Discounted Cash Flow Analysis or “DCF” is a valuation method used in M&A transactions in order to determine the value of a company for sale. This method projects the future free cash flows of the company for sale and then discounts these future cash flows to their present value. Cash flows received farther in the future have less value to the business today and so are discounted more than cash flows that will be received in the near term. DCF analysis is one of the most commonly used valuation methods in M&A. While this method can be very useful in determining the value of a company, it can lead to inaccurate valuations if the underlying inputs of the analysis are unrealistic. In other words, the outputs of a DCF analysis are only as good as the inputs used in it.

M&A transactions sometimes require financing, and buyers must carefully weigh their financing options to ensure a successful acquisition, i.e., one that will not jeopardize their financial condition. It’s also helpful for sellers to understand why buyers offer equity versus cash or sometimes ask the seller to finance part of the purchase.

Two of the most common forms of financing for acquisitions are the use of debt or the issuance of equity to fund the acquisition. Given that there are advantages and disadvantages to each form, many buyers use a combination of the two.

Financing an M&A transaction through the use of debt can be appealing since it is typically cheaper for the company to issue debt compared to equity, which usually carries a much higher rate of return expectation from investors. Issuing debt has tax benefits because the interest payments are tax deductible, and the increased leverage can also boost a company’s return on equity. Another benefit of issuing debt is that no additional shares are issued, and so there is no dilution of ownership. On the other hand, there are many notable downfalls to financing through debt. The issuance of too much debt will hurt the company’s credit rating, which would hinder its ability to borrow money in the future and would lead to an increase in the company’s cost of debt. Debt issuance may also be limited by existing lender covenants that set a restriction on the amount of debt the firm can assume. This might make it impossible for some companies to borrow enough money to make a large acquisition.

When equity financing is utilized, a buyer can either offer its stock to the target firm’s shareholders or offer cash, which would be generated by the proceeds from an equity offering. Despite the higher cost of equity, it is still very common in M&A transactions because of the flexibility it provides the issuers. Some of the benefits of equity include (i) no mandatory interest payments, (ii) no principal that must be repaid, and (iii) no restrictive covenants related to its issuance. Financing an M&A transaction with equity has no impact on a company’s credit rating, therefore allowing them to issue debt in the future if needed. Equity offerings can however have negative side effects. Issuing stock can hurt a firm’s earnings per share and return on equity as it becomes less leveraged. Furthermore, the volatility of a company’s share price can cause uncertainty about the exact acquisition valuation, which in turn can increase the amount of time needed to reach a closing or even destroy the planned transaction.

Frequently, public companies use equity financing as their preferred form of payment in M&A transactions. Nevertheless, debt still plays an important role because of its cost effectiveness and the advantages of leverage.

An experienced M&A advisor can help buyers and sellers figure out the best combination of debt and equity for any particular transaction.

Versailles Group, Ltd.

Versailles Group is a Boston-based boutique investment bank that specializes in international mergers, acquisitions, and divestitures.

Since 1987, Versailles Group’s skill, flexibility, and experience have enabled it to successfully close M&A transactions for companies with revenues greater than US$2 million. Versailles Group has closed transactions in all economic environments, literally around the world.

Versailles Group provides clients with both buy-side and sell-side M&A services and has been completing cross-border transactions.

More information on Versailles Group, Ltd. can be found at

www.versaillesgroup.com

For additional information, please contact

Donald Grava

Founder and President

+617-449-3325

A Confidential Information Memorandum or “CIM” is used to market a business for sale to prospective buyers. The CIM or Offering Memorandum is usually created by the financial advisor of the business for sale and includes important information that a prospective buyer would need to submit an initial offer for the company. The CIM describes the business and its operations in detail, as well as includes the company’s financial statements. A strong CIM will highlight the company’s strengths and help prospective buyers understand the full potential of the investment. Normally, CIMs are not distributed to buyers until they have signed strict Non-Disclosure Agreement which prohibits the prospective acquirer from using any of the information for purposes other than the sale transaction.

There are several reasons why a company should make acquisitions. Listed below are some scenarios in which establishing an acquisition program can ensure your company’s continued success.

You may need to strengthen your position in the market if it is expected to have little or no growth or to mitigate competition. You may also want to “jump” into a related market or even venture into a new growing market.

