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FINANCIAL TECHNIQUES FOR BUSINESS ACQUISITIONS & DISPOSALS: 1998 UPDATE Ian Smith
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A Thorogood Special Report
FINANCIAL TECHNIQUES FOR BUSINESS ACQUISITIONS & DISPOSALS: 1998 UPDATE
Ian Smith
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Techniques for Successful Management Buy-outs
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The author Ian Smith, BA, CA is Managing Director of Capita Corporate Finance Limited. Capita Corporate Finance Limited is a leading UK advisor on unquoted transactions exclusively endorsed by the IoD. It is a wholly owned subsidiary of The Capita Group plc, a small management buy-out which has grown into a FTSE 250 company in eleven years. Ian specialises in acquisition and divestment work and has completed dozens of deals over the past decade. Prior to joining Capita in 1994 he held several senior positions within the Thomson Corporation in the eighties before developing Livingstone Guarantee into a leading UK Corporate Finance Boutique. Ian regularly presents seminars for independent companies on acquisitions, disposals and management buy-outs. He is also author of The Essential Guide to Buying and Selling Unquoted Businesses, Techniques for Successful Management Buy-outs and co-author of Commercial Due Diligence, all published by Thorogood.
Financial Techniques for Business Acquisitions and Disposals Contents
PART
Introduction ...........................................................................1
1 Chapter 1:
The Main Stages of Acquisitions and Disposals The Acquisition Process .............................................................4 Preparation Stage ......................................................................6 Search Stage ..............................................................................7 Verification / Commercial Due Diligence .................................7 Valuation – Initial Studies..........................................................9 Valuation – Final Stages.............................................................9 Deal Structures........................................................................10 Negotiation..............................................................................10 Due Diligence..........................................................................11 Draft Contract .........................................................................11
Chapter 2:
The Disposal Process................................................................12 Preparation Stage ....................................................................14 Finding Buyers ........................................................................15 Buyer Assessment ....................................................................15 Valuation .................................................................................16 Negotiation..............................................................................16 Final Stages to Completion .....................................................17 Part 1: Summary.......................................................................18
PART
2 Chapter 3:
Valuation Site Visits and Information to be Gathered ................................21 Initial Meeting .........................................................................22 Further Site Visits ....................................................................23 Further Information to be Assessed ........................................26 Key Financial Checklist...........................................................26 Key Operational Areas.............................................................28
Chapter 4:
Commercial Rationale (the Basis of Value) and Sustainable Profits ...................................................................31 Basis of Value – Buyer’s Perspective........................................32 Basis of Value – Seller’s Perspective ........................................33 Buyer’s Perspective – Adjusted/Sustainable Profits.................34 Seller’s Perspective – Adjusted/Sustainable Profits .................34
Chapter 5:
Valuation Techniques: Tools of the Trade...................................36 Price Earnings Ratios (PERs) ...................................................37 FT Actuarial Table ....................................................................39 Return on Investment (ROI) ...................................................40 Discounted Cash Flows (DCF)................................................40 DCF Example ..........................................................................41 Net Asset Backing....................................................................42 Summary of Techniques ..........................................................43 Part 2: Summary.......................................................................44
PART
3 Chapter 6:
Deal Structures and Tax Angles General Guidance .....................................................................46 Assets or Shares.......................................................................47 Forms of Purchase Consideration ...........................................48
Chapter 7:
Earn-out Deals ..........................................................................51 Key Features............................................................................52 Alternatives to Earn-outs .........................................................52 Why Use Earn-out Deals? ........................................................53 The Rule Book.........................................................................54 Management Control Issues....................................................54
PART
Part 3: Summary.......................................................................56
4 Chapter 8:
Negotiation
Negotiation Key Features..........................................................58 Overview.................................................................................59 Ball Park Price .........................................................................60 Assets or Shares.......................................................................60 Earn-out Period........................................................................61 Assets to be Excluded .............................................................61 Directors/Relatives to Resign..................................................61 Preferred Purchase Consideration ..........................................62 Conditional Purchase Contract ...............................................62 Deadline for Final Negotiation ................................................62
Chapter 9:
Heads of Agreement .................................................................63 Part 4: Summary.......................................................................66
PART
5 Chapter 10:
Management Buy-outs Guidance on Each Stage of the Process....................................68 Overview.................................................................................70 Preparation Stage ....................................................................71 Funding Stage – Initial.............................................................72 Funding Stage – Advanced ......................................................74 Negotiation..............................................................................74 Due Diligence..........................................................................75 Legal Contracts........................................................................76
Chapter 11:
The Structure of a Management Buy-out ...................................77 Part 5: Summary.......................................................................81
Introduction
losing deals, whether buying or selling, in any economic environment is a difficult, sensitive and demanding goal to achieve. This report focuses on practical financial tips for executives who are intermittently involved in leading deals, or for people who are unaware of the complexities of the process and therefore may welcome some guidance. One key assertion underlying this report is that buying is not the opposite of selling. An executive who has completed many disposal assignments at attractive prices, will find this experience invaluable in attempting to acquire businesses. However, it would be complacent to assume that disposal experience was sufficient to equip the deal leader with all the skills necessary to complete acquisitions at attractive prices. This report is designed to guide the reader through the many lessons to be learnt from dozens of cross border deals, both from a buyer’s and seller’s perspective. In contemplating an acquisition or disposal readers should be aware that the odds are stacked against them in terms of reaching a successful conclusion. Comprehensive research has been completed in the last five to ten years on the success or failure of acquisitions and, although not comprehensive, reasons for failure include: insufficient planning of the deal, over-paying for the target and negative vendor management attitude post acquisition. Therefore, completing deals requires a measured and professional approach.
C
1
INTRODUCTION
This report does not examine the strategic importance of buying and selling companies, but instead assumes that this important stage of decision making has been completed. The text concentrates on practical financial tips to aid the deal leader through the important stages of valuation and negotiation with some illustrations of tax efficient deal structures. In a guide to financial skills of buying and selling, it seems appropriate to review the management buy-out process.As a financial technique, it deserves a detailed explanation to demonstrate to executives how balance sheets can be leveraged up in a reasonably safe manner to produce high quality deals for all parties involved. Finally, key points in each chapter are illustrated by brief ‘real life examples’ and a summary is attached to each Part as a checklist of the major topics covered. N.B. Users of this report will find the overview diagrams in the Appendices useful, particularly when referred to at the same time as reading the more detailed sections to which they refer.
2
The Main Stages of Acquisitions and Disposals Chapter 1 THE ACQUISITION PROCESS
Chapter 2 THE DISPOSAL PROCESS
1
part
The Acquisition Process Preparation Stage Search Stage Verification/Commercial Due Diligence Valuation – Initial Stages Valuation – Final Stages Deal Structures Negotiation Due Diligence Draft Contract
chapter
1
PART
1:
THE
MAIN
STAGES
OF
ACQUISITIONS
AND
DISPOSALS
The Acquisition Process Preparation Stage
Strategic Review
Profiles
Search Stage
Desk Research
Advertising
Internal Knowledge
Verification/ Commercial Due Diligence & Initial Contact
Understand the Sector
Understand the Target / People
Initial Approach
Valuation – Initial Stage
Site Visits
Commercial Rationale
Valuation – Final Stages
Sustainable Profits
Tools of the Trade
Deal Structures
Assets or Shares
Forms of Purchase Consideration
Negotiation
Outline Terms Meeting
Heads of Agreement
Accounting/legal Due Diligence
Brief your Team
Identify Exposures
Assessment of Future and Historical Performance
Legal Contract Stages
Warranties & Indemnities & Disclosure Letters
Sale & Purchase Contract
Net Asset Adjustments & Earn-outs
Legal Completion
Public Announcements
First 60 Days
Group Integration
External Advisors
Earn-out Deals
Circulars & Stock Exchange Requirements
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Chapter 1 The Acquisition Process
The illustration on page 5, demonstrates the complexity of the acquisition process, and attempts to show clearly the chronological order of events starting with a strategic review of the desired sector through to legal completion.
Preparation Stage Strategic Review The success or failure of an acquisition depends heavily on the initial strategic review of the sector. Sector issues to be reviewed should cover growth trends, fragmentation of the sector and the competitive edge of the various players within the sector. Acquisition Profile The result of this strategic review should be a clear and concise one or two page document summarising the specific characteristics of the desired target. Details would include location, number of staff, pre tax profits and, of course, the products/services on offer.
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Search Stage It is surprising the numerous techniques available to acquirers seeking attractive target companies.Although not exhaustive, a range of techniques should include: 1.
Desk research
2.
Knowledge within the business
3.
Advertising
4.
Explaining the acquisition profile to advisers
By approaching the search from a range of perspectives you will increase the probability of finding attractive targets, and as an incidental bonus you are likely to discover a range of important facts about the sector to aid your assessment of the target.
Verification/Commercial Due Diligence A considerable number of acquirers fail to complete sufficient homework on the sector and target. It is insufficient to have requested the latest set of accounts from Companies House and have a vague knowledge of the target’s products and services. It is possible from a collection of public domain information and quality desk research to build a detailed picture of the target and thus at the earliest possible stage to understand the strategic fit of acquiring the company. This level of rigour will be essential to ensure you are properly prepared before contacting the decision maker of the target. Understand the Sector An outline review of the sector should have been undertaken prior to finalising the acquisition profile, however, it is now necessary to ensure the acquisition team understand the sector in some detail prior to meeting the target. Market research reports from Euromonitor, Keynote and statistics from economic units of banks or trade associations may be used to build up a picture. Press coverage and City analysts reports may shed light on issues affecting the sector over the next five years.
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Understand the Target / People In building a picture of the target acquirers should accumulate key statistics and perceptions including: 1.
Market share
2.
Customer views
3.
Press coverage
4.
Product / service quality
5.
View of industry specialists
As vendor management are likely to play a key role in the success of the acquisition, acquirers should investigate and establish: 1.
Shareholder base
2.
Credit checks on key directors
3.
Press coverage of the management team
4.
Directors’ other directorships
5.
Membership of professional bodies
6.
