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Private Equity and Venture Capital Glossary

Acquisition – The process of taking over a controlling interest in another company. Acquisition also describes any deal where the bidder ends up with 50 per cent or more of the company taken over.

Acquisition finance – Companies often need to use external finance to fund an acquisition. This can be in the form of bank debt and/or equity, such as a share issue.

Advisory board – An advisory board is common among smaller companies. It is less formal than the board of directors. It usually consists of people, chosen by the company founders, whose experience, knowledge and influence can benefit the growth and direction of the business. The board will meet periodically but does not have any legal responsibilities in regard to the company.

Alternative assets – This term describes non-traditional asset classes. They include private equity, venture capital, hedge funds and real estate. Alternative assets are generally more risky than traditional assets, but they should, in theory, generate higher returns for investors.

Asset – Anything owned by an individual, a business or financial institution that has a present or future value i.e. can be turned into cash. In accounting terms, an asset is something of future economic benefit obtained as a result of previous transactions. Tangible assets can be land and buildings, fixtures and fittings; examples of intangible assets are goodwill, patents and copyrights.

Asset allocation – The percentage breakdown of an investment portfolio. This shows how the investment is divided among different asset classes. These classes include shares, bonds, property, cash and overseas investments. Institutions structure their allocation to balance risk and ensure they have a diversified portfolio. The asset classes produce a range of returns – for example, bonds provide a low but steady return, equities a higher but riskier return. Cash has a guaranteed return. Effective asset allocation maximises returns while covering liabilities.

Balanced fund – A fund that spreads its investments between various types of assets such as stocks and bonds. Investors can avoid excessive risk by balancing their investments in this manner, but should expect only moderate returns.

Benchmark – This is a standard measure used to assess the performance of a company. Investors need to know whether or not a company is hitting certain benchmarks as this will determine the structure of the investment package. For example, a company that is slow to reach certain benchmarks may compensate investors by increasing their stock allocation.

BIMBO ‘buy-in management buy-out’ – A BIMBO enables a company to re-shuffle its allocation of share capital to bring about a change in management. Internally, a group of managers will acquire enough share capital to ‘buy out’ the company from within. An outside team of managers will simultaneously ‘buy in’ to the company management. Both parties may require financial assistance from venture capitalists in order to achieve this end.

Bond – a type of IOU issued by companies or institutions. They generally have a fixed interest rate and maturity value, so they’re very low risk – much less risky than buying equity – but their returns are accordingly low.

Bridge loan – a kind of short-term financing that allows a company to continue running until it can arrange longer-term financing. Companies sometimes seek this because they run out of cash before they receive long-term funding; sometimes they do so to strengthen their balance sheet in the run up to flotation.

Burn rate – the rate at which a start-up uses its venture capital funding before it begins earning any revenue.

Business angels – individuals who provide seed or start-up finance to entrepreneurs in return for equity. Angels usually contribute a lot more than pure cash – they often have industry knowledge and contacts that they can pass on to entrepreneurs. Angels sometimes have non-executive directorships in the companies they invest in.

Buy-out – This is the purchase of a company or a controlling interest of a corporation’s shares. This often happens when a company’s existing managers wish to take control of the company. See management buy-out

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Capital call – see drawdown

Capital drawdown – see drawdown

Capital commitment – Every investor in a private equity fund commits to investing a specified sum of money in the fund partnership over a specified period of time. The fund records this as the limited partnership’s capital commitment. The sum of capital commitments is equal to the size of the fund. Limited partners and the general partnermust make a capital commitment to participate in the fund.

Capital distribution – These are the returns that an investor in a private equity fund receives. It is the income and capital realised from investments less expenses and liabilities. Once a limited partner has had their cost of investment returned, further distributions are actual profit. The partnership agreement determines the timing of distributions to the limited partner. It will also determine how profits are divided among the limited partners andgeneral partner.

Capital gain – When an asset is sold for more than the initial purchase cost, the profit is known as the capital gain. This is the opposite to capital loss, which occurs when an asset is sold for less than the initial purchase price. Capital gain refers strictly to the gain achieved once an asset has been sold – an unrealised capital gain refers to an asset that could potentially produce a gain if it was sold. An investor will not necessarily receive the full value of the capital gain – capital gains are often taxed; the exact amount will depend on the specific tax regime.

Capital under management – This is the amount of capital that the fund has at its disposal, and is managing, for investment purposes.

Captive firm – A private equity firm that is tied to a larger organisation, typically a bank, insurance company or corporate.

Carried interest – The share of profits that the fund manager is due once it has returned the cost of investment to investors. Carried interest is normally expressed as a percentage of the total profits of the fund. The industry norm is 20 per cent. The fund manager will normally therefore receive 20 per cent of the profits generated by the fund and distribute the remaining 80 per cent of the profits to investors.

Catch up – A clause that allows the general partner to take, for a limited period of time, a greater share of the carried interest than would normally be allowed. This continues until the time when the carried interest allocation, as agreed in the limited partnership, has been reached. This usually occurs when a fund has agreed a preferred return to investors – a fund may return the cost of investment, plus some other profits, to investors early.

Clawback – A clawback provision ensures that a general partner does not receive more than its agreed percentage of carried interest over the life of the fund. So, for example, if a general partner receives 21 percent of the partnership’s profits instead of the agreed 20 per cent, limited partners can claw back the extra one per cent.

Closing – This term can be confusing. If a fund-raising firm announces it has reached first or second closing, it doesn’t mean that it is not seeking further investment. When fund raising, a firm will announce a first closing to release or drawdown the money raised so far so that it can start investing. A fund may have many closings, but the usual number is around three. Only when a firm announces a final closing is it no longer open to new investors.

Co-investment – Although used loosely to describe any two parties that invest alongside each other in the same company, this term has a special meaning when referring to limited partners in a fund. If a limited partner in a fund has co-investment rights, it can invest directly in a company that is also backed by the private equity fund. The institution therefore ends up with two separate stakes in the company – one indirectly through the fund; one directly in the company. Some private equity firms offer co-investment rights to encourage institutions to invest in their funds.

