Archive for the ‘Blog’ Category
Bubbles Everywhere
It seems that bubbles are everywhere. First it was the dotcom bubble in the late 1990s. Then it was the housing bubble that led to the Great Recession. Now we hear of bubbles in student loans, government debt and Bitcoin. Is it possible that the federal government is also causing a bubble in small company valuations? This question occurred to us when a very capable broker recently explained that he expects to get 1.5x sales for a metal fabrication company with less than $5 million in revenue and significant exposure to the retail sector.
What’s Going On?
There are various theories on why small company valuations are higher than their historical norms. According to some people, a slowly growing economy is causing relatively large strategic buyers to acquire even the smallest companies. The theory is that, because valuation multiples for these companies are so much higher than those of their competitors in the lower middle market, absent other growth opportunities, they are willing to buy small companies and outbid individual and financial buyers in the process.
Others claim that a rising tide is lifting all boats and that higher valuations for large companies are having a sympathetic effect on all company valuations. As a result, even individual and financial buyers are raising their bids for small companies. Still another theory is that the market is simply becoming more efficient and the increase in multiples simply reflects a movement toward intrinsic value.
But what if the real reason is that the SBA’s loan programs are so generous that they are artificially inflating small company valuations? As buyers, we love the SBA’s programs and use them whenever we can. The extra leverage they provide, as well as their manageable interest rates and amortization schedules, make it easier to stretch on valuation. But when, for instance, a company’s idiosyncrasies or the dynamics of the sale process preclude us from using an SBA program, we are frequently unable to meet the seller’s expectations. In these cases, we wonder whether our equity return expectations are too high or whether the SBA really is inflating small company valuations.
Recommendations
Regardless of whether the SBA has caused a bubble, its loan programs are a key reason why many small business owners are able to sell their companies, retire comfortably and ensure the ongoing job security of their employees. In many situations, especially when a company is not able to attract the interest of strategic buyers, the outcome for sellers will be much improved when they can accommodate a buyer’s occasionally cumbersome use of a government loan program to help finance the acquisition.
The more that sellers appreciate the impact that the availability of debt, regardless of its source, has on a buyer’s valuation, the more willing they may be to work with potential buyers to support their fundraising processes, and ultimately the higher the price their companies may fetch. During the debt raising process, we encourage all business owners to view buyers less as counterparties and more as partners working to maximize the amount of total capital available for their transactions.
Bootstrap Capital
If you are aware of business owners who would like to sell their companies, please consider introducing them to Bootstrap Capital. We are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. We work with a number of lenders who offer several different types of financing and endeavor to utilize the capital that best matches both the company and the business owner’s goals. Bootstrap Capital is a patient counterparty and can be a constructive partner in helping sellers through the sale process.
Patient Persistence
We were recently reminded how easy it is for a buyer to get overlooked in a sale process. We readily admit to having been frustrated on occasion with the responsiveness of sellers or their brokers. But we cannot recall an instance when we were not rewarded for our patient persistence. Nor are we aware of an instance when we were purposefully ignored. We must keep in mind that the very nature of the marketing efforts for small businesses can trigger responses that overwhelm even the most organized brokers. When we are able to do just that, it is easy to remain persistent, patient and respectful.
What’s Happening Behind the Scenes?
At a recent industry association event, two former business owners each described their experiences during the sale process. Despite the companies having similar enterprise values, their processes could not have been more different. One of the owners described a targeted process whereby his agent personally called about 40 potential buyers; and the other owner described a much broader approach with emails going to more than 700 buyers, as well as a post hitting the deal listing services.
Similarly, a broker recently told us about a deal for which he had just gone to market. In less than 24 hours, his firm had received more than 50 signed non-disclosure agreements from prospective buyers and sent out the company’s confidential information memorandum to every single one of them.
He offered that, in the midst of this near-chaos, the buyers who demonstrate “patient persistence” are frequently rewarded. It seems gratuitous to add that, given this level of competition, the buyers who fail to follow up, or worse, follow up with “nastygram” emails rarely get a positive response from the broker.
