M&A Advice: Remove Concentrated Risk

By Tom Zucker,
President

In Michael Porter’s book, Competitive Advantage, he succinctly states his views of risk management with the quote, “Risk is a function of how poorly a strategy will perform if the ‘wrong’ scenario occurs.” The concept that one customer, supplier or even industry downturn can cause irreparable harm to a business was proven quite painfully to many businesses during the last recession. Generally, a business with one customer greater than 20% or the top 5 customers comprising more than 40% of their revenue is considered a concentrated risk. Additionally, a supplier who provides more than 30% of the necessary raw materials or products for a business is also a potential risk position. Additional concentration risk may occur when a business operates in one specific industry (i.e. automotive, oil & gas, agriculture, or construction) or geography (east coast, southwest, west coast, etc.). Many business owners operate comfortably with these risks, but a selling owner with these risks needs to proceed with caution and possibly a revised strategy.

The entrepreneur’s comfort with a customer comprising a large percentage of the business may seem rational and logical to the business leader and outsiders (why go to many customers when you can generate significant business from one or a few?). The owner with concentrated risk positions in their company often have seemingly mastered the many factors that reduces the risk of losing their large customers such as possessing unique capabilities that makes the owner’s company hard to replace, superb on-time delivery, credit insurance, or just better client service. The hidden risk for a business owner with these concentrated positions lies when the owner tries to sell the business.

The harsh reality of the M&A buying marketplace is that concentrated risk positions impact buying demand and purchase price. Lenders have been trained to avoid and/or be extremely cautious when providing credit to companies with customer and/or industry concentrations. Since the banks often provide more than 50% of the cash to support the overall purchase price, this concentration negatively impacts the purchase price for sellers. Additionally, the number of buyers that are willing and capable of accepting the risks associated with a supplier, customer relationship, or industry concentration are significantly less than a company without such risks. Buyers fear that if the large customer or supplier goes out of business or exits the relationship, or a cyclical industry experiences a downturn, the buyer’s investment will be severely impaired. This risk greatly affects how buyers value such businesses.

At EdgePoint, we have advised many clients with concentrated risk positions. The following are just a few recent examples:

• Customer concentration: Metal fabrication business with 95% customer concentration and operating solely in the oil and gas sector
• Supplier concentration: Agriculture processing business with 100% of their grain supply being sourced from one vendor.
• Leadership concentration: Polymer processing business with a business owner solely possessing the sales, technical and operational knowledge necessary to operate the business.

The M&A market for these companies was adversely effected by their respective concentrated positions. Many of the most strategic and high value buyers were unwilling or cautious in participating in the purchase process because of these risks. Although EdgePoint was successful in the sale process, these sellers could have taken strategic actions necessary to diversify and minimize their concentrated risk positions and further increase the buyer interest and positively impact value.

For owners contemplating a sale in the foreseeable-future, the following are a few of the strategies that others have implemented that have limited concentration risks and increased the value of their businesses.

• Acquisition: Evaluate an acquisition of a business prior to the sale of your business. An acquisition with an unconcentrated customer base can greatly reduce an existing concentration in your business. An acquisition is also a great way to acquire potential leadership to enhance your management depth, diversify geography or acquire capabilities to serve a different industry. Additionally, acquiring new customers potentially in different markets can take time and a strategic acquisition is a good strategy to accelerate this process when a sale is contemplated in the nearer term.
• Increase Sales Efforts: The ability to hire additional sales professionals or establish partnerships in alternate markets is a great way to make a customer concentration evaporate. With the proper amount of pre-planning and effort, the supplier or customer concentration within your business can be reduced to acceptable levels. Acquiring new customers diminishes the percentage concentration of larger customers over time.
• Reposition your Business: The likely buyer of a business with a concentrated position is a larger customer who can integrate your business into theirs. The large customer concentration will not impact a significantly larger business. These buyers tend to view the acquisition of a new large customer as a positive event. However, these buyers often want to consolidate your business into theirs.

The existence of concentrated risk positions as described above may not be developed intentionally but rather have evolved over time. As an ongoing operator of a business these risks are acceptable and rational, and have not adversely affected the profitability of the business. As one begins to prepare for the sale of their business, these same concentrated risk positions require additional thought and planning. The involvement of a skilled investment banker and other advisors prior to the sale of your business is essential to making sure the concentration risks that have been a benefit to a business do not unintentionally become a curse when it is time to sell.