The advantage for an institution is that it should see a higher return than if it invested all its private equity allocation in funds – it doesn’t have to pay a management fee and won’t see at least 20 per cent of its return swallowed by a fund’s carried interest. But to co-invest successfully, institutions need to have sufficient knowledge of the market to assess whether a co-investment opportunity is a good one.

Company buy-back – The process by which a company buys back the stake held by a financial investor, such as a private equity firm. This is one exit route for private equity funds.

Corporate venturing – This is the process by which large companies invest in smaller companies. They usually do this for strategic reasons. For example, a large corporate such as Nokia may invest in smaller technology companies that are developing new products that can be assimilated into the Nokia product range. A large pharmaceutical company might invest in R&D centres on the basis that they get first refusal of research findings.

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Debt financing – This is raising money for working capital or capital expenditure through some form of loan. This could be by arranging a bank loan or by selling bonds, bills or notes (forms of debt) to individuals or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay principal plus interest on the debt.

Distressed debt (otherwise known as vulture capital) – This is a form of finance used to purchase the corporate bonds of companies that have either filed for bankruptcy or appear likely to do so. Private equity firms and other corporate financiers who buy distressed debt don’t asset-strip and liquidate the companies they purchase. Instead, they can make good returns by restoring them to health and then prosperity. These buyers first become a major creditor of the target company. This gives them leverage to play a prominent role in the reorganisation or liquidation stage.

Distribution – see capital distribution

Distribution in specie/Distribution in kind – This can happen if an investment has resulted in an IPO. A limited partner may receive its return in the form of stock or securities instead of cash. This can be controversial. The stock may not be liquid and limited partners can be left with shares that are worth a fraction of the amount they would have received in cash. There can also be restrictions in the US about how soon a limited partner can sell the stock (Rule 144). This means that sometimes the share value has decreased by the time the limited partner is legally allowed to sell.

Dividend cover – A dividend is the amount of a company’s profits paid to shareholders each year. Dividend cover is the calculation used to show how much of a company’s after-tax profit is being used to finance the dividend. The formula is: Dividend Cover = (Earnings per share/Dividend per share).

Drawdown – When a venture capital firm has decided where it would like to invest, it will approach its own investors in order to draw down the money. The money will already have been pledged to the fund but this is the actual act of transferring the money so that it reaches the investment target.

Dry Close (Dry Closing) – A dry close is when a private equity firm raises money for a fund early on in the cycle, but then agrees to not levy any management fees on the money raised from its Limited Partners until it actually begins investing the fund. Most private equity firms will start raising a new fund when their current fund is around 70% invested. Venture firms tend to raise new funds earlier than buy-out firms, because they usually need to invest in follow-on rounds for their portfolio firms.

Due Diligence – Investing successfully in private equity at a fund or company level, involves thorough investigation. As a long-term investment, it is essential to review and analyse all aspects of the deal before signing. Capabilities of the management team, performance record, deal flow, investment strategy and legals, are examples of areas that are fully examined during the due diligence process.

Early-stage finance – This is the realm of the venture capital – as opposed to the private equity – firm. A venture capitalist will normally invest in a company when it is in an early stage of development. This means that the company has only recently been established, or is still in the process of being established – it needs capital to develop and to become profitable. Early-stage finance is risky because it’s often unclear how the market will respond to a new company’s concept. However, if the venture is successful, the venture capitalist’s return is correspondingly high.

Equity financing – Companies seeking to raise finance may use equity financing instead of or in addition to debt financing. To raise equity finance, a company creates new ordinary shares and sells them for cash. The new share owners become part-owners of the company and share in the risks and rewards of the company’s business.

Evergreen fund – A fund in which the returns generated by its investments are automatically channelled back into the fund rather than being distributed back to investors. The aim is to keep a continuous supply of capital available for further investments.

Exit – Private equity professionals have their eye on the exit from the moment they first see a business plan. An exit is the means by which a fund is able to realise its investment in a company – by an initial public offering, a trade sale, selling to another private equity firm or a company buy-back. If a fund manager can’t see an obvious exit route in a potential investment, then it won’t touch it. Funds have the power to force an investee company to sell up so they can exit the investment and make their profit, but venture capitalists claim this is rare – the exit is usually agreed with the company’s management team.

First time fund – This is the first fund a private equity firm ever raises – whether the firm is made up of managers who have never raised a fund before or, as in many cases, the firm is a spin-off, where managers from different, established funds have joined forces to create their own, new firm. In the first instance, the managers do not have a track record so investing with them can be very risky. In the second instance, the managers will have track records from their previous firms, but the investment is still risky because the individuals are unlikely to have worked together as a team before.

Follow-on funding – Companies often require several rounds of funding. If a private equity firm has invested in a particular company in the past, and then provides additional funding at a later stage, this is known as ‘follow-on funding’.

Fund of funds – A fund set up to distribute investments among a selection of private equity fund managers, who in turn invest the capital directly. Fund of funds are specialist private equity investors and have existing relationships with firms. They may be able to provide investors with a route to investing in particular funds that would otherwise be closed to them. Investing in fund of funds can also help spread the risk of investing in private equity because they invest the capital in a variety of funds.

Fund raising – The process by which a private equity firm solicits financial commitments from limited partners for a fund. Firms typically set a target when they begin raising the fund and ultimately announce that the fund has closed at such-and-such amount. This may mean that no additional capital will be accepted. But sometimes the firms will have multiple interimclosings each time they have hit particular targets (first closings, second closings, etc.) and final closings. The term cap is the maximum amount of capital a firm will accept in its fund.

Gatekeeper – Specialist advisers who assist institutional investors in their private equity allocation decisions. Institutional investors with little experience of the asset class or those with limited resources often use them to help manage their private equity allocation. Gatekeepers usually offer tailored services according to their clients’ needs, including private equity fund sourcing and due diligence through to complete discretionary mandates. Most gatekeepers also manage funds of funds.

General partner – This can refer to the top-ranking partners at a private equity firm as well as the firm managing the private equity fund.

General partner contribution/commitment – The amount of capital that the fund manager contributes to its own fund. This is an important way for limited partners to ensure that their interests are aligned with those of the general partner. The US Department of Treasury recently removed the legal requirement of the general partner to contribute at least one per cent of fund capital, but this is still the usual contribution.