You may decide that it is necessary to increase the size of your business through an acquisition to gain economies of scale. Doing this may allow you to keep up with larger competitors that qualify for better interest rates, access to commercial paper markets, and generally are able to get better terms for financing. By realizing these advantages through an acquisition of another company, division, or product line, one will be able to grow the business faster.

Another issue that some businesses face is that they sell a specialized product line to a limited number of customers. Due to market conditions, these customers in turn “force” the company to accept smaller profit margins. In turn, when suppliers see the company becoming less profitable they are less inclined to offer favorable terms for payment. Meanwhile, larger competitors that sell to a more diverse customer base or sell a broader array of products are not affected by these problems. The acquisition of another company is a viable option to expand the customer list or product line and avoid these problems.

The challenge is ultimately to understand how your company is positioned in the market and visualizing how you would like to position it in the future. It is important to accurately identify your company’s strengths and weaknesses so that you can eliminate or mitigate the weaknesses and enhance your strengths through an effective acquisition program.

With regard to M&A, due diligence is an audit of a potential investment, which takes place prior to the closing of a transaction. Due diligence is not only an opportunity for buyers to thoroughly examine the financial statements, physical assets, intellectual property, etc. of a potential acquisition, but is also an opportunity for the seller to assess the potential buyer and their ability to fund the transaction at closing. Due diligence is a critical step in the M&A process, as buyers use it to ensure they understand what is being purchased and sellers use it to become better acquainted with the potential acquirer.

Deciding whether to sell a business is often a difficult decision for an entrepreneur to make, particularly the first time seller. Over the years, we have found that entrepreneurs have five fears: legacy, customers, employees, value, and confidentiality.

One common fear entrepreneurs have when deciding to sell a business is the wellbeing of their legacy. Entrepreneurs may be concerned that the sale of their business could mean the end of their product or service or possibly the discontinuation of their company’s legacy. In most cases, buyers are interested in a business for the value its products or services bring to customers or the reputation of the company’s brand. Buying a business simply to remove a competitor is not commonplace and is typically not a good use of funds by an acquiring company. A good financial advisor should be able to identify reputable buyers that will respect the entrepreneur’s legacy. Typically, these buyers will place a higher valuation on the company as they want to leverage the company’s brand.

Entrepreneurs also worry about their customers and how they will be affected by the sale of the company. For many entrepreneurs, the customer has been their main focus throughout the years and they want to ensure these customers will continue to have their needs met. The customer list is an important asset that a buyer is acquiring in a transaction and is often times seen as one of the key areas for potential synergies. Acquiring companies seek to continue great relationships with newly acquired customers in order to sell additional products or services to them and to maintain their own reputation in the marketplace. For these reasons, entrepreneurs should feel confident that their customers would receive the same level of attention and service that they had been provided in the past.

Entrepreneurs worry about the future of their employees, especially those employees who have worked with the company for years or maybe even decades. The thought of co-workers and friends being terminated after an acquisition is terrifying to most business owners. As worrisome as this may seem, the reality of the situation is usually just the opposite. In the middle-market, there are rarely acquisitions in which a company is acquired and the employees are fired. Most buyers are purchasing a business to grow it so they are usually anxious to keep the staff and to add additional employees. In the rare instances when employees of an acquired firm are fired, the buyer will ensure that they receive generous severance packages and may even help these employees find new positions. Buyers do this, as it is important for them to maintain a positive reputation as a responsible buyer. If they do not do that, they risk not being able to acquire other companies.

Another fear of entrepreneurs is that they will not achieve the maximum value for the business they have built. This focus can sometimes lead to sale paralysis during times when the business is growing. Entrepreneurs may think to themselves “my sales have been improving, if I hold off on selling my business for another year or two, perhaps I can get a lot more for my business.” This mentality exposes an entrepreneur to many unforeseen risks. Should sales decline before the start of the sale of the business or during the sale of the business, the valuation of the company will be significantly reduced as buyers like to see positive trends and are willing to pay in the present for future cash flow. To solve this dilemma, an entrepreneur’s financial advisor would structure and negotiate an “earn-out” to the deal structure that will reward the entrepreneur with future cash payments should the business meet performance thresholds. With this type of mechanism in place, entrepreneurs do not have to worry about not receiving “credit” for future performance. It also eliminates the risk of a reduction of value should the business have a sales decline before or during the sales process.

