Ask Private Equity

If you are thinking about selling your business, all of a sudden potential suitors or your advisors may be asking questions about C’s, S’s and LLCs.

The Short Answer:

S-Corps and LLCs are good because they’re more flexible and allow the buyer to achieve a ‘step up in basis’ which provides tax advantages to the buyer. In short, the buyer calculates the difference in the purchase price for yoru company less the book value of equity (i.e. stockholders equity) on the balance at the time of the sale), and the buyer gets to deduct 1/15 of that number on his taxes each year going forward. That can add up to some big savings that can attract more buyers.

C-Corps are bad because assets sales are not practical for the seller, and a stock sale of a C-Corp does not allow for achieving a step-up.

The Longer Answer:

Aside from basic legal diligence and potential sale structuring, the key reason that people want to know about your legal type of company is to discern whether you can practically sell assets rather than stock (more on that [here]), and if you want to sell stock whether the buyer can realize a ‘step up in basis’ (or ‘step up’ as it’s casually referred) as part of the stock purchase transaction. An asset sale or a stock sale with a ‘step up’ provides tax benefits to the buyer, but is practically only available if the seller has an S-Corp or an LLC.

Again, your attorney can give you more detailed information, but effectively if you’re an LLC you can sell your units (i.e. your stock), or if you’re an S-Corp you can sell your assets (typically with a minimal tax disadvantage – more on that [here]) or sell stock with a 338h10 election (again more on that [here]), and the buyer can obtain this mystical ‘step up in basis.’

Simply, a ‘step up’ is a tax benefit derived from the difference between the purchase price of your company and the amount of equity value on your balance sheet (i.e. book value of equity). Since most companies are worth more than the stockholders equity portion of their balance sheet, this difference effectively creates a tax benefit for a new buyer. Said differently, think of a ‘step up’ like this: you’re an LLC, and your company’s balance sheet assets less your balance sheet liabilities equals $5 million (i.e. your stockholders equity on your balance sheet is $5 million). A buyer comes along and pays you $50 million for your company. The difference between purchase price and your stockholders equity is $45 million ($50 million purchase prices less $5 million book value of equity). The term ‘step-up’ relates to the ability for the buyer to effectively expense that $45 million of purchase price in excess of book value over 15 years (i.e. $3 million per year), thus giving a tax shield of ~$1.2 million per year ($45 million divided by 15 equals $3 million; then multiplied by a presumed tax rate of 40%).

Thus, over a 15-year hold period by the new buyer, the buyer would get ~$18 million ($1.2 million multiplied by 15 years) in cash savings per the taxes that they don’t have to pay after achieving a step-up. This is good for the buyer, and can potentially command incremental value when selling your business.

If you’re a C-Corporation, you obviously know that you have been paying corporate-level taxes, and then having to pay personal taxes on any dividends out of your company. This company type is admittedly not ideal from a buyer’s standpoint, because: 1) you would never choose to sell them assets (which would allow them to achieve a step-up) because you would get taxed twice. Once at the corporate level once you sell the assets, and again when you dividend the cash out to yourself; and 2) since you have to sell stock, selling the stock of a C-Corp does not allow for the buyer to claim a ‘step-up.’ Thus, the benefits we just discussed from a buyers perspective don’t exist if you own a C-Corp.

One question that I get quite frequently is how to prepare a company for sale in order to maximize the price and make the sale as easy as possible.

The Short Answer

Three things: 1) get your financials organized so that you can show a buyer at least 3 years of annual financials in Excel; 2) organize metrics for your business – at least having unit count or unit economics to help understand the business; and 3) craft your story – practice articulating your value proposition and having answers to questions like why you’re different than competitors, why you win customers over competitors, etc.

