A COMMON GOAL AND COMMON UNDERSTANDINGS
- Agreed: Our common goal is to make the best possible deal for both parties based upon a fair assessment of the business opportunity in question.
- Agreed: you do not buy or sell a business, you buy or sell a business opportunity.
- Agreed: the seller’s reasons for selling and the buyer’s reasons for buying probably have nothing to do with each other.
- Agreed: fair market value and a fair price are not the same thing.
- Agreed: It does not matter how you get to the same price, as long as you get there.
- Agreed: the best deal for both parties rarely means either party gets their best deal on price.
- Agreed: There is no “right price” for a business, only a range of reasonable prices.
- Agreed: We will disclose our calculations and the reasons behind our assumptions, but will not emotionally debate those assumptions again and again.
- Agreed: There is more to a good deal than price.
- Agreed: Price depends on structure.
- Disclosed: the seller’s reasons for selling.
- Disclosed: the buyer’s reasons for buying.
RECASTING THE COMPANY BALANCE SHEET – ADJUSTED BOOK VALUE and REDUNDANT ASSETS
- Receivables
- Inventory
- Capital assets
- Intercompany receivables or other which the seller does not wish to sell or the buyer does not wish to buy with the company
- Redundant assets or assets which are not important to company operations
- Removing any goodwill figures (which will be negotiated separately – see below)
- Liabilities which have been under or overstated
- Liabilities which the buyer does not want to assume
- Unusual items related to the seller’s tax planning
- Identified, quantified and discussed: controversial items from recast balance sheet items
- Identified, quantified and discussed: controversial items from redundant asset discussion
- Identified, quantified and resolved: non-controversial items from redundant asset discussion.
RECASTING THE INCOME STATEMENT: NORMALIZED SUSTAINABLE EARNINGS (aka EBITDA)
- after tax profits from financial statements
- plus taxes, interest expense, depreciation and amortization, all owner compensation (salaries, bonuses, cars, spouses, management fees, etc.), all owner perks (club memberships, toys), charitable donations, and non-recurring or unusual one-time expenses
- less the cost of hiring independent management to perform the owner’s functions in the business
- less capital expenditures required to maintain normal earnings, and non-recurring or unusual one-time revenues
- and other adjustments as required (e.g., to normalize rents or other costs related to common ownership real estate or other assets) (could be plus or minus).
- Identified, quantified and discussed: controversial items from historical earnings.
- Identified and discussed: controversial items with respect to projected earnings.
ASSESSING THE BUYER’S RISK: MULTIPLES AND CAPITALIZATION RATES
- Discussed, and quantified and agreed to where possible: key risk factors in business opportunity.
- Identified and discussed, and quantified where possible: controversial items with respect to buyer’s perception of key risk factors in business opportunity
| Higher Risk/Lower Multiple/Higher Capitalization Rate/Lower Price | Lower Risk/Higher Multiple/Lower Capitalization Rate/Higher Price |
| new business or short time frame upon which to base normalized sustainable future earnings | established business and reliable, historical basis for normalized sustainable future earnings |
| weak balance sheet | healthy balance sheet |
| questionable growth trend | good growth trend |
| weak position in weak industry | strong position in strong industry |
| few barriers to entry for competition | significant barriers to entry for competition |
| company competes heavily on price, or provides commodity product or service | company sales not price dependent |
| customer loyalty, sales, company management strongly tied to personal goodwill of departing owner | company performance not tied to personal goodwill of departing owner |
| share purchase | asset purchase |
| deal structure means absence of healthy future depreciation and amortization opportunity to shelter cash flow | deal structure favours healthy future depreciation and amortization opportunity to shelter cash flow |
| no vendor take-back financing | vendor take-back financing with good terms |
| purchase price not tied to post-closing performance, no “earn-out” | purchase price tied to post-closing performance, and vendor sharing in post-closing risks |
| vendor providing excellent management but not staying on | vendor providing excellent management and staying on for extended period of time |
| lack of proprietary assets or sustainable competitive advantage | lots of valuable intellectual property and sustainable competitive advantage |
| business poorly managed or poorly positioned, buyer providing the “sustainability” | well managed and well positioned business, seller providing “sustainability” |
| significant personal goodwill with seller; risk of loss of key customers, suppliers and employees | minimal personal goodwill with seller; lots of corporate goodwill with customers, suppliers and employees |
| minimal synergy for buyer | lots of synergy with buyer’s other enterprises |
| negative trends in margins | good margin trends |
| questionable or negative trends re: key suppliers or raw materials | strong bargaining position on supply side, including favourable contracts for future supply |
| questionable or volatile labour trends in near future, including increasing costs, labour strife, shortage of supply, lack of predictability, layoffs required | solid trends in reasonably priced labour |
| significant currency risks | minimal currency risks |
| buyer inexperienced in the industry | buyer well established and familiar with the industry |
| economy or industry in or headed into a downturn | economy or industry coming out of downturn, or appears to be on track for strong future in the foreseeable future |
| no, questionable, poor or uncertain prospects or contracts for future sales | good prospects or contracts in place for future sales |
| buyer does not “need” to do a deal | buyer “needs” to do a deal |
| vendor “needs” to do a deal | vendor does not “need” to do a deal |
| buyer not afraid of competitor making the acquisition | buyer wants to eliminate or acquire a competitor, or to deny a competitor the opportunity to acquire the business |
| tax situation favours seller at buyer’s expense (e.g., none of purchase price allocated to post-closing management fees or depreciable assets) | tax situation favours buyer at seller’s expense (e.g., lots of purchase price allocated to management fees or other taxable income to seller) |
| acquisition or business hard to finance at low rates | good opportunity for buyer to finance business or acquisition at very competitive rates |
| assets over valued on balance sheet | assets undervalued on balance sheet |
| No opportunity for post-closing breakup of business assets | good opportunity for post-closing breakup value |
| Significant capital investment required in near future | no significant capital investment needed in near future |
| Buyer accepted normalized sustainable earnings at the high end of the range | seller accepted normalized sustainable earnings at the low end of the range |
RECASTING COMPANY PERFORMANCE RATIOS
- Discussed, and agreed to where possible: key company performance ratios.
