About 19801320

With our strong economy projected to continue, should you sell your company now, or wait until after the election?

The Denver Post | BUSINESS

PUBLISHED: November 24, 2019 at 6:00 am

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

_________________________________________________________________________________________________________________________________

Negotiation mistakes that will kill a business sale — a case study

The Denver Post | BUSINESS

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

PUBLISHED: October 27, 2019 at 6:00 am

I recently witnessed a business sale that went “south” and has not closed as a result of mistakes made by the lead negotiator during the negotiation process. A transaction that was supposed to close in Q4 has been pushed back to sometime next year. Below are some of the mistakes made. The lead negotiator DID NOT:

  1. Negotiate the transaction process and deadlines before negotiating the substance of the sale. As a result, with no process deadlines in place, the buyer controlled the momentum and the pace of the transaction process from the outset. Deadlines work. They are powerful because they force action. Deadlines force people to choose either one option or the other. A deadline’s implicit threat is that lack of action has unpredictable consequences.
  2.  Obtain a signed letter of intent (LOI) after providing a comprehensive confidential information memorandum (CIM) to the buyer before he started the negotiations. Had the negotiator clearly established the need for a signed LOI before negotiations would begin, the negotiator would have known the major deal points and well-defined elements of the deal structure.
  3. Establish the price and terms of the deal initially.  By contrast, the lead negotiator allowed the buyer to “anchor” a “low-ball” purchase price and deal structure from the outset. Anchoring is an attempt to establish a reference point (the anchor) around which negotiation will revolve and will often use this reference point to make negotiation adjustments.
  4. Identify the major deal terms (deal points) that needed to be negotiated before the buyer captured control of the negotiating process and anchored the purchase price. In addition, the buyer had developed an acquisition formula that they used in previous acquisitions and made it clear that they would not deviate from most of the formula as it “had worked well” in the past.
  5. Use various negotiating techniques such as “trading off” (“I will give you this, if your give me that”) and limiting concessions without receiving something in return.  In fact, the lead negotiator did not win one deal point from the buyer. As the negotiations drug on, the buyer’s interest level waned and the closing was postponed until sometime next year, if it closes at all.

The following four steps will help prevent those mistakes listed above.

Step 1. Don’t begin negotiations until you have a signed LOI.

An LOI details the buyer’s proposal and gives the seller a first look at the major deal points including very detailed deal terms and conditions. The details of deal terms of any transaction are crucial. I much prefer a detailed LOI vs. a general Term Sheet.  Difficult or contentious issues are flushed out immediately, allowing the seller to plan his/her negotiating strategy. Typical issues are:

  • The amount and length of the escrow hold back for indemnification claims. The typical scenario for a seller is 10% or 20% for 12 months, but it can be longer;
  • The exclusive nature of the escrow hold back for breaches of the Asset Purchase Agreement;
  • The conditions to closing (a seller will want to limit these to ensure that it can actually close the transaction quickly);
  • The adjustments to the price (sellers want to avoid downward adjustment mechanisms;
  • The nature of the representations and warranties. A seller wants materiality, intellectual property, financial and liability representations, and warranties as thinned down as possible;
  • The scope and exclusions of the indemnity;
  • The provisions for termination of the acquisition agreement; and,
  • The treatment of any litigation, if any.

Step 2. Be clear about what your negotiation needs to achieve.

  •  Know the issues that absolutely must be addressed for the deal to close successfully. Some call these deal-breakers or walk-away deal points. Perhaps you have a price you’re not willing to go below. You don’t want to be unreasonable, but if you clarify limits before entering negotiations, you’ll know when to say “yes” and when to say “no”.
  • What’s being purchased. The assets of your business (an asset sale) or your business entity and all its assets and liabilities (an entity sale).
  • The purchase price, which will likely be 70-90% of the asking price.
  • How the price will be paid, including how much will be paid at closing.
  • How the price will be allocated among the IRS-defined asset classes.
  • How to address issues discovered during due diligence, whether through price concessions or actions that rectify conditions of concern.
  • How to handle the transition period, including how and when to contact customers or clients; whether employees will be rehired; how and when the sale announcement will be made; how suppliers, vendors and distributors will be notified; how work-in-progress will be completed; and, how unknown liabilities that become apparent after the sale will be addressed.
  • Your post-sale involvement with the business, including the transition period, compensation, post-sale decision authority, and a non-compete covenant.
  • How contingencies will be addressed/removed, including acceptable transfer of leases, contracts and other assets.

Step 3. Once you begin negotiating details, consider this advice:

  • Use your objectives as steering devices. If you need to concede on one point, negotiate an offsetting advantage on another point, particularly in price negotiations. If you need to settle for a lower price, your advisors can help you balance the concession by structuring the price for greater tax advantages.
  • Do not increase your asking price. You may begin to think your business is worth more than you asked, but don’t try to increase the price during negotiations.
  • Do not get complacent about protecting your interests. By this stage in the game you may almost feel in partnership with your buyer. Still, don’t let your guard down.
  • Do not issue ultimatums or seize one-sided victories. It’s safe to assume if you’ve gotten this far, you both want the deal to close. So, aim for a win-win conclusion by offsetting each of your necessary demands with a compensating buyer advantage. Work together to address the issues necessary to meet both your objectives.

Step 4. Be ready to keep negotiations moving.

Delays are deal killers — especially during the negotiation process. During negotiations you will need to call a few timeouts in order to obtain input from your advisors regarding legalities and tax implications. But, obtain the necessary information in the same day, if possible. Delays either dampen interest or heighten concern – neither of which supports the kind of healthy negotiations that lead to a victorious closing day.

Most of these “Do’s and Don’ts” are basic to the negotiating process, but in the sheer magnitude and emotion of business negotiations, even practiced M&A advisers lose sight of some obvious negotiating techniques that can lead to successful outcomes of a transaction.

Gary Miller is CEO of GEM Strategy Management Inc., a M&A consulting firm that advises small and medium sized businesses throughout the U.S. He represents business owners when selling their companies or buying companies and raising capital. He is a frequent keynote speaker at conferences and workshops on mergers and acquisitions. Reach Gary at 303.409.7740 or gmiller@gemstrategymanagement.com.

RELATED ARTICLES

Gary Miller: Negotiations don’t start until someone says “no”

Gary Miller: Know when to walk away from a deal

Gary Miller: Know what capital structure is and how to use it to grow your business

 

Negotiations don’t start until someone says “no”

Denver Post | BUSINESS

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

PUBLISHED: September 29, 2019 at 6:00 am

Countless books and articles offer advice that can help deal makers avoid missteps at the bargaining table. But some of the costliest mistakes take place before negotiators sit down to discuss the substance of the deal. Sellers fall prey to a seemingly reasonable, but ultimately a false assumption, about deal making. Sellers and their negotiators often take it for granted that if they bring a lot of value to the table and have sufficient leverage, they’ll be able to strike a great deal. While those things are certainly important, many other factors influence where each party ends up.

