Techniques for Successful Management Buy-Outs (A Hawkesmere Report)

T

TECHNIQUES FOR SUCCESSFUL MANAGEMENT BUY-OUTS

Ian Smith

A Hawksmere Report published by Thorogood

IFC

A Hawksmere Report

TECHNIQUES FOR SUCCESSFUL MANAGEMENT BUY-OUTS

Ian Smith

published by Thorogood Ltd

© Ian Smith 1997 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, photocopying, recording or otherwise, without the prior permission of the publisher. This report is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, re-sold, hired out or otherwise circulated without the publisher’s prior consent in any form of binding or cover other than in which it is published and without a similar condition including this condition being imposed upon the subsequent purchaser. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author or publisher. A CIP catalogue record for this book is available from the British Library. ISBN 1 85418 092 4 Published by Thorogood Limited, 12-18 Grosvenor Gardens, London SW1W 0DH.Thorogood Limited is part of the Hawksmere Group of Companies. Printed in Great Britain by Printflow Limited.

Acknowledgements I would like to thank Julian Ahern for his chapter on public sector deals which ensured this Report covered the MBO topic comprehensively and yet remained a practical, simple guide to understand. As always, I am grateful to Michele Crosier my PA, for all her hard work in typing the manuscript and of course for all contributions gratefully received from my fellow deal leaders. Ian Smith

The Author Ian Smith BA, CA. Ian Smith is Managing Director of Capita Corporate Finance Limited. Capita Corporate Finance Limited has established a reputation for innovative financial advice to its clients in both the public and private sectors. It is a wholly owned subsidiary of The Capita Group Plc, which itself was a buyout from CIPFA in 1987 and subsequently obtained a Stock Market listing in 1989. Ian specialises in acquisition and divestment work and has completed dozens of deals over the past ten years for a range of private and public sector clients. At 38 he still expects to be leading deals for clients for many years to come. Prior to joining Capita he held several senior positions within the Thomson Corporation, developed a leading UK Corporate Finance Boutique and enjoyed a brief spell with Mercury Asset Management. Ian regularly presents seminars for independent companies on acquisitions, disposals and management buy-outs. His passion for athletics reached its height in 1987 when he joined the Scottish athletics squad at 800m and was a member of the winning Haringey British League team.These days his spare time is spent at his home in Hertfordshire with his wife and two young daughters.

Techniques for Successful Management Buy-outs Contents

1 1.1

An Introduction to Management Buy-outs

Concepts ................................................................................................2 The Simple Mechanics Explained...........................................................2 The Management Buy-out Triangle .........................................................3

1.2

A Worked Example of a £25m Deal ....................................................4

2 2.1

The Main Stages of Management Buy-outs

MBO Model – Overview of the Process ..............................................7 Preparation Stage ....................................................................................8 Sourcing Funders ..................................................................................10 Initial Bid Stage .....................................................................................10 Further Bidding Rounds .......................................................................11 Preferred Bidder ...................................................................................11 Legal Completion..................................................................................11

3 3.1

Preparation

Appointing Advisers............................................................................13 Role of the Principal Adviser ................................................................13 Previous Experience .............................................................................13 Fee Basis................................................................................................14 Other Advisers ......................................................................................14

3.2

Composition of the Management Team ............................................15 The Roles within the Team ...................................................................15 Management’s Personal Wealth.............................................................16 Conflicts of Interest ..............................................................................16 Equity Split............................................................................................16

3.3

Level of Staff Involvement .................................................................17 Information Release..............................................................................17 Bidding Process ....................................................................................18 ESOPS....................................................................................................18

3.4

Vendor Contact ....................................................................................21 Clearance Approvals .............................................................................21 Management of Information .................................................................22 Timetables.............................................................................................23

3.5

The Business Plan...............................................................................24 Executive Summary ..............................................................................24 History, Background..............................................................................24 Marketing Strategy ................................................................................25 Marketplace, Competition ....................................................................25 Financial Performance ..........................................................................25 Management and Staff ..........................................................................25 Growth Plans ........................................................................................26 Potential Returns to Funders ................................................................26

4 4.1

Sourcing Funders and Pricing MBOs

Debt, Equity and Mezzanine Funders................................................28 Debt Players..........................................................................................28 Venture Capitalists ................................................................................29 Mezzanine Players.................................................................................30

4.2

Understanding the Type of Finance Needed ....................................31 Structuring the Deal – Using a Real Life Worked Example ..................31 The Venture Capitalist’s Return – Using Discounted Cash Flows ........36 Pricing and Capital Structure – Summary ............................................37

4.3

How to Choose the Most Appropriate Funder ..................................38 Rehearsal of the Business Plan .............................................................38 Relevant Institutions .............................................................................38 The Criteria for Selection .....................................................................39

5 5.1

Negotiation Advice

Tactics with the Vendor......................................................................42 The Controlled Auction ........................................................................42 The Information Trap............................................................................43 The Non-price Points............................................................................44 How to Deal with Each Bidding Round ...............................................44

5.2

Detailed Negotiation Meeting with the Vendor ...............................47 Suggested Agenda for the Meeting .......................................................47 The Offer for the Business....................................................................48 Cut-off Arrangements ............................................................................49 Anti-embarrassment Clauses .................................................................49 Due Diligence Still Outstanding ...........................................................49 Lock-out Arrangements .........................................................................50 Timetable to Completion......................................................................50

5.3

Tactics with the Funders ....................................................................52 The Venture Capitalists .........................................................................52 The Bankers ..........................................................................................53

5.4

Detailed Negotiation with Funders ...................................................55 Suggested Agenda for the Venture Capitalist Meeting ..........................55 Repayment Terms and Early Repayment Penalties ...............................56 Dividend and Interest Rates .................................................................56 Equity Stakes and Ratchet Mechanisms................................................57 Follow on Money – the Next 3 Years ...................................................57 Non-executive Director Role and Fees .................................................57 Salary Levels and Headline Service Agreement Issues..........................58 Personal Capital and ESOPS..................................................................58 Pension Arrangements ..........................................................................59 Nature and Extent of Outstanding Due Diligence................................59 Issues Surrounding Banking Instruments .............................................60 Keyman Insurance and Arrangement Fees ...........................................60 Suggested Agenda for Other Funders’ (Debt and Mezzanine) Meetings...........................................................60

5.5

Negotiating Legal Agreements ..........................................................61 Shareholders Subscription Agreement and Articles of Association ......61 Banking Agreements .............................................................................62 Sale and Purchase Contract ..................................................................62

6 6.1

Public Sector Buy-outs – Additional Considerations

Public Sector Buy-outs – Additional Considerations .....................64 Introduction..........................................................................................64 History ..................................................................................................64 Packaging the Business.........................................................................65 The Sale Process ...................................................................................66 The Buy-out Team .................................................................................67 Raising the Finance...............................................................................68 Deal-specific Issues ...............................................................................69 Conclusion............................................................................................70

Appendix Valuation Models for Pricing Companies.........................................72 Price Earnings Ratios (PERs).................................................................73 Return on Investment (RoI) .................................................................78 Discounted Cash Flows (DCF) .............................................................78 Net Asset Backing .................................................................................80

An Introduction to Management Buy-outs Chapter 1.1 CONCEPTS Chapter 1.2 A WORKED EXAMPLE OF A £25M DEAL

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Chapter 1.1 Concepts

The Simple Mechanics Explained A management buy-out (MBO) is an acquisition by the management team of their business from the owner of that business. The basic mechanics of every MBO are the same. Diagrammatically this is explained as follows:

NEWCO (newly formed shell company)

Shareholders 1. Management Team 2.Venture Capitalists

Acquires

Target Business

The target business may be owned by a private company, a listed group or a public sector body. The price paid maybe £1 or £100m. The relationships to be handled will be similar in each case. There will be a vendor, one or more funders and a management team.

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The Management Buy-out Triangle

Vendor

Management Team

Funders

Thus the management buy-out triangle is formed. Each relationship needs to be carefully managed. The management team must maintain a friendly and professional relationship with their employer, the vendor. The management team must also establish a strong rapport with a preferred venture capitalist and banker. The preferred funders need to understand the motivation of the vendor and the key issues to be negotiated prior to completion. Every MBO has different nuances but the basic structure follows a pattern. The management team will attempt to borrow sufficient capital to pay the vendor, cover initial working capital requirements and pay transaction fees. This borrowed capital will appear in Newco’s balance sheet as medium-term bank debt and as long-term redeemable preference share capital or unsecured loan stock. The next chapter illustrates the real life management buy-out of CentreWest from London Transport completed in September 1994.

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Chapter 1.2 A Worked Example of a £25m Deal

In round terms the £26m management buy-out of CentreWest can be broken down as follows: Application of funds £000 Acquisition price . . . . . . . . . . . . . . . . . . . . . . . 26,000 Working capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 27,000 Sources of funds £000 Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 Unsecured loan stock . . . . . . . . . . . . . . . . . . . 8,700 Ordinary shares – Institutions . . . . . . . . . . . . . 75 – Management . . . . . . . . . . . . . . . . . . . . . . . . . . 225 27,000 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.

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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 (this is explained later). 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 £18m: £9m, ie 2:1. The detailed characteristics of all the financial instruments are explained in later chapters. The next chapter reviews the various stages of the management buy-out process and acts as an Executive Summary of the detailed chapters of this Special Report.

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The Main Stages of Management Buy-outs Chapter 2.1 MBO MODEL – OVERVIEW OF THE PROCESS

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Chapter 2.1 MBO Model – Overview of the Process

The number of stages involved in a management buy-out will be determined by the vendor. In some high profile auctions it is quite common to go through three rounds of pricing. The key stages are illustrated below and reviewed in outline in this chapter to assist management teams understand the chronological order of events. The Management Buy-out Process Preparation stage

Sourcing funders

Initial bid stage

Second round bid

Appoint advisors

Composition of the management team

Level of staff involvement

Understand the type of finance needed

Choose funders

Pricing models

Tactics with vendor

Tactics with funders

Assessment of staff involvement & deal structure

Data room

Pricing

Due diligence

Capital structure of Newco finalised

Vendor contact

Final bid stafe

Full and final offer on price

Preferred bidders

Period of exclusivity

Detailed negotiations with vendor

Detailed negotiations with funders

Final due diligence

Shareholders subscription agreement

Articles of association

Banking agreement

Sale and purchase contract

Legal completion

Business plan

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Preparation Stage The preparation stage is key to the success of the management buy-out. It may become obvious during this stage that an MBO is not feasible. Equally it is a time for the management team to articulate their plans, understand the timetable of the vendor and prepare themselves for raising the money. The amount of work to be completed will depend on the approach taken by the vendor.The vendor can take four basic approaches: 1. No auction, one to one deal with management and a minimum acceptable price. 2. As in 1. but with no price given. 3. An auction process with a minimum price given (unlikely). 4. An auction process with no price given. For the purpose of explaining the various stages let us assume the most complex model, namely 4. above, an auction process with no price given by the vendor. Later chapters in the report will deal with issues in detail but the rest of this chapter will act as an executive summary of the key stages to be completed. Appoint Advisers On the obvious assumption that the head of the MBO team has the approval of the vendor to stage an MBO then the first stage should be to approach advisors. The cynic may claim that the author as an MBO advisor would of course suggest this approach. However, the case for appointing advisors is compelling. Management have a business to run at the same time as completing one of the most complex corporate transactions they will encounter. In outline, management should beauty-parade for a lead corporate finance advisor, demanding references for the individual team members and agreeing fees for reward if successful. Some advisors will work on a no deal no fee basis.