Holding period – This is the length of time that an investment is held. For example, if Company A invests in Company B in June 1996 and then sells its stake in June 1999, the holding period is three years.

Hurdle Rate – see preferred return

Incubator – An entity designed to nurture business ideas or new technologies to the point that they become attractive to venture capitalists. An incubator typically provides physical space and some or all of the services – legal, managerial, technical – needed for a business idea to be developed. Private equity firms often back incubators as a way of generatingearly-stage investment opportunities.

Institutional buy-out (IBO) – If a private equity firm takes a majority stake in amanagement buy-out, the deal is an institutional buy-out. This is also the term given to a deal in which a private equity firm acquires a company out right and then allocates the incumbent and/or incoming management a stake in the business.

Initial public offering (IPO) – An IPO is the official term for ‘going public’. It occurs when a privately held company – owned, for example, by its founders plus perhaps its private equity investors – lists a proportion of its shares on a stock exchange. IPOs are an exit route for private equity firms. Companies that do an IPO are often relatively small and new and are seeking equity capital to expand their businesses.

Internal rate of return (IRR) – This is the most appropriate performance benchmark for private equity investments. In simple terms, it is a time-weighted return expressed as a percentage. IRR uses the present sum of cash drawdowns (money invested), the present value of distributions (money returned from investments) and the current value of unrealised investments and applies a discount.

The general partner‘s carried interest may be dependent on the IRR. If so, investors should get a third party to verify the IRR calculations.

Later stage finance – Capital that private equity firms generally provide to established, medium-sized companies that are breaking even or trading profitably. The company uses the capital to finance strategic moves, such as expansion, growth, acquisitions andmanagement buy-outs.

Lead investor – The firm or individual that organises a round of financing, and usually contributes the largest amount of capital to the deal.

Leveraged buy-out (LBO) – The acquisition of a company using debt and equity finance. As the word leverage implies, more debt than equity is used to finance the purchase, eg 90 per cent debt to ten per cent equity. Normally, the assets of the company being acquired are put up as collateral to secure the debt.

Limited partners – Institutions or individuals that contribute capital to a private equity fund. LPs typically include pension funds, insurance companies, asset management firms and fund of fund investors.

Limited partnership – The standard vehicle for investment in private equity funds. A limited partnership has a fixed life, usually of ten years. The partnership’s general partnermakes investments, monitors them and finally exits them for a return on behalf the investors – limited partners. The GP usually invests the partnership’s funds within three to five years and, for the fund’s remaining life, the GP attempts to achieve the highest possible return for each of the investments by exiting. Occasionally, the limited partnership will have investments that run beyond the fund’s life. In this case, partnerships can be extended to ensure that all investments are realised. When all investments are fully divested, a limited partnership can be terminated or ‘wound up’.

Lock-up period – A provision in the underwriting agreement between an investment bank and existing shareholders that prohibits corporate insiders and private equity investors from selling at IPO.

Management buy-in (MBI) – When a team of managers buys into a company from outside, taking a majority stake, it is likely to need private equity financing. An MBI is likely to happen if the internal management lacks expertise or the funding needed to ‘buy out’ the company from within. It can also happen if there are succession issues – in family businesses, for example, there may be nobody available to take over the management of the company. An MBI can be slightly riskier than a MBO because the new management will not be as familiar with the way the company works.

Management buy-out (MBO) – A private equity firm will often provide finance to enable current operating management to acquire or to buy at least 50 per cent of the business they manage. In return, the private equity firm usually receives a stake in the business. This is one of the least risky types of private equity investment because the company is already established and the managers running it know the business – and the market it operates in – extremely well.

Management fee – This is the annual fee paid to the general partner. It is typically a percentage of limited partner commitments to the fund and is meant to cover the basic costs of running and administering a fund. Management fees tend to run in the 1.5 per cent to 2.5 per cent range, and often scale down in the later years of a partnership to reflect the GP’s reduced workload. The management fee is not intended to incentivise the investment team – carried interest rewards managers for performance.

Mezzanine financing – This is the term associated with the middle layer of financing in leveraged buy-outs. In its simplest form, this is a type of loan finance that sits between equity and secured debt. Because the risk with mezzanine financing is higher than with senior debt, the interest charged by the provider will be higher than that charged by traditional lenders, such as banks. However, equity provision– through warrants or options – is sometimes incorporated into the deal.

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Portfolio – A private equity firm will invest in several companies, each of which is known as a portfolio company. The spread of investments into the various target companies is referred to as the portfolio.

Portfolio company – This is one of the companies backed by a private equity firm.

Placement agent – Placement agents are specialists in marketing and promoting private equity funds to institutional investors. They typically charge two per cent of any capital they help to raise for the fund.

Preferred return – This is the minimum amount of return that is distributed to the limited partners until the time when the general partner is eligible to deduct carried interest. The preferred return ensures that the general partner shares in the profits of the partnership only after investments have performed well.

Private equity This refers to the holding of stock in unlisted companies – companies that are not quoted on a stock exchange. It includes forms of venture capital and MBO financing.

Private markets – A term used in the US to refer to private equity investments.

Private placement – When securities are sold without a public offering, this is referred to as a private placement. Generally, this means that the stock is placed with a select number of private investors.

Public to private – This is when a quoted company is taken into private ownership – more recently by private equity firms. Historically, this has involved a large company selling one of its divisions. A new trend has been for whole companies to be bought out and subsequently delisted.

Ratchets – This is a structure that determines the eventual equity allocation between groups of shareholders. A ratchet enables a management team to increase its share of equity in a company if the company is performing well. The equity allocation in a company varies, depending on the performance of the company and the rate of return that the private equity firm achieves.

Recapitalisation – This refers to a change in the way a company is financed. It is the result of an injection of capital, either through raising debt or equity.

Secondaries – The term for the market for interests in venture capital and private equity limited partnerships from the original investors, who are seeking liquidity of their investment before the limited partnership terminates. An original investor might want to sell its stake in a private equity firm for a variety of reasons: it needs liquidity, it has changed investment strategy or focus or it needs to re-balance its portfolio. The main advantage for investors looking at secondaries is that they can invest in private equity funds over a shorter period than they could with primaries.