Personal interests
After this level of research the acquirer can contact the vendor with the knowledge he understands, in outline, how the target may fit within the acquiring group. Initial Approach Contrary to popular belief, arguably the most effective way is to contact the key decision maker not by letter, but by telephone. In private companies this should be the majority shareholder, who may not necessarily be the managing director. In listed groups the key decision maker is likely to be the chief executive, or depending on the size of the group, it may be appropriate to contact a divisional managing director who is on the Board and could confirm, therefore, in an authoritative manner whether a particular subsidiary was for sale. Assuming a successful outcome to the contact, it is important to prepare thoroughly for the initial meeting with the vendor.
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Valuation – Initial Stages Site Visits In Part Two within Valuation we examine site visits in some detail. In outline the key for acquirers is to establish a comprehensive agenda in their own mind and remember at the end of the day to ask the question – ‘As an acquirer do I wish to proceed to the next stage of this acquisition?’ Commercial Rationale This is examined in more detail in Part Two, however, the key to this stage of the process is to evaluate, as soon as possible, the fit of owning the particular target and in essence to construct a post acquisition scenario. This will allow the buyer to identify a range of operational issues in merging the target with their group and allow them, in an informed way, to value the business based on the benefit to their group.
Valuation – Final Stages Sustainable Profits Once considerable homework has been done by both buyer and seller, the important issue of sustainable profits of the vendor must be established.This is dealt with in Chapter 2 under Valuation. Tools of the Trade A range of techniques is available to aid acquirers and vendors to establish a valuation for the target business, and these include: Price Earnings Ratios, Return on Investment, Discounted Cash Flows and Net Assets Basis.A detailed review of each technique follows in Chapter 5.
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Deal Structures Assets or Shares Once value has been established in the acquirer’s mind, a plethora of deal structures are available to achieve specific objectives. Part Three reviews possible solutions. Whatever the deal structure the first issue to be agreed between buyer and seller is whether assets or shares are being acquired. Forms of Purchase Consideration The next major issue will be the form of the purchase consideration. Cash may only form part of the overall deal structure as other types of consideration may be more relevant. Part Three examines the alternatives. Earn-out Deals In certain circumstances it may be relevant to defer some of the purchase consideration to a later date. This type of deal structure deserves a special mention, and is discussed in Chapter 7. Having considered valuation and deal structure, the acquirer is then in a position to enter serious negotiations.
Negotiation The precise timing of the negotiation meetings will depend on the process, eg whether an ‘auction’ (involving many buyers) or ‘unsolicited approach’ (where the acquirer is hopefully on a one-to-one basis with the vendor) but in general consists of two separate stages.These are, firstly an initial stage to agree the key features of the deal and secondly, a meeting to negotiate a formal Heads of Agreement. It is likely that after the first negotiation meeting the vendor would wish you to confirm your offer in writing and this is often referred to as ‘a letter of intent’. The specific aspects of these negotiating meetings are discussed in Part Four.
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Due Diligence Assuming buyer and seller agree on outline terms, it is at this point that the buyer will expect to do relevant due diligence work to verify a range of facts issued by the vendor or gathered separately by the acquirer. It is now more common and highly recommended that acquirers conduct, not only financial due diligence by a relevant team of accountants, and legal due diligence by their lawyers, but also a commercial due diligence into various strategic and commercial issues surrounding the target and its sector.
Draft Contract Normally the acquirer would issue the sale and purchase contract after being satisfied with the due diligence process, and through a range of drafting meetings involving both sides and their lawyers, a final sale and purchase contract is agreed by all parties leading to legal completion of the deal.
11
The Disposal Process Preparation Stage Finding Buyers Buyer Assessment Valuation Negotiation Final Stages to Completion Part 1: Summary
chapter
2
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The Disposal Process Preparation Stage
Strategic Review Alternatives
Information Memo
Finding Buyers
Desk Research
Advertising
Buyer Assessment
Contact Buyers
Strategic Fit
Valuation
Basis of Valuation
Negotiation
Internal Knowledge
Contact Financial Institutions
Sustainable Profits
Deferred Consideration
Further Stages Prior to Invitation to Bid
Invitation to Purchase
Heads of Agreement
Forms of Purchase Consideration
Managing Due Diligence
Prepare for Site Visits
Stage Manage Extent of Investigation
Legal Contracts Stages
Warranties & Indemnities
Disclosure Letters
Legal Completion
Public Announcements
Ongoing Relationship Established Between Vendor and Acquirer
Net Asset Adjustments
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Chapter 2 The Disposal Process
The diagram on page 13, illustrates the disposal process with respect to an unquoted company or division of a listed group.This attempts to show clearly, as in the acquisition example earlier, the complete process from strategic review through to legal completion. The differences in approach between selling and buying are best demonstrated under the detailed chapter headings, later in the report, concerning valuation and negotiation. However, the stages, whether buying or selling, follow a similar pattern and are described below.
Preparation Stage Strategic Review Before embarking on a comprehensive disposal process, it is important to assess all other options open to the vendor.As a private company, although not exhaustive, it is important to consider alternatives such as: •
Flotation
•
Private placement of your shares, ie selling a minority stake to an institution
•
Selling a minority stake to an industrial partner
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Information Memorandum It is important to produce a document that sells the business to buyers. The strength of the vendor within its relevant market should be explained and the quality of the management team demonstrated. It is recommended that forecasts are not included at this stage as these merely serve as negotiation points for the acquirer to focus on.
Finding Buyers Once a decision has been made that disposal is the best route, it is then important to conduct comprehensive research into relevant buyers, ensuring that you understand those buyers with most to gain from the acquisition. It is surprising the attractiveness to overseas purchasers of fairly small, well run, UK businesses. The scope of this report does not allow detailed review of all the search techniques available, but these would include: 1.
Desk research – world-wide
2.
Knowledge within the business
3.
Contact with financial institutions
4.
Advertising
It is important not to restrict the search for buyers merely to the vendor’s sector, but to think broadly of all buyers with most to gain from the acquisition. For example, training companies may consider selling to a large business services group, an electronic control systems company may consider selling to a larger engineering group, a film distribution company may consider selling to a film production company or even a telecommunications specialist selling out to a large security group.
Buyer Assessment Contacting Buyers and Releasing Information The vendor should ensure that confidentiality letters are signed up before releasing the information memorandum and should assess the approach of the buyer to managing the business.
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Strategic Fit Buyers with the most to gain should attribute the highest value to the vendor’s business. Vendors should prioritise the short-list of buyers at this stage and it may be desirable to have a fast-track list likely to complete a deal within sensible time-frames.
Valuation Basis / Sustainable Profits / Deferred Consideration The valuation of unquoted companies is not a science, but in Part Two this guide attempts to clarify a rigorous process to establish a reasonable value for the business.The key to disposals must be for the vendor to ensure an auction process is put in place to deliver the maximum price from a range of interested parties. Further Stages Prior to an Invitation to Bid From the vendor’s perspective the key to the process is to release the minimum information whilst keeping the acquirer keen.This is likely to involve a series of meetings including site visits, and the release of standard additional packs of information to all prospective purchasers.
Negotiation To enable vendors to negotiate with the preferred buyer in an informed manner, it is important that all potential purchasers are invited to bid for the company under the same conditions. Offers should clarify the price to be offered, the structure of the deal and the conditions to be satisfied prior to completing the deal. The result of this process will be the selection of a preferred purchaser to negotiate the Heads of Agreement, including the forms of purchase consideration. Part Four examines these issues in detail.
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Final Stages to Completion As can be seen from the illustration, purchasers will expect to commence due diligence after signing the Heads of Agreement.This will involve reviewing the accounting records, but not necessarily on site.This process will probably take up to two or three weeks. On the assumption that a clean due diligence report is obtained, the purchaser will issue a draft legal contract. This contract will form the basis of further detailed discussions involving both sets of lawyers, until a final contract is agreed, at which point a formal legal completion will take place. This report now examines in some detail specific financial aspects of buying and selling unquoted companies, commencing with the valuation process.
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Part 1: Summary ACQUISITIONS 1.
Acquirers are able to use a range of techniques to find attractive vendor targets.
2.
Sufficient homework should be completed on the target’s sector, activities and people before valuation begins.
3.
A range of pertinent information can be gathered on the target through site visits and careful verification of findings.
4.
Valuation is not a science but a reasonable estimate can be obtained by applying several techniques to the quantitative analysis conducted on the strategic fit of the business.
5.
Remember only by assessing the post acquisition strategy can acquirers assess the sustainable level of profits of the vendor. This analysis will form a key input to acquirers pricing their targets.
6.
An attractive deal structure can transform an unacceptable price into an acceptable deal from the vendor’s perspective.
7.
Acquirers should conduct thorough due diligence, reviewing both historical data as well as the deliverability of future sales and profit forecasts before legally completing a deal.
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DISPOSALS 1.
Vendors should consider alternative options before choosing the disposal route, eg flotation, private placement of shares to an institution, or disposal of a minority stake.
2.
Research buyers world-wide to find the party with the most to gain from the acquisition.
3.
Vendors must prepare a precise and up-beat marketing document which explains the opportunity to interested parties.
4.
Maximum value is obtained by vendors conducting an auction process (probably covert rather than public) amongst a range of interested parties.
5.
Sensitive information must be released by vendors at the end of the day to obtain full value for their business, but the key must be to release the minimum amount whilst keeping the acquirer keen. Confidentiality letters are important, but cannot be relied upon by vendors.
6.
Vendors must obtain written offers from acquirers to enable them to choose the preferred party in an informed manner.
7.
Vendors must aim to articulate agreements with the preferred acquirer through a Heads of Agreement.The acquirer must be forced to explain deal structures with examples to prevent any misunderstandings at contract stage.
8.
Vendors need to stage manage the due diligence process to minimise the impact on the business. Investigations should be limited to two or three weeks, and the majority of it done off-site if possible.
