks for companies on both sides of the border, when reporting income is in the “home” currency. However, for businesses with already a significant commercial presence in the other country, acquiring operating business with expenses in the “importing” country can act as a hedge against significant currency fluctuations, Luckily, both Canada and the US have relatively stable economies (when compared to many other countries) and currencies. 5. Foreign Investment Regulations: In the US, foreign companies must comply with the rules and regulations set by the Committee on Foreign Investment in the United States (CFIUS), which reviews foreign investments that could potentially pose a threat to national security. In Canada, foreign companies must comply with the Investment Canada Act (ICA), which regulates foreign investment in a wide range of sectors and activities. Both countries also have specific rules for mergers and acquisitions involving foreign companies, particularly those that could result in a significant loss of Canadian or US ownership or control. These rules are designed to protect national security and ensure that foreign investments do not compromise the integrity of key industries or pose a risk to national interests. 6. Integration Challenges: Cross-border M&A deals require effective integration strategies to realize the potential benefits. Successful integration requires alignment of business processes, culture, and technology. Sometimes companies fail to understand the differences in many of the operating regulations that are specific to each country. For example, in Canada, many consumer products like food must have both French and English labels. Despite the existence of a free trade agreement between Canada and the US, there also may be tariffs or other trade restrictions that may limit raw material supplies or trade in finished goods. Cross-border M&A deals between Canada and the US offer significant opportunities notwithstanding these and other considerations. There are extensive business and cultural linkages between the two nations, and their economies are heavily linked. These connections can give businesses access to new markets, clients, and technological advancements. Cross-border M&A transactions can also aid businesses in scaling up operations and improving their position as industry leaders. In conclusion, cross-border M&A transactions between the US and Canada offer both opportunities and obstacles. Regulatory, legal, cultural, and financial risks related to the transaction as well as the post-acquisition and integration plan must be carefully considered by businesses before a cross-border acquisition is pursued. But, with the proper planning, strategy, and advisors, cross-border M&A can offer important advantages and aid businesses in achieving their growth goals. Once you have decided to sell your business, the next big decision lies in “how” to sell your business. For most entrepreneurial-led, and/or privately-owned businesses, taking a “do-it-yourself” approach by negotiating directly with a single buyer rarely results in a positive outcome (unless it is under some very specific circumstances - see DIY pros and cons). By interviewing several M&A Advisors, it will become clear that it matters a lot about the type of sale process you choose to pursue. This blog article will highlight some of the key issues sellers should consider, once the decision to sell the business has been made. First, let’s outline some the sale process options you will need to consider. While everyone’s definitions of 1) a negotiated sale, 2) a narrow process, and 3) a broad auction process will differ slightly, we like to think of the number of potential buyers for each as, a “handful” for a negotiated sale, perhaps 20-50 in a narrow process, and perhaps 300 or more in a broad auction process. While all three approaches differ, they all include at least some level of competitive tension amongst buyers. Choosing the right approach starts with gaining a clear understanding of the seller’s objectives and priorities. There is a lot to consider. For a quick review of the key questions we ask before recommending a process, see our seller’s priorities questionnaire. Best buyer vs highest price The best buyer may not be willing or able to pay the highest price. Most business owners know some of the best potential buyers for their business, based on their viewpoint on the best strategic fit. This could be based on the buyers’ complimentary products, services, customers, markets served, etc. If selling to the “perceived” best buyer is a higher priority than obtaining the best value, then a narrower, or even a negotiated sale process should be considered. A broad auction, however, can uncover high-quality buyers never previously considered; some may be willing to pay top dollar and could be an excellent strategic fit. It is amazing how many M&A deals are completed with an unexpected buyer. The reality is that it is very difficult to gain detailed insight into what motivates a buyer to pursue an acquisition unless you allow them to articulate their strategy in a confidential dialogue. Confidentiality Maintaining confidentiality from the outset through to close is paramount to ensure employees, customers, and suppliers don’t defect and create obstacles to correct if a deal doesn’t close. When competitors become aware of a potential sale, they can try to take advantage of the market uncertainty that arises from the M&A process as well. No NDA is foolproof, and logic would dictate that the risk of a confidentiality breach is higher with a broad auction process than with a negotiated sale. Before deciding on what type of process to pursue, the sensitivity of the business to a confidentiality breach with each of its important stakeholders should be considered. Some processes are defined as broad because a lot of Private Equity Groups (PEGs) and/or financial-type buyers are included. A confidentiality breach by a financial buyer is typically less impactful than a breach by another industry participant. Therefore, it is not only the type of process that should