The Art of Client Service Today

By Russ Warren,
Managing Director

The servant leader is as old as the Bible. But how is the art of service practiced in the 21^st Century?

An investment bank is a specialized client service firm, advising owners of middle-market businesses on the most important projects of their professional career, harvesting the work of a lifetime, or multiple lifetimes. Consistent with the definition of the word service, we perform our work to benefit our clients and promote their interests. To thrive, we must consistently provide better service than competitors.

It’s About the Client – Core Values

Integrity. At the heart of a true service firm is a “Client First” culture. Nothing is as important as earning the reputation of consistently and decisively putting the best interests of the client first.

Service begins with checking egos at the door, listening to develop a thorough understanding of what a business owner wants to accomplish and answering questions and any concerns about the process. It includes offering a realistic threshold value and tailored ideas on advantageous financial structures, using a company-specific, forward-looking financial model with appropriate input assumptions. It means leading a client to think about the future “unfettered”—in other words, what could this business be with the right resources? What would the owner want to do after the closing?

Agreeing on the objectives of a transaction enables the bank’s client service team to conduct a process well proven to flush out more premium offers with better price and terms and ‘clear the market’. The client maintains control of key decisions, but the client service team does all the heavy lifting.

Exceptional service requires frequent, friendly and above all clear communications to keep everyone on the same page—the owner, other advisors, and employees brought onto the Transition Team.

Service excels when the client service team treats each engagement as a long-term advisory relationship rather than as a one-time transaction. In return, future referrals flow from such service.

Client Service – What’s New

The core principles of client service have changed little over the years. Nonetheless, if teamed with today’s evolving business practices and underlying enabling technologies, business owners can expect a gratifying 21^st Century Client Experiencewhen they decide to transition their business.

Expertise and Talent: Leading investment banks are specializing to better serve clients in selected industry segments within the middle market by creating dedicated Industry Service Teams led by a Managing Director with deep experience. Doing so enables us to tell the Company’s story effectively and to efficiently find the best prospective buyers—strategic, private equity, and family offices. Frequently interacting with these important industry players means they take our calls and listen to why we believe the idea is compelling. Examples of Industry Teams are: Industrials, Distribution, Business Services, Food and Consumer, Healthcare and Energy.

Leveraging the Computer: Tailored Resources: Electronic search capabilities and customized database platforms have enabled the creation of powerful in-house and subscription databases, search tools, and unique management systems to track prospective buyers’ interests and manage follow-up actions. Until this breakthrough, many prospective buyers of companies with less than $100 million in revenues were challenging to identify efficiently and contact.

One product of these custom resources is a prioritized Bespoke Buyers List, stating why each buyer is likely to be interested. The client can delete any sensitive prospects before calls begin. As a result, fewer calls can be made to better prospects, reducing the elapsed time to closing with less unproductive exposure of client information.

Another way the internet has changed the art of client service is in powerful research for the Confidential Information Memorandum. Years ago, it took a research librarian a week to locate specific information if it could be found at all. Today, a skilled Associate can find information on the company’s competitors and markets in an afternoon to support marketing claims and financial projections.

Long Reach: Today, many middle-market companies operate in a global market sector, which means they could attract strong buyer interest outside the United States. Cross-border transactions have an additional layer of complexity but can add value for some clients. Premium service includes the ability, resources, and experience to source and negotiate with foreign buyers using local support when needed. Therefore, investment banks have formed international alliances, such as the Alliance of International Corporate Advisors (AICA), which two times a year brings together similar member firms from the Americas, Europe, the Middle East, and Asia. Members assist each other by identifying local counter-parties and dealing with those parties in the local language as needed.

Communications and Expectations: Responsiveness and clear communications are cornerstones of exceptional service. The U. S. Postal Service doesn’t get much business related to M&A transactions anymore, because there are ‘instantaneous’ options. A client has the right to expect an appropriate, timely response to developments throughout the process using texts (“Got your message, we are on it, and will talk with you tomorrow morning…”); phone calls for when two-way interaction is most effective; and emails that lay out in writing for future reference important matters and conclusions. Of course, electronic transmission speeds scanned documents like draft purchase agreements on their way for review. However, meetings can also be important at key stages of the process, like management presentations or walk-through the most interesting Indications of Interest.

Technology has changed everyone’s expectations of appropriate response time. Years ago, many negotiations were conducted by mail, with plenty of time to think and respond carefully. While we would not want to go back to the ‘good old days’, there are times in a negotiation when it is best to heed the reminder of psychologist Victor Frankel— “Between stimulus and response, there is a space. In that space is our power to choose our response.”

The Opaque Value of Middle Market Investment Banking Services: Many business owners have more difficulty deciphering the economic return from purchasing a service than from buying a physical asset like a machine tool, or even in fully understanding what the service entails and why they need it.