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Valuation Chapter 3 SITE VISITS AND INFORMATION TO BE GATHERED
Chapter 4 COMMERCIAL RATIONALE (THE BASIS OF VALUE) AND SUSTAINABLE PROFITS
Chapter 5 VALUATION TECHNIQUES: TOOLS OF THE TRADE
part
2
Site Visits and Information to be Gathered Initial Meeting Further Site Visits Further Information to be Assessed Key Financial Checklist Key Operational Areas
chapter
3
PART
2:
VALUATION
Chapter 3 Site Visits and Information to be Gathered
The valuation process can be broken down into two distinctive stages designed to answer the question, how much is the target worth? Firstly the initial stages of valuation should cover the gathering of information and an assessment of the commercial rationale or strategic fit of the deal. Secondly, the final stages of valuation then uses this key data to assess sustainable profit levels and applies the various valuation techniques to establish value. Once value is established, a possible deal structure can be designed ranging from a cash at completion of the deal to a more complicated earn out deal involving bank guaranteed loanstock.
Initial Meeting The initial meeting with the vendor is an opportunity to confirm key facts which the acquirer has obtained either directly, or through the vendor. By preparing rigorously for the meeting it is possible for the acquirer to glean sufficient information even at this early stage to decide whether the target is a strong fit. A typical agenda might include the following: 1.
The last three years’ results
2.
Performance to date
3.
Staff structure
4.
Geographical spread of offices
5.
Customer base
6.
Suppliers
7.
Identification of one-off items
8.
Why is the vendor selling?
9.
Clarification of the shareholder base
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VALUATION
Real life example Site visit An overseas buyer calmly announced, at the reception of the vendor, his name and company and the names of his four advisors. In addition on a brief inspection of the works a member of the advisory team was caught filming the warehouse with a video camera
Conclusion As a vendor, stage manage all site visits, limit the numbers on site, agree cover stories and control walk-abouts.
Obviously buyers and sellers will have different agenda, but with careful stage management it should be possible to cover the above and therefore to complete the initial picture of the target. Vendors of course should take this opportunity to confirm the buyer’s objectives and strategy.
Further Site Visits Realistically it is impossible to cover all the ground buyers desire on the first visit and therefore, further meetings may be required to cover in detail issues such as people, premises and key financial data. Although not comprehensive, the items listed below could be covered in later meetings: • Quality of the management team •
Skeletons in the cupboard and gold in the ground
•
Pricing – opportunities to increase or hold
•
Order book – asset or liability
•
Key customers, suppliers, contracts and leases These points are now dealt with in more detail.
Acquirers often forget the most important issue of all in assessing value – the people factor. Constantly throughout the process acquirers must assess the true worth of the management team and their likely roles post acquisition.
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PART
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VALUATION
Real life example Quality of management A niche contractor in the South of England looked an attractive target for a large listed group. However, the two main directors were aged 51 and 66. Closer inspection revealed relatively inexperienced second tier management in their early 30’s who had been managed autocratically by the double act at the top. This was not revealed from the comprehensive structure chart advertised in all the offices
Conclusion Post acquisition management difficulties were identified and material problems in managing the business were foreseen. The acquirer walked away from the deal.
Again as the deal progresses practised acquirers are always seeking to spot hidden liabilities, e.g., litigation problems, unfair dismissal claims, environmental issues. Equally as important are hidden assets, including surplus properties, and under exploited marketing opportunities.
Real life example Skeletons/hidden liabilities At a fairly advanced stage in negotiations with a specialist recruitment business the acquirer discovered that the Edinburgh office manager who had been sacked in the previous 12 months had set up in competition with the target. In addition he had failed to pay the tax on his termination payment to the Revenue who were now pursuing the target for clarification of this and other tax matters.
Conclusion The acquirer clarified there was no tax liability to the target and aggressively pursed the restrictive covenant in place to limit the tactics of the ex-manager.
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PART
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VALUATION
Real life example Gold in the ground In identifying potential purchasers, a UK vendor in the DIY supply market, and its advisors were able to find key purchasers who could exploit the under utilisation of the vendor’s production capacity. Forecast sustainable profits for these buyers were much higher than the vendor could achieve on its own.
Conclusion The target was sold to a Dutch buyer with most to gain from the acquisition.
Real life example Gold in the ground Analysis of BTR’s acquisition of Hawker Siddeley revealed that cost cutting rather than the usual BTR price increases led to margins at Hawker Siddeley rising from about 6.7% to the low teens.
Conclusion As an acquirer, understand, prior to valuing the target, ways of improving margins post acquisition whether from price increases or cost cutting.
In terms of product pricing, investigations should cover whether there are opportunities to increase the prices in the marketplace or even to hold them steady. Although the target may have a strong order book, the question must be asked – at what price have the goods or services been promised? It is not unusual to find order books turning into liabilities as the deliverability of the service at the price offered is not viable. What is the status of the key customers in terms of contracts, and sustainability of order book? Is the target reliant on unique sources of supply and, if so, are stand-by arrangements in place as a contingency?
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VALUATION
Real life example Key customers – fragility of business – vendor tip Before meeting potential purchasers, advisers to a sales promotion business were surprised to discover that few contracts existed tying in key customers for any reasonable length of time.
Conclusion During the sales process the vendor was able to demonstrate, by careful analysis of its track record, the relationship between the target and all key clients, including how the managers of target and client worked closely together on all projects.At the appropriate time senior officials of the key clients met with the preferred purchaser, providing the purchaser with sufficient comfort for the deal to progress.
Another point worth emphasising throughout the process is the fact that the acquirer should be selling the benefits of their Group to their prospective employees, the vendor management.
Further Information to be Assessed During the valuation process the quality of information gathered will determine the accuracy of the valuation placed on the target. If material information is either wrong or omitted, then the valuation is likely to be flawed. Therefore acquirers must build up a clear and comprehensive picture of the target. Although not comprehensive, the following checklist serves as an aide memoire regarding areas worth assessing:
Key Financial Checklist 1
Aged debt analysis
2
Aged work in progress and stock analysis
3
Gross margin history
4
Material movements in overheads from year to year
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PART
5
Sales history and projections
6
Future cashflows
7
Salary costs for key employees
8
Owner benefits
9
Accounting policies understood and appropriate
2:
VALUATION
10 Capital investment for expansion 11 Cost of refurbishment 12 PAYE/VAT history
The experience of many deals suggests that debtors and stock/work in progress are areas fraught with problems for the uninitiated acquirer.The simple fact is that material balances may not be collectable, and within private company balance sheets vendor management may have persuaded auditors not to restate balance sheet values downwards to reflect reality, due to the low net asset value in these balance sheets supporting bank debt.
Real life example Financial checklist A mechanical and electrical sub-contractor appeared to have strong profit growth throughout the recession 1990-93. On closer inspection, retention monies in excess of £1 million were doubtful and subject to legal dispute. The original problem was not with the vendor and his client, (main contractor) but between the main contractor and his client.
Conclusion If debts or work in progress are old, even although quality documentation and a strong legal case exists, as an acquirer follow through the audit trail of the original transaction to establish whether the cash will be collected.
A study of gross margins over several years should reveal whether sales are being won at any price, the competitive nature of the sector and the volume and yield drivers influencing the target’s performance.
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PART
2:
VALUATION
On reviewing sales history and projections it is important for an acquirer to identify one-off items which might distort historical trends. Future cashflows should reveal the cash generative nature of the business and whether a refinancing may be required in the short to medium term. The need to understand the cost base is obvious, but specifically in private companies, the subject of owner benefits can reveal significant cost savings.A review of owner benefits is undertaken in the next chapter. Accounting policies misunderstood can lead to a completely wrong picture of the target being assembled. Items treated as extraordinary or exceptional must be understood. Costs that have been capitalised must be broken down and reviewed through an acquirer’s eyes to determine their true impact on the profit and loss account. The need for material capital investment must be clarified, explained and options discussed.
Key Operational Areas Although vital in assessing valuation, the financial items discussed above will not give an acquirer the full picture of the target. If an accurate post acquisition scenario is to be developed then key operational areas must be understood and compared with the acquirer’s own business. The following areas serve as a useful checklist: 1
Details on premises
2
Vendor’s assessment of competitors
3
Production capacity and efficiency
4
Distribution channels
5
Research and development of projects
6
Service contracts
7
Health and safety issues
8
Compatibility of culture and style
9
Environmental issues
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VALUATION
These checklist points are examined in more detail below. Under premises, acquirers must clarify whether all relevant buildings are owned by the company as it is common for private company shareholders to own some or all of the premises from which the company trades. Are valuations up to date, or is the balance sheet over-stated? Although analysis should be conducted into the sector and the competitiveness of all the players within the sector, it is important for acquirers to understand the vendor’s assessment of its competitors. It is likely that the vendor will have conducted a detailed review of the strengths and weaknesses of its competition in the marketplace. An assessment of the vendor’s production capacity will enable a meaningful assessment of post acquisition profits, and identify at any early stage crucial factors in integrating the target into the acquiring group.
Real life example Production capacity A vendor presenting the financial case to the acquirer was careful to explain the unnecessary production units both in Ireland and within the South of England factory. The former was sited there for tax reasons at the time and the latter site was a smaller, inefficient version of the buyer’s larger site in the Midlands.
Conclusion The acquirer was able to discuss in more detail the post acquisition integration of the business with his Board.
An understanding of distribution channels is also key for the acquirer to build a complete picture. Several industries including steel, tyres and paper have consolidated over the years by manufacturers acquiring distribution outlets. By understanding the distribution channels in detail, acquirers will be able to access the true value of owning the target and the necessary changes that will be required post acquisition.
29
PART
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VALUATION
Real life example Distribution channels In considering distribution channels, branding and vertical integration must be considered eg on branding acquirers must consider whether to impose their group name or retain the original brand. Prudential chose to brand their estate agents while Legal & General chose not to. Regarding vertical integration, a manufacturer branding a distributor is in danger of alienating all other distributors in the market-place.
Conclusion Acquirers may be able to boost sales of their product / service by acquiring a distributor, but careful assessment is required of the effect on the vendor’s business as well as the attitude of other distributors.
