Life After the Perfect Storm — Selling Privately Owned Businesses in Today’s Market Bill...

Life After the Perfect Storm — Selling Privately Owned Businesses in Today’s Market

Bill EastwoodDoering & Eastwood, Ltd

May 16, 2003

Doering & Eastwood, Ltd 2

Total Transaction Value(in millions)

$0

$300

$600

$900

$1,200

$1,500

1985

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2001

2002

The U.S. M&A Market Peaked in Terms of Transaction Value in 1999 at $1.4 Trillion, After Eight Consecutive Years of Unprecedented Growth

Virtually All of the Drivers of M&A Activity Were Operating During the Latter Half of the 1990s

Source: Mergerstat

Overview -- Long Term M&A Market


Overview -- Long Term M&A Market

Transaction Volume Composition

71.0% 70.7% 67.6% 69.4%76.5% 79.0%

20.7% 20.4% 21.7% 20.7%16.2%

15.9%

8.3% 8.9% 10.7% 10.0% 7.3% 5.1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1997 1998 1999 2000 2001 2002

Under $100 MM $100MM - $500MM Above $500MM

Middle Market M&A Activity May Be Somewhat More Resilient Than Large Deal Activity


The Perfect Storm -- Obvious Parts November 2000 — November 2002

• Poor Earnings• Rapidly Falling Stock Prices

– No Longer Currency for Acquisitions

• Recession/Slow Growth Economy• Excess Capacity• Geo-political Events

– 9/11– Iraq– Korea


The Perfect Storm -- Obvious Parts November 2000 — November 2002

• Loss of Credibility in Financial Statements and Corporate Management

• Attitude That Acquisitions Do Not Increase Stockholder Value– World Com — MCI – Tyco — CIT– ATT — TCI Cable– Qwest — U.S. West– Lucent — Ascend– AOL — Time Warner


The Perfect Storm -- Less Obvious Parts November 2000 — November 2002

• Falling Interest Rates and Stock Prices Make Returns From Proceeds of a Business Sale Much Less Attractive

• Entrepreneurs Evaluating Sale of Business Need Proceeds to Last the Remainder of Their Life– In 1999 Projecting 15% Stock Returns and 7.5% Fixed Income

Returns, Lifestyle and Income Level Needs Were Much Easier to Satisfy Than In 2002 With Negative Stock Market Returns and 1% Money Market Rates

• For Private Equity Funds, the Public Market Is No Longer a Reliable Exit Strategy



• Banks’ Risk Tolerance For Acquisition Financing Reduced– Average Equity Requirements to Obtain Financing

Increased From 25% to 40-50% of the Purchase Price

• Most Private Equity Acquisition Criteria Is Based on Return on Equity (“ROE”) of 25-35%Example: Pre Fall 2000 Post Fall 2002

Acquisition Price 1,000 1,000Debt 750 550Equity 250 450Total Funding 1,000 1,000



7.0%

9.7%

13.4%

20.7%22.0%

25.2%26.2%

23.7%22.9%

3.3%

30.0%

3.5%

31.6%

4.1%

35.7%

3.9%

37.8%

5.5%

40.6%

2.7%

40.0%

4.2%

41.0%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

1987 1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 4Q02

Average Equity Contribution to Leveraged Buyouts 1987 - 4th Q 2002

Rollover Equity Contributed Equity

Source: Leveraged Buyouts



• For a Private Equity Group with a 25% Hurdle Rate, Reduced Bank Financing Make the ROE Below the Threshold, Now a Deal is Not Doable Without Price Adjustments or Owner Financing

EBIT = Earnings Before Interest and Taxes Interest at 7.5%PBT = Profit Before Tax PAT = Profit After Tax at 37% Tax RateROE = Return on Equity = PAT/EquityEBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization

Pre Fall 2000 Post Fall 2000EBIT 180 180Interest 56 41PBT 124 139PAT 78 87ROE 31% 19%Debt 750 550Equity 250 450Equity % 25% 45%


The Perfect Storm -- Less Obvious Parts November 2000 - November 2002

• Owners’ Failure to Accept Current Value of Business – During 1998-2000, Owner Had an Offer or a Friend in

the Business Had an Offer 8-10 Times EBIT

– Today’s Market 5-7 Times EBIT for Owner’s Industry

– With Earnings Down 10%, Owner’s Business Only Worth 60% of Perceived Prior Value

– Even Though Business Fundamentally Continues to Degenerate, Owner Waits Until the Market Returns to Prior Valuation



• Principal Types Of Businesses Sold During the Perfect Storm– Outstanding Business With a Competitive Advantage

and a Growth Story

– Businesses in Industries That Benefited From Consolidation (Costs and Pricing Power)