1. Organize your historical financials. Have your accountant review your internal financials, have him/her ensure you’re following GAAP (generally accepted accounting principles), and be able to have at least your annual historical financials over the past 3 years in a consolidated Excel sheet.
2. Get metrics driven.You want to have operational metrics that can tell the story behind the historical financials. Buyers like businesses that they can understand – and metrics help them understand the business. In a buyers’ eyes, a well-run business is a metric driven business. At the very least you should have the unit economic metrics. This means that if, for example, your company sells umbrellas, you should lay out the sales price less all the discrete direct cost items for that product (breakdown of materials cost, labor cost for each unit, sales commissions, etc.). Further, you should have the total number of umbrella units you have sold each month, so that you can easily show revenue per umbrella, cost per umbrella etc. by simply dividing the total revenue and costs by that umbrella unit count. This will go a long way in helping buyers conceptualize your business, which will get them quickly up to speed on your business
3. Craft your story. Just as important as the financials and metrics is telling the story and positioning your company the right way. Just like with metrics – buyers like businesses that they can understand, and articulating your story helps them understand your company. Start with the value proposition – this is the statement of value that you bring to your customers. The value proposition of an umbrella manufacturer may be that they ‘provide rain protection products that are more portable and convenient to carry and last longer than conventional umbrellas at a highly competitive price.’ It sounds simple to articulate the relative value you bring to your customers, but it is alarmingly common for a business owner to be unprepared to articulate this. In addition to the value proposition, you want to be able to articulate why customers choose you over competitors – examples may be product quality, lead time delivery, low warranty return rate, geographic location, etc. It is tempting just to speak to ‘customer service’ or ‘good customer relationships’ – and buyers hear these reasons from nearly all company owners – so to differentiate the story but I would urge you to, if at all possible, dig deeper to get to specific factors that engender that good service or good customer relationships. Lastly, a buyer is going to be focused on how you’re going to keep your current customers, particularly any large customers, as well as how the company can grow. Be specific in addressing both of these concerns – describe the key customer relationship dynamic specifically, and have at least 2-3 specific avenues for ways to grow the company. Per future growth, the more specific the better. For example, rather than saying “we could grow by selling umbrellas to the big box retailer channel – we have never seriously gone after them,” you should rather focus on “the umbrella category buyer at Costco is open to evaluating our product line, which could represent a $5 million annual opportunity per region.”

Once you have your financials in order, have metrics that help tell the financials, and most importantly have a story that explains both the financials and metrics and helps buyers understand the businesses past, present and future – you’re ready!

With the proliferation of lower middle market private equity, more and more small business owners are in a position to consider selling their company to a private equity firm. Since most small business owners are not wholly familiar with private equity apart from intimidating sounding Wall Street Journal headlines of the global “megafunds,” it is important to better understand the process that a private equity firm will typically undertake in order to purchase your business.

The Short Answer

In short, throughout the initial review, initial bid (IOI), management meeting, letter of intent (LOI), post-LOI diligence, and closing process, you can expect a lot of diligence requests and a lot of questions that will take up a substantive amount of your time. That being said, you can expect a much more structured process than with other buyers, and you can expect these professional investors to generally expeditiously move forward with an acquisition.

You can almost certainly expect to meet with some uncomfortable, or impractical questions or data requests – I suggest you try to keep your cool and understand that these private equity firms are simply trying to understand your business as best as they can. That being said, don’t forget that throughout this process, they should be at least partially in marketing mode – if any issues arise, don’t be afraid to cut off communication and move on to a different private equity firm.

For a more detailed look into the steps of the bidding process, see the next post here.

Last time we looked at the role of an intermediary in a sale process, as well as what makes a good intermediary. In this post, we’ll take a quick look at why you might (or might not) want to go the intermediary route.

Pros of Using an Intermediary

1. Outsource the process and lessen your headaches during the process. Intermediaries primarily manage the communication and organization of the sale process, and externalizing these headaches that go along with interacting with buyers, managing a process, etc. is a valuable proposition to you as a business owner.

2. Maximize value through externally managed competitive auction. Since the intermediary is primarily tasked with running a competitive process, and the intermediary is arguably more focused on this process than you could be during this time period, then the outcome should result in a purchase price at least as high, if not higher, than you could achieve on your own.

Cons of Using an Intermediary

1. The biggest con is the cost of the success fee that intermediaries charge. Of course, at some price the administrative work even a mediocre intermediary does – but that’s the crux, there are standard fees in the intermediary world. For companies under $2 million of EBITDA, business brokers can charge up to 10% of the sale price in a commission structure. For larger companies, the commission percentage is smaller, but the commission fee on a dollars basis increases and is still in the 1.5% – 2.5% range even for deals with $15 million or $20 million of EBITDA. Suffice to say – it’s a real expense that thus deserves consideration.

