The strategic fit is well established, there couldn’t be a better complement between the parties. The chemistry amongst the Management team and the buyer is solid and both can envision robust growth together. Customers welcome a combination between the two parties as the merger will create a compelling value proposition. Everything looks great from the perspective of future possibilities as the operational folks talk and explore a combination. But even with this perfect operational fact pattern, the parties are unable to consummate a transaction. What happened?
Often, failed transactions with this fact pattern arise due to a financial disconnect between the parties. While the operational team is very supportive of the transaction, the economics of the transaction must make good business sense to the C-level executives (CEO and CFO). Right, wrong, or indifferent, the earnings of a Target, and the resultant implied valuation, almost always trumps strategic and operational fit. Yes, the qualitative aspects of the business are important and are what creates the interest in the Target; however, it is the financial profile of the Company that determines if a transaction can be consummated.
Disconnect on valuation, misunderstanding about the financial profile of the Target, and / or lack of sophistication in the finance function of the Target are the most common culprits of deal failure amongst middle market private companies. This write-up explores these common deal-killing financial problems and provides suggestions to “to-be” sellers on how to anticipate and cure these defects before they derail the perfect strategic combination.
Valuation Expectations
The most common financial deal-breaker encountered in the middle market is a disconnect between buyer and seller on a fair valuation. With robust M&A activity and public markets trading at record levels, it is easy (and rightful) for Sellers to expect high valuations for their business. It can often be the case, however, that the Buyer universe recognizes the same market dynamic and takes a different perspective – that the good fortunes of the Target cannot last forever. And because investors are buying the future, fear of market peaks translate into an obvious disconnect between optimistic sellers and cautious buyers. Furthermore, Seller expectations can be influenced by what they read in the news and hear from their contemporaries about high valuations -perhaps in other industry (such as technology) and assume that these valuation multiples should apply to their Company.
Of the three financial-related deal-breaker issues, this is the easiest fix – the solution is to hire an investment banker. You have heard us say it before, but the best way to ensure alignment and prevent the disconnect is to have an investment banker help evaluate market possibilities to establish expectations – on both sides. From the perspective of the Seller, the investment banker will calculate the implied valuation from Target earnings and provide the details of precedent transactions in the relevant industry to establish reasonable expectations. At the same time, a good banker will push the market to the highest levels through a competitive process, help a potential buyer understand the Target attributes and market comparable transactions to support higher valuations, and ensure market clearing to give the Seller confidence that they are looking at the most lucrative offers for their Company. Finally, to the extent that the parties still cannot see eye-to-eye on valuation, seasoned bankers can help parties develop creative structures to bridge any valuation gaps.
Financial Profile
The second most common financial pitfall that contributes to a failed sale process is a disconnect between the parties on the financial profile of the Target. While this can arise through a few scenarios, the most common is a presented financial profile that cannot be verified by the Buyer’s accountant. Reported transactions in the Target financials, such as non-recurring income, delay in payment of expenses, deferred capital investment that is necessary to run the company, and overly aggressive forecast that can’t be supported are all also common scenarios that create an expectations gap between Buyer and Seller.
The solution to this fact pattern can be much more complicated than the first disconnect above. In yet another shameless plug – yes, you need an investment banker to help evaluate the financial presentation from the perspective of a buyer. Even with audited or reviewed financial statements, financial transactions and projections should be reviewed thoroughly and perhaps with the help of a CPA that has experience with “quality of earnings” reviews – prior to disclosure to a potential Buyer. This effort will uncover difficult-to-explain accounting treatment, non-recurring earnings, under-accrual of expenses during the interim periods, or just plain errors and ensure that there is no misunderstanding between the parties on the financial profile. Some of the more common accounting issues that we see from private companies that can have create a disconnect between the parties include –
Equally important to the accounting transactions is the reliability and detail of the projected financial statements. Because an acquirer is buying the future of the Target, demonstrating that (1) Management knows the drivers of their business and (2) that their projections can be trusted by function of pre-closing verification of the outlook is critical to create the confidence necessary to close the transaction. There are a couple of best practices that a Seller should employ to create that confidence.
Integrity of the Financial Function
The third most common financial pitfall we encounter in stalled transactions is a lack of sophistication in the financial function of the Company. Many private companies do not invest significantly in deep accounting and financial talent, opting instead (and rightfully so) to invest in development, equipment, or customer support resources. However, when professional investors or large strategic buyers intend to invest millions of dollars into a Target, a lack of financial integrity can be problematic. So what is a level of financial sophistication that will be viewed as adequate to a sophisticated buyer, but at the same time not divert cash from what can actually add value to the organization? While we don’t think middle market private companies need to have a Wall Street-caliber finance department, there are some suggested “must-have” capabilities in your finance function to ensure a smooth transaction.
While not a comprehensive collection of all financial matters that should be considered to reasonably ensure that a transaction doesn’t derail, the above are helpful guidelines for a Seller to consider as they prepare for interactions with sophisticated financial and strategic buyers.
© Copyrighted by EdgePoint. Paul Chameli can be reached at 216-342-5854, by email at pchameli@edgepoint.com or on the web at www.edgepoint.com