This article explains how to sell a mid-market business in New Zealand. It goes through this process:
- Understand Buyers
- Brief Advisors
- Buyers List
- The Approach
- The Offer
- Due Diligence
- Final offer and Contract
- Earn out
What is “Mid-Market”?
In New Zealand, middle or “mid” market businesses have revenue of $2 million to $50 million. Despite the mid-market being 6.5% of NZ businesses they make up 32% of NZ’s sales, have an average of 23 employees and $5 million of annual revenue. About 35% are in Auckland, 11% in Wellington and 14% in Canterbury, with the rest spread across New Zealand.
The process for selling a mid-market company is somewhat different from a small business. There is a lot more preparation involved, the buyers can usually be identified right at the start, financial buyers are a possibility, a partial sale rather than 100% sale may be conducted, and a share sale rather than an asset sale is possible.
1. Understand Buyers. There are two types of buyers in mid (and large) market deals: 1) strategic buyers and 2) financial buyers. Strategic buyers are within the industry and are driven by the desire to grow. Financial buyers bring capital and have the desire to make a good return on their investment. The buyers will take different perspectives on the deal and you should be prepared for both.
2. Brief Advisors. Your accountants and lawyers are very important but the advisor that will drive the deal is a specialist expert. Specialists include investment banks, accounting firms with a specialist team, boutique investment banks, M&A advisors, and business brokers. You’ll brief the advisors, they will appraise the value of the business and set out their fee structure.
3. Preparation. The advisors will then work with yourself and your management team to really understand your business and your objectives in selling. The advisors will also work with your financial controller and your accountants to create a financial model that includes forecasts and valuation. This information will go into an Information Memorandum (IM).
4. Buyers List. The advisors and you will brainstorm a list of possible buyers: strategic, financial, in the region, in NZ and overseas.
5. The Approach. The advisors will contact the people on the buyer list, give the prospective buyer a short description and if they’re interested send them a Non Disclosure Agreement (NDA). Once the NDA is signed the Information Memorandum is sent.
6. The Offer. Prospective buyers will use the IM and their own resources to consider whether to make an offer. They will ask many questions and conduct site visits. When they have sufficient confidence and information they will send an expression of interest that includes an offer conditional on due diligence.
7. Due Diligence. You’ll need to open the books to the selected buyer. You’ll field many questions during this time so make sure you, the financial controller and someone else has time free to assist.
8. Final Offer and Contract. No company is perfect, they’ll find various issues and then look to reduce the price and lock down various terms. This is where a good lawyer earns their keep. If, or when, you reach final agreement then a completion (i.e. settlement) date will be set.
9. Earn-out. This is sometimes used to bridge a price gap by agreeing to deferred payments based on the performance of the company over the next year or two.
1. Understand Buyers
Whether it’s a NZX 10 multinational behemoth or your friendly private competitor down the road most companies strive for growth. Consistently growing revenue and earnings results in higher stock market valuations, easier financing, higher employee retention, and happier boards and investors. And companies can meet their growth needs by acquiring other companies—much easier and quicker than growing through customer revenue or developing new products.
There are two types of acquirers of mid-market companies: 1) strategic buyers and 2) financial buyers. It’s important to understand what drives their decisions.
Strategic buyers are competitors, suppliers and customers within the industry, they are the most common buyer by far. Strategic buyers will look to buy companies in a similar industry. They can then get synergies: economies of scale through cost reduction such as eliminating head office costs, or revenue enhancement such as using their existing salesforce and channels to sell the acquired products. They may also expect an increase in pricing and purchasing power. Less fashionably, strategic buyers can also be from outside of your industry and are looking to diversify their revenue. They can also issue shares to pay for companies along with cash and debt. Chances are they want to buy 100% of your company as they have the management already and don’t need you to assist. Strategic buyers considerations are more around integration into their business—can they realise expected economies of scale or pricing power—as well as investment return. Strategic buyers make decisions slowly, they have to be approved by local management team, the local board, the overseas management committee, opinion of other Asia Pacific CEOs…
Financial buyers bring capital and have the desire to make a good return on their investment. They include private equity firms, venture capital firms, hedge funds, family offices and high net worth individuals. They are often looking to grow the company, and/or cut costs, invest capital and realise their investment within about 5 years (or sometimes much longer). In order to increase investment returns they often use leverage so their considerations are around how much cash is generated to service debt. Unless they are bolting on a company onto their existing investment, they can’t use shares to pay for a company, only cash and debt. They also investigate whether the industry is attractive, whether management systems are strong, and how they will exit in 5 years’ time. Financial buyers buy companies for a living and are set up to make comparatively quick decisions.
