M&A as Innovation Pipeline for Consumer Companies

By EdgePoint

The largest consumer companies have struggled for many years to grow through internal development programs, despite a sector-wide renaissance in innovation driven by cutting edge manufacturing technologies, big data marketing strategies, and, at a fundamental level, a shift in consumer behavior itself. As a substitute, they have turned outward to external growth strategies such as M&A, which has presented a significant opportunity for smaller companies with the right attributes to achieve exit goals for their shareholders and other stakeholders.

According to a McKinsey & Company analysis of Nielsen data (“From lab to leader”, September 2018) of the food and beverage consumer category from 2013-17, the top 25 manufacturers are responsible for 59 percent of sales but only 2 percent of growth. Conversely, 44 percent of category growth has come from the next 400 manufacturers. Various reasons for this are offered by many consultants and industry experts, from inertia of scale, to entrenched systems to public market earnings requirements. Regardless of which reasons and in what measure they are responsible for this phenomenon, the widely held opinion is smaller, more nimble companies just innovate better.

Give the large companies credit though. They recognize their shortcomings and are trying to innovate through means of mergers & acquisitions, venture/growth arm investments and business incubators, which can all be viable external growth strategies for them depending on their growth and return goals. The number of consumer M&A transactions tracked by EdgePoint over the last nine years is consistently up over 56% on average annually from 2009 recession lows. Most of the largest consumer companies now have formal or are beta testing venture capital investment affiliates or start-up company incubators staffed with both seasoned parent company functional professionals as well as outside investment professionals. Participants include General Mills (301 Inc.), Tyson Foods (Tyson Ventures), Kraft Heinz (Evolv Ventures and Springboard incubator), Unilever (Unilever Ventures), Nestle (Inventages Venture Capital), Kellogg (Eighteen94 Venture Capital), Chobani Incubator and many others. Some are also investing in outside consumer-focused venture and growth capital funds.

Venture/growth investments and incubators give the larger companies unique and often proprietary perspective into the smaller company’s category niche and target consumer behavior. It also gives them a “spot at the front of the line” of potential acquirers if the business prospers and is offered for sale. Despite the widely believed notion that this relationship requires the larger company receive a right of first refusal to buy the smaller company within a specified period of time, often this is not the case. The terms of the relationship are typically much more balanced. From the smaller company’s point of view, the relationship is in effect a valuable opportunity to “model at scale” its business strategy in the market using resources provided by the larger company. The primary purpose behind venture/growth investments and incubators is as a “dry run” on the fit and combination of the two businesses.

By contrast to scaling up, controlling stake acquisitions of later stage innovative businesses by large consumer companies presents an opportunity to exit on favorable terms in a seller’s market for owners of small and middle market consumer businesses. The sector finds itself in a period where the attributes by which consumers make their purchasing decisions are changing rapidly, where new attributes like “purpose-driven” products and services, and “flexitarianism” (a diet rooted in vegetarian principles but with the flexibility to enjoy animal products in moderation – one-third of U.S. consumers now say they are flexitarians) in the food & beverage category, are gaining prominence. Companies that embody these new attributes and can demonstrate penetration of a new consumer niche market will draw extensive interest from strategic buyers with the infrastructure and systems to act as the engine and pathway to growth. Sellers of controlling stakes in these situations can garner strategic multiples near the upper end of the historical pricing range. For example, consumer M&A transactions tracked by EdgePoint show that on average EV/EBITDA multiples over the last twelve months have been in the 12x range (irrespective of size – this figure is skewed by large transactions in excess of $500 million – multiples for smaller transactions are inevitably smaller). Private equity firms play a part in the story as well. Given their overhang of investable funds, in some situations PE buyers will outbid strategic buyers if it can be shown a PE sponsored growth path is nearly as compelling as a strategic one.

