There are many steps that need to be taken when organizing the acquisition of a company, division, or product line. Initially, an acquisition strategy needs to be developed. An acquisition strategy is essentially a business plan which acts as a road map for completing a successful acquisition. The objectives of the acquisition search need to be clarified, and potentially, written down. Another important aspect of this plan is to detail the guidelines to be used when screening acquisition candidates. One does not want to get caught wasting time on a target when the probability of closing is too small or on a target that will not add value in the future. A defined acquisition strategy will give the buyer a method to evaluate potential acquisition candidates relative to the stated objectives of making such an acquisition.

Another crucial aspect of a well-defined acquisition strategy is establishing an acquisition team. An acquisition team must have their responsibilities and authorities clearly mapped out. It is also important that different parts of the company are represented within the acquisition team since they may have conflicting interests within the organization. Typically, the owner or CEO is responsible for selecting team members and being aware of any conflict of interests that may exist between parts of the company. For example, the sales people may be focused on selling low margin products whereas finance may only want to acquire targets with high gross margins.

The acquisition team should be comprised of product specialists, finance, legal, marketing, etc. so that the target can be understood at multiple levels. Like any team, the CEO needs to guide the team members to insure that objectives are met, conflicts are minimized, and the resulting acquisition is successful.

Every company is unique in its own way and management knows better than anyone what makes their company different. It is important to understand current market share, manufacturing costs, whether or not you are on the low or high end of the market, where working capital is being utilized, how much marketing is being done, etc. By analyzing these aspects, the buyer will be able to develop an acquisition strategy that compliments the buying company’s strengths and mitigates its weaknesses.

Many times, in middle market transactions, buyer and seller do not agree on the purchase price. One way to bridge the valuation gap between buyer and seller is to structure an earn-out. An earn-out is a payment plan in which the buyer will make additional payments to the seller based upon the performance of the newly acquired business. Earn-outs can be essential to closing M&A transactions in which the buyer and seller cannot agree on the value. Earn-outs are designed to ensure that each party receives fair value as a result of the transaction.

There are several advantages to structuring an earn-out. Earn-outs can reduce negotiation time in cases where neither buyer nor seller can agree on a valuation. An earn-out can help the selling party receive the full value for their business by the seller making specific payments, over time, based on the seller achieving specific performance criteria. Through the use of an earn-out, the selling company may receive more money (or shares) than they would have if the acquisition were a one-time payment at closing. Buyers like the use of earn-outs because it reduces the risk of overpaying for an investment that does not achieve its financial projections. Because of this risk mitigation for both buyer and seller, earn-outs are oftentimes used as a way to make a fair compromise on the purchase price of the target company.

Experienced M&A advisers can help structure and negotiate an earn-out that will be acceptable to both buyer and seller. A well-structured earn-out can be beneficial to all parties involved. The buyer feels confident they are not overpaying for the company because the seller has to achieve certain performance thresholds in order to receive additional payments. The seller is satisfied because additional consideration will be paid if the business does achieve its forecasts. The earn-out has the added benefit of demonstrating to the buyer that the seller believes in the forecasts and that the seller is not in a hurry to exit the business. (Most of the time, the founder or seller of a company stays with the company during the earn-out period to help insure that the company will achieve the desired results.)

One of the most challenging aspects in structuring an M&A transaction is not necessarily the determination of a purchase price, but rather how that purchase price is allocated between the assets being sold. The major conflict at the core of this issue is the existence of tax polarity between the buyer and the seller. Generally speaking, the seller of the business is trying to maximize after tax proceeds while the buyer is trying to minimize the consideration relative to the after tax cash flow of future operations. Given these concerns, sellers typically look to sell stock while buyers usually want to buy assets. (Many times buyers prefer asset purchases because, in most jurisdictions, it limits liability. In Brazil, for example, it does not limit liability.)

Section 1060 of the IRS tax code attempts to mitigate conflicts regarding the allocation of the purchase price to various assets. Under Section 1060, both the buyer and the seller of a business are required to use the residual method for purchase price allocation. This means that the purchase price is first allocated to assets to the extent of their fair market value and any excess will be allocated to goodwill and going concern value.

A purchase price allocation is important to include in a purchase contract between a buyer and a seller because it gives guidance as to the tax consequences of the transaction. An allocation acknowledged by the two parties will allow the buyer to determine the basis of depreciable and amortizable assets while the seller is able to compute the sales price of the individual assets in order to determine any recapture amounts. With an allocation in place, the seller is also able to determine capital gains and ordinary income from an asset sale.

Although coming to an agreement about purchase price allocation can be challenging, having a tax expert and an experienced investment bank negotiating between buyer and seller will help both parties reach agreement on an allocation that is beneficial or at least fair to both parties and that conforms to IRS standards.

When determining the value of a business, there are three basic approaches that can be used to determine the fair market value. These three approaches are the underlying asset approach, the market comparable approach, and the income approach.

The underlying asset approach is a technique in which the assets of the business determine how much it is worth. The assets being valued are both tangible and intangible which means they are considered in the valuation regardless of whether or not they show up on the balance sheet. The final value of the business is determined by a simple formula: Assets – Liabilities = Value of the Business.

Another common method of valuing a firm is the market comparable approach. This is where one compares a business to publicly held firms whose stock is trading. A value is derived by examining the public firm’s EV/EBITDA or EV/Revenue multiples and applying a similar multiple to the non-public, target firm. (EV = Enterprise Value and EBITDA = Earnings Before Interest Taxes, Depreciation and Amortization)

The third way of valuing a company is the income approach. The income approach is based on the company’s potential earnings in the future. The most common way of doing this is by using the discounted cash flow method. The discounted cash flow method (DCF) is where one projects the cash flows that the business will generate and then discount these returns to their present value.