be considered but also the make-up of financial vs strategic buyers that are included in the process. It is also much easier to stagger customized and/or sensitive information flow to potential buyers in a negotiated sale and a narrow process than it is in a broad auction process. Speed If closing a deal quickly is a high priority, sometimes it may best to focus on a handful of the best buyers and open a confidential dialogue. However, under some circumstances, this can backfire. Large buyers, such as publicly traded companies, often move at a “snail’s pace” when it comes to M&A (unless it is an opportunity identified and pursued by the executive team or board). A narrow or broad auction process usually involves a two-step bidding process. Potential buyers are provided an opportunity to provide an initial bid, which can lead to further discussions with a subset of the best initial candidates, who then may get an opportunity to submit a more detailed Letter of Intent (LOI). As such, the marketing material, data room, and preliminary Q&A sessions must all be completed before the real negotiations begin, which can add time to the process when compared to a negotiated sale. Flexibility Sometimes business sellers don’t know what they want but will know it when they see it. In this case, the M&A Advisor’s role is to focus on creating options for the seller to consider. This usually means going out to a broader market that includes financial buyers, foreign entities, companies in adjacent industries, etc. Flexibility on the type of deal structure, equity rolls, sale or retention of assets such as real estate, transition periods, etc. can drive value and open up opportunities for the seller that were never considered at the onset of the process. This is often the recommended approach for highly marketable businesses, that are well-run, and are anticipated to capture high valuations from the market. If the business and the seller's flexibility are conducive to a PEG recap (see here for desirable criteria), a broad auction process should be seriously considered. Of course, like everything in M&A, the choices you need to make can’t be simplified down to a blog article. The key is to look for an M&A Advisor that will listen carefully to you and your objectives and guide you to the right process for your situation. That means working diligently to understand your business, your market, and discover potential buyers' motivations, etc. to design the best process for your situation. Taking time to brainstorm with team members on how to improve the business can take many forms. One useful technique is the “Start…Stop…Continue” exercise. It is a very simple process whereby each team member is asked to list a few things they think the team should start doing, stop doing, and continue doing. Usually, the facilitator will provide some guiding questions beforehand to get the ideas flowing.
A few leading questions for the “Start” session could be: • If money wasn’t a factor, where would you invest or what positions would you add to the team? … or, • What projects should we initiate to grow topline sales the fastest? Compiling the list and going through a priority-setting process should lead to two or three key initiatives to implement. Deciding on the activities that do not add value to the business and therefore should be stopped can feel like a breath of fresh air for the team. Taking a hard look at all the team activities that don’t fit with the core purpose of the business should be part of the process. Some potential questions could be: • What are the daily or weekly tasks that you “mentally” place on the bottom of your “to-do list” and why? …or, • What tasks are completed inconsistently and what is (or was) the impact? If it had a minimal negative impact, then why keep doing it? From a customer’s perspective, if value equals benefits minus costs, perhaps there are unnecessary customer costs that can be reduced or eliminated. Discontinuing services or processes can free up resources to focus on priority initiatives identified from the “Start” exercise. For the “Continue” part of the exercise, it is important to identify the initiatives that are working well and to figure out ways to do more of them. How are you measuring progress on these initiatives and how can the team dedicate more resources to accelerate the success? Perhaps there are examples of how the team “wowed” a customer or helped turn a bad situation into a win. Sometimes, changes can be made to how critical processes are undertaken through a “Start…Stop…Continue” exercise and meaningful improvements can be made. You should look for at least a few small wins each time you execute the process to gain buy-in and momentum for the next session. Of course, if nothing changes after the exercise, team members will quickly disengage from future sessions. Almost every entrepreneur considering a future sale of the business is interested in knowing what comparable businesses are selling for and what the typical multiple of earnings (EBITDA) are for their industry. However, there are many variables to consider when comparables are used to estimate enterprise value, many of which can lead to inappropriate assumptions about the value of the business. While comparable transactions can be one component of a pre-sale valuation, they should always be used along with other valuation techniques. In the end, the actual multiple a business trades for depends on 1) the prevailing market conditions, 2) the nuances of the business and the industry it participates in, and 3) how the business is marketed and sold. The number of direct comparables. For companies in the lower middle market (Enterprise values of between $10 million and $100 million), there are often very few direct comparables, let alone those with a similar growth or profitability profile. Typically, data on EBITDA multiples come from databases that extract information from press releases and from disclosures made by publicly traded companies when acquiring private companies. Under most circumstances, there is no reason for private companies to disclose the