Big Players Love the Lower Middle Market

Written by Danielle Fugazy and provided courtesy of Axial.net

The M&A environment continues to be as competitive as ever. Looking for relief from high valuations and hotly contested auction processes, many private equity firms and strategic acquirers are moving down market.

It’s no secret that companies purchased at lower entry valuation generally achieve better returns because of their potential for multiple expansion. This is not lost on many of the largest players in the private equity industry. The venerable KKR has taken an interest in smaller technology, healthcare, and industrial businesses — some generating as little as $25 million — and is currently raising a middle market fund. Two years ago, another giant private equity firm, The Carlyle Group, raised $2.4 billion to pursue middle market buyouts in North America. The fund targets control investments requiring equity capital of as little as $20 million to $200 million per transaction.

As the larger private equity firms move down market, so do the lenders. “The larger lenders compete for smaller deals when their sponsor relationships come down. They follow their clients, but it’s not necessarily where they focus,” says Joseph Burkhart, a managing director with Saratoga Partners.

Impact on Traditional Lower Middle Market PE Firms

The impact of larger players moving down is twofold: first, traditional lower middle market private equity firms are pursuing additional strategies so they can continue to compete as the larger players come in to the space while others are working harder than ever to win deals today. For example, earlier this year Sentinel Capital Partners, which was already investing in the lower middle market, closed on Sentinel Capital Partners VI at $2.15 billion, and Sentinel Junior Capital, a $460 million fund that gave the firm a presence in the mezzanine financing market. Also early this year, Huron Capital closed on its inaugural non-control fund The Huron Flex Equity Fund with $142 million, which gives the firm flexibility to make non-control investments that are  smaller than their typical deals.

Watervale Partners, a private equity firm that spun out of Linsalata Capital Partners last year, is looking for deals pretty far down market in hopes of escaping some of the competition in the larger markets. Unlike Linsalata—a private equity firm focused squarely on the middle market—the Cleveland, Ohio-based Watervale is looking to make control investments in companies with less than $6 million of EBITDA. The typical transaction value for Watervale will likely be less than $50 million.

“There’s no question that firms are moving down market in general, but at some point—we think around $6 million in EBITDA—the economics call for a different model and all of your support systems change,” says Bacon. “One of the advantages of larger firms is their ability to absorb dead deal costs or spend more money before exclusivity; that isn’t as prevalent to these smaller deals where the company really can’t handle multiple bidders simultaneously.”

In today’s frothy market one of the biggest impact of larger firms coming down market is the lack of exclusivity on potential deals. With bankers asking multiple parties to do the proper due diligence on a company, many lower middle market firms are at a disadvantage. While the larger firms can afford to spend with no exclusivity it’s not easy for smaller firms to that.

Dan Ryan, a partner at lower middle market private equity firm Milestone Partners, says his firm recently submitted a letter of interest to acquire for a tech-enabled solutions platform. When the process started the company’s valuation was a little higher than $100 million. A firm with a $2 billion fund wound up as the winner and by the time the deal was closed the valuation has risen by 33 percent. When the deal was closed there were seven parties that had undergone  extensive due diligence without exclusivity. “A larger firm can more easily afford to spend significant dollars with attorneys, accountants and other vendors to conduct preliminary due diligence without exclusivity. It’s over $100,000 spend all-in. For a lower middle market firm, $100,000 is meaningful. We can’t expose ourselves and our LPs to that risk without real confidence in our ability to close the deal and add value,” says Ryan. “We really need to pick our spots.”

Additionally, buyers are competing on speed to close and larger firms typically don’t have a financing contingency, which gives the larger firms an advantage.

While these dynamics have made it tough for lower middle market buyers, conversely, it’s a great time to be a seller in the lower middle market. Case in point: Inverness Graham is squarely a lower middle market firm investing out of its $283 million third fund. When the firm recently sold a business with $23 million in revenues, they got 74 letters of interest on the business. Fifty percent of them were from firm with funds north of $750 million; some of those firms had funds of more than $1 billion.