• Banks

• Cable Television

• Oil and Gas

– Distress — Must Sell Business



• Owners Who Accepted Realistic Prices– Buyers Stretch to Make Transaction Attractive, Often

Including Seller Paper

– Doering and Eastwood, Ltd. Is a Member of IMAP (“International Network of M&A Partners”), Which Completed 217 Transactions With Total Value in Excess of $4 Billion in 2002


What Is Happening After The Perfect Storm

• The Good News– Private Equity Firms Have Hundreds of Billions in

Equity Capital• Financial Times in April 2 Article Estimates That the Largest

450 Private Equity Firms Had Over $250 Billion in Committed Funds

– Assuming a 40% Equity Requirement, Capacity to Complete $650 Billion in Acquisitions

• Private Equity Groups Acquire Questdex Phone Directory Business for $5 Billion+

• Increased Role in Middle Market Transactions• Pressure to Invest or Return Proceeds to Investors• Interest Rates Are at All Time Lows• Prices Are More Reasonable



• The Good News– Strategic Buyers Are Acquiring Companies in Their

Industry• First Data Announces $7 Billion Acquisition of Concord —

Both in Credit Card Merchant Processors• Comcast Cable Acquires AT&T Cable Properties• Numerous Regional Bank Mergers • Acquisition Discussions Increasing Dramatically Between

Potential Buyers and Sellers (Source: Business Week, April 21 P.82-83)

• Large Companies Are Looking at Smaller Company Add-ons to Grow Without Huge Risks



• The Good News– Private Business Owners Have Become More Realistic

in Value Expectations• Aging Baby Boomer Population Is Under Increasing Time

Pressure to Sell and Enjoy Retirement

– Banks and Financial Institutions Are Cautiously Increasing Commitment to Buyout Loans

– Buyers and Sellers Are Becoming Flexible and Creative - Seller Financing, Retained Equity, Earnouts



• The Bad News – Perfect Storm Conditions Continue in Varying Degrees

• Tenuous Economy

• Rising Unemployment and “Spent Out” Consumers

• Continued Accounting and Management Credibility Issues (Healthsouth)

• Poor Potential Returns to Sellers With Business Sales Proceeds

• Buyers VERY CAUTIOUS



• Slight Increase in the Deal Closings in the Middle Market

• Ability to Sell Varies Greatly Depending Upon Company and Industry

• Committed Sellers Are Succeeding By:– Maintaining or Growing Earnings

– Managing Their Business Well

– Flexibility in Deal Terms


Value of Privately Owned Businesses

• Types of Valuation– Fair Market Value -- Estates, Gifts, Disputes

– Market Value -- What the Business Will Bring If Sold

• Real Market Value Determined When Offers Are Received

• Most Valuations Are Earnings Multiple Based (Example 5 Times EBIT)



• Specialized Industries May Have Different Valuation Rules of Thumb– Computer Software — Multiple of Sales

– Banks — Multiple of Book Value

– Cable Companies — Price Per Subscriber



• Market Valuation Approaches:– Highest Value —“Strategic” or Investment Value

– Median Value —“Stand Alone” Value

– Lowest Value — Liquidation Value

• Market Comparable — Used for This Presentation• Recasting Earnings• EBIT Multiple — Most Common Measuring Rod;

3 to 7 Times EBIT — 6 to 12 Price Earnings Multiple



• Factors That Differentiate a 3 Multiple Business From a 7 (an “A” Business From a “C” Business):– Industry

– Size

– Growth in Sales

– Earnings — Growth and Consistency

– Balance Sheet Strength

– Perceived Competitive Advantage — Brands, Patents, Technology, Costs

– Margin As Percent of Sales

– Strength and Continuity of Management



• Exceptions to the 3 to 7 EBIT Rule:– Each Buyer Will Have a Different Criteria for

Valuation

– Examples:• Private Equity Firms Evaluate Based on Projected ROE

• Food Brand Purchaser May Project Savings in Costs From Adding a Brand to Its Existing Distribution System

• Cable Company Computes Savings From Purchase of Programs


Value of Privately Owned BusinessesQuantitative Study By IMAP

A 59 Member Middle Market Intermediary Group With Offices in 25 Countries

Proprietary vs. Non-Proprietary Manufacturers — NAFTA


Value of Privately Owned BusinessesQuantitative Study By IMAP

Multiples of EBIT — 2002 Transactions


When Should A Business Be Sold?

• With Expert’s Assistance, Objectively Analyze Business’s Sales Prospects– When the Business Is Performing Well

– When There Are Good Prospective Buyers Within a Reasonable Time

– When the Owner Is Committed to Spending the Time and Money to Market the Business Properly


When Should A Business Be Sold?