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Composition of the Management Team Who is to be included in the management? Each sector demands a slightly different mix of skills but financial backers to the team will expect to see a minimum range of skills. Leadership, finance and marketing are probably the core skills. However, in some sectors, IT, personnel and engineering experience may be imperative. Financial Institutions will expect the managing director heading the MBO to have a clear vision of the composition of his team. Level of Staff Involvement There is no correct answer.The best advice to MBO teams is probably to delay the decision of staff involvement to the later stages of the process. Again, financial backers will often look to the MBO team to suggest the level of staff involvement. Demonstrably, in a business which relies heavily on a large number of staff to deliver the service directly to the customer then perhaps an Employee Share Ownership Plan is appropriate (explained later) eg the bus or contract catering sector.The balance to be struck is to ensure that the MBO team have control over the company (operationally if not through voting control) whilst motivating the relevant staff to deliver a first class service. Vendor Contact Management must remember when dealing with their employers, the vendor, that the deal may not happen and therefore serious disagreements should be avoided! Assuming an auction process, it should be possible for the management team to understand the vendor’s agenda much better than the other bidders. The downside for the management team is that the vendor’s aspiration on price may be outside the affordability range of the MBO model (see Structuring the Deal chapter 4.2). MBO teams should establish a sensible timetable with the vendor as soon as possible and attempt to influence the timetable to their advantage.

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Business Plan An essential output of the preparation stage is the business plan. The precise elements are described later but the essence is the production of a document that sells the opportunity to investors, illustrates the strength of the business within its market, describes the quality of the management team and articulates a believable growth strategy. Therefore the management team with the assistance of their advisors will now be clear on the type of finance required, the composition of the management team (or, of course, obvious gaps in the management team) and the growth path that is possible from the MBO business. The management team are now ready to consider appropriate funders.

Sourcing Funders Thus the third element of the MBO triangle comes into play – the money men. The three basic sources will be considered: venture capital, mezzanine capital and bank debt. The characteristics of all financial backers and the application of the money in a specific transaction is explored in Section 4. The timing for choosing your preferred funders relative to pricing the bid is not easy. There is a temptation to run with several venture capitalists as backers to get through the initial bidding rounds instead of choosing one preferred lead funder to support your bid.The precise tactics are discussed in Chapter 4.3.

Initial Bid Stage Assuming a competitive auction process the vendor will set a deadline to receive initial offers. Precise instructions will be issued by the vendor, regarding their requirements covering, price, staff plan, strategy for the business, ability to fund the offer and conditions attaching to the offer (these requirements will vary considerably depending on the specific circumstances of the deal eg an owner of a private company selling to his management team will mainly be interested in the ability of the offer to be funded). The key areas therefore worth exploring in detail are: pricing models for MBO teams, recommended tactics at this stage of the process with the vendor and how to deal with your funders.These areas are explored in Sections 4 and 5.

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Further Bidding Rounds As mentioned earlier the number of bidding rounds will depend on the tactics of the vendor.The diagram indicates three rounds which is common in auction processes. The specific tactics to be employed at each stage are discussed in Section 5 and cover how to deal with both the vendor and the funders.

Preferred Bidder Assuming a successful outcome, the final stages of this complex process will see the MBO team selected as the preferred bidder. It is likely at this stage that final negotiations will be conducted by the MBO team and their advisors with both the vendor (Chapter 5.2) and, separately, with the financial backer to finalise terms (Chapter 5.4). Due diligence will have been an on-going process conducted by the preferred lead funder but it is likely that only at this preferred stage will the vendor give permission for the funder to examine in detail the books of account. Thus even at this late stage it is possible for the preferred funder to pull out because of facts uncovered in their investigations into the business. It is therefore imperative for MBO teams to ensure that funders are not surprised by these final investigations.

Legal Completion As in all corporate transactions there is a need for all aspects of the deal to be legally documented. The key elements include the Shareholders Agreement, Articles of Association, Banking Agreements and the agreement between buyer and seller – namely the Sale and Purchase Contract. Therefore the report now explains the above stages in detail, highlighting commercial calls to be made and stating benchmarks where appropriate.

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Preparation Chapter 3.1 APPOINTING ADVISORS Chapter 3.2 COMPOSITION OF THE MANAGEMENT TEAM Chapter 3.3 LEVEL OF STAFF INVOLVEMENT Chapter 3.4 VENDOR CONTACT Chapter 3.5 THE BUSINESS PLAN

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Chapter 3.1 Appointing Advisers

Role of the Principal Adviser The management buy-out process needs to be carefully stage managed. Appointing a lead advisor makes sense for almost any size of transaction. The Principal advisor will be a management buy-out specialist and their role is to guide the management buy-out team through every stage, including the appointment of specialist help at the appropriate time eg lawyers, personal tax advisors, pension advisors. In summary, the advisor will: groom the MBO team, pointing out deficiencies and skills gaps that need to be filled; edit the business plan to ensure a robust believable document is produced; raise the money; recommend the best capital structure and assist in negotiations with the vendor and the funders to ensure that management have the best deal possible.

Previous Experience The MBO team may be completing their first major corporate finance transaction and probably their first MBO transaction. Therefore choosing a reputable name to advise you is only half the problem solved.The other half is choosing a director or partner within the advisory company who will actually do the work and who, personally, has completed many such transactions. Ask for at least three up to date references of MBO deals the deal leader personally lead to allow you to test the sales pitch.

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Fee Basis The main MBO advisors will probably expect some form of cost indemnity to cover some of their costs and a win bonus payable at completion of the transaction.There is no rate card for fees but expect cost indemnities between £10k to £20k and win bonuses of 1-2% with minimum win bonuses for small transactions. It is helpful to fix the win bonus up front, after all, the MBO team would not want to incentivise the advisor to recommend overpaying!

Other Advisers There is a time and a place to appoint other advisors.As a guide, and referring back to the process map in chapter 2.1, lawyers could be appointed at the end of the preparation stage when the MBO team know they have a credible team and a robust business plan. Pension advisors could be appointed much later in the process, probably before the final round of bidding, to ensure that all pension aspects have been factored into the bid. Personal tax planning can be left until the preferred bidder stage. Obviously there will be other appointments made by parties to the transaction. MBO teams should be aware that the vendor will obviously have legal representation, the funders will have their lawyers and due diligence accountants and possibly strategic/sector specialist advisors.

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Chapter 3.2 Composition of the Management Team

The Roles within the Team Financial backers to an MBO will never back a poor management team in an attractive sector (they may buy a business in an attractive sector and recruit a new management team but that would not be an MBO), but may back a good management team in an average sector.Therefore the management team need to know whether they are credible. An honest advisor should be able to point out the obvious flaws in the skills base. In some cases this may require the recruitment of a new manager. It is not helpful to go to the venture capitalists with an incomplete team, even if one or more members are exceptionally good. The roles to be covered will include a clear leader of the team, a financial director, a sales/marketing director and possibly a technical director related to the sector.The financial backers will be keen to know there is a quality second tier management team in place below the inner cabinet. However it is a myth to assume the funders will have strong views on who gets shares within the management team or staff.The backers will expect the leader of the buy-out team to recommend the composition of the inner cabinet and their entitlement to a share of the cake. Additionally, they will expect the leader of the buy-out team to recommend how far the share allocation is distributed across the staff structure. Of course the preferred funder will be very clear on one issue – the amount of total equity staff and management are entitled to – but the split between the staff is the responsibility of, primarily, the MD.

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Management’s Personal Wealth If MBO teams consisted solely of the five wealthiest managers in the company there would be very few management buy-outs! Financial backers like to see the management team commit approximately six months salary. However, the reality can vary considerably from this benchmark. Financial backers want to see commitment. A manager putting £50,000 on the line who is worth many millions may be less committed than a manager with no savings who has borrowed £25,000 through a mortgage on his house. Surprisingly it is possible for managers to negotiate a higher salary package with their backers to compensate them for their interest payments on the new borrowings they have taken on. Also, the interest payable by the manager on those personal borrowings should be tax deductible against his income.

Conflicts of Interest It is worth explaining at this stage the important area of fiduciary duties. Managers should be aware that in conducting a management buy-out of their subsidiary or division, they are in direct conflict with their duties to run the business. Clearance must be sought in writing from the owners of the business that they have given management the authority to seek finance, prepare a business plan, and attend all the various meetings needed to complete the transaction. Owners of businesses need to realise it is not realistic to expect managers to do all of the tasks required in their own time outside of office hours.

Equity Split The report explains in some detail, later, how to negotiate the maximum slice of equity for management. It is worth noting at this stage that there are no benchmarks of equity percentages to guide managers. Overall equity percentages can vary greatly from small minority stakes to substantial majority stakes. As a guide, within management teams, the managing director would expect to own around 50% of the management’s stake (irrespective of his or her personal wealth).

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Chapter 3.3 Level of Staff Involvement

Information Release In some ways it would be very easy to announce to all staff that a management buy-out was being staged. Secondly, that all information in management’s possession, and each stage of its progress will be shared with staff.These tactics are not compatible with the MBO team winning a competitive bid where any information released by the vendor could be decisive to the bid. For the purposes of giving advice within this report we have assumed that management are in a competitive auction and that the bid is large enough to justify seeking at least debt and equity finance. Within the preparation stage it may be obvious that an employee share incentive scheme is required eg the management may need to access more capital to increase their fire power and their negotiation strength with the financial backers. Alternatively the reason for incentivisation of staff may be directly related to the type of business.We will review this issue under ESOPs below.The tricky issue with staff involvement is to balance the need to create a genuine swell of support amongst staff behind the MBO (assuming they know the business is for sale, eg a public sector auction, or a listed company has announced the subsidiary is non-core) and the need to keep vital information required for the bid confidential. Perhaps the best way forward on staff is to address the workforce to explain a buy-out team is in place and that the team are working towards the first deadline set by the vendor. If the team are successful in moving to the next stage then a working party of senior managers will be set up to disseminate information to staff.

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Bidding Process It is possible to have at least three rounds of bidding in an MBO and therefore warming up staff regarding the timetable to completion; promising them shares in the new company or worse still promising them job security when the MBO team succeed is highly dangerous! The process can take up to 18 months but should be completed in under 9 months. Staff should be reminded that there are no guarantees and the MBO team’s task is to get into the next round at each stage. In this preparation stage it is worth being aware of the following items regarding staff involvement: 1. Do any of the staff outside of the management team possess important technical knowledge of the business? Assess how you will involve these staff members. 2. How keen are staff to invest in the potential MBO? 3. Which profit centre managers could be worth incentivising who are outside of the main MBO team? The management team need to decide, prior to the last round of bidding, the likely allocation of shares amongst staff. It is important to finalise the capital structure of Newco prior to this final bid. If the management team can raise £200,000 but the combined wealth of management and staff can raise £1.2m, this could be decisive in the final pricing of the bid and the amount of employee equity the financial backers are prepared to allow within the structure.

ESOPs Another technique worth considering is an ‘employee share ownership plan’ (ESOP). As mentioned earlier this may be a useful device to allow staff to invest in the management buy-out or to be gifted shares in the buy-out. ESOPs come in many different types and sizes, but they all have a common purpose – that of improving corporate performance by enabling employees to participate in the ownership of their employing companies. Although ESOPs can have widely varying structures, the following elements are common to all: 1. The company establishes a trust (‘the ESOP Trust’). 2. The ESOP Trust acquires an equity stake in the Company, usually making use of external borrowings.

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3. The ESOP Trust makes a market in shares in the Company; buying them from departing employees and other willing sellers and distributing them to new and continuing employees through employee share schemes. 4. The ESOP Trust repays its borrowing from voluntary contributions from the Company, which may be tax-deductible.This makes the ESOP an effective tool in corporate finance since the Company may be able to get tax relief for principal as well as interest on its borrowings.

Outline of a Simple ESOP Structure YEAR 1+ Repays bank debt Employee Benefit Trust(s)

BANK

2 Cash Shares Profit Sharing Trust

Employee Benefit Trust(s)

Employees Distributes Shares (Years 1-5(?))

1

NEWCO

1. Tax qualifying distributions made to Profit Sharing Trust. Note: normal dividends do not attract tax relief. 2. Bank releases security on shares, allowing Employee Benefit Trust(s) to distribute to the Profit Sharing Trust.

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Considerations of Which Scheme to Choose An important commercial point to be aware of is the fact that ESOP arrangements can be structured to suit the specific circumstances of each deal. The following considerations will determine which arrangement is relevant: 1. Tax treatment the company seeks to achieve. 2. Type of company and the shares subject to the scheme. 3. Which employees are to be invited to join and on what terms. 4. Costs and administration.

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Chapter 3.4 Vendor Contact

This is one of the cornerstones of the MBO triangle. How should employees deal with their employer throughout the transaction? The report touches on this area throughout the text, however this chapter explains some tips to ensure the management team give their MBO bid the best possible chance.