However, Matt Moran, a principal with Inverness, notes that sector focus does make a difference when it comes to the larger players’ appetite. Moran says you can expect to see more firms pushing into the lower middle market around sectors like healthcare services, vertical software, and industrial technology that have large consolidation play opportunities.

Saratoga Partners’ Burkhart agrees. “I have a relationship with an owner of a nurse staffing business with less than $2 million in EBITDA and people are clamoring to look at the business — but nursing is one of those hot sectors right now.”

In hopes of looking more unique sellers many lower middle market firms have turned to specialization. “There’s a huge trend toward specialization. Firms are changing their entire hiring, fundraising, and sourcing strategies. It’s staggering,” says Moran.

““Being a generalist fund isn’t viewed as favorably as it once was. Sector specialization in the lower middle market has become a differentiator,” says Burkhart. It’s important to note, that although more firms are heading toward specialization the returns aren’t proving out to be exponentially larger. According to research done by RCP Advisors, a limited partner that invests in lower middle market private equity firms, the likelihood of earning an outsized return on a transaction executed by a manager whose strategy is characterized by sector specialization is only about 100 basis points higher than a deal that is executed by a generalist fund.

How to Win

The increased competition has made it hard but not impossible for traditional lower middle market firms to win. The market dynamics has forced these firms to stay true to their strategies. “You can’t let what others are doing change your process. Our best deals are when we stick close to our knitting. There is more noise out there and that probably won’t change, but you still have to go after what you want with certainty and conviction,” says Moran.

Milestone’s Ryan says his firm has lost more deals than it’s won. Many of the deals they have won have come down to operating expertise and/or relationships. In one case the firm’s operating partner had specific operating experience in a company’s niche and was able to make a strong connection with the company’s CEO as a result. In another case, as a result of a longstanding relationship with Capstone Headwaters, the investment banker on the deal, Milestone got to meet the team ahead of the process, which was extremely helpful. “This doesn’t happen all the time. But Capstone Headwaters understands our approach and our industry focus and what we get excited about, and they called us early. It was really helpful,” says Ryan. “It’s these kinds of things that allow the smaller firm to win deals in today’s market.”

 

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Setting Up for Selling Your Business

JoAnn Lombardi, VR Business Brokers/Mergers & Acquisitions, President

How to Develop a Successful Exit Strategy

Recently, many entrepreneurs fulfilled their life-long dreams of buying a business. Others have seen their businesses grow gradually over the years. They are pursuits these business owners have enjoyed and cherished. However as a business owner, you have to remember there will be a time you will have to pass your dream along to somebody else – owning the business you have started.

Whether you’re selling the business because of burnout, retirement or the desire to move on, when the time arrives to do so, do it right and receive the optimal sales price.

Often when you contemplate, plan or pursue the opportunity to sell your business, you discover the selling process doesn’t give you the flexibility needed to make the best deal. But you don’t need to fear, feel manipulated by or go through the resale process alone.

You will be at an advantage as an owner if you start thinking about selling the business before you actually proceed. You will easily be able to identify the important elements of the resale process, and have some control over them in the future. Preparing to sell before you move forward will help you better understand the business transaction, your needs as an owner and be in a better position to develop a strategy to make it through the resale efficiently and profitably.

There are five obstacles in the resale process you will have to examine as you proceed. With each one, there are some helpful tips every VR business intermediary will recommend to you. This will assist you in understanding the process better and successfully sell your business.

  1. Position Your Business for Sale.
  2. Determine a Fair Listing Price.
  3. Running Your Business during the Marketing Period.
  4. Finding the Qualified Buyer.
  5. When to Consider Selling Your Business.

Position Your Business for Sale

The day you purchase the business is the day you start positioning your business for resale. You might not think so, but thinking about building long-term value for your business is just as important as making money in the short term.

You want to maintain detailed records of finances, permits, licenses, equipment and inventory through your ownership. This will be critical when you are trying to sell your business, so don’t neglect this part!

Determine a Fair Listing Price

There are many methods you can use to price your business. The most common method includes a multiple of cash flow – normally, 1 to 3 times annual cash flow, depending on the type and size of the business. Also included in this method are value of equipment and inventory plus one year’s cash flow, 3 to 12 monthly gross sales and book value of assets.