- Discussed, and calculated where possible: controversial items with respect to buyer’s perception of adjusted key performance factors.
| Annual Break Even = Fixed Expenses ¸ (Gross Profit ¸ Net Sales) |
| Annual Break Even (Months) = Fixed Expenses ¸ (Gross Profit ¸ Net Sales) ¸ Net Sales X 12 |
| Margin of Safety (As Percentage) = (Net Sales – Annual Break Even) ¸ Net Sales X 100 |
| Operating Leverage = (Net Sales – Variable Costs) ¸ Pre-Tax Profits Operating Leverage X % Change in Sales = % Change in Profits |
| Working Capital = Current Assets – Current Liabilities |
| Current Ratio = Current Assets ¸ Current Liabilities |
| Age of Inventory = Closing Inventory ¸ (Cost of Goods Sold ¸ # of Months) |
| Age of Accounts Receivable = Accounts Receivable ¸ (Net Sales ¸ # of Months) |
| Age of Accounts Payable = Accounts Payable ¸ (Credit Based Purchases ¸ # of Months) |
| Debt to Equity Ratio = Total Debt ¸ Total Equity |
| Debt Service Coverage = (Pre-tax profits + Depreciation + Interest Expense) ¸ (All Annual Current Loan Payment Requirements for Principal and Interest) |
| Interest Coverage = (Pre-Tax Profits + Interest Expense) ¸ Interest Expense |
| Return on Assets = Pre-Tax Profits ¸ Operating Assets |
| Return on Shareholders’ Equity = Pre-Tax Profits ¸ (Adjusted Book Value + Shareholders’ Loans). |
USE OF COMPARABLES
- List of useful comparable sales identified, compared and shared
- Relevance of comparables discussed
BRIDGING THE GAP: SHARING THE RISK – PRICE ADJUSTMENT FORMULAS, EARNOUTS, VTB FINANCING
- Discussed, and quantified where possible: potential for price adjustment mechanisms.
- Discussed, and quantified where possible: potential for earnout or seller risk participation.
- Discussed, and quantified where possible: potential for price deferral through escrow funds, VTB security, etc.
BRIDGING THE GAP: SHARING THE BURDEN
- Seller contributing to certain buyer expenses
- Buyer contributing to certain seller expenses
- Paying part of the purchase price by consulting fees or non-competition payments or other ways which are more favourable to the buyer from a tax perspective than to the seller
- Seller providing financial support by deferring payments, holding a VTB with no or low interest rates, holding on to key assets and leasing them back to the buyer
- Seller keeping certain assets for itself, reducing the price to the buyer but leaving the seller with the opportunity to liquidate those assets at a later date to the benefit of the seller
BRIDGING THE GAP: SHARING THE TAX SHIELD
- Discussed, and quantified where possible: tax shield to buyer based on buyer’s preferred price range and deal structure.
- Discussed, and quantified where possible: tax shield to seller based on seller’s preferred price range and deal structure.
- Discussed, and quantified where possible: potential to bridge the price gap through sharing the tax shield.
BRIDGING THE GAP: INTANGIBLES
- Discussed: intangible reasons for bridging the gap, including:
- how badly each party “needs” to do the deal
- how badly each party “wants” to do the deal
- how badly the parties want to do business with each other
- what synergies the buyer thinks it can bring to the table to drive normalized sustainable future earnings to higher levels, thereby effectively reducing the buyer’s multiple
- how the buyer is financing the deal, and whether that financing package ultimately reduces his risk to an acceptable level
- how the deal is structured, including vendor take back financing, price adjustment clauses, post-closing support, etc.
- how the deal is structured for after tax cash flow to each party.
© Phil Thompson – www.philthompson.ca