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There is very little information available on middle market transactions (defined as deals valued between $2 million and $250 million) to enable a potential selling owner to know what is involved in the sale process. Correspondingly, prospective sellers are often under numerous misconceptions that can be harmful. During many years in acquisitions and input from thousands of owners/entrepreneurs, I have determined that there are six common pitfalls, based on erroneous beliefs, for middle market owners.
The Misconceptions and Pitfalls
Valuation is a numbers-crunching process.
Nothing could be further from the truth. A properly conducted valuation involves the complete investigation of a company’s business foundation. It includes defining the company’s future opportunities and major risks along with its projected impact. The following factors must be evaluated during this process:
a. The strength of the company’s marketing program, including the diversity and control of its customer base.
b. For manufacturing companies, the ability to produce a high quality, low cost product, and the caliber and productivity of its research and development function.
c. For distribution or service businesses, the demographics of its trading area, the quality of its product and/or service line, the attractiveness of its locations and the ability to run its operation in a cost-effective manner.
d. The quality of the management team and the presence of a reasonably paid, well-motivated work force.
These factors become a prime determinant of the multiple to apply to the company’s expected future earnings.
Planning and timing the sale of a company increases the transaction price.
Prudence dictates that the seller plans and times the sale to maximize the transaction price. As part of the planning process, all factors defined in previous points are evaluated, and suggestions are made to strengthen the business foundation. The solidifying of the business foundation will increase the transaction price. In addition, the planning of the sale will enable a company to be prepared to go to market at the appropriate time to generate the maximum price. It also enables an owner to be capable of responding intelligently to the unsolicited interest of a prospective acquirer.
The deal is fundamentally completed when a preliminary price is established at the letter of intent (LOI).
In fact, the execution of an LOI is merely the start of the negotiating process. Unless a seller has a sophisticated, experienced advisory firm that has a strong personality and the ability to control the deal, it is not unusual for an acquirer to demand a price reduction between the LOI and the closing. It is in the seller’s best interest to see to it that an acquirer knows these demands will never be productive.
The negotiation of the definitive purchase agreement (DPA) is a difficult, confrontational and time-consuming process. The DPA includes all the critical representations, warranties and indemnifications that are of potentially equal financial importance to the deal price itself. If they are not negotiated to provide the seller maximum protection, it can give the acquirer a post-closing opportunity to recover a considerable portion of a seller’s deal proceeds.
Owners should only sell near the end of their careers.
Definitely not. Most owners don’t understand many of the benefits that can arise from a sale. Usually owners of closely held corporations have a vast majority of their personal wealth concentrated in the business. In and of itself, this is poor financial planning, but it is a typical by-product of owning a closely held corporation. By selling all or part of the company, owners can reduce their concentration of wealth in the business. In addition, it puts their estate in more liquid condition.
Younger owners, too, must evaluate their financial condition and whether they want to enjoy the finer points of life while still in prime health. After their covenant-not-to-compete expires, which could occur after a five-year period, they can get back in business if they so choose. However, they will commit only a small portion of their sale proceeds to the new business endeavor. This will assure that they have lifetime financial security. They will likely be refreshed and might even be eager to pursue a new business endeavor. From a personal standpoint, this is a very attractive alternative for a number of owners.
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