Exit Planning Exchange

By William A. Duratti

Recent changes to Mergers and Acquisitions accounting has given rise to new questions, confusion, and sometimes even hesitation over completing a deal. Requirements under FAS141R are behind it all, and companies will have to comply beginning in calendar year 2009 – a date that looms large for many who are considering business combinations.  However, the challenges presented by FAS141R should not stand in the way of intelligent deal making. Buyers and sellers alike will adapt to the salient changes and base their decisions on whether an acquisition is a good deal at the right time for them.  Even as their accounting and valuation teams make the necessary adjustments, they know that advantages can be gained from the new system. The changes under FAS141R complete a joint effort by the FASB and the IASB to improve financial reporting for business combinations and to promote the international convergence of accounting standards.

FAS141R will cause some major changes and fluctuations to post-merger balance sheets. Understanding the new guidance, modeling deals accordingly and gauging impact on the financial statement before closing the transaction will help reduce any potential negative effects.  Complications arise due to the tricky nature of fair value and deal modeling, especially when estimating intangibles like unresolved contract contingencies. Calling in valuation specialists mitigates the damage that can result from poor assessments. When financial analysts evaluate transactions and earnings, they’ll be looking for how fair value was applied and what normalized earnings will look like on a forward looking basis.  This is especially timely as fair value under FAS141R will follow the guidance of FAS 157 and is defined as: “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measure date.”

Major changes to this definition include the marketparticipant perspective, exit price and more reliance on observable inputs, all of which create more difficulty in financial reporting for business combinations.

When all is said and done, these revisions mean that company leaders can expect ups and downs. When it comes to M&A activity, an acquired entity will likely cause turmoil in financial statements until the merger stabilizes over a number of reporting cycles.

The most significant changes coming under FAS141R include:

1. TIMING OF DEALS AND REPORTING

The biggest challenge for financial departments may come with the increased emphasis on timing and a growing list of disclosure requirements. FAS141R provides a more stringent timeline for reporting business combinations, and if deadlines are missed then provisional amounts must be reported for incomplete terms. That means not having the most qualified information, which can lead to more serious issues down the road.  There is a grace period of one year after the deal is closed – called the “measurement period” – during which provisional items can be adjusted.

Also, the expanded disclosure requirements make meeting the deadlines even more difficult and often will force a company to speed through the process. A deeper planning process and having the right team in place early will help avoid sacrificing quality and accuracy for speed.

2. CONTINGENT CONSIDERATION

Perhaps the most significant accounting change is the requirement that the purchase price of a business combination now include the fair value of contingent consideration. This change could significantly increase the upfront purchase price recorded on deal transactions, as well as increase the volatility of subsequent accounting.  The contingent consideration will be recorded by the acquirer as a liability at fair value as of the transaction date and will need to be adjusted to fair value at each subsequent reporting period. Given the major uncertainties as to future amounts and timing of payments of the contingent consideration, the fair value of this liability may materially fluctuate over time as more information is obtained.

Companies putting contingent payments into the deal structure will need to closely assess fair value of the 2 contingency. There is no predicting the future, but modeling and understanding the shapes that a deal can take will help mitigate the potential fluctuations in reporting.

3. IN-PROCESS R&D (IPR&D)

Under previous regulations, companies could record the fair value of IPR&D as a period cost of a transaction.  FAS141R, however, requires that the fair value of IPR&D be recorded as an intangible asset on the balance sheet. If the IPR&D does not come to fruition, it will subsequently need to be written down to its fair value, potentially zero, resulting in an impairment charge to the income statement.

4. DEAL COSTS

Acquisition-related costs such as negotiations that involve banking and legal fees were traditionally reflected as deal costs that could be capitalized along with the purchase price, but FAS141R calls for these items to be expensed immediately as period costs.