Responsibilities
When we take the time to understand the nature of the process a broker is running and how fully time consuming it can be, it is easy for us to persist calmly and patiently. We also become keenly aware of our responsibility to screen businesses thoroughly and thoughtfully, pursuing only those which are in keeping with our investment theses and we absolutely want to own.
Bootstrap Capital
If you are aware of business owners who would like to sell their companies, please consider introducing them to Bootstrap Capital. We are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. We endeavor to demonstrate patient persistence at all times and commit to pursuing only those companies we honestly want to acquire. Bootstrap Capital is a patient counterparty and can be a constructive partner in helping sellers through the sale process.
Ideas, Opportunities & Futures
Almost every company that is for sale seems to have near limitless potential that the current owners just can’t bring themselves to take advantage of. We routinely review offering documents that list countless opportunities to grow businesses or make them more profitable that, if not for the implied neglect of the current owners, could make the businesses much more valuable. The implication is that we buyers should pay more for these companies, because their futures are brighter than their pasts.
What’s Worth Paying For?
Clearly, there are some projected improvements that have significant value, but others are downright worthless. What separates a bona fide opportunity from a crack pot scheme? Generally, the bona fides require skills or resources that the company already possesses and for which the management team has either developed a credible business plan or has already made considerable progress in executing. While there are no specific definitions, we try to characterize future value-adding initiatives as ideas, opportunities and futures.
Ideas: The most common idea put forth in offering materials is that the new owner could increase sales simply by reaching out to customers in a new market. The implication is that sales would materialize almost immediately, with little cost, risk or investment. No matter that these customers are either unswayed by the company’s value proposition or are content with their current suppliers. For us, an idea has little value and is rarely worth considering in the pricing discussion.
Opportunities: Opportunities have a little more value, but usually do not have a huge impact on our proposed purchase price at closing. Rather, we may use a risk-sharing arrangement, such as an earnout, to address a particular opportunity. Examples include the recent development of a new product or the expectation that, after months of ongoing negotiations, a new customer will sign a multi-year purchase agreement. In these cases, the company has made significant and credible progress in converting an idea into cash flow, but significant execution risk remains.
Futures: Futures are almost certain to happen. When opportunities turn into successes, they also turn into futures. When a new product successfully completes field trials at a customer’s facility, the future improvement in financial performance is more easily forecasted and infinitely more credible. For these reasons, we are willing to factor these “futures” into our valuations.
Recommendations
We recommend that advisors help business owners understand the difference between, on the one hand, ideas and opportunities that may make their companies more attractive to buyers, but not necessarily more valuable, and on the other hand, futures that actually increase the value of their businesses. When business owners can make informed decisions about whether to bring their companies to market now or instead wait until their ideas become opportunities and their opportunities become futures, they are likely to be much happier with the outcomes of their sale processes.
According to Pepperdine University’s 2017 Private Capital Markets Report, 27% of investment bankers’ clients were unable to sell their companies and, in 30% of those instances, the sellers wanted more for their businesses than the buyers were willing to pay. It is unclear how often these unbridgeable bid-ask spreads resulted from owners ascribing too much value to their ideas and opportunities, but our experience is that it is a common factor when deals fall apart.
Bootstrap Capital
If you are aware of business owners who would like to sell their companies, please consider introducing them to Bootstrap Capital. We are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. Bootstrap Capital is a patient counterparty and can be a constructive partner in helping sellers through the sale process.
Even Buyers Get Value from the Broker
Small business buyers, and even many sellers, love to complain about brokers and investment bankers. In the midst of a contentious deal, we have heard some epic rants and may have even indulged from time to time ourselves. But the truth is that these advisors bring significant value to the deal process that benefits both buyers and sellers.
How do Brokers Add Value?
Accelerator: Brokers add credibility to business owners’ processes which causes buyers to act with a sense of urgency and the deals to move more quickly. Similarly, a broker’s involvement signals to buyers that owners are committed to selling their companies and that they have reasonable valuation (and other) expectations. Through these signals and by formalizing the sale process, brokers reduce the number of broken deals and make the deal processes more efficient.