There are many factors contributing to pricing your business:

  • Financial terms.
  • An earnout.
  • Non-compete clause.
  • General attractiveness of the business.
  • Future potential.
  • How the business fits with the buyer’s strategic plan.
  • Size of the business – larger businesses bring a higher multiple.
  • Rarity of the business.
  • Whether the business is a service business tied to the seller’s relationship with customers, retail or other type of a business with a skilled staff in place.

Any VR business intermediary will help you determine the right method to use, given our 40-plus years standing as a contributing innovator of business sales, understanding the marketplace, taking into account the various ways a business can be sold and a comprehensive database of comparable sales.

Running Your Business during the Marketing Period

Just because you are planning to sell your business doesn’t mean you neglect it during the process. You have to continue to personally attend to the business and not place too much time and effort in the selling process. If you do, a deterioration of revenue and ultimate the resale value will happen.

This is where your VR business intermediary will be beneficial in assisting you in finding qualified buyers, while you concentrate on managing your business to ensure you maintain the maximum resale value possible.

Finding the Qualified Buyer

Not every potential buyer is qualified to take ownership of your business. Your VR business intermediary will attempt to find a qualified buyer through examining their capital and source of that capital, motivation to buy, needs and expectations, background and skills. Your VR business intermediary will sit down with the buyer, asking all the pertinent questions to determine if the business will transition successfully to them.

When to Consider Selling Your Business

The right time to sell a business will vary from one owner to another. You may have a complete realization it’s time to move on. Thinking and planning the sale of your business before you decide will be much more satisfying and profitable; whether it’s when the business is doing well, in a non-seasonal downward trend, hitting its peak of growth, deciding it’s time for retirement, family issues, health issues or simply tired of being the owner. This question can only be answered by you.

 

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Preparing Before Presenting

Follow the Necessary Steps to a Successful Business Sale

Most business owners, who are looking to sell, make the mistake of not preparing early enough. This can result in not receiving the maximum dollar amount for your business.

The selling process should start when you buy your business. You should know the return that you are receiving on your investment so when the time comes to sell you will not leave any money on the table. In order to consummate a successful sale with a qualified buyer, each VR business intermediary has been trained to help you take the necessary steps. Most business owners should be preparing to sell long before they make the decision to move forward. The following are some helpful ways that will keep your business in good shape, and prepare you for when the time’s right to have your VR business intermediary search for a qualified buyer.

Evaluate Your Business Before the Buyer Does

If you want the buyer to avoid finding anything that could jeopardize your chances of successfully selling your business, you should perform due diligence before they do. A qualified buyer will perform a comprehensive evaluation that goes beyond financial records; therefore, it’s a smart decision to make sure everything is accounted for before presenting the business to them. Make sure that the due diligence covers a variety of different areas such as:

  • Operations
  • Marketing
  • Personnel
  • Technology
  • Legal
  • Regulatory
  • Environmental
  • Insurance
  • Contractual, credit and accounting issues

Every buyer has specific criteria that they are not going to compromise on such as their return on investment. Depending upon the industry, current economic climate and the type of buyer that walks through the door, it’s important to understand what their needs are before negotiations take place. As the seller, you will be able to maximize the likelihood of completing a successful transaction.

Cleaning Up the Balance Sheet

Buyers will always examine balance sheets first after they sign a confidentiality agreement so they can start reviewing the business. You want to avoid revising a balance sheet after this point. By doing so, you will raise concerns from the buyer about the legitimacy of the business’ financial documents, and increase the chance of the deal falling apart. If there is real estate, equipment, copyrights or patents or excess cash that you do not want included in the balance sheet, remove them before a qualified buyer reviews.

Have Your Financials Audited

As a seller, you will put your business in a better position for sale if you have financials audited. This will help add both legitimacy and value in the business to a qualified buyer. They will want to make sure everything financially is accurate and correct through their due diligence, and this will help move the process along. At the very least, a seller should have a credible CPA observe the year-end inventory and file it away if you can’t afford an established auditor. The cost will be minimal, and this often makes a retroactive audit possible if all other financials are in order.