Clearance Approvals As mentioned earlier all MBO teams need clearance in writing to mount a bid. (Of course, as a few MBO teams will testify, there is no need for clearance as long as the head of the MBO team has prepared his resignation letter in a sealed envelope, ready to use if the bid is not well received!). Preferably the use of ‘non-Rambo’ tactics is to be recommended and therefore management teams should seek the following clearances and clarifications: 1. The vendor is seeking no other bids (unlikely but possible if the MBO team have made a subtle but pre-emptive strike). 2. The vendor is prepared to put in place a cost indemnity to pay for a proportion of the MBO team’s corporate finance advice. 3. The outline timetable for the transaction. 4. The price required for the business (unlikely to be given if an auction is to be conducted, but if there is no one else in the ring the vendor may set a reserve price). 5. The authority to let the management team spend time assessing the likelihood of an MBO and then the implementation of the transaction.

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Management of Information Management have access to information that other bidders may never see even if they are successful in buying the business. (Of course, if they are successful the information could not have been that relevant).The management team have a detailed knowledge of the business and therefore the vendor will attempt to create a level playing field by issuing a comprehensive Information Memorandum to all bidders. The relevance of all the data released on the business is obviously to allow bidders to form a personal view on value.As the report covers later, the value for the MBO bid will be governed by one simple fact – affordability, mainly because nearly the whole purchase price will be borrowed from the banking and venture capital community. The management team must collect the information available to them to produce a credible and exciting business plan. Information will be issued by the vendor throughout the transaction and, ironically, will be prepared by management running the business – the MBO team. Therefore, it is important for the MBO team to differentiate between answers to questions posed by the vendor and forecasts or policies which the MBO team believe will be relevant when they own the business. The MBO Business Plan, for example, is the property of the MBO team and their advisors and should not be confused with the annual budget process completed to conform to group procedures.

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Timetables It is difficult to be prescriptive on timescales but a likely timetable of a controlled auction process of a business involving a management buy-out is as follows: Deadline Timetable Registration of interest by parties .....................................................Day 0 Issue of Information Memorandum .................................................Day 30 Submission of initial bid ............................................................................Day 75 Shortlist of bidders announced ...........................................................Day 90 Supplementary information released .............................................Day 100 Second round bid ............................................................................................Day 130 Shortlist of bidders announced ...........................................................Day 140 All final information released, including relevant visits and draft sale and purchase contract .........................................................................Day 150 Final bids submitted ......................................................................................Day 160 Clarification meetings with one or more bidders...............Day 170 Exclusivity granted to one preferred bidder ...........................Day 180 Sale and purchase contract drafting meetings .......................Day 190 Due diligence completed by preferred party .........................Day 220 Sale and purchase contract signed - legal completion ....................................................................................Day 250 The above is only a guide to MBO teams when dealing with vendors.The next chapter deals with the final stages of preparation – The Business Plan.

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Chapter 3.5 The Business Plan

The business plan has to convey many facts about the business and its management. Despite the maturity of the MBO market there are still too many poorly drafted business plans. Verbosity, sloppiness and ambiguity all infiltrate many documents. Say what you mean and mean what you say. The purpose of the document is to wet the appetite of potential financial backers to the MBO bid.They will expect to see the following covered:

Executive Summary Summarise your plan, highlighting major achievements by the management team, describing clearly the activities of the business, the financial performance to date and the potential for growth. An explanation of the reason to exist for the business is vital.

History, Background The Plan needs to describe to the reader the major landmarks of the business. Explanations of major changes in policy over the years are essential. Evidence of management successfully dealing with change inflicted on them is always impressive. Equally, evidence demonstrating management’s ability to exploit technology is always impressive. If the business relies on major bids to win business then evidence of historical major contract wins is helpful in understanding management’s chance of sustaining growth.

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Marketing Strategy How does the business win work? An explanation of the techniques employed by the sales team should be covered and perhaps any differences, if they exist, with the competition. New policies to be employed after the MBO has completed should be highlighted, especially if the MBO has been unable to implement them under its current owner eg due to cash constraints, or public sector owned and therefore ultra vires.

Marketplace, Competition It is important to put the business and its activities into perspective. How does it compare with its competitors and how will it operate in the future given the trends within the marketplace. A table showing the growth rate of the sector and the competition relative to the business can be helpful. Trends need to be reported and commented on with evidence of how management have dealt with them eg changes in legislation, influx of overseas competition, advancement of technology.

Financial Performance Reasons behind variances to plan and previous years’ performances show that a management team understand their business. Evidence of management beating previous budgets is always helpful in convincing backers that the forecasts are believable. Future plans should go out 5 years with robust assumptions behind the figures. Management should have clear policies on all aspects of the business based on a clear post MBO management of the business. Significant improvements in margin percentages are rarely believable and growth forecasts should be supported by believable management action eg export expansion or new product development or roll out of further identified sites.

Management and Staff Brief four line summaries should be sufficient to convey the qualifications and experience of each key member of staff.

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This section should cover the main inner cabinet running the business along with the key members comprising the second tier management team.

Growth Plans A balance needs to be struck between visionary strategic objectives and believable actions to achieve growth. The narrative should explain how management will exploit the current trends in the sector. Growth statistics for the section should be noted with credible research sources. Threats to the business should be addressed whether from competitors, technology or legislation. Cross reference should be made to the financial forecasts and an explanation of major assumptions made going forward.

Potential Returns to Funders A discounted cash flow demonstrating the potential internal rates of return (IRR) to the venture capital backers is helpful. This should show various IRRs achievable at various purchase prices and demonstrate the sensitivity of these IRRs to the flexing of repayment terms and exit values. This is explained in detail in the next Section.

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Sourcing Funders and Pricing MBOs Chapter 4.1 DEBT, EQUITY AND MEZZANINE FUNDERS Chapter 4.2 UNDERSTANDING THE TYPE OF FINANCE NEEDED Chapter 4.3 HOW TO CHOOSE THE MOST APPROPRIATE FUNDER

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Chapter 4.1 Debt, Equity and Mezzanine Funders

At the present time in the UK the main sources of finance for an MBO are bank debt, venture capital equity and mezzanine finance.The players involved in the marketplace, their characteristics and cost of money are now described in detail.

Debt Players Most mainstream clearing banks contain acquisition finance teams who supply the MBO market eg Bank of Scotland, Royal Bank of Scotland, NatWest, Lloyds, Barclays. In addition a range of institutions are keen to supply debt instruments to the UK market. Experienced advisors will have strong relationships with a range of European and American finance houses supplying debt. Main Characteristics and Cost The key features of bank debt in UK MBOs are as follows: 1. Cost, 1.5% – 2% above base. 2. 5 – 7 year repayment terms, payable annually or six monthly. 3. First in the queue regarding receivership. 4. Lenders of bank debt will resist the repayment of other non-bank debt instruments until they are repaid in full (negotiate!). 5. Lenders will expect to put in place rigorous covenants regarding profit to interest cover and cash flow to interest cover.These will be set quarterly going forward and penalties may be incurred if breached. 6. Lenders will look for security over relevant assets.

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7. Lenders will expect to co-invest with a venture capitalist (except in small MBOs). 8. Lenders will be wary of debt: equity ratios much in excess of 1:1 except in highly cash generative businesses.

Venture Capitalists Venture capitalists raise their money from various sources perhaps through their owners (those owned by banks), through independent fund raising and also from public offering. Their clients can therefore be large pension funds, high net worth individuals or in the case of those investing their bank’s money, the client will be the group board of the holding company. For management teams the sources of venture capital are important. If the money is coming from a newly raised fund, is there a requirement for the venture capitalists to return monies in a set timeframe (closed end fund). Venture capital sourced from the internal cash flow of a large bank is often extremely competitively priced (ie relatively cheap). The British Venture Capital Association publish a guide to the main players, with addresses and telephone numbers. Main Characteristics and Costs The key features of venture capital in UK MBOs and the cost are as follows: 1. Cost: the venture capitalists will expect a return pre tax on their investment equivalent to an average compound return in excess of 30%. (This may seem excessive but it does include an assumption on sales proceeds or float proceeds at the end of their investment). 2. A large tranche of their investment will be made in the form of redeemable preference shares or unsecured loan stock.The venture capitalists will expect these instruments to be repaid over 5-10 years.The cost of these instruments at the present time is around 8% to 10% (this is of course included in the 30% mentioned above). 3. In terms of a winding up of the business, venture capital instruments such as unsecured loan stock and preference shares will sit behind debt and mezzanine instruments in the queue.

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4. MBO teams should watch for aggressive dividend policies after 3 to 5 years ie the venture capitalists may document the right to a 5% dividend up to year 3 and thereafter rising to 10% in year 4 and 5 and then 40% in year 6 onwards! 5. Part of their investment will of course be in ordinary shares with voting rights (benchmarks on equity percentages are explained later). The rights attaching to their shares will be comprehensively documented in the Subscription Agreement. Subscription agreements are explained in Chapter 5.5.

Mezzanine Players Mezzanine capital is unquoted capital which, in terms of risk and reward, ranks between bank debt and equity capital. The return to the mezzanine capital investor generally comes in two forms – firstly by way of income and secondly by way of a capital gain. The income return – either fixed or floating – is usually at a rate above senior debt providers, 3% to 4%. The capital gain typically comes in the form of a warrant or option to subscribe for shares, which is realised into cash on flotation or sale. The income and capital returns are expected to deliver an equivalent average compound return of around 8% to 10% above base rates. Most of the major banks run specialist mezzanine teams and specialist companies have been formed over the last years to exploit this market eg Intermediate Capital and PRICOA Capital Group.

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Chapter 4.2 Understanding the Type of Finance Required

Structuring the Deal – Using a Real Life Worked Example A detailed review of the real life MBO explained in Chapter 1.2 reveals key aspects of structuring MBOs.This has been amended slightly to reflect the exact structure of the real deal. Application of funds £m Acquisition price . . . . . . . . . . . . . . . . . . . 25,600 Working capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Fees. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 26,600 Source of funds £m Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,500 Unsecured loan stock . . . . . . . . . . . . . . . 5,350 Preference Shares . . . . . . . . . . . . . . . . . . . . 2,350 Ordinary shares – institution . . . . . . . . 100 Ordinary shares – management . . . . . 300 26,600 The above table summarises the final position of the deal structured with the banks and venture capitalists, but how did the management team and their advisors arrive at the price for the target and the relevant stake for management and the debt to equity ratio and what lessons can be learned from the process? Let us assume that the management team had produced the following cash flows going forward for the business, see Table A.