2. Risk/probability that intermediary does not spend sufficient time on process. Even if an intermediary answers the 5 questions well, hits it off you with on interpersonally, and pledges to work as hard as they can – there is a chance that once they have you signed up with an engagement letter, that tune changes. Few things feel worse in the transactional finance world than paying a $1 million success fee to an intermediary who didn’t earn it.

The Fundamental Trade-off

The fundamental question per the above is to weigh the hefty fee that you will pay an intermediary versus the value that you place on outsourcing the sale process organization management by running an externally managed competitive auction. Often, that trade-off may not make sense even with a good intermediary, but if an intermediary can ensure they will properly devote the time to organize and manage the process, maximize the value of your company through a fulsome auction process, then you should think long and hard about engaging an intermediary.

Feel free to send me a note here and I can refer along a good intermediary or two depending on the size/industry of your company.

If you’re interested in exploring a partial or full sale of your company, a big question is whether to hire an intermediary (i.e. a business broker, or an investment bank; we will use the term intermediary, business broker, and investment banker interchangeably in this article) to facilitate the process. Is this a good idea?

Short Answer

Hiring a good intermediary can be a good idea; hiring a bad intermediary is always a bad idea. To identify a good intermediary you want to ensure that they: 1) have experience doing deals in your industry and with companies of your size; 2) can articulately identify the most probably buyers for your initial buyers list; and 3) you are going to get a sufficient degree of attention from them. You want to see if you have a good intermediary before even starting to weigh cost/benefit because of the huge variability of the intermediary that exists in the market.

If they meet these criteria, weigh the cost vs benefit of hiring an intermediary. The fundamental decision on whether to hire an intermediary will come down to weighing whether the intermediary fee is justified by the administrative burden you can outsource and the incremental purchase price you can get by hiring them rather than just relying on your accounting and legal resources.

In summary, a great intermediary is worth the headache of dealing directly with potential buyers because you will get a painless-as-possible process and possibly a higher value than you otherwise would have received. Great intermediaries are very rare. An OK intermediary is potentially worth it if you greatly value the admin tasks you can outsource to them, but I would not count on receiving a higher value than you otherwise could independent of an intermediary. A bad intermediary is going to slow your process down, likely to be a drag on value, and in general be a terrible experience for you.

Longer Answer

Let’s think through the role of an intermediary in your company sale process, dig deeper in how to identify a good intermediary candidate, and then examine the pros and cons of hiring someone for this role in your exit process:

What a Business Broker/Investment Banker Does

For privately held companies, an intermediary is going to organize your materials into a presentation format, develop a buyers list of logical acquirers, approach those buyers, have the prospective buyers sign confidentiality agreements, and then look to educate these prospective buyers on the business while positioning your company in the best light to receive the highest bid.

After engaging the buyers, the intermediary will then set a date for the submission of initial bids that will gauge interest in the buyer universe in terms of relative purchase price submitted by each buyer. Typically, a subset of bids will be selected and those buyers will be chosen to meet with you and your team at the company to learn more about the company and the acquisition opportunity. For the meeting, the intermediary will generally prepare some additional materials to discuss during the meeting to give structure to the in-person meeting. After this meeting, additional requests and questions are fielded by you and the intermediary, and a final bid date is set by the intermediary.

After final bids are received, generally one party is selected by you to complete the transaction over a 45-90 day period. During this final time period before closing, the intermediary is working with you to fulfill diligence requests and coordinate legal documentation (i.e. the purchase agreement) up until the closing date where money is wired, all while ensuring that the buyer remains on track to consummate the transaction on the terms and timing you agreed to at the time of the final bid submission.

That was a whirlwind description of the process and the intermediaries responsibilities – but it really boils down to this: intermediaries organize your materials, they coordinate communication with the buyers, and they set the initial and final bid dates and organize the bids that you get at both stages of the process. Finally, they help keep the final selected buyer on track during the final stage before closing.

How to Identify a Good Intermediary

You don’t want to even consider hiring an intermediary unless it’s a good intermediary. And even if you have identified a good/great intermediary, you don’t want to hire them until it passes the cost vs. benefit analysis we’ll talk about later. So before we start weighing the pros and cons, let’s talk about good intermediaries.