Stable Management in Place

Many businesses have managers assist the owner in its operation. Unless your business is a oneperson show, you must make sure that you have no loose ends when it comes to management. Businesses that appear to operate “fly by night” will not look appealing to prospective buyers. Stable management that has been in place for more than 90 days is important. Many buyers in the market for a business consider management to be one of their top priorities.

Using Comparisons to Better Position Your Company

If you’re shopping in a grocery store, it’s natural to compare different brands of foods to decide which one you’re going to purchase. The same analogy can be used for buyers when it comes to businesses for sale. They will compare similar businesses with yours, so you should maintain a comparison of your financial and operating statistics against those of your competition.

Review sources such as trade associations and bankers’ industry profile books. If you own a business in the middle-market, seek out annual reports. A VR business intermediary will assist you in documenting the facts on your competition and doing an objective comparison of what are the similarities, differences, strengths and vulnerabilities. It should be both understandable by someone not familiar with the industry and believable to one that’s well versed in it.

Publicity Generates Value

Having good and credible publicity clippings will not only help visibility for your business but create value for qualified buyers. In addition to using local and regional press, you can also put yourself in national publications such as Business Week. Many businesses will employ a PR firm or consultant that knows how to generate publicity.

Through VR Business Sales, you will be able to work with advisors who have decades of experience in working with both buyers and sellers in all industries worldwide. We will be able to facilitate the selling process from start to finish, providing you with counsel you can trust.

 

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5 Predictions for Manufacturing in 2019

Article written by Kay Cruse of Strategex and Anthony Bahr, and provided courtesy of Axial

On November 1, Strategex and Axial brought together a diverse group of private equity investors, family offices, lenders, and advisors in Cleveland for a manufacturing-focused event. Over lunch, the group discussed today’s most prevalent topics in manufacturing, and the direction in which they see the industry heading in the short term. Here are the top-five takeaways from this conversation.

1. An economic contraction is coming, but the short-term outlook is strong.
While the group unanimously agreed the next recession is matter of “When?”, not “If?”, the consensus was that leading indicators are overwhelming positive and the economic expansion — now in its ninth year — is expected to continue through 2019 and potentially 2020. However, acquirers are beginning to place more value on targets which have the ability to weather a downtown. For example, targets with a healthy aftermarket business, which tend to be countercyclical, are increasingly attractive to buyers.   

2. The labor supply is the dominant challenge in manufacturing today.
A near-record low unemployment rate, increasing minimum wages, more restrictive immigration policies, and an aversion to manufacturing jobs among younger cohorts are just some of the factors which have resulted in a severe shortage of qualified candidates. Furthermore, the ability to retain productive employees is becoming more difficult as fewer see manufacturing as a viable long-term career. In response, manufacturing firms are investing heavily in the employee experience, flex benefits (tuition reimbursement, gym memberships, paid parental leave, etc.), and workplace culture.

3. Industry 4.0 is on the horizon, but implementation will be slow.
Deal professionals see the advent of “Industry 4.0” as a potential solution to the labor and talent delimma, but the timeline for implementation is unclear. One component of 4.0, the utilization of computerization and robotics, is starting to take hold, but most don’t see a complete overhaul of traditional manufacturing taking place anytime soon.

4. Increasing interest rates are both a threat and an opportunity.
Many manufacturers are experiencing growing pains such as severe backorders, over-utilized facilities and equipment, and obsolete information technology infrastructure. Recent interest rate hikes have deterred some from borrowing to finance capital expenditures and capacity building, putting their ability to sustain growth at risk.

On the other hand, many lenders have seen a spike in originations as borrowers attempt to lock in rates given the expectation they will only increase in the short term. On the private equity front, the increasing aversion to debt has led to an increased demand for growth equity investments.

5. The lack of stability is the new norm, and agility is essential for success.
Above all, markets seek stability, but current socio-economic conditions are anything but stable. Volatility is everywhere, including tariffs, regulations, trade agreements, tax policy, and fluctuations in government spending (particularly infrastructure spending). Those involved in running manufacturing businesses, however, have come to accept volatility as business as usual. Rather than deferring action in hopes of tides turning, and rather than proactively embracing change to get ahead of the curve, managers agree nimble planning and rapid execution is key to succeeding in this new reality.