Large consumer companies will continue to work at improving their innovation function and, given a wealth of resources to devote, undoubtedly get better at developing new products and services through internal means. But to achieve their growth objectives they will always have a need to look outward at buying, rather than building, cutting edge innovation businesses whose owners have a unique perspective and desire to solve problems and deliver new solutions for consumers. “Big food’s inability to quickly innovate creates continued opportunity for smaller, more nimble brands to disrupt and innovate within the market,” said Jon Sebastiani, founder and CEO of Sonoma Brands and also the founder of Krave Pure Foods which was acquired by The Hershey Company in 2015. “While the landscape has certainly become crowded with these smaller brands, they truly innovative and differentiated brands will continue to excel and garner attention from strategics, propelling M&A activity”. This attention represents a significant opportunity for such smaller companies to monetize in the current M&A market and to achieve owners’ and stakeholders’ exit goals.

© Copyrighted by EdgePoint.  800-217-7149, www.edgepoint.com

Common Financial Deal Breakers and How to Avoid Them

By Paul Chameli,
Managing Director

The strategic fit is well established, there couldn’t be a better complement between the parties. The chemistry amongst the Management team and the buyer is solid and both can envision robust growth together. Customers welcome a combination between the two parties as the merger will create a compelling value proposition. Everything looks great from the perspective of future possibilities as the operational folks talk and explore a combination. But even with this perfect operational fact pattern, the parties are unable to consummate a transaction. What happened?

Often, failed transactions with this fact pattern arise due to a financial disconnect between the parties. While the operational team is very supportive of the transaction, the economics of the transaction must make good business sense to the C-level executives (CEO and CFO). Right, wrong, or indifferent, the earnings of a Target, and the resultant implied valuation, almost always trumps strategic and operational fit. Yes, the qualitative aspects of the business are important and are what creates the interest in the Target; however, it is the financial profile of the Company that determines if a transaction can be consummated.

Disconnect on valuation, misunderstanding about the financial profile of the Target, and / or lack of sophistication in the finance function of the Target are the most common culprits of deal failure amongst middle market private companies. This write-up explores these common deal-killing financial problems and provides suggestions to “to-be” sellers on how to anticipate and cure these defects before they derail the perfect strategic combination.

Valuation Expectations
The most common financial deal-breaker encountered in the middle market is a disconnect between buyer and seller on a fair valuation. With robust M&A activity and public markets trading at record levels, it is easy (and rightful) for Sellers to expect high valuations for their business. It can often be the case, however, that the Buyer universe recognizes the same market dynamic and takes a different perspective – that the good fortunes of the Target cannot last forever. And because investors are buying the future, fear of market peaks translate into an obvious disconnect between optimistic sellers and cautious buyers. Furthermore, Seller expectations can be influenced by what they read in the news and hear from their contemporaries about high valuations -perhaps in other industry (such as technology) and assume that these valuation multiples should apply to their Company.

Of the three financial-related deal-breaker issues, this is the easiest fix – the solution is to hire an investment banker. You have heard us say it before, but the best way to ensure alignment and prevent the disconnect is to have an investment banker help evaluate market possibilities to establish expectations – on both sides. From the perspective of the Seller, the investment banker will calculate the implied valuation from Target earnings and provide the details of precedent transactionsin the relevant industryto establish reasonable expectations. At the same time, a good banker will push the market to the highest levels through a competitive process, help a potential buyer understand the Target attributes and market comparable transactions to support higher valuations, and ensure market clearing to give the Seller confidence that they are looking at the most lucrative offers for their Company. Finally, to the extent that the parties still cannot see eye-to-eye on valuation, seasoned bankers can help parties develop creative structures to bridge any valuation gaps.

Financial Profile
The second most common financial pitfall that contributes to a failed sale process is a disconnect between the parties on the financial profile of the Target. While this can arise through a few scenarios, the most common is a presented financial profile that cannot be verified by the Buyer’s accountant. Reported transactions in the Target financials, such as non-recurring income, delay in payment of expenses, deferred capital investment that is necessary to run the company, and overly aggressive forecast that can’t be supported are all also common scenarios that create an expectations gap between Buyer and Seller.