No matter which approach is used, the accuracy of the valuation will depend on the level of detail and depth of analysis that is used in deriving that valuation. It is important to ensure the accuracy of all inputs used in these valuation approaches as these inputs will ultimately impact the value calculation of the target company.

One final note on valuations; “paper” valuations are interesting and useful, but they may or may not be an indication of what a willing buyer may pay a willing seller. Versailles Group has sold a number of businesses for more than any “paper” valuation would have indicated. The key to achieving such a valuation is to have the right buyers and a strong auction.

Versailles Group is pleased to announce the publication of its first eBook, "When To Sell Your Business."

Most entrepreneurs spend more time building their businesses than planning for eventual sale. This guide is meant to assist entrepreneurs in deciding the timing for the sale of their business.

To download your copy, please follow the link at the top of the page.

M&A deal activity is continuing at a rapid pace. Global volume this year has already exceeded US$3 trillion and will likely surpass last year’s record volume.

One particularly bright spot for M&A activity has been Europe. For the first time in recent history, European M&A has expanded dramatically. For the first three quarters of 2014, this has meant nearly US$800 billion of transaction volume. By comparison, for the same time period last year, there was less than US$500 billion of transaction volume in Europe.

What is Due Diligence?

A question sellers often have is what is due diligence? Due diligence is the process that takes place after a letter of intent (LOI) is signed, but before the closing of the deal. It is a detailed investigation into the potential investment in order to verify the assets and liabilities and to make sure that the buyer understands what it is acquiring. Normally, it entails a complete review of the business, products, customers, facilities, background checks on the management, technological reviews, etc.

If the due diligence process is not comprehensive, then the buyer runs the risk of serious financial losses. It is imperative for the buyer to understand how the business operates and the potential risks before closing the deal no matter how big or small that acquisition may be. Due diligence is a way to ensure that neither party involved in the transaction was misled so the deal can be closed successfully.

Three major areas of financial due diligence
Most often the three most important areas of the financial diligence are; (i) the quality and accuracy of the financial statements and related information, (ii) the sustainability of the cash flows, and (iii) a thorough understanding of the tax issues that may arise due to a possible change of ownership. Prior to a sale, owners can significantly improve the value of their business by focusing on these three areas to make sure there are no issues.

Most buyers prefer audited financial statements; however, in the middle-market, a majority of the companies do not have audited statements, primarily due to the high cost. If a seller does not have audited financial statements, the most important thing is to have accurate financial data that is prepared in accordance with GAAP. Sloppy or inaccurate accounting data always makes buyers nervous about the value of the assets and the possibility that liabilities are under-reported.

The sustainability of the seller’s cash flows is very important to potential buyers as this information provides excellent visibility into the possible future performance of the target company. Buyers also like to know which products and services generate the highest margins and have the greatest growth potential in order to better recognize how they can integrate these products and services into their strategic plans and current product offerings. Buyers tend to pay higher multiples when there is a strong, diversified customer base from which they can grow the company.

It’s important that a seller understand that if the diligence doesn’t go well, the buyer may elect not to close the transaction or may ask for a price reduction. For that reason, sellers should make sure that their accounting records are up to date and accurate. Furthermore, to the extent possible, sellers should think about the most important parts of their business and make sure that they are ready to withstand the scrutiny of someone else’s due diligence.

When a business owner is considering the possible sale of their company, one of the first questions he or she is probably going to ask is who wants to buy it?

There are typically two types of possible buyers in an M&A transaction. The first type of buyer is financial sponsors usually called private equity firms. These firms look to make acquisitions as financial investments. The second type of buyer is strategic buyers who look to make an acquisition of a business that is a potential fit into their current operations or enables them to achieve strategic goals.

The financial buyers generally are more concerned with the valuation and risk of an acquisition compared to strategic buyers. The financial buyers care much more about the target company’s current and projected financials and are generally in constant contact with financial advisers and intermediaries looking for possible acquisition candidates to pursue. By definition, financial buyers are very value conscious.

Strategic buyers are generally looking for companies that can fit into their own operations and, other than the obvious candidates, can be more difficult to identify. Strategic buyers or just “strategics” usually are competitors, suppliers or other companies that operate in the seller’s industry or related industries. The advantage of these types of buyers is that they tend to operate a similar a business so it may be easier for them to understand the seller’s operations, motives for selling, and possible risks.

Depending on an owner’s motives for selling and his or her desire for involvement post-closing, either type of buyer may be appropriate. Having an experienced M&A adviser to identify, contact, negotiate, and structure a transaction with these buyers is essential in order to ensure the most value for the business and the best terms to make sure that the owner is properly compensated and, if wanted, a desirable role with the company after the acquisition is complete.

As the chart below shows, M&A activity has expanded rather dramatically over the last five years. We expect this trend to continue, but not forever!

Are you prepared for the next bear market?

We all know that the world’s economies are cyclical. The current bull market has been going for about 5.5 years versus an average of 4 years. Given this simple fact, it’s important to focus on your M&A goals and strategies. To be clear, we do not believe that the next bear market is imminent. We do; however, believe in being ahead of the curve.
Now is a good time to start a transaction that will either close by year-end or early next year. Too many entrepreneurs and companies procrastinate only to find it’s too late to maximize value or miss valuable opportunities. The question is, given the current strength of the M&A market, why wait to pursue a transaction?

The chart below shows the first six months of M&A activity for both 2013 and 2014. In all geographies, the volume, year over year, has increased.

The gradual improvement in the world’s economies is driving this increase in M&A activity and pushing multiples up. For example, across all industry sectors, the Enterprise Value to Revenues multiple, has increased from 1.17x in 2012 to 1.26x in 2013 to 1.50x in 2014.