Selling the Story

By Tom Zucker,
President

The famous 1920’s quote by Elmer Wheeler, “People don’t buy the steak, they buy the sizzle” emphasizes the importance of appealing to the senses and emotions of the buyer to induce a desired action. The “sizzle” is especially important when convincing M&A buyers of an opportunity associated with an acquisition. The sharing of the facts surrounding a seller’s business is expected in a transaction but demonstrating the true synergistic opportunity for the buyer is ideal. The professional story teller who can sell the unique aspects and unique positioning of your business is a priceless M&A advisor.

Every business has a story to tell, but who should tell the story? For example, if I ask an accountant, they will share your financials and pontificate on the historical performance of your business. Stories that are retrospective and solely fact-based are often not truly representative of the premium value your business represents to a strategic buyer. The reality is that your business is multi-faceted, complex, and compelling from many perspectives. The story teller needs to reference the company’s facts and the past performance, but more importantly sell the strategic opportunities. The right story teller needs a diverse business background, the ability to identify and convey hidden value, and the credibility to ensure the message is not only heard but believed. Therefore, professional business sellers, such as private equity firms, as well as private business owners frequently utilize capable investment banking firms to tell their story and achieve above market valuations.

So why tell a story? So why not just share your legal and financial documents with a buyer? The simple answer is that premium buyers buy future cash flows. The nuance to this statement is that future cash flows may be different for every buyer. It is the investment banker’s job to uncover these hidden value drivers and build a compelling story for each buyer. This requires deep business and industry expertise to develop and convey these unique buyer story lines. The bridge to the company’s future financial performance and the historical numbers are essential to building a compelling story and enabling a buyer to pay full price for your business. The hectic pace of most corporate development professionals necessitates the investment banker clearly highlight and illustrate the synergistic opportunities that your business represents for the buyer. These sophisticated buyers need the story teller to provide the “sizzle” to justify the investment of their limited time.

Experienced story tellers can support their stories with successful and impressive outcomes. The following are just a few stories to illustrate the impact of a proven M&A advisor such as EdgePoint:

• The fintech business that had break even profitability that sold for 5X revenue required a story about the buyer’s cross-selling opportunities with the seller’s Fortune 500 clients.
• The industrial manufacturing company products were well positioned to complete the large buyer corporation’s product suite. The buyer’s fear of international competitors entering their markets needed to be emphasized and enlarged. The positioning and competition were important to above market purchase multiples.
• The business just emerging from a turn-around situation who had not realized their full economic potential required a story to sell their business for a high multiple of projections two years out rather than historical performance.

The accountants and attorneys play an important role in supporting the bridge. From an M&A perspective, the continuation of the past is fine, but we are more interested in what unlocked potential cash flows and value may exist. For example, a valuable patent which has been successfully leverage in your industry may have immense value if another entity can exploit this technology patent over a broader set of industries. How valuable is this patent to a larger organization with more established sales channels? In this situation, the value equation of two plus two might actual be higher than 4. This is one reason why a story teller is critical to bringing buyer interest but more importantly conveying to the buying market the full potential of your business.

Selling the “sizzle” is more than just fast talking and impressive word choice. It is developing and selling a compelling future for a business acquisition. If done well it can be lucrative and transformative for both the buyer and seller. As you build out your advisory team during your pre-sale planning, ensure that your team has a proven story teller.

© Copyrighted by Tom Zucker, President of EdgePoint Capital, merger & acquisition advisors. Tom can be reached at 216-342-5858 or on the web at www.edgepoint.com.

Leveraging the Letter of Intent

By EdgePoint

You’ve just spent months preparing your business for sale. Completing lengthy diligence request lists, developing complex financial forecasts, creating extensive marketing materials, reviewing IOI’s, and spending time in management meetings and Q&A sessions with potential buyers. The amount of time and energy invested in the process has been great. But you’ve finally reached the apex of your negotiating power – the LOI.

The letter of intent (“LOI”, sometimes called the “term sheet”) serves as an outline of key provisions and is used to help facilitate the preparation and negotiation of a definitive purchase document. A non-binding LOI is often negotiated in good-faith, meaning any deviations from the terms stated in the LOI typically require justification.

