Exit Planning Exchange

By Jack Beauregard

An estimated seven million baby-boomer business owners will exit their companies over the next 20 years — and many of them are your clients.  How can CPAs take advantage of this growing wave so that, instead of  losing your clients, you can actually develop new business opportunities from these transitions?  When you are ready to exit from your own company, how can you transition most successfully for both your maximum financial outcome as well as your personal satisfaction?  The process of personal transition planning can successfully answer these questions. Transition planning will benefit your business-owner clients.  CPAs who work with clients through the transition planning process can open up new business opportunities for themselves. CPAs thinking about leaving their own businesses can benefit personally from engaging in their own transition planning.

The Time Factor

A major reason why owners fail to make successful business transitions is because of costly misconceptions about time. Many owners believe that it is too early for them to plan what they are going to do with their businesses or with their lives after leaving their businesses.   Another common misconception is the belief that they do not have the time to make a plan for exiting their companies. Owners often think it will take no time to sell their businesses, which causes them to walk into a business brokerage or M&A firm and announce that they want to sell their companies immediately.  The fact is that if owners fail to take the time to plan, they have created a plan to fail.  Overnight transactions are not based in reality, since owners will need time to meet with professional advisors such as lawyers, financial planners, etc. with expertise in the exiting process. It also takes time to create a strategic game plan, so the owner can get the company into the best business and financial shape possible to realize the maximum amount of money.

What Transition Planning Can Do For Your Clients — And For You

A transaction does not happen until an owner makes a decision to transition out of his company.  Just as a successful business reflects well thought-out ideas about growing one’s business, owners also need to take the time to think about and decide “How do I want to leave my company?” In fact, 75 percent of baby-boomer owners who have already exited their companies report regretting leaving because they did not make well thought-out exit decisions, were not aware of all their options and did not develop a planfor their lives after they had left their companies.  Qualitative issues are as important as quantitative considerations when transitioning out of a business.  Often, psychological and emotional issues hold business owners back from thinking about leaving their companies or beginning the actual planning process.  Owners who engage in transition planning are able to deal successfully with both the “hard” and “soft” issues involved in transitioning out of a business. As part of the process, they also work with a team of experienced advisors — including a CPA and other professionals — to develop and implement the best financial and business strategies for exiting and passing on their businesses successfully.   A CPA who is part of this team opens up new billable hours by preparing a business plan, cash flow projection and preliminary estimate of value as part of the transition process. You are also in a position to get in “on the ground floor” with the new owner, as well as make new contacts and develop new business leads through working with the lawyers, financial advisors, wealth management consultants and other professionals on the transition team.  Finally, as reported in the Wall Street Journal on February 16, 2010,  Americans in the 55 to 64 age group have posted the highest rate of entrepreneurial activity for the last 10 years, so a CPA’s next new client may be a business formed by the former owner of an existing client.

Seventy-eight percent of baby-boomer business owners do not currently have plans for exiting their companies. If this includes your clients, you will be doing both them and yourself a favor by encouraging them to start thinking now not only about what they wantto do with their businesses but also what they want to do with the rest of their lives after leaving their companies.

The Head Issues

Owners have created their companies and worked hard to make them grow.  An owner who has put so much time and energy into building the company wants to ensure that costly mistakes aren’t made at this stage. By applying the power of planning, owners can be clear about both their business and personal objectives for leaving their companies in the next five to 10 years, develop clear, concise strategies to maximize return, reduce risk and maintain their sanity in the process.An owner who does not engage in transition planning can experience “owner’s indecision”, which can divert time and attention away from running the company, lead to loss of sales revenue and hamper the efforts of business intermediaries who are representing the owner in trying to sell the company.  Lack of planning and the owner’s indecision can also reduce a company’s profits, cause an upward capital cycle to be missed and lead to loss of business value.

The Heart Issues

Selling or transitioning out of one’s business is fraught with emotional anxiety. In order for owners to transition successfully, they need to do an objective appraisal of how psychologically prepared they are to exit their companies, clarify their goals and be aware of what is motivating them to leave.  Owners need to deal successfully with the complexities involved in making the major life transition of leaving their companies.  They especially need to avoid the debilitating distress of exit remorse and the depressing effects of post-transaction stress disorder,which can cause them to experience boredom, desperation and even an increased chance of dying prematurely after leaving their companies.