Secondary buy-out – A common exit strategy. This type of buy-out happens when an investment firm’s holding in a private company is sold to another investor. For example, one venture capital firm might sell its stake in a private company to another venture capital firm.

Secondary market – the market for secondary buy-outs. This term should not be confused with secondaries.

Second stage funding – the provision of capital to a company that has entered the production and growth stage although may not be making a profit yet. It is often at this stage that venture capitalists become involved in the financing.

Seed capital – the provision of very early stage finance to a company with a business venture or idea that has not yet been established. Capital is often provided before venture capitalists become involved. However, a small number of venture capitalists do provide seed capital.

Sliding fee scale – A management fee that varies over the life of a partnership.

Spin-out firms – These are captive or semi-captive firms that gain independence from their parent organisations.

Strategic investment – An investment that a corporation makes in a young company that can bring something of value to the corporation itself. The aim may be to gain access to a particular product or technology that the start-up company is developing, or to support young companies that could become customers for the corporation’s products. In venture capital rounds, strategic investors are sometimes distinguished from venture capitalists and others who invest primarily with the aim of generating a large return on their investment.Corporate venturing is an example of strategic investing.

Syndication – The sharing of deals between two or more investors, normally with one firm serving as the lead investor. Investing together allows venture capitalists to pool resources and share the risk of an investment.

Take downs – see drawdown

Term sheet – A summary sheet detailing the terms and conditions of an investment opportunity.

Tombstone – When a private equity firm has raised a fund, or it wishes to announce a significant closing, it may choose to advertise the event in the financial press – the ad is known as a tombstone. It normally provides details of how much has been raised, the date of closing and the lead investors.

Turnaround – Turnaround finance is provided to a company that is experiencing severe financial difficulties. The aim is to provide enough capital to bring a company back from the brink of collapse. Turnaround investments can offer spectacular returns to investors but there are drawbacks: the uncertainty involved means that they are high risk and they take time to implement.

Venture capital – The term given to early-stage investments. There is often confusion surrounding this term. Many people use the term venture capital very loosely and what they actually mean is private equity.

Vintage year – The year in which a private equity fund makes its first investment.

Two Bites at the Apple

A private equity recapitalization, “recap”, or “2-stage deal” is a financial vehicle that is being increasingly used by savvy business owners to both fund growth and hedge risk.  As an owner of a privately-held business, you can use a recap to:

  • Create liquidity by paying down bank debt, removing personal guarantees, and enhancing the working capital of the business allowing investment in organic growth.
  • Diversify risk by cashing in a portion of the equity in your business such that you may diversify your wealth portfolio to create peace of mind for you and your family.
  • Drive upside by accelerating your company’s growth and positioning it for a higher valuation in a subsequent sale.
  • Remove barriers to your success by augmenting your company’s expertise, available capital, and access to strategic relationships.
  • Enhance wealth by achieving a second, possibly larger liquidity event when the investor ultimately exits the investment five to seven years after the initial investment.

Novus Biologicals is currently on a path to achieve these benefits from a recap.  “Even though our industry has historically been minimally impacted by macroeconomic factors, today’s climate is just too unpredictable” says Karen Padgett, CEO of Novus Biologicals.  “We wanted to take some chips out of our business and off the table, as well as have capital readily available for European expansion.  Partnering with a private equity group through a recap enabled us to achieve those ends and more.”

Investors today find recaps attractive because they provide opportunities to achieve higher returns in an environment that they can help influence.  According to David Kessenich, President of Excellere Partners, a U.S. private equity firm, “The current market provides an excellent opportunity for entrepreneurs with a compelling strategic vision to partner through a recap with a value-added private equity firm.  The business platform then has the capital and strategic resources to capitalize on market uncertainty and accelerate growth while competitors are distracted by internal challenges.”

How Does a Recap Work? A Numerical Example…

Stage 1: Let’s say your firm is valued at $15 million. You as the Owner need capital to fund growth,  and partially exit through selling 67% of the firm to an outside Investor for $10 million.  You retain 33% of the equity in the firm, but the private equity group has allowed you to diversify your wealth and has brought working capital to the business to fund further growth.

Over a five-year period, you and the private equity group develop and implement a strategic plan that includes components for organic growth (growing current markets) and inorganic growth (acquiring other companies) to achieve significant growth objectives.

Stage 2: After executing the growth plan, you and the Investor fully exit through a sale to a third party. The company is now valued at $70 million, and you are realizing the upside of the recap through your remaining equity stake, totaling $23 million ($70 M x 33%).

Benefits to both parties:  You have received the working capital you needed to grow the company to almost five times its original size, while still being able to get an additional $23 million in cash.  At the same time, you have been able to diversify your wealth to better balance the risks associated with equity ownership in your company.  The investor has benefited from keeping you on board, leveraging your expertise and motivation to create a significant return all shareholders.

The above example is an easy and straightforward one to illustrate the concept.  In reality however, recaps are complex structured vehicles, demanding the right understanding and expertise.  First, you will need an attorney that has extensive experience with multiple recap structures, ideally having represented both sides of the transaction.  Second, you will need a tax expert who understands the nuances of these types of deal structures and some of the pending tax code changes relevant to a recap.  Third, you need an M&A advisor that is an expert on creatively structuring and negotiating recaps.

An M&A advisor, in particular, will drive deal value by bringing together the right parties and positioning the right investment thesis.  An experienced M&A advisor will maximize the size of “the pie”, and then make sure you get your fair share.

“When we first explored the option of doing a recap, we seriously underestimated the complexity it involved.  We hired Forbes Mergers & Acquisitions to quarterback the overall process, and they referred us to Kamlet Shepherd & Reichert to handle the legal and tax mechanics…Putting together the right team was the best decision we ever made.” –Karen Padgett, CEO of Novus Biologicals.

Is a recap right for you?

Whether or not it is time for you to start exploring the recap option depends on many factors.  The strongest candidates for recaps are companies that are well run, are leaders in their market niche, and that have well defined opportunities for significant growth.  Oftentimes the private equity group will prefer a controlling interest in your firm, so while you maintain day-to-day control of the business, you may need to get comfortable with a new partner participating in strategic decisions. If you think a private equity recap might help you achieve your strategic goals, an M&A advisor is your best resource begin a dialogue.

