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At Smythe Advisory, we are typically engaged to assist our clients in four specific areas. These include:
While all aspects of our business can be both stressful and rewarding, running a divestiture process has significantly more at stake. Our clients are often converting a life-time of hard-work into cash, and they have only one chance to do it right. Another destabilizing aspect of a divestiture is that most business owners have never been involved with one before and don’t know what to expect in terms of both the process and negotiating a deal.
Pepperdine University publishes an annual Private Capital Market Report where they analyze the behaviour of the private capital markets by surveying lenders, private equity groups, venture capital firms, business brokers and valuators. The study was conducted in the United States (US), but is still relevant in the Canadian marketplace. While we recommend you read the report, we have included select data from the 2016 report, along with our comments as follows:
As a starting point, it is important to note that not all transactions are successful. Approximately 35% of business sale transactions are terminated without closing, according to the 2016 report.
The top three reasons behind a failed transaction were a valuation gap in pricing, unreasonable demands and lack of capital. The valuation gap can sometimes be overcome with earn-out arrangements, but unreasonable seller or buyer demands are hard to deal with, especially if they come later in the process.
The following chart summarizes the amount of valuation gap that resulted in the failed deal.
The following chart highlights the length of time required to complete a deal, with 70% of deals taking longer than six months to close. These time frames match our experience.
While this may or may not matter to the seller, it is interesting to have a perspective on how purchasers analyze a deal when submitting their offers. The basics are the same in that an investor is investing to acquire a future cash flow stream. The discounted future earnings and capitalization of earnings method specifically determines value based on expected cash flow, where guideline methods looks at similar transactions in either the public or private domain.
Pricing of a deal is typically presented as a multiple of EBITDA (earnings before interest taxes depreciation and amortization). While EBITDA is still subject to interpretation, it is a pretty good proxy for operating profit. On our first review of these multiples they appeared somewhat high for EBITDA up to $1 million, but it speaks to the demand for investments in private companies. It should be noted that these transactions are US based. A summary of deal multiples has been summarized as follows:
A basic concept of finance is that the higher the amount of debt that can be used to finance an investment the higher the return on equity. Simply put, you can leverage your investment and earn a higher return on your cash (equity) by using more of the banks money and less of your own. With proper tax planning the interest on the loan can be offset against the investments earnings increasing your return further. Total debt would include debt from all sources including vendor financing. We have summarized the total leverage (debt/EBITDA) from the study below:
Senior debt represents money that has been lent for a business acquisitions and has first charge on all the assets of the business. Generally senior debt is provided by banks and comprises term and demand loans. Typically, senior lenders offer better rates of interest than other lenders but are not willing take on as much risk. The chart below indicates the amount senior debt being offered based on various EBITDA levels:
Using the three preceding charts, let’s look at an example of how a possible deal might be structured. Assuming the acquisition target is a wholesale distributor and has EBITDA of $1M. Based on the median data from the report, the deal might be structured as follows:
A strategic buyer is a competitor, supplier, or another company operating in the same market space. Typically, they can combine the target entity with their own and take advantage of synergies to increase overall profits. A financial buyer generally will operate the company on a stand-alone basis and is interested in a long-term return on equity. In a properly executed auction, you would expect to see more transactions with strategic buyers, which is the case as outlined in the 2016 Pepperdine report.
While every transaction is unique, it is important for both buyers and sellers to have some understanding of the dynamics that influence the pricing, terms and structure of similar deals in the marketplace.
 Everett, Craig R., “2016 Private Capital Markets Report” (2016). Pepperdine University Graziadio School of Business and Management