Exit Planning Exchange

By Joseph C. Marrow

Choosing the best exit strategy for a company is a daunting task.  The goal for business owners is to maximize the value of the enterprise for themselves, their employees and their stockholders.  Some popular exit strategies include a sale to the highest bidder or a strategic partner, a public offering in the United States or abroad, or a sale of an interest in the business to a private equity investor.  To determine the best alternative, it is necessary to weigh several factors.  Is the business best positioned for a sale (based on the industry or the scope and size of the enterprise) or do the public markets or a private equity investor present an opportunity to brand and grow the business?  Do the business owners desire to remain with the company or is the preference for a clean break?  Is it a buyers or sellers market?  Are the capital markets open to new issuances?  These are some of the questions that should be assessed when making a determination how to proceed.  The best advice is to plan ahead.  Even if you have no immediate plans to pursue an exit, you should understand the markets and think strategically to best position your business for a liquidity event down the road.

Planning for an exit event is critical for you and your business.  What steps should you be taking in the planning process?  As counsel to a variety of business at different stages, we are often asked to weigh in on strategic alternatives.  Having worked with business owners over the years in planning for and effectuating liquidity events, several common themes have emerged.

1.  FOCUS ON EXECUTION

Above all else, keep focused on the execution of your business plan.  Planning for and executing a liquidity event can be an extremely time consuming and distracting process.  Don’t let it be!  If you remain steadfast in the achievement of your business objectives, execute on your plan, dedicate yourself to attracting real customers and revenues, your exit event will take care of itself.  The primary focus of the business owner should always be on the success of the enterprise, not the consummation of the exit.

2.  BE BOUGHT, NOT SOLD

One common mistake business owners make in the pursuit of an exit strategy is to lose sight of the short-term needs of the business.  For example, a business may have some short-term capital needs to address to attract, retain and grow its customer base.  The business owner, believing an exit event is at hand, may elect to forego the short-term expense in light of an impending transaction.  A failure to address short-term cash needs, however, could have long-term repercussions.  Several factors dictate that it is better to spend the money now.  Transactions can often disappear as easily as they arise or a transaction can take significantly longer than expected.  Equally important, the long-term success of the business may be tied to the transaction.  Often times earn-outs, bonuses under employment contracts or other consideration depend on the financial performance of the seller’s business post-liquidity event.  For these reasons, sellers should continue to run their businesses in the ordinary course and meet short-term capital needs to achieve long-term objectives.  Saving a few dollars now could certainly cost the seller many dollars in the long run.

3.  SURROUND YOURSELF WITH EXCELLENT ADVISORS

Unless you have some transactional experience, a liquidity event poses many challenges to a business owner.  The nature of the transaction (M&A or IPO), the specific terms of the transaction and continuing obligations after the sale, employment issues and tax and accounting considerations present a litany of issues to consider.  It is neither necessary nor advisable to go through the process alone.  Seasoned professionals are available to guide the seller through the process.  Very early on, you should engage an experienced attorney, accountant and other advisors (such as an investment banker) to assist you.  Lean on your advisors.  It is not uncommon to hear the CEO of a company explain that he or she has achieved great success because he or she has surrounded himself or herself with smart people.  If you choose carefully, the advisors will have a great deal of experience to draw from and will be able to provide excellent guidance recommending exit alternatives, structuring the transaction, avoiding pitfalls, preparing the company for a liquidity event and completing the transaction.  Many business owners raise concerns regarding the costs involved in engaging service professionals, however, most business owners that have experienced a liquidity event will attest that the right professionals add to, rather than detract from the value of a particular transaction.  In addition, the better the advisors, the more time a business owner can devote to the matter at hand – the day-to-day operations of the business.