5. ASSETS AND LIABILITIES ARISING FROM CONTINGENCIES

FAS141R improves the completeness of the information reported about a deal by changing the requirements for recognizing assets and liabilities that arise from contingencies. An acquirer is now required to recognize these elements as they arise from both contractual contingencies and noncontractual contingencies as of the acquisition date, measured at their acquisition-date fair values. Again, post-merger adjustments to the fair value of these contingencies can create significant fluctuations in reported earnings.

ACTION ITEMS

With these items and others looming large at the beginning of 2009, companies that are pursuing acquisitions should take a few important steps to solidify their position.

• Re-assess current deals to determine the impact that FAS141R might have, and consider if it will be beneficial to close after the deadline passes.

• Be certain that the right teams are in place to understand and apply new fair value concepts to aspects of a transaction.

• Instruct teams to prepare for the new guidelines and adjust their approach as best as possible to minimize impact on the balance sheet and fluctuations in future reporting.

Despite the changes and action items that accompany FAS141R, the reasons for sourcing and completing deals should remain the same. Company leaders will still strive to make decisions that are strategically sound for their business or come at a good investment price at the right time. The fact is, pre-141R accounting was already a mystery to many. Adjustments will come from the valuation and accounting side to ensure that deals go through smoothly and under the best possible terms.

Material Discussed in this Insight is meant to provide general information and should not be acted on without obtaining professional advice tailored to your firm’s individual and specific needs. This information is for general guidance only and is not a substitute for professional advice.

By Andrew Crain and Rod Robertson

The knockdown wave that paralyzed merger & acquisition activity in the lower- and middle-market since September 2008 has rapidly receded, promising a rising tide of dealmaking in 2011.  All the components for an active M&A market are in place:  pent-up deal supply, as frustrated sellers adjust valuation expectations and private equity funds seek to realize long-held portfolio investments; pent-up buyer demand, as corporations replace their recent fixation on cost cutting and liquidity preservation with an increased focus on top-line revenue growth and as private equity groups put uninvested funds to work; and increased capital availability, as credit is once again available at favorable rates and companies once again have healthy balance sheets and cash to invest.

M & A TRENDS AT 2010 YEAR-END

Dealmaking began to rebound in the second half of 2010.  Thomson Reuters reports that “as of December 14, dealmakers have announced 7,258 U.S. transactions worth $773.5 billion this year though some may not be completed.  Last year, 6,503 deals worth $731.5 billion were completed.”   PriceWaterhouse Coopers found a similar trend in the middle market, “logging 724 deals worth a combined $240 billion in disclosed value, up 54% over 2009.  Average deal size also grew, elevating to $247 million, compared to $219 million last year, a trend PwC attributes to the availability of debt, strategic buyer optimism and the substantial private equity overhang,” as reported in Mergers Unleashed on December 10.

Our conversations with buyers and sellers indicate that many more deals were pushing to close by 2010 yearend, but sellers motivated to close for tax reasons paused for breath once the Bush tax cuts were extended and those deals will now kick off a strong 2011 instead.

SELLERS RELUCTANTLY RETURN

The decade-long run up to the recession, with both earnings and valuations (as multiples of earnings) growing year after year, set sellers’ expectations at levels reminiscent of the internet bubble.  The downturn paralyzed most M&A activity as the new playing field was met with dismay by owners of small- and medium-sized businesses.  Depressed valuations, the return of in-depth due diligence, and the disappearance of covenant-lite purchase & sale agreements all combined to drive patient sellers to the sidelines.  Those left to sell in 2009 and early 2010 were, typically, distressed companies selling at distressed prices in bankruptcy or liquidations.

As the economy steadied and credit loosened in mid-2010, valuations began their return to pre-recession levels.  According to GF Data Resources, which tracks private equity deals ranging in value from $10 – $250 million, enterprise valuations across that size range averaged 6.0X in the third quarter of 2010, and even the smallest size subset ($10 – $25 million) reached an average of 5.8X EBITDA.

