Summit’s mergers and acquisitions process is a logical step-by-step process for both sellers and buyers. Since selling or buying a company is quite possibly the most important financial decision that an owner or board will make, and one that most business owners will encounter only once, it is critical that the approach is professional, strategic and logical. One mistake, one error in judgment, one faulty valuation estimate or method, one miscalculation of the competition, or the revenue potential, or the profit and loss statements, or the assets and liabilities, or the forecasted sales budgets, or the profit center margins, or the management team, or in the negotiations and deal terms could turn post-acquisition or sale euphoria into despair overnight.
Indeed, a bad consulting experience may cost more money than what was expected, but the client does not lose generations of wealth, unnecessary or expensive financing can add more debt service, but it is unlikely to destroy a company’s net worth, and even a ill-advised turnaround can end up in bankruptcy or liquidation, but the company was already distressed. However, with a merger or an acquisition the calculated risks between a profitable transaction and a lost opportunity are higher. Therefore, Summit believes that each step of a business sale demands a highly specialized effort when striving to achieve maximum financial rewards.
The following is a general representation of the phases of the process so the prospects of winning big are assured:
Phase 1: Strategy
Successful mergers and acquisitions, on the buy side, require a well-defined and concise growth strategy. On the sell side having a precise strategic marketing and exit strategy helps reduce the likelihood of critical mistakes during the process. Strategy informs, it clarifies, and it answers the questions: “How will buying this company make my/our existing business have more growth potential, have more value and become more profitable, or how will selling my company make me/us wealthier and more financially secure providing the platform to move on to new opportunities or to comfortably retire?” The answers to these basic questions are confidential between us and our client and are rooted in strategy – and strategy has been in CSC Capital’s heritage since its founding. However merger and acquisition strategy is also about understanding the future of an industry sector, and what kind of company will become a winner or a loser in the years ahead. And after twenty years of experience in strategic decision making sometimes the best deal is the one that never occurred. Summit’s strength lies with this heritage and experience in advising companies in developing time-tested strategies, understanding the deals that create value and the ones that do not. In essence, a merger or acquisition failure is usually first a failure in strategy.
Why? Because all phases of the transaction henceforth, the research and analysis and document preparation, marketing and the identification of qualified buyers and sellers, valuation, assembling the deal team, negotiations and due diligence, sale agreement and closing, as well as post-closing integration are all predicated upon strategy. Importantly a correct and timely planned strategy. Military wars are won or lost on strategy not tactics, and so are the winners and losers in the mergers and acquisitions process.
Three years after selling the building material supply company mentioned above as well as conducting many engagements and transactions in the industry, in a December 2001 article entitled “Building for the Future” in Do-it-Yourself Retailing,” CSC Capital had some prophetic words about acquisitions in an industry that was radically reshaping itself:
“Financial acquirers of building material suppliers have dissected the cost-value equation and come up with new retail concepts. Their stories have attracted interest in the public equity investment world. The end result has been to persuade dozens of fiercely independent suppliers to sell out, forcing a financial-orientation consolidation upon the industry.”
What did this mean regarding practical advice to the independents in the industry? CSC Capital’s advice was to get on board: restructure, and sell out to the financial acquirers and profit. Here timing was everything and a number of the firm’s clients did just that in the next several years – restructuring then selling out to industry consolidators, Pro Build, or Builders FirstSource or 84 Lumber and others for huge monetary gains. What happened to many of the other independents that did not profit from the strategic timing of restructuring and selling? Literally thousands of them were forced to close after the financial crisis in 2008. And for Pro Build and the other consolidators who paid out enormous multiples for these companies, they too suffered the consequences of the housing and construction melt-down having to shut down or divest hundreds of their former acquisitions for pennies on the dollar. What could have saved these giant acquirers as well the smaller independents: strategy! Again more strategic advice was given in August 2002 in an article in Pro Sales Magazine entitled “Up Up and Away” from CSC Capital’s Founder & CEO. His words are even more profoundly prophetic today:
“Two-thirds of Americans own homes. The gains and values of those assets have encouraged a steady increase in consumer spending, largely supported by refinancing and borrowing against that property. That should be a good thing because at the bottom of the economic food chain lies consumer spending – where the buck does indeed stop. However, a problem arises when consumer spending arguably can be traced to a corresponding increase in consumer debt. If that debt as a percentage of one’s asset base increases (and given it’s not an asset that is not liquid), then the problem is compounded. Also, when a homeowner’s debt increases but the value of the home decreases at the same time, it limits the consumer’s ability to borrow money based on the value of the asset base – in this case, the home. Indeed, debt is fixed, while asset values are not. If asset values drop or debt increases in a declining market, an economic bubble develops, and eventually it can burst. In residential construction, it could bring down one house at a time, affecting the entire housing industry, and perhaps the economy as a whole.”