Research and Development is not only the province of manufacturing companies. It should be just as relevant for a service company to continually research service gaps in the marketplace that it can serve eg media advertising in buses, post offices and petrol station forecourts. It may seem odd to discuss under operational issues the detailed service contracts of key managers, but acquirers must assess at the earliest possible stage, the cost of rationalising the management team and for those managers remaining with the business the on going employment costs. Assessing differences between the acquirer and the vendor regarding culture and style is difficult. However, if an acquirer ignores material differences, eg between a large institution such as a regional electricity company and a vendor target in the contracting sector, there is a danger that post acquisition problems will arise and motivation and performance will suffer. Strategic fit cannot be solely focused around markets and financial numbers but must take into account the styles of the various management teams working closely together. Finally, ignorance of environmental issues surrounding the vendor is likely to prove costly for even the most practised acquirer.
30
Commercial Rationale (the Basis of Value) and Sustainable Profits Basis of Value – Buyer’s Perspective Basis of Value – Seller’s Perspective Buyer’s Perspective – Adjusted/Sustainable Profits Seller’s Perspective – Adjusted/Sustainable Profits
chapter
4
PART
2:
VALUATION
Chapter 4 Commercial Rationale (the Basis of Value) and Sustainable Profits
Having taken time to gather the relevant information on the target, visiting the sites and meeting the management team, the acquirer is now in a position to assess value.
Basis of Value – Buyer’s Perspective The acquirer should consider the net asset value of the business, and decide the cash generating ability of the assets he is buying, eg should property be included in the deal. The buyer should be aware of the cost and time of completing alternatives to acquisition, such as joint ventures or organic growth through new product development or investment in infrastructure. Deals such as GEC and BAe’s pursuit of VSEL, illustrate that in some cases acquirers also need to assess the cost implications of not completing an acquisition given that the target is likely to be sold to a direct competitor. Strategic significance and rarity value were both characteristics evident in the 1980’s when estate agents were being acquired with unnatural speed by building societies and insurance companies.At the time estate agents in prime locations had rarity as acquisition targets. In the early 1990’s software houses, especially those associated with virtual reality games, commanded large premiums such as Pearson’s acquisition of Software Tool Works. The headline numbers showed £310 million of acquisition cost, against £2.6 million pre-tax profits.
32
PART
2:
VALUATION
Basis of Value – Seller’s Perspective Sellers on the other hand must consider similar factors from their own perspective. For them the commercial rationale must be to seek buyers with the most to gain from the acquisition. A private catering company will always obtain potentially more value from a larger catering group as opposed to a smaller or medium sized player in the same sector. The reality being that because of cost savings available to the larger player, it can assess the value of the vendor on almost purely a gross margin basis, as opposed to a pre-tax profit basis and thus generate a higher valuation. Vendors should consider other forms of capital release including flotation or through aggressive dividend payments. It may be possible for a vendor to achieve personal objectives by releasing some of the equity through disposal to a City Institution for cash, or to a larger player within a strategic alliance. However, evidence from the past indicates that vendors obtain maximum value for their shares by selling a clean company to a buyer with the most to gain involving clear and easily understood deal structures. Another factor for vendors to consider is of course timing. Unfortunately acquirers are unforgiving of dips in profit records, and often unfairly downgrade a company’s value because of one poor year. For some vendors who have run lifestyle companies the equation boils down to the effect on their standard of living by selling out. If a vendor can see a more lucrative future by continuing to take high yields from the company rather than a lump sum payment from the acquirer, he may not be attracted to the deal.
33
PART
2:
VALUATION
Buyer’s Perspective – Adjusted / Sustainable Profits Both historical and future profits should be assessed to establish sustainable profits. Future profits should be restated to reflect upstream or downstream benefits to the acquirer, eg it may be possible for the acquirer to enhance the profitability of its existing production facilities by the strategic purchase of relevant distribution or wholesale businesses. Similarly activities carried out by the vendor may be more efficiently performed by the acquirer, due to economies of scale. Thus acquirers must consider the post acquisition position early in the process if they are to understand the future sustainable profit levels of the target. Specifically, adjustments made by buyers should include: 1.
Effect of the buyer’s accounting policies on the vendor’s numbers
2.
The need for a qualified Finance Director
3.
Higher insurance cover, if required
4.
Wage and salary differentials
5.
Additional pension contributions
6.
The cost of services to be provided by group, for example accounts departments or computer systems
7.
Any one off credits or costs
Seller’s Perspective – Adjusted / Sustainable Profits In a similar manner vendors must be ready to present the numbers to reflect sustainable profits to that particular acquirer. Specifically these adjustments may include: 1.
An add back of allocated management charges
2.
Excessive directors salaries / pensions
3.
Sponsorship / owner extravagances
4.
Significant one off events, eg bad debts or relocation costs
5
Specific savings available to the acquirer eg finance costs
Within reason the vendor should be ready to admit mistakes if these have caused one-off costs.
34
PART
2:
VALUATION
General Points From both a buyer’s and seller’s perspective the future should be examined and assessed.The following should be considered:1.
Additional sales opportunities
2.
Cost rationalisation savings
3.
Tighter control / cash management
4.
Surplus asset realisation
5.
Up-stream / down-stream benefits elsewhere in the Group
The sophistication of these points depends on the deal, but at the very least the buyer should be bringing either new clients or customers to the party or at least allowing the vendor to pitch for new business with increased financial strength behind it.
35
Valuation Techniques: Tools of the Trade Price Earnings Ratios (PERs) FT Actuarial Table Return on Investment (ROI) Discounted Cash Flows (DCF) DCF Example Net Asset Backing Summary of Techniques Part 2: Summary
chapter
5
PART
2:
VALUATION
Chapter 5 Valuation Techniques: Tools of the Trade
The commercial assessment of the target has been done in some detail. It is now possible to assess value through a range of techniques as a benchmark for commencing negotiations. The four main techniques worth noting are as follows: 1.
Price Earnings ratios
2.
Return on investment
3.
Discounted cash flows
4.
Net asset backing
Price Earnings Ratios (PERs) Firstly for the uninitiated, a listed company has a price earnings ratio noted everyday in the Financial Times. It comprises of the following: Current Share Price Earnings (profit after tax) per share = Market capitalisation divided by number of shares Earnings divided by number of shares = Market capitalisation Earnings eg
PER Quoted Share Share Price Earnings Number of Shares PER = 5 = 20/40
5 0.5
£5.00 £20 million 40 million. = 10
37
PART
2:
VALUATION
The problem with quoted PERs therefore, is their dependence on share values. General sentiment in the market can shift a company’s price earnings ratio dramatically during a relatively short period as evidenced by Body Shop’s ratio which was in excess of 60 in the early 90’s but had dropped to around 17 at the end of 1994. One of the reasons behind this drop was the fact that the high expectation of profits built into the share price was not delivered. Nevertheless, in acquiring unquoted companies it can be useful to note the PER of a target’s quoted competitor or the sector average relating to that particular target. Sector averages are listed every day in the FT – FT Actuarial Table(see page 39). Another useful measurement is the PERs of deals done in the target’s sector over the previous 12 months. There are many databases available from publishers, eg the Financial Times and Acquisitions Monthly, which detail all deals done in a sector, the price paid and the PE attributable to that price. In assessing the relevant PER to use for unquoted companies discounts of up to 50% of the quoted PER are common in unfashionable sectors, and as mentioned earlier in this report, rarity value can generate premiums way beyond the PER of a sector as listed in the FT Actuarial Table of quoted shares. The extract on page 39 from the FT dated 6.4.98 demonstrates the PERs of all the FT classified sectors. Note the PER of the FT-SE Actuaries All-Share was 22.59 but that Electricity was only 13.49 and Support Services was as high as 40.97. This is because the sector averages are calculated by taking the market capitalisation of the whole sector and dividing by the whole sector’s post tax profits. Therefore, if a sector’s profits are expected to grow rapidly then the share price often reflects this expectation, thus keeping the share price high. If historical profits by definition have not achieved this growth, then the PER will also be high ie at a point in time the ‘P’ based on perception in the marketplace is high relative to the ‘E’, the earnings based on the actual results. As results come through PERs fall reflecting amongst other things the profits achieved.