Three of those “other factors” can have a significant impact on the outcome of the negotiations.

Gary Miller

1. Negotiations start when someone says “no”

One of the greatest inhibitions clients have is risking rejection. This is particularly true in the post-’08 meltdown and continuing jobless recovery from the worst economic period since the Great Depression. Our reluctance to negotiate past “no” is even harder because both men and women miss the key point: Negotiation is a conversation whose goal is to reach an agreement with the buyer whose interests are not perfectly aligned with the seller.  Invite the buyer to your side of the table to figure out how both parties can get as much as each party wants as possible.

2. Negotiate process before substance

A couple of years ago, two co founders of a tech venture walked into a meeting with the CEO of a Fortune 100 company who had agreed to invest $10 million in their company. A week earlier, the parties had hammered out the investment amount and valuation, so the meeting was supposed to be celebratory more than anything else. When the cofounders entered the room, they were surprised to see a team of lawyers and bankers. The CEO was also there, but it soon became clear that he was not going to actively participate.

As soon as the cofounders sat down, the bankers on the other side started to renegotiate the deal. The $10 million investment was still on the table, but now they demanded a much lower valuation; in other words, the cofounders would have to give up significantly more equity. Their attempts to explain that an agreement had already been reached were to no avail.

What was going on? Had the co founders misunderstood the level of commitment in the previous meeting? Had they overlooked steps involved in finalizing the deal? Had the CEO intended to renege all along — or had his team convinced him that the deal could be sweetened?

Upset and confused, the co founders quickly assessed their options. Accepting the new deal would hurt financially (and psychologically), but they’d get the $10 million in needed funds. On the other hand, doing so would significantly undervalue what they brought to the table. They decided to walk out without a deal. Before they left, they emphasized their strong desire to do a deal on the initial terms and explained that this was a matter of economics. Within hours, they were on a plane, not knowing what would happen next. A few days later, the CEO called and accepted the original deal.

The gutsy move worked out for the co founders, but it would have been better not to let things go wrong in the first place. Their mistake was a common one: focusing too much on the substance of the deal and not enough on the process. Substance is the terms that make up the final agreement. Process is how you will get from where you are today to that agreement. My advice to deal makers: Negotiate process before substance.

The more clarity and commitment you have regarding the process, the less likely you are to make mistakes on substance. Negotiating process entails discussing and influencing a range of factors that will affect the outcome of the deal. Ask the buyer: How much time does your company need to close the deal? Who must be on board? What factors might slow down or speed up the process?

Of course, you can’t always get clear answers to every question at the outset—and sometimes it is premature to ask certain questions. But you should seek to clarify and reach agreement on as many process elements as possible—and as early as is appropriate—to avoid stumbling on substance later.

3. Control the frame, the psychological lens

The outcome of a negotiation depends a great deal on each side’s leverage—the better your outside options are and the more ways you have to reward or coerce the other side, the more likely you are to achieve your objectives. But the psychology of the deal can be just as important.

In my experience, the psychological lens, through which the buyers and sellers view negotiations has a significant effect on where they end up. Are the parties treating the interaction as a problem-solving exercise or as a battle to be won? Are they looking at it as a meeting of equals, or do they perceive a difference in status? Are they focused on the long term or the short term? Are concessions expected, or are they seen as signs of weakness?

Effective negotiators will seek to control or adjust the psychological lens early in the process—ideally, before the substance of the deal is even discussed. Here are two elements of the psychological lens that negotiators would be wise to consider.

a. Your alternatives versus theirs

Research and experience suggest that people who walk into a negotiation consumed by the question “what will happen to me if there is no deal?” get worse outcomes than those who focus on what would happen to the other side if there’s no deal. When you are overly concerned with your own alternatives, and especially when your outside options are weak, you think in terms of “what will it take (at a minimum) to get them to say yes?” When you make the negotiation about what happens to them if there is no deal, you shift the frame to the unique value you offer, and it becomes easier to justify why you deserve a higher price or better terms and conditions.

b. Equality versus dominance

Not so long ago I was consulting on a strategic deal in which our side was a small, early-stage company and the other was a large multinational. One of the most important things we did throughout the process—and especially at the outset—was make sure the difference in company size did not frame the negotiation. I told our team, “These folks negotiate with two kinds of companies—those they consider their equals and those they think should feel lucky just to be at the table with them. And they treat the two kinds very differently, regardless of what they bring to the table.” Over the years, I’ve seen many large organizations impose demands on their perceived inferiors that they’d never require from those they considered equals. In this negotiation, I wanted to make sure our counterpart treated us like equals.

In “The Art Of War,” Sun Tzu states that every war is won or lost before it even begins. There is truth to this sentiment in most strategic negotiations. While it would be unwise for negotiators to minimize the importance of carefully managing the substance of a deal, they should make every effort to avoid the mistakes that can occur before the buyer has formulated an offer. By paying attention to the three factors discussed here, you increase your chances of creating more-productive interactions and achieving more-profitable outcomes.

Gary Miller is CEO of GEM Strategy Management, Inc., a M&A consulting firm that advises small and medium sized businesses throughout the U.S. He represents business owners when selling their companies or buying companies and raising capital. He is a frequent keynote speaker at conferences and workshops on mergers and acquisitions. Reach Gary at 303.409.7740 or gmiller@gemstrategymanagement.com.

Popular in the Community

Know when to walk away from a deal

The Denver Post  BUSINESS SECTION

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management, Inc.

POSTED:  August 25, 2019 at 6:00

It was about 4:30 on a Friday afternoon when Matt, the owner of a furniture distribution company, was anxiously awaiting a response to his counter offer from Tom, a potential buyer. Tom had until 5 p.m. to respond.

Tom had sent Matt a fourth revision to a Letter of Intent a week earlier. Up to now, negotiations had been tough. The deal terms and conditions in the last LOI weren’t much better than the previous LOI, but Matt was still hopeful that most of their differences could be worked out. The biggest stumbling block was the purchase price. Tom had offered $2.8 million for Matt’s company – $1.7 million lower than Matt had expected. Earlier in the year, Matt had sought an outside, independent valuation firm to provide him with a certified Opinion of Value. The valuation firm stated that the fair-market value of the firm was $4.5 million.

Gary Miller

Matt was beginning to sense that this deal may not close. He was nervous because only 30 minutes were left before his response to Tom’s last LOI would expire. From a deal standpoint, it was technically dead if Tom didn’t respond by the deadline.