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Table A – Free cash flows prior to new capital structure Year ending 30 September 1995

1996

1997

1998

1999

£000

£000

£000

£000

£000

Sales receipts

41,875

41,062

43,771

47,661

48,999

Other income

0

0

0

0

0

Total receipts

41,875

41,062

43,771

47,661

48,999

(24,460)

(22,870)

(24,099)

(27,419)

(29,150)

Other cost of sales

(6,439)

(6,360)

(6,543)

(7,147)

(7,298)

Other overheads

(2,998)

(3,035)

(3,764)

(5,525)

(6,484)

(265)

(20)

730

387

0

0

0

0

0

7,713

8,777

10,095

7,957

6,067

Cash

0

0

0

0

0

Secured loan

0

0

0

0

0

Equity

0

0

0

0

0

Preference

0

0

0

0

0

Secured debt

0

0

0

0

0

Preference

0

0

0

0

0

Net cash flow

7,713

8,777

10,095

7,957

6,067

Opening balance

(180)

7,533

16,309

26,404

34,361

Closing balance

7,533

16,309

26,404

34,361

40,428

Payroll

Capital expenditure (NET) Tax Cash flow before financing Interest:

Dividends:

Repayments:

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Table B – Cash flows with the new proposed capital structure superimposed Year ending 30 September 1995

1996

1997

1998

1999

£000

£000

£000

£000

£000

Sales receipts

41,875

41,062

43,771

47,661

48,999

Other income

0

0

0

0

0

Total receipts

41,875

41,062

43,771

47,661

48,999

(24,460)

(22,870)

(24,099)

(27,419)

(29,150)

Other cost of sales

(6,439)

(6,360)

(6,543)

(7,147)

(7,298)

Other overheads

(2,998)

(3,035)

(3,764)

(5,525)

(6,484)

(265)

(20)

730

387

0

0

(1,019)

(1,863)

(2,133)

(1,340)

7,713

7,757

8,232

5,824

4,727

(5)

71

142

115

(23)

(1,480)

(1,280)

(1,040)

(720)

(360)

(535)

(535)

(535)

(2,115)

(1,215)

(24)

(24)

(24)

(24)

(24)

(141)

(176)

(823)

(2,115)

(1,080)

(2,500)

(3,000)

(4,000)

(4,500)

(4,500)

0

0

(3,000)

(1,000)

(1,350)

0

0

0

(1,000)

(1,350)

Net cash flow

3,028

2,813

(1,048)

(5,535)

(5,175)

Opening balance

(180)

2,848

5,661

4,613

(922)

Closing balance

2,848

5,661

4,613

(922)

(6,097)

Payroll

Capital expenditure Tax Cash flow before financing Interest: Cash Secured loan ULS Dividends: Equity Preference Repayments: Secured debt ULS Preference

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To decide on the type of finance required a decision is needed on the following: 1. How much should the management team pay for the target? 2. What equity stake should be assumed for the management team given the amount of personal wealth they are prepared to risk? 3. How much more money is needed to be raised over and above purchase price for working capital and fees? 4. What is a sensible debt to equity ratio to assume given the quality of the cash flows forecast? Answers to these questions are best addressed using a forecast cash flow for the target with the proposed capital structure superimposed on top of the free cash flows (table A above) and a discounted cash flow model to demonstrate the potential returns to the venture capitalists. Firstly, let us look at table A again but this time we have superimposed the eventual debt from the banks and the financial instruments onto the cash flows, see Table B. Also, for clarification, the balance sheets on day 1 of the MBO and forecasts over the next 5 years are given below, Table C.

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Table C – Balance sheets of target with new capital structure superimposed Opening

Goodwill Fixed assets Depreciation

1994

1995

1996

1997

1998

1999

£000

£000

£000

£000

£000

£000

9,869

9,869

9,869

9,869

9,869

9,869

29,729

29,994

30,014

29,284

28,897

28,897

(15,583) (17,661)

(20,163)

(22,725)

(26,275)

(13,230)

Net

Year ending 30 September

16,499

14,411

12,353

9,121

6,172

2,622

4,022

4,986

15,775

18,659

20,000

(4,022)

(4,986)

(15,775)

(18,659)

(20,000)

0

0

0

0

0

337

337

337

337

337

337

Debtors

3,016

1,690

1,712

1,829

1,993

2,044

Cash

(180)

2,848

5,661

4,613

(922)

(6,097)

Current assets

3,173

4,875

7,710

6,779

1,408

(3,716)

2,941

2,307

1,980

1,432

56

(1,875)

Tax

0

1,019

1,863

2,133

1,340

1,015

Dividend

0

0

0

0

0

0

2,941

3,326

3,843

3,565

1,396

(860)

232

1,548

3,867

3,214

12

(2,856)

(16,000) (13,000)

(9,000)

(4,500)

0

Leased assets – WDV Leased assets creditor Net leased assets Current assets Stocks

Current liabilities Creditors

Current liabilities Net current assets Secured loan

(18,500)

ULS

(5,350)

(5,350)

(5,350)

(2,350)

(1,350)

2,750

4,478

7,739

10,854

10,203

9,635

400

400

400

400

400

400

2,350

2,350

2,350

2,350

1,350

0

Redemption reserve

0

0

0

0

1,000

2,350

Profit & loss account

0

1,728

4,989

8,104

7,453

6,885

2,750

4,478

7,739

10,854

10,203

9,635

Net assets Share capital & reserves Equity Preference

Shareholders funds

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Conclusions from the Above Therefore the assumptions made on the purchase price of £25.6 million and fees of £1 million totalling funds required of £26.6 million appear to be affordable, funded by £18.5 million of bank debt and £7.8 million of venture capital and £300,000 from the employees. The cash flows reveal the need for a small refinancing in year 1999. The evidence on affordability rests in the cash flows with the conclusion that the interest payments, dividend payments, repayment of bank debt and unsecured loan stock can be met.

The Venture Capitalist’s Return – Using Discounted Cash Flows The next test on this structure is to look at the return to the venture capitalist. For this we need to construct a forecast discounted cash flow of the venture capitalist’s money (Table D). Table D – Venture capitalist’s return Opening

Year ending 30 September

1994

1995

1996

1997

1998

1999

£000

£000

£000

£000

£000

£000

Dividends (gross) – ord

8

8

8

8

8

– pref

176

220

1,028

2,644

1,350

535

535

535

2,115

1,215

ULS repay

0

0

3,000

1,000

1,350

Pref redemptions

0

0

0

1,000

1,350

IRR Venture Capitalist Initial Investment

(7,800)

ULS int

Exit value Cash flow

6,600 (7,800)

719

763

4,571

6,766

11,872

1.00

0.79

0.56

0.42

0.31

0.24

DCF

(7,800)

564

430

1,916

2,098

2,792

IRR

33.58%

Discount Factor

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As table D illustrates the original investment by the venture capitalist of £7.8m has generated an internal rate of return of 33.58%. What do we mean by IRR? This is the equivalent average compound return on the original investment of £7.8m on day 0 over the life of the investment ie in this case 5 years. Note, in this instance an assumption is made regarding the disposal proceeds needed in year 5 to allow the venture capitalists to obtain their minimum acceptable IRR. Now the one question which is worth reviewing briefly is,‘what are the traditional ways of valuing target businesses?’This is important because to use the above models effectively it is important to be aware of the potential market value of the business which the vendor might be aspiring to and, secondly, it is important to place an exit value on the business to calculate the venture capitalist’s IRR. So what are the traditional ways of valuing businesses? Appendix I explains the main valuation models for pricing companies.

Pricing and Capital Structure – Summary Therefore, as can be seen from the above analysis, understanding the type of finance needed, the amount, the payment required to the vendor and management’s equity stake are all interlinked.The order of events is as follows: 1. Produce a robust free cash flow model of the target going forward including supporting profit and loss accounts and balance sheets. 2. Assess a likely capital structure including bank debt, mezzanine and equity. 3. Assume various equity stakes for management to test the model. 4. Produce a valuation of the business on traditional lines as indicated and assess a likely value on exit. 5. Produce a full financial model of the business going forward with the new capital structure. Ensure the capital structure is affordable. 6. Test the likely IRRs for the venture capitalists based on a conservative exit assumption on disposal or flotation of the business.

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Chapter 4.3 How to Choose the Most Appropriate Funder

In terms of the overall process the MBO team and their advisor will have completed the preparation stage ie they will have produced a credible and attractive business plan and they will be comfortable with the composition of the management team and they will understand the type of money needed and the likely purchase price of the business.

Rehearsal of the Business Plan It is important for the management team to rehearse the presentation of their business plan. Each member of the team must be clear of their role in the presentation to potential backers of the transaction. It is not helpful for the MD to dominate the proceedings by delivering the strategic message and the operational action plans as well as answering all questions. Be sure of the evidence behind your assertions. Rehearse the key issue for the backers concerning ‘reason to exist’ and believability of future growth plans and therefore financial forecasts.

Relevant Institutions The corporate finance advisor to the MBO team should be clear, given their detailed knowledge of the venture, bank and mezzanine markets, who to contact. Therefore an initial tranche of funders will be drawn up, who should be interested in backing the MBO team’s proposition. It is important for the advisor to ensure that the business plan is sent in advance of any formal presentations.

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The key institutions to action immediately must be the equity backers ie the venture capitalists. The advisor to the MBO team will expect to facilitate the shortlisting of relevant institutions, the presentation of the business plan, the production of supplementary packs of information and effectively the delivery of a term sheet detailing the basic assumptions on which the institutional offer should be made (basic assumptions should cover price to be paid for the business, exit proceeds on sale or flotation and personal finance to be invested by the management team).

The Criteria for Selection Assuming the MBO team have received several equity offers of support it is then important to determine the quality of the offers against key criteria. Equity Percentage/Price of Money/Repayment Terms The offer of financial support needs to be modelled to determine the Internal Rate of Return likely to be achieved by the institution. It is important when modelling to be consistent with exit proceeds on flotation or trade sale. The higher the equity percentage given to management, the further out the repayment terms on the financial instruments and the lower the coupon on the dividend are all features influencing management’s decision. Chemistry of Deal Leader Clarify the identity of the non-executive likely to be appointed to Newco’s Board. It is quite common for this to be the Investment Director leading the deal.Will this work on a monthly basis? This may seem a soft point at the time of choosing a funder but 18 months down the line the management may regret their decision. Future Funding Requirements – Approach Understood It is very important to understand the institutions view on follow on money. The business may need further development capital in several years time for capital expenditure, acquisitions or new product development.

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Early Repayment Penalties If cash flow grows strongly over the next few years and the institutions loan stock is repaid early, are there penalties to be incurred? Approach to Salary Levels Do the backers have strong views on the current salary levels in the business ie are they too high or too low? Information Requirements How does the venture capitalist monitor their investment? Are the financial report requirements demanding in terms of volume or timing? Previous Track Record, References Do the management team have reference sites to interrogate eg the management team of a recent successful MBO backed by the institution. Synergy/Conflicts with other Portfolio Companies Does the institution have other investments in the sector or even investments in direct competitors? Are there, therefore, difficult conflicts to resolve? Type of Funds Being Used Is a closed end fund being used to make the investment? If so is there a long stop date by which the institution will need to exit? House Style Is the track record of the institution ‘hands off’ or ‘interventionist’? Do they get involved in developing the business? These are some of the criteria which management should find helpful in evaluating equity institutional offers of finance. The next section of the Report concentrates on negotiation advice to assist management teams get the deal they desire.

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Negotiation Advice Chapter 5.1 TACTICS WITH THE VENDOR Chapter 5.2 DETAILED NEGOTIATION MEETING WITH THE VENDOR Chapter 5.3 TACTICS WITH THE FUNDERS Chapter 5.4 DETAILED NEGOTIATION MEETING WITH THE FUNDERS Chapter 5.5 NEGOTIATING LEGAL AGREEMENTS

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Chapter 5.1 Tactics with the Vendor

The Controlled Auction As discussed earlier, it is likely that the management team will have to deal with the pressures of a controlled auction. For example, direct competitors may be bidding for the business, searching for facts and figures to help them price the business to ensure they get into the next round. In this environment, how should the management team deal with the vendor? Firstly, the issue of price is important to get right. However, as demonstrated in the previous section, the issue of price for the MBO team is centred around affordability. Understanding the vendor’s aspiration on price is helpful but in an auction process is somewhat meaningless. Management teams should have one main advantage over the other buyers – detailed knowledge of the business. In a controlled auction, where time is precious, this knowledge should be used to ensure the management bid leads the field. How can this be done? As a management team consider the following: 1. Ensure the vendor understands the quality of service you intend to offer after post acquisition. 2. Ensure the vendor understands the involvement of staff in your bid and the security of their jobs post acquisition. 3. Customers may be much happier with the existing staff of the business running the show than a new, much larger plc.

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4. Are there any conflicts between bidders and the existing customers or suppliers? 5. Are there any advantages to the vendor of selling to management eg retaining an equity stake going forward, receiving a favourable deal as a customer of the business going forward? 6. Are the management team able to close a deal to a much tighter timetable? 7. Will selling to a management team involve less due diligence and prevent some bidders investigating the vendor’s business? 8. Does the vendor realise the consequences of not selling to the management team! (especially in a low asset backed people business, eg recruitment, public relations, contract catering)?