The Identity Factor

It’s hard for manyowners to leave their companies because the business is their “baby.” For many owners, their lives are identified with being a business owner, and they think they will lose their personal identity once theyno longer own a business.  They may view their lives after leaving their companies as irrelevant, feel they will lose status in their communities and dread the day they call up other business owners they used to know, only to be given the “bum’s rush” because they are no longer “players.”

The Fear Factor

Unacknowledged fear is often responsible for owners procrastinating about what to do with their companies. Fear can also cause them to suddenly walk away from the sale of the business due to emotional misgivings.  An owner can suddenly experience seller’s remorse and unexpectedly cut off the transaction process, which can incur legal and financial costs, reduce the chance of selling the company in the future and increase employee turnover.

The Death Factor

Many owners view the prospect of leaving their businesses as a kind of death, which prevents them from even thinking about creating an exit strategy.  However, not having a plan for post-ownership life can cause owners to want to die at their desks — and that is sometimes where they end their lives.

Looking Ahead to the Rest of Your Life

Personal transition planning is essential for owners who have no interest in a post-ownership life that consists of sitting on the porch in a rocking chair or playing golf 24/7.   Running a business is intellectually stimulating, which is one reason why owners need to create a game plan for keeping their minds active after leaving their companies.  Owners also need to determine if they want to spend their post-ownership lives working part-time, starting a new business, doing volunteer work or any combination of these.

Owners who engage in personal transition planning are able to answer the crucial question of “What’s next?”  Creating a strategic lifestyle game plan allows them to know where they want to live, how they are going to replace their social contacts, and  how they are going to take care of themselves physically in their post-ownership lives. They also will have dealt with the issue of finding new common interests with their spouse, so they will not experience a divorce or have each partner go a separate way at this stage in life. Finally, owners who have engaged in transition planning have created tactical plans for how they will practically implement each of their lifestyle decisions.  Personal transition planning helps owners become aware of and effectively deal with the various fears associated with transitioning out of a business, so they can successfully navigate the uncharted waters of leaving their companies. Transition planning changes an owner’s perception of what it will be like to leave the company — transforming it from an “ending” to a “new beginning”.  Keep in mind that at some point in the future, you too can benefit from transition planning when you are ready to begin thinking about exiting your own business and considering what you want to do with the rest of your life.

Jack Beauregard is the CEO of theSuccessful Transition Planning Institute and co-founder with Kevin Long, CPA, Esq.of Apollo Transition Advisors. Beauregard can be reached at jack@ thenexttransition.com or 617.576.5728, www.successfultransitionplanning.com.

By Rob Edwards

I. OVERVIEW OF LEGAL REQUIREMENTS

A. An Employee Stock Ownership Plan (“ESOP”) is usually structured as a tax-qualified “stock

bonus” plan. Properly designed, an ESOP can offer significant financial benefits to the

sponsoring corporation while also providing employees with a valuable stock ownership benefit

at no cost to them.

1. An ESOP must cover a nondiscriminatory classification of employees who have attained

age 21 and completed a year of service (2 years if the plan provides for 100% vesting).

Employees may not otherwise be excluded solely by reason of age or service. Effective in

2007, an ESOP must provide for either graduated vesting of participant accounts, with full

vesting required after 6 years of service, or cliff vesting of participant accounts, with full

and immediate vesting after 3 years of service. Nonvested benefits are subject to

forfeiture if the employee quits or is fired before normal retirement age.

2. Employer contributions to an ESOP can be made in the form of employer stock (valued at

fair market value) or cash. ESOP contributions are tax-deductible within prescribed limits

and may be made under a formula or in the employer’s discretion.

3. Assets held in an ESOP may include employer stock and other investments. ESOP plan

assets must be held in a trust. The ESOP trustee may be an individual or individuals

affiliated with the employer.

4. The ESOP must provide for allocating contributions among participants and for

distributing benefits upon a participant’s retirement, death, disability, or separation from

service.