Matt didn’t know what to do. Should he call to inquire if Tom was going to meet the deadline? Or, should he just wait it out and see what happens? So far, Matt and his advisers had spent a lot of time, money and effort to get this far in the negotiations and yet it seemed that little progress had been made. It appeared to Matt that every time the two parties got together, the negotiations felt like a “beat down.” Yet, Matt thought that he “just needed to keep moving forward” – that, in the end, the deal would work out.

In reality, chasing a bad deal, whether from the seller’s or buyer’s point of view, rarely works out, even if the transaction closes. The result of a bad deal closing usually results in a costly mistake. According to a Harvard Business Review report, the failure rate for mergers and acquisitions sits between 70 and 90 percent.Therefore, one of the most powerful pieces of knowledge is knowing when to walk away from a deal. Below are six rules that Matt should have followed when negotiating with Tom.

Establish your “walk-away number” before negotiations begin

Think through the purchase price and the terms and conditions carefully before the transactions process begins and stick to it throughout the negotiating process. “Walk away” simply means the time and place when it no longer makes sense to continue the negotiations. For example, one deal structure that a buyer may propose is called an “earn-out.” Earn-outs favor the buyer far more extensively than the seller. Earn-outs are generally used more during poor economic conditions. If a buyer insists on an earn-out structure in today’s market, that is a red flag and it may be time to “walk away.”

Think like a buyer

Write down what you think is fair — and what is not — before the heat of the moment takes over. If you do this in the context of thinking like a buyer, seeing your thoughts in black and white often tempers your demands. Next, develop the rationale to support what you think is fair. If you do this, you’ll know when deal terms and conditions are going too far out of the range of acceptability and when the deal structure and price is unfair.

Develop the Best Alternative to a Negotiated Agreement (BATNA)

BATNA is a concept developed at Harvard’s negotiation school. Think about what alternative you have if your deal goes south. What will you do if this negotiation doesn’t work out? In the simplest terms know how strong and likely your “Plan B” is. I have a simple saying the drives this point home: “The person that can’t walk away loses.” If you aren’t ready to leave the negotiation table, you are going to lose.

Keep an eye on your walk-away number during the negotiation process

As you get into the negotiation process, always look back to that “walk away number” that you set before the negotiations began. Are we still in the bounds of a possible agreement or is it time to consider leaving the negotiations? How far have we gotten to our goals versus how close we are to the walk away number?

Matt, our furniture distributor, felt compelled to “keep on going” to put this deal together, even though all the signs of a bad deal were there. But he didn’t have a walk away number or a Plan B alternative to move on and find another potential buyer that will be able to justify Matt’s $4.5 million purchase price.

Know when you are acting on emotion

Selling your business is one of the most emotional times in a business owner’s life. It is almost always a one-time event, so it is important to keep emotions in check. The problem is that emotions often come in to play while negotiating and cause owners to push hard for the deal. We have to get that “win”. When emotions take over, both sellers and buyers often strike bad deals.

Reassess, if it doesn’t feel right

If you are in the middle of negotiations and it just doesn’t feel right, it probably isn’t. So, if it doesn’t feel right, think about why you are feeling that way. Write down the reasons and ask yourself, “Am I uncertain about closing this transaction because I lack confidence, or do I actually see legitimate red flags?”

Many studies have shown how perceptive human beings are. Ignoring these perceptions and feelings in a deal will not help you in the long run. Believe in your intuition. Trust that “little voice” inside you. If you see the wrong things preventing the transaction process from moving forward, then back out and start over again with a new prospective buyer. It’s a big world out there and plenty of buyers are looking to buy well run companies. It’s OK to walk away.

Matt did not get a call from Tom on that late Friday afternoon. When Matt and Tom did connect, Tom informed Matt that unless he could agree to his purchase price, he could not go through with the deal. In the end, Tom increased the purchase price by another $200,000 stating that was his final offer. Matt accepted the deal believing that he had no alternative. In fact, Matt didn’t.

Matt falls in that group of business owners who are dissatisfied with the sale of their businesses. According to Gold Family Wealth, more than 50 percent of sellers are dissatisfied with their post-sales results — especially the financial results (including the valuation, the agreed-upon sale price, the tax hit and the residual proceeds).

Having a “walk away number” and an alternative Plan B is key to knowing when to walk away from a deal.

Gary Miller is CEO of GEM Strategy Management, Inc., a M&A consulting firm that advises small and medium sized businesses throughout the U.S. He represents business owners when selling their companies or buying companies and raising capital. He is a frequent keynote speaker at conferences and workshops on mergers and acquisitions. Reach Gary at 303.409.7740 or gmiller@gemstrategymanagement.com.

Know what capital structure is and how to use it to grow your business

The Denver Post

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

POSTED;  August 7, 2019 at 12:31 pm | Gary Miller writes a monthly column for The Denver Post.

Today, many small business owners are trying to sell or grow their businesses in this booming economy. But, more often than not, growth capital is required to achieve an owners’ growth goals. Because of the regulatory environment, many banks are reluctant or cannot lend what their customers need. Therefore, owners have to look for alternative sources of capital. The problem is, many owners aren’t knowledgeable about capital structure and how to use it to meet their goals.

Why is it important to understand a company’s capital structure?

By design, the capital structure reflects all of the firm’s equity and debt obligations. It shows each type of obligation as a slice of what’s called the “Capital Stack”. This stack is ranked by increasing risk, increasing cost and decreasing priority in a liquidation event (e.g., bankruptcy).  For small corporations and pass through entities (LLCs, S-corps etc.), the capital stack is as simple as owners’ common stock/membership interests and senior debt from their local bank.

For large corporations, the capital stack typically consists of senior debt, followed by subordinated debt, followed by hybrid securities, followed by preferred equity (preferred stock) and last, common equity (common stock).

The capital stack is effectively an overview of all the claims that different players have on the business. Debt owners hold these claims in the form of lump sums of cash owed to them (i.e., the principal and interest payments). The equity owners hold these claims in the form of access to a certain percentage of a firm’s future profits.

The capital stack is heavily analyzed when determining how risky it is to loan money to a business. Specifically, capital providers look at the proportional weighting of different types of financing used to fund the company’s operations.

For example, a higher percentage of debt in the capital structure means increased fixed obligations. More fixed obligations result in less operating buffer and greater risk. And greater risk means higher financing costs to compensate lenders for that risk. Consequently, all else equal, getting additional funding for a business with a debt-heavy capital structure is more expensive than getting that same funding for a business with an equity-heavy capital structure.

Medium- and small-business owners are seeking mezzanine financing

Today, many small to medium size business owners are looking into mezzanine financing to achieve their specific goals when bank debt or other senior debt is no longer an option. Mezzanine financing serves as a means to an end. It is not used as permanent capital, but instead, used as a solution-oriented capital that performs a specific purpose and can later be replaced with a more permanent source of capital.