Again this was written in 2002 about unforeseen future events at the time. Clearly this indicates the importance in strategy in the buying and selling of businesses or for that matter assets in general. Summit is not flexible in its application of strategy to mergers and acquisitions and neither is CSC Capital’s founder.
Phase 2: Research and Analysis
Summit believes in an “old fashioned” diagnostic survey and assessment of the companies and assets involved in the proposed transaction; both externally in the industry and internally within the companies. This is conducted for clients who are both sellers and buyers. Using state-of-the-art resources through CSC Capital’s Industry Practices Division we first conduct research and analysis of external factors such as industry growth potential and customer trends, all aspects of the competition (human, financial, organizational, operational, pricing, etc.) to determine weaknesses and strengths, market niches, and demographic and geographic influences to evaluate a seller or buyer in the current marketplace. Whether a local or global company, understanding external factors often plays a considerable though discreet role in merger and acquisition success or failure. Knowing your environment and your enemy, as Chinese General Sun Tzu wrote over two thousand years ago is critical for victory. It is during the negotiation of deal terms when such information surfaces of great importance. Summit believes in being prepared at every stage of the transaction, especially the last.
While negative external factors rarely prevents a willing pursuit of an acquisition nor the willingness of the seller to sell, negative internal factors often cause huge obstacles and can kill a potential deal before it ever started. Many advisory firms conduct fancy and overvalued valuations to lure potential clients into a listing agreement. Inflated appraisals as well as under appraising are caused by a lack of adequate internal analysis or unethical practices. Helping a client understand what creates value in the market reduces time wasted and money lost, and if 95% of valuation prices are determined on internal factors then it is worth the correct analysis. This is where Summit’s diagnostic survey and assessment of our client’s company or of the target acquisition company is crucial, though it is often the case that digging up all the “skeletons” of a privately held target company is not easy in practice. Nonetheless, knowing your business or your acquisition target’s business as well as understanding a corporation’s true value are essential elements to making appropriate decisions to maximize liquidity in selling or leverage in buying.
In order to conduct this research and analysis Summit uses CSC Capital’s time-tested Organizational Assessment Survey and Information Summary (OASIS). This is the firm’s original comprehensive analysis actually created before the firm’s founding. When applied to a merger or an acquisition it becomes one of the most innovative and detailed corporate analysis techniques in the industry. Through this systematic approach Summit is better prepared to market a company for sale, or assist an acquirer in buyer intelligence thoroughly understanding its prospective target. Most important the cost benefit analysis phase with its summation of the current and prior year’s financials provides the foundation of creating a true understanding of a company’s value both current and forecasted.
OASIS has nine output categories creating a body of information that becomes critical for a total understanding of the companies involved and furnishes the bulwark of our findings that ultimately turns into what we call “The Book.” The Book is then transformed into a marketing document for sellers or an insider’s view of buyer intelligence necessary for selecting the right company to acquire. Its versatility allows us to be more effective and efficient during our Research and Analysis Phase on all analysis fronts. OASIS output categories are summarized below.
1) Cause and Nature of the Present Situation
This includes a chronological outline of the history of the organization, the present situation, the opportunities (of the seller’s company), and opportunities and problems (of the buyer’s target company). It discusses in detail the reasons why the seller is selling or why the buyer is interested in acquiring. If there are any contingent liabilities, legal and tax ramifications it is included in this section. If either the seller or the prospect acquisition is distressed, the situation is discussed in completed detail, and if any remedies are being conducted (e.g., restructuring, Chapter 11 bankruptcy, divestitures, etc.) a full discussion of these matters are also included.
2) Strategic Outlook for the Organization
This includes a discussion of the strategic position of the companies in question. The competitive nature of the industry including a listing of all direct competition with as much detailed organizational, personnel, and financial information as can be ascertained is included. A market share analysis is conducted comparing the seller or buyer’s target company market with that of the competition. The trade reputation of the seller or the prospect acquisition is included in this section as well. If there are any corporate strategies underway by management a full discussion of these activities are included. If there are any strategic concerns noted through this investigation they are detailed as well. This strategic outlook discussion is different than the Strategy Phase mentioned above. The strategic outlook is provided for open discussion and for marketing purposes. The Strategy Phase is a “behind the closed doors” frank acknowledgement of corporate and personal objectives between us and our client.
