The phrase “Mergers and Acquisitions” (“M&A”) is most often associated with large deals of the type prominently highlighted in financial publications and featured in general media outlets. However, for every high profile M&A transaction involving well-known, publicly-traded companies, there are dozens of lower profile transactions in the middle-market involving privately-held companies across a broad spectrum of industries. Despite the obvious differences between large transactions and smaller ones, the end goal – to increase shareholder value post-transaction – remains the same. Additionally, many of the strategic tactics employed to reach this goal remain consistent. These strategic objectives include:
- Reaching critical mass quickly;
- Increasing product mix and revenues through cross-selling opportunities;
- Reducing operating costs by capturing “synergies” of the combined entity (i.e. enhanced purchasing power with vendors, elimination of duplicative overhead);
- Reducing cost of capital; and
- Enhancing access to the capital markets.
M&A – Considering the Opportunity
If there are so many benefits to M&A, why aren’t there even more transactions? The answer obviously has something to do with the vested interest of the parties and the relative safety of the status quo but is also intertwined with the basic economic question: is the transaction financeable? Abiding by the time-tested adage, “Cash is king,” cash is the preferred “currency” from the perspective of the selling party (“seller”). Publicly traded companies have the luxury of using their publicly traded stock to effect a sizable portion of the purchase price, with the gap then filled in by additional debt or equity. However, in transactions involving privately-held companies, the currency needed to effect the purchase is generally all cash. In these cases, the purchasing party (“acquirer”) will have to do more leg work, generally needing to secure a combination of bank debt, mezzanine debt and private equity to pay for the acquisition. A number of additional factors also influence the M&A market on both macro and micro scales, including:
- the desire by the owner to retire, especially if there is no family member interested in or qualified to run the business;
- the belief that the company is at its maximum realizable value and, thus, an opportune time to “cash out”;
- the interest by a larger company to shed non-core businesses that do not fit into the strategic plan;
- the desire of a leveraged buyout group or a financial buyer to recapitalize the company in order to exit their investment, after having reached their investment horizon; and
- the pressure from creditors to enact a sale if a company is under financial duress.
Finally, the decision for a seller to put his/her company on the auction block is always an emotional as well as economic one, with questions of legacy, family and personal success intermingled with financial outcomes and return expectations. In other words, a number of disparate and often conflicting components must come together for an M&A transaction to reach its completion.
Determining Enterprise Value
The first step a business owner must take when contemplating the sale of his/her company is to understand and assess its enterprise value. The most commonly accepted valuation method in the investment community is to determine the enterprise value as a “multiple of cash flow” minus outstanding debt, where cash flow is defined as earnings before interest, taxes, depreciation and amortization, or “EBITDA”. Companies tend to command higher or lower cash flow multiples based on a number of external and internal factors, including industry and company growth rates, general market sentiments on the industry group as a whole and the company’s operating leverage and continued sustainability. In determining a valuation multiple, the most common approach is to look at the public equities markets if the company is public, or if private then to review privately and publicly-held companies in the same or similar business sectors to see how these companies have been valued in recent M&A transactions. Privately-held companies are generally smaller than comparable publicly-held companies and are thus more vulnerable to competitive and economic pressures. Therefore, the valuation of such companies are generally subject to a “haircut” or a percentage discount off of the resulting valuation multiple.
Approaching the Market
Next, the owner must determine how best to approach the market. In some instances, the owner will choose to run the sale themselves, often involving the closest confidantes of the company (i.e. its legal counsel and accountant) or family, friends and “country club contacts.” In other cases, the owner will retain the services of a “sell side” M&A advisor, investment banker or business broker. The former approach affords the owner more control of the process and saves them an M&A fee but has the disadvantage of generally reaching a smaller audience. The latter approach is more expensive and puts more control of the process into the hands of the retained professionals but has the advantage of achieving greater market penetration and, potentially, a better price. In either case, the owner of the company has ultimate control, since s/he holds the exclusive right to accept or reject all offers for the company.
Due Diligence and Negotiations
Once potential purchasers start to look at the company, analyzing its historical performance, management, market presence, production and distribution capabilities, future prospects and financial projections, the real action begins. The seller will attempt to justify a higher enterprise value through aggressive projections, while the potential purchasers will take a more conservative tack. A handful of potential purchasers will visit the company to conduct “due diligence” investigations, trying to move beyond the two-dimensional presentation of the company in the offering materials and really learn about what makes the company tick. After due diligence, those potential acquirers interested in moving forward will submit “Letters of Intent”, or “LOIs”, stating their proposed price and terms under which they intend to purchase the company. These letters generally contain a financing contingency and seek an “exclusivity period” during which the seller will refrain from meaningful discussions with any other potential purchasers. The financing contingency makes the purchase offer subject to the buyer obtaining the capital necessary to complete the purchase. Interestingly, letters of intent citing lower prices than competing letters are often accepted because the seller and his/her advisors feel that that one bidder has a higher probability of successfully closing the transaction in a timely manner than the other.
Closing the Deal
If everything goes along according to plan, the M&A deal will likely close within 45 to 60 days, during which there will be periods of intense negotiation and stretches where the seller will need to simply wait for one or more of the capital providers to complete their due diligence and internal review processes. Sometimes these negotiations and review processes go quickly and without a hitch; sometimes they do not, and in those cases the seller will often accept a backup offer or simply take the deal off the market until conditions improve.
Each M&A transaction is unique in its own way but most follow the basic outline laid out above. The process is heavily impacted by overall economic conditions, the conditions present in the industry within which the deal is being done and the markets for senior debt, subordinated debt and private equity.