Lastly, entrepreneurs worry about sharing confidential information during the sales process. While this fear is certainly understandable, in many cases it is blown out of proportion. An experienced financial advisor can guide an entrepreneur through the sale process in such a way that anonymity of the business for sale is maintained until a potential acquirer has proven itself to be serious and have executed a strict Non-Disclosure Agreement or “NDA.” Such NDA would prohibit the buyer from utilizing any information obtained from the process for purposes other than the sale transaction. It is also important to note that acquiring companies and financial buyers go to great lengths to maintain their reputation as professional buyers, which means that they use confidential information very carefully. Companies that fail to respect confidential information, either before or after executing a Non-Disclosure Agreement, are rarely shown deals by sellers or their financial advisors. This penalty is real!

The best way for an entrepreneur to ease these five fears is by engaging a professional financial advisor in the sales transaction. An advisor with a proven record of accomplishment for obtaining exceptional value and maintaining confidentiality can help an entrepreneur achieve the best possible transaction while mitigating his or her fears, and eliminating the risks related to selling the company.

A critical function of a sell-side advisor during an M&A transaction is the creation of a comprehensive buyer list. During the screening process of potential buyers, your M&A advisor must be thorough in their analysis of both potential strategic and financial buyers. This detailed analysis can heavily contribute towards the success of a sell-side M&A engagement. Several factors are examined when developing a buyer list including but not limited to the financial capacity of an acquiring firm, potential synergies, and current market share.

If the list of potential buyers isn’t well-researched, there’s a risk that the “right” buyer may miss the opportunity to bid on the company. This could be an expensive mistake for the seller.

It is crucial that the sell-side advisor understand the potential buyers and what might motivate them. Having a thorough understanding of their strategies, operations, and financial stability is essential in marketing the business for sale. Your M&A advisor must help potential buyers understand how synergies can be realized through the acquisition of a client’s firm. This is an important step as it will help the potential buyer to truly understand the value of the business for sale.

Boutique investment banks with a global reach are capable of developing a comprehensive worldwide prospective buyer list. A list that is not limited by geographies, language, or customs will allow the best possible acquirer to be discovered so that the best value and terms can be derived for the seller. M&A experience is equally important as investment banks with decades of transaction experience will be more capable of helping potential buyers understand the synergies that can be realized through acquisition, are better equipped to deal with buyers from around the world, structure the transaction, and know how to manage the process to a successful conclusion.

In M&A transactions, an escrow or a holdback is used to ensure that certain conditions are met by the seller before an agreed amount of funds is released. These structures help allocate risk between buyer and seller and are common in middle-market business sales.

If an escrow is used, a third party known as the escrow agent holds the funds until receiving instructions that certain obligations have been satisfied and the funds can be released. Most of the time, the escrow agent is a large, reputable bank or trust company that provides this service.

In middle-market transactions, escrow and holdback structures are often heavily negotiated and can materially impact a seller’s net proceeds, timing of payment, and overall risk exposure.

How Escrow Accounts Work

The escrow agent holds the funds pursuant to an escrow agreement executed at closing. That agreement governs how claims are submitted, the required notice procedures and timelines, dispute resolution mechanisms, the conditions for release of funds, and the investment of escrowed funds along with the allocation of interest.

In most transactions, escrow funds are invested in low-risk instruments. The interest earned is typically paid to the seller upon release, although this is negotiable.

Despite the fact that escrow accounts are very common in M&A transactions, the specific terms can vary greatly. The average escrow amount typically ranges between 10 percent and 20 percent of the purchase price. The holding period generally ranges from 12 to 24 months following closing. In certain situations, however, both the percentage and the duration may be increased depending on the perceived risk of the transaction.

Why Escrows Are Used

Escrows are designed to protect buyers against unforeseen financial losses after closing. Buyers are often concerned that undisclosed liabilities may surface once the transaction is complete.

Funds are typically released to the seller at pre-agreed times. Sometimes, partial releases occur as early as six months after closing. It would be unusual for the entire escrow to be released that early, but buyers and sellers frequently agree to release portions after six or twelve months if no claims have been made.

The funds are released only if all agreed obligations have been fulfilled. If unknown liabilities arise, or if the seller fails to meet certain pre-agreed conditions outlined in the Purchase and Sale Agreement, the buyer may have the right to recover amounts from the escrow.