38
PART
2:
VALUATION
FT ACTUARIAL TABLE 6/4/98 Apr 6
Day’s chge% Apr 3
Apr 2
Year ago
Gross yield%
Net yield%
Net cover
P/E rato
Xadj. ytd
Total Return
FTSE 100
6105.8
+0.7
6064.2
6052.8
4271.7
2.68
2.27
2.05
22.75
50.86
2659.41
FTSE 250
5558.4
……
5557.6
5544.8
4519.0
2.94
2.47
2.07
20.53
39.89
2371.35
FTSE 250 ex IT
5596.8
……
5597.4
5586.7
4560.9
3.03
2.55
2.13
19.35
40.96
2396.37
FTSE 350
2923.3
+0.6
2907.0
2901.3
2106.5
2.73
2.30
2.06
22.30
23.72
2601.18
FTSE 350 ex IT
2928.6
+0.6
2912.1
2906.5
–
2.74
2.31
2.07
22.07
23.95
1336.61
FTSE 350 Higher Yield
2867.8
+0.6
2849.8
2856.3
2034.9
3.67
3.14
1.96
17.37
28.08
2176.65
FTSE A 350 Lower Yield
2990.5
+0.5
2975.3
2960.0
2184.5
2.01
1.67
2.19
28.43
20.02
2165.81
FTSE SmallCap
2636.38
-0.1
2640.09
2637.29
2284.27
2.88
2.33
1.54
28.16
15.54
2281.55
FTSE SmallCap ex IT
2628.54
-0.3
2635.31
2633.42
2296.84
3.08
2.50
1.60
25.39
15.65
2296.86
FTSE ALL-SHARE
2847.07
+0.5
2832.37
2826.98
2077.93
2.73
2.30
2.02
22.59
22.71
2570.85
FTSE ALL-SHARE ex IT
2855.08
+0.5
2840.25
2834.92
–
2.76
2.32
2.04
22.22
23.00
1326.33
Net yield%
Net cover
P/E rato
Xadj. ytd
Total Return
FTSE Actuaries Industry Sectors Apr 6
Day’s chge% Apr 3
Apr 2
Year ago
Gross yield%
10
RESOURCES (22)
4770.57
+0.1
4724.62
4727.25
3969.90
3.15
2.72
1.84
21.54
29.11
2173.86
12
Extractive Industries (5)
3169.78
-0.3
3178.86
3184.35
4049.13
4.32
3.98
2.08
13.91
72.61
999.17
15
Oil, Integrated (4)
5345.73
+1.2
5282.62
5277.47
4066.40
3.11
2.67
1.80
22.35
19.43
2500.75
16
Oil Exploration & Prod (13)
3199.47
-0.4
3188.01
3238.83
3455.46
1.81
1.49
1.92
36.06
29.18
1986.01
20
GEN INDUSTRIALS (221)
2224.93
-0.6
2239.29
2240.57
1996.10
3.36
2.93
2.19
17.02
21.79
1302.34
21
Construction (38)
1615.88
-0.2
1619.79
1623.40
1334.25
3.00
2.44
2.51
16.61
12.40
1435.17
22
Building Matis & Merchs (27)
1851.77
-0.3
1857.68
1861.21
1854.32
4.01
3.42
2.03
15.34
20.31
1003.24
23
Chemicals (24)
2872.14
-1.3
2909.43
2928.29
2271.81
3.27
3.05
1.83
20.94
30.36
1464.95
24
Diversified Industrials (10)
1461.05
+0.4
1455.04
1460.32
1477.96
3.89
3.64
2.22
14.48
17.93
896.23
25
Electronic & Elect Equip (26)
2510.52
-0.7
2527.77
2527.83
2225.24
3.44
2.78
1.65
22.09
18.13
1381.71
26
Engineering (62)
3006.64
-0.9
3035.23
3033.30
2607.51
3.16
2.80
2.38
16.58
30.93
1934.44
27
Engineering, Vehicles (10)
4140.22
–
4142.06
4087.14
2874.86
2.15
1.97
3.31
17.54
26.22
2273.44
28
Paper, Pckg & Printing (24)
2229.57
-0.2
2234.47
2244.26
2502.63
4.60
3.86
2.18
12.49
27.24
1002.75
30
CONSUMER GOODS (92)
5994.19
+1.2
5925.14
5882.34
4107.96
2.40
2.18
1.82
28.55
59.10
2365.65
32
Alcoholic Beverages (6)
4227.30
+1.3
4173.97
4139.25
2887.70
2.75
2.72
1.85
24.50
55.09
1651.40
33
Food Producers (25)
4163.30
+1.1
4116.20
4028.78
2843.29
2.60
2.22
1.90
25.30
23.58
2005.63
34
Household Goods & Texts (24)
3578.75
-1.0
3613.28
3537.47
2837.28
3.05
2.72
2.22
18.46
38.12
1504.78
36
Health Care (14)
2359.63
-0.3
2366.67
2344.78
2173.86
2.12
1.92
2.30
25.54
9.49
1499.29
37
Pharmaceuticals (20)
10205.38
+1.2
10080.23 10001.66 6407.37
1.79
1.59
1.70
40.90
85.22
3646.19
38
Tobacco (3)
4696.91
+2.0
4602.62
4773.04
4324.06
5.11
4.83
1.78
13.74
121.61
1312.24
40
SERVICES (279)
3461.97
-0.3
3471.79
3455.81
2618.07
2.44
1.98
2.00
25.63
15.91
1895.43
41
Distributors (28)
2842.95
-0.1
2846.81
2841.27
2645.28
3.32
2.75
2.02
18.64
25.32
1112.67
42
Leisure & Hotels (27)
3913.31
-1.3
3965.39
3945.13
3471.83
2.57
2.06
2.36
20.61
50.51
2215.75
43
Media (41)
4476.38
+0.2
4466.60
4477.36
4224.63
2.30
1.93
2.17
25.05
44.49
1693.91
44
Retailers, Food (13)
3097.74
-1.2
3134.28
3148.27
2000.15
2.72
2.18
2.27
20.26
5.49
2087.88
45
Retailers, General (49)
2402.70
–
2402.64
2395.00
2062.57
3.01
2.41
2.22
18.69
11.16
1453.75
46
Telecommunications (10)
3918.55
-0.4
3933.08
3875.87
2264.05
2.25
1.82
1.51
36.74
4.04
1905.29
47
Breweries, Pubs & Rest.(24)
4398.11
+0.4
4378.61
4368.86
3298.00
2.68
2.15
2.40
19.41
15.53
2231.62
48
Support Services (62)
4901.62
+0.2
4891.08
4900.81
2852.73
1.21
1.02
2.53
40.97
5.32
3215.76
49
Transport (25)
3573.30
-0.9
3605.08
3559.17
2737.82
2.88
2.35
1.28
33.81
21.90
1585.88
60
UTILITIES (23)
3882.59
–
3883.41
3895.75
2700.12
4.00
3.20
1.69
18.49
6.35
1831.05
62
Electricity (9)
4376.73
+0.3
4365.52
4368.12
2896.55
4.26
3.41
2.17
13.49
7.28
2525.13
64
Gas Distribution (2)
2837.99
-0.7
2857.93
2888.89
1606.54
2.29
1.84
–
–
0.00
1625.50
68
Water (12)
3468.43
–
3467.58
3473.15
2462.12
4.92
3.94
2.20
11.53
10.26
2106.64
69
NON-FINANCIALS (637)
2823.28
+0.2
2817.67
2808.52
2139.72
2.78
2.36
1.94
23.19
18.99
2287.80
70
FlNANCIALS (109)
5909.71
+1.4
5826.16
5837.75
3759.44
2.69
2.22
2.33
19.89
69.48
2728.19
71
Banks, Retail (12)
8642.62
+2.1
8466.30
8499.67
5471.34
2.72
2.18
2.29
20.00
116.92
3026.01
73
Insurance (17)
2810.30
-0.5
2823.76
2789.75
1637.75
3.02
2.73
2.92
14.20
35.32
2313.12
74
Life Assurance (8)
7497.26
+1.3
7401.40
7501.12
4481.30
2.51
2.16
2.57
19.37
67.64
3331.01
77
Other Financials (26)
4892.41
+0.6
4861.34
4799.04
3087.39
2.23
1.82
2.20
25.45
33.75
2967.38
79
Property (46)
2375.81
-0.6
2389.05
2382.27
1854.18
2.73
2.26
1.45
31.60
9.74
1549.97
80
INVESTMENT TRUSTS (117)
3964.95
+0.4
3948.85
3937.72
3228.30
1.99
1.61
1.18
52.99
20.72
1440.15
89
FTSE ALL-SHARE (863)
2847.07
+0.5
2832.37
2826.98
2077.93
2.73
2.30
2.02
22.59
22.71
2570.85
105
FTSE ALL-SHARE ex IT (746)
2855.08
+0.5
2840.25
2834.92
–
2.76
2.32
2.04
22.22
23.00
1326.33
Information Technology
1488.97
+0.1
1487.28
1481.12
–
0.58
0.46
3.32
65.44
1.95
1491.19
FTSE Fledgling
1410.97
–
1411.12
1410.79
1294.91
3.11
2.52
1.44
27.90
8.33
1555.39
FTSE Fledgling ex IT
1429.19
-0.1
1430.76
1430.80
1317.99
3.48
2.82
1.49
24.15
9.28
1580.98
FTSE AIM
1065.10
-0.4
1068.9
1063.6
–
1.15
0.91
0.59
80.00
2.69
982.99
39
PART
2:
VALUATION
Summary Therefore, in summary by identifying a range of relevant PERs, a suitable multiplier is established for the target and then applied to the target’s sustainable post tax profits.
Return on Investment (ROI) This is often used by acquirers as a good ‘rule of thumb’ to quantify the return forecast from the target.This ratio is defined as: ROI = Adjusted Pre tax profit (for the second full year of ownership) Total acquisition price
Two points should be borne in mind, firstly that the profits mentioned are before charging the finance cost of the investment and secondly the second year is used for profits to allow time for the acquisition to bed down, although it may be more relevant to use the third full year of profits if an earn-out deal has been structured to cover three years. It is difficult to set a reasonable benchmark for every acquisition, but a ratio in the range 20-25% would appear to reflect the appropriate level of risk premium in addition to the cost of capital. eg Pre tax profits – year 3 of acquisition Initial acquisition price Earn-out payment year 3
£000 2000 6000 1000
ROI = 2000 = 28.6% 7000
Discounted Cash Flows (DCF) This technique uses the following formula to calculate a Discount Factor: Discount Factor = 1 (1+i)n where i = the investment return the project is generating n= the year of the cash flow.
40
PART
2:
VALUATION
The discount factor is then applied to the cash flows of the target to arrive at a set of discounted cash flows. At the point where these add up to zero the project is generating a net present value of zero and the investment return at that point is called the Internal Rate of Return.The following example illustrates a DCF technique covering a five year period as applied to acquisitions.
DCF Example Acquisition Price
£2 million
£000 Cash generation pre tax Capital expenditure Surplus assets realised Acquisition price Net cash generated Discount Factors
0
(2000) (2000) 1
= Discounted cash flow
1 (2000)
1 700
Years 2 800
3 900
4 1000
5 1200
(300) 356
(400) 500
(100)
(200)
(300)
756 1 (1+0.3)1 0.769 581
900 1 (1+0.3)2 0.5917 533
800 1 (1+0.3)3 0.455 364
800 1 (1+0.3)4 0.350 280
900 1 (1+0.3)5 0.269 242
Total discounted cash flow at 30% = Zero
Therefore, the acquisition which cost £2 million has generated, pre tax, certain cash flows over a five year period which equate to a compound return of 30%. This technique therefore, allows acquirers to compare a range of acquisitions over identical terms to determine the most attractive return. In practice the weakness within the technique is in predicting the future cash flows of the target. There is no correct percentage return but an acquisition generating at 15% of an IRR should in the author’s opinion give the acquirer some comfort. More sophisticated versions of this technique build in probabilities to the future cash flows and termination values (to take into account cash flows to infinity). In addition the calculation can be done post tax to determine the precise discounted value of a future set of post tax cash flows. In using post tax cash flows be careful to use a post tax discount rate. The issue of which discount rate to use depends on the purpose of the calculation.