The solution to this fact pattern can be much more complicated than the first disconnect above. In yet another shameless plug – yes, you need an investment banker to help evaluate the financial presentation from the perspective of a buyer. Even with audited or reviewed financial statements, financial transactions and projections should be reviewed thoroughly and perhaps with the help of a CPA that has experience with “quality of earnings” reviews – prior to disclosure to a potential Buyer. This effort will uncover difficult-to-explain accounting treatment, non-recurring earnings, under-accrual of expenses during the interim periods, or just plain errors and ensure that there is no misunderstanding between the parties on the financial profile. Some of the more common accounting issues that we see from private companies that can have create a disconnect between the parties include –

• Inventory valuation – while a CPA may accept that labor and overhead be expensed as incurred for in process inventory, this accounting treatment may create a disconnect between Seller and Buyer on the expectation of future profits (as future periods will have higher profit than the historical periods)
• Non-recurring expenses – compiling adequate support to prove the non-recurrence of these costs and also proving where these amounts hit the income statement is a necessity to ensure that the Buyer universe gives credit to non-recurring costs and / or owner perquisites. Your investment banker will help you accumulate the evidence to demonstrate to the buyer that these costs are truly one-time in nature.
• Accrued expenses – not uncommon for private companies to “expense-as-incurred” or only accrue a series of expenses, such as bonus expense, warranty, commissions, and other similar amounts at the end of a year and, as such, interim periods may appear more profitable to Seller than to Buyer, creating an obvious disconnect. Performing analysis up front to determine if accruals have been made consistently through interim periods will ensure that the Adjusted earnings of the Company are consistent with the manner in which a Buyer will calculate.
• Expensing of Capitalizable items – this goes the other way. Private companies that are motivated to reduce earnings for tax purposes will likely expense as much as possible. The most common example is to expense repairs and maintenance that prolong the useful life of an asset – these amounts could be capitalized and depreciated over the useful life of the asset. When the Seller proposes a pro forma adjustment for this treatment, the Buyer may undoubtedly be skeptical. The best advice is to similarly accumulate the amount of these costs up front and collect the supporting detail so that the buyer universe can see and accept these adjustments early in the process.

Equally important to the accounting transactions is the reliability and detail of the projected financial statements. Because an acquirer is buying the future of the Target, demonstrating that (1) Management knows the drivers of their business and (2) that their projections can be trusted by function of pre-closing verification of the outlook is critical to create the confidence necessary to close the transaction. There are a couple of best practices that a Seller should employ to create that confidence.

• Interim financial projections – the Seller should publish monthly projections for the current fiscal year, demonstrating through the sale process how the Company is tracking to those projections. These projections should be compiled such that Management team can achieve – or beat them slightly – each month of the marketing phase. We recommend that Managers project their results using a “most likely, optimistic scenario” standard, resisting the temptation to under-promise and then significantly over-deliver on the projections. While the Management team is understandably motivated to project low and beat the projections by a significant margin, the Buyer universe does not typically find that type of forecast to be advantageous – it either suggests that Management is too focused on looking good or doesn’t know their business very well. Neither of those attributes are favorable for a transaction.
• Details – providing a detailed model that illustrates (1) revenue segmentation by customer, product line, geography, customer channel, and other meaningful driver of the business; (2) profitability by each of those segments; and (3) the operational factors that contribute to success (i.e., miles driven, production units, sq. ft. produced, etc.) will enable the Buyer to see that the Management team knows the factors that drive the business – and at the same time, also be able to correlate the operational metrics with financial results. And this analysis will also provide the Buyer with the macroeconomic data points for which to build an investment thesis and forecast expectation.
• Macro-economic support – To the extent the Management team can collect or has access to this information, we recommend that a Seller provide the Buyer universe with any industry reports or analysis that supports a positive outlook for the future. But more importantly, the Management team should be ready to explain why their forecast exceeds or underperforms relative to the overall industry growth. If demand for a certain product is projected by analysts to grow 4% per year, Management must be ready to substantiate their 15% growth forecast.

Integrity of the Financial Function
The third most common financial pitfall we encounter in stalled transactions is a lack of sophistication in the financial function of the Company. Many private companies do not invest significantly in deep accounting and financial talent, opting instead (and rightfully so) to invest in development, equipment, or customer support resources. However, when professional investors or large strategic buyers intend to invest millions of dollars into a Target, a lack of financial integrity can be problematic. So what is a level of financial sophistication that will be viewed as adequate to a sophisticated buyer, but at the same time not divert cash from what can actually add value to the organization? While we don’t think middle market private companies need to have a Wall Street-caliber finance department, there are some suggested “must-have” capabilities in your finance function to ensure a smooth transaction.