 

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Selling Your Business? Learn to Think Like a Buyer

You’ve built a great business with love and care. It has grown larger than you’d ever imagined. It generates a nice profit. As a result, this has allowed you and your family to live comfortably.

Now, you’re ready to sell. You assume there’s a buyer out there. You want someone to pay you a fair price and nurture the company with the same attention you have. Most importantly, selling the business is a major part of your retirement plan.

Needless to say, buyers look at businesses differently than sellers. So to achieve the outcome you want, it’s important to think like buyers and understand how they evaluate a business.

Knowing What Buyers Want

There are many types of buyers: strategic and financial, individuals, companies and private equity funds. Despite differences, all buyers consider how much they’ll invest to acquire a business, the amount of risk they’ll bear and the potential return on their investment. To evaluate an opportunity, buyers focus on three major areas:

1. Cost and terms. What will it take to acquire the business? How much cash and how much debt? What are the deal’s terms and conditions? There’s one standout issue: the amount of cash required to make the deal. By decreasing the cash requirement and increasing the acceptable debt portion, a seller can make its company more attractive — and perhaps even increase its selling price. The biggest factor directly affecting a deal’s attractiveness is the asset base. Simply put, the more the buyer can borrow against (or for post-transaction capital), the less cash it needs upfront. As collateral, banks usually accept land, buildings, equipment, inventory and accounts receivable. Many entrepreneurs have purchased the land their business resides on and leased it to the company. An often unanticipated side effect is this structure reduces the company’s asset base. As a result, this decreases the amount of debt leverage the seller can obtain.

Another way sellers can reduce the buyer’s initial cash requirement is by accepting part of the purchase price over time. Commonly known as “seller paper,” this can do a great deal to lubricate a sale.

2. Continuity. Will the business continue to operate similarly after the sale? Much of the risk of buying a company relates to continuity. For example:

  • The current owner has personal relationships with customers, distributors or vendors that the new owners may have to struggle to maintain
  • The owner has special expertise that is undocumented and difficult to learn
  • Key personnel aren’t committed to staying
  • Offshore competition looms.

Sellers armed with solid responses to these types of continuity concerns are more likely to get their desired price. Even if you don’t want to sell your business for a few years, take steps now to ensure it can run smoothly without your personal involvement. That independence could be worth millions when you sell.

3. Growth. Are there unexploited opportunities? You may have focused your sales efforts in one geographic region, but there may be many opportunities to take the product national or international. A buyer will pay more for the business if they believe it can increase revenues substantially over one assuming the current owners have already maximized opportunities.

What Sellers Should Do

It may seem counterintuitive, but the things you may be most proud of can work against getting the best price for your company. Not many entrepreneurs like to boast their company could run just fine without them. They don’t want to seem like they’ve failed to capitalize the numerous opportunities out there as an owner. Yet these may be the very factors buyers seek, along with lower cash requirements. Contact VR Business Brokers today in understanding how to best present your company for sale.

 

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3 Things to Consider Before Selling Your Business

Article written by Giff Constable and provided courtesy of Axial

For business owners, summer often brings extra challenges like slower sales cycles and the musical chairs of employee vacations. However, summer is also a good time to unplug and take stock of where you are in your life and your business. If that process leads you to think about a sale of your business, you’re going to want to get ahead of the game in three key areas:

#1: Deal with the things that scare buyers away

There are a few big red flags that scare buyers away, especially financial buyers who play an increasing role in one’s exit options today. You will want to review your business, acknowledge where you have weaknesses, create a plan to improve what you can, and be ready to explain what you cannot.

Some common red flags include:

  1. Revenue concentration: try to avoid a situation where more than 20% of your revenue is tied up in the hands of one or two customers.
  2. Customer churn: High growth is attractive, but not if it comes with a really high churn rate. If your customer lifecycles are short, you’ll want to examine how you are generating leads, how you are converting leads, and ultimately how well you are delivering on your product or service promises.
  3. Legal risk: Are your intellectual property rights clean? Do you have any outstanding lawsuits that can be closed off? While legal risk doesn’t always scuttle a deal, you might end up needing to accept worse escrow and indemnity terms than you’ll want. If you can’t clean these items up before you start a process, you’ll want to disclose them early on.
  4. Key person risk: A lot of lower-middle-market businesses run pretty lean, but you’ll want to avoid too much dependence on any one person, especially the CEO. Now might be a good time to prioritize where you should bring in the right lieutenants and start those recruiting cycles.