What is mezzanine financing?

Mezzanine financing is a form of junior debt that sits between senior debt financing and equity financing in the capital stack. It is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in a company in case of default. It helps bridge the gap between debt and equity financing and is one of the highest-risk forms of debt.  It is subordinate to senior debt, but senior to common equity.

Mezzanine financing is more expensive than senior debt but cheaper than equity.  It is also the last stop along the capital structure where owners can raise substantial amounts of liquidity without selling a large stake in their companies. Mezzanine financing rates range between 12% to 20% per year.

Often, mezzanine debt has embedded equity instruments attached, known as warrants, which increase the value of the subordinated debt. It is frequently associated with acquisitions and buyouts.

Mezzanine financing can be a useful addition to a company’s balance sheet because it is a source of “patient” capital financing that requires interest-only payments, with no required principal amortization payments before maturity. During the life of the mezzanine financing commitment, a company has time to recover from the significant “event” that drove the initial financing need – be it an acquisition, shareholder buy-outs, growth financing, or other capital needs.

Mezzanine financing provides incremental leverage to facilitate a wide variety of uses. Eight of these are:

  1. Recapitalizations involve raising new capital to restructure the debt and equity mix on a company’s balance sheet. Mezzanine financing is used in this scenario, especially when owners want to achieve partial liquidity and maintain control of their businesses. For example, mezzanine financing can be used in situations where a group of shareholders are seeking partial or full liquidity, while other shareholders seek to remain actively involved in the business.
  2. Leveraged buyouts often use mezzanine financing by purchasing shareholders’ interests, such as a private equity funds or other institutional groups, to maximize their available borrowing capacity at the time of the purchase. Leveraged buyouts are typically completed by companies looking to raise large amounts of capital to support an ownership transition or significant growth event.
  3. Management buyouts also use mezzanine financing when a management team buys out the current owners, such as private equity or other investors, and gain control of the business. Therefore, this allows the management team to determine the direction of the company.
  4. Growth capital is obtained through mezzanine financing to help companies achieve their goals for organic growth, such as significant capital expenditures or constructing a large facility. Mezzanine financing is also used to enter new markets by developing new products and/or subsidiaries.
  5. Acquisitions are often funded by mezzanine financing where companies purchase other businesses with the goal of growing and responding to customers’ needs more quickly.
  6. Shareholder buyouts often use mezzanine financing for family-owned businesses that in order to increase their ownership stake, want to repurchase shares that may have fallen out of the hands of the family or from particular family members.
  7. Refinancings are commonly achieved by using mezzanine financing to pay off or replace existing debt to take advantage of lower interest rates and/or access better terms. Refinancing, using mezzanine financing, adds flexibility to a company’s debt capital structure, better preparing them to seize opportunities like acquisitions and shareholder buyouts.
  8. Balance sheet restructurings often add mezzanine financing to a company’s balance sheet. Doing so can optimize their debt capital structure, helping to fulfill debt requirements for transactions such as acquisitions and management buyouts, while giving the company time to recover from those expenses. It can also satisfy a senior lender’s requirement for a junior capital raise or create additional senior debt capacity for a business.

Mezzanine capital providers are now moving “downstream” into the lower middle-market and small businesses for companies that need raise capital beyond senior debt. Mezzanine capital fulfills an immediate need that supports the continuing success of the business.

Gary Miller is CEO of GEM Strategy Management Inc., a M&A consulting firm that advises small and medium sized businesses throughout the U.S. He represents business owners when selling their companies or buying companies and raising capital. He is a frequent keynote speaker at conferences and workshops on mergers and acquisitions. Reach Gary at 303.409.7740 or gmiller@gemstrategymanagement.com.

RELATED ARTICLES

 

 

When I sell my company, should I consider “rolling over equity” into the buyer’s company?

The Denver Post | BUSINESS

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

PUBLISHED:  June 23, 2019 at 6:00 am

It depends. It is no secret that this year and next may be the best time to sell your company. A lot of money is on the sidelines looking for investment opportunities and buyers are paying premiums for well run, privately held companies. Often, buyers offer business owners an opportunity to roll over a part of the purchase price proceeds into the buyer’s company.

Gary Miller

This is particularly true with many private equity (PE) firms who are searching for companies in the lower end of the middle market space. We see many private equity acquisitions and some add-on deals offering business owners what is referred to as rollover equity. Rollover equity arises when certain equity holders in the target company, including founders and key members of the management team roll a portion of their ownership stake over into the new equity capital structure put in place by the acquiring PE firm. In other words, they sell less than 100% of their interest with the balance becoming equity in the new capital structure.

Equity rollovers generally result in post-transaction ownership by the seller from 10% to 40%. In a 30% rollover, for example, the private equity firm would own 70% of the newly capitalized equity in the business with the seller “rolling” a proportionate amount of value to equate to 30% of the new equity. Most PE firms strongly prefer equity rollovers for seven reasons:

1. Asymmetric information benefits the Seller. The seller has more knowledge than the buyer since the owner has operated in his/her industry over many years. Buyers believe that the acquisition will be more successful with the sellers at the helm.
2. Confidence is built with the buyer. When the seller accepts an equity rollover, it signals confidence to private equity buyers that continuity will be assured, and the interests of the seller and buyer will be aligned.
3. Rollover equity incentivizes sellers to continue to grow the business. With “skin in the game” sellers provide buyers with some comfort that those who built the business are incentivized to continue to grow it since they retain an economic interest in the business.
4. Less capital is needed in the acquisition from the buyers. Since the sellers are investing some of their profits from the sale into the buyer’s business, less capital is needed from the buyers to buy the seller’s business.
5. Alignment between the parties provides the buyer to grow the business in a shorter period of time. This arrangement helps align the seller’s management team to align with the buyer’s management team’s growth objectives since the seller will continue to have “skin in the game” post-acquisition.
6. Seller receives major liquidity from the initial sale of their company. At the same time rolling over a portion of their equity allows them to participate in further upside — a “second bite at the apple” in a second sale by the PE firm.
7. Sellers rolling over equity can defer taxes. From a tax perspective, taxes can be deferred by sellers on the portion of the purchase price that is rolled over into the new capital structure from the seller.

How does an equity rollover work?

Owners contemplating an equity rollover often find themselves facing a new world in terms of capital sources and leverage. Most of our clients have a modest amount of bank debt and a single class of stock (perhaps split among several shareholders/members). Private equity capital structures typically consist of multiple tranches of debt (mezzanine, junior, and senior debt), or one large piece of “unitranche” debt. Also, the structure can include differing levels of liquidation preferences in the equity structure of the capital stack. The increased complexity of the capital stack and the different debt structures are not business characteristics many owners are experienced or comfortable with.