Good intermediaries are very rare. Whether you’re a $500,000 EBITDA company or a $10 million EBITDA company, there are no shortage of people who want you to sign an engagement/fee letter with them guaranteeing them payment if/when you sell your company. However, you only want an intermediary that has previous knowledge and experience selling businesses in your size range and in your industry. In other words, a good intermediary will know your business, and thus knows the likely universe of buyers. Incremental to their experience and buyers list prowess, you want to ensure they will have time to dedicate the necessary resources to give you the attention you deserve. If your key point person will be juggling more than 3 active transactions during the months of your deal process, even if they have great experience they will likely not be a good intermediary for you. Further, if they don’t have support staff (i.e. analysts, vice presidents) to help them execute the deal, you will find yourself doing more of the work than you would like.

As a more concrete litmus test, if your intermediary cannot articulate answer all of the following 5 questions, they are not a good intermediary for you:

1. Tell me about a similar sized deal in my industry that you recently worked on.
2. Given what you know as of now, who are the top 5 buyers for my company?
3. How do you propose positioning my company to maximize value and accentuate the investment highlights?
4. What are the key risks or negative characteristics of my business that potential buyers will be most focused on?
5. How many active engagements will you be working on during my sale process, and what does your support team look like?

If an intermediary meets the above criteria with passing answers on the above 5 questions, then you’ve identified one of the relatively rare good intermediaries. It’s now time to weigh the pros and cons of using a good intermediary.

Pros of Using an Intermediary

1. Outsource the process and lessen your headaches during the process. Intermediaries primarily manage the communication and organization of the sale process, and externalizing these headaches that go along with interacting with buyers, managing a process, etc. is a valuable proposition to you as a business owner.
2. Maximize value through externally managed competitive auction. Since the intermediary is primarily tasked with running a competitive process, and the intermediary is arguably more focused on this process than you could be during this time period, then the outcome should result in a purchase price at least as high, if not higher, than you could achieve on your own.

Cons of Using an Intermediary

1. The biggest con is the cost of the success fee that intermediaries charge. Of course, at some price the administrative work even a mediocre intermediary does – but that’s the crux, there are standard fees in the intermediary world. For companies under $2 million of EBITDA, business brokers can charge up to 10% of the sale price in a commission structure. For larger companies, the commission percentage is smaller, but the commission fee on a dollars basis increases and is still in the 1.5% – 2.5% range even for deals with $15 million or $20 million of EBITDA. Suffice to say – it’s a real expense that thus deserves consideration.
2. Risk/probability that intermediary does not spend sufficient time on process. Even if an intermediary answers the 5 questions well, hits it off you with on interpersonally, and pledges to work as hard as they can – there is a chance that once they have you signed up with an engagement letter, that tune changes. Few things feel worse in the transactional finance world than paying a $1 million success fee to an intermediary who didn’t earn it.

The fundamental question per the above is to weigh the hefty fee that you will pay an intermediary versus the value that you place on outsourcing the sale process organization management by running an externally managed competitive auction. Often, that trade-off may not make sense even with a good intermediary, but if an intermediary can ensure they will properly devote the time to organize and manage the process, maximize the value of your company thru a fulsome auction process, then you should think long and hard about engaging an intermediary.

Feel free to send me a note here and I can refer along a good intermediary or two depending on the size/industry of your company.

Last time, we went through the nitty-gritty work of calculating your company’s Adjusted EBITDA. The fun part is now to apply a multiple to that EBITDA to determine your company’s value.

If calculating Adjusted EBITDA is a generally objective process, EBITDA multiples are a much more subjective process. In other words, the multiple is in the eye of beholder, as a certain company earnings stream may be valued differently by different buyers.

While multiples can vary subjectively across buyers, and each multiple is both industry and company dependent, telling you that the multiple “generally depends” isn’t very helpful to you – so let’s talk about some general ranges. The primary driver of multiple is typically size. Putting venture capital, bleeding-edge tech companies aside (i.e. if you own the next Facebook this will not be relevant for you), smaller companies trade at lower multiples than larger companies. This is because larger size generally correlates with “staying power” and thus stability (as we discuss below), and thus a more valuable cash flow stream.

