THE STRATEGIC BUSINESS SALE

by ROBERT D. BILLOW
MANAGING DIRECTOR, BILLOW BUTLER & COMPANY, L.L.C.

Presented at
THE "NEW MONEY FOR NEW BUSINESS" CONFERENCE
Sponsored by INSIGHT INFORMATION INC.

Toronto, Ontario, January 29, 1997

For over twenty years I have been representing owners in the sale of their companies. These owners have operated successful businesses, throughout the U.S., Canada and Mexico, in a wide array of industries. Clients' industries and processes have ranged widely within general manufacturing from machining to fabrication, and from metalworking to plastics. Certainly, important clients have also included wholesale and catalog distribution operations and service firms, as well. Markets served have covered a wide scope from automotive to consumer to scientific products.

Now you must appreciate the great privilege it has been serving as the investment banker to these owners. That is because the operators of these businesses are sharp, hard working, spirited individuals with a creative vision. Collectively, their industriousness forms a part of Adam Smith's "invisible hand" contributing in great degree to the "wealth of [our respective] nations".

Whether their companies have been middle market or larger, and whether ownership has been first generation entrepreneur or a successor to the founding members, these client firms have operated very successfully. They all face the same challenge though. At some time, most all of them must address the issue of how to best convert their success from the company balance sheet or income statement to the sum to be wire transferred at the closing.

In approaching this formidable task owners all have common concerns and issues in the business sale context. It just hasn't mattered what kind of business they run, be it a proprietary house or a custom job shop. In the well over 100 transactions with which I have had personal involvement, the following three questions had to be addressed in the successful effort to sell the business for the maximum sale price:

I. What are those matters or attributes of my company that represent or enhance its value?
II. What can I do to help plan and prepare for making the sale of my company successful?
III. What is my business worth?

This paper will endeavor to offer a brief insight and response to these matters.

RECOGNIZING AND CREATING VALUE IN A BUSINESS
It is probably a good start to recognize that Rule Number 1 for acquirers and investors is that they all expect to make money through accomplishment of their acquisition of the target business. The business owner has been making money and through the sale and transfer of ownership interests, it now becomes the buyer's turn. But in the transfer of ownership the owner's first step is recognizing those elements of success which the business has already achieved and how it has done so. For to capture the best price in the market he must understand the assets (irrespective of the formal legal structure of the transaction) he is selling---the formula or recipe by which his business has had the right to command not only respect, but profits. Accordingly, an effort must be made to catalog the business' assets and strengths. (Similarly, the business owner must be prepared to undertake a review and determination of the threats and weaknesses to the business-to which further reference will be made in a moment.) Since it is important that this be done on a most objective basis, it is generally recommended that an investment banker be obtained to assist in this process.

From an internal perspective first, the analysis would evaluate how the seller's business ranks in respect to many important attributes. These could include, but not be limited to, the following matters:

1. Type of Product or Part
a) position in life cycle (whether house product or custom part)
b) steady (recurring) demand
c) favorable trend forecast

2. Growth in Sales
a) favorable historical trends
b) valid basis to support sustainable growth forecast

3. Cash Flow
a) sustain working capital needs in growth scenario
b) size of capital expansion budget
c) availability of sufficient returns on equity

4. Existence of Product or Production Proprietaries
a) brand awareness
b) trade secrets
c) know-how
d) drawings, designs, tooling
e) patents, trademarks and copyrights

5. Market Niche\Share
a) nature of competitive matrix
b) extent to which nature of niche position is secured or established
c) nature and insurmountability of barriers to entry
d) support for growth in niche/share

6. Intact Customer Base; Prospect Database

7. Criteria for Competition
a) basis by which business succeeds in selling against competition
b) essential competitive criteria
i) quality-better built product or service; more features, better designed
ii) more value added service -faster, expanded warranties
iii) pricing- the cheaper sale
c) risk of foreign competition

8. Intact Customer Base; Prospect Database

9. Leadership, Reputation, Accolades, Awards

10. Pricing Flexibility Through Efficient Cost Structure

11. Excellence of Intact Management

12. Stability of Employees
a) length of tenure
b) extent of training, cross-training, supervision
c) work ethic

13. State of Systems-Facilities-Equipment
a) productivity enhancements
b) ISO-QS certifications
c) reflective of management quality and care
d) representative of reinvestment in business

14. Cyclicality-Degree of Recession Resistance

15. Local Environment \Community
a) ease of transportation
b) freight costs
c) tax abatement availability

Certainly, the above listing is not intended to be a complete litany of all the elements of value resident in the company. It is also very clearly the case that not all of these factors are necessary to characterize a business as a most attractive acquisition candidate. But it is a necessary starting point for the client and his investment banker to explore the bases of value and relative attractiveness of the business from an acquisition point of view. At the very least, this exercise should accomplish (1) an understanding of the intrinsic character and orientation of the business, (2) a perspective on its core competencies, and (3) a sound basis on which to evaluate why its customers buy its products or services.