purchase price and/or terms of any companies they acquire, let alone any details about the businesses themselves. Some databases allow companies to extract financial data on a no-names basis in turn for submitting financial M&A transaction data, however, this only helps to guide users with average multiples, the median multiple, and/or ranges of valuations in specific industries/segments. Timing. The prevailing market conditions for the general economy and the specific industry in which the company participates are in constant flux. This means that valuations vary over time based on competitive factors as well as external factors such as the cost of money. The timing of comparable deals is especially sensitive in cyclical industries. Size. In general, larger companies trade at higher multiples so it is important that when researching comparables, companies of similar size are used, or the transaction data is size adjusted. Since much of this data comes from high-profile deals and/or when publicly traded companies are required to disclose transaction details to shareholders, this usually means that the published, or publicly available transaction data is scarce for smaller companies in the lower-middle market. Location. Some businesses trade at higher multiples simply because of where they are located. Differences in labour laws, tax incentives and rates, compliance requirements, average wages, skilled labour availability, etc. make it very difficult to make valid comparisons between deals in Europe and Canada/U.S. for instance. Public vs private. Publicly traded companies trade at higher multiples, not only because they are typically larger, but also because of the liquidity it provides shareholders. Shareholder liquidity is usually much more complicated and expensive for investor holdings in private companies. EBITDA multiples period. Often when comparable data is available, it is not clear whether the EBITDA multiple is based on the trailing twelve months (TTM), the last fiscal year, or a forward multiple on projections. Some public companies will only report the multiple after synergies to help gain support from analysts and shareholders that they are not overpaying for an acquisition. The standard protocol calls for EBITDA multiples to be based on TTM, but there is nothing requiring anyone to comply with this standard. EBITDA Adjustments. It is normal for business buyers and sellers to adjust the TTM EBITDA based on their judgment of maintainable earnings under new ownership. Normally, there is little if any hard data on what, or if any EBITDA adjustments have been included in a reported EBITDA multiple. Assumed debt/liabilities. Most deals are completed on a cash-free/debt-free basis, but that may not always be the case. If liabilities, such as a Line of Credit, are assumed by the buyer, they may report the price they paid, along with the TTM EBITDA, but it may not be reflective of the Enterprise Value (equity plus debt) as a multiple of EBITDA. Minority/majority deals. Generally, investors expect a discount on an investment when only taking a minority position and this may not be fully disclosed. In conclusion, there are a lot of variables that limit the value of comparable transaction data as the primary means of estimating a company’s enterprise value. That is not to say it doesn’t provide value – it must simply be used to supplement other valuation techniques. There are also a lot of comparable data points that Investment Bankers and M&A Advisors have access to through their experience but are not available to the broader market. For example, when bidding on a company in a competitive process, buyers and their advisors get a sense of the multiple they need to pay to remain competitive. On sell-side engagements, M&A professionals are given the opportunity to observe bids from multiple buyers, giving them a much deeper appreciation of expected trading multiples in a given industry. This insight is much more valuable than any database that reports on EBITDA multiples, as the nuances of the business and the industry are understood. Getting a fair price for your business, when it is time to sell, is largely based on its “transferable value”. Here are ten quick tips to focus on in advance of a potential sale of your business to improve its marketability and therefore its transferable value. 1. Make yourself redundant. Too many lower-middle market businesses thrive when run by their founder and falter when run by the next generation or new owners. Astute buyers intrinsically understand that if a business acquisition is to be successful, there must be a way to reduce its reliance on its existing owner/ownership team. Taking the time to build the management bench generates buyers that are much more open to acquisitions when the risk of transitioning is reduced. 2. Build/Develop a strategic growth plan. Many entrepreneurs didn’t become successful by spending inordinate amounts of time on generating fancy powerpoints from their strategic planning sessions. Typically, they know their market backward and frontwards and instinctively know where they are headed and how they will get there. Unfortunately, that doesn’t translate well into transferable value. Sellers benefit from having a well-articulated, documented, strategic growth plan even if it differs from their “thesis” on how to grow the business. 3. Clean up your financials. For some companies that means getting their books audited, for others, it means cleaning up their balance sheet by writing off or selling obsolete inventory or redundant assets. Working capital levels need to be adjusted to an appropriate amount as historical levels will likely be part of the negotiations. Owner’s benefits and related party transactions are another area that should be cleaned up in advance of a sale. 4. Rationalize your spending. Deep scrutiny of operating expenses should be an ongoing process, but it is even more important when preparing the business for a sale. Furthermore, while no one would suggest that you should radically reduce capital expenditures in advance of a planned sale, focusing primarily on maintenance or replacement Capex would be prudent. Any expansion-type Capex should have clear ROIs to help new owners understand how the benefits will accrue to them. 5. Focus on Quality of Earnings. High-quality revenue is generally considered to be sales that are sustainable and predictable, are profitable, and come from a diversity of products, customers, markets, etc. High-quality revenue reduces the risk for any new owner or management team and therefore can increase business value. 