The Information Trap Given the competitive environment of the auction process, the MBO team must be careful when dealing with the vendor regarding information requests.This works both ways. Firstly, MBO teams must realise that all answers to questions set by the vendor will be passed onto the other bidders to assist their bid. Equally, answers given by the vendor to the MBO team will also be issued to all bidders.These tactics are employed by a well-advised vendor to ensure a level playing field. The MBO team must therefore be careful when dealing with the vendor regarding information release and additionally care must be taken regarding information release to staff. Management’s business plan should be the property of the management team and their advisors and should reflect the specific view of the future of the business through the eyes of the existing management team. (This, of course, may assist MBO teams to value businesses at higher levels than are perceived by other buyers, within affordable limits). Management must attempt to gather information which supports their view of future profits, eg conversations with senior officers of the vendor regarding future work of relevant evidence from the vendor which affects any aspect of the business going forward or detailed knowledge of the business which they have built into future profits.

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The Non-price Points Buyers of businesses must focus on all relevant non-price points if a deal is to be closed. Management teams must consider all of these and emphasise those that reinforce the attractiveness of their bid.The main ones to consider may be: 1. The level of on-going quality of service to the vendor. 2. The security of employment for the staff. 3. The development of the business by the buyer and the access to funds. 4. The ability of the vendor business to succeed under the buyer’s regime. 5. The requirements of the buyer regarding warranties and indemnities. 6. The level of due diligence required to be done prior to completion. 7. The ability of the buyer to deliver on the completion timetable. 8. The track record of the buyer in similar situations. There may be many more points to consider, but, ignoring price, the management team have a unique opportunity, due to their knowledge of the business, to ensure their bid reflects all relevant issues important to the vendor.

How to Deal with Each Bidding Round Good advice to all acquirors in an auction process must be to give it your best shot.There seems little upside in trying to second guess the tactics of the other bidders.At each round of bidding it is imperative for the management team to produce the best bid possible covering all aspects of their offer. Management teams should never assume a clear run to preferred bidder status. It is also imperative for management teams to be both realistic and cautious in deliberations to staff. It is depressing to watch the effect on a business where the employees have been led to believe that winning the bid is a certainty. To improve their chance of success, management teams need to strengthen their bid as soon as possible. Therefore in a perfect world, even at the first round of bidding, management will be clear on a range of issues:

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1. Preferred equity backer. 2. Preferred debt backer. 3. Preferred mezzanine backer. 4. Level of staff involvement and their career prospects. 5. A clear vision of the strategic direction of the business. 6. The structure of the deal, cash at completion, assumptions on balance sheet cut off, treatment of intercompany debt and on-going management charges or service charges payable to the vendor if relevant. 7. The assumptions on which the bid is based. 8. The treatment of any potential redundancies. Therefore, in the initial round of bidding, the MBO team and the preferred funder should aspire to the best possible bid covering all aspects of interest to the vendor. In a heavy contractual environment, eg the bus sector, local authority contracting, logistics businesses, it would be wise for the management team to ensure their lawyer had addressed relevant issues on the contract front within the bid. Assuming the MBO team are successful getting through to the next round, the agenda then moves to a formalisation of all aspects of the bid. Because the second round of bidding could be the final round, it is important that all aspects of the bid are revisited, improved where possible and finalised. It is likely that new information released by the vendor, perhaps though access to a data room, will have more impact on external bidders compared with the internal MBO team. However, all facts and figures on the business need to be reviewed to ensure the plan remains robust, and that the price placed on the business is the best shot and of course affordable. Finalisation of ESOPS, capital structures of Newco, term sheets for the financial backers, equity stakes for management, pension arrangements for staff need to be considered at this important stage.The financial backers to the deal will have done limited due diligence at this stage but will probably have reviewed the sector in detail, interviewed the key people, understood the history and development of the business and tested the robustness of the plan and therefore the affordability of the purchase price. All buyers will probably only be allowed to do detailed on-site due diligence on being granted exclusivity ie preferred bidder status.

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In summary, tactics with the vendor up to the final bid stage can be prioritised into three key areas: 1. Understand the requirements of the vendor at all times. 2. Ensure the vendor has comfort with the credibility of your bid in respect of financial backing, staff and viability going forward. 3. Give each bidding round your best shot within affordability limits.

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Chapter 5.2 Detailed Negotiation Meeting with the Vendor

Suggested Agenda for the Meeting After all final bids are received the vendor and their advisors will consider the quality of the bids and choose one or more priority targets for further discussions.These meetings will decide the identity of the preferred bidder. As an MBO team (assuming success at being shortlisted) this is a particularly difficult meeting. Parties to this meeting will probably include the vendor and their advisors, the MBO team and their advisors and probably lawyers on both sides. It is likely, but is not always the case, that the equity/venture capitalist backer will join the meeting. A likely agenda will include: 1. Draft sale and purchase contract issued by the vendor and changes needed. 2. Pension arrangements for staff. 3. Confirmation of ESOP arrangements. 4. Confirmation of operational plan post acquisition including personnel issues. 5. The offer for the business and the strength of financial backing. 6. Cut off arrangements regarding balance sheet items, eg debtors, stock, cash balances, intergroup trading. 7. Anti-embarrassment clauses. 8. Due diligence still outstanding. 9. Lock-out arrangements. 10. Timetable to completion.

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Given the above agenda it is vital for the MBO team to remain competitive even at this late stage eg perhaps the changes to the draft sale and purchase contract regarding warranties can be minimal (a trade player may need much more comfort from the vendor) or perhaps the operation plan for staff is more accommodating of the vendor’s wishes. Some aspects of this agenda, from the offer downwards, are now discussed in detail.

The Offer for the Business In this final negotiation meeting there is always a temptation to sweeten the deal for the vendor to obtain exclusivity. The MBO team must remember that external finance is being used and that overpaying for the business may be the kiss of death to future viability. If the vendor’s aspiration on price is not being met then options worth considering are: 1. Deferred consideration. 2. Buying less than 100% of the equity. 3. Offering the vendor an attractive supply agreement eg a logistics business where the vendor will remain a major customer. It is quite common for the vendor to benefit from the upside of the business going forward by maintaining an equity stake or to assist in the financing of the MBO by taking a Vendor Loan Note payable on flotation or change of control. It is also helpful for the credibility of the bid if the venture capitalist supporting the bid has cleared his credit committee and is ready to do the deal subject to final due diligence and contract.

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Cut-off Arrangements This is an area often left to the last minute and because of time pressures ambiguity can creep in. The MBO team must be clear on the cut-off point for the balance sheet on which the deal is based. Is there to be a net asset adjustment (ie a £ for £ adjustment to price upwards or downwards depending on the level of net assets at completion)? How is the balance sheet to be audited at completion by the acquirer? Would a cut-off point one month prior to completion make sense to allow both parties to sign off all adjustments by completion? Will debtors at completion be collected by the new acquirer and creditors paid off? How will bank balances at completion be handled? These issues are all key to the MBO team’s working capital requirements immediately post the deal.

Anti-embarrassment Clauses Vendors may seek clawback arrangements regarding the target business (or specific assets) being sold on to third parties by the acquirer, realising super profits.These clawback arrangements will cover periods 12-24 months post the sale. MBO teams should resist these arrangements but this may be more difficult in public sector transactions.

Due Diligence Still Outstanding The vendor is obviously worried at these late stages of negotiation that the acquirer cannot deliver a deal.This may be for many reasons but the main one will be due diligence problems. Therefore the MBO team can take this opportunity to reassure the vendor that due diligence will cause them no problems; they understand the business in detail – they run it! However, despite this intimate knowledge it is still important to articulate the areas requiring further investigation by the financial backers.

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It is worth making clear to the vendor any areas where the vendor could give the financial backers comfort on the future operations of the target eg in a regulated environment where the vendor retains some regulatory power over the target business: the Civil Aviation Authority or London Transport are good recent examples.

Lock-out Arrangements It is worth confirming with the vendor that the preferred bidder status will be accompanied by an exclusivity arrangement or lock-out arrangement.This is an agreement between buyer and seller that the vendor will deal only with one buyer for an agreed period. From the MBO’s perspective an ideal period is eight weeks but of course agreeing to a 4 week period does send attractive signals to the vendor that you are ready to close a deal quickly. Note, in the UK exclusivity arrangements are legally binding (unlike heads of agreement) and therefore they should be documented and signed by both parties.

Timetable to Completion Always end a detailed negotiation meeting on a positive note, if possible. A discussion of a completion timetable is a good method of flushing out all outstanding events. There may be many issues outstanding at this final stage and, although not exhaustive, the following timetable checklist should prove helpful: (note, not all of these points would be discussed with the vendor). 1. Announcement of preferred bidder status. 2. Date of on site due diligence commencing – accounting and legal due diligence (operational due diligence would be limited with an MBO team). 3. Tax clearances. 4. Mechanism regarding balance sheet cut-off issues agreed. 5. Drafting meetings regarding sale and purchase contract. 6. Drafting meetings regarding Subscription Agreement.

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7. Drafting meetings regarding Legal Agreements. 8. ESOP arrangements finalised. 9. Financial Assistance hurdles cleared, including statutory declarations. 10. Personal finances of MBO team put in place. 11. Due diligence signed off. 12. All property matters signed off. 13. All pension issues signed off. 14. All TUPE issues signed off. 15. All environmental issues signed off. 16. Subscription, Legal and Sale Agreements signed off. 17. Legal Completion and Public Announcements. Hopefully, after these detailed negotiations have been completed, the vendor can announce the preferred bidder.

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Chapter 5.3 Tactics with the Funders

It is worth reviewing some aspects of the relationship between the management team and the funders in more detail. These tips are aimed at assisting management teams in obtaining the best terms from the venture capitalists and bankers prior to the submission of the final bid.

The Venture Capitalists The auction process puts pressure on management teams to pick a lead funder who will be their financial partner to execute the deal. As discussed earlier, it is preferable for the MBO team to have selected their lead financial partner before submitting their first bid. However, due to time pressures, or perhaps due to the unattractive terms being offered, it may be desirable to delay choosing one preferred backer at the first round of bidding. As long as several reputable names are supportive of the bid at the price indicated then the vendor will not be concerned about the financial credibility of the management’s bid. However it is not practical to run an MBO bid with many venture capitalists backing the team. Of course the preferred venture capitalists you choose may (with managements approval) decide to syndicate the deal post completion. Therefore, eventually, and probably prior to the first round of bidding, the management will choose a preferred funder to supply the equity required for the transaction. Criteria for selection was discussed in Chapter 4.3.

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As a management team it is worth being aware of the many issues that effect the equity backers, view of the target business and the target’s management team. The Report now reviews the key issues that motivate the venture capitalists. What makes venture capitalists competitive? Build up strong evidence of the likely exit value of the target to ensure their DCF models produce a reasonable IRR. Maximise the amount of personal money the management team can raise to ensure the backers are convinced the team want to win the auction of their business. Demonstrate the affordability of the purchase price and in particular the headroom in the cash flows for early repayment of their financial instruments. How do venture capitalists view the management team? It is important to demonstrate the quality of the whole team including the second tier management not just the MD. Each key manager should be allowed to demonstrate their abilities in a series of meetings. It is preferable for the venture capitalist to have met the key second tier managers prior to their submission of an offer of support. The auction process. Whether the institutions like it or not, management teams must benchmark offers of financial support from several institutions. In a recent deal the difference in equity stakes offered by various institutions using identical assumptions on the same deal was 45% to 75%, therefore it pays to shop around. What are venture capitalists looking for from the financial forecasts? It is a myth that venture capitalists need to see exciting growth prospects for the next 5 years. They want to see believable growth and potential exit routes at the end of 5 years. They also need to see consistency between the narrative of the business plan and the financial projections. Don’t let gaps open between strategic rhetoric and financial modelling.

The Bankers Ironically, although the majority of the money for the transaction may be in the form of bank debt, the bankers will not receive equity. Neither will they expect a board position. As discussed earlier, under Chapter 4.1, the bank debt will attract an interest rate of around 1.5% to 2% above base rate and there will be an expectation from the lender to be repaid their money within 5 to 7 years.