In most circumstances, the LOI represents the last opportunity for the seller to fully exert his or her bargaining power in the transaction. This loss of leverage results from an “exclusivity-clause”, a common LOI feature precluding the seller from speaking with any other interested parties. Once an LOI is executed, a seller’s negotiating power often diminishes.

Private equity groups and other sophisticated buyers have a great deal of experience in utilizing an LOI to defer specific language on key transaction points. These groups will intentionally keep language on key issues vague in the LOI to preserve flexibility in drafting a final purchase agreement that weighs in their favor. Key phrases often used to preserve buyer flexibility include:“to be mutually determined”, and “subject to customary exceptions” or “obligations which are reasonable for transactions of this size and type.”An experienced advisor will guide their client by inserting specific, comprehensive language covering key negotiating points.

A common practice used by a transaction advisor is the comparison of key features of each bidder’s LOI to reveal potential shortcomings. By identifying unclear or ambiguous terms to relevant bidders, the advisor seeks to improve specific LOI terms within the backdrop of a competitive bidding process. This aids in negotiations and often works to improve key transaction terms.

Key terms such as transaction structure, working capital, financing arrangements, indemnification obligations, and deal timelines can often be modified to preserve transaction leverage in the seller’s favor.

Transaction Structure

A seller usually prefers a stock deal as it typically affords the most favorable tax treatment. Buyers typically prefer an asset deal, which gives them the ability to “cherry pick” preferred assets, avoid corporation specific liabilities, and provides them with a stepped-up basis on assets, producing a lower taxable gain in the event of a future sale of those assets. A well-informed seller with a clear picture of proposed tax implications resulting from both an asset sale or a stock sale is encouraged to specify the preferred transaction structure while negotiating an LOI.

Another important piece in negotiating the transaction structure is to clearly define which entities will be involved in the proposed transaction. Sellers must define the specific legal entities that will be involved in the transaction, along with the potential for the sale of any related real estate holdings. By having a clear picture of which entities will be involved in the transaction, sellers can achieve greater clarity in the allocation of purchase price amongst their portfolio of holdings.

Working Capital
A seller often has the most leverage in negotiating a favorable working capital outcome prior to signing an LOI. Under ideal circumstances, both parties would be able to agree upon a working capital target at the LOI stage. In the absence of an agreed upon target, both parties should at least agree upon a working capital methodology which defines the working capital accounts to be included in the working capital calculation. A common methodology is for buyers to agree to the target being determined by using trailing twelve month working capital average.

Financing Arrangements
When a transaction involves financing leverage, sellers should encourage buyers to provide potential financing commitments to improve the certainty of fulfilling funding obligations. The sources and timing of approvals for finance should also be disclosed to better assess the likelihood of closing.

Indemnification Obligations
The buyer of a business may offset a portion of potential risk related to breaches of seller reps and warranties by asking the seller to hold-back, or escrow, a percentage of the total transaction value. This enables the buyer to file a claim against the escrowed amount to recoup a portion of the purchase price if a material breach is found. The seller should seek to clearly define the amount required for escrow (usually 5-10% of the purchase price), the survival period of escrow (typically between twelve and eighteen months), and a quantification of specific fundamental representations during the negotiation of the LOI.

Alternatively, sellers and buyers can agree to use reps & warranties insurance in lieu of an indemnity agreement that requires escrowed funds. Reps & warranties insurance can provide the benefit to the seller of receiving a greater amount of purchase price at closing while reducing legal costs, collection concerns and increasing the indemnity period.

Deal Timeline
To prevent the disclosure of confidential information on a contemplated transaction to employees or key customers, a transaction advisor needs to be aggressive in negotiating a defined timeline for site visits, management discussions, and customer discussions. By having a pre-approved timeline, the seller minimizes unintended disclosure. The clearly defined deal timelines reduce the risk of disruptions in customer and supplier relations, employee satisfaction, and workforce morale. A speedy and efficient deal timeline is critical in limiting the chances of renegotiations, and often works to provide greater certainty of close.

Conclusion
For the seller, the LOI often represents the apex of his or her negotiating leverage in a transaction. Seeking the counsel of an experienced transaction advisor who can guide the seller in negotiating key transaction terms is critical in structuring the LOI to ensure a speedy deal timeline, reducing the risk of renegotiations which can erode value, and maximizes financial value to the seller.

© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com

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MBA 101- Basics of Synergy in a M&A Transaction

By Paul Chameli,
Managing Director

The increased prominence of Private Equity investors and their valuation approach has created a simplified approach to business valuation in the marketplace. Once extensively grounded in a detailed consideration of discount rates, future assumptions about cash flow projections, and appropriate assumptions regarding terminal values, conventional valuation tends to be more focused on valuation multiples of EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). While perhaps adopting this approach to valuation is better for purposes of efficiency, this mindset has the effect of causing sellers and even their investment bankers to take their eye off a critical element of financial theory that can have significant impact to valuation – synergy opportunity. When synergy opportunities exist for a strategic buyer of a Target – or a financial investor that has an existing portfolio company for which the Target can be affixed – the Target has higher intrinsic value to the strategic buyer. As a result, the strategic buyer can in theory pay more to acquire the Target since the benefits are higher than the reported earnings of the Target.

Considering this clear benefit, Sellers and their investment bankers should focus on developing a synergy hypothesis that can be communicated to potential buyers and financial investors. While sophisticated buyers and investors are acutely aware of, and actively seek out these synergy opportunities when pursuing targets, demonstrating to the buyer universe that the Seller is aware of synergy potential will establish the expectation that the benefits of these synergies be inherent in the valuation of the Company.

This write-up is a refresher on common categories of synergy that are available to, and form the basis of, M&A motivation and value creation.

Synergy Opportunities

Cross-Selling

The most common synergy opportunity sought by strategic buyers in an M&A transaction is the opportunity for cross-selling. This is a generally well-understood synergy opportunity, but not one as often communicated by Sellers to Buyer candidates. Cross-selling is, as the name implies, the ability to sell the Buyer’s product to the Target’s customer and vice versa. A strategic buyer will often consider if there are “bundling” opportunities, or the ability to package up multiple logically adjacent products in one package and as a result offer a value proposition to the customer in terms of overall value and perhaps better pricing.

Another common associated synergy with cross-selling is the ability for a sales person with a customer relationship to manage a greater number of products with that one particular customer. So, for example, a pharmaceutical salesman for Pfizer visits a Doctor to present product. As that salesman is walking out the door, a salesman for Merck Pharmaceutical walks in to see the same Doctor. If Pfizer and Merck were to combine, the first salesman could in theory handle both product lines and either rationalize or repurpose the other salesman.

Geographic Presence

Related to the above, but a big enough consideration to warrant its own category, is synergy achieved by localized presence. Because or cultural differences and customs, it may be difficult for an American company to sell product into Germany, or vice versa, without a local on the ground to “vouch” for the foreign company. Because customers tend to buy product from local country personnel, the acquisition of a Target with established local distribution and a local brand is viewed as an opportunity to achieve sales that the Company would not otherwise achieve without the local presence.

New Distribution Channels

Further related to cross-selling is the opportunity for a Buyer or Target to achieve access to a new distribution channel through a combination. Often employed by consumer oriented industries but increasingly employed in other sectors, this motivation gives the Buyer or Target another medium for which to sell product. For example, a brick and mortar retailer that acquires a company focused on e-commerce, or vice versa, has the clear motivation to capitalize on multiple forms of purchasing behavior. In the industrial application, a combination may give one company that has exclusively sold through independent sales representatives (“ISR”) access to a catalog or network of stocking distributors to sell their product, while at the same time allowing the Buyer to access new channels themselves through the ISR network of the Target.

Operational Cost Savings

A significant driver of M&A in the 1980’s, due in large part to bloated middle management ranks, the idea of synergy from significant operational cost savings has largely dissipated in recent decades. Some of this is the result of the fact that many companies operate much leaner than they did in the 1980’s, the fact that technology has already created a lot of those savings, but also because M&A strategists have learned their lesson from the disasters of 1980’s combinations. In those days, large holding companies attempted to overlay a common operational infrastructure over a number of companies, many of them in unrelated industries. Remember Beatrice? Companies like this would establish a common platform for all of its companies, including accounting, customer service, purchasing, etc. This didn’t work as well once business managers learned that operational functionality needs to be tailored for the uniqueness of a business. Most strategic buyers nowadays acknowledge that the operational back office gives the organization a solid backbone for success and that it has to be tailored.