The most common way to value a mid-market company is to look for comparable sales, see what the EV / EBITDA ratio is, then multiply this by the company’s EBITDA. EV stands for Enterprise Value and is equal to equity plus debt less cash, and the ratio is called the “multiplier”.
For example, a large stock-market listed company with an EV / EBITDA multiplier of 12, using cash, buys a mid-market company with a multiplier of 7 and EBITDA of $10 million (mn), then it pays (7X $10mn) $70 million. The market will value the additional EBITDA at 12X not 7X, so immediately the acquirer has increased its value by $50million. Yes, really, that simple, an immediate increase in value.
Now let’s say it has to issue equity and therefore increase the number of shares on issue, and that the acquirer found that synergies increased earnings by a further 10%. If the acquirers Earnings per Share (Net Profit After Tax divided by shares on issue) is higher post deal than pre deal then it is known as “accretive”, if its lower then “dilutive”, or equal then “neutral”. If it accretive then, all things being equal, the stock price will increase by the % increase in EPS. Another simple increase in company value, which is why there are so many M&As.
However, also note that if only cash is used then interest income will drop, if debt is issued then the interest cost will rise, both of which decrease earnings. There will also be other costs including depreciation and amortization, acquirer’s taxes and transaction costs. So adjustments need to be made to post deal earnings.
By using their higher multiples, accretive EPS (if listed on the stock-market and the acquisition is significant) and earnings increase from synergies, a strategic buyer can get a large increase in the value of their company by buying yours. There is evidence in an overvalued market, the strategic buyer can use their overvalued shares to buy overvalued companies. This accounts for the boom in M&A activity, then the bust in an undervalued market when strategic buyers can no longer use debt.
Financial buyers include private equity firms, venture capital firms, hedge funds, family offices and high net worth individuals. The sad fact is that the New Zealand stock-market has not developed to the same extent as in other Western countries, has not performed terribly well for companies outside of the Top 50, and has high compliance costs. Indeed retail investors seem to be enthralled with property investment holding back the productive side of our economy. This often means that an IPO not an option.
On the other hand, with the rise of Kiwisaver, New Zealanders have increased their savings rate. Those savings go into investment funds whose managers invest some of that money in private equity.
Private equity is a small but significant player in the New Zealand business investment scene. There are eight NZ firms: Direct Capital, Knox Investment Partners, Maui Capital, Oriens Capital, Pencarrow Private Equity, Rangatira Investments, Pioneer Capital, and Waterman Capital. There are also 14 Australian PE firms that invest in NZ, and six other international firms that have invested in NZ.
Private Equity Investments (small and mid-sized buyouts, NZD)
Year | # | Value
2010 14 $130m
2011 12 $223m
2012 12 $85m
2013 15 $192m
2014 19 $244m
2015 17 $284m
They made up 3% to 24% of M&A activity by number or value (2010-2016), typically 5-10%.
Here’s how they work. In NZ, private equity (PE) firms tend to be general investors rather than specialising in certain sectors as they might do overseas, our market is too small to allow such specialisation. They have different investment parameters with some having minimum investment of $10m and others being more flexible, some want control, others don’t. They want profitable firms with at least $5-10mn EBITDA. There is not really a maximum investment because they can club up with other private equity firms or their own investors.
Private equity managers, called general partners, seek investment for their funds, from institutional funds (e.g. super funds, ACC), family offices or high net worth individuals, and are called limited partners. The limited partners have a portfolio of investments of different risk types and private equity investments are regarded as being high risk but also high return. They invest in the private equity firm’s fund by committing capital up front, allowing the PE firm to draw down capital as companies are purchased. PE firms must return the cash invested in about 5 years’ time. So they have a limited investment window for each fund they raise and then realise.
The general partners are paid a management fee of about 2% of funds, and about 20% of the profit they make on the investment—this is called “carried interest” or just “carry”. The profit is calculated after a minimum annual return, say 8-12%, that the limited partners are entitled to get before the general partners start to get carry (they usually also have to pay back the management fee before carry starts). Research shows that NZ private equity firms have made a 35% IRR on their $5-50mn investments since 2000, and tend to make a “multiple of money” invested (money made / money invested) of 2x to 3x. They tend to exit their investment 4-6 years after they make it. Here’s the results of one private equity fund.