—

© Copyrighted by Tom Zucker, President of EdgePoint Capital, merger & acquisition advisors. Tom can be reached at 216-831-2430 or on the web at www.edgepoint.com.

The Value of Certainty

By Tom Zucker,
President

The ability to have someone express interest in buying your business is common.

The ability to receive a qualified letter of intent to purchase your business is unusual.

The ability to close the transaction at desired price and terms is priceless.

The closing of an M&A transaction involves great technical skill combined with finesse only gained from years of experience. The orchestration of family, attorneys, accountants, buyers, sellers, and a variety of other important stakeholders would make an orchestra conductor blush. The transaction advisory role requires the ability to be an assertive and forceful negotiator at one moment, and a friendly and comforting advisor the next. While the M&A transaction does not involve life or death decisions, it certainly carries great financial gain or potential harm to one’s business. Yet countless business owners attempt to sell their businesses without proper M&A representation and suffer the greatest risk of all… the lack of certainty that the transaction will close timely and at the price and terms that are acceptable to the business owner.

An M&A transaction can be disruptive to your business. The owner and the leadership of the business are bombarded with significant requests for information, bludgeoned with probing questions, and are travelling down a road rarely or never travelled. The different terminology and perspectives would make a skilled business owner wonder if they ever played the game of business before, and cause them to respond and react much more slowly and cautiously. An often heard phrase on M&A transactions rings loud and true, “Deals do not get better with time”. The role of an M&A advisor is vital to ensuring that the momentum of the deal is maintained and that a delay in timing is not detrimental to the business.

In addition to maintaining momentum and minimizing the risk of time, the other important role that an M&A advisor plays is reducing anxiety and fear. Fear and anxiety are experienced by both the buyer and seller during a transaction by both the buyer and seller. The buyer fears that hidden risks and problems exist and are being withheld during their discovery process. The seller fears that the buyer is going to modify price and terms of the transaction. The legal documentation process involves an important element called representations and warranties. A simplistic summary of this part of the purchase agreement is that the seller will set aside money in escrow to satisfy any representations that are inaccurate or untrue. If the owner tells the truth and properly discloses potential issues, the risk from having a representation and warranty claim is greatly reduced. Sounds simple but this is one area where fear runs rampant… and imagined and unlikely risks get larger.

In a recent transaction, the seller of the business was reviewing his first version of the asset purchase agreement. The fearful topic of representations and warranties emerged and the fear of disaster hit my client like a ton of bricks. The lawyer explained that half of the purchase price could have to be returned if…. my client stopped listening and the blood rushed out of his body. After 20 years of building the business the thought of having 50% of the purchase price returned to the buyer was paralyzing. The lawyer did not know what they said nor the emotional impact on the client until those fateful words left his mouth….. “The sale is off.” The room was silent and binders and folders ready to be packed. I spoke softly and reassuredly to the group and my client. If you tell the truth and present the facts of your knowledge… the risk is minimal. A pulse returned. I explored the likelihood of the events that would cause such a claim and realized that no such event has happened in the past and the likelihood was low of it happening in the future. Lastly, I reassured him that our deal experience and the attorneys’ transactional experience would protect him from this risk. The deal was back on… the blood was flowing again. This is just one example of how fear impacts the M&A process and how important perspective and experience is during the sale of one’s business.

The ability to have a qualified back up buyer provides additional certainty to a seller. Without the fear of competition and potentially not purchasing the desired business, the buyer has the upper hand at the negotiating table. By having multiple offers on your business, the buyer knows that timing, price and terms are not easily renegotiated if they desire to purchase your business. The certainty provided by having other offers in the event that the buyer modifies price or terms is priceless. This certainty only comes from having multiple offers and competition usually provided by a competitive auction process.

Most business owners will claim that the role of an M&A advisor is to make a market for your private business. Many former business owners who have sold their businesses would indicate that the true value of an M&A advisor is the certainty that they provide that a transaction will occur and the desired price and terms.

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

CAUTION: Multiples of EBITDA Ahead

By Russ Warren,
Managing Director

A buyer is willing to pay a certain amount for a business’ future cash flows, aka Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA). But, because future cash flows are uncertain, a proxy is needed.