About the author:

Bob Forbes, President, is a Mergers & Acquisitions Master Intermediary with over 15 years of experience in business transactions, as a transaction advisor, business owner, and private equity executive. Mr. Forbes has started, built, acquired and sold numerous companies.  He presently serves on the board of directors for the Colorado Association of Business Intermediaries and is an active member of the M&A Source, IBBA, and Association for Corporate Growth.

Are acquisitions part of your company’s growth plan?

Harvard Business Review Blog Network

by Ron Ashkenas  |  10:00 AM February  6, 2013

Odds are the answer is yes. In the first half of 2012, thousands of merger and acquisition deals were announced globally, worth more than $900 billion. And this was a slow year. Predictions are that 2013 will be even more active as companies that have stockpiled cash look to invest in new growth opportunities.

But acquisitions can be risky business. Studies show that as many as two out of three deals do not realize their originally stated goals. And of course some of these fail spectacularly and end up hurting more than helping. HP’s acquisition of Autonomy is a recent case in point in which a transaction that was supposed to be transformative ended up in a multi-billion dollar write-off and messy accusations of fraud.

Given the fact that acquisitions and mergers are critical pathways to growth, companies will continue to pursue them, no matter what the potential downsides. To reduce the risks however, there are two steps that managers can take to make sure their firms are ready for the challenges of integration before committing to an actual deal. So if you and your colleagues are contemplating an acquisition, here’s a possible game plan.

First, create a high-level picture of what you want a combined company ideally to look like one year after a successful integration — not just in terms of finances, but also in regard to operational practices, strategic initiatives, organizational structure, and culture. This thought-process will smoke out your assumptions about how much change you think the company needs. More importantly, it will give you a basis for dialogue with other managers about their expectations for change, which might be different than yours. In fact, one of the reasons that integrations falter is the lack of alignment among managers about what will actually happen.

In a certain integration at a healthcare services organization, for example, senior leaders were ambivalent about whether they wanted to allow the newly acquired company to continue its own care standards or adopt their more stringent policies. In the absence of a clear decision from above, product managers and caregivers all made their own choices, which led to quality and compliance problems. The real issue was the extent to which the management team was willing to devote time and resources for training, documentation, communication, and all the other aspects of a major change effort. Knowing this ahead of time would have made the leaders think twice about what they were getting into.

Once you have a picture of the combined company, the second step is to do what we might call “backward resource planning.” This means starting with the vision and then working backwards to see what will it take to achieve it — what resources will be needed (e.g. teams, leaders, investments), what oversight and governance might be required, what skills would be essential.

One of the fundamentally flawed assumptions that companies make about integrating acquisitions is that managerial and professional time is infinitely expandable. The reality is that the best people — the ones that need to be assigned to diligence and integration teams — already have full-time and important jobs. So when they are asked to also take on integration assignments, they end up making choices about what not to do. When that happens, all sorts of other things start falling through the cracks, which is why we often see, during integrations, a degradation of customer service, increases in cycle time, and other performance shortfalls.

Some executives deal with this problem by hiring armies of consultants to do the heavy lifting. What they don’t realize is that managers still need to work with these consultants, give them direction, share information, and make sure that the work is being done properly. More importantly, unless managers are deeply involved, they won’t own the eventual outcomes of the integration process. So there’s no getting around the resource issues. What you as a manager can do, however, is prepare. Go into the integration process with a clear sense of the tradeoffs: Given the resources needed, what else can be stopped or delayed? What priorities can be reset? What goals need to be deferred? What work can be eliminated? What managers can be freed up to contribute to the integration projects? And will the eventual outcome be worth the effort?

Combining all or parts of two companies will always be challenging and entail a certain amount of risk. But before chasing the shiny new deal, it’s important to take a hard look at what it will take to succeed, and what it will take to get ready.

For more advice from Ron Ashkenas and others on this topic, read The Merger Dividend and Integration Managers: Special Leaders for Special Times.


The Anatomy of a Deal

The following might be a subtitle for this true account of how one deal was put together: “In spite of everything, you need only one buyer – the right one!” (Although the transaction is factual, names, financial data and other details are fictional.)

The company (let’s call it IndustrialTech) has carved a niche in a billion dollar industry. It manufactures proprietary electronic products and is owned by a private equity firm that wants to sell it for liquidity reasons. At the beginning of 2010, the private equity group retained Forbes Mergers & Acquisitions to take the company to market. The goal was to have it sold by the end of the year.

IndustrialTech had annual sales of about $12 million, gross margins of 50 percent, an EBITDA of $1.8 million (15 percent) and a reconstructed EBITDA of $2 million. It also had been growing over the past ten years at a 10 percent rate and had always been profitable. It had a diverse customer base split about equally between end-users and OEM accounts. However, the seller wanted to set a very aggressive full price, with all-cash in a not-so-vibrant M&A market.

On the plus side, however, the seller was cooperative and provided any information that Forbes needed. It also had audited statements, conservative accounting and instant monthly statements. IndustrialTech was, in addition to these factors, on the verge of getting a substantial amount of new business.

In preparing to take the business to market, Forbes came up with a basic game plan. For confidentiality reasons, certain direct competitors were eliminated from the buyer search. Synergistic buyers were targeted-either because they served similar markets or utilized similar manufacturing methods. Forbes also elected to contact selected private equity groups and other intermediary firms.