4.  CHOOSE CORRECT EXIT STRATEGY

There are several options when considering exit alternatives.  For many, a sale of the business is the logical choice.  Others may opt to raise money through the public markets or to sell a piece of the company to private equity investors.  Recently, the public markets, in particular, have not been an attractive option.  While many are familiar with the perceived downsides to going public (compliance costs, personal liability exposure of officers and directors and short-term financial performance pressures), there can be legitimate reasons to test the public markets (creating a national brand, providing liquidity to employees and investors or using the publicly-traded stock as currency in a roll-up strategy).  Still others have used the public offering route to attract buyers.  In addition, private equity can provide a much needed capital infusion to a company.  A business that accepts private equity investment should note that with the investment comes a fairly short-term liquidity horizon – 5 to 7 years to position the company for sale or to go public.  Once again, professional advisors can be extremely helpful in vetting the available options and guiding a business through the process.

Choosing and pursuing an exit strategy is both exciting and intimidating.  A business owner contemplating a liquidity event is faced with a myriad of issues.  Selecting the correct route to follow is not always easy.  Moreover, above all else, in pursuing a liquidity path, make sure your number one priority is the continued health and prosperity of the ongoing business.

For more information, please contact Joseph Marrow at jmarrow@mbbp.com.

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 Sarah Richmond

The media is filled with reports of the red hot merger-and-acquisition market. In the technology sector in particular, the volume and transaction value of 2007 M&A deals are both forecast to approach levels not seen since 2000. And despite improvements in the IPO market in recent years, M&A remains the liquidity event of choice for venture-backed companies.

These trends bode well for entrepreneurs hoping for a sale to a strategic buyer. However, for many of these aspiring sellers, a deal will never be concluded even though their business’s fundamentals are solid and buyer interest is strong. These “M&A casualties” occur because too often entrepreneurs do not exercise sufficient planning, realism and creativity.

An early mistake that sellers make is not having a realistic picture of how much their business is really worth. Much as many parents overestimate the intelligence and beauty of their own children, many founders overestimate the value of their own company, causing them to expect an unrealistic price. If you are a seller thinking about your exit, finding comparables in the marketplace will help you arrive at a realistic valuation. Much of this type of data is available online, and there are also outside advisers who can assist you.

Even realists sometimes find that their expectations are out of sync with a buyer’s willingness to pay, so thinking of creative solutions that can bridge the gap is important. One solution that is frequently employed is an earnout, which defers some of the sale price to future payments, which are contingent on sales targets, product developments or other milestones. An earnout satisfies the seller’s desire to be compensated for the expected future value of its assets, while also satisfying the buyer’s desire not to overpay for value that has not yet been realized at the time of the sale. However, sellers should be mindful that earnouts are only successful for the seller when very careful attention is paid to the structuring of the earnout when negotiating the deal.

The due diligence process is another contributor to deal failure. Major problems result when a seller fails to disclose important information about the company, and this information is later ferreted out by the buyer or its attorneys in their due diligence review. This can result in a purchase price reduction midstream, or even the suspension of negotiations. At the very least, because the “trust factor” has been impaired, the buyer will now feel the need to dig deeper and spend more time on due diligence than they otherwise would have.

Entrepreneurs can help smooth the way by doing their own due diligence on their company before the negotiations even begin. This will provide an opportunity to fix problems in advance, and even if this is not possible, at least it allows the seller to frame the issue for the buyer with the appropriate context, while retaining the buyer’s trust.

Many things outside the entrepreneur’s control can kill a deal midstream, and reducing the time-span of the due diligence period minimizes the likelihood of these events occurring. Priorities at the acquiring company may change during the process, making the acquisition seem less compelling. In addition, market conditions can change at any time, and a drawn-out process is the seller’s enemy.

Lastly, the acquisition period is an intense and distracting time for the entrepreneur and the company’s senior management team. Since a significant amount of time and effort is typically required to negotiate the deal documents and coordinate the due diligence review, many of the seller’s key people may not be able to focus as tightly on their day-to-day responsibilities. If this impairs the business’s performance leading up to the closing, the buyer will get nervous and the acquisition itself may be jeopardized. Management should be sure to keep its eye on the ball and continue to focus on running the company despite the distractions of the deal.

Deals fall through for a number of reasons. Anticipating the types of things that can go wrong, and working to address them with creative solutions, will contribute to ultimate deal success.

Sarah C. Richmond is a partner at Gesmer Updegrove LLP, a Boston law firm focused on entrepreneurial companies and their investors. She can be reached at sarah.richmond@gesmer.com.