Thus, we have the storied ‘Multiples of EBITDA’ bandied about club locker rooms for decades. Few concepts in finance have generated more confusion or irrational angst. A selling owner once told me,‘Oh, it’s a good price, but I think the multiple is a bit low.’ Really!

***

Multiples of What? Let’s start with EBITDA, which we’ve defined above – or have we?

EBITDA is gross cash flow. It is useful in comparing the earnings (and hence value) of companies because it looks through differences in financing structure (interest), corporate structure (taxes), capital investment policies (depreciation) and the wake of past acquisitions (amortization of goodwill).

Which EBITDA? There is more than one EBITDA candidate to be multiplied. Is it the current year’s annualized? Trailing Twelve Months’ (TTM)? Latest full year’s? In a cyclical industry, the average over the cycle? Since the buyer is buying future cash flow, it is arguable that in a growing business next year’s EBITDA, if supportable, is the most meaningful. If forward-looking EBITDA cannot be convincingly supported, TTM (the most recent actual) is often used.

What Adjustments to EBITDA? What would EBITDA be if another owner operated the business? For example, should there be adjustments (or “add-backs”) for:

• Expenses at the owner’s option (‘discretionary expenses’) – e.g. owner compensation and perks above that necessary for capable a hired CEO
• Compensation for employees that will not continue under new ownership (net of any replacement cost)
• Non-recurring expenses – e.g. a new IT system, major lawsuit, above-market rent to related parties
• ‘Negative add-backs’ if any; like the loss of a major customer or drop in product selling price (Think Oil) or an owner paid less than market (it happens)

In sum, which EBITDA is used significantly impacts the implied valuation of the business. A business owner ‘talking on the first tee’ rarely mentions, or even thinks about the underlying subtleties mentioned here.

The Multiple bulks up EBITDA into an ‘Enterprise Value’. That is, the value a buyer pays for the cash-free and interest-bearing debt-free business. In either an asset or a stock transaction, the Buyer gets the assets and assumes the normal operating payables and accrued expenses.

How Does the Multiple Relate to Return on Investment? If a buyer pays five times TTM EBITDA and the company generates the same EBITDA next year, the buyer gets a 20% free cash return before deducting interest, income taxes and capital expenditures. If next year’s EBITDA is higher, the buyer earns more than 20%, if lower, vice versa.

So, What Determines the Multiple? Buyer demand, which is based on attributes like predictability of earnings, concentration risk, outlook and synergy. Company size plays into each of these determinants, and is therefore one of the most predictable drivers.

Size Matters. There are break points based on size. Interest from private equity groups begins at about $1 million of EBITDA. A greater number of PE firms are seeking $3 million and more yet $5 million. (Think ‘Return on Bother’) A different set of larger PE acquirers salivate at $10 million. Strategic acquirers need something big enough to ‘move their needle’, so a small business must have something very special – e.g. strong intellectual property, a sizzling brand name, or strong cost synergies (Think plant shutdowns and layoffs) – to attract their attention and fetch a high multiple.

Factors raising the Multiple include strong management, proprietary products or services, pricing power, recession resistance and a growing, defendable market niche.

Factors lowering the Multiple include customer concentration, no CEO successor or weak management bench strength, supplier vulnerability, poor financial records, the inability to forecast reliably and other discernible risks.

What Multiples Are We Seeing? Our firm advises sellers on middle market M&A transactions with $2-to-15 million of EBITDA. Middle market M&A pricing at mid-year 2017 is as strong as it has been in the last 40 years. (“Subject to change without notice”, as they say.) We are seeing today one to three turns of EBITDA higher than prevailed during the downturn of 2008-10.

The take-away is you need to understand what EBITDA is appropriate to use and what value enhancers and detractors apply to the Company. Use Multiples of EBITDA with CAUTION.

Use them as a reality check to test the market reasonableness of company-specific, future-oriented valuation methods like Leveraged Buy Out (LBO) and Discounted Cash Flow (DCF) financial models.

To achieve the highest multiple, and enterprise value, you need to create strong buyer demand – an orchestrated competition among motivated buyers for your business, but that’s a story for another day.

© Copyright by EdgePoint, M&A advisors. You can reach us at 216-831-2430, or on the web at www.edgepoint.com