In order to make these gains they provide capital, governance and managerial capability to increase EBITDA through revenue improvements and cost cutting. They tend to want use leverage, so also want to pay down debt over the term of the investment. They play the same leverage game as a house buyer: if they put in 30% cash and 70% debt and the house price increases, then that increase is their return on their cash, the lower the cash, the higher the return.
They exit by selling to strategic buyers, other PE firms or even keep the company by distributing a very large dividend paid for by new debt. Remember they need to repay their limited partners at the end of their fund.
They tend to see 100-200 deals per year, get serious with 10% of them and invest in 1-2.
Private equity firms are looking for steady cash flows with little cyclicality including minimal ongoing capital expenditures and working capital needs. Like all investors, they want to invest in undervalued firms so they can make a better return on exit. They leave management in place so they need a strong proven management team.
Some people believe they have a bad reputation, I beg to differ. The problem is when there’s good news from the sector, the media doesn’t report it, yet there is far more good news than bad news, company owners get fair market value for their shares and other owners get investment to grow. When there is bad news, e.g. Dick Smith, then the media is all over it and PE firms are portrayed as the devil incarnate. Don’t get me wrong, they are savvy business people who won’t overvalue a company, but they are also smart enough to see growth potential and pay fair market value.
Other Financial Buyers
There are five Venture Capital firms who make about 60 odd deals every year totalling $30-90 million pa, but they are more start up and high growth focused, and tend to only invest in the Technology and IT sector (69%) and Biotech (12%). There is also the related early stage investment by “Angel” investors who invested $69 million across 112 deals in 2016, along with the New Zealand Venture Investment Fund’s seed funds. Unless you have a software or tech company this part of the investor market is not for you.
Family offices and high net worth individuals are possible investors, perhaps the NBR Rich List is the best attempt at numbers. For 2016 it states there are 190 individuals and families with at least $50 million in private wealth (net assets) worth a combined $60 billion. Add in international billionaires based in NZ and that figure jumps to $73 billion.
2. Brief Advisors
Your accountants and lawyers are very important but the advisor that will drive the deal is an intermediary.
Accountant and Lawyer
The first advisor off the ranks is your chartered accountant and/or financial controller. On top of the financial accounts they will need to prepare management accounts for the last 3-5 years. The problem with financial accounts is they are prepared for the IRD so earnings are tax-minimised based off theoretical accounting rules. Once they have prepared the P&L, a balance sheet and hopefully a cash flow statement on a management account basis then you’re ready to talk to an intermediary.
You’ll also want to give your lawyer a heads up. Most law firms are quite capable of advising their clients on a sale and purchase of a business. If you are a larger mid-market business then you may want to instruct a corporate lawyer with expertise in business acquisitions and disposals. Certainly those members of NZ Law Society’s Commercial & Business Law Committee are senior practitioners in this area. You’ll be asking them to look at agreements to do with appointing an M&A advisor, confidentiality agreements, assignment of contracts, and the sale and purchase agreement itself.
Intermediaries include investment banks, large accounting firms and banks with a specialist team, boutique investment banks, M&A advisors, and business brokers.
Large companies, especially those listed on the NZX will likely use an investment bank. Goldman Sachs is probably the most well-known international investment bank, NZ ones include Forsyth Barr and First NZ Capital. They tend to offer many services including debt raising, share broking, managed funds, hedge funds, IPOs, fairness opinions, money market trading, and mergers, acquisitions and divestment. A large company will retain the investment bank who will charge a retainer fee that I understand can be as high as $1 million per project. They will also charge a success fee of a 3% to 6% percent from which the retainer fee is deducted. They are likely to work with the company’s Big 4 accounting firm that will charge out work at hourly rates. Large companies can afford large fees. Only companies expecting investment above $100 million tend to use these folk.
Large Accounting Firms
The Big 4 accounting firms have a M&A or corporate finance team e.g. PWC that will assist with selling your business along with many other finance services. They also have retainer fees, I hear one firm is charging up to $500,000 though I believe others are charging less than $100,000 for mid-market businesses. They will also charge a success fee of a few percent from which this retainer fee is deducted, and may also add hourly charges for other advice. The other larger accounting firms and even the large banks often have people who do this work too.
Boutique Investment Banks
Boutique investment banks are a smaller version of their big brothers. Often the directors have worked for other investment banks or they are Chartered Accountants who have specialised in this area. They may be regional in nature or industry specialists.