6. Stage your business for a sale. Similar in concept to staging your house in advance of a sale, it is important to make sure that the office and business premises are neat, uncluttered, and clean. 7. Reduce risk for buyers. Business buyers and sellers view risk from an entirely different frame of reference. Anything a seller can do before marketing the business to improve terms or secure improved supplier, customer, or employee contracts can reduce the perceived risk for a new owner. The degree of reliance on key suppliers is also something that a seller can focus on by finding alternatives or having backup plans in place. Putting stay bonuses in place with key employees may also be necessary. 8. Review and upgrade IT Systems. A thorough review of all things IT-related is usually a good idea when preparing for a sale. How reliable and secure are your systems? Is all your software properly licensed and up to date? Many times how you collect, analyze, interpret, and utilize your customer, product, and market data is incredibly important to a buyer and needs upgrading. 9. Document your processes. Buyers typically want to make sure that all operating procedures and company policies are well documented and up to date. Sellers should consider imposing a vigourous “self-audit” similar in substance to what would be undertaken under any third-party audit. 10. Implement HR best practices. For top-performing teams, everyone must have a clear understanding of what is expected of them, their role, and how it fits within the organization’s goals. Putting HR best practices in place for recruiting, onboarding, evaluating, training, developing, promoting, and retaining employees can make a business much more marketable when it's time to sell. Most rational people enter an M&A deal negotiation with the intent to close the deal but with an understanding that some compromises will be required along the way. There may be some healthy skepticism on the probability of a successful close by one or both parties but typically there is also some level of hope that it will work out and that a deal is doable. However, like any important negotiation process, it is critical to know your “red lines” and when to say "no", even if it ends negotiations of what is otherwise a good M&A deal. The challenge is to ensure those items are dealt with early in the negotiations so that you and your team minimize the amount of time and resources you waste on a deal that can’t be completed. Defining your red lines early doesn't mean being closed-minded to finding creative solutions to address your concerns. Both parties need to look beyond their counterparty’s “position” to explore their “interests” and focus on inventing options for mutual gain. It can be hard work but worth it if an otherwise undoable deal becomes doable. Unfortunately, it's not enough for only one side to focus on such principles. Far too often, one party walks away from the deal at the "11th" hour based on issues that should have been addressed early or that they should have known much earlier in the process. For the buyer, this can happen for any number of reasons. Sometimes, the buyer’s deal team may seem to be uncoordinated and unclear on the deal’s major objectives. Some members of the deal team are focused on immaterial due diligence details while some of the key decision-makers may not have entirely bought into the concept. This seems to be more common with larger corporate buyers. Larger corporations sometimes require a diverse group of internal approvals across the organization, and it often seems that almost anyone can veto the deal if they’re not completely on board. Of course, the more senior the “objector”, the more likely their input and opinion can kill the deal. The deal team must keep the key decision-makers on board throughout the negotiation and due diligence phase to ensure that the entire process does not waste valuable resources, nor does it sour relations with the seller if the buyer walks late in the process. The deal team needs to thoroughly explore the acquisition from a wide range of perspectives and have an early and deep understanding of the red lines from each of the key decision-makers’ frames of reference. Sellers' red lines usually center around value but could be any number of factors, such as the amount of rolled equity or its share structure, non-competition clauses, transition or employment contracts, etc. Sellers should insist on having discussions about the key deal terms and “must-haves” early in the process and each should be spelled out clearly in the LOI. All too often a lot of key deal terms are excluded from the early negotiations because the buyer is unwilling to commit without further due diligence. Sellers should insist they be agreed to, at least in principle, so the buyer knows up front what is non-negotiable. Some sellers are reluctant to expose certain aspects of the business early on in the negotiations and due diligence if they feel they could devalue the offer. This is usually a mistake and is a good way to waste everyone’s time and money. Every M&A deal negotiation has its nuances, however, the probability of a successful close increases when both parties 1) ensure all key decision-makers are on board from the beginning, 2) address the most important “must-haves” and “red lines” upfront or early in the process, and 3) remain open-minded to finding creative solutions to address their counterparty’s interests. Of course, any business buyer should first formulate their acquisition strategy before going out and seeking potential target candidates. They also should formulate a