More specifically, Forbes planned on creating a list of 100 potential buyers. A buyer was defined as an entity that had signed a Confidentiality Agreement, had been pre-approved by the seller, and therefore, had been sent an Offering Memorandum. Forbes anticipated 15 written Term Sheets leading to five Letters of Intent which, hopefully, would lead to the best deal. Forbes advised IndustrialTech that the market was currently below the multiples asked by the seller. However, they succeeded in getting the seller’s premium valuation, and that success was to be based on the following:

  • Preparing a thorough and compelling Offering Memorandum and detailing out the positive future prospects. This required the complete cooperation of IndustrialTech’s management team.
  • Developing a complete list of possible buyers both in the U.S. and abroad.
  • Contacting the buyers to see if they would be interested in the company, but still maintaining confidentiality.
  • Administering all of the potential buyer activity and sending the Offering Memorandum to the appropriate parties.
  • Following up with all of the prospects who received the Offering memorandum and arranging tours of the facilities with the serious prospects.
  • Setting time frames for expressions of interest and term sheets, and fielding questions from the serious prospects.
  • Holding the deal together in spite of fall out from the global recession, which resulted in a two-month delay that could have been much longer.
  • Making sure that complete confidentiality was maintained and making sure that any future confidentiality leaks did not occur.
  • Constantly reminding IndustrialTech’s management to stay focused on maintaining sales and profit goals.
  • Maintaining communications with both the buyers and IndustrialTech’s lawyers and other outside advisors.

Forbes was able to develop a list of 85 possible acquirers; however, five would not sign the Confidentiality Agreement. Here is a breakdown of the 85 possible buyers:

  • Strategic – 45
  • Some Synergy – 20
  • Private Equity Groups – 20

Of the 85 possible buyers, 15 were companies or divisions of firms with annual revenues of $1 billion or more. 12 of these 15 were foreign or owned by foreign companies. IndustrialTech chose not to deal with four of the buyer firms due to negative industry knowledge. Two of the buyers were individuals that had financial backers. Four buyers were just “bottom fishing.” Three of the 85 decided not to move forward due to the credit crisis. One buyer only wanted to acquire assets, not the stock, of IndustrialTech. Interestingly, eight of the 85 firms had previously talked to IndustrialTech about a possible merger or acquisition.

Of the buyers who elected not to proceed or move forward, the majority felt that acquiring IndustrialTech was just not a good fit. Some of the other reasons why other buyers decided not to continue were:

  • Management was too thin
  • Since IndustrialTech was a good company, the price would most likely be too high
  • Buyer purchased another firm
  • One potential acquirer was acquired itself
  • Buying company was having its own internal problems
  • Buyer wanted to move company – this was unacceptable to the seller

After all of this, Forbes arranged five visits for acceptable buyers – the target number. Overall, Forbes received:

  • Term Sheets 4
  • Verbal Offers 2
  • Letters of Intent 4

Of the five buyers who visited the business and met with IndustrialTech’s management, two wanted to acquire the company. These were the best prospects. There were also two other firms, held in abeyance, in case one of the other two didn’t work out.

One of the original two and IndustrialTech’s preferred acquirers competed for the business and ultimately offered the desired price and terms. The buyer was:

  • A public company that wanted to grow through acquisition.
  • One with a synergistic product line.
  • Unlike some of the private equity groups, not totally focused on the financial aspects.
  • One with an appreciation of IndustrialTech’s product lines, its technology and the company’s potential.

Forbes started with 85 possible buyers. The final list came down to just a few and global recession certainly did not help in the sales efforts. IndustrialTech was not a company for just anyone. Despite all of this, Forbes got the deal done – proving once again, that you need only one buyer – the right one!

Business Valuation: Do the Financials Tell the Whole Story?

Many experts say no! These experts believe that only half of the business valuation should be based on the financials (the number-crunching), with the other half of the business valuation based on non-financial information (the subjective factors).

What subjective factors are they referring to?  SWOT is an acronym for Strengths, Weaknesses, Opportunities and Threats – the primary factors that make up the subjective, or non-financial, analysis. Below you will find a more detailed look at the areas that help us evaluate a company’s SWOT.

Industry Status – A company’s value increases when its associated industry is expanding, and its value decreases in any of the following situations:  its industry is constantly fighting technical obsolescence; its industry involves a commodity subject to ongoing price wars; its industry is severely impacted by foreign competition; or its industry is negatively impacted by governmental policies, controls, or pricing.

Geographic Location – A company is worth more if it is located in states or countries that have a favorable infrastructure, advantageous tax rates, or higher reimbursement rates.  A company with access to an ample educated and competitive work force will also enjoy increased value.

Management – A company with low turnover in management and a solid second-tier management team comprised of different age levels is also worth more.

Facilities – A company operating profitably at 70 percent capacity is worth more than a company currently near capacity. Equipment should be up to date and any leases – either equipment or real estate – renewable at reasonable rates.

Products or Services – A company is worth more if its products or services are proprietary, are diversified with some pricing power, and have, preferably, a recognizable brand name. In addition, new products or services should be introduced on a regular basis.

Customers – A company is worth more if there is not heavy customer concentration, but rather recurring revenue from long-time, loyal customers, as well as from new customers created through a regular and systematic sales process.

Competition – A company not contending head to head with powerful competitors such as Microsoft or Wal-Mart will rate a higher value.

Suppliers – Finally, a company is worth more if it is not dependent on single sourced key items or items available from only a limited number of suppliers.

Do You Have an Exit Plan?

“Exit strategies may allow you to get out before the bottom falls out of your industry. Well-planned exits allow you to get a better price for your business.”

From: Selling Your Business by Russ Robb, published by Adams Media Corporation

Whether you plan to sell out in one year, five years, or never, you need an exit strategy. As the term suggests, an exit strategy is a plan for leaving your business, and every business should have one, if not two. The first is useful as a guide to a smooth exit from your business. The second is for emergencies that could come about due to poor health or partnership problems. You may never plan to sell, but you never know!

The first step in creating an exit plan is to develop what is basically an exit policy and procedure manual. It may end up being only on a few sheets of paper, but it should outline your thoughts on how to exit the business when the time comes. There are some important questions to wrestle with in creating a basic plan and procedures.

The plan should start with outlining the circumstances under which a sale or merger might occur, other than the obvious financial difficulties or other economic pressures. The reason for selling or merging might then be the obvious one – retirement – or another non-emergency situation. Competition issues might be a reason – or perhaps there is a merger under consideration to grow the company. No matter what the circumstance, an exit plan or procedure is something that should be developed even if a reason is not immediately on the horizon.