5. Assets held in the ESOP must be valued at least annually.

6. Benefits may be distributed in the form of employer stock or cash. The participant must

have the right to receive a distribution of stock, unless the employer is an S corporation, or

a bank prohibited from repurchasing its own shares, or the employer’s charter or by-laws

restrict ownership of substantially all employer stock to current employees or to a trust

under a qualified plan. Generally, an ESOP participant must be permitted to elect to begin

receiving ESOP benefits not later than one year after the participant’s death or retirement,

or six (6) years after the participant separates from service for any other reason.

7. If ESOP benefits are distributed in employer stock that is not readily tradable on an

established market, the participant must have a limited right (the “put option”) to require

the employer to repurchase the stock at fair market value. The future cost of repurchasing

employer stock distributed from the ESOP under the put option is referred to as the

employer’s “repurchase liability”. Distributed shares may be subject to a right of first

refusal in favor of the employer and the ESOP.

8. Voting rights with respect to employer stock of a company that is registered under the

Securities Exchange Act of 1934 must be “passed through” on all shares that are allocated

to participants’ accounts. For employer stock that is not publicly traded, pass-through

voting is required for shares allocated to participants only on mergers, recapitalizations,

liquidations, dissolutions or similar major transactions. Unallocated shares, and allocated

shares voted on matters for which pass-through voting is not required may be voted by the

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ESOP fiduciary, on a pass through basis, or as provided in the plan document. An ESOP

established by a nonpublicly traded company may also provide for per capita voting (1

person 1 vote). If per capita voting applies, the percentage of votes cast will govern the

voting of all employer stock (both allocated and unallocated shares) held in the ESOP.

9. If the employer is a member of a controlled group of corporations, the ESOP may be

established by one member with respect to the stock of another controlled group member.

10. Since 1998, ESOPs have been permitted to invest in S corporation stock without adverse

tax consequences.

11. State law often restricts the ownership of shares in a corporation which is authorized to

carry on certain professional practices (e.g., architecture, engineering, accounting,

medicine, etc.) to individuals who hold professional licenses. While ESOPs are prohibited

under the laws of most states from owning stock in such a corporation, the corporation

may be able to establish an ESOP if it qualifies to do business under the general business

corporation act of the state in which it is incorporated, if a “grandfathered” charter is

available, or if incorporation under the laws of another state is possible.

12. An ESOP may be part of a 401(k) plan or arrangement (a KSOP). KSOPs are common in

publicly-held companies. Some nonpublic companies have also adopted KSOPs to fund

matching contributions to their 401(k) plans in the form of employer stock, and to help

create a market for their stock. KSOPs which allow participants to elect to invest their own

salary reduction contributions in employer securities must comply with federal and state

securities laws.

13. An ESOP must comply with all Internal Revenue Service and Department of Labor rules

and requirements applicable generally to qualified employee benefit plans.

B. Special qualification requirements apply to “leveraged” ESOPs. A leveraged ESOP is designed to

use borrowed funds (an “exempt loan”) to purchase employer stock, with the loan repaid from

future employer contributions to the ESOP, plus dividends on the shares purchased with the

exempt loan proceeds. An exempt loan almost always involves a guarantee or extension of credit

(this may take the form of an installment purchase obligation) between the ESOP and a

“disqualified person” (usually the sponsoring employer and/or its shareholders) that would be

prohibited in any other kind of employee benefit plan.

1. A leveraged ESOP must be designed to invest primarily in “qualifying employer

securities”. This generally means either voting common stock with full dividend rights, or

preferred stock that is readily convertible into voting common.

2. A leveraged ESOP must provide for the release of financed shares that are held in the

ESOP’s suspense account as the exempt loan is repaid. The release of employer stock

under the ESOP must be made under one of two alternative methods. One method allows

the release of employer stock in proportion to the repayment of principal and interest on

the exempt loan. The other method allows for employer stock to be released in proportion

to the amount of principal only repaid on the exempt loan.

3. Employer stock of a company that is not publicly traded held in a leveraged ESOP must be

valued annually by an independent appraiser.