In addition to those four, you’ll also want to deal with excessive debt (leverage) in the business, employee churn, and high degrees of sales cyclicality.

#2: Prep for a Fast Process

You want to preserve momentum during an sale process. Delays rarely works in the sellers’ favor because so many things can go wrong. The buyer might change their focus or strategy. You could lose a key customer or an important employee. You could miss your numbers in a key month. Any of these things might be fine in normal course of business, but sometimes it doesn’t take much to give a buyer cold feet.

Much of your preparation is simply about getting organized:

  1. Get your financial books in order, and, if relevant, work with an accountant to disentangle personal finances from the business;
  2. Gather your legal documents;
  3. Assemble your key historical metrics (product, sales funnel, marketing funnel, etc) and market data (addressable market, competition);
  4. Organize your go-forward plans (product roadmap, growth plans, etc).

More complicated is dealing with the human psychology around a deal. Do you know your own mind and are you clear about your own goals? Do you want to continue running the business? Are there showstopper terms and conditions where you simply won’t budge?

Lastly, you need to get your key shareholders on the same page. You want to put in the work to align your current co-owners and set their expectations before the deal process begins in earnest.

#3: Build Your Deal Team

Selling a business is stressful, not least because you’re likely trying to run the business at the same time. Surround yourself with advisors you trust such as an excellent attorney, tax accountant, and sell-side advisor.

It’s also worth pulling your key executives in early. They will likely need to be involved in the due diligence process, and you’re going to need them to stay focused on operational execution during all of this. An exit process is not the time to take the foot off the gas. Help them understand why you want to sell the business. Use your sell-side banker to help set their expectations on what the process will look like, and to help tamp down their fears of the unknown.

Coach your involved executives on the fact that a sale process is just that — a sales process. If they are going to be talking to the buyer, you want to make sure they have been coached on what to say. You’ll want to keep a united front.

In conclusion, while 2018 is a good year to be a seller, it’s still a good idea to take care of the above list. Go into your sales process knowing your own mind, having a clean house, and having built a great team around you.

 

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Small Businesses are Selling at Record Pace!

According to BizBuySell.com, the Internet’s largest business-for-sale marketplace, all statistical data regarding the Business Transaction Market Place continues an upward trend.

The number of closed transactions reported through the 3rd quarter of 2018 has increased by 8% over the first 3 quarters of 2017!

More importantly for Business Owners, sales prices continue to increase as well.  BizBuySell.com also reported that sale prices of businesses sold in the third quarter of 2018 reached new highs.  Median Sales prices on transactions reported in the 3rd quarter increased 10.7% from the same period last year!  The record sale prices are directly related to stronger business financials which also hit new levels in Q3. With buyers able to offset increasing prices by acquiring healthier businesses, the result is a well-balanced market.

The market place is also seeing good diversity across the various industry segments is indicated by the chart below.

BizBuySell’s 2018 Buyer-Seller Confidence Index supports the idea of an equally beneficial market to both buyers and sellers. In fact, buyers are slightly more confident in today’s business-for-sale market than last year. While seller confidence remains unchanged compared to 2017, 60 percent of owners said they are confident they would receive an acceptable sales price if they exited today.

“The foundation of small business is about taking advantage of opportunity,” said Bob House, president of BizBuySell.com and BizQuest.com. “To be in a place where both buyers and sellers are able to capitalize without the other party losing out is fantastic and a testament to the strong will of entrepreneurs.”