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The bankers will seek to charge the assets in the target’s balance sheet. They will also have strong views on the redemption profile of the venture capital financial instruments, resisting payment until their instruments are repaid. Their money will be accompanied by a collection of covenants. These covenants are a series of ratios eg ‘profit pre interest’ to ‘interest’, which they will set after consultation with management. The covenants finally negotiated with management and the venture capitalists will be inserted in the banking documents. There are often draconian penalties for breach of these covenants and therefore grace periods must be negotiated to allow management to correct the breach. Cash flows of the target will be paramount. Bankers will conduct detailed reviews of the monthly cash flows going forward to ensure the capital structure is affordable. Bankers will also have specific requirements regarding due diligence which will overlap but not replicate those of the venture capitalists. Bankers to the MBO will be looking closely at the proposed debt equity ratios. In the present market as a benchmark the further the ratio moves from 1:1, the riskier the transaction from the bankers perspective. Of course a highly cash generative business could justify a ratio closer to 2:1. Another issue worth noting in this area is timing. A common mistake made by many buy-out teams is to leave the banking finance to the advanced stages of the process. Do not underestimate the time needed to get the banking finance through credit committee.Although the lender of the bank debt is not investing in the equity, the lender will still require a high level of comfort on many issues.This may include: 1. A comprehensive assessment of the management team. 2. The credibility of the profit and loss cash flow and balance sheets. 3. All commercial assumptions behind the business plan. 4. Major sector trends. 5. Competitive position. 6. Valuation of all balance sheet items. 7. Any environmental exposure. In addition, the banks are also after the day to day Transmission Business of the target which can deliver higher yields to them than the actual term debt.

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Chapter 5.4 Detailed Negotiation with Funders

Suggested Agenda for the Venture Capitalist Meeting Probably after the management have been selected as preferred bidder it is useful to have a full scale meeting with the venture capitalists to the transaction.This gives management the opportunity to negotiate all commercial aspects of the funding prior to legal drafting of the subscription agreement. The likely agenda will include: 1. Repayment terms of all financial instruments. 2. Early repayment penalties. 3. Dividend and interest yields on all instruments. 4. Clarification of management’s equity and ratchet mechanisms. 5. Follow-on money needed over the next 3 years. 6. Non-executive director role and fees. 7. Salary levels of key managers and main service agreement issues. 8. Precise levels of personal capital being invested by the management team. 9. ESOP arrangements. 10. Pension arrangements. 11. Nature and extent of outstanding due diligence. 12. Issues surrounding banking instruments. 13. Keyman insurance required. 14. Arrangement fees.

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Some specific negotiating tips on some of these agenda points should prove helpful.

Repayment Terms and Early Repayment Penalties It is possible to structure the venture capital money to deliver a guaranteed IRR for the investor and an enhanced equity position for the management team. This can be done where the business can afford to repay the preference shares, for example with an implied premium on redemption to give the investors their desired return. More traditional structures produce repayment terms for the preference shares and unsecured loan capital between 2 to 10 years. It should be noted that because many MBOs exit through trade sale or flotation within 5 years of the deal, it is common, at the point of exit, for the outstanding preference capital to be redeemed out of disposal/flotation proceeds. Management teams must attempt to push the repayment of financial instruments out as late as possible but retain the right to repay early if the cash is available in the business.

Dividend and Interest Rates Management teams should not expect dividends on their personal capital invested in the deal. Dividend yield and interest rates on unsecured loan instruments or preference shares should be around 2% to 3% above base rates, but of course the venture capital money needs to be assessed on overall IRR terms. Some venture capital houses will attempt to secure rising profit participating dividends as an incentive for management to exit. Percentages starting at 8% and rising to 40% of profits by year 5 are sometimes employed.

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Equity Stakes and Ratchet Mechanisms Management presumably have chosen the preferred funder primarily because of their generosity regarding management’s equity stake (amongst many other things – see Chapter 4.3). However, it is worth clarifying that the venture capitalists have given the equity position their best shot. Management teams must aspire to the best position possible. However, realistically, the IRR model described earlier will demonstrate the reasonableness of management’s equity position given the price being offered for the business. Ratchet mechanisms are worth exploring as a means of rewarding management, especially if they are starting with a relatively low equity position. These can operate in different ways, driving off the back of exit values or profit performance or early repayment of financial instruments.

Follow-on Money – the Next 3 Years In some deals it is important for management to clarify that further money is available for future investment after completion, eg landfill where the acquisition costs of further sites can cost several millions each time or a retail environment where the concept will be rolled out over many sites. The two issues are, firstly, the availability of further funds and, secondly, the effect on equity stakes. Solutions to allow management to draw down further cash in later years could include partly paid up shares, unsecured loan stock or of course ensuring that debt capacity is built into the deal.

Non-executive Director Role and Fees The venture capitalists will expect to appoint a non executive director who may be the investment director leading the deal or an external candidate with relevant industry knowledge. On larger deals a non-executive chairman may be required in addition to their nominated non-executive director. Management will be involved in these appointments where an external candidate is being nominated and, in fact, management may be encouraged to suggest some names.

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The roles of these non-executives are clearly to look after the interests of the shareholders. The investment director of the venture capitalist will be looking after their investment but of course they are also there to make constructive suggestions to grow the business. Fees will be in the range of £10k to £20k per annum.

Salary Levels and Headline Service Agreement Issues Management will be curious to know their salary levels post the deal. It is unusual for salary levels to drop post the deal unless management were being rewarded at a unreasonably high level prior to completion. The service agreement will impose limits on salary levels and bonus arrangements. Restrictive covenants will be addressed to legislate for managers leaving the group. Conditions under which managers leave the group will be discussed and in the event of a manager being sacked the issue of his shares needs to be addressed. Management must expect to lose their shares if they are convicted of fraud or commit some other illegal offence. It is worth reviewing and seeking agreement in outline between management and the venture capitalists before each set of lawyers get their professional claws into the detail.

Personal Capital and ESOPS Management will be pressed at this stage on the precise amounts being invested by each manager and staff. Loans may need to be arranged and in some exceptional cases the need for salary levels to rise to take account of the borrowings may be sanctioned. An important point is that the interest on the borrowings used to invest in the business should be tax allowable for each manager ie able to be set off against salary for tax purposes. The complex issue of ESOPS should have been discussed before the final negotiation meeting and therefore only final arrangements should be outstanding. It is common, given the quickness of the MBO process, for the ESOP arrangement to be finalised after the management own the business.Whatever makes sense in each deal must be discussed and actioned.

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Care must be taken with the level of shares being allocated to the ESOP and the conditions that staff must meet to receive shares. The question of whether staff should pay for their shares or be gifted them is a difficult one. Ideally, one wants the key managers to have shares not the richest!

Pension Arrangements Management should have appointed pension advisors prior to the final negotiation meeting with the funder.This meeting, therefore, is an opportunity to clarify management’s intention on employee and employer contributions. Another issue worth discussing is the transfer arrangements from the previous pension scheme run by the vendor. It is likely that generous contributions made in the past will not be affordable by Newco post the deal.

Nature and Extent of Outstanding Due Diligence Management must clarify all material issues likely to affect the venture capitalists’ ability to close the deal. There are many aspects of the business which will have functioned perfectly adequately under the vendor’s control eg insurance cover, guarantees or performance bonds, foreign exchange arrangements, group tax relief, pensions and, concessionary arrangements to staff; however, under the new ownership of management and their backers these aspects need to be examined in detail. It is important for management, with their detailed knowledge of the business,to assist the venture capitalists in prioritising the due diligence required. A specific area to examine is the cut-off arrangements.Are the MBO team and the financial backers clear on the balance sheet they are acquiring at completion? What if the actual balance sheet is less than forecast? What is the vendor’s proposed treatment of group balances owing by or owed to the targets. All cut-off arrangements regarding balance sheet items and payment and receipts procedures which traverse the completion date need to be discussed and a set of proposals need to be drawn up and agreed with the vendor.

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Issues Surrounding Banking Instruments Prior to a final meeting with the bankers to the transaction (before they finalise their due diligence and documentation) it is imperative that management and the venture capitalists compare notes on all material issues. These could include, repayment terms of the venture capital relative to the bank debt, security required by the bankers, interest rates charged on all instruments, acceptable covenant levels on all major ratios and penalties for missed repayments. It is also important to ensure the bankers understand why the MBO team and the equity providers believe the business is worth backing.The up to date news on the business needs to be presented to the bankers and therefore a summary of all new key facts and figures should be agreed by the team and issued to the bankers as a supplementary information pack.

Keyman Insurance and Arrangement Fees Finally, there are many detailed elements to agree with the venture capitalists before they produce a final version of their documentation. It is worth confirming any issue which will effect the funds needed to be raised. Keyman insurance could be a significant premium cost to the business on day 1 of the MBO. Keyman insurance premiums could be as high as £3000 per person for £1/2 million in cover. This figure will be considerably less for young members of the team that do not smoke. Arrangement fees will be charged at the rate of 1%-2% of the finance invested. Management must negotiate all such fees to get the best deal.

Suggested Agenda for Other Funders’ (Debt and Mezzanine) Meetings The likely agenda will follow a similar pattern to the venture capitalist meeting. The key differences with other funders meetings will be the emphasis on affordability of the capital repayments and interest payments. Also, the other funders to the deal will have specific due diligence requirements which need to be discussed and factored into the timetable.

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Chapter 5.5 Negotiating Legal Agreements

Finally, it is worth commenting on the various legal documents that management will encounter towards the end of the process.

Shareholders Subscription Agreement and Articles of Association These documents articulate the detailed commercial agreements reached with management regarding the share capital of Newco. Management must watch carefully the investors’ rights on a range of issues: 1. Change of control. 2. Refinancing. 3. Drop in performance of the business. 4. Failure to pay dividends on time. 5. Failure to repay capital on time. 6. Early repayment of capital by management. 7. Management’s rights regarding syndication of the deal. 8. Restrictions on management actions. 9. Death of key managers. 10. Resignation of key managers. 11. Appointment of directors. 12. Fees and expenses. 13. Non-compete clauses. 14. Management salaries.

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Management must therefore ensure they have quality legal advice on their side to assist them in negotiating a fair deal. The lead corporate finance advisor would expect to play a pivotal role in securing a favourable subscription agreement, but of course working as a team with management’s lawyers.

Banking Agreements The banking covenants will have to be studied in detail by management to ensure there is sufficient headroom. The rights of all classes of lenders will be articulated in a series of priority agreements or inter-creditor agreements. Management need to understand all lenders rights in respect of defaults and in respect of change of control of the business. All commercial aspects of the banking arrangement need to be checked to ensure the documentation reflects previous oral and written agreement.

Sale and Purchase Contract The final document which will require careful negotiation is the sale and purchase contract. The battle which is often played out at this stage is between the vendor on the one hand denying responsibility for many aspects of the business and on the other hand the acquirer (the MBO team and the venture capitalists) seeking warranties. The vendor will claim they can’t be held responsible for the actions taken by management regarding running the business. A key to these discussions is often for management to be as specific as possible in their requests for vendor warranties. At the end of the day the vendor will have enjoyed the benefit of audits and internal control checks whilst under their ownership. Therefore if management’s requests on a warranty area are covered by previous audits then the vendor should be sympathetic to the management’s cause. Tax is an area where the vendor must expect to deliver quality indemnities, given the fact that tax matters would probably have been dealt with on a group basis across all divisions. As in all sale and purchase contracts, there will be heavy negotiation regarding maximum warranty limits and minimum levels before a claim can be made. In the last section of this Special Report we now turn to the special case of the public sector buy-out.

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Chapter 6.1 Public Sector Buy-outs – Additional Considerations

Introduction In many ways public sector buy-outs are no different from those in the private sector – a business is being acquired by its existing management with financial support being provided by a debt and equity funder. There are, however, certain key differences which reflect the status of the vendor and the nature of the business being acquired, some of which will directly affect the likely financial structure of the buy-out. This chapter sets out these differences and highlights additional considerations relevant to a public sector buy-out.

History Whilst MBOs as a form of business divestment are still a relatively young phenomena, having developed in the early 1980s following clarification of company legislation relating in particular to financial assistance, public sector buy-outs are even more recent. The largest impetus to this type of transaction was the 1988 Local Government Act which required Local Authorities to adopt compulsory competitive tendering (CCT) procedures for certain of their services. This forced Local Authorities to offer the private sector the opportunity to bid for contracts to provide these services. In so doing existing management had two choices: 1. To bid for the contract as an in-house team and thus, if the successful bidder, to continue to provide the service as local authority employees.