Opportunities

Equity rollovers offer substantial upside, and downside. For example, consider the hypothetical transaction involving an equity rollover with a PE firm. Two brothers jointly own a distribution business. They are considering a transaction with a private equity firm. The enterprise value of their company is $12 million; the outstanding debt is $1 million, and a $2 million equity rollover has been requested from the PE firm. After paying off the debt and reinvesting the $2 million, the brothers pocket $9 million. The new capital structure, post transaction, is 50% equity and 50% debt (a mixture of senior and mezzanine debt), with the PE firm owning 80% and the brothers owning 20% of the recapitalized company. Leverage is implicitly touted as a benefit to sellers considering an equity rollover. The argument is that when the business grows, debt is paid down, and the business is eventually sold to a strategic buyer for a higher price. In this example, the second transaction will yield $50 million for the business. All equity owners earn a return on their investment. In this case, the brothers parlayed their $2 million equity rollover into nearly $10 million.

Risks

Equity rollovers can also bring risk. PE investors generally operate with a more leveraged capital structure than family-owned firms or entrepreneurial firms. While added leverage boosts equity returns, risk increases as well. For the PE firm considering this business as one in a portfolio, the risk/return ratio might be more suitable to the buyers than to the sellers with this being their only investment.

PE firms love to promote success stories, particularly the instances where an owner made more on the second sale than in the initial sale. A seller doesn’t typically hear about the disasters. A seller considering a rollover should ask for the capital structure pro-formas, and detailed financial pro-formas the PE firm has created to support such a capital structure and financial projections.

For those considering a rollover, the following four questions should be asked:

  1. Taxes — Will the transaction enable a tax-deferred rollover?
  2. Corporate governance — What say does the seller have in ongoing strategic, operating, and financial decisions?
  3. References — How has the PE group behaved in partnership with previous sellers?
  4. Debt — Does the higher leverage require personal guarantees of the debt in what will most likely be a more leveraged business?

To roll or not to roll

Our clients are generally entrepreneurs or families who have built successful businesses over many years or decades. When they finally reach the difficult decision to sell, most sellers do not contemplate retaining a piece of the business. It is not because they have a negative view of the business, but because they have poured so much of their lives into their businesses that retaining any involvement — financially, operationally, or emotionally — conflicts with their decision to sell. Those owners should seek a strategic buyer who wants to own a 100% of their businesses.

For those owners rolling over equity need to fully appreciate that while they are partnering with the PE group “buying” their company, the seller’s influence over important decisions may be minimal. Compatibility with the new owner with regard to strategy, expectations, culture and performance metrics are important to asses before becoming partners. It is important to be comfortable with the decision-making rules of the governance agreement. Some PE firms expect a hidden form of return (fees) that often doesn’t show up until the deal is being documented:

  1. Management fees
  2. Finders fees
  3. Administrative fees
  4. Breakup fees
  5. Transaction fees
  6. Origination fees

All the fees above contribute to a skewing of the returns among the parties. PE firms will argue these expenses are non-recurring and therefore shouldn’t affect value in a future sale, but they are real cash expenses that alter the return profile of the two parties. Asking for a complete schedule of proposed fees earlier in the process will reduce unpleasant surprises further down the road.

Getting professional advice in advance and during discussions with PE firms or other strategic buyers is a must if you want to avoid disappointments down the road. So, the answer to the question, “Should I roll over equity in the buyer’s company”?

It depends.

Gary Miller is CEO of GEM Strategy Management, Inc., a M&A consulting firm that advises small and medium businesses throughout the U.S. and represents business owners on how to maximize the value when selling their companies or buying companies and raising capital. He is a frequent keynote speaker at conferences and workshops on mergers and acquisitions. Reach Gary at 970-390-4441 or gmiller@gemstrategymanagement.com.

Sooner or later you will probably want to sell your business

The Denver Post | BUSINESS

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

PUBLISHED: May 26, 2019 at 6:00 am

Every company will need a growth story.

Many business owners come to that point in their lives when they know it is time to sell their company. Whether their decision is due to health, fatigue, boredom, burnout or retirement, the fact remains they want out. At that point, the composite characteristics and attributes of each business paints a picture that is viewed by the business community, competitors, creditors, employees, suppliers, customers and potential buyers. That picture can tell a story of dynamic growth, sedentary stability, or decline. It should be the story of a thriving company culture, perceived opportunity, and growing enterprise value.

More often than not, owners are not prepared for the rigors of a robust due-diligence process brought on from potential buyers eager to hear the “success” story – causing many deals to fail. We advise clients to think like buyers and ask themselves . . . “what do buyers look for when buying a business”?

Gary Miller

When investors screen for and perform due diligence on businesses, they spend an inordinate amount of time analyzing the products or services, market size, competition, pricing dynamics, customer experience, financial history, proformas, and strength of the management team. They do this because these are the important factors that will help them preserve capital and earn an acceptable return on investment.

A strategic business plan including a growth plan need not be about “hockey stick” projections. In fact, it doesn’t necessarily mean getting bigger; rather, it means getting better. And, in that regard, every company should have a growth story showing the ability to analyze and overcome adversity and continue on a positive growth path.

In corporate finance language, getting better means improving the present value of future cash flows. The set of strategic actions should increase cash flows, extend their duration, and/or improve predictability. Changing the trajectory of these factors by making strategic decisions makes the business better.

Seven Actions that Improve Business Value

  1. Strengthening relationships with customers
  2. Diversifying suppliers
  3. Investing in technology to improve efficiency
  4. Putting redundant systems in place
  5. Making customer experiences easier, more efficient, and productive
  6. Accelerating new product or service offerings
  7. Expanding into new channels and geographies for growth or diversification.

Investing in a capable team, efficient processes, and systems that allow the business to operate independently of any one person further achieves the goals and improves the business value. The market place is dynamic, and competition makes it difficult, if not impossible, to generate superior returns on capital indefinitely unless owners and managers watch for growth opportunities.

Growth affects culture, opportunity and value

Orienting a business toward growth can empower the workforce and attract greater talent. Managers take direction from their owners and, without a directive or incentive to “think outside the box”, the future will look like the past. In our engagements, we often encourage owners to install retention plans that incentivize key employees to stay with the company through a transaction.

In almost every case, we find that aligning interests serves as a catalyst for new ideas and creates a sense of urgency. It is no surprise that cost savings are easier to find, and expansion opportunities become more attractive to managers when they perceive that owners are receptive to new ideas. Plus, it is more fun than just repeating yesterday, and that dynamic alone makes it more interesting to employees. Making this a priority ahead of, rather than during a transaction, can help the value accrue to the current owner rather than the new one.