Provided the agreed conditions are met, escrow funds ultimately belong to the seller. Buyers do not expect escrow funds to be returned to them. Rather, the escrow serves as a protection mechanism in the event issues arise.

Because the funds are held by a neutral third party and can only be released in accordance with the escrow agreement, escrows can reduce a seller’s risk of not being paid.

The Alternative: Holdbacks

The alternative to an escrow is a holdback. In this structure, the buyer simply retains a certain percentage of the transaction consideration instead of depositing it with a third-party escrow agent.

In some transactions, a holdback is used to secure a specific known risk such as a pending tax matter, while general indemnification risk is covered through a separate escrow.

The primary risk of a holdback is that the funds remain in the buyer’s possession. If the buyer were to go bankrupt or otherwise become unable to pay, the seller could face increased credit risk. While such situations are uncommon, this risk is one reason many sellers prefer the added protection of a formal escrow arrangement.

Representation and Warranty Insurance (RWI)

In recent years, representation and warranty insurance, often referred to as RWI, has become more prevalent in middle-market transactions. RWI allows an insurance policy to cover certain breaches of representations and warranties, which can reduce the need for larger escrow amounts.

For sellers, this can increase cash received at closing, reduce post-closing exposure, and improve overall deal competitiveness. However, RWI does not eliminate escrow entirely and often excludes known risks. It is typically used as a complement to traditional escrow structures.

Escrow accounts and holdbacks are important tools for allocating risk in M&A transactions. While they are standard components of many deals, their structure, size, and duration can significantly affect a seller’s ultimate proceeds and risk profile.

Written by Don Grava

Versailles Group, Ltd.

Founded in 1987, Versailles Group is a boutique investment bank that specializes in international mergers, acquisitions, and divestitures. Versailles Group’s skill, flexibility, and experience have enabled it to successfully close M&A transactions for companies in the middle and lower-middle market. Versailles Group has closed transactions in all economic environments, literally around the world.

Versailles Group provides clients with both buy-side and sell-side M&A services and has been completing cross-border transactions since its founding in 1987.

More information on Versailles Group, Ltd. can be found at

www.versaillesgroup.com

For additional information, please contact

Donald Grava

Founder and President

+617-449-3325

The decision to sell your business is one of the most difficult decisions a person will ever make. It is not only a major financial decision, but a personal decision as well. Each instance is unique and the selling of a business requires attention to detail on many issues, some of them complex.

 
There are several reasons why it may be time to consider selling.

• If it’s difficult to raise the capital needed to grow the business or you believe it is too risky to do so.

• If too much of your net worth is “locked” in your company, you may feel it is time to diversify this wealth.

• If you are nearing retirement or are experiencing health problems, you may want to find a new owner or partner to continue your legacy with your employees, customers, etc.

• If you want to pursue a new business or hobby, you may want to “unlock” the value of your company and be compensated for all the hard work and time you have put into it.

Versailles Group’s eBook, “When to Sell Your Business” has a more detailed look at these issues. It can be downloaded from our website.

After deciding that you may want to sell and have determined that it is a good time to do so, there are some important items to address: (i) What is the expected value of the company? It is important to have a realistic expectation of what a buyer will pay and always be mindful of the fact that this is an important decision for the buyer as well. (ii) How are you going to engage the right buyers and get them interested in your company? The best way to do this is through a broad based approach that searches for potential buyers around the world. The best buyer for your company may not always be the obvious one or one in your country or even on your continent.

M&A experts can help you address these and the myriad of other issues that come up when selling a business. Selling your company is an important process and it should be done professionally in order to maximize the value and terms. It is also important to have proper legal and accounting representation.

As one can see from the chart below, global M&A, as we’ve reported before, is flying high!

M&A activity for the 11 months ended November 2014 is at a record high since 2011 as buyers and sellers are coming together at a very rapid pace. Our belief is that many companies and entrepreneurs want to get deals done before interest rates increase, there is a change in US President, or there is another economic or political crisis. Many people remember the depths of the Great Recession and are taking the necessary steps to ensure their companies and personal net worth are better protected from any future economic downturns.
Buyers are strengthening their companies and sellers are paying off debt, diversifying, and in some cases retiring. What are you doing to increase or protect your shareholder value?