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2. To bid for the contract via a management buy-out vehicle, backed by external funders. The early success of management in winning bids in either of these situations often reflected the complexity of the bidding process and the inexperience of trade bidders. It did, however, quickly establish the management buy-out as an effective means to externalise public sector services and has since been used by both local and central government. Examples of services which have been successfully acquired via buy-out include: the provision of bus services, leisure services, refuse collection, street cleaning and grounds maintenance and the management of children’s homes. More recently, a number of management teams have bid for businesses formerly operated by British Rail, ranging from the train operating companies themselves, through to training and support services. Indeed, to encourage management buy-out bids, the Department of Transport allowed a 5% price advantage to MBO teams in comparing their bids with trade buyers. The main stages of management buy-outs summarised in chapter 2 remain relevant to public sector transactions. In addition there are specific issues relevant to a public sector deal which are discussed below.

Packaging the Business A key feature of most public sector buy-outs is that Newco will rely heavily on income from services provided to the vendor. This is likely to be by way of contract and, in Local Authority buy-outs, it is often the case that the contract to provide services is the principal ‘asset’ being acquired. Such contracts are typically of 5 to 7 years duration, with the contractor assuming the plant and equipment necessary to perform the contract perhaps by way of payment of an upfront sum. In other cases, such as the privatisation of British Rail, substantial assets are transferred but again the viability of the business is dependent on the existence of one or more contracts with public sector or ex-public sector customers. Accordingly, the value of the business will depend heavily on the duration and terms of these contracts. Indeed if the business is to be attractive to the private sector, and hence suitable for an MBO, it may be necessary for the vendor to pay a subsidy over the contract term – a feature seen in the majority of rail franchise transactions.

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The Sale Process Whether a sale of a contract to provide services or a sale of a business, a public sector transaction will be conducted by a tender or auction process, in the former case in a manner laid down by the European Services Directive. A public sector transaction will be a public transaction, possibly being subject to review by the National Audit Office, Public Accounts Committee or District Auditor. Audit Commission advice is that a local authority ‘would generally be in breach of its fiduciary duty to its rate payers/charge payers if it awarded a long-term contract to a management buy-out company without seeking competitive tenders’. EC procurement legislation sets out procedures to be followed, depending on the activity being externalised. By far the most common is the restricted procedure which sets out a two stage tendering process in which at the first stage tenderers are evaluated and only those that pass the evaluation criteria are invited to submit a bid. Thus the following key steps are likely: 1. Advertising of the business/contract in the European Journal (OJEC) and national/relevant press. 2. Registration of initial interest. 3. Issue of application forms and pre-qualification questionnaires. 4. Evaluation of tenderers and determination of shortlisted parties. 5. Issue of invitations to tender/information memoranda. 6. Access to dataroom/opportunity to undertake due diligence. 7. Submission of tender/bid. 8. Selection of preferred purchaser. 9. Contract negotiations. 10. Completion.

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The Buy-out Team Frequently in a public sector buy-out, the existing management team may need to be strengthened in one or more key areas. For example, it may be the case that previously the financial control and accounting for the business was handled centrally in which case an appropriately qualified finance director will be needed to complete the team. This is not a problem providing the need to strengthen the team is identified sufficiently early in the buy-out process to enable a suitable candidate (or candidates) to be found. In cases where external managers join internal managers to strengthen the team the term BIMBO is used – Buy-in Management Buy-out. An issue for any buy-out, and probably more sensitive in a public sector context, is the conflict of interest that inevitably arises if a management team wishes to bid for its business. In order to ensure the best price is obtained for the business and to prevent cries of foul play the vendor needs to ensure that all parties have access to the same information. This is frequently achieved by placing information in a dataroom to which all interested parties have equal access. Furthermore, the vendor must ensure that other interested parties are not unfairly discouraged from bidding for the business by the action of the management team. Accordingly, in some public sector buy-outs the official policy is that on declaring an interest, the leader of the management team should be temporarily put on ‘gardening leave’.As long as existing management behave sensibly, such a policy is rarely implemented in practice as the value of the business being sold will quickly decline if deprived of its key management. Furthermore, it will be in the management team’s interest to maintain a good relationship with the vendor as this will be critical to the future success of the buy-out. Ground rules, however, will be established concerning the conduct of the management team during the bidding process. For example, a representative of the vendor may attend if trade buyers seek meetings with management. Another common feature of a public sector MBO is that the contributors of equity to the buy-out vehicle extend beyond the core management team, perhaps to include a layer of senior management. Indeed it is possible to extend the principle to a significant proportion of or all employees of the business – a so-called management and employee buy-out (MEBO) – either through direct subscription on completion or through some form of employee share ownership plan (ESOP) which provides a market in the shares after completion.

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ADDITIONAL

CONSIDERATIONS

Raising the Finance Raising the finance to support the buy-out bid will largely follow the same pattern as that outlined earlier for a private sector transaction. Management will need to produce a business plan, demonstrating a viable business proposition. Financial projections will need to include all costs of running the business on a stand alone basis, some of which may previously have been lumped together in central management charges or not recharged at all, and some of which will be new costs. Such new costs will typically include audit fees, insurance premia (which may be substantial) and pension costs (see Deal Specific Issues, below). The projections should show growth of the business organically and perhaps through the winning of further contracts. However, any funding structure will need to be supported by contracts in place at completion and not reliant on future contract wins. Funding issues peculiar to public sector deals may include: 1. The need for a performance bond to guarantee performance under the contract.This is, in effect, a risk exposure to the bond provider (usually either the working capital provider or an insurance company) and will be charged for accordingly. 2. Difficulty in banks perceiving security value in the business, given the penalty and default provisions in the contract in the event of unsatisfactory performance. Banks will therefore need to lend on the basis of cashflow and seek comfort from the calibre of the management team (perhaps enhanced by taking personal guarantees). 3. The need to carefully consider an exit strategy for the equity provider.Whilst it may be possible to build up a portfolio of contracts and then sell the business to a trade buyer or float – a recent example being Parkwood Holdings – consideration should be given to structuring a deal with an equity provider without fixed exit horizons who is more willing to consider a longer-term income driven deal. As with any deal, funders who you choose to approach should ideally have relevant prior experience – in this case, of public sector deals.

68

PART

6:

PUBLIC

SECTOR

BUY-OUTS

–

ADDITIONAL

CONSIDERATIONS

Deal-specific Issues A successful management buy-out team is likely to have to address a number of issues specific to the public sector. 1. Deal structure In a public sector buy-out, the acquirer will have no influence over the structure of the entity being acquired – the vendor will have decided whether it will be a contract, a sale of the assets of the business or a sale of the shares of the company which carries out that business.This will vary from case to case – taking British Rail as an example, all activities to be sold were vested into wholly-owned subsidiaries of the British Railways Board and the shares of those companies sold. 2. TUPE The Transfer of Undertakings (Protection of Employment) Regulations 1981 and subsequent legislation mean that employees terms and conditions of employment will transfer with the business activity.This applies equally to the transfer of a public sector contract as it does to a private sector business. In a public sector transaction, employee benefits, particularly in respect of redundancy, may be more generous than for a typical private company and such costs need to be included in management’s projections. However, once the buy-out is completed, the MBO team is free to seek to renegotiate the contracts of employment. 3. Pensions Pensions are an important issue given that, again, public sector schemes are typically far more generous than their private sector equivalents. Whilst TUPE probably does not encompass pensions (this has been an area of great debate among the legal profession), from a business perspective, the last thing a buy-out needs is a disgruntled workforce resulting from a reduction in pension entitlement. One way of addressing this issue is to set up a pension scheme which, although not identical to the public sector scheme, is confirmed by actuaries to be ‘broadly comparable’. However, such defined benefit schemes will be costly and actuarial advice should be taken to ensure a realistic cost is reflected in the projections.

69

PART

6:

PUBLIC

SECTOR

BUY-OUTS

–

ADDITIONAL

CONSIDERATIONS

4. Warranties/Indemnities In many public sector transactions the vendor wishes to transfer, substantially, all residual risk to the acquirer, as a result only very limited warranties and indemnities will be conceded. Of course management must negotiate the best possible deal. 5. Consideration There is likely to be an overwhelming desire by the public sector vendor for the consideration to be in the form of cash payable on completion for the entire business.This contrasts with many private sector transactions where the vendor may retain a small equity stake in Newco ie effectively taking some of the consideration in shares in Newco.

Conclusion In many ways public sector buy-outs are identical to their private sector counterparts, however, there are specific characteristics which need addressing. An experienced advisor will steer a public sector management team to a successful completion.

70

Valuation Models for Pricing Companies

appendix

APPENDIX

Appendix Valuation Models for Pricing Companies

The traditional methods for valuing businesses are explained below. The first point to make on valuation is the author’s belief in the following assertion: ‘Buyers perceive value,Vendors aspire to price’. It is the buyer who needs to take a personal view of value, based on how the buyer will run and benefit from owning the target. On the other hand, at the heart of a vendor’s price perception is an aspiration for top dollar. Therefore, buyers need to examine the findings of the commercial due diligence and the post acquisition planning exercises very carefully before commencing the valuation exercise. Tools of the Trade 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.

72

APPENDIX

Price Earnings Ratios (PERs) A listed company has a price earnings ratio noted everyday in the Financial Times. It comprises the following:

PER

=

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

73

APPENDIX

Financial Times Saturday 1 March 1997 FTSE Actuarial Share Indices

The UK Series

Produced in conjunction with the Faculty and Institute of Actuaries

Feb 28 FTSE 100 FTSE 250 FTSE 250 ex IT FTSE 350 FTSE 350 Higher Yield FTSE 350 Lower Yield FTSE SmallCap FTSE SmallCap ex IT FTSE All-Share

4308.3 4654.4 4697.2 2134.0 2048.4 2227.0 2353.90 2364.78 2107.86

Day’s chge% -0.7 -0.2 -0.1 -0.6 -0.4 -0.8 -0.1 __ -0.6

Feb 27 4339.2 4663.0 4703.3 2146.9 2056.1 2245.4 2356.22 2365.21 2119.74

Feb 26 4329.3 4660.7 4700.1 2142.8 2055.0 2238.1 2353.35 2362.03 2115.81

Feb 25

Year ago

4344.7 4665.0 4704.1 2149.2 2065.8 2239.9 2352.31 2360.19 2121.62

3752.7 4236.4 4256.2 1876.0 1875.2 1881.9 2058.71 2039.13 1852.03

Year ago

Div ytd%

Div ytd% 3.68 3.38 3.46 3.62 4.73 2.51 2.90 3.06 3.56

Net cover 2.08 1.50 1.52 1.97 1.86 2.17 1.66 1.74 1.95

P/E ratio 16.29 24.66 23.68 17.55 14.21 22.91 25.93 23.50 18.02

Xd adj ytd 14.68 10.08 9.96 6.71 3.20 10.49 5.74 5.57 6.51

Total Return 1808.58 1912.0 1934.14 1829.75 1479.54 1571.80 1971.60 1995.05 1834.67

FTSE Actuaries Industry Sectors Feb 28

Day’s chge%

Feb 27

Feb 26

Feb 25

Net cover

P/E ratio

Xd adj Total ytd Return

10 12 15 16

MINERAL EXTRACTION(20) 3978.42 Extraction Industries(5) 4007.05 Oil, Integrated(3) 4080.67 Oil Exploration & Prod(12) 3478.81

-1.0 -1.1 -0.9 -0.8

4016.58 4051.24 4119.46 3508.42

4004.71 4027.19 4113.02 3471.01

3972.24 4023.19 4069.93 3480.05

3284.17 4171.31 3327.65 2247.99

3.76 4.04 3.99 1.56

2.10 2.33 2.08 1.79

15.82 13.26 15.07 44.68

15.36 0.00 20.17 0.00

1750.50 1194.30 1846.82 2109.12

20 21 22 23 24 25 26 27 28 29

GEN INDUSTRIAL(272) 1993.55 Building & Construction(35) 1369.07 Building Matts & Merchs(32)1873.53 Chemicals(26) 2339.72 Diversified Industries 1448.03 Electronic & Elect Equip(39) 2247.75 Engineering(70) 2546.46 Engineering, Vehicles(13) 2854.10 Paper, Pckg & Printing(27) 2513.41 Textiles & Apparel(14) 1076.35