Auctioneer: Brokers are able to bring many potential buyers into a process and have the resources to keep the process moving with several of them at a time, especially early in a process prior to the execution of a letter of intent. While buyers would prefer not to have to compete for deals, the resulting increase in price may be a fair trade-off for the deal process efficiencies brokers provide.
Diplomat: It may be counterintuitive that an aggressive broker can keep the peace. By leading the negotiations, however, a broker can preserve the seller’s role as “good cop” and protect the relationship between the buyer and seller, who frequently must work together following deals in the lower middle market.
Detective: The smaller the deal the more likely a seller’s advisor will be aware of, and may have relationships with, more potential buyers than the business owners previously knew. But even in larger deals, it is rare that an M&A advisor cannot materially expand the list of serious buyer candidates. It is their job to understand the acquisition strategies of as many buyers as possible. The good ones do this well and help both buyers and sellers find each other.
Recommendations
Despite our endless search for the unshopped deal, we do recommend that all business owners who intend to sell their companies should retain an M&A advisor or a broker. We reluctantly admit that, while the sellers reap the most benefit from a broker’s involvement, we buyers also benefit. It is important, though, that business owners run a fulsome evaluation process so that they identify and ultimately retain the advisor who is most qualified and experienced in selling businesses similar to theirs. An unqualified or inexperienced broker can destroy as much value as a good one can create.
Bootstrap Capital
If you are aware of business owners who would like to sell their companies, please consider introducing them to Bootstrap Capital. We are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. Bootstrap Capital is a patient counterparty and can be a constructive partner in helping sellers through the sale process. We also understand the roles that brokers play in sale process and appreciate each and every deal they bring to our attention.
Working Capital Confusion
In the transactions we pursue, the negotiations concerning working capital are often the most difficult. It can be easier to settle on the overall purchase price than to agree on how to treat working capital. We can spend weeks working through the theory of why a going concern needs working capital to operate, agreeing on how to calculate it and setting a net working capital target. More than once, we have had to bid for only the hard and intangible assets of a business in order to avoid the discussions around working capital altogether.
Why is Working Capital so Troublesome?
It is unclear exactly why working capital is such a troublesome topic in the lower middle market, but there seem to be a confluence of factors all playing a role.
- Working capital is not something an entrepreneur actively seeks to create. Rather, it’s something that naturally develops in the business and may not get much attention along the way;
- Working capital is not reflected as a single line item on the financial statements, nor is it a fixed investment number. Rather it is comprised of many accounts which can be volatile, especially in project-based or seasonal industries. As a result, it is hard to think about it in summarized and static terms;
- Sellers feel like they have “earned” the net investment in working capital and do not think of that investment in the same terms as the investment they made in equipment;
- Business education tends to focus much more heavily on how to value companies than the composition of the balance sheets needed to operate their underlying businesses; and
- Some brokers representing the smallest businesses began their careers as, or may primarily still be, real estate agents who have limited experience with the operating businesses.
Why Not Buy the Business Without Working Capital?
The simplest solution can be to bid for just the fixed and intangible assets and let the sellers keep the working capital. We have done that, for instance, by offering a price for the “base businesses” and also to buy the inventory balance at closing for book value. This can help avoid the confusion around working capital, but it is not ideal.
One problem is that it can make our bids look lower than other offers. When we bid for the base business, we simply subtract the working capital target amount from our enterprise value. If other bidders are bidding for all the assets, their bids may appear more attractive. And, if we get a chance to explain why our bid is lower, it may open up the whole working capital discussion we were hoping to avoid.
The other problem is more operational in nature. After we purchase a company, we want to control the interactions with customers. In asset deals, when we are opening new bank accounts, we also want to minimize the confusion about where to send payments. When we do not purchase the working capital, the sellers sometimes feel entitled to receiving customer payments and are less willing to let us collect them on their behalf, creating confusion among the customers.
Recommendations
We do not know of a silver bullet for negotiating working capital. Our perspective is that it is a topic that simply requires patience, dialogue and flexibility. We believe that industry associations and accreditation authorities could make considerable headway in reducing the time dedicated to working capital negotiations by developing educational material and other resources for sellers, buyers and brokers alike.