3) Executive and Management Personnel and Methods of Accountability
This includes a discussion and appraisal of executive talent as well as detailing current methods of holding management accountable for their performance. This is conducted for the sellers company, without negative input of management personnel (though a candid discussion with our client about management personnel if necessary is conducted) However, for the acquirer’s target company, we provide complete objectively on executive and management personnel strengths and weaknesses. This is largely facilitated by interviews and by an investigation of the executive’s record both quantitative and qualitative. If there are concerns as to the performance ability of a management member is it backed up with specific examples. We make no personnel assumptions without documentation. All budgeting methods are discussed and how specific executives interact with this process, as well as their budget performance. Performance evaluations and job descriptions are reviewed to discover trends in performance. Select though critical non-management personnel may be also assessed.
4) Organization Structure and Functions
This includes the present plan of organization as well as organizational standards for all companies in question. A discussion of functions and positions are detailed, and whether the structure is consistent with strategy. If inefficiencies and lack of effectiveness of personnel are created by the organizational structure they are highlighted in this section. If there are formal profit and cost centers within the structure it is discussed in detail, and there is an absence of these responsibility centers in the organization it is duly noted. If organizational improvements can be designed and implemented to increase revenues, margins, profits and cash flow they are discussed in detail. If possible the organizational structure is tested for compatibility against the financial structure.
This includes a discussion of the major policies for the sellers company and of the acquirer’s target company. The analysis of sales policies include a review of the products or services performed and whether they are separated by customer segment on the financial statements. Also we review the customer base, channels of distribution, whether a breakeven analysis by unit is performed, and how sales forecasting is accomplished. The analysis of operating policies includes production planning and standards, operating controls including inventory control and quality control, and purchasing. The review of purchasing includes the sizes of purchases in relation to sales, quality standards, price determination and the selection and control of vendors. Personnel policies are reviewed including the selection, training, compensation, benefits and industrial relations in general. Incentive plans and pay-for-performance packages are evaluated on their ability to motivate and their calculated cost-effectiveness. Finally all accounting and financial policies are reviewed; the budget process, account receivables and collection practices, and payables. If any financial policies are deemed inadequate, or could produce unwanted costs or expenses, lack of cash flow or profits a detailed discussion on the reasons are provided.
6) Facilities, Information Technology, Transportation, Equipment, and Inventory
This includes inspecting the organization location(s), including all real estate owned or leased by the seller or the buyer’s acquisition target. This review includes the size and layout of facilities as it applies to conducting an efficient and cost-effective work-flow. All computer systems and other methods of information technology including mobile and cellular technology, as well as internet providers and wireless spaces are reviewed for function and applicability. Finally, all equipment, including fleet vehicles, yard, warehouse and maintenance vehicles and other heavy equipment are given a needs assessment to the volume of business. All other vehicles (e.g., executive and sales personnel transportation, etc.) whether owned or leased are also assessed for purpose, and in-house repair and maintenance operations are reviewed for applicability. Finally, all inventory levels including raw materials, finished goods, stock for re-sale, even product displays and gondolas are audited against sales and usage timeframes. We contend this review is important due to the fact that real assets often have a different tangible value as opposed to their balance sheet value. As such, this review can be particularly instructive for buyer intelligence.
7) Human and Intellectual Capital
This includes all paid owners and board members, executive officers, management and employees on salary or wages, full-time and part-time, 100% commission employees, professionals on retainers, and all sub-contractor 1099 personnel full and part-time. Besides reviewing the number of personnel in individual departments and groups, we also review the ratio of management and employees compensation including benefits and taxes to sales volume by profit and cost center by location. This ratio is calculated as a percentage. Then armed with this information, we then conduct interviews with select management and other personnel comparing the complied information to the organizational chart and the necessary positions to carry out day-to-day activities. This company-wide personnel needs assessment is very helpful for buyer intelligence. Lastly, the company’s intellectual capital is valued which is helpful for sellers.