M&A Advisors tend to be small M&A advisory firms or individuals that are specialised in selling mid-market companies. They have a retainer fee that can vary depending on size of the deal and how much work is required but $3000 per month or a $10-30,000 flat fee are examples. There are also success fees on the sale of the company of between 2.5% ($50mn sale) and 8% ($2mn sale), the retainer fee is be subtracted from the success fee. In the US, a large part of the mid-market intermediary market are M&A Advisors. This is partly because they don’t want to called investment banks with the negative connotations of large fees and Wall St wolves, partly their M&A specialisation, and partly to signal they service mid-market rather than the corporate market. In New Zealand, there are only a few of us (yes, this is where I fit in) and we also use the title business broker as well, though a business broker follows a different process.
Business brokers tend to sell small businesses up to $2 million in company value though they tend to be less than $500,000. There are no retainer fees and commission rates are about 7-8%. They tend to list businesses with a price on business-for-sale websites. The vast majority of small NZ business are sold through business brokers (or privately).
Real Estate Agents
Real estate agents are also legally able to sell businesses. Some real estate agents have real expertise, in particular in land based businesses like commercial property, farming, or horticulture. Occasionally residential real estate agents sell businesses.
Business Broker vs M&A Advisor
The difference is in the level of advice you receive and preparation involved (or you can afford). A small business IM will be two pages with a good summary of financial and company information. It will include the proprietor’s wages in EBITDA (called EBPITDA), use historical information, comparable sales multiples (from BizStats) and capitalisation rates to value a company. A small business can be bought by almost anyone which makes compiling a sensible buyers list problematic, instead the business is advertised on business-for-sale websites (and the obvious local competitors sometimes contacted by the broker).
A mid-market IM will be 40+ pages covering not just the company but also industry and competitor information, and valuation and investment options. It will cover management and systems, company structure, tax issues, major contracts and commitments, and risks. There will be a financial model that uses P&L, balance sheet and cash flow statements to forecast future EBITDA, NPAT, free cash flow, share price, debt cover and capacity, capital expenditure, margins, growth rates and other relevant information. It may conduct sensitivity and scenario analysis to show what drives company value. A mid-market company valuation will look at NZ and Australia mid-market transaction comparable information from expensive databases (e.g. MergerMarket) as well similar trading comparatives from like companies on the stockmarket. Lastly, it will check the comparable valuation through discounted cash flow analysis including WACC and terminal value. You’re able to sensibly identify the likely 50+ buyers of a mid-market business, and come up with 2-3 bids at the end of the process. Given the greater preparation and advice mid-market business owners don’t mind paying a retainer or advisory fee. The fee is also a small part of the a mid-market business price (but would be a large part of small business price).
M&A Advisor vs Investment Bank
Investment banks are full service firms who offer everything from debt raising, share broking, managed funds, hedge funds, IPOs, fairness opinions, and money market trading—as well as advice on selling, acquiring or merging companies. M&A advisors specialise in selling mid-market companies. From time to time they may assist a company with acquisition projects or capital raising that includes debt (I’m doing one of those now), but the focus is on selling companies.
Selling businesses falls under the Real Estate Agents Act 2008 and financial products under the Financial Markets Conduct Act 2013. The former needs to be licensed with the REAA and is usually called a business broker. In the case, the intermediary needs to be a registered financial advisor. If you’re selling less than $750,000 of shares you need to make sure the person holds the relevant license. Intermediaries will always have someone on their staff who holds one or both of these licenses. (Please see my disclaimer below, I’m not a lawyer.)
Whoever you decide to use, you’ll sign an engagement letter, also known as a retainer letter or agency agreement. It will outline the scope of services including a timeline, fees, termination provisions and tails. A “tail” is a means by which the advisor ensures the seller cannot simply avoid fees by terminating the agreement. A tail clause states that if the business is sold to a party introduced by the M&A advisor then the fee must be paid.
Initial Appraised Value
Before you appoint a M&A advisor you ask them to prepare an appraised value. The key figure for them will be EBITDA from the historical management accounts and forecasts you provide. They will prefer as much information as possible but at the very least they need the operating cash flow figure EBITDA for the last three years to provide an appraised value. They will look for sales of other similar businesses, see what the EV / EBITDA multiplier was, adjust for any differences and apply the multiplier to your business. So if they see similar businesses selling at a 6X multiplier, and your EBITDA is $5million, then the Enterprise Value is $30million. Your equity is $30 million less debt plus cash. More on this in Valuation below.
The advisors will then work with yourself and your management team to really understand your business and your objectives in selling. The advisors will also work with your financial controller and your accountants to create a financial model that includes forecasts and valuation. This information will go into an Information Memorandum (IM). Other documents including financial reports, assets lists, and leases will be compiled and put into a dataroom. You will also put together a Non Disclosure Agreement (NDA) and a one page summary to give to interested parties.