Sellers today have reconciled to the fact that valuations have rebounded to sustainably sensible levels, and they are no longer sitting on the sidelines in hope of higher returns.  Many owners who plowed ahead funding losses, counting on an economic rebound for rescue, now see economic forecasts for slow growth at best.  Aging owners who postponed retirement are now ready to sell.  Private equity owners who held portfolio companies beyond planned time horizons are now rushing to realize their investments, especially those who will be fundraising in 2011 and 2012. Thus we foresee a steady flow of sellers coming into the M&A market this year.

A FIELD DAY FOR BUYERS

Well-capitalized strategic buyers remained active acquiring distressed competitors throughout the recession and, armed with inexpensive credit and abundant cash, continue to be opportunistic.  Other companies are entering the fray as confidence returns and leaders shift their focus from preservation to acquisition.  Others, faced with a sluggish recovery and prospects for slow growth, seek acquisitions to drive growth externally.  The combined impact of these motivations will be substantial, as a recent mergermarket.com survey showed that 82% of US business executives expect increased M&A activity over the next 6 to 12 months.

Private equity buyers are equally motivated to do deals.  With the “overhang” of uninvested PE funds reaching a reported $500 Billion, there is urgency to put those funds to work.  PE managers are also cognizant that acquisitions done during and after economic downturns historically yield higher returns than those completed during boom years.  As a result, according to GF Data Resources, “private equity groups are becoming less discriminating in their choice of targets given the pressure on them to invest funds.  There are more B and B+ properties on the market now and sponsors are willing to pay a little more for them.”

Entrepreneurial buyers, driven to the sidelines in the boom years by larger and better-financed financial and strategic buyers paying high valuations, are now re-entering the game.  The recession flushed many senior- and middle-management executives into the job market through downsizing and corporate closures.  Many of these talented executives are taking matters into their own hands, using their strategic skills to identify and acquire companies with favorable investment characteristics.  However, many entrepreneurs find that they must rely on seller financing or private equity backing in order to credibly pursue and close acquisitions of even modest size.

THE TIPPING POINT

We believe that this confluence of events will lead to a resurgence of M&A activity in 2011.  Orphaned companies and firms mortally stricken during the recession have been purchased, cannibalized or are seeking a buyer as we write.  Sellers realize that if they want to exit, now is the time as the economy rebounds and as favorable tax rates have been extended for another two-year window.  Strategic, private equity and entrepreneurial buyers have returned to the market and enterprise valuations have rebounded to pre-recession levels.  Commercial banks and mezzanine lenders are permitting buyers to place more debt on pragmatic deals.  In sum, sellers, buyers and lenders have all returned to the M&A market and are converging on common ground where excesses have been curbed and sensibility should reign once again, permitting dealflow to flourish in 2011.

By Bonni Carson DiMatteo

Often motivated by business “burn out”, a strained business climate or the image of an endless vacation, founders begin to consider selling their business. It seems like a perfectly left brain solution to frustration, malaise or boredom. They may talk to their spouse about how they are burned out or want to extend their winter vacation in Naples, or have more time to visit the grandchildren, and before you know it they are talking to their accountant, lawyer, financial planner or a business broker about selling their business. Their business advisor helps them crunch some numbers, estimate how long it might take to sell the business in the current environment and to determine the value proposition. When all the signs point in the direction of “Sell”, why do some businesses fail to execute? Founder reluctance and a founder centric culture will derail the ability of many businesses to “close the deal”.How can these companies change their mindset so that they can implement a successful exit strategy? Which advisors are best equipped to address the right brain thinking that can often instigate or derail the sale?

Over the last several years, exit planning advisors have been thwarted by a business climate marked by declining sales and earnings, shrinking bank credit, and a poor economic outlook. Consequently, there have been few buyers in the market since the beginning of the financial meltdown in 2008. With cash reserves built up over the last 2-3 years, and gradual improvement in economic conditions, companies are showing more interest in buying new businesses. The availability of buyers is estimated to exceed that of sellers in 2011. As more deals are executed, company valuations are expected to increase. This appears to indicate a great opportunity for companies to jump into the market and sell their business.