41
PART
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If the acquiror wishes to determine whether an acquisition will produce an acceptable equivalent compound pre tax return, given a set of future cash flows and an assumed purchase price then the discount rate will be the rate which produces a DCF of zero. Using the technique to produce a specific value requires the acquiror to use post tax figures and a discount rate equivalent to the cost of capital for the company. Remember also that an acquisition may produce erratic cash flows which equates to an acceptable overall IRR although the volatility and degree of risk attaching to future cash flows may render the project unacceptable.
Net Asset Backing Another important measurement that acquirers should apply is the net asset backing behind the acquisition price. Specifically if a loss making company is being considered for acquisition it is not only vital to assess the net asset value at the time of the deal, but also to project forward a level of net assets at the point when losses are eliminated. By its very nature a loss making company takes time to turn around and its assets will continue to deteriorate in value until the loss is eliminated. A discount of up to 50% of net assets is not uncommon when purchasing a business from the receiver. The acquirer is relieving the owner of a major problem and must allow time and resources to put the business back on an even keel. Of course, net asset valuations are just as important with quality profitable businesses. In particular if an acquirer is assessing a low asset backed business, such as a sales promotion company, the acquisition price may contain a large element for goodwill, the amount by which the purchase consideration exceeds net assets. Similarly a high net asset value company such as a heavy engineering subsidiary of a listed group, may not warrant an acquisition valuation much higher than net assets due to the weakness of the profit stream being produced by the business.
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In summary, net assets are one measurement for determining an acquirer’s comfort factor within the chosen acquisition price. However, there may be specific reasons why the ultimate value to the acquirer is less than net assets, or where the value of the business to the acquirer justifies a material goodwill element.
Summary of Techniques In brief all the four main techniques have strengths and weaknesses and some of these are summarised below:
1 2
Price earnings ratios DCF
3
ROI
4
Net asset backing
Strengths market rate reflects effect of future cash flows good safe target and easy to calculate determines comfort factor in worst case
Weaknesses no cash effect difficult in practice to calculate future cash flows no cash effect, broad brush may not reflect benefit to buyer
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Part 2: Summary 1.
Initial site visits by acquirers should be planned in precise detail with specific agendas in mind, and should include: the quality of the management team, hidden liabilities and assets, pricing opportunities, order book review and a discussion on key customers, suppliers and contracts.
2.
Information on financial and operational areas should be gathered in sufficient detail to allow acquirers to assess the impact of running the business under their ownership.
3.
Buyers and sellers must understand the other side’s perspective to enable the true value of the deal to be identified. Rarity value, accounting policies, wages and salary differentials, and owner benefits may all be issues worth considering.The result should be an identifiable stream of sustainable profits that the acquirer can justify.
4.
A range of techniques are available to buyers and sellers to add rigour to the valuation process and these will include: Price Earnings Ratios, Return on Investment, Discounted Cash Flows and Net Assets Basis.
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Deal Structures and Tax Angles Chapter 6 GENERAL GUIDANCE
Chapter 7 EARN-OUT DEALS
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General Guidance Assets or Shares Forms of Purchase Consideration
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Chapter 6 General Guidance
Assets or Shares There are only two ways of acquiring a business, either through the purchase of shares or the purchase of assets. It is common for private company vendors to sell the shares of their business instead of assets because of the danger of the double tax trap. If a vendor sells assets there is a possibility of a capital gain within the company from which the assets were sold, thus crystallising a tax charge.Assuming after this event that the vendor then dividends out the proceeds less tax from the disposal of the assets he is then taxed again on the receipt of the dividend. Therefore, there is a danger that through the disposal of assets a vendor is effectively taxed twice on the one transaction. If we compare this with a vendor selling shares, the position is much simpler.The vendor exchanges shares for cash and thereby potentially creates a capital gain on those shares on which he is taxed. From an acquirer’s perspective it can be attractive to acquire assets instead of shares, because in doing so an acquirer leaves behind the history of the company in the form of hidden liabilities. In an asset purchase the acquirer identifies the assets and where appropriate the liabilities that he will be acquiring from the vendor. The purchase of specific assets would be particularly relevant in the acquisition of a business from the receiver. However, it should be noted that in acquiring the assets of a business, an acquirer will be forced through the Transfer of Undertakings Regulations 1981, and by the subsequent Trade Union Reform and Employment Rights Act 1993, to take on the employment costs of all employees from the target company.
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Forms of Purchase Consideration Although many deals are structured as a simple cash transaction at legal completion, it is possible to structure deals involving non-cash consideration to the satisfaction of all parties. Although not comprehensive, the following list illustrates the variety of purchase considerations possible: 1.
Shares
2.
Loanstock
3.
Redeemable preference shares
4.
Pre-completion dividend
5.
Lump sum personal pension contribution
6.
Purchase of certain assets
7.
Service contracts
8.
Consultancy agreements
In brief these items are discussed below. Shares Taking shares in an acquiring company can be a risky investment. However, if the proportion of shares being accepted is small relative to the overall consideration, then it may be worth taking a small risk.The advantage certainly on the tax side is that tax is only payable when the shares are sold, and thus a gain is realised. From a quoted acquirer’s perspective, although issuing paper ie shares to the vendor is probably one of the main reasons for being listed on a stock market, the downside could be that earnings per share drops significantly after the deal.
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Loanstock An efficient way for vendors to receive their consideration could be by way of loanstock from the acquirer. Effectively this ‘IOU’ from the acquirer is redeemed by the vendor on agreed dates in the future. Assuming these are structured correctly the vendor need only pay tax when the loanstock is redeemed for cash. The key of course for the vendor is the security of the financial instrument, and in this regard a well informed vendor would request a bank guarantee behind the loanstock to ensure he receives payment. Redeemable Preference Shares Similar to the above the vendor may receive some form of preference share with a dividend yield attached to it, and these redeemable shares would have agreed redemption dates to suit buyer and seller. Depending on the quality of the acquirer, it may be appropriate for the vendor to consider these instruments which give him a running yield on an annual basis, but defer the taxable gain until the shares are redeemed. Pre-completion Dividend Another important technique for structuring deals is the use of pre-completion dividends.The table below illustrates how these work: Company’s Books Net dividend ACT 25% Gross dividend
Shareholder’s Position £ 100 25 125
Net dividend received Tax credit 25% Gross dividend Shareholder taxed at 40% Less tax credit Tax due % tax rate
£ 100 25 125 50 (25) 25 25%
Therefore, the shareholder receives in the example above, £100 but is liable for only £25 of tax, ie an effective tax rate of 25%. If the vendor had received £100 by the way of capital gain he may have incurred capital gains tax at 40%.
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From an acquirer’s perspective in the example above the acquirer would have to fund in the left hand side of the table the ACT of £25 until it is recoverable.Therefore, there is a cost from an acquirer’s perspective, and this is likely to form part of the negotiations of the final deal structure. Net Asset Adjustments It is quite common for acquirers to fix their final price for the deal by reference to the value of net assets at completion. This technique allows a price to be fixed subject to the final audit of net assets. At completion a consideration is payable by the acquirer but this will be subject to additional sums being paid if audited net assets exceed the agreed amount. Or of course, if net assets are less than the agreed amount the acquirer will be due a refund of consideration. Where net asset adjustments are used it is also quite common for the use of retention accounts. The acquirer will set aside a small proportion of the consideration, probably put on Escrow with his lawyers until the net asset adjustment is completed.The Escrow account is then released to the acquirer or vendor depending on the amount of the assets.
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Earn-out Deals Key Features Alternatives to Earn-outs Why Use Earn-out Deals? The Rule Book Management Control Issues Part 3: Summary
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Chapter 7 Earn-out Deals
Key Features For the uninitiated, earn-out deals are not as one vendor once described, the purchase of a company on ‘Hire Purchase’ (HP). They involve the purchase of 100% of the equity on day one with further consideration being payable dependant on the profits of future years. From an acquirer’s perspective the initial consideration will reflect profits to date of the target and take into account the current value of net assets. The vendor is unlikely to accept an initial consideration less than net assets if the business is profitable. In structuring earn-out deals, acquirers are likely to look for increased profit performance in future years to justify paying further tranches of acquisition consideration.
Alternatives to Earn-outs The key to any earn-out deal must be for the acquirer to keep relevant vendor management fully motivated throughout the earn-out period.This objective can be achieved by two alternative means, namely: 1.
Put and call options
2.
Profit related bonus / service agreements
The concept of put and call options are where the buyer may buy say 75% of the equity on day one, and negotiate with the vendor a set of call options (ie the right to buy) around the remaining 25% exercisable under certain conditions. Equally a well informed vendor will negotiate the right through put
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options (ie the right to sell) to sell their 25% stake to the acquirer under certain conditions. Thus it is possible that a deal is structured such that the acquirer purchases 75% of the shares on day one with put and call options surrounding the remaining 25%, possibly exercisable at prices calculated by reference to agreed profit targets with formulas built into the documentation to give comfort to both sides. Alternatively the acquirer may wish to simply put in place a large profit related bonus for the first year or two of the acquisition to ensure that vendor management are driving the business forward under new ownership.
Why Use Earn-out Deals? Over the years there has been much bad press concerning the use of earn-out deals such as the fact the vendor target company is ring-fenced from the Group for the period of the earn-out. Because of the short term hit to profits, a vendor may be reluctant to develop new markets. However, it is possible for well structured earn-out deals to allow for strategic development whilst still delivering significant capital sums to the original vendor management. These are discussed below under management control issues. On the positive side the following reasons may justify the use of earn-outs: 1.
The owners are important for future profitability
2.
The asset backing is low
3.
Profit is vulnerable eg through the loss of a major contract
4.
The owner is to continue as the Managing Director
Earn-out deals may also be useful in helping to close price gaps between buyer and seller, and for some large groups divesting of non-core activities earn-outs may be the only route for the vendor obtaining their perceived value of their non-core subsidiary.
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The Rule Book The failure of earn-outs in the past may have been partly due to the lack of rigour within the legal agreements between the parties at completion. It is important that the Sale and Purchase Contract contains detailed rules concerning the operation of the target company within the earn-out period. These rules would include the following: 1.
Accounting policies to be used
2.
Management charges eg payroll, legal, treasury services
3.
Central service charges eg warehousing or distribution
4.
Intra group transfer pricing
5.