 

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Too Much Customer Concentration at the Top Can Ding Your Value in an Acquisition

Article written by John Wagner, Managing Director at 1StWest Mergers and Acquisitions, and provided courtesy of Axial

Let’s say you were doing business with just one or two very large customers. Your business could, quite rightly, be categorized as overly dependent on too few sources of income. The reason is simple: Any move that those two customers made, good or bad, up or down, would cause an equal reaction in the fortunes of your company, good or bad, up or down. And if one suffered a catastrophic misfortune, so would your company. That may be stating the obvious. After all, you didn’t have to go to Harvard B school to see the importance of spreading risks like these. And that’s what most business do. They engage in transactions with any many businesses as possible, so that the negative performance or outright failure, of any one customer wouldn’t have an outsized negative impact on the provider company.

Yet as businesses scramble to make their numbers, and sales people do what sales people naturally do (book orders, any order, from anyone; all money is green) those sales are often done without respect to what percentage of your gross revenue may be concentrated into your top-volume customers. However, this customer concentration metric is especially important when you take your company to market to seek an acquirer.

IM Disclosures

Any decent Informational Memorandum (a.k.a. “deal book”) that you and your investment banker prepare to bring your company onto the market for acquisition should have a section that declares your Customer Concentration. It’s a very revealing section of the Informational Memorandum indeed, because every potential acquirer will want to review what percent of your business would cease if you lost a few of your biggest customers.

Is heavy concentration at the top of your customer list truly a terrible thing? Not always. If those top performers are predictable and pay on time, there may be no problem at all. In fact, you’d probably be surprised to see how many companies have greater than 40% of their business concentrated in just ten or twelve customers. Plus, as anyone who’s been in business for any length of time knows full well, many large customers take less effort to serve. They often have technology (like mobile scheduling tools or portals for managing digital purchasing) to smooth out delivery and payment schedules.

Rule of thumb: No one customer should represent more than 10% of your business.

Your invoicing might be simplified as well, if you can submit a superbill to a national accounting department, with a strong cash position and a seven-figure credit line. So, high-quality receivables from large buyers can be an asset, not a liability…until there is too much concentration in too few accounts. That might make an acquirer a little nervous, generating a request for more detail about the nature of the customers you are dealing with at that level. Is there a rule of thumb that acquirers look for? Indeed there is. No one customer should represent more than 10% of your business. Anything more than 10% will bring the attention of the acquirer’s due diligence team, wanting to dig into just how consistent that customer will be for years to come.

Are You Holding Your GPMs Too?

When reviewing customer concentration in the list of your biggest customers, a potential acquirer will also review the gross profit margins (GPMs) for each customer on the list. Their interest in GPMs reaches beyond mere curiosity. Here’s why: If you are heavily discounting your highest-volume buyers, expecting, as old joke goes, “to make it up on volume,” that is a source for worry. It usually indicates that you may be shipping large volumes of product at very low margins… a scenario that would potentially ding your company valuation. Maintaining GPM discipline, even among large-volume customers, is certainly a KPI of a well-run company.

If you are heavily discounting your highest-volume buyers, expecting, as old joke goes, “to make it up on volume,” that is a source for worry.

That said, if your GPMs are around the GPMs you are maintaining for your other down-list customers, this indicates you are running a disciplined operation, and that you’ve stuck to your guns when negotiating price, even with your high-volume accounts. That discipline is widely seen as a sign of a well-run business.

Before you go to market, calculate your customer concentration; it’s an instructive exercise to engage in, now or at any time, actually. Run a spreadsheet of your GPMs in the process, and compare those to the GPMs of your smallest customers to plot the spread, and see how they compare. If you are preparing to seek an acquirer, make adjustments now. Then, when you are finally ready to reveal your financials to potential acquirers, you can put them at ease that you’re well within accepted norms for customer concentration and GPMs, even for high-volume accounts.

 

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Which Is Better, a Financial Buyer or a Strategic Buyer?

If you decide to sell your business to an outside acquirer, you’re going to have to decide between a financial and a strategic buyer—understanding the different motivations of these two buyers can be the key to getting a good price for your business.

A financial buyer is acquiring your future profit stream, so they will evaluate your business based on how much profit it is likely to make and how reliable that profit stream is likely to be. The more profit you can convince them your company will produce, the more they will pay for your business.