Stalled at the Altar

The companies most likely to stall at the altar are those that have what we call a “founder centric culture”. These companies, often started by boomers 25-40 years ago, have been operating for more than a generation. If they do not have a succession plan they are looking for some way to capitalize on their biggest investment, their business. What obstacles are inhibiting these companies from successfully completing a sale? Many attribute the failure to execute the sale to factors such as disagreement on price and market conditions. Buyers looking for a good investment may back away from companies that have an immature internal structure and a founder centric culture. Often, the emotional founder ambivalence and founder centric culture of the company are the biggest hurdles to overcome.

Symptoms of Founder Ambivalence

Founder ambivalence is marked by:

• Difficulty with following through on action plans suggested by advisors.
• Being preoccupied by a stream of company crisis that distracts from the big picture.
• An over worked and stressed founder who has no reason to focus on the big picture.
• Lack of a clear personal and family strategic plan to take them into the next 10-20 years
• A clearly defined sense of purpose and mission beyond the business

• Company leadership deficits
• Process deficits
• Culture deficits

The business is the founder and the founder is the business. Therein lies the challenge. Their greatest strengths are often their greatest weaknesses. In founder centric companies, you often find a Founder who is actively involved in working in the business, but not on the business. They are a key rain maker or customer evangelists. They are what we call a Founder Hero because they are often the only one who can serve customers right. There are frequent fire drills and often the founder is the one rescuing the day.

It is what Michaels E. Gerber refers to in The E MYTH as the conflict that rages among the three hats of entrepreneur, manager, and technician. They may be the chief decision maker and process saboteur; they have no succession plan or strategic plan; They have no advisory board; They simply meet each day’s challenge; keep a steady pace and do things in ways that have worked in the past. They see no reason to have a vision or a plan. The company mantra is “we’ve always done it this way”.

Buyers are wary of a lack of process and systems that can survive beyond the founder. They may, or should, have a certain skepticism that this founder will be able to let go of something that gives him or her such a sense of identity and purpose, or that staff, vendors and customers will be able to transfer their loyalty to a new owner.

Company/Leadership Deficits

In the founder centric company there are noticeable leadership deficits. While the founder is clearly the culture creator, and larger than life in many ways, the sense of leadership dwindles from there. Often there is a key executive who has been with the company almost as long as the founder and follows his or her path. There are little to no leadership/management competencies or development. If there is a management team, it may be one that does not function effectively.

Buyer Red Flags

Buyers may be cautious of such leadership vacuums, knowing that without the founder there is little capacity to decide, execute and achieve results.

Process Deficits

In founder centric companies there are often great ambiguities among people in terms of roles and responsibilities. This is further complicated by the lack of a systemized process that allows for efficiency and success. The firefighting caused by last minute crisis ultimately results in the erosion of profits. To further compound the problem, decision making often occurs only at the top and there is no accountability throughout the company.

Buyer Red Flag

Buyers observe this cautiously. Process improvement and tightening may create an opportunity to improve profits, but the current state of the organization points to weakness.

Culture Deficits Are Created By The Leader/ Founder

In founder centric companies there are often extreme levels of morale and engagement. Larger than life personalities often create a tightly woven family of employees. They are loyal to the founder and the founder is loyal to them. There are blessings and curses with this.

As the company grows it is difficult to change the guard and the guard is not always adaptable to change.

The culture is often marked with crisis du jour, stress, complacency, silos, no sense of accountability. There are challenges with retention/talent attraction, an aging work force, lack of diversity, change resistance, and no sense of vision of the future due to strategic plan deficits.