Shedding Light: In 2016, finance professor Michael McDonald at Fairfield University conducted an independent study on “The Value of Middle Market Investment Bankers.” Casting a wide ‘blind’ net, the study obtained empirical data and commentary from 85 owners who sold their businesses for between $10 million and $250 million between 2011 and 2016. From written comments, “the majority of business owners felt that investment bankers added value in the sale transaction… with 84% of respondents citing the final sale price as being equal or higher than the initial sale price estimate provided by the investment banker.” Ranking the importance of the elements comprising the bankers’ service, the respondents revealed experience at odds with popular beliefs. They learned that there is a lot more to selling a business than finding the buyer:

• Managing the M&A strategy and process (Most important)
• Structuring and negotiating the transaction
• Adding credibility to the seller
• Enabling management to focus on running the company
• Educating and coaching the owner
• Preparing the company for sale
• Identifying and finding the buyer (Least important)

Creative Fee Structures: For better alignment with some clients, investment banks can offer ‘gain-sharing’ fee agreements in which a lower percentage is earned up to the midpoint in a pre-agreed value range and a higher incentive fee is applied to the premium for win-win results.

WIIFM – What’s in It for Me?

Benefits to the client of these recent improvements in the art of client service today coupled with the core principle of Client-First Service can mean exceptional results for a middle market business owner:

• Highly incentivized client service team
• More premium offers
• Higher Certainty of Close
• Faster process to Closing
• Market clearance – highest price, best terms at closing date

By the way, the acquisition market for middle-market businesses is very strong as we go to press.

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

Quality of Earnings

By Matt Keefe,
Managing Director

Preparing your business for sale requires you to act and think like a buyer

It is standard practice for a buyer to conduct extensive financial due diligence of an acquisition target and an increasingly standard part of a buyer’s accounting diligence is a Quality of Earnings (“Q of E”). A Q of E is a report prepared by a third-party accounting firm that confirms that the stated financial results are accurate and as represented. The report is not as exhaustive as an audit and places more focus on the income statement than the balance sheet. The Q of E can also identify potential risks, accounting irregularities, working capital issues and even cost-saving synergies. A quick (and non-scientific) polling of the bankers at EdgePoint suggests that a Q of E has been a part of every buyer’s due diligence process over the last three years: a group that includes large strategic buyers with expansive accounting and finance departments.

For a seller, the Q of E conducted by the buyer poses several risks. First, the report can identify errors on the underlying financial statements that were used by the buyer to establish a target’s valuation. This situation almost always leads to a reduction in value. Second, a Q of E can slow down the closing process considerably, especially if the seller is not prepared to handle the volume of requests that accompany a Q of E. Slowdowns are never good for sellers. Momentum is key to getting to a successful closing so getting bogged down during the early part of a buyer’s due diligence process does not bode well for a positive outcome.

To combat the eventual buyer Q of E, more and more sellers are engaging their own Q of E’s prior to launching a sell-side process. A seller conducting a Q of E prior to the launch of their sell-side process receives several benefits:

1. Creates credibility for the seller. All the information that will be ultimately requested will already be identified, reviewed and organized in a data room. Being able to respond quickly to buyer information requests drives credibility and trust.
2. Provides buyers with validation of the revenue and EBITDA. Hiring a third-party accounting firm to conduct a Q of E greatly reduces the ability of a buyer to “re-trade” during due diligence as the numbers presented during the process will “stand-up” to scrutiny. Moreover, the Q of E focuses on the “add-backs” and provides a third-party validation of the adjustments.
3. Conforms non-GAAP financial reporting to GAAP (as most lenders and buyers require).
4. Sheds insight into potential risks or issues prior to a sell-side launch. The opportunity to pro-actively modify accounting practices or minimize risks prior to launch can yield a significant valuation increase for a seller.
5. Consolidates all entities into a single financial presentation. Consolidation can be a timely exercise and being able to provide the buyers’ accountants with a road map reduces the closing period.
6. Provides the advisors working on a seller’s behalf the ability to negotiate from “firm ground.” With little concern about financial results shifting during diligence, advisors can push to get optimal terms at the LOI stage.

The cost of a Q of E depends on the scope of the assignment, the status of the company’s financial reporting and the number of entities being consolidated. Although a Q of E can be a material cost to sellers, the expense is almost always offset in savings gained by reducing the closing period (estimated 1-2 months). Furthermore, a proactive Q of E provides greater likelihood of a successful closing.

The sophistication of buyers, advisors and lenders in the lower middle market continues to drive innovation in due diligence and processes. Many of these innovations are techniques typically associated with larger transactions. Due to the growing sophistication of buyers, sellers require equal sophistication to prepare their businesses for a successful sale process. That is why we are seeing sell-side Q of E’s becoming almost standard in today’s M&A environment and a key component of a seller’s preparation for market.

© Copyrighted by EdgePoint. Matt Keefe can be reached at 216-342-5863, by email at mkeefe@edgepoint.com or on the web at www.edgepoint.com

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