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Valuing the Deal: It’s What You Keep that Matters
Insurance Journal, East Region, February 2009
We talk with clients all the time about the M&A marketplace, advising owners on positioning their businesses for the best exit whether they are three months or three years away from transitioning out. Once fit has been determined and price is settled, clients may think the work is “over.” It is true that once the timing is right for a client to go to market, we spend much of our energy analyzing and negotiating deal pricing to get the best results. We haggle with buyers over pro forma earnings before interest, taxes, depreciation and amortization (“EBITDA”), and we go back to them to make the case for why higher EBITDA multiples are justified. We negotiate structure: guaranteed proceeds versus earn-out, stock sale versus asset sale, and many other facets.
Ultimately, three components must align in order for a deal to close: culture, pricing / structure, and terms. As advisors, we will typically justify our fee several times over through our impact on pricing and structure alone. However, more deals unravel over terms than anything else.
We will focus on the terms that generate various kinds of hard costs, holdbacks, and soft costs that are the frictional costs of selling a private business and impact every deal. These often come as “surprises” to our clients who are selling their businesses. Getting our minds around these issues early in the process avoids loss of momentum later; as clients get comfortable with these costs, the resulting net number they should be expecting is revised to a realistic level.
Let’s use an example of an agency with $10 million in net commission revenues, and pro forma EBITDA of $3.0 million or 30%. After negotiations, the parties agree on pricing of 7.0x EBITDA guaranteed (most now, some later), plus an earn-out potential of another 1.0x EBITDA. The many ways earn-outs can be structured have been the subject of many an article, and will not be repeated here. This example implies a potential gross value to the seller of $24 million. While there is some kind of target to be hit over a 2-4 year timeframe to achieve the $3 million earn-out component, it is the maximum number, in this case $24 million, that typically becomes the “anchor” number in the seller’s head. It is important to note this will be the gross amount the buyer is willing to pay for the “earnings power” of the business represented on the income statement.
Now for a walk through the hard and soft costs that will erode this number significantly.
Hard Cost 1: Balance Sheet and Working Capital Requirement
Balance sheet adjustments can include the removal of intangible assets resulting from acquisitions (the buyer can’t count them twice, as the earnings power represented by these assets is already being paid for as a multiple of the income stream). Producer vesting or deferred compensation liabilities can also be significant and often leave balance sheets neutral or even negative. Let’s say our agency has the following simplified balance sheet:
All amounts in $000
Cash $200
Receivables 300
Intangibles 1,000
Total Assets $1,500
Payables $300
Equity $1,200
Since the buyer is paying for the earnings power of intangibles that are already flowing through the income statement, these are removed and the pro forma equity (“tangible net worth”) is now $200k.
Our agency’s pro forma expenses of $7.0 million per year imply average operating expenditures of $580k a month. A buyer does not want to pay you $24 million for your business and then have to inject more money into the business during the first month in order to keep the lights on and make payroll. This is why a working capital holdback is customary. A 30 day working capital requirement in this case would result in a $580k deduction from proceeds. Some buyers start by asking for 60 days, which would be almost $1.2 million. The seasonality of revenues, the margins, and the likeliness that revenues will recur all drive a buyer’s comfort level as to how low a requirement they will accept. We find that 30-45 days is reasonable in most cases.
Using 30 days in this example, recall there is $200k of tangible equity in the business and a working capital requirement of $580k. Though the mechanics are different in a purchase of stock versus a purchase of assets, in either case the buyer will reduce the purchase price received by the seller by a net of $380k to have sufficient working capital in the business on day one.
Hard Cost 2: E&O Tail Insurance
Sellers are responsible for securing their own E&O insurance for incidents taking place after closing. A typical coverage period would be 3 years. A premium in the range of $50,000 to $100,000 for this size business is a small price to pay rather than suffer a claim that could jeopardize the entire pot.
Hard Cost 3: Other closing costs
Hiring competent advisors for the transaction along with legal and tax representation will provide instant return on investment while also dramatically increasing the likelihood that a deal gets done at all. A working assumption might be 3-7% of the total purchase price, depending on the complexity of the transaction and the way the agreements with the various advisors are structured.
Hard Cost 4: Capital Gains Tax
Most deals are structured so that sellers capture capital gains rates above their cost basis. In an asset deal, a buyer will allocate this amount between intangible assets (which are “amortizable” and provide a tax shield) and goodwill, which is not. Capital gains taxes are currently at an all time low of 15% at the federal level. The theoretical best case is that the rate stays at its current level, with the fallback that it reverts back to 20% in 2011. With the inauguration of a new administration this month, it is a good bet that the rate will increase to as much as 25% or even 28%. No matter where it ends up, it is better than income tax rates but will always be the biggest item reducing the seller’s take-home proceeds.
Soft Cost 1: Escrow
This holdback is one of the least understood by sellers. In fact, many become personally offended at the implications of this customary inconvenience. Our favorite answer to the question of “what is normal?” is “it depends.” Let’s use 2.5%-7.5% of purchase price as a range, though prior to our negotiations it might be more like 5-15%. Twelve to eighteen months is a typical timeframe. In 99% of cases, the seller recovers this, with interest. Buyers need this cushion to true up the working capital and make sure they’ve bought the asset that was represented. Still, there is a small risk that some or all of this amount could be forfeited.
Soft Cost 2: Indemnification, Representations, Warranties
Seller clients often ask us why the buyer wants more than just their word that the accounts, relationships, and the entire business being transferred is above board. Anyone paying $24 million for someone’s business would want reassurance that potential skeletons in the closet were vetted. Buyers put themselves at the highest risk when they buy the stock of the selling corporation. Since most agencies are S corporations, most deals are transacted as asset purchases which mitigates these risks for buyers.
Wrongful termination claims, sexual harassment claims, ERISA non-compliance, tax liabilities, and slip/fall claims are just some examples of time bombs that can theoretically come back and bite a buyer. What if an error is discovered by accountants or tax authorities post deal? Consider “knowledge” in the legal context: what if it is alleged the seller knew at the time of sale that two or three of the top accounts would be non-renewing? Whether groundless or not, costs would be incurred in defending these claims. If action were to be taken just after a transaction, the buyer and seller would likely both be named.
What is normal as far as indemnification? For more than one of the public buyers, it is 100% of purchase price paid, jointly and severally shared among all shareholders. An honest seller negotiating in good faith should be able to sleep at night with these terms. However, soft costs can keep even the most ethical seller awake at night until everything is collected and all related agreements have expired.
So, what is left for shareholder(s) after this sample transaction?
In this example, 20% of the total purchase price is lost to adjustments. Obviously the vast majority is lost to taxes, but even so these other items in this example clip several percentage points and several hundred thousand dollars from the deal proceeds.
Bear in mind when you hear “so and so sold for 8x EBITDA” that perhaps 6x or 7x of that was guaranteed, and the rest had to be earned after the closing. Further, realize that every seller incurs some combination and magnitude of the above costs and holdbacks which make up the accumulated frictional costs of selling a privately held business. Being informed about all of these components will help you set a more accurate and realistic goal when you try to decide what your net “number” is. Terms are at least as important as price; good advisors can easily pay for themselves yet again by negotiating the most favorable terms once price has been settled.
Alfonso Ventoso is a vice president with Hales & Co., located in the Hartford, CT office.
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