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4. A participant age 55 or older with 10 or more years of participation in a leveraged ESOP

must be offered the option to “diversify” his or her ESOP account. The option is

exercisable annually over a period of 5 years, and allows a qualified participant to direct

the investment of 25% of the employer stock that has ever been allocated to the

participant’s ESOP account (including any stock diversified under prior elections) into

investments other than employer stock. If the leveraged ESOP does not offer at least three

investment options inside the ESOP, the participant must be allowed to cash out the

diversified amount or to have the diversified portion of the account transferred to another

qualified plan which offers three or more investment options. In the sixth and final year of

the option period, the participant must receive a similar one-time option covering 50% of

the account. Cashout distributions are eligible to be rolled over into an IRA. KSOP

arrangements which allow investment in publicly traded stock are subject to more rapid

diversification requirements.

5. Leveraged ESOPs benefit from certain favorable rules:

(i) Effective for plan years beginning in 2002, the general limit on deductible

contributions to individual account plans was increased from 15% of covered

compensation to 25% of covered compensation. However, an employer taxable as a C

corporation may deduct all contributions to a leveraged ESOP which are used to pay

interest on an exempt loan, plus loan principal payments up to 25% of covered

compensation. S corporation deductible contributions are limited to 25% of covered

compensation

(ii) Dividends paid on employer stock held in a leveraged ESOP are tax deductible if they

are distributed currently to participants in cash, used to repay an exempt loan the proceeds

of which were used to acquire the employer securities with respect to which the dividend

is paid, or at the election of the participant, invested in the plan in employer stock.

Distributed dividends are also exempt from the 10% penalty tax on early distributions to

employees under age 59 1/2. Distributions with respect to employer stock of an S

corporation are not deductible, and are subject to the 10% penalty tax if the recipient is

under age 59 1/2.

(iii) Dividends on C corporation stock and S corporation distributions may also be used to

repay an exempt loan, provided that employer stock equal in value to the dividends (or

distributions) paid on allocated shares is allocated to the participants’ accounts.

(iv) A leveraged C corporation ESOP is permitted to allocate forfeitures and interest on an

exempt loan under a special provision of Section 415 of the Internal Revenue Code, if not

more than one-third of employer contributions for the year are allocated to highlycompensated

employees. If this special rule applies, the only amount taken into account

for Section 415 purposes is the principal reduction on the exempt loan. Interest on the

exempt loan, deductible dividends and forfeitures of employer stock acquired with an

exempt loan are not included in calculating the maximum permissible allocation. A stock

bonus or profit-sharing plan, in contrast, must include all allocations of principal, interest

and forfeitures in computing the Section 415 limitations.

(v) An ESOP participant who receives a lump sum distribution of employer stock will

only be taxed on the ESOP’s cost basis for the stock. The “net unrealized appreciation”

(the difference between its fair market value at the date of distribution and its cost to the

ESOP) is not taxable until the stock is sold. This favorable tax treatment extends to

distributions from stock bonus and profit-sharing plans.

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6. To guard against the possibility of self-dealing, leveraged ESOP transactions are subject to

special regulatory scrutiny to ensure that the transaction is primarily for the benefit of

ESOP participants and their beneficiaries. Purchases and sales of employer stock held in a

leveraged ESOP are subject to fiduciary rules enforced by the Department of Labor,

including the requirement that the ESOP cannot pay more than “adequate consideration”

for employer stock.

7. For newly formed ESOPs, and existing ESOPs after 2004, severe tax penalties are

imposed on S corporation ESOP sponsors for any year in which “disqualified persons”

collectively own or are deemed to own 50% or more of the corporation. A “disqualified

person” is a person who (i) individually owns 10% or more of the S corporation’s

“deemed-owned” shares, or (ii) collectively with other family members owns 20% or more

of its deemed-owned shares. Deemed-owned shares are the individual’s allocated ESOP

shares, a proportionate share of any unallocated ESOP shares, and any “synthetic equity”

owned by disqualified persons. Synthetic equity is broadly defined to include the right to

acquire stock of the corporation or to share in the corporation’s value or growth through

equity-based compensation. These rules are complex, but will generally preclude small S

corporations with ten or fewer employees from adopting an ESOP. Corporations with up

to 50 (or more) participating employees will also need to carefully monitor their ESOP

program to ensure compliance.