With respect to small private companies, I believe that size dictates the multiple of the company more than any other one factor, and thus is a good place to start. For a services, distribution or light manufacturing company, at $1M of EBITDA or less, the owner can likely expect a 3.0x – 4.0x multiple or thereabouts. When that same company grows larger to $3-12 million of annual Adjusted EBITDA, that same company can expect a mid-high single digit multiple in the 5.0x – 8.0x range, and when the Adjusted EBITDA jumps to $15M or above, that same company can expect a 9.0 – 12.0x multiple. Said differently, size matters.

But in addition to size of the company, there are 3 other industry and company dependent factors that dictate EBITDA multiple:

1. Capital Intensity.The more capital equipment or investment in inventory you need to make in your business, the lower the multiple will be – all else equal. While EBITDA is the commonly accepted proxy for normalized cash earnings, things like required capital expenditures (i.e. buying equipment) is a drain on cash earnings, and lower true cash earnings means a lower multiple assigned to that EBITDA. So a $5 million EBITDA manufacturing business with $1 million of annual capital expenditures required is going to fetch a lower multiple on that $5 million EBITDA amount then is the $5 million EBITDA services business with $0 capital expenditure requirements.
2. The higher the historical and/or projected growth of an industry or specific business, the higher the multiple. The logic here is intuitive – you would pay more for an earnings stream that is growing faster than one that is staying flat, or declining. A $5 million EBITDA software company growing at 20% per year historically, and is projected to grow 20% to $6M EBITDA next year is worth more than a flat $5 million EBITDA distribution business
3. Just as important as the growth profile of the company is the stability of its financial performance. Buyer investment themes like seeking companies with ‘recurring revenue,’ ‘repeat customers,’ or ‘predictable cash flows’ all are aiming to identify stability. In my mind, this single aspect determines an EBITDA multiple more than any other. Buyers want to buy a business that delivers a “guaranteed” reliable, stable, predictable cash flow. Customer repeatability, and consistent margins are the key drivers of consistent margins. Most importantly, buyers can convince themselves of future growth without historical growth, and they can convince themselves they can be more efficient with capital spending than historical – but they can rarely convince themselves that volatile cash flows will become stable. Thus, stability is key, and the more stable the year-to-year performance, the higher the multiple assigned to that EBITDA stream.

Stability, growth and capital intensity are the primary reasons that software companies are worth higher multiples than a “job shop” manufacturing company. Software companies can scale (i.e. grow) easy with no capital investment (thus low capital intensity), they generally embed themselves into their customer’s business operations and thus have customer repeatability and stable performance, and software generally is considered a growth sector. So low capital intensity, high stability, and high growth. Conversely, a machine shop has to continually buy equipment to grow, and thus is capital intensive in its operations, U.S. domestic metalworking manufacturing is not generally considered a growth sector, and a CNC ‘job shop’ tends to experience inconsistent customer repeatability and volatile year-to-year financial performance. Obviously, the software EBITDA stream, even if the same size as the CNC machine shop, warrants a much higher multiple.

Now that we’ve discussed how to calculate Adjusted EBITDA and where to start in finding a multiple – let us do the work for you! Head here, fill out as much information as you can, and we’ll give it some thought and send you back something that will hopefully be helpful in valuing your company.

Determining what a company is worth is the single biggest question in any business owners mind.

The Short Answer

Find your Adjusted EBITDA, which is your normalized earnings before interest, taxes, depreciation, and amortization. Then, multiply that Adjusted EBITDA by a multiple to get to the value. The multiple will depend on your company’s size, growth trajectory, stability and capital intensity – and will almost certainly be in the 3.0x to 12.0x range.

Small, private companies less than $1 million in annual Adjusted EBITDA will likely trade for 3.0x or less, and companies with publicly traded market capitalizations in the hundreds of millions will generally trade in the double-digit Adjusted EBITDA multiples. We’ll take a closer look at what factors drive the EBITDA multiple next time.

Take a look at our free valuation submission form here in a new tab to have us do some free work for you on estimating what your business should be valued at.

The Longer Answer

A business owner’s most valuable asset is generally not the equity in their home, but the equity in their business. This is because unlike homes that usually only modestly appreciate based on underlying subjective property values, businesses are valued based on a multiple of the earnings that they generate. So an increase in profitability from gaining a new customer, decreasing costs, or increasing efficiency is subject to a multiplier effect in terms of the value you’re creating in your business.

