Friday, 28 September 2012

What About the Form of Payment?

Public company take-over bids typically consist of all cash or a combination of cash and shares.  This is largely because the board of directors of a public company agreeing to an earn-out will be subject to serious questions (read lawsuits) if things turn out other than expected.
Consideration in private company acquisitions will usually include a sizable portion in cash (50 to 100%) but will often include an unsecured note and/or an earn-out as well.  This is typically because: (i) the buyer does not have (or have access to), the amount of cash required to complete the acquisition (particularly in the case of an MBO), (ii) the greater risk surrounding private companies (risks such as customer concentration, dependence on key suppliers, etc.) and (iii), buyers can usually stretch to a higher price if the purchase price is not all cash.  For example, $25 million all cash vs. $30 million two-thirds cash and one-third note ...which one would you pick?
There are a number of issues to consider when assessing the likelihood of realizing deferred consideration.  A dollar not received at closing is a dollar at risk.  In the case of a vendor note, the first question is, can it be fully secured by hard saleable assets (such as land, a building or other fixed salable assets owned by the acquirer).  This is not often the case.  If the amount is under-secured (i.e. 50% asset coverage) or unsecured, the terms have to reflect increased risk and due diligence should be performed on the buyer to get comfortable with its risk profile and prospects.  The higher the risk the higher the interest rate, and the more covenants and timely reporting are required.  Perhaps the most important item is timely reporting allowing for quick remediation.  Issues such as lawsuits, product defects/recalls, loss of customers can turn the fortunes of a company very quickly.
Earn-outs are tricky as well.  Earn-outs are more prevalent when the seller presents a strong growth forecast (for which he/she wants value).  If the seller will not entertain an earn-out, does that mean he/she does not believe in the forecast? They are not usually ironclad.  Many earn-out proposals begin with a premise along the following lines.  If you achieve $5 million in EBITDA you will earn another $x amount in purchase price.  Does this mean that if the company generates $4.9 million you get nothing? … and how is EBITDA calculated?  The acquiring company could incur discretionary expenses that you would not incur, or layer on additional overhead or, most drastic, a fundamental change of business direction could be required?
There are many possible situations to consider and many creative mechanisms and approaches to making vendor notes and earn-outs work.  For example, if the seller agrees that 75% of the earn-out will be paid if 75% of the target revenues are reached then he/she should also seek 125% of the earn-out when 125% of the revenues are reached.  Earn-outs can be tied to achieving development milestones, securing customer contracts but if earn-outs are based on the financial statements, then the higher up the income statement (i.e. sales vs. profit) the better… less room for manipulation. From a legal perspective it is important that purchase and sale contracts are clear, account for all possible scenarios, and that security is properly perfected in all relevant jurisdictions.
Un(der)secured notes and earn-outs can get very complex and this is where experienced advisors and lawyers really earn their stripes.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Thursday, 13 September 2012

A Multiple of What (and When)?

I discussed the pitfalls of relying on publicly available value comparisons in a recent post but what if an owner of a similar business to yours says “I sold my business at a 10 times multiple!”? or you hear, the tech sector is trading at a 25 multiple.  Early stage companies trade at 2 to 3 times.  The question is a multiple of what?
For public companies the most noted multiple is that of after tax net income.  For early stage companies it is quite often a multiple of revenues because, either they are not profitable or, they are in high growth mode, where profit levels are depressed as a result of higher than long-term average spending on R&D and product/service marketing.  For established private companies, the most commonly cited valuation metric is a multiple of EBITDA. 
EBITDA stands for Earnings Before Interest, Taxes and Depreciation and it allows for comparison of profitability by canceling the effects of different asset bases (by cancelling depreciation), different takeover histories (by cancelling amortization often stemming from goodwill), effects due to different tax structures as well as the effects of different capital structures (by cancelling interest payments).  The drawbacks of using EBITDA are that it doesn’t account for maintenance/required capital expenditures (CAPEX) to sustain the business and, because it is a non-GAAP metric, it is often presented on an adjusted basis excluding (sometimes questionable) one-time items thereby boosting profitability.
The relationship of an EBITDA multiple to other multiples can vary widely across industries.    For consulting or software companies, that typically don’t or can’t carry long term debt and have little investment in fixed assets, EBITDA is often the same as earnings before tax.  For capital intensive companies, an EBITDA multiple of five might be the equivalent to an EBIT multiple of seven.  When we speak of a five times EBITDA multiple for a private company, the value may actually be the same as 15 or 20 times net income after tax for a profitable public company.
The period the multiple applies to is also important. While valuation is conceptually a forward looking principle, the standard is to use a historical multiple as a result of the difficulty of predicting what the next 12 months of earnings might be.  Some variants of timeframes used are “run-rate” (annualizing the last month or quarter), “latest twelve months” (LTM, typically calculated on a rolling four quarters basis), or last calendar or fiscal year.  Why does the timeframe matter?  Let’s look at a fast growing public company such as Apple.  On August 20th, its market cap was approximately $620 billion.  Its latest fiscal year ending (EBITDA was $35.5 billion and its 12 month consensus forecast EBTIDA was $55.8 billion.  People will say Apple is trading at 17.5 times EBITDA but the more proper metric is that it is trading at 10.7 times forecast EBITDA, a difference of 70%.
Finally, in addition to the specifics around the multiple, there are many bigger picture questions such as: did the buyer assume the debt; were there working capital adjustments; was the amount paid in cash on closing or will it be paid over time? Different answers to such questions will also measurably impact the net multiple paid.  So the next time someone tells you they sold their business for a great multiple, think about a multiple of what and when.