clear post-transaction strategy for businesses they seek to acquire. For the seller, finding the right buyer via a “strategy-first” approach is a little dependent on the overall objectives of the seller. If getting the top-selling price is the highest priority, business sellers should run a broad, professional, competitive process. There are however situations when a strategy-first approach might be more appropriate. By this, I mean when the seller is seeking a buyer/investor that 1) brings a specific strategic fit to the deal, whether that is access to markets, resources, etc., and 2), the strategic fit is more important to the seller than getting top dollar. Deciding on the right priorities before engaging in a discussion with potential buyers or hiring an investment bank to run a process is a critical first step. Once a seller has decided what his/her highest priorities are, then the decision on what approach to take is a little easier. Here is a link to the types of questions you should answer before you start. When the strategic fit is the sellers’ highest priority and when there are only half a dozen or more buyer candidates, a limited sell-side process may be appropriate. When the strategic fit is critical and there are very few suitable candidates, the seller is in a delicate position. Approaching a buyer directly to explore whether they are interested in acquiring your business can be a little intimidating, particularly if there is no pre-existing relationship. If the buyer candidate is a direct competitor or a potential future competitor, it can put the seller in a precarious position. However, establishing a working relationship with a potential buyer can be a non-threatening way to explore the strategic fit between the buyer and the seller, without the seller even exposing that they may have an interest in an eventual sale. Without explicitly outlining that a sale might be considered, potential sellers should look for ways to build a commercial relationship as a first step. Of course, once a trusting relationship has been established, it can be easier to explore synergies, business strategy, cultural fit, etc. Whether you’re a future business buyer or a business seller, one of the most important exercises you should undertake before going to market is to identify your highest transaction priorities. Often, business sellers fail to think through what they want to achieve from a sale, other than obtaining the highest price. Likewise, business buyers often know they want to grow through acquisitions but fail to clearly define their priorities and resource their acquisition strategy accordingly. If obtaining the maximum value is a seller’s highest priority, it is usually advisable to hire an Investment Bank/M&A Advisor to run a broad process to create competitive tension between potential buyers. However, not all businesses and situations are well-suited to the traditional sell-side controlled auction process. Interestingly, the most obvious buyer(s) sometimes submit a mediocre offer or decide to “pass”, and unexpected buyers sometimes submit impressive initial offers. While an unexpected buyer can cause some consternation, as they may not know what they don’t know, a broad, competitive process, helps ensure that the highest selling price is obtained. The highest selling price, however, often comes in the form of a structured deal. So, if the priority is to obtain the highest total enterprise value, business sellers should be prepared to accept earnouts or other contingent payouts and/or provide financing support such as equity rolls or vendor takebacks (VTB), etc. It is important to calculate how much “cash at close” will be needed after tax and all other expenses are considered. An equity roll or VTB demonstrates the sellers’ confidence in the future of the business and therefore it can drive valuations, or at the very least, help ensure that the best buyers submit offers. Furthermore, many buyers will require a transitional role for owner/managers. If “handing over the keys” and walking from the business is your highest priority, the type of sale process you engage in and the buyer universe you approach should be designed to achieve this priority. On the other hand, perhaps you are looking for a specific ongoing role under new ownership. Either way, defining your priorities on your potential post-transaction role, if any, is critical. Maintaining or ceding control is also often one of the most important priorities to decide at the onset of any buy or sell process. In some situations, selling the shares of the business (rather than the assets) may generate higher after-tax net proceeds but buyers may offer less because they may lose some potential tax benefits and assume more liability. Sellers need to decide how important is it is to sell equity (shares) vs the assets of the business. Also, sellers should decide how important it is for them to retain (and lease-back) or divest any real estate (if owned by the business or an affiliate) that the business utilizes. Other important priorities to consider include the importance of the retention of the management team by any new owner, the cultural fit, the impact of a transaction on employees, customers, suppliers, and other stakeholders. Business sellers need to think through the impact a sale to a direct competitor may have on the business and decide whether it is important the business remain as a stand-alone entity. Is it important that the legacy of the business’s operations, brands, etc. be maintained? In other cases, the priority may be to capture needed synergies or to facilitate needed industry consolidation to survive and thrive in the future. For business buyers, many of the same questions need to be answered. Rarely do acquisition or divestiture processes proceed exactly as planned. The approach you take, however, needs to be shaped by your highest priorities. Take our business seller survey to help you sort through your most important transaction priorities. |
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March 2024
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