Let’s take a step by step look at how to calculate a value based on the multiple of earnings concept.

How do I calculate my company’s earnings?

The earnings that are used for multiplier purposes to calculate your company’s value is EBITDA (an acronym for Earnings before Interest, Taxes, Depreciation, and Amortization). We use this as the earnings amount because it’s an apples-to-apples proxy for pre-tax cash flow in the business. In other words, EBITDA is meant to be representative of the income that a business generates before subjective variables like debt balance, tax payor status, or equipment purchase timing come into play. In other words, EBITDA answers the buyer’s most important question of “If I buy your company, how much money do I make per year?”

Calculating EBITDA is easier than it may sound. Here is a simple guide that will get you there:

Step 1: Look at your income statement, and find Net Income (generally it’s all the way at the bottom)

Step 2: Find the interest expense line item in your income statement, it should be in the operating expenses, and add it to the Net Income number (Note: if you run a debt-free company, you won’t have any interest expense so this number will be zero)

Step 3: Find the income tax expense line item in your income statement (ongoing taxes you pay to regulatory authorities, like a permit fee doesn’t count), and add this to Net Income as well. Note that if you’re an LLC or an S-Corp (more on this here), you probably won’t have an income tax line item expense, so this number will be zero.

Step 4: Find the depreciation and amortization expense. This can be both in cost of goods sold (“COGS”) and operating expenses, depending on how your accountant allocates this, but will typically just be in operating expenses. Find all the depreciation and amortization, and add this to Net Income as well.

After taking net income, and adding back interest, taxes, depreciation, and amortization, we now have EBITDA!

Before we move on from our EBITDA calculation, however, take one last look through your income statement – add any other line items that exist between operating expenses and net income that have not been added to net income already (i.e. gain/loss on sale of assets, non-cash stock compensation). Most small business income statements won’t have these line items, so if you don’t see them don’t worry – it’s normal not to. But it’s important to add these back if they do exist to get to a fully scrubbed EBITDA number.

Now that we have your EBITDA number, there is one step left to get to the earnings that we will apply a multiple to in order to get to the value of your company. Let’s call them ‘additional add-backs,’ although they are also known as ‘extraordinary expenses,’ ‘non-recurring expenses,’ or ‘one-time expenses.’ These are a little harder to find, but they are effectively any expenses that would not necessarily be incurred by a new owner. The most common expenses are going to be:

1. Excess owner compensation. Calculate the difference in the amount you pay yourself or the ownership group annually, less the amount it would cost to replace them and still run the business on a “business as usual” basis. For example, as an owner you pay yourself $500,000 per year in salary to take some profits out of the company as a salary; but you could replace your managerial role for $150,000 per year. Add $350,000 ($500,000 less the $150,000 replacement managerial expense) to your EBITDA number. Be sure to include any accompanying payroll taxes.
2. Owner/non-essential expenses. Nearly all closely held businesses have some owner expenses running through the income statement for tax purposes. Rest assured that no buyer is reporting you to the IRS for those tickets where you may have taken your daughter to the game rather than a client that one time. Add up all the expenses that you or the ownership group expense through the income statement that a new owner does not need to run the business going forward. Automobile, travel, entertainment, health insurance, benefits, etc. are usually the most common line item expenses where these owner expenses or non-essential expenses reside.
3. One-time expenses. These are other one-off expenses not related to your compensation, but those expenses that would not be expected to recur every year. For example, you had a flood in your building, and had to pay a flood insurance deductible. (Hopefully) having floods in your building is not an inherent part of your business model, so that insurance deductible payment will be a one-time expense, and will be added back to EBITDA.

Add all the additional add-backs (i.e. excess owner compensations, non-recurring expenses, etc.) to EBITDA, and then we have our Adjusted EBITDA. This is your earnings number, adjusted for non-recurring expenses, to which we will apply a multiple and get your company’s value. This is a number that you can tell to any investment banker, private equity professional, or effectively anyone who works in transactional finance and they will immediately understand. It’s the universal language of deal making!

Next time, let’s find your EBITDA multiple so we calculate how much money you have tucked away in your business.