Once the intermediary, who I’ll call a M&A advisor from now on, has been appointed, the first thing they’ll do is start to collect information. They’ll try to be as diplomatic as possible because they know you’re not prepared for the upcoming avalanche of requests, but at some stage you’ll realise that selling a business is a large project, and you and your finance team need to put aside a significant amount of time over the coming months.
Along with the historical financial and management accounts the M&A advisors already have, they will also ask for information:
- On management forecasts going out 3 to 5 years, so they can sell either a stable earnings or a growth story.
- They’ll want to show capability so ask for organisation charts and key management backgrounds.
- Operations, and sales and marketing so they can accurately describe the business, and sales analysis to check for customer concentration issues.
- Corporate documents and shareholder information as well as debt information including principle and interest payments, and covenants.
- Lease or property information along with any big supplier agreements.
- Industry and market research reports are very helpful.
They’ll supplement this information by asking to interview senior managers and visit sites with yourself. Any documents will be uploaded into a virtual data room, an online storage area that can provide secure provision of company information.
Every company has issues, rather than hide them, its best to declare them and how you’re fixing them. So the M&A advisor will want to know about any legal issues, debt/bankruptcy issues, shareholder disputes, any large differences between financial accounts and management accounts, and any previous attempts to sell the company or raise money.
One key section is your reasons for selling. If you’re at retirement age then that’s a great reason. If you need more capital to fund growth and can’t find it at reasonable cost then this also is a great reason. Sometimes the owner wants to invest in another business, this can be problematic because prospective buyers will wonder what is wrong with the current business. Looming bankruptcy or overwhelming debt will only attract turnaround experts and even then it may be too late.
At some stage they will ask you to fill out a business disclosure form and sign a statement saying that the information supplied is true and correct and you have not left out any material facts that should be known to the advisor or prospective buyers.
Let’s go into some detail about financial preparation.
Mid-market companies prepare accurate financial reports to the IRD which minimise earnings to minimise tax. However, financial accounting doesn’t provide an accurate picture of the value of a mid-market business and management accounts will also be needed.
The M&A advisor will work with you and your finance team to “normalise” the accounts as if they were a normal company unaffected by the owner’s private affairs. The M&A Advisor will prepare a financial model in a spreadsheet based on what they’re told drives business results. The following are key financial figures.
Shows the operating cash flow of the company without the influence of its capital structure. It is normalised by adding back the excess amount of an excessive owner salary, personal expenses, and extraordinary items. Also by reducing EBITDA by the maintenance capex (instead of artificial depreciation) but not growth capex, and the additional amount of a below market owner salary.
A decision also has to be made about including discontinued operations or a poorly related subsidiary. For example, you may be selling a restaurant company that also has a property development division attached for odd historical reasons. You would want to split the property development company out of the restaurant company before sale. The restaurant company may also have closed down some of its outlets, if this is a one off occurrence you may want to take it out, or if it is regular part of running the business you may want to keep it in.
Enterprise Value (EV) is equity plus debt less cash. By cash we really mean excess cash not needed to run the company. Cash is taken out because you buy equity from shareholders, debt from banks, and cash with cash…makes no sense, no one wants to use cash to buy cash, we just take it out. The resulting the ratio EV / EBITDA is the key ratio for valuing a business and is called a “multiplier”, we say a company may have a “5X valuation”. Note this is different from a PE ratio which is the share price / earnings per share, or put another way equity / earnings, which is an equity ratio that can also be useful for listed company valuation.
Free Cash Flow
Private Equity firms will be especially interested in free cash flow (FCF). EBITDA shows operating cash flow, but not how much cash is available to pay for working capital and capex for growth, interest for debt, and dividends for shareholders. FCF tells them how much more leverage they can place on the company, dividends they can take out, or self fund growth plans.
The settlement date, the day that the sale purchase contract is completed, is known as the completion date. It will be 1-3 months after the date the sale and purchase agreement was signed. During that time an evil owner could not pay accounts, collect accounts receivable early, and run down inventory, thereby increasing cash. The day before completion the owner then empties the cash account into his personal account, boosting the cash he receives from the company and leaving it in a poorer state than at the agreement date.
Of course, buyers are aware of this, so seek a working capital peg that outlines what normal levels of working capital and how this is calculated. Once the actual working capital is calculated as at the completion date, then an adjustment is made to the seller or buyer.