Bootstrap Capital
If you are aware of business owners who would like to sell their companies, please consider introducing them to Bootstrap Capital. We are keenly in tune with the issues business leaders face when they decide to sell their companies, including the issues surrounding working capital. Bootstrap Capital is a patient counterparty and can be a constructive partner in helping sellers through the sale process.
The Many Roles of Seller Paper
In the lower middle market, sellers have become increasingly willing to accept a note for a portion of the purchase price for their companies. In fact, the smaller the deal, the more common this so called “seller paper” seems to be. Our experience, however, is that business owners do not always understand why seller paper is so important to the buyer. It seems as though advisors are simply telling their clients that they will need to help finance the deal and business owners are accepting that guidance at face value.
Why is Seller Paper So Important?
When it comes to deals for the smallest of companies, where buyers tend to be individuals who are in the market to “buy a job,” seller paper may indeed be needed to help the buyer finance the acquisition. In slightly larger transactions, however, buyers are more likely to have sufficient capital, but have other equally important reasons for using seller paper.
We see two principle reasons why buyers require the sellers to finance part of the transaction. The first is alignment of incentives. In short, if payment of a meaningful amount of the purchase price is dependent on the future creditworthiness of the company, sellers are generally more willing to put forth the effort necessary to transition the business to the buyer and to help the buyer work through any issues the business might encounter.
In larger deals, it is more common to seek alignment with an earnout or by having the seller retain a minority equity stake. In smaller deals, however, this approach can be problematic. Exiting entrepreneurs and the new owner-operators may refuse to partner with each other; sellers may need the cash to replace their salaries; and in deals financed through the SBA, these mechanisms are specifically prohibited.
The second reason is more pragmatic. In the event that the seller misrepresents the state of the business in the purchase agreement and the buyer has a valid indemnification claim, the note can be (i) the only source of leverage to bring the seller to the negotiating table and (ii) potentially the only asset that the buyer can legitimately expect to access for settlement of that claim. Additionally, the risk that future claims could reduce the size of the note is a powerful incentive for the seller to provide honest disclosure about the business during the due diligence period and in the purchase agreement.
Recommendations
As business owners have become more accepting of the role of seller paper in lower middle market transactions, negotiations have become less contentious. But we believe that the advisors can help the negotiations go even more smoothly by educating their clients about all the reasons buyers insist on seller financing. And when businesses have multiple owners, advisors can help their clients see a note as a way to manage their own liability. Faced with a future indemnification claim, for instance, it might be much easier for them to reduce the face value of a note than to chase each individual seller for his/her share.
Bootstrap Capital
If you are aware of business owners who would like to sell their companies, please consider introducing them to Bootstrap Capital. We are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. Bootstrap Capital is a patient counterparty and can be a constructive partner in helping sellers through the sale process.
Why Metrics Matter
Many business owners wonder why buyers insist on reviewing operating data as a part of their due diligence efforts. They protest that the metrics are immaterial, because their effects are already baked into the financial statements, which the buyers have analyzed ad nauseam. Sellers are usually comfortable providing the more administrative due diligence items, such as contracts and the tax returns, but struggle to understand why they should supply data on their companies’ operating activities.
Key Performance Indicators
Isn’t it true that the financial statements incorporate the impact of the operating metrics? If so, why are the key performance indicators critical to the buyer’s analysis? These “KPI” are important, because their trends can be the best indication of a company’s future prospects, and because they are the main inputs for calculating synergies (strategic buyers) and validating investment theses (financial buyers).
A simple example involves a manufacturing company that is performing well financially, but has seen its quoting activity fall significantly in recent months. Everything else equal, it would be logical to assume that the company will post reduced revenue and profits in the near future, but this potentiality would not be evident in the financial statements.
Another basic example relates to this same company’s scrap rates, changeover times and raw material prices. For buyers who either have similar operations or are familiar with industry benchmarks, these KPI indicate whether there is an opportunity for improvement, which, for strategic buyers, could also apply to their existing businesses. In addition, these data are integral to calculating, for instance, the benefits of facility specializations and rationalizations.