Creating excitement for the future of the business has an added benefit. During the sale process, information is shared through statements of facts (i.e. memorandums, data sites, etc.) and through communication with management (i.e. management presentations). While it is important that the former is organized to position the business positively, the latter offers the best opportunity to form an emotional connection with the buyer. When managers have the opportunity to share their excitement in the future and can inspire a buyer’s confidence, the perception of risk decreases, and the perception of
value increases.

Regardless of how it is expressed, at the end of the day, value is a function of the perceived future cash flows of the business. To illustrate the impact of growth on valuation for example, if a business is growing at 2% annually, assuming $2.5 million in operating profit and a cost of capital of 10%, the discounted cash flow analysis implies an intrinsic value of $21.75 million. Growth in cash flow, either as a result of lower costs, increased prices, or greater volumes, drives values higher.

Developing the growth plan

A good growth plan will separate revenue growth into achievable actions that have been vetted through data and analysis. The plan might include current market penetration, product or service extensions, geographic expansion, complementary acquisitions, or potential price increases. The size of each opportunity and the likelihood of success will only be limited by competition, customer demand, and business infrastructure.

Given the limited resources of middle market or small businesses, the capability to size each opportunity accurately may not exist internally. Using a third party skilled at customizing market studies and consumer research to the specific needs of a business can give owners the valuable information needed to prioritize initiatives efficiently.

Likewise, the cost structure can be affected by focusing on and continuously monitoring the cost of growth. Revenue growth by definition will provide leverage on fixed costs, while pricing, the use of new technology, and process improvements can drive down variable costs. Combined, revenue growth and operational cost improvements drive greater future margins and higher value. Increasing shareholder value is never easy and there is generally no “silver bullet.”

Rather, success requires a combination of initiatives, and by breaking down each of these growth strategies into actions, the numbers or results can follow. Business planning is a dynamic process with no target end point.

Those organizations that prioritize continuous improvement and consistent growth will be best positioned to maximize shareholder value.

As you prepare to sell your business, remember what Rod Stewart said almost 50 years ago. “Every Picture Tells a Story”. As a business owner, you can determine how your business picture will look. The picture you paint will ultimately determine your business’s enterprise value.

Gary Miller is CEO of GEM Strategy Management Inc., which advises business owners on how to sell their businesses or to buy companies and raise capital. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

How to retain employees during the labor shortage

The Denver Post |  BUSINESS

By GARY MILLER | gmiller@gemstrategymanagement.com |

PUBLISHED : April 28, 2019 AT 6:00 AM | UPDATED: April 25, 2019 at 12:52 pm

America’s labor shortage is approaching epidemic proportions. Across the country, more jobs are available than workers to fill them. The unemployment rate has dropped to a nearly two-decade low. Businesses are complaining of worker shortages, arguing they could do more, sell more and build more if they could just find skilled employees.

According to the Department of Labor, at the end of January 2019, the U.S. economy had 7.6 million unfilled jobs, but only 6.5 million people who looking for work. It was the 11th straight month the number of job openings was higher than the number of job seekers. This shortage has translated into higher wages to retain and attract workers, which increases employers’ costs of doing business.

What can a business do to attract and keep skilled employees? In addition to paying competitive wages, many business owners are considering adding retention and performance programs for their most valuable employees. One such program is called a Phantom Stock Plan.

What is Phantom Stock?

A phantom stock program is a form of long-term incentives used by businesses to award employees for improved company value without actually giving away equity. As a result, no dilution occurs for shareholders. It is a type of deferred bonus offered to key employees, where the future payout is tied to appreciation in the equity or market value of the sponsoring company. The term “phantom stock” may be used broadly or narrowly since no formal or statutory definition of the term exists.

Some companies use the term phantom stock to denote any type of plan for which employees must wait until a future date to receive the promised financial value. More narrowly it indicates a plan that is intended to mirror restricted stock awards or stock option grants. In this usage, the sponsoring company creates certain units or “phantom shares” that may resemble actual stock. But actually, it is a commitment to pay the employees cash upon fulfillment of certain conditions such as duration of employment or growth in company value or both.

Phantom stock may also be known by such terms as phantom shares, simulated stock, shadow stock or synthetic equity. Participants in phantom stock plans are expected to view the company’s objectives through the same lens as the shareholders. These types of plans can help attract employees and retain and differentiate a company’s value proposition from its competition. Phantom shares do not result in owner equity dilution because actual stock is not being transferred to the participant.

Seven good reasons to consider a Phantom Stock Plan

  1. Phantom stock helps align goals between business owners and their key employees for growing the business. Most owners want great talent that thinks like an owner and can execute a business plan. If a company is
    focused on growth, employees are the most critical assets for this growth objective.
  2. Phantom stock helps create value by turning other long-term incentive plans into growth drivers.
  3. Phantom stock helps a company compete for employees who have the ability to be growth catalysts for businesses.
  4. Phantom stock plans can retain employees because employees must wait until a future date to receive the financial value of a promise given today.
  5. Phantom stock plans demonstrate fairness because they share value with those who help create it by protecting both the shareholder and the employee interests.
  6. Phantom stock plans are linked to the same business objectives as the owners.
  7. Phantom stock plans form long-term incentives used by businesses to award employees for improved company value. As a result, it is a type of deferred bonus where the future payout is tied to appreciation of the equity, or market value of the sponsoring company.

The term “phantom stock” may be used broadly or narrowly since there is no formal or statutory definition of the term. More narrowly it indicates a plan that is intended to mirror restricted stock awards, stock appreciate rights (SARs) or stock option grants. In this usage, the sponsoring company creates certain units or “phantom shares” that may resemble actual stock but are actually a commitment to pay the employees cash upon fulfillment of certain conditions such as duration of employment or growth goals of the company.

Types of Plans

In general terms, three types of phantom stock arrangements are available. They are not mutually exclusive; a company could have just one type or all three depending on its objectives.

1. Full Value Phantom Stock Plan is a deferred cash bonus arrangement that creates a similar result as a restricted stock plan. The sponsoring company determines a “phantom” stock price through an internal or external valuation of the company. Employees are awarded some number of phantom shares that carry specific terms and conditions. At some point, key employees will receive a cash payment equaling the value of the original shares plus appreciation of the stock.

For example, assume an employee receives 100 phantom shares with a starting price of $10. At a pre-determined future date, the company will calculate the value of the phantom stock and pay the employee the full value. Let’s assume that the share price appreciates to $18. The company will pay the employee $1,800 as a cash distribution. This $1,800 reward is taxed at ordinary income rates.

2. Performance Phantom Share Plan is a type of plan contains two distinct performance-based elements. First, employees must achieve certain pre-determined performance targets. If they do, they are awarded phantom shares. The number of shares may vary by employee and by the degree to which the targets were achieved. Financial targets might include such measures as Pre-tax Income, EBIT or EBITDA.