If working capital will be a large part of the purchase price, your M&A advisor will include working capital peg calculations as part of the price negotiations. Otherwise it may be left till due diligence as a general obligation to leave sufficient working capital.
Assets and Debt
Any personal assets in the company should be taken out e.g. that new Mercedes you just bought and perhaps a boat (and, yes, I’ve even seen a plane). You also likely gave personal guarantees for company debt, when the personal guarantees are removed will interest rates increase? If so, you need to note this in your accounts and perhaps adjust interest forecasts. You may have contributed capital in the way of Shareholder Advances rather than Equity to help manage risk, these advances are really equity for the purposes of selling a company.
I’m not going to go into financial models in this article, but the M&A Advisor will create a three statement model that includes all these normalizations. The model outputs will be put into the IM.
Information Memorandum (IM)
In New Zealand, we call the company information document that is sent to buyers an Information Memorandum (IM). It is sometimes also called an offering memorandum, confidential information memorandum, marketing book, company profile, or prospectus.
In essence it’s a brochure that sells the company. It tells a story that makes buyers interested in looking at the company (but is not misleading).
The contents might look like this:
- Executive Summary
- Business Overview (history, products, differentiation, sales channels, growth opportunities)
- Management (senior, organisation chart, capability, reason for selling)
- Industry (market, competition)
- Financials (Three Statements, normalisation)
- Investment (valuation, desired transaction)
- Appendix (risks, financial details, DCF, operational detail)
The IM may be in a Word document format or a presentation slide format. If in a Word document then a short presentation may also be created to highlight key facts.
The IM could be very long especially including the appendix and the excel model, it should get a prospective buyer most of the way to making an offer.
From this IM, a one or two page summary flyer is created. This does not identify the seller but helps to garner enough interest from a prospective buyer to get them to sign an NDA in order to get the full IM. A short verbal description will also be developed to use over the phone (again not identifying the company).
The M&A advisors will have provided an appraised value prior to their appointment. They now sufficient information to provide a more robust valuation by looking at transaction comps, trading comps and DCF.
Transaction comparatives or “comps”. The M&A advisor will have access to expensive M&A databases that investigate and report on mid-market and corporate deals. These deals will be by New Zealand by sector. There are not many NZ transactions so we also include Australian transactions, given also that Australians are key buyers of NZ businesses. We look at the revenue, EBITDA and deal size, and calculate the EV / EBITDA multiplier. We compare your company to the other companies sold and decide on what we be a fair range of multipliers. We then apply those multipliers to your EBITDA to calculate your EV.
Trading comps. Strictly speaking we can’t really compare a mid-market private company to a large listed company. A listed company has a liquidity advantage for buyers that a private company just doesn’t have. Likewise, a much larger company has more diversification of revenue sources and so is less risky than a smaller company. However, acknowledging this stretch, we also compile information about similar listed companies EV / EBITDA multipliers. It is another solid data point and there is some research that shows that as listed companies multiples increase, then so do private companies albeit at a lower multiple.
Discounted Cash Flow. This is theoretically the perfect way to value a company. You forecast future free cash flow, discount each period’s cash flow for the time value of money, add an amount at the end that represents the company’s value in perpetuity (“terminal value”) also discounted, and you have the value of the company. The discount rate is based on a weighted average cost of capital which takes into account the risk of equity markets, industry, company size, and debt costs. This piece of financial beauty can be manipulated in a thousand ways depending on your assumptions. For this reason it is used as a check of the comps methods of valuation.
Some industries are very asset heavy ( e.g. airplane, construction machinery) in which case a professional asset valuation should be done as asset value may be worth more than the business. Your M&A advisor may also suggest you sell assets before selling your company even if that means leasing them back.
The IM will include valuation slides usually in the format of a multiplier bar chart showing where the company sits in relation to other transactions. Trading and DCF information may be provided in summary form.
Before we start contacting buyers, we need to prepare an Non Disclosure Agreement (NDA), also known as a Confidentiality Agreement (CA). Your lawyer will provide a superb agreement…that you will find no one will sign without editing. In particular, you’ll find the indemnity clause crossed out (especially by PE firms). You’ll need to decide whether you provide information despite the edits on a case by case basis with your M&A advisor and lawyer.
We now have the IM, IM flyer and NDA, we’re ready to move on to the buyers.
4. Buyers List.
The advisor and you will brainstorm a list of possible buyers.
Strategic. Who are the local, regional and national competitors? How about Australia, are there any competitors there large enough to move into NZ, are there any buyers aggressively expanding (perhaps with PE firm backing)? Are there any other international competitors that have invested in Australia, perhaps even Asia? What about companies in a related industry, e.g. building industry not just joinery or timber? How about large customers or suppliers?