What If The Data Do Not Exist?
The smaller the business, the more likely the owners do not track all the information that sophisticated buyers want to review. But this issue may lead to even more exaggerated problems with novice buyers who, lacking experience, are unable to prioritize their due diligence needs and end up asking for everything.
We have encountered many business owners who managed their companies with an intuitive feel and had no way of producing historical operating data. In these cases, it may be necessary to reduce risk by lowering purchase price, increasing the amount of seller financing or seeking more robust representations and warranties.
In most cases, however, there is usually a way to create a time series of information about a very short list of the most important metrics. As a result, we recommend that buyers focus on the KPI that are critical to their analyses and then work with the owners to develop actual or proxy data for these fundamental items. If possible, sellers would benefit from spending time in advance of taking their companies to market in order to generate basic KPI data.
Bootstrap Capital
If you are aware of business owners who would like to sell their companies, but lack straightforward operating data, please consider introducing them to Bootstrap Capital. We have dealt with these due diligence issues as both sellers of the businesses we built and as buyers of other entrepreneurs’ companies. As a result, we are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. In situations where a business owner is working through these issues, Bootstrap Capital is, at a minimum, a patient counterparty and, even better, frequently a constructive partner in helping him or her through the process.
To Invest or Not To Invest
When business owners decide to sell their companies, they frequently have questions about how much they should continue to invest in their businesses. Just as homeowners must decide, for instance, on whether to upgrade the kitchen before putting the house on the market, business owners face myriad decisions about short and long-term investments in systems, personnel, equipment and R&D.
What Makes it so Difficult?
One of the reasons that sellers struggle with investment decisions is that the answers depend on more variables than usual, some of which are knowable only to the potential buyers. As a result, rules of thumb are hard to come by.
Whether to invest in a new machine depends on whether it is critical to a new piece of business, how profitable that new business could be, how integral it is to the company’s growth story, and whether potential buyers would relocate the machine or need it at all.
The analysis is just as complicated for the decision to hire new salespeople, create a new marketing campaign, upgrade a website or commission a new site survey. In all of these decisions, business leaders must weigh the impact of the investment on cash flow, current and future profitability and the company’s future growth rate.
Over time, depending on market conditions, the strategic needs of potential buyers and the historical performance of the company, the importance of each of metric to a sale process could change dramatically.
Recommendation
There is one exercise that we can recommend. Most business owners can list the investments that would have the biggest impact on the value of their companies in 2 to 3 years. We recommend that owners try to picture the sale process falling apart after months and months of negotiations and think about the investments on that list which they would most regret having postponed. Going through this exercise usually brings the highest priority investments into focus.
On a related note, our experience is that business owners sometimes have trouble seeing the value of a good M&A advisor. In addition to the more obvious benefits, such as creating an auction dynamic, a good agent can provide well-informed advice about how the market is likely to perceive a whole host of activities, including making specific investments in the business.
Bootstrap Capital
The principals of Bootstrap Capital principals have sold their own companies and dealt with these investment decisions during their own sale processes. As a result, we are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. In situations where a business owner is working through these issues, Bootstrap Capital is, at a minimum, a patient counterparty and, even better, frequently a constructive partner in helping him or her through the process.
Succession Planning is So Personal
Business owners put off succession planning for a number of reasons. It is hard work that takes time away from the day-to-day operations. Hiring professional advisors to assist with the process is expensive. It disrupts the status quo and creates risk for the business. And many owners honestly (and in most cases, legitimately) believe that, if push comes to shove, they will simply sell their companies.
But a less obvious reason is that the process isn’t just business. It’s personal… or at least it feels that way.
Why So Emotional?
At the core of succession planning is an emotional paradox that forces business owners to make difficult choices and betray their instincts. In overly simplistic terms, the more successful the successor becomes, the more inadequate the business owner might feel. The more the successor builds the founder’s legacy, the worse the founder is likely to feel about it.