But there is a limit to how much they will pay, because financial buyers are playing the buy-low, sell-high game. They do not have a strategic rationale for buying your business. They don’t have an army of sales reps to sell your product or a network of retailers where your product could be merchandised. They are simply trying to get a return on their investors’ money, so they tend to buy small and mid-sized businesses using a combination of this investment layered on top of a pile of debt, and they want to buy your business as cheaply as possible with the hope of flipping it five or ten years down the road.

Because financial buyers are usually investors and not operators, they want you and your team to stick around, so they rarely buy all of a business. Instead, they buy a chunk and ask you to hold on to a tranche of equity to keep you committed.

A strategic buyer is a different cat—usually a larger company in your industry, they are evaluating your business based on what it is worth in their hands. They will try and estimate how much of their product or service they can sell if they added you into the mix. Because of their size, this can often lead to buyers who are willing and able to pay much more for your business.

Tom Franceski and his two partners had built DocStar up to 45 employees when they decided to shop the business to some Private Equity (PE) investors. The PE guys offered four to six times Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), which Franceski deemed low for a fast-growing software company.

Franceski was then approached by a strategic acquirer called Epicor, which is a global software business with a lot of customers who could use what DocStar had built. Epicor offered DocStar around two times revenue—a much fatter multiple than the PE firms were offering.

 

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2 Valuation Experts on What Destroys Value in a Deal

Article written by Giff Constable and provided courtesy of Axial

The lower middle market is getting more sophisticated when it comes to mergers and acquisitions, but both investors and owners are still making many of the classic mistakes around assessing and building value. We asked two valuation experts, Scott Hakala of ValueScope and Ken Sanginario of Corporate Value Metrics, what they’re seeing in the market today and their advice for both buyers in the current economic climate.

The biggest mistake Ken sees among business owners is chasing a financial target in an unsustainable way. “Someone tells them that they need to be at a certain EBITDA level, and then they slash costs but not in a strategic manner,” Ken said. “Owners think that they can cut costs for a year or two and have no one notice. But it doesn’t take a buyer long to get wind of what they have been doing.”

The same thing happens when a business takes on revenue that is hard to fulfill or retain. That revenue usually comes with tangible and intangible costs. When it disappears, the company is left in a deeper hole than before. If a seller is taking delayed consideration for their business, in the form of an earnout or a rollover of equity, these short-term measures can cause that future value to evaporate. “I was doing turnarounds for 15 years, and many of those situations came from companies chasing revenue or chasing EBITDA,” Ken said.

Buyers are also guilty of short-term moves that can destroy value and trigger failed expectations on both sides. “A lot of what I see is penny-wise, pound-foolish behavior,” said Scott. “The buyer squeezes R&D or sales compensation. This boosts EBITDA but the cost savings prove to be illusory. What do you do when half your sales force quits within a year?”

A lot of heroic assumptions are going into valuation models in order to reach deal-winning multiples in today’s market, but with rising interest rates and employment rates, returns may be harder to come by for both sides. Earnouts are a common tool for bridging a valuation gap and getting a deal done, but both buyers and sellers need to be careful not to make short-term moves that backfire. “We see a lot of examples where earnout issues are taken for granted by buyers assessing transaction risk and sellers taking an earnout as part of the deal,” said Scott. “Then both sides feel defrauded by the other side when it doesn’t work out.”

Both Ken and Scott encourage buyers and sellers to focus on the intangibles. For buyers, “the big buzzword today is quality-of-earnings reviews,” says Scott. “It’s usually easy to catch whether someone was running personal expenses through the business. The real issues are things like management infighting or lack of product diversity.” Once the deal is done, Scott recommends that buyers stay humble and seek to ask the right questions about the business rather than making assumptions. “There’s less room for error in the lower middle market,” he said. “One or two critical mistakes can blow up an entire firm.”

Ken encourages business owners to think about business intangibles years in advance, rather than months. “I think that most private companies can double or triple their value over a three to five year period if they directly work on their weaknesses. It takes getting to the root causes of value,” he said. “Too many owners think that value is driven by what they did last year, as opposed to what the company’s future cash stream looks like. If they plan ahead and build for the future, they will see improved multiples and their deal will close faster.”

 

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