Financial. Do you meet PE firm investment parameters? What about family offices or high net worth individuals? The latter especially if they have a background or interest in your industry and are actively investing.
Does each possible buyer have the financial resources to buy your company? Do you want to risk approaching local competitors when you know they won’t buy just seek to find out confidential information through abusing the process? Take these out of the list.
Then rank them by attractiveness and by speed of decision. Strategic companies are slow so talk to them first, then speak to PE firms who can be much faster in making an offer. You may now have a list of 50 (30-100) on your Buyer’s List.
For the purposes of completeness, talk to your M&A advisor about an IPO. In NZ, chances are you will be too small for it to be worth the stock-market compliance cost. You also are unlikely to be covered by equity research post IPO, thereby seeing your stock price drift downwards as it gets no coverage post the IPO public coverage.
5. The Approach
Running the Sale
There are various ways to run a company sale. We don’t recommend contacting only a small number of likely buyers, this limits competition and you could be left with anyone making an offer. On the other hand, we don’t recommend contacting everyone on a long list of buyers immediately. It becomes unmanageable especially with lots of tyre kickers or information thieves i.e. competitors trawling for information.
Some M&A advisors run a strict auction process where all the buyers know the deadline to put in a bid along with their comments on a suggested sale and purchase agreement. The problem is many companies regard this process as a waste of their time, there is lots of effort and expense in making an offer, and too many buyers scares some companies away.
We recommend a managed auction process also called a modified or limited auction. This is an auction that is not an auction, or at least isn’t presented as an auction to the buyers. The M&A advisors will work their way down the buyers list until they have at least two bidders that have made an offer close to the valuation who can show they have the financial resources.
The M&A advisors will use email and the phone to contact the people on the buyer list. They will give the prospective buyer a short description and then send them the flyer. If the person is interested they will send the NDA. Once an acceptable NDA is negotiated, then the IM is sent or presented to the buyer.
Buyers will ask numerous questions, many of which can be answered by the advisor, others will need your input, and the rest will be politely deferred to due diligence. Indeed, a competitor may get very limited information compared to someone else depending on how much you trust them. About half the buyers who received the IM will want to have a site visit and management discussions.
6. The Offer
Once prospective buyers have sufficient information and believe buying your company will be a good investment, they will give you an offer. They may call it a “non binding expression of interest conditional on due diligence”, perhaps a “letter of intent”, “heads of agreement” or “memorandum of understanding”, but in practice its the offer. It will likely contain their price, deal structure, warranties and other conditions such as financing. Legally it may be arguable as to whether their expression of interest is non binding (pdf, also very good legal guide on NZ M&A).
Whatever their document is called, if they demand exclusivity of negotiation for a period of time, then they are the bidder. If you cannot reach agreement then the other parties will wonder why and perhaps cool on the deal in the meantime.
If they make it conditional on due diligence then you can reduce the risk of being left high and dry by setting out specific parameters where the buyer may withdraw. You can also ask for a break fee, a fee paid if the buyer doesn’t continue, this will probably halt fishing expeditions by competitors.
One way to avoid due diligence being a condition is to provide due diligence reports prepared by your team, M&A advisors and accountants for prospective buyers. This means opening the books to more people earlier in the process. Before you do that you may want to ask for truly non-binding expressions of interest with a valuation range and other terms. They get then due diligence documentation and can make a binding letter of intent without requiring extensive due diligence. It also ensures that you have more potential bidders than just the one who demanded due diligence.
If there aren’t any offers close to valuation, then the M&A advisor will seek to negotiate the offers up to an acceptable price. This might be possible as most buyers leave themselves some extra room to increase their price during negotiations—but not drastically increase their price. If offers can’t be negotiated up to a minimum price, then the M&A advisor may suggest expanding the original buyer list or withdrawing the business from the market.
7. Due Diligence
Once you’ve accepted an expression of interest, you’ll need to completely open the books to the buyer. This is where your preparation pays off as your dataroom has most of the documents they are after, and you and the management team are prepared for the due diligence onslaught. You’ll field many questions during this time so make sure you, the financial controller and someone else has time free to walk them their due diligence.
Although you have perfect information about the company, it’s your baby after all, you’ve nurtured it for decades, the seller has only had access to company information for a short period of time. They’re about to place a large bet with a large amount of money and they don’t want to get this wrong. So they’ll look for the smoke that is suggesting a smouldering fire that will burn down their acquisition. They’re sure to find something and try and negotiate the price down.