Next, any existing agreements with other partners or shareholders that could influence any exit plans should be reviewed. If there are partners or shareholders, there should be buy-sell agreements in place. If not, these should be prepared. Any subsequent acquisition of the company will most likely be for the entire business. Everyone involved in the decision to sell, legally or otherwise, should be involved in the exit procedures. This group can then determine under what circumstances the company might be offered for sale.

The next step to consider is which, if any, of the partners, shareholders or key managers will play an actual part in any exit strategy and who will handle what. A legal advisor can be called upon to answer any of the legal issues, and the company’s financial officer or outside accounting firm can develop and resolve any financial issues. Obviously, no one can predict the future, but basic legal and accounting “what-ifs” can be anticipated and answered in advance.

A similar issue to consider is who will be responsible for representing the company in negotiations. It is generally best if one key manager or owner represents the company in the sale process and is accountable for the execution of the procedures in place in the exit plan. This might also be a good time to talk to Forbes M&A for advice about the process itself. Forbes M&A can provide samples of the documents that will most likely be executed as part of the sale process; e.g., confidentiality agreements, term sheets, letters of intent, and typical closing documents. We can also answer questions relating to fees and charges.

One of the most important tasks is determining how to value the company. Certainly, an appraisal done today will not reflect the value of the company in the future. However, a plan of how the company will be valued for sale purposes should be outlined. For example, tax implications can be considered: Who should do the valuation?  Are any synergistic benefits outlined that might impact the value?  How would a potential buyer look at the value of the company?

An integral part of the plan is to address the due diligence issues that will be a critical part of any sale. The time to address the due diligence process and possible contentious issues is before a sale plan is formalized. The best way to address the potential “skeletons in the closet” is to shake them at this point and resolve the problems. What are the key problems or issues that could cause concern to a potential acquirer? Are agreements with large customers and suppliers in writing? Are there contracts with key employees? Are the leases, if any, on equipment and real estate current and long enough to meet an acquirer’s requirements?

The time to address selling the company is now. Creating the basic procedures that will be followed makes good business sense and, although they may not be put into action for a long time, they should be in place and updated periodically.

Why Do Deals Fall Apart?

In many cases, the buyer and seller reach a tentative agreement on the sale of the business, only to have it fall apart. There are reasons this happens, and, once understood, many of the worst deal-smashers can be avoided. Understanding is the key word. Both the buyer and the seller must develop an awareness of what the sale involves–and such an awareness should include facing potential problems before they swell into floodwaters and “sink” the sale.

What keeps a sale from closing successfully? In a survey of business brokers across the United States, similar reasons were cited so often that a pattern of causality began to emerge. The following is a compilation of situations and factors affecting the sale of a business.

The Seller Fails To Reveal Problems 
When a seller is not up-front about problems of the business, this does not mean the problems will go away. They are bound to turn up later, usually sometime after a tentative agreement has been reached. The buyer then gets cold feet–hardly anyone in this situation likes surprises–and the deal promptly falls apart. Even though this may seem a tall order, sellers must be as open about the minuses of their business as they are about the pluses. Again and again, business brokers surveyed said: \”We can handle most problems . . . if we know about them at the start of the selling process.

The Buyer Has Second Thoughts About the Price 
In some cases, the buyer agrees on a price, only to discover that the business will not, in his or her opinion, support that price. Whether this “discovery” is based on gut reaction or a second look at the figures, it impacts seriously on the transaction at hand. The deal is in serious jeopardy when the seller wants more than the buyer feels the business is worth. It is of prime importance that the business be fairly priced. Once that price has been established, the documentation must support the seller\’s claims so that buyers can see the “real” facts for themselves.

Both the Buyer and the Seller Grow Impatient 
During the course of the selling process, it\’s easy–in the case of both parties–for impatience to set in. Buyers continue to want increasing varieties and volumes of information, and sellers grow weary of it all. Both sides need to understand that the closing process takes time. However, it shouldn’t take so much time that the deal is endangered. It is important that both parties, if they are using outside professionals, should use only those knowledgeable in the business closing process. Most are not. A business broker is aware of most of the competent outside professionals in a given business area, and these should be given strong consideration in putting together the “team.” Seller and buyer may be inclined to use an attorney or accountant with whom they are familiar, but these people may not have the experience to bring the sale to a successful conclusion.

The Buyer and the Seller Are Not (Never Were) in Agreement 
How does this situation happen? Unfortunately, there are business sale transactions wherein the buyer and the seller realize belatedly that they have not been in agreement all along–they just thought they were. Cases of communications failure are often fatal to the successful closing. A professional business broker is skilled in making sure that both sides know exactly what the deal entails, and can reduce the chance that such misunderstandings will occur.

The Seller Doesn\’t Really Want To Sell 
In all too many instances, the seller does not really want to sell the business. The idea had sounded so good at the outset, but now that things have come down to the wire, the fire to sell has all but gone out. Selling a business has many emotional ramifications; a business often represents the seller\’s life work. Therefore, it is key that prospective sellers make a firm decision to sell prior to going to market with the business. If there are doubts, these should quelled or resolved. Some sellers enter the marketplace just to test the waters; to see if they could get their “price,” should they ever get really serious. This type of seller is the bane of business brokers and buyers alike. Business brokers generally can tell when they encounter the casual (as opposed to serious) category of seller. However, an inexperienced buyer may not recognize the difference until it\’s too late. Most business brokers will agree that a willing seller is a good seller.

Or…the Buyer Doesn’t Really Want To Buy 
What\’s true for the mixed-emotion seller can be turned right around and applied to the buyer as well. Buyers can enter the sale process full of excitement and optimism, and then begin to drag their feet as they draw closer to the “altar.”

And None of the Above 
The situations detailed above are the main reasons why deals fall apart. However, there can be problems beyond anyone’s control, such as Acts of God, and unforeseen environmental problems. However, many potential deal-breakers can be handled or dealt with prior to the marketing of the business, to help ensure that the sale will close successfully.

A Final Note 
Remember these components in working toward the success of the business sale:

  • Good chemistry between the parties involved.
  • A mutual understanding of the agreement.
  • A mutual understanding of the emotions of both buyer and seller.
  • The belief, on the part of both buyer and seller, that they are involved in a good deal

What is a Company Worth?