II. ADVANTAGES OF LEVERAGED ESOP FINANCING

 

A. Section 1042 Rollover for Selling Shareholder. If a leveraged ESOP owns at least 30% of the

company after purchasing employer stock, a selling shareholder who has held (for at least 3 years)

employer stock that was not acquired in a distribution from a qualified plan or in an employmentrelated

transfer, may qualify for nonrecognition of gain under Section 1042 of the Internal

Revenue Code if the seller reinvests in “qualified replacement property”. Qualified replacement

property includes stocks, bonds, notes and other evidence of indebtedness issued by active U.S.

operating companies. In order to qualify for the rollover, the qualified replacement property must

be purchased within a 15-month period beginning 3 months before the sale, and the employer must

consent to the nonrecognition treatment and agree to pay a 10% excise tax in case of certain

premature dispositions of the acquired securities within 3 years after the sale. In addition, the

seller, the seller’s family members and 25% or more shareholders are prohibited (or restricted in

certain cases involving a selling shareholder’s lineal descendants) from receiving allocations of

acquired shares. Sales of S corporation stock are not eligible for the tax free rollover.

B. Tax Benefits for ESOP Sponsor. Because the ESOP sponsor can deduct its entire ESOP

contribution, principal as well as interest paid on the ESOP loan becomes, in effect, tax-deductible.

This affords ESOP financing an immediate advantage over a conventional loan, although the

liquidity necessary to fund the employer’s future repurchase liability (see I.A. 7.) needs to be

considered. In addition, the increased contribution and allocation limits, and deductible dividends

available to leveraged C corporation ESOPs (See I.B.5) add even more flexibility to leveraged

ESOP financing.

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III. PRINCIPAL REASONS FOR A COMPANY TO ADOPT AN ESOP

 

A. Business Succession. A leveraged ESOP creates an immediate market for the sale of a founder’s

stock. The founder benefits by deferring income tax on the sale proceeds, and the employees

benefit by acquiring a significant interest in the employer without any cost to them.

B. Financing Vehicle. A leveraged ESOP can be used as a vehicle to obtain financing for the

employer, with a full tax deduction allowed for ESOP contributions used to repay principal as

well as interest.

C. Employee Productivity. An ESOP can serve as a means of enhancing employee productivity by

providing substantially all employees with an economic stake in the financial success of their

employer. A sound ESOP communications program is essential to help ensure that this benefit is

realized.

IV. ILLUSTRATION OF ESOP BENEFITS

 

A. Leveraged ESOP. Assume that DEF Engineering, a C corporation, is valued at $2,000,000 and

that D, the principal owner, wants to sell a 70% interest in the company to an ESOP for

$1,400,000. The ESOP will borrow the funds and repay the loan in level annual installments over

7 years at 9%. The following table illustrates the potential ESOP tax savings in this transaction

compared with a stock redemption:

COMPANY

REDEMPTION ESOP

1. TOTAL INTEREST AND PRINCIPAL PAYMENT $2,013,018 $2,013,018

2. TAX DEDUCTIBLE PORTION $613,018 $2,013,018

3. TAX BENEFIT AT 34% $208,426 $684,426

4. NET AFTER-TAX COST (1 – 3) $1,804,592 $1,328,592

As illustrated above, the potential federal tax savings to the Company in this example is $476,000, which

represents the difference between the after-tax cost of a stock redemption loan versus an ESOP loan.

B. Additional Rollover Benefits. If D makes a qualifying Section 1042 rollover, the total tax

benefits in the transaction are significantly increased. If D had only a nominal tax basis in his

stock of DEF, his federal tax savings could be as much as $280,000. The total federal tax

benefits for the employer and the selling shareholder in the $1,400,000 transaction illustrated

could amount to as much as $756,000, or 54% of the sale proceeds. Additional tax savings for

both the employer and the selling shareholder may be available under state law.

C. Nonleveraged ESOP Financing Alternative. As an alternative to the leveraged ESOP illustrated

in IV. A. above, it is possible to obtain many of the ESOP’s financing advantages with a

nonleveraged ESOP or even a profit-sharing plan in conjunction with a loan to the company.