8. Final Offer
Even if your company is squeaky clean they will demand the owner warrants all the information is correct and there has been full disclosure. This is where a good lawyer earns their keep. The buyer may also demand money is placed in escrow for a period of time to cover any unforeseen issues. (Please see my disclaimer below, I’m not a lawyer.)
Note that in a property sale the date funds are transferred from the vendor to purchaser is called the settlement date, in a mid-market business sale it is called the completion date, as in the contract is “completed”.
We’ve talked about a working capital peg above. Let’s talk about how this works into the final price. The Enterprise Value price has been agreed by the parties. At completion date, the company has cash added to that price, less debt— the net debt adjustment. Then the actual working capital is added and the working capital peg is subtracted—the working capital adjustment. The Enterprise Value, less net debt adjustment, plus the working capital adjustment, equals the final purchase price.
A company which has large cash and working capital accounts which vary widely, could see a substantial change in the final price. Who holds the benefit or risk of changes comes down to the price mechanism.
There are two mechanisms to get from Enterprise Value to Equity Value: 1) Completion accounts and 2) Locked box. Completion accounts are the more common, the vendor estimates the completion balance sheet and funds are held back to cover differences from the estimate. When the balance sheet can be calculated then one party or the other prepares the completion accounts and a final “true up” payment is made from the set aside funds. Locked box is where the most recent balance sheet is used on the locked box date, adjustments are agreed beforehand, and any adjustments are made based on the Locked box balance sheet.
Mid-market companies can be sold as assets (more common for smaller companies) or shares (more likely for larger companies). The buyer prefers to avoid buying shares because they also buy hidden or unforeseen liabilities of the company, they use warranty clauses in the sale and purchase agreement to attempt to leave with you these liabilities. These warranties will have a time and dollar cap and will likely be a source of debate. The seller prefers the simpler share sale rather than multiple assignments of various contracts and assets.
There will be tax considerations that your accountant and lawyer will advise you on. In particular, if sell assets at a higher price than their book value then IRD will charge you tax on depreciation recovered. The business is likely sold as a going concern (assets) or as a financial service (shares) so does not attract GST. If you sell more than 51% of shares and have accumulated tax losses then you may lose this tax benefit (but check this with your lawyer).
You are like to have a restraint of trade clause restricting you from operating a similar business for a period time in a particular geographic area.
Buyer’s financing will be a critical clause, do they really have the funds to complete the purchase, if not, what is the penalty for not completing the purchase.
Likewise, buyers may offer you their shares, ask you to provide vendor financing, or take a significant part of the price in a post-sale consulting contract. You will need to carefully consider the risk of these options. It may be better to take a lower price than have so much of the price at risk in a company you no longer control.
Let’s turn to another well-known form of deferred payment, the earn out.
You’ve just launched a new product, about to open two new stores, or entered a new export market. You’ve spent years working on these new projects and are sure they will add millions of revenue. They buyer isn’t so sure, and you have a stand-off over whether to use the forecast earnings in the valuation of the company or not. This is where a contingent deferred payment, or earn-out, helps to bridge the price gap. They buyer only pays if the forecast earnings materialise.
You need to structure the earn-out based on the following:
- what is the financial metric (revenue, EBITDA, NPAT etc.)
- what is the time period (e.g. two financial years)
- is it based on the old company or the newly combined one
- how is the financial metric calculated
- what is the dispute resolution process
Any good accountant can substantially change NPAT and still remain within accounting rules, however, changing revenue is much harder. Likewise, corporates are infamous for adding bloated head office costs. Despite EBITDA being the best indicator of company value, you probably want to choose a figure that is more difficult to manipulate higher up the P&L.
Next time your golf partner says he got the highest ever price within his industry ever known in the history of NZ, ask him about the earn-out details…
The process for selling a mid-market business is different from a small business. Start by understanding what buyer wants. Strategic buyers are looking for synergies and return on investment. Financial buyers, mainly private equity, are looking for return on investment, ability to leverage (FCF) and how they’ll exit. There are a wide range of M&A advisors who can assist with selling companies with different fee structures and mid-market expertise. They will work with you to prepare an Information Memorandum (IM) and appraise the value of your business. The M&A advisor will then contact a list of possible buyers. Some of those buyers will sign NDAs, some of them will conduct research beyond the IM information and make an offer. The successful bidder will conduct due diligence and then a final offer made and contract negotiated. Sometimes a deferred payment based on company performance will be paid over the next year or two.