– When the Condition of Financial Records Is Sound• Are the Statements Audited?

• Possibility of Restatement in Due Diligence

– When Contingent Liabilities Are Limited and Estimable

• Warranty Claims

• Environmental

• Employee Issues

• Litigation


Who Are The Buyers?

• Strategic Buyers– A Buyer in the Same Business As the Seller (May Also

Be an Extension of Existing Business)

– Examples:• First Data Buys Concord Credit Card and ATM Processing

• Wells Fargo Acquires First National Bank of Lincoln


Who Are The Buyers?

• Financial Buyers — (“Private Equity Funds & Leverage Buyout Groups”)– Use Equity Provided by Institutions, Pension Funds,

Insurance Companies and Other Investors

– Borrow Money to Increase the Return

– Examples:• Carlyle and Welsh Carson Acquire QwestDex (Telephone

Directory)

• Texas Pacific Acquires Burger King


Who Are The Buyers?

– Funds Raised Over $800 Billion From 1997-2002• Hundreds of Billions Left for Investment

– Thousands of Buyout Funds With Billions in Capital Can Generally Borrow 1-2 Times Equity to Buy a Company


Who Are The Buyers?

– Many Different Types of Buyout Funds• Each Has a Profile of Types of Investments Pursued by Size

and Industry

– Some Look to Consolidate a Niche Industry• Example — Hicks, Muse Radio Stations

• Almost All Have a Limited Ownership Time Horizon (5 Years Average) to Sell the Company

– Most Encourage Management to Own Part of the Company (5% — 20%)


Who Are The Buyers?

– Look for 25% — 35% Return on Equity

– Have Different Minimum EBIT Thresholds• Some Acquire Only Very Large Companies

– KKR

– Hicks, Muse

• $5 Million, $2 Million (Most Common), $1 Million

• Most Consider Even Smaller “Add-ons” That Complement an Existing Business


Who Are The Buyers?

• Private Investors– Local Entrepreneur Buys Printing Business


Financing Sources

• Strategic Buyer — Cash Flow From Operations; Existing Bank Lines; or Project Specific Financing

• Private Equity Funds:– Equity 30-50%– Loans — Banks and Other Financial Institutions

• Asset Based Loans– Revolver — Accounts Receivable, Inventory– Term Loan — Fixed Assets

• Cash Flow Based Loans • Mezzanine Debt• Seller Financing


Structure of the Deal Affects Value

• C Corporation With Value Substantially in Excess of Equity Brings Less Than Comparable Company (Subchapter S, LLC) That Can Sell Assets Without “Double Taxation” in Middle Market Transactions

• Licenses, Leases, Inherited Liabilities and Other Contracts


Structure of the Deal Affects Value

• Currency– Cash Is King

– Seller Financing Brings Higher Price• With Bank Financing More Difficult and More Expensive to

Obtain, Importance of Seller Financing Is Increasing — Particularly on Deals Valued Under $20 Million

– Stock Swap — Tax Deferral and Liquidity Consideration, Negative Stock Market Risks


The Marketing Process

• Prepare Business for Sale– Dressing Up Prior to Sales Effort

– Maintain Management Continuity

– Utilize Pass Through Entity (Sub S, LLC)

– Identify and Resolve Litigation, Intellectual Property, Environmental and Other Contingent Liabilities

– Determine Reliance on Key Customers or Suppliers

– Identify Personnel Issues

– Obtain Audited Financial Statements



• Offering for Sale– The Team Is Critical – Lawyer, Accountant, Trusted

Financial Adviser, and Investment Banker– Determine Advisability of a Merger and Acquisition

Professional • Business Value Less Than $1 Million, Usually Not Advisable• Business With Less Than One-half Million EBIT

– If M&A Professional Desirable, Evaluation and Choice Is Critical



• Communication Among Team Members Critical• Be Aware of Deal Snipers



• Business Sales Strategy– Prepare a Business Summary or Offering Memorandum

and Teaser– Identify Potential Buyers– Open Negotiation Process:

• With One Purchaser at a Time• To a Few Prospects (“Selective Marketing”)• With a Controlled Auction to All Qualified Prospects



• Major Legal Documentation– Confidentiality Agreement – Letter Of Intent– Due Diligence– Definitive Agreement and Closing

• Management Must Concentrate on Running the Business


Conclusions

• Successful Businesses Are Marketable• A Marathon, Not a Sprint• Seller Must Be Realistic About Price and Timing• Having a Trusted Team Critical• Do Not Ignore Running the Business. If Business

Falters, All Other Work Is Wasted

Life After the Perfect Storm — Selling Privately Owned Businesses in Today’s Market Bill...

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