It should be recognized that some of the most important of these characteristics are intangibles. For profits from intangibles are just as real as profits from brick and mortar. Intangibles can be more difficult for a business to assemble than even the most sophisticated equipment. For example, talented managers who are very capable of executing the corporate strategy or running the plant are exceptionally difficult to identify and retain. But for these same reasons, very often it is these assets that form that part of a business' infrastructure that is less vulnerable to the competition. The greater the list of intangibles, arguably the more attractive the acquisition candidate-since its assets are less likely capable of being resourced or replicated by the acquirer.

In addition to the analysis of these strengths, consideration must be given to the various weaknesses which characterize the business at the present time and in its current state. These can include capital inadequacy, gaps in the management infrastructure, lack of a business plan, and the absence of a sales force. Clearly though, what can impinge on a firm's success on a stand-alone basis does not necessarily present a negative to the buyer because of the potential benefit of synergies, ie., the ability of the buyer to erase these failings through meritorious opportunities derivable from a strategic combination.

A thorough review of external factors, both opportunities for growth and threats or risks to fulfillment of objectives or achievement of the strategic plan must be undertaken, as well. Macro factors such as industry growth, consolidation and technological breakthroughs can often exert a tremendous influence on the acquisition attractiveness of companies in a given industry.

At the end of the day this whole process allows the business owner and its investment banker to determine whether the business is "built to last" following its sale and the eventual loss of its owner's vision and guiding hand. Will the firm conquer the challenge of change better than its competitors? The process will also afford direction as to which firms are perhaps the most likely acquirers due to perceived fits. It will also result in the development of an opinion or estimation of market value as to the subject business. This last accomplishment is of critical importance. Without the development of some clear measure of value, and a consensus as to the same between the business owner and the investment banker, a significant basis on which to judge the probability of a successful accomplishment of the closing is absent.

PLANNING FOR EXIT
Timing is always critical to the making of a good deal. The right time to sell a business, all other things being equal, is when the M&A market is strongest, and not when the business owner's need to sell is greatest. An owner should be ready to sell when the conditions are ripe, as they are now. In the U.S., 1996 celebrated the third consecutive record year of M&A dealmaking. U.S. deal activity culminated in 10,000 transactions worth about $659 billion. This surpassed the prior 1995 record of 9,542 deals and $519 billion.

Global M&A activity eclipsed $1.14 trillion up from $950 billion in 1995. Middle market deals under $50 million shot up 53% to about 1,700 deals last year. In fact, deals under $20 million increased to the point that they now comprise around 20% of all acquisitions. Notably, businesses selling for under $100 million represented about 75% of all announced transactions in 1996. Factors commonly referred to as explanatory for this hot market include: industry consolidation efforts (banking, telecommunications, and health care); low interest rates and easily available funds; high stock prices; cash rich balance sheets resulting from corporate cost cutting; global competition and the desire to gain market advantage and boost corporate wealth through external corporate development strategies. It is believed that middle market acquisitions are viewed as an especially low risk route to fill product line holes, gain technological advantages or acquire important accounts.

Given the need to sell in the right market, bearing in mind the foregoing vibrant conditions, and recognizing that the business might be approached as a target, it is important for the business owner to advance plan his exit from the business. Accordingly, following the engagement of its investment banker one of the first steps undertaken would be that advisor's preparation of the previously referred to "SWOT" (strengths, weaknesses, opportunities and threats) study. The investment banker's aid in this effort is critical because he is better able to look at the seller's business through the eyes of the potential buyer.

At the same time this advisor could undertake a substantial market and valuation study of the client's operations. This would typically be based on several different methodologies not intended to be covered within the scope of this paper. But in the end, whether the value opinion is on target in the view of the business owner or not, and whether the client is then ready to proceed to market its business for sale or not, much remains that can still be properly accomplished to prepare for its eventual sale.

For example, a next step could include working with the investment banker to develop a business plan. Beyond being adaptable for use as an offering memorandum, it enables the owner to take stock of his company. Compilation of the plan would entail further possible focus and research on the company's markets and competition. It can serve to refocus the owner as to his approach to marketing, advertising and promotion, product development, relocation, facility expansion and management additions.