With all of that being said, there are operational cost savings that are commonly sought by strategic buyers – but these are smart strategies that don’t disrupt the operational fabric of the Company. We most typically see strategic buyers attempt to reduce costs through greater purchasing power with vendors or suppliers. Insurance and raw material purchase savings, for example, are achievable when buying in bigger volumes.

Production Synergies

While offshoring to a low-cost country (“LCC”) has been over the past 20 years the biggest operational synergy, a focus on domestic manufacturing in recent years has created a series of new and interesting synergy opportunities, including commercialization of new technologies, domestic production capabilities, ability to capitalize on Buy America credits, and ability to capitalize on excess capacity.

A benefit possessed by a smaller and more nimble organization is its ability to quickly evaluate, commercialize, and integrate new emerging technology into its organization. While larger strategic buyers certainly have the resources to acquire these sort of technologies, they are often not as agile in their integration. For this reason, we often see the expertise in these new technologies as a compelling synergy opportunity for strategic buyers.

While facility consolidation had been a common synergy opportunity, in this environment of limited production assets in the United States we see more often that strategic buyers seek opportunities to push more production into acquired facilities. Or often a strategic buyer who has a history of outsourcing non-core production will seek to preserve the margin loss by moving the production to the acquired Target. While vertical integration has questionable merit in most industries, it can be a synergy benefit that otherwise justifies an acquisition or can enable for higher pricing.

Vertical Integration

While the benefits of this have been debated for many years, vertical integration is a possible synergy category for strategic buyers. Vertical integration, owning either a supplier or a customer, is generally an attractive investment for operations managers who worry about managing the cost of their production supply or want to ensure that they don’t lose a customer. While that seems like a great rationale from an operations strategy, the availability of benefits from a financial perspective are generally absent so long as there is an ability to continue to do business with the customer or supplier. If a company can continue to sell product to a customer, what benefit is there to owning the customer – the only benefit is to prevent a competitor from selling to the customer. In that case, however, the company can simply lower its pricing to stave off the competitor. For these reasons, vertical integration is less common in most industries. That being said, there are certain industries for which vertical integration is deemed to be an attractive synergy from a strategic perspective. For example, controlling the only supplier of a required production technique or product can put a company in an advantageous position relative to its competitors. Or in the case of a foreign company that wants to do business in a country but needs local content (for example, to be compliant with “Buy America” provisions), the acquisition of a customer can have clear benefits that would be otherwise unachievable.

Benefits
The benefits associated with synergy analysis and presentation are clearly valuable. In a recent example monitored by EdgePoint, Wabtec (NYSE:WAB) has proposed to acquire GE Transportation Systems for 13.5x the reported TTM EBITDA of GE Transportation Systems. This value was in excess of the multiple for which Wabtec was trading at that time, and from an objective standard a high value for a cyclical business. However, after taking into account all of the cross-selling and operational synergies, Wabtec calculated the synergy-adjusted multiple to be 9.5x and was able to justify the high purchase price as a result. In essence, the synergy opportunity translated into higher value for the shareholders of GE Transportation Systems.

In a transaction recently managed by EdgePoint, the presentation of synergy opportunities to the buyer universe significantly increased the valuation multiple. The Target, broke financial covenants on its loans and was pressured by their lender to liquidate or monetize the investment. Conventional multiples for companies such as the Target were approximately 6.0x EBITDA at that time, which would have resulted in a valuation that just barely covered the debt balance (wiping out all shareholder investment). The presentation of the above synergy opportunities and contribution margin to a strategic buyer, as well as the competitive process managed by EdgePoint, drove valuation multiples to a level almost twice that amount.

Conclusion
Considering the clear motivation, Sellers with a mind on highest value for their Company should prepare themselves and their investment banker for synergistic pricing by accumulating and documenting the synergy opportunities with potential strategic buyers and be ready to present those ideas as part of the sale process.

© Copyrighted by Paul Chameli, Managing Director of EdgePoint Capital, merger & acquisition advisors. Paul can be reached at 216-342-5854 or via email at pchameli@edgepoint.com