The cost of finance provided by the group
6.
Dividends payable to the group
7.
The appointment of auditors
8.
Rules concerning changes to staff structure
The key to the above rules is the fact that you do not want arguments post acquisition. It may seem strange, but it may well be relevant for an acquirer for example to provide finance to the subsidiary at a favourable rate to encourage growth strategies.This may have the effect of increasing the targets profits, and thus the earn-out consideration payable, but the business at the end of the day will have grown and the acquiring group will have achieved its objectives.
Management Control Issues As an acquirer structuring earn-out deals, it is important to agree with the vendor the operational issues which will affect the success of the deal. These may include changes which alter costs eg a qualified finance director or an agreement on the minimum level of directors salaries as well as the maximum level. Issues surrounding non-competition with other group subsidiaries have to be discussed and documented. If business opportunities are to be pursued overseas it may be relevant to agree separate budgets outside of the earn-out deal to encourage vendor management to pursue growth strategies. Administration issues such as budgets and monthly account preparations should be agreed between the parties as accepted requirements of the acquirer.
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Acquirers must establish Board control of their vendor targets and procedures should be put in place for public announcements including dealing with customers and suppliers and any relevant legal issues affecting the company. Above all else acquirers must remember that earn-outs do not absolve acquirers from the responsibility of monitoring the target’s business in detail, and intervening if things go wrong.
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Part 3: Summary 1.
The purchase of assets may limit the downside of the acquirer, but may also be tax disadvantageous to the vendor. The vendor is therefore, likely to be attracted to selling shares but the acquirer inherits the past in purchasing them.
2.
Type of consideration may include items other than cash including, loanstock, shares, pre-completion dividends, pension contributions and consulting arrangements.
3.
Where the owners are important to the future profitability of the target, and net assets are low, then an earn-out may be the appropriate structure.
4.
The key to earn-outs is to ensure the rule book on how the target will be run during the earn-out period is documented in the Sale and Purchase Contract and secondly that the formulae used motivate the vendor management.
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Negotiation Chapter 8 NEGOTIATION KEY FEATURES
Chapter 9 HEADS OF AGREEMENT
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Negotiation Key Features Overview Ball Park Price Assets or Shares Earn-out Period Assets to be Excluded Directors/Relatives to Resign Preferred Purchase Consideration Conditional Purchase Contract Deadline for Final Negotiation
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Chapter 8 Negotiation Key Features
Overview It is worth noting that acquirers have the ability to spoil the final stages of the deal with poor negotiation tactics. One of the main reasons for acquisitions failing from an acquirer’s perspective is often cited as the vendor management’s attitude post the deal. It is quite likely that the attitude of vendor management has been shaped throughout the negotiation process. Experience shows that the process is most successful when broken down into key stages. Firstly the agreement between the parties of the major headline items and then secondly at a later meeting the parties should meet to negotiate a Heads of Agreement. The headline items requiring agreement may take many meetings but will probably include the following: 1.
Ball park price
2.
Assets or shares
3.
Earn-out period (if any)
4.
Assets to be excluded
5.
Directors / relatives to retire / resign
6.
Preferred purchase consideration
7.
Conditional purchase contract to defer capital gains beyond the current tax year
8.
Deadline for final negotiation
These are now discussed in more detail.
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Ball Park Price It is likely that buyers and sellers will be involved in one of two types of transaction. Firstly the auction process where the acquirer is one of many in the ring trying to acquire the target company. Special care is needed in these circumstances by acquirers.The key must be firstly to get to the next stage of the auction ie assuming there are various short list stages. It would be disappointing for an acquirer to shoot low on price at an early stage in the process and be excluded from further rounds of negotiation only to find the final negotiated price is lower than they would have offered. On the other hand, if an acquirer has offered the maximum price they are prepared to pay to own the business, and their offer is still rejected, then they should be comfortable with their tactics. As always price is a matter of judgement based on the specific circumstances of the acquirer. In the second type of acquisition where the acquirer is on a one-to-one basis with the vendor outside of an auction process, then the negotiation tactics may be different.Again, it is open to acquirers to offer their maximum price but this may not be necessary. In the experience of the author, vendors aspire to a price and acquirers perceive a value.Therefore, the question to be answered is, what is the vendor’s aspiration on price? (which may be less than the acquirer’s perceived value)
Assets or Shares Acquirers should understand vendor’s tax position and vice versa. In most cases the issue of whether assets or shares are being sold is not a problem. However, it is important for both sides to understand the true post tax effect of both routes, assets or shares, from both a buyers and sellers perspective. It is possible that the acquirer may have to purchase shares of the main business to satisfy the vendor, in addition to selected assets not owned by the target company but owned by an associate company to the target, or the vendor personally.
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Earn-out Period It is recommended that earn-out deals cover no more than two years because of the need to separately legislate for operational management of the target during the earn-out. If properly documented, it is possible to allow vendor management to develop their business during the life of the earn-out as discussed earlier. However, there is a danger beyond two years that market factors may come into play which could not have been forecast at the time of the original deal and therefore, these factors eg legislation, render the ‘rule book’ (conditions of the Sale and Purchase Contract) unworkable.
Assets to be Excluded This may be relevant where the acquirer may not wish to purchase property or assets of a personal nature eg boats, horses etc. as part of the deal. The key is to establish market value as part of the negotiations and an independent arbitrator may be useful to limit the emotional element of the discussions. It is reasonable for acquirers to regard assets, received by vendors, at discounts to market value, as part of the purchase consideration. It is quite likely that concessions of this nature by acquirers, ie allowing specific assets to be sold back to vendors at knock-down prices, will bring advantages to the acquirer way beyond the concession’s apparent value.
Directors / Relatives to Resign It is worth stating the obvious when dealing with this delicate subject. It is quite common for private companies to employ family members in various managerial positions within the business.These people may not be fulfilling a necessary function, but this should be assessed not assumed.
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Preferred Purchase Consideration Well advised vendors are unlikely to take the majority of the purchase consideration in shares, even if the shares are in the most blue chip of acquirers. On the other hand well structured deals can make an unattractive deal pre-tax in a vendor’s view into an acceptable post-tax deal. In terms of negotiation, don’t allow this important issue to be left off the agenda until the final stages. Non-cash considerations offered by acquirers should be discussed with vendors early in the process.
Conditional Purchase Contract In terms of good tax planning it may be possible to defer the capital gain on the transaction beyond the end of the tax year. For example, the vendor may agree to sell his business assuming a key tender is won.The tender success being an event capable of happening beyond the tax year.
Deadline for Final Negotiation Throughout the initial negotiation meetings, it is important to continue momentum between the parties and, although an obvious point, an effective method is to focus on a legal completion deadline as a target.
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Heads of Agreement Part 4: Summary
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Chapter 9 Heads of Agreement
Assuming the parties have established sufficient common ground for a final negotiating meeting, it is likely to be productive for both buyer and seller to have one final meeting to agree the Heads of Agreement. This meeting is so important to the final outcome of the deal that it is worth considering in some detail the agenda which both sides may wish to cover. From an acquirer’s perspective the following list probably covers the main issues, but the order of events must be down to judgement on the day. These may comprise: 1. Up-date since last meeting It is vital to clarify even at this late stage any change of information which affects the deal. 2. Confirmation of what is included It is possible that misunderstandings still exist – what are the key assets to be included in the deal? 3. Price of certain assets to be purchased by directors This is a sensitive but necessary part of the negotiation process, and must form part of the acquisition price. 4. Earn-out formula and period Too often in deals, due to time pressure or other reasons, earn-out deals are not clarified in sufficient detail. It is important to illustrate the earnout formula with examples to ensure all parties understand the deal.
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5. Treatment of existing share options Hopefully this has been explored earlier in the process, but it is time to agree the final treatment as part of the deal. 6. Transfer of pension funds An area often underestimated in terms of complexity. Sufficient time is required to solve the issues. It is quite acceptable for the detailed administration of pension fund benefits to be transferred and finalised over a 6-12 month period post completion. 7. Intellectual property rights Acquirers must ensure that the relevant rights are within the target company they are purchasing, and that they do not rest with individual directors or other group companies outside of the target. 8. Removal of personal guarantees Acquirers can afford to offer the release of guarantees which are regarded quite rightly as an important benefit by the vendors. 9. Key warranties and indemnities Although an issue to be discussed in detail between the lawyers at the contract stage, it is still important that the parties involved in the deal discuss the main warranties and indemnities expected. 10. Purchase price and consideration The final price negotiations must be concluded at this meeting and its position on the agenda should be driven by the acquirer. 11. Timetable to completion Again, an experienced acquirer will ensure the momentum is maintained between the parties by setting future deadlines.
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Part 4: Summary 1.
Break the negotiation process into distinct stages – firstly a series of outline meetings to agree the key features of the deal and secondly a final meeting to negotiate a Heads of Agreement.
2.
Decide early in the process whether assets or shares are being purchased.This will affect the execution of the whole process.
3.
Earn-out deals should be articulated using worked examples to avoid confusion and if necessary, these should be attached to the Sale and Purchase Contract.
4.
All concessions relating to personal assets, family members employment and future consultancy arrangements are part of the purchase consideration, ie concessions by either side must be earned.
5.
Acquirers must be certain of the maximum price the target business is worth to them prior to the Heads of Agreement meeting to ensure they don’t overpay during final negotiations. This is particularly relevant in an auction process.
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Management Buy-outs Chapter 10 GUIDANCE ON EACH STAGE OF THE PROCESS
Chapter 11 T H E S T R U C T U R E O F A M A N A G E M E N T B U Y- O U T
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Guidance on Each Stage of the Process Overview Preparation Stage Funding Stage – Initial Funding Stage – Advanced Negotiation Due Diligence Legal Contracts
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The Management Buy-out Process
Preparation Stage
Contact to Confirm Business is for Sale
Early Discussions on Members of MBO Team.