The second, performance element relates to the potential improvement in value that may come through phantom stock value appreciation. Once awarded, the phantom shares may still be subject to vesting schedules or other restrictions. The tax effect to employees is identical to that of full value phantom stock.

For example, let’s assume an employee receives 100 phantom stock options (PSOs) with a starting price of $10. At a pre-determined future date, the company will calculate the value of the phantom stock price and pay the employee any positive difference between the original price and the appreciated price. Assume the share price grows to $18 from $10. The company will pay the employee $800 (the increased value).

3. A Phantom Stock Option Plan, also known as a Stock Appreciation Rights (SARs) plan, is a deferred cash bonus program that creates a similar result as a stock option plan. As with the previous two plans, the sponsoring company determines a phantom stock price through an internal or external valuation of the company. Employees are awarded some number of phantom options that carry specific terms and conditions. Should the company phantom stock appreciate over time, employees will receive a cash payment equaling the difference between the original price and the appreciated price.

Most business owners and CEOs intrinsically understand the principle, “the more value you help create, the more reward you will receive”. They know that sharing value through long-term incentive plans is essential to capturing the loyalty and commitment of top achievers.

Fairness might best be summarized as follows: Successful companies share long-term value with high performers because it builds trust and confidence between ownership and its employees.

Regardless of which plan(s) are chosen, employers have the opportunity to eliminate or greatly reduce employee turnover among key personnel. The cost of adding these plans are minimal at best. The increase in performance and longevity of employees is self- liquidating when the cost of employee turnover and the increased profits and value added from incremental growth are analyzed.

Gary Miller is CEO of GEM Strategy Management Inc., which advises business owners on how to sell their businesses or how to buy companies and raise capital. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

CEOs of small businesses must take active role in monitoring workplace behavior

The Denver Post | BUSINESS

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

POSTED:  March 24, 2019 at 6:00 am

A little over a year ago, I represented Paul who was selling his business to a strategic buyer from the west coast. His company had 47 employees, was 27 years old, and very profitable. Paul’s company served the food processing industry. The transaction process was going smoothly. The buyer was paying a significant premium for his business and Paul was on top of the world.

About two and half weeks before the closing of the transaction, Paul received notice that he, his company, and Roger, VP of sales, were being sued for sexual harassment. The complaint alleged that Roger, three years earlier, had begun sexually harassing one of his subordinates (Megan) at a sales meeting in Dallas. The complaint further alleged that, despite Megan’s rebuke of each of Roger’s advances, the harassment continued for the following two years, creating a hostile work environment for Megan. She finally left the company, without explanation, a year before it was put up for sale.

Paul was blindsided. He had no idea that Roger had been harassing Megan. However, Paul had been puzzled and disappointed when Megan, a rising star in the company, had resigned so suddenly.

Paul immediately contacted me and his law firm to explain the situation. We all agreed that Paul had to disclose the lawsuit to the buyer, since the lawsuit, now, was a potential liability to the buyer in the future. The closing was postponed until the buyer could decide whether to go through with the transaction. In the end, the buyer walked away.

Paul was now left with a company that would have to defend him and his company in a lawsuit, potentially dismiss his VP of sales, and start all over to find another buyer after the lawsuit was settled.

The subject of sexual misconduct in the work place is dominating mainstream conversations and board room agendas. This crime doesn’t just plague men and women who run large global enterprises, Fortune 500 behemoths, film studios, and media platforms. Small businesses, though not as newsworthy, are experiencing similar situations.

In the U.S., 43 percent of employees work in organizations with 50 or fewer people. It would be a mistake to think that a smaller workforce means a decreased chance of sexual harassment. In fact, a few characteristics make small firms more susceptible. For example, at a smaller firm, people may interact more frequently, and that proximity can provide repeated opportunities for harassment.

Also, many small firms, especially those with fewer than 30 people, do not have formal HR departments. The absence of HR means that CEOs must take more responsibility to keep current and design, communicate, and monitor rules regarding workplace behavior. Another challenge is that without an HR department, more incidents might go unreported, as in Paul’s company.

Aureus Asset Management studied 57 CEOs from small businesses. The majority (70 percent) said they are more worried now about sexual harassment affecting their employees and their businesses than they were a year ago. They attributed this heightened anxiety to high-profile cases and reverberations, coming to light, rather than on any specific incident within their companies.

They worried, and rightly so, that the existence of inappropriate behavior, lurking in the shadows, would damage their office culture leading to poor morale and productivity.

They realized that they must produce a clearly written harassment policy to protect both employees and the firm’s reputation. Twenty of the CEOs acknowledged that they too, are more aware of their own behavior today than in the past.

Small businesses do not actually need an HR department to root out and prevent sexual harassment if management is educated about the topic and:

  1. Looks for factors that lead to a toxic culture, such as having a predominantly male executive staff in power and being indifferent to allegations;
  2. Establishes clear policies (in writing) outlining what constitutes sexual harassment, which behaviors will not be tolerated, and what employees should do if they see or experience misconduct;
  3. Looks for potential signs of misbehavior such as: a. Touching others frequently; b. Women quitting more frequently than men; c. Telling inappropriate jokes continuously; and, d. Drinking too much at company events.
  4. Asks the alleged accused to take a leave of absence until the owner investigates the entire situation and seeks to resolve the problem internally. If seeking resolution internally is impossible, the owner should seek outside counsel.

 

Should the complaint be litigated, sexual harassment claims have two classifications:

  1. “Quid pro quo” harassment: for example, when a supervisor, or an employee in a position of power, demands sexual favors from a subordinate/worker either in exchange for a job benefit, like a promotion, a raise, or to avoid a job detriment, like getting fired or demoted.
  2. “Hostile work environment” harassment: for example, sexual conduct or behavior that interferes with an employee’s job performance or creates an intolerable work atmosphere. The offensive conduct, however, must be “pervasive” or common place.

 

For example, a single “dirty” joke told by a male worker at the water cooler probably doesn’t rise to the level of a hostile work environment. Telling such jokes around the office every day would.

Employers must investigate any sexual harassment claim brought to their attention. If an employee complains about sexual harassment by a co-worker or a supervisor, or even a customer, and management fails to investigate, the company can be liable under Title VII of the Civil Rights Act of 1964.

On the other hand, an employer is liable if one of the supervisors or managers takes adverse action against an employee, such as firing or refusing to promote the person because he or she refused the supervisor’s sexual advances.

How do you protect your employees and company?