Even recognizing that the identity of any eventual buyer is unknown at the outset, and that the special attraction to such buyer is not known with certainty, there are several matters that nevertheless can be evaluated in concert with the investment banker as part of a forward planning program. These could include a study concerning the risks to a deal arising from matters concerning:

1. the presentation and positioning of various items in the financial statements
2. environmental remediation matters
3. formalization of contracts with third parties as to which there is material dependence
4. the potential for exclusivity arrangements
5. assignability of contracts
6. diversification of account base
7. minority ownership interests
8. security (continuity) of related party transactions
9. review of product liability coverages and self-insurance limits
10. direction of R&D efforts
11. review of capital budgets for expansion
12. investments in system automation
13. compliance with laws
14. possession of necessary permits
15. the state of employee relations and the institution of retention oriented bonus programs

Additional matters which would clearly need some serious focus concern income and estate tax planning. These topics are well beyond the scope to be covered here. However, a seller should be wary about committing to a course of action before various trust systems and family partnerships can be explored. Executed transactional type documents that predate various estate plan instruments may vitiate or render null the desired beneficial tax effects of those plans.

Let us recognize that once the investment banker is actually authorized to market a deal the time required for a closing can range anywhere from six months to over a year. This period can depend on the subject industry, markets, need for external financing etc. Given that time line and the fact that the owner active in his business will likely be required to remain active for at least some transitional period, it is always appropriate to commence preparation for exit well in advance of when the desired actuality may be contemplated.

STRATEGIES FOR DEALING WITH THE DYNAMICS OF THE PRIVATE TRANSACTION MARKET
While buyout groups enjoyed their most vibrant year since 1989, with over $22 Billion in announced buyouts, the current period has been referred to as the one of the "strategic" deal. Sure, it can take a tremendous effort and become a substantial challenge to merge the people, systems and cultures of two wholly different organizations. Nevertheless, it has clearly been the case that horizontal (market share), backward vertical (supply source), and forward vertical (customer source) combinations, as well as other strategic buys have occurred at a fairly torrid pace over these past couple of years.

When corporate America sees attractive different capabilities in a company and that differential is viewed as either too expensive, time consuming or fraught with risk to replicate, then time and again the acquisition route has been pursued. At that time, a seller can most handsomely benefit from premium pricing. This is because synergistic pricing will entail not just the value of that single operation on a stand-alone basis. Rather, it will possibly include some measure of the potential value conferred on that entire organization by that new division.

Generally, the principals at our firm have noted a marked favorable differential in acquisition multiples paid by strategic buyers versus financial buyers. It is not true that this will happen in all cases, of course. However, we have noted that while the extent of the strategic premium will vary by industry and by deal to deal, the differential as a multiple has been as much as over four times higher in one particular deal with which I am very familiar. Other deals which we closed with strategic buyers may have more commonly involved a multiple premium of one to two times earnings.

There are many theoretical financial bases that provide justification for the synergistic premium. These would include: greater confidence reposed by the acquirer's management in the certainty of realization of future projections; lower costs of operation realizable by the acquired operation on a going forward basis due to sharing of facilities, systems and management and the consequent reduction of redundancies in operation; greater marketing potential of the acquired firm's product base through use of the buyer's existing distribution and promotional avenues and channels, etc. Perhaps the greatest support for the foregoing is a 1992 analysis by MIT and Harvard professors. In their study they found that companies acquired by strategic buyers in similar industries showed higher post acquisition earnings growth than achieved by financial buyers. The proof is in the pudding. Presumably, synergies, tax and accounting (pooling) benefits contributed mostly to these greater financial rewards.

Now, the critical role of the investment banker, certainly, is to exploit the opportunity of potential synergies to the business seller's greatest advantage in maximizing price. The typical approach used to accomplish is to market a business without an asking price - through a carefully structured or controlled auction process. This would be the culmination of a comprehensively constructed strategic marketing campaign in which buyers were identified and screened on a selective and confidential basis. One colleague reports that by exploiting the competitive dynamics of the marketplace sellers could "expect to see an average 80% increase in share premium in cases with more than one bidder."

CONCLUSION
Probably, the best conclusion I can leave you with is that, from beginning to end, the client business owner is best advised to plan for his ownership transfer early and with proper professional assistance. For where professionals can demonstrate the value of the subject enterprise most clearly to the buyer, and when the "enabling powers" derivable from the business combination can be understood by the acquirer to be most compelling, then the acquisition and pricing decisions can become that much easier for the buyer, and the combination will likely be realizable with that much greater certainty. It is true that the process of a business sale is complicated and time consuming, yet the expected rewards mandate the investment in the process by both sides. But with proper assistance, guidance and management the process can be made much more smooth and be fraught with much less peril to employees, customers, vendors and the success of the project itself.

Note: Statistics cited in this paper were excerpted from a January, 1997 issue of The National Review of Corporate Acquisitions, A Publication of Acquisition Research Corporation.

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