This question can only be answered by addressing other related questions, specifically: Who’s asking and for what purpose?

From the perspective of the owner, prospective buyers, the IRS, lenders and divorce & bankruptcy courts, the value of a business for purposes of a sale, estate planning, orderly or forced liquidation, gifting, divorce, etc. can be vastly different.

[restrict …]Intrinsically tied to the various purposes of valuation are numerous definitions of “value.” Here are a few examples:

Investment Value – The value an acquirer places on a business based on a future return on investment determined by assessing past and current performance, future prospects, and other opportunities and risk factors involving the business.

Liquidation Value – The value derived from the sale of the assets of a business that is closed or expected to be closed following the sale.

Book Value – Book value is the difference between the total assets and total liabilities as accounted for on the company’s balance sheet.

Going Concern Value – Used to define the intangible value which may exist as a result of a business having such attributes as an established, trained and knowledgeable workforce, a loyal customer base, in-place operating systems, etc.

Fair Market Value
For the purpose of this article, the focus will be on transaction related valuations. Fair Market Value (“FMV”) is the most relevant definition of “value” and is of the most interest to business owners. The more knowledge business owners and prospective buyers have about the valuation process, the more likely they will come to an agreement on a purchase price.

FMV is the measure of value most used by business appraisers, as well as the Internal Revenue Service (IRS) and the courts. FMV is essentially defined as “the value for which a business would sell assuming the buyer is under no compulsion to buy and the seller is under no compulsion to sell, and both parties are aware of all of the relevant facts of the transaction.” IRS Revenue Rule 59-60 lists the following factors to consider in establishing estimates of FMV:

1. The nature and history of the business.
2. The general economic outlook and its relation to the specific industry of the business under review.
3. The earnings capacity of the business.
4. The financial condition of the business and the book value of the ownership interest.
5. The ability of the business to distribute earnings to owners.
6. Whether or not the business has goodwill and other intangible assets.
7. Previous sales of ownership interests in the business and the size of ownership interests to be valued.
8. The market price of ownership interests in similar businesses that are actively traded in a free and open market, either on an exchange or over-the-counter.

What is Goodwill?
An important element of value, when it exists, is goodwill. The IRS defines goodwill in its Revenue Rule 59-60, stating, “In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value for the tangible assets exceeds the net book value of such assets.”

Valuation Approaches and Methods
Exploring valuation techniques requires an understanding of the tools available. Which tools are utilized depends in part on the purpose of the valuation and the circumstances of the subject company. Generally there are several approaches to valuing a business. Within these approaches, there are several different methods. Listed below are the three major approaches along with some examples of specific methods that fall under each category.

• Income Approach
Discounted Cash Flow Method
Single Period Capitalization of Earnings Method
• Market Approach
Comparable Publicly Traded Company Analysis
Comparable Merger & Acquisition Analysis
• Asset-Based Approach
Adjusted Net Asset Method
Excess Earnings Method

All of the above methods and approaches are frequently used in business valuations.

Normalizing the Financial Statements
Before the approaches and methods above can be applied, it is necessary to analyze and normalize both the income statement and balance sheet of the business for the current and past periods selected to form the basis of the valuation.

• Normalizing the Income Statement

Normalizing the Income Statement generally entails adding back to earnings certain personal expenses, non-recurring and non-cash items. Examples of these “add-backs” could include depreciation, amortization, auto, boat and airplane expenses, one-time extraordinary expenses and other excess expenses such as owner’s salaries and family member’s salaries that are above fair market value, travel and entertainment, bonuses, etc. Owners usually tend to be extremely liberal when normalizing the income statement in order to bolster earnings, which can artificially inflate valuation. Each item must be carefully analyzed and scrutinized to insure that the normalization process is credible.

• Normalizing the Balance Sheet

Normalizing the Balance Sheet includes adjustments that eliminate non-operating assets and other assets and liabilities that are not included in the proposed transaction, and therefore the valuation. The book value of the assets will be adjusted up or down to reflect their fair market value. Inter-company charges will also be eliminated. Inventory may be adjusted upward or downward based on prior accounting procedures and/or obsolescence. Accounts receivable may also require an adjustment based on an analysis of collectibility.

Relevant Terminology:

EBIT – An acronym for earnings before interest and taxes

EBITDA – An acronym for earnings before interest, taxes, depreciation and amortization.

Capitalization Rate – Any divisor that is used to convert income into value. This is generally expressed as a percentage.

Discount Rate – The rate of return that is used to convert any future monetary gain into present value.

(Note: when determining FMV, the earnings stream selected to be capitalized or discounted should be normalized.)

Even with all the terminology and definitions discussed above, the answer to the original question has not yet completely been answered: What is the company worth?

The value driver of a business is the ability of the entity to generate future cash flow or earnings. Business appraisers will assign an appropriate capitalization rate (or multiple) to a selected earnings stream to derive an overall value for a business. The value of the net assets of the business will be compared to the cash flow valuation and may be adjusted upward or downward. For example: if the earnings based valuation is less than the net asset value, an upward adjustment may be in order. Conversely, if the net assets are negligible, a downward adjustment is more likely to occur.

Many appraisers typically use a common range of multiples to arrive at a “ballpark” indication of value (for example, 4 to 6 times EBITDA). While this approach is commonplace, an in-depth valuation of the subject company will produce a more accurate result. There are too many intangible factors to be considered to rely solely on the capitalization of earnings. Of course, the ultimate value of a company will be determined by the marketplace, which can greatly differ from a seller’s expectation, as well as the expectations of potential acquirers.

It is not uncommon for business owners to have an inflated sense of value of their company. This could be due to a variety of factors including emotional attachment to the business, unwillingness to accept the impact of the risk factors of the business, outside influence from previous market conditions, incorrect conclusion of normalized earnings, comparable transactions, etc. Conversely, acquirers often undervalue businesses. In their quest to “buy right” they often end up paying a lower multiple for a company with serious negative factors, while passing up on higher multiple opportunities, which, due to the quality, are actually better buys.

Valuation is a complex process. Owners and buyers will be well served if they rely on professional advisors such as their accountants, business appraisers, intermediaries or investment bankers.[/restrict]