This technique involves a redemption of stock by the company which then makes tax-deductible

contributions of employer stock to a qualified plan each year in an amount equal to the principal

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value paid down on the loan during the year. Because the fair market value of contributed stock

is tax-deductible, the company has, in effect, obtained a deduction for the principal repaid on its

loan. This alternative method has some advantages and some limitations in comparison with

leveraged ESOP financing:

1. Advantages.

(i) Avoids prohibited transactions problems.

(ii) Allows use of a profit-sharing or traditional stock bonus plan.

(iii) If the value of stock increases over the loan period, the number of contributed

shares is reduced. This results in less dilution of shareholders’ equity, and spreads

dilution over a greater period.

(iv) Greater flexibility.

2. Limitations

(i) A selling shareholder cannot obtain a tax-free rollover.

(ii) Financing may be more difficult to obtain for a stock redemption than for an

ESOP.

(iii) Higher deduction limits apply to a leveraged ESOP, so larger deductible

contributions are permitted.

(iv) A leveraged ESOP may have a greater effect on employee productivity.

 

Rob Edwards is a partner with Steiker, Fischer, Edwards & Greenapple, P.C.

The Foundry Corporate Office Center

235 Promenade Street, Ste. 497,

Providence, RI 02908

tel. – 401/632-0480

 

Valmark Securities

WHAT IS A LIFE SETTLEMENT?

• A life settlement is the sale of an existing life insurance policy on the secondary market to a third party for fair market value.
• The owner sells policy in exchange for a lump sum settlement that can be higher than cash surrender value.*
• The third party institutional investor becomes the owner of the policy, makes premium payments, and collects the death benefit at the insured’s death.
• With institutional investors, policies are owned in large blind trusts with other policies.  This can help to assure client confidentiality.

CHARACTERISTICS OF A POTENTIAL LIFE SETTLEMENT CANDIDATE

• Insured’s age is 65 and older
• Life expectancy of 15 years or less
• Decline in health from original policy issue
• Life insurance policies with a net death benefit of $250,000 or more (no maximum)
• Policy type Universal Life, Survivorship Universal Life, Variable Universal Life and Convertible Term (Sometimes Whole Life)
• Owner can be an Individual, Trust, or Corporation
• Premium should be 5% of the Death Benefit (or less) and Cash Surrender Value should be 20% of Death Benefit (or less)

A FEW REASONS WHY YOU MAY WANT TO SETTLE YOUR POLICY

• Insurance is no longer needed and you would like to sell the policy for a lump sum cash payment
• Term policy is nearing the end of a term period. You can convert to a permanent product and receive, through a life settlement, proceeds for an asset that will terminate if not converted.
• Policies held within a trust are no longer meeting the original trust plan objectives
• Business is sold or changes are made that result in insurance no longer being needed
• Funds are required to focus on other personal needs such retirement, long-term care insurance, or family emergencies

*Actual offer will be dependent on your particular age and health status, the condition of your life insurance

In a life settlement agreement, the current life insurance policy owner transfers the ownership and beneficiary designations to a third party, who receives the death proceeds at the passing of the insured. As a result, this buyer has a financial interest in the seller’s death. When an individual decides to sell their policy, he or she must provide complete access to his or her medical history, and other personal information, that may affect his or her life expectancy. This information is requested during the initial application for a life settlement. After the completion of the sale, there may be an ongoing obligation to disclose similar and additional information at a later date. A life settlement may affect the seller’s eligibility for certain public assistance programs, such as Medicaid, and there may be tax consequences.

Individuals should discuss the taxation of the proceeds received with their tax advisor. ValMark Securities considers a life settlement a security transaction. ValMark and its registered representatives act as brokers on the transaction and may receive a fee from the purchaser. A life settlement transaction may require an extended period of time to complete. Due to complexity of the transaction, fees and costs incurred with the life settlement transaction may be substantially higher than other securities.

SECURITIES OFFERED THROUGH VALMARK SECURITIES, INC., MEMBER FINRA, SIPC RINGSIDE DR., SUITE 300 
 3 -5201

For more information, contact Dan Guglielmo, Trust Design, dam@ trustdesign.com.

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.