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.

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?

Worldwide M&A activity is continuing at a rapid pace this year for a number of reasons including the availability of credit, the robust liquidity of large companies and private equity firms, and the continued improvement in the economy.

By sector, Financials, Healthcare, and Consumer Discretionary transactions accounted for over half of the M&A transaction value. If one examines M&A transactions by the number of transactions, 66 percent of the transactions were completed in the Financial, Consumer Discretionary, and Industrials sectors.

The following pie chart and table show M&A activity by sector.

M&A activity was very strong in Q1; in fact, the M&A market this past quarter was more active than any quarter in the last several years. April and May continued this trend with a high level of activity in terms of both deal value and the number of transactions.

This heightened activity is driving multiples up as depicted in the chart below, which shows the percentage increase in TEV/Revenue multiples by industry from the last 12 months to the last 90 days.

Why do deal multiples matter? If you’re a seller, you’ll receive more value for your company. If you’re a buyer, you’ll end up paying more. Therefore, it’s an opportune time for sellers to put their company on the market. Similarly, buyers should consider a transaction before the multiples increase further.

M&A activity in the first quarter of 2014 was quite strong. The value of transactions announced in the first quarter exceeded both 2012's and 2013’s first quarter. The value of announced transactions in the first quarter of 2014 also exceeded the last quarter of 2013, which is very dramatic as the fourth quarter is usually the busiest quarter of the year for M&A.

They say that April showers bring May flowers. M&A is similar! Devising a strategy and working hard to insure the proper execution always results in a superior transaction. I’ve been doing M&A for over 30 years and have helped a large number of corporations and entrepreneurs achieve excellent results whether they are buying or selling a business. One of the key ingredients is careful thought to insure that the strategy and tactics will achieve the desired result.

With regard to building shareholder value, business owners and companies frequently ask themselves:

Is this the best time to sell my company or a part of my company?

Is this the best time to buy a company or part of a company?

The charts below demonstrate from both a value perspective and the number of M&A transactions announced that now is the time to pursue these strategies.

The dramatic run-up of both deal value and number of transactions announced in Q1 2014 versus Q1 2013 is very evident, despite the fact there are still 15 working days left in March.

Versailles Group is pleased to announce that Photon Technology International Inc., an electro-optical systems and components manufacturer with offices in the U.S., Canada, U.K., and Germany, has been sold to Horiba Ltd., a world leader in analytical and measurement systems that is headquartered in Kyoto, Japan. Versailles Group represented Photon Technology International.

The text of the Press Release is listed below for your convenience.

BOSTON, Feb. 12, 2014 -- Versailles Group, Ltd. (www.versaillesgroup.com) announced today that Photon Technology International Inc. (www.pti-nj.com), with operations in the U.S., Canada, Germany, and U.K., has been acquired by Horiba Ltd. (www.horiba.com) (TSE:6856). Versailles Group acted as exclusive financial advisor to Photon Technology International Inc. Terms were not disclosed. The transaction closed on Feb. 10.

Versailles Group, a 27-year-old Boston-based investment bank that specializes in international mergers, acquisitions, and divestitures, advised Photon Technology International Inc.'s shareholders on the transaction. Versailles Group works with companies in the U.S., Europe, Canada, Asia, and South America.

Founded in 1983, Photon Technology International Inc. ("PTI") is a leader in electro-optical systems and components technology. The company's light based systems are used in laboratories for research, healthcare, industrial processes, quality control, biomedical, environmental science, and many other applications. PTI pioneered a line of proprietary and / or patented optical building blocks which form the basis of all light-based instrumentation. The company sells these building blocks as standalone units and uses these building blocks to develop its open architecture fluorescence systems. PTI is the world leader in microscopy based fluorometers, especially for ion imaging, in part due to a long-standing research and development collaboration with a prestigious laboratory in the Faculty of Medicine and Dentistry of the University of Western Ontario in Ontario, Canada.

"The acquisition of PTI fulfilled the primary shareholders' desire for a liquidity event. It also provides a path for the majority owner to retire in the next few years" said Donald Grava, Versailles Group's founder and president. By utilizing Versailles Group's worldwide approach to finding the right buyer, PTI was sold to Japan-based Horiba. This will enable PTI the ability to sell its products via Horiba's worldwide sales organization. Furthermore, it provides Horiba access to PTI's fluorescence spectroscopy products, and PTI's low cost production capabilities in Canada.

Headquartered in Kyoto, Japan, Horiba Ltd. is the world leader in analytical and measurement systems in the fields of engine emissions, scientific analysis, industrial and process control, environment monitoring, semi-conductor process control, healthcare, and biotechnology. Founded in 1945, Horiba is a global company that has offices in Asia, Europe, North America, and South America. The company is publically traded on the Tokyo Stock Exchange and has annual revenues of approximately ¥118 billion.