• Revenue and profit segmentation – at a minimum, we recommend that the Company be able to present its revenue and profitability by product / service, customer, and by delivery channel. Ideally, the ERP or accounting system will track this data on the face of the income statement (or subaccounts) through GL categories for each segment. It is very common that an investor will want to understand concentrations of revenue and profitability, and the absence of this basic information is adequate to raise enough doubt about the transaction and ability for the Target to integrate into the Buyer organization.
• Monthly closes – we recommend that the books of the Target be closed each month, that the results be reportable within two weeks, and that all balance sheet accounts (except Tax accounts) be updated each month. While it is certainly possible to close a transaction without this, sophisticated financial investors and strategic buyers increasingly view this as a necessity to ensure a smooth integration into their organization.
• Business Drivers – we view an understanding by management of the basic operational drivers of the business to be a necessity for sophisticated financial investors. Whether the measurement be the number of units, sq. ft. produced, billable hours, pounds delivered, hours rented, or any other operational metric, it is worth the time and investment to accurately collect and track these operational metrics for review by an investor or buyer. Not only does this information help demonstrate that the Management team understands what contributes to the success of the business, this data will essentially answer most questions on the revenue mix of the business. Furthermore, good operational data, when matched with industry data, can be support for future revenue projections. For example, if the Target’s increase in revenue is linked to new aircraft delivery, the buyer of the Target can use published data on new aircraft deliveries to substantiate the Company’s projections.

While not a comprehensive collection of all financial matters that should be considered to reasonably ensure that a transaction doesn’t derail, the above are helpful guidelines for a Seller to consider as they prepare for interactions with sophisticated financial and strategic buyers.

© Copyrighted by EdgePoint. Paul Chameli can be reached at 216-342-5854, by email at pchameli@edgepoint.com or on the web at www.edgepoint.com

Recession Concerns? A Time to Plan

Russ Warren,
Managing Director

Storm Clouds?

As the U. S. economic expansion approaches a decade in June 2019, the R-word is weighing on the minds of many business owners and CEOs. Today’s economy has been likened to a close baseball game in the 8^th. Will it go into extra innings?

In the third quarter of 2018, EdgePoint spoke with Alexander Cutler, former Chairman & CEO of Eaton Corporation Plc, who framed the economy like this: “We are in one of the longest economic expansions since World War II, yet overall inflation is benign and we are not seeing protracted labor inflation. There do not seem to be ‘bubbles’ in real estate or stocks. Commodity prices are expected to surge, and copper did heat up but has now cooled off. Mid-cap and large-cap stocks are doing well. Will it last into 2019; into 2020? Most concerning to me are trade conflicts. We have never taken on Canada, Mexico, Europe and China all at the same time. Other countries have elected uber-nationalistic leaders. We can’t say where it is going.”

Two surveys – by CNBC and Gallup – were conducted in January and February of 2019. CNBC found 53% of the 2,200 small-business owners they surveyed across the country expect a recession in the next year. Gallup found U. S. small-business owners’ optimism, while still strong, has declined from its record high in late 2018 to where it was from Q3 2017 through Q2 2018.

In my 40-year M&A career, I have experienced a double recession in 1980 and 82 from within a Big 4 accounting firm, then in 1990-91, 2001 and the “Great Recession” of 2008-09 as a business owner and managing director of small firms. Very different experiences. In those trials-by-fire and the months leading up to them, I observed that some companies took no proactive measures, while others strengthened their long-term situation or pulled off a successful transaction. What made the difference? I would say “awareness and preparation”.

What can owners and managers do to come through a recession with the best outcomes?