Buyers eye this phenomenon guardedly. They understand that if the founder leaves there may be a vacuum too big to fill and the loyalty will soon dissipate. Buyers are looking for a company that can evolve beyond a company founder. As buyers observe the challenges of a founder centric company often the financial value begins to diminish.

What can a founder and their advisor team do to reshape their company and make it buyer friendly?

Steps In Evolving From A Founder Centric To A Buyer Friendly Company

Buyer friendly companies have evolved from a founder centric culture by implementing best practices in leadership, management, organizational development and process/ profit focus. They differ from founder centric companies in that they focus primarily on working ON the business rather than IN the business, utilizing a more systematic business process. The following steps are needed to evolve the company from founder centric to buyer friendly.

Key Advisors Needed At Each Step

To execute a sale that maximizes the company value, key advisors must work together and in tandem to help reset the company’s GPS.

1. Founder Readiness: Creating A Legacy And Resetting The GPS Personal Strategic Planning:

The execution of a sale begins with a focus on legacy and personal strategic planning combined with corporate strategic planning. This enables the founder to create a vision, mission, values, and goals for him/herself, as well as leaving the business in a position that commemorates their legacy of success.

ADVISOR TEAM: Management Consultants; OD/Coach; Recruiter

The company and the founder need to prioritize building a leadership/management bench by identifying key leadership capabilities and competencies, and through training or coaching in house managers or recruiting new blood. There also needs to be some team building to solidify a cohesive team to set and execute goals and to develop a new organization chart that clearly defines roles and responsibilities.

ADVISOR TEAM: Business Coach/ OD Consultant Corporate Strategic Planner

As with a personal legacy, the founder and executive team need to create a strategic plan that closes the gap of vision and current reality and sets executable goals for:

• Decentralized decision making
• Management competencies
• Process improvement
• Innovation
• Increased revenues

It is necessary to set the stage for growth and operational effectiveness that will attract the right buyer at the right price. The discipline of executing on a 1-3 year plan will much better position themselves for a good sale.

ADVISOR TEAM: Business Coach, Organizational Development or Management Consultant

Help create the change necessary to maximize the volume of the business. Heath & Heath’s book, The Switch, is a good reference for this. This step is not only a process improvement leap, but a mindset and cultural leap as well.

ADVISOR TEAM: Financial Planner/Accountant to help owner finance the future

Understanding what the owner needs, what they have, and closing the gap

ADVISOR TEAM: Lawyer, Coach, Financial Planner, and Accountant

Addressing the 4-legged stool: the legal, financial, long-term financialgoals and the personal legacy the owner wants to create

7. Finding The Buyer:

ADVISOR: Broker

Identify the new value of the company and determine the strategies for selling and finding the best buyer.

ADVISOR TEAM: Lawyer, Accountant, Coach, Broker, Financial Planner.

This is where seller ambivalence most rears its head. The collective input of all advisors, particularly the coach who best knows the right brain challenges needed to help take the founder to the altar.

Both advisors and sellers can benefit from the lessons learned from implementing these steps. Evolving from an Entrepreneur to Founder owner to Leader is not an easy or fast process. However this can be accomplished in 6-12 months once the founder mindset is fully engaged in the process and the outcome. Specialists in behavioral economics and organizational culture are essential to unbind the organization and leader from a founder centric mindset and homeostatic behavior. Experts in this field are an essential part of the Exit Planning Team that provides right brain balance to the left brain experts.

A sale that maximizes the value of the company can best be reached when the first 7 steps are completed. As the founder resolves their ambivalence they become more confident and committed to the sale. In turn, buyers respond with a similar confidence and enthusiasm. It is only through creating the changes inside and outside the founder and the company that the sale can be fully achieved at its greatest value and without last minute ambivalence that can undermine the final signing of the agreement.

Copyright Bonni Carson DiMatteo 2011 Atlantic Consultants 27 Mica Lane, Suite 106, Wellesley, MA 02481 5