-0.3 -0.1 -0.2 -0.3 -0.1 -0.7 -0.2 -0.1 -0.6 -0.1

1998.90 1369.82 1877.10 2345.72 1449.93 2262.47 2551.72 2856.50 2529.63 1077.10

1969.96 1363.20 1871.16 2341.74 1451.67 2234.82 2532.26 2840.72 2537.39 1076.48

2000.49 1363.57 1875.32 2345.71 1460.77 2271.34 2546.69 2844.08 2543.49 1081.05

2071.66 1105.57 1911.68 2533.87 1788.40 2364.61 2332.54 2645.50 2723.07 1489.95

3.94 3.00 4.25 4.46 4.95 3.48 3.24 3.80 4.14 6.53

1.88 1.70 2.54 1.42 1.61 1.34 2.40 1.71 1.79 1.29

16.81 24.46 11.59 19.75 15.67 26.74 16.08 19.20 16.86 14.81

2.11 1.54 0.44 0.56 4.02 1.22 3.67 0.25 0.00 2.25

1116.59 1170.40 968.48 1136.05 839.83 1194.40 1577.88 1507.59 1072.12 682.45

30 32 33 34 36 37 38

CONSUMER GOODS(85) Alcoholic Beverages(7) Food Producers(25) Household Goods(17) Health Care(16) Pharmaceuticals(18) Tobacco(2)

4093.93 2721.36 2831.70 2865.41 2259.29 6408.50 4488.36

-0.6 -1.3 -1.0 -1.0 -0.4 -0.5 …

4120.47 2756.86 2859.85 2893.61 2267.27 6438.49 4489.62

4111.52 2749.48 2862.99 2933.37 2267.14 6385.93 4556.03

4128.25 2815.97 2864.87 2905.64 2281.30 6391.15 4565.27

3599.54 2800.98 2555.89 2538.26 1954.87 5074.97 4836.87

3.55 4.74 3.84 3.51 2.61 2.67 5.78

1.90 1.87 1.80 2.23 1.89 1.84 2.13

18.55 14.10 18.10 15.95 25.32 25.41 10.18

12.53 31.28 5.07 1.06 4.13 13.45 0.00

1553.19 1019.37 1312.96 1156.92 1398.50 2219.08 1155.83

40 41 42 43 44 45 47 48 49

SERVICES(273) Distributors(30) Leisure & Hotels(31) Media(44) Retailers, Food(15) Retailers, General(53) Breweries, Pubs & Rest(22) Support Services(56) Transport(22)

2676.07 2741.24 3492.77 4319.66 1939.45 2111.97 3409.69 2995.55 2850.59

-0.6 -0.6 -1.0 -0.7 -0.9 -0.6 -0.2 -1.1 -0.2

2693.43 2756.91 3527.39 4349.74 1956.58 2124.25 3416.74 3027.92 2857.54

2691.23 2753.92 3525.51 4342.21 1942.60 2123.55 3415.36 3031.41 2866.78

2701.60 2768.22 3529.23 4384.59 1948.96 2132.18 3422.50 3036.50 2858.60

2337.26 2634.22 2942.46 3852.01 1870.32 1928.86 3003.57 2121.34 2320.81

2.83 3.11 2.55 2.21 4.08 3.09 3.19 1.69 3.38

1.97 1.99 1.66 2.12 2.31 2.02 2.10 2.47 1.26

22.34 20.20 29.45 26.73 13.27 20.03 18.68 29.98 29.44

7.68 0.46 18.16 11.48 4.28 6.94 16.99 1.46 6.35

1423.27 1030.75 1910.63 1586.48 1265.51 1237.86 1681.92 1934.79 1221.23

60 62 64 66 68

UTILITIES(31) Electricity(10) Gas Distribution(2) Telecommunications(8) Water(11)

2704.29 2856.88 1589.76 2274.65 2525.75

-0.9 -0.5 -3.1 -0.8 -0.4

2729.30 2871.96 1640.23 2293.55 2536.41

2730.26 2749.13 2870.41 2875.05 1623.41 1658.74 23.5.42 2322.86 2516.44 2525.55

2479.06 2795.49 1601.05 2039.01 2099.73

4.94 5.89 7.67 3.67 5.89

1.49 2.20 * 1.56 2.31

16.92 9.63 * 21.56 9.18

5.34 22.08 0.00 0.38 0.00

1229.01 1577.97 869.87 1074.00 1460.81

69

NON-FINANCIALS(681)

2153.24

-0.6

2167.21 2162.97 2169.74 1956.63

3.62

1.86

18.51

5.48

1682.75

70 71 73 74 77 79

FINANCIALS(106) Banks, Retail(8) Insurance(18) Life Assurance(7) Other Financial(29) Property(44)

3920.23 5724.84 1728.93 4574.10 3248.06 1896.05

-0.2 -0.3 +0.1 -0.7 +0.2 -0.1

3928.82 5739.58 1726.90 4608.12 3241.29 1898.70

2955.51 4186.33 1482.37 3583.56 2543.04 1450.59

3.55 3.41 4.88 3.52 3.16 3.37

2.36 2.65 2.15 2.13 2.02 1.33

14.92 13.85 11.91 16.67 19.59 27.98

20.47 44.80 4.50 0.00 1.32 2.57

1739.44 1931.21 1343.28 1944.75 1899.50 1200.06

80

INVESTMENT TRUSTS(127) 3330.34

-0.7

3354.51 3354.66 3358.01 3134.95

2.16

1.12

51.74

8.25

1182.62

89

FTSE All-Share(914)

2107.86

-0.6

2119.74 2115.81 2121.62 1852.03

3.56

1.95

18.02

6.51

1834.67

1336.16 1357.96

-0.2 -0.1

1338.41 1337.44 1338.47 1157.05 1359.89 1358.91 1360.46 1158.65

2.90 3.17

0.55 0.49

77.83 80.00

3.28 3.44

1425.23 1450.86

FTSE Fledgling FTSE Fledgling ex IT

3921.81 5743.16 1699.73 4575.76 3247.92 1900.77

3928.05 5748.97 1722.66 4583.31 3215.77 1904.12

74

APPENDIX

The problem with quoted PERs, therefore, is their dependence on share prices. General sentiment in the market can shift a company’s price earnings ratio dramatically during a relatively short period – as evidenced by Bodyshop’s ratio which was in excess of 60 in the early 90’s but stood at around 17 at the end of 1994 as the market corrected its perception of profits flowing through. 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. Discounts of up to 50% of the quoted PER are common in unfashionable sectors and rarity value can generate premiums way beyond the PER of a sector as listed in the FTSE Actuaries Share Indices Table (as shown opposite). The sector averages are calculated by taking the market capitalisation of the whole sector and dividing by the post tax profits of the whole sector. Therefore, if a sector’s profits are low, as in the case of Construction, but the market believes that the sector will recover, thus keeping the share price high, then the PER will look artificially high, ie at a point in time the ‘P’ based on perception in the marketplace is high relatively to the ‘E’, the earnings based on the actual results. As results come through PERs correct themselves reflecting amongst other things the profits achieved. Another useful measurement is the PERs of deals done in the target’s sector over the previous 12 months. As in the FTSE table illustrated, previous deals done are another benchmark to guide acquirers in choosing a sensible multiplier or PER to apply. 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. The next key issue using PERs is establishing a sustainable profit figure pertinent to the acquirer. Set out below is an illustrative example. Firstly, the acquirer will have gathered sufficient information to restate the historical performance of the vendor, for example:

75

APPENDIX

Valuation Example

Commercial Stationery Business £’000

1992

Profit before tax

December 1993 1994

1995

300

400

450

540

Add backs excess directors’ salaries 150 lease costs of second cars 20 bad debt – exceptional daughter’s horse box/ sponsorship 25 overseas buying trips – Brazil 30

150 20

150 20 60

150 20

20 30

30 30

30 30

Less

(25)

(25)

(30) (50)

(20)

(20) (50)

(30) (60)

(20) (70) (60) (40)

480

525

570

rental costs of property stock valuation bad debt provision litigation provision insurance claim

Adjusted profits

580

As can be seen, the owner benefits which will not continue post acquisition are added back to uncover the real wealth being generated by the business. Equally, costs not accounted for by the vendor in the past, which have flattered profits, need to be deducted to establish a more accurate picture of the vendor’s track record. However, the above is only half the picture as acquirers also need to forecast how they will run the business.

76

APPENDIX

The example below illustrates the practical implications of a buyer forecasting potential profits from the vendor.

£’000 Adjusted profits

1992 480

December 1993 1994 1995 525

570

580

Sustainable 550

Adjustments by buyer 1. accounting policies

(50)

2. higher insurance cover

(50)

3. need for qualified FD

(60)

4. cost of services to be provided by group

(25)

5. enhanced buying power – share

100

6. sales force reduction – share

100

SUSTAINABLE PROFITS

565

FULL TAX CHARGE 33% SUSTAINABLE EARNINGS

(186) 379

The level of sustainable profits based on restated historical results is a judgement call and in this instance a figure of £550k is chosen. The post acquisition scenario is then laid on top of this sustainable level to arrive at a level of profits the acquirer believes represents a reliable benefit accruing from the transaction. It is worth noting that acquirers who are not prepared to share some of the upside they bring to the party (lines 5 and 6 in the example) may lose out in competitive auctions. Therefore, under the PER basis an acquirer establishes both a relevant PER and a sustainable profit figure to arrive at a valuation. In the above examples assuming a PER of 7, the valuation is £2.6m.

77

APPENDIX

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. In the above example the calculation would be:

Pre tax profits in year 2, say Initial acquisition price ROI =

565 2,600

£000 565 2,600 = 22%

For comparative purposes with other capital projects this ratio is best kept free from the burden of cost of borrowings.Thus the profits to be used are prior to any funding cost of the acquisition.As an acquirer if you can access low cost finance then that must be an upside to be kept to yourself.

Discounted Cash Flows (DCF) This technique uses the following formula to calculate a Discount Factor: Discount Factor =

1 (1+i)n

where i = the discount factor (the acquirer’s required rate of return) n = the year of the cash flow.

78

APPENDIX

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 target’s cash flows are generating a net present value of zero and the discount rate assumed in your calculation is called the Internal Rate of Return. The example opposite illustrates a DCF technique covering a five year period as applied to acquisitions. DCF Example

Acquisition Price

£2.6 million

Years £000

0

1

2

3

4

5

600

850

936

1000

1000

(300)

(100)

(100)

(100)

(100)

750

836

900

900

Cash generation pre tax Capital expenditure Surplus assets realised

300

Acquisition price

(2600)

Net cash generated

(2600)

Discount Factors

1

600 1

1

(1+0.15) = Discounted cash flow

1

1

0.870

0.756

0.657

0.571

0.497

(2600)

522

567

549

514

448

3

(1+0.15)

1

(1+0.15)

2

(1+0.15)

1

1

4

(1+0.15)5

Therefore Total discounted cash flow at 15% = Zero Therefore, the acquisition which cost £2.6 million has generated, pre tax, certain cash flows over a five year period which equate to an equivalent compound annual return of 15%.This technique, therefore, allows acquirers to compare a range of capital projects to determine the most attractive return. In practice, the weakness with the technique is in predicting the future cash flows of the target. Again, it is difficult to be prescriptive on a ‘good’ rate but a compound rate of return pre tax, as illustrated, of 15% would be a good benchmark. 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.

79

APPENDIX

The issue of which discount rate to use depends on the purpose of the calculation. If the acquirer 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 acquirer 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 equate 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 reviewed 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 round and its assets will continue to diminish 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.

80

APPENDIX

In summary, net assets are one measurement for determining an acquirer’s comfort factor with 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:

Strengths

Weaknesses

1 Price earnings ratios

market rate

no cash effect

2 ROI

good safe target and easy to calculate

no cash effect, broad brush

3 DCF

reflects effect of future cash flows

difficult in practice to calculate future cash flows

4 Net asset backing

determines comfort factor in worst case

may not reflect benefit to buyer

81