Before a Recession is Imminent – A Time to Watch and Plan

• Study current data about economic health and trends, and continuously track ‘leading economic indicators’, which foretell changing conditions before they are generally noticeable. One source is theConference Board Leading Economic Index: An example (from March 21, 2019) is: https://www.advisorperspectives.com/dshort/updates/2019/03/21/conference-board-leading-economic-index-expanding-in-near-term Another source of useful data and charts is the Federal Reserve Bank serving your region (which reflects the mix of area businesses).
• Review your company’s revenue, profit and working capital performance in the last recession and reflect on the effectiveness of actions that were taken and results obtained. (Coulda, woulda, shoulda.)
• Conduct a financial ‘stress test’, much like banks do, to see how your company might perform with a 10%-20% drop in business or loss of a major customer.
• To be able to react quickly should the need arise, create a detailed and very specific cost-cutting plan for a revenue drop of 10% (or other decline). If if requires that employees must be let go, name names in the plan, then lock it in a drawer.

During a Recession – A Time to Mow – or Sow?

• Execute your plan sooner than later, cutting fat but protecting muscle. I’ve seen anecdotal evidence that a business with a ready-to-go plan can act smarter and faster, minimizing the negative effects of a recession.
• Consider offensive/positive moves to improve long-term competitive position if conditions permit. Good employees become available in hard times to fill a void or upgrade a position. Customers come ‘up for grabs’ as your competitors struggle. ‘Gently used equipment’ comes on the market at bargain prices. And so on.
• Remember, the Chinese symbol for “crisis” consists of two characters – one means ‘danger’ and the other, ‘opportunity’.

And Now – A Time to Reap?

A special situation, of great interest to our firm, is the owner who plans to transition the business within three to four years but fears a recession will intercede to destroy value or defer the plan. What to do?

In a previous article, Aligning the Stars for Exit, we discussed aligning the three ‘stars’ or elements that enable a business sale to maximize shareholder value. They are: owner needs, strategic business needs and the macro environment – the U. S. economy and industry conditions. All should be considered.

Owners’ needs include controllable events like retirement, estate planning, and pursuit of other interests and non-controllable concerns (e.g. health-related). Controllable events can be aligned with business needs and the macro environment. Owners may temper the impact of non-controllable events by planning techniques such as a leveraged refinancing to take chips off the table while continuing the journey.

Business needs reflect the unique competitive and marketplace requisites of the business to thrive in its environment – achieving profitability, consistent performance and growth. Perhaps a financial investor/partner is needed to best ride out the “crisis”.

Because owner needs and business needs are on-going, middle market mergers and acquisitions occur during all phases of the business cycle, unlike large transactions driven by stock prices of large public companies, which dry up in a downturn. However, there are costs to selling during a downturn and for several years thereafter.

We are today seeing buyers ask how a business did during the last recession (ten years ago). The response and its supporting data affects the price and terms they offer.

Price is determined as a Multiple of EBITDA. In a seller’s market like we enjoy currently, multiples have risen by 1.5 to 2 (or more) turns from recession levels. EBITDA usually drops with reduced revenue, so in a recession, price takes a double hit. If many buyers decide to wait out a downturn (they may also need to fix the businesses they already own), the seller’s price advantage disappears. It becomes a buyers’ market. Today’s transactions tend to be cash heavy. To obtain a full price in a downturn, expect cash to be less, and the rest to be earnable in a contingent payout – IF pre-agreed profitability is achieved, which can be a steep hill to climb.

Timing becomes increasingly important if you believe a recession will negatively affect your business. Many people don’t understand that an effective full sale process (in contrast to negotiating with one or two buyers already at the table) will take at least five or six months from the time an investment bank is engaged and may take nine months (or longer if there are due diligence problems, for example).

What should you do if you think a recession is one to two years away and your intent is to transition the business within three to four years?

Consider moving up your timetable or decide to hold for another four to five years, the time it typically takes to regain a company’s valuation in a seller’s market. The most frequent costly mistake I’ve seen owners make is waiting too long. From experience, when a seller’s market like we are enjoying deteriorates, it happens quickly. If I were a typical middle market seller, I would rather be “in market” (having buyers called on my behalf) in the first half of 2019 than in 2020. My crystal ball does not have 2020 vision.

© Copyrighted by EdgePoint. Russ Warren can be reached at 216-342-5859 or on the web at www.edgepoint.com.