The best thing is to have and follow a written sexual harassment policy, which should:

  • Define what constitutes sexual harassment, providing real-life examples;
  • Make clear that sexual harassment will not be tolerated in the work place;
  • State that all claims of harassment will be investigated;
  • Set forth an easy-to-use complaint procedure that designates at least two managers or supervisors to whom employees can address complaints as well as one person outside of management;
  • Require supervisors and managers to report any incidents of sexual harassment;
  • State the corrective or disciplinary measures to be taken for sexual harassment, up to and including discharging the harasser from his job.

Generally, a company will avoid liability under Title VII if it has and follows an anti- harassment policy. The policy must provide a complaint and investigation procedure, and the employee must take advantage of those procedures by following the established protocol. Not only does this protect employers who are dealing with harassment claims, it also discourages false claims from being waged.

RELATED ARTICLES

Almost every CEO of a small company has concurrent goals to grow into a highly profitable business and to create a vibrant and desirable office environment. If a blind eye is turned toward sexual misconduct at work, high financial, reputational, and energy-sapping costs of dealing with a sexual harassment lawsuit will injure the company significantly.

Small businesses can prevent sexual harassment by establishing a healthy internal culture, which means listening, observing and encouraging an open, honest, dialogue among managers, supervisors and employees. The well-being of your employees, thus your company are at stake.

Paul is still fighting the lawsuit. Scores of thousands of dollars and hundreds of man hours have been spent in investigations, depositions, interrogatories, and attorney client meetings and conferences calls. All could have been avoided had Paul anticipated the potential for a sexual harassment situation.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. He can be reached at 970-390-4441 or gemstrategymanagement.com.

 

 

EBITDA: It’s important to understand it when selling your business

Denver Post | BUSINESS

BY GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

Posted: February 24, 2019 at 6:00am | Digital Edition

Most business owners have heard of EBITDA, (Earnings Before Interest, Taxes, Depreciation, Amortization), but don’t fully understand how it can affect the value of a company and the price buyers pay for a business. EBITDA is a financial calculation that measures the financial strength of a company. This calculation is often used by financial analysts, investors and potential buyers when valuing and analyzing potential acquisitions. It a meaningful measure of operating performance as it allows businesses and investors to more fully evaluate productivity, efficiency, and return on capital, without factoring in the impact of interest rates, asset bases, taxes and other operating costs.

By minimizing the non-operating effects that are unique to each company, EBITDA allows investors to focus on operating profitability as a singular measure of performance. Such analysis is particularly important when comparing similar companies across a single industry, or companies operating in different tax brackets.

Photo provided by Mark T. Osler

Gary Miller

EBITDA first came to prominence in the mid-1980s as leveraged buyout investors examined distressed companies that needed financial restructuring. They used EBITDA to calculate quickly whether these companies could pay back the interest on various financed deals. The use of EBITDA has since spread to a wide range of businesses. Its proponents argue that EBITDA offers a clearer reflection of operations by stripping out expenses that can obscure how the company is really performing.

EBITDA is calculated using the company’s income statement of net income (Total Revenue
Minus Total Expenses = Net Income) and adding back interest, taxes, depreciation and
amortization. It is important for business owners to understand this metric when selling their
businesses because many businesses are sold by a multiple of EBITDA (for example, a
business might sell for five times EBITDA).

However, EBITDA alone may not reflect the true value of a company. Therefore, a business owner should add back certain expenses that are categorized as discretionary, extraordinary, and non-recurring. This calculation is referred to as “adjusted” EBITDA or “normalized” EBITDA.

When combing through expense accounts looking for add-backs, keep some questions in mind: Were these expenses necessary for the operation of the business? Will a new owner incur these same expenses?

Below are some examples of typical add-backs for each category:

Discretionary: A primary discretionary expense is how much owners pay themselves in salaries and benefits (“perks”), including salaries and benefits paid to family members. It’s not unusual for business owners to pay excessive (i.e. well above market rate) salaries to both family members and longtime employees. “Perks” such as a personal car, entertainment, travel, life insurance policies, rent expense, or even sponsorship of your child’s little league team are purely discretionary. The amounts for these expenses should be adjusted to fair market or normal levels. Negative adjustments would include filling any gaps in the management ranks such as hiring a new CFO after the transaction is completed.

I recently met an antique dealer who traveled with his wife to Europe four to six times a year searching for antiques. Not surprisingly, the associated travel expenses were significant. Was this a legitimate business expense? Sure. Would it be necessary for a new owner to travel the same number of times with his wife to continue operating the business successfully? I doubt it.

Nonrecurring: These are one-time expenses, including moving expenses, cleanup and repairs from storm damage, purchasing new computer equipment etc. It’s reasonable to assume that these expenditures would not be incurred by a new owner.

While I am a firm believer in the EBITDA metric, buyers and sellers should be aware of the pitfalls of relying on EBITDA as the sole measure of a company’s operating performance. For example, if a company’s performance has varied in recent years, the time period for which EBITDA is calculated could significantly influence the implied multiple.

Consider a company that produced an EBITDA of $200,000 last year, has an EBITDA run-rate of $140,000 this year and is expected to produce EBITDA of $260,000 next year.  A 5x multiple would suggest values ranging from $700,000 to $1,800,000 – quite a wide range. So what EBITDA should you use? The proper EBITDA would be a current “normalized” level of EBITDA (which can require significant analysis to ascertain).

Another weakness of EBITDA is that it excludes “CAPEX (capital expenditures) and working capital requirements.” While EBITDA is often mistaken as a proxy for net cash flow, it is important to remember that EBITDA is not equal to net cash flow. “CAPEX” reduces a company’s net cash flow but is not factored into an EBITDA calculation since CAPEX does not hit the P&L statement. Also, as companies grow, higher levels of inventories, receivables, and other working capital assets are required to support higher revenue levels.

These investments are a use of future cash but are not reflected in EBITDA. Since most buyers look to future growth in cash flow, growth cannot be captured in a static EBITDA or an adjusted EBITDA calculation.

Often, multiples are assumed based on the expectations and experience of business owners and their advisers. While it is commonplace to hear about multiples of 5x to 10x, there are many industries where EBITDA multiples can be much higher or lower. Also, company-specific factors should influence the selection of an EBITDA multiple. Assessing the proper multiples of EBITDA requires in-depth analysis of companies within the same industry, geography, size (revenues, assets, employees), growth rates, margins and profitability.

While an EBITDA multiple can assist in developing a proxy for value, this should be done only after careful analysis of the factors above. In addition, the analysis should be supplemented with a comprehensive discounted cash flow analysis, which can reflect a company’s projected growth in revenues, profits and cash flows.

Finally, be prepared to defend any add-backs that you include in your adjusted EBITDA. Not surprising, discussions about add-backs with a buyer can become contentious. A savvy buyer will expect you to be able to justify each add-back and explain it in detail.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. He can be reached at 970-390-4441 or gemstrategymanagement.com.