Adding insult to injury, the more that departing leaders suppress their instincts to take charge and instead give their successors enough autonomy to properly establish their own authority, the more intense these feelings can become. And when success is coupled with substantive change (or worse, because of it), the owner can start to feel downright inferior. Even when the changes are due to relatively benign generational or stylistic differences, they can feel like direct criticisms.
So Why Do It?
It is therefore no wonder that so many entrepreneurs perpetually procrastinate when it comes to this time consuming, expensive, risky, potentially unnecessary and definitely emotional process. But for those owners who can detach themselves from the process and view the succession itself as a product of their own design, the rewards (both financial and personal) can be significant.
There are few wealth creation opportunities that compare favorably to ownership in a smoothly running private business. And when the founder can see the successor’s success, no matter how achieved, as yet another one of his/her own successes, the personal fulfillment can be tough to match.
Due to the numerous business and personal impediments to succession planning, we recommend that business owners engage a professional advisor who is familiar with the emotional aspects of the process to guide them through it. Hiring advisors who focus too heavily on the sanitized analytics or basic mechanics to the detriment of the softer issues adds unnecessary risk to an inherently difficult task.
Bootstrap Capital
If you have clients who cannot bring themselves to take on the emotional task of succession planning, please consider introducing them to Bootstrap Capital. Our approach is to provide turnkey succession plans by personally managing our portfolio companies. We have extensive experience as business founders, owners and leaders, which we bring to each and every one of our portfolio companies. In short, we provide the liquidity and leadership that business owners who lack a succession plan need in order to retire.
The “Chase a Buck” Syndrome
Many business owners constantly see opportunities to make money and do not hesitate to take advantage of them. One of the great benefits of owning a business is the insight it reveals about what is working well and not-so-well in an industry and how to profit from the issues that develop from time to time. But sometimes entrepreneurs see almost too much opportunity and make money too many ways.
What’s Wrong with Making Money?
In the abstract, there is absolutely nothing wrong with making money. But if an entrepreneur pursues too many disparate opportunities by “chasing a buck” rather than strategically investing in the business, the resulting company can be difficult for buyers to understand, command a lower valuation multiple or become altogether unattractive.
One example involves a company that was founded decades ago as a direct-mail advertising agency. In response to changes in the industry and to newer technologies, the company had evolved into a provider of turnkey promotional programs for salesforces, offering everything from conceptual design to ERP interface, performance tracking and prize/product fulfillment.
Along the way, the company added its own call center and began providing outsourced customer service to its best clients. And over time, instead of investing in the higher value elements of the business, such as the ERP interfaces and the program management software, the owner fell victim to the “chase a buck” syndrome and began to funnel most of the free cash flow into the call center. His rationale was that it provided attractive cash-on-cash returns.
By the time the owner was ready to sell, the call center was as large as the promotional program business and had a material influence on the overall value of the business. At the time, the EBITDA multiple for call centers had fallen to 3x, while the multiple for the ERP integration business was closer to 10x. However, buyers had a difficult time looking past the call center and the owner struggled to get bids north of 5x EBITDA.
Keep an Eye on the Exit
When they are allocating capital and setting objectives for their companies, entrepreneurs and family business owners should fight the urge to “chase a buck” and instead take into account the impact their decisions are having on the valuation multiple buyers might ascribe to the business. We recommend this practice even when the intention is to hold the business forever. It usually leads to faster value creation and provides better options in the event that circumstances change.
Investment bankers, M&A advisors and private equity investors are great sources of information on these issues. While there is some risk that they will do more than simply share their opinions, our experience is that, in the interest of establishing a relationship and positioning themselves for a future opportunity, most of them will be patient, act in a professional manner and resist the temptation to start a de facto sales process.
Bootstrap Capital
If you have clients who could benefit from a point of view about how a buyer might view their businesses or how certain strategic initiatives might impact the attractiveness of the business to potential buyers, please consider introducing them to Bootstrap Capital. Because we invest our own capital, we are not subject to the pressures of a fund’s investment timeline and are happy to share our insights without any expectations about an immediate investment opportunity.