Assessment on Price/Vendor Price Target
Funding Stage Initial
Business Plan Completed
Equity Players Met
Debt Players Met
Funding Stage - Advanced
Advisers Enter into Negotiations with all Funders including Site Visits
Basic Term Sheet Issued to Funders by Advisors as a Basis for Offers
Offers Assessed using DCF Models and Preferred Backers Selected
Negotiation
Heads of Agreement Meeting Between Backers and Management
Heads of Agreement Meeting Between Vendor, Management and Financial Backers
Due Diligence
Financial Due Diligence by Funders
Strategic Due Diligence by Funders
Legal Contracts
Warranties & Indemnities
Investment Agreement
Sale & Purchase Contract
Mezzanine Players Met if Appropriate
Banking Documents
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Chapter 10 Guidance on each Stage of the Process
In describing a range of techniques useful in buying or selling businesses, it would seem appropriate to cover in some detail the management buy-out process.As a technique the advantages for buyers and sellers are numerous. For sellers, management buy-outs are a means for the group to exit clearly from a non-core activity whilst generating significant cash to develop the core businesses left behind. Good examples of this include Thorn EMI’s exit from lighting and security activities through management buy-out and Forte’s exit from contract catering with the sale of Gardener Merchant to the management team. For the acquisition team the management buy-out can be a route map to significant personal wealth, greater focus for the business unit in question and delivery of fast growth not possible under the numerous objectives of the original parent. One of the most successful buy-outs from a parent company has been the management services group Capita which in the space of eleven years from 1987 to 1998 grew from an initial value of £300,000 to a market capitalisation of around £900 million.
Overview As can be seen on page 69, there are many facets to a successful management buy-out.This chapter concentrates on explaining the financial technique used in most buy-outs, and in particular the importance of sensible debt to equity deal structures.
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Preparation Stage Initial Contact For many managing directors running subsidiaries of listed groups it is still regarded as a career limiting move to suggest a management buy-out! Instead, executives should consider appointing advisors to test the water with their group, maintaining anonymity. Members of the MBO Team Selecting the best management team to ensure the success of the bid is not an easy task. Funders of the deal may base their decision to finance the deal on the basis of the quality of the management team alone. It is likely that many other factors will influence the decision, but if the composition of the team is weak the buy-out will be unable to secure the finance required.The key elements of leadership, finance and sales should be covered in any management team. Additional skills may be added to the team depending on the sector.A difficulty arises where key members of the current management team are not appropriate to form the basis of the new management team which will bid for the company. In this case more junior managers need to be added to the team or external managers introduced to form a mixture of management buy-in / buy-out. (Bimbo). Assessment of Price If possible, management should attempt to establish the price aspiration of the vendor to save time and energy. It is quite possible that the price aspirations of the vendor cannot be funded using external money because the business cannot afford to service and repay the financial instruments.The key to price for a management team must always rest with affordability rather than market value because of the financial structure of the deal.
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Funding Stage – Initial Business Plan A quality Business Plan written for the Group Board on an annual basis will not suffice for external financiers. Key areas that require to be brought out for external funders to review include the quality and experience of the management team, development potential of existing services and products, new product or service areas worth pursuing and the cash generating ability of the business before interest over the next 3 to 5 years. The Plan should be strong in evidence regarding achievements, and assertions on the marketplace should be supported by third party research. The document should be measured but contain sufficient detail to allow the backers to understand the marketplace and the company easily.Topics to be covered include:
· · · · · · · · ·
activities and services awards won key customers and suppliers sales and marketing structure the marketplace key competitors key financial data brief C.Vs of the management team a strategy for growth
An executive summary is imperative.
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Equity Providers – Key Features The Venture Capital industry is the main supplier of equity finance to the buyout market, but increasingly mezzanine finance is being used to support deal structures and this is explained below. Key features of most venture capital supplied to buy-outs will include the following: 1. The internal rate of return expected by venture capitalists from their investment is around 30-35% compound per annum. 2. Part of the investment will comprise redeemable preference shares which will be expected to be repaid within five to seven years. 3. These preference shares are likely to carry a dividend coupon of between 7-10%. 4. A participating profit dividend may attach to some of the equity finance, and in some structures can be quite draconian. 5. Management teams may be incentivised to exit through a trade sale or flotation within five years.
Debt Providers – Key Features Most bank finance provided to management buy-out teams is of a similar nature and indeed can be regarded as a commodity product. The key features of the finance should include the following: 1. Five to seven year repayment terms. 2. Cost approximately 2-3% above base rates. 3. Bankers to the deal will expect their money to be matched pound for pound by equity finance, unless the target is very cash generative. 4. Bank finance will rank first in the queue in terms of a charge on liquidation proceeds. 5. Arrangement fees charged are likely to be between 1-2%. 6. Bankers will resist the repayment of other forms of finance before they have their bank debt repaid in full. Mezzanine Providers – Key Features This form of capital is cheaper than equity but more expensive than bank debt. Key features would include the following:
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1. Five to ten year formal repayment terms although in reality financiers would expect their money to be repaid within three to five years. 2. Cost approximately 4% above base rates with a premium on redemption taking the cost of the instrument up to 12% to 16%. 3. Mezzanine is normally subordinated to senior debt in terms of security, and has a second charge, ranking behind the senior debt over the assets of the investee company. Meetings with Funders The key to these meetings must be to allow the management team to demonstrate their knowledge of the business and their strategy for growth. Each member of the management team must be confident of their role in the meeting and their specific subject matter.
Funding Stage – Advanced It is essential that funders have their questions answered, assess the business through site visits if relevant and, therefore, understand the business before invitations to finance the deal can be requested.All funders must be given the same set of assumptions on which to base their offer, eg acquisition price, cashflows of the business and likely exit value.This should ensure that from a range of offers it is possible for the management team and their advisors to assess the most appropriate deal for them.
Negotiation Heads of Agreement – Management and Financial Backers All conditions of the proposed investment agreement between the financial backers and the management should be discussed at this meeting. Issues such as dividend yields, redemption periods, management’s personal investment, salary levels of executives and the most important of all, the equity stake to be held by management on day one.
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This is the stage to negotiate deal structures such as ratchet mechanisms. This technique allows management to increase their equity stake depending on the performance of the company.The key to this type of structure is to keep it simple and to ensure that both sides understand the formula in place by agreeing a range of worked examples. Typically these will involve various scenarios involving either profit targets covering the next five years, or exit value targets. Heads of Agreement – Involving the Vendor and the Management / Financial Backers The two key issues which will arise in these final meetings amongst many others will be the price to be paid, and the extent of warranties and indemnities being offered by the vendor. Price negotiations are normally led by the financial backers assisted by the management and their advisers. In terms of warranties, management must be careful not to accept unreasonable ones. This is often attempted by vendors to limit their downside.
Due Diligence The financial backers will conduct both a financial and a strategic due diligence exercise.The extent of this will vary depending on the size of the deal, and will often involve a detailed review of assertions and statements made in the Business Plan, especially the likelihood of the forecasts being delivered.
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Legal Contracts This final stage of the process will be driven by each side’s legal advisers. However, it is important that management understand their responsibilities in respect of all contracts. These responsibilities will cover the warranties and indemnities they are giving within the Sale and Purchase Contract, and within the Investment Agreement and Banking Documents. One important issue that should be understood in some detail is the banking covenants to be adhered to within the banking documents. It is in the interest of both the management and the equity financial backers to ensure these are reasonable as defaulting from these covenants often leads to loss of control of the company to the bankers.
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The Structure of a Management Buy-out Part 5: Summary
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PART
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MANAGEMENT
BUY-OUTS
Chapter 11 The Structure of a Management Buy-out
The following example illustrates the anatomy of a real life management buyout and demonstrates the funding structure on day one. The purchase price was £26 million. The following figures illustrate the debt and equity structure.
The Structure of an MBO Funding required
£000
Purchase price
26,000
Working capital
0
Costs and expenses
1,000
Total
27,000
Sources Term debt – bank
18,000
unsecured loan stock
8,700
Institutional ord. shares
75
Management equity
225
Total
27,000
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The Detailed Conditions Included: Most management buy-outs can be analysed into the above components. The significance of the above numbers is as follows: 1. The amount of funds to be raised has to cover not just the purchase price, but also working capital and fees. In this case the cash generative nature of the business meant that no working capital was needed 2.
The sources of funds for a management buy-out can come from a range of sources: –
bank finance, in this case £18 million repayable over 5 years.
–
equity finance from a venture capitalist, in this case £8.7m of unsecured loan stock repayable over 5 years and an ordinary share investment of £75,000.
–
mezzanine finance, in this case not needed.
–
finance from the management team, in this case around £225,000.
3.
Note that the split of equity between unsecured loan stock (or similar finance eg. redeemable preference shares) and ordinary share capital is negotiated. In this case management received 75% of the ordinary shares on day 1 for £225,000 in a deal worth £26 million.This is why management’s stake is called sweet equity!
4.
Note the debt: equity ratio in management buy-outs is often around 1:1. In this case the business could afford a higher level of debt than the norm because of the cash generative nature of the operations. In this case a debt: equity ratio of £18 m:£9m, ie. 2:1.
Therefore, the anatomy of a Management Buy-Out comes down to the ability of the buyer vehicle, NEWCO to repay the ‘IOUs’ which are placed on the balance sheet on day one.The buyer vehicle is effectively paying for itself over several years through dividends and loan repayments back to the financiers.
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In terms of the valuation of a management buy-out target company it must come down in the final analysis to what the management team and the financiers can afford, rather than necessarily its market value.This is not to say that the financiers to the deal will not assess the value of the business using a range of techniques as described in Part Two to ensure they are not overpaying, but the key financial criteria for the backers to the deal will be a discounted cash flow calculation.This must demonstrate that at a given purchase price and a given range of assumptions on dividend income to them and eventual exit proceeds to them, they will be able to obtain a return in excess of 30% plus per annum on their original investment.
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Part 5: Summary 1.
Management teams should ensure their Business Plan demonstrates the quality of their team and the potential of the business over the next five years.
2.
A range of financial backers should be contacted to ensure the best deal is obtained regarding the funding of NEWCO.
3.
It is important that identical assumptions are given to all backers regarding purchase price and exit value to allow all offers to be measured on an equal basis.
4.
The starting point to maximising management’s wealth is to negotiate the lowest value possible for the ordinary shares whilst putting in place a safe capital structure regarding interest bearing or fixed dividend financial instruments.
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