8) Financial Condition
This includes analyzing the financial conditions and operating results of the sellers company and the buyer’s target company over the past five years. Besides the profit and loss statements by location and profit center if available, the balance sheet, and all cash management tools are reviewed and analyzed in detail. We also review computer generated sales and costs analysis reports by product line and customer classification. We then run trend analyses over the five year period throughout most sales, costs and expense line items calculating comparison ratios. The balance sheet is reviewed with respect to our former hard assets assessment, as well as all accounts and notes receivables are analyzed against aging reports and validity standards. Further, each liability is analyzed for correct documentation and validity. Our previous human capital assessment is compared with actual salary, wages and benefits over the most efficient year. Inclusive of the internal financial conditions and analysis we also conduct an analysis of these operating results to industry financial standards.
9) Cost Savings Analysis and Preliminary Valuation
Our final output category includes condensing all the applicable eight categories above into a brief, simplified and conservative cost savings analysis. This analysis is based upon the comparative operating findings of both the sellers company and the buyer’s target company. This analysis focuses on line item efficiencies with respect to actual operating percentages. We also compare the seller’s actual numbers to the most efficient percentages thus re-calculating margins and profits to higher levels. This demonstration is useful in showing how the seller could increase the company’s overall value through restructuring, and the buyer if successful in the acquisition could achieve higher efficiencies through restructuring. In essence, we perform two preliminary valuations for both seller and buyer. The first valuation is based upon the seller’s current situation and the target’s current situation, and the second is Summit’s innovative forecasted valuation based upon the seller’s company achieving the efficiencies represented by the highest margin percentages and the lowest expense percentages. The valuation method used is our weighted cash flow analysis approach to estimate value. Using the same analysis we also demonstrate to buyers that if an acquisition was completed there are considerable cost-savings implementation opportunities to realize.
10) Document Preparation: The Book, Video and One Page Blind Summary
This includes the preparation of the documentation package, The Book and video, for the seller. To the extent possible a full documentation package is also created for every Buyer’s prospect target, which outlines the former nine categories of the OASIS. The Book is a professional written description that is the centerpiece of our marketing plan to help sellers succeed. To compliment The Book a five minute video is also created and presented which showcases The Book’s content. For sellers a one page blind summary of the “The Book” is also created and is distributed to our data base of potential buyers worldwide, through regular mail and email depending upon the prospect. The blind summary, which does not reveal the name of the sellers company, is a test marking vehicle and is distributed before The Book or video is finalized. Summit follows up by phone to select prospect buyers on the data base to verify levels of interest. Based upon feedback from the recipients, the contents of The Book and video may be factual altered for enhanced marketing purposes. The blind summary also includes the two estimated values previously calculated as a market high and low, again only a market test.
Phase 3: Marketing and Generation of Interest
Unlike our large global data base of potential buyers used for test marketing the sellers company, Summit carefully screens interested buyers to create a qualified short list into an A, B and C list. This list may be made up of data base prospects, referrals, Summit’s direct contacts, marketing and advertising inquiries, as well as seller contacts. With more marketing exposure there is more interest from qualified buyers, so our short list may grow and evolve over time. Only those qualified buyers that are willing to schedule initial meetings and sign confidentiality agreements with the seller’s file number (no business name is provided at this time), either in person or through a webinar format, which includes the presentation of the video with Summit, are classified as an “A” list candidate. However, only “A” list candidates that we know are interested, qualified and have available financing, if necessary, receive a copy of The Book, though must sign additional confidentiality documents which only now finally disclose the seller’s company name. During this phase confidentiality must be carefully safeguarded for numerous reasons. Summit prides its attention to detail for strict client confidentiality every step of the transaction.
On the flip side after Summit has determined an acquirer’s specific acquisition criteria, we will generate an aggressive corporate search on the buyer’s behalf to identify, solicit and analyze prospective acquisition targets. While we use the same OASIS outline of categories in analyzing targets there is neither a formal “Book” nor video that is necessary. Hunting is vastly different than being hunted, and it is the same in mergers and acquisitions. Summit acts as an acquirer’s corporate development partner, thus simplifying the search process and improves the likelihood of indentifying targets that meet the buyer’s objectives. Importantly, the firm’s restructuring background greatly assists in conducting realistic valuations of the target company. We have seen too many times so-called sophisticated acquirers overpaying so much that eventually the debt service was staggering. Moreover, a post-acquisition integration and restructuring was not conducted so many of these overvalued mergers and acquisitions resulted in the buyer literally “growing themselves out of business.” WorldCom’s demise can be sourced directly to an overly expensive acquisition strategy.
Summit conducts its corporate search through utilizing CSC Capital’s Industry Practices Division for both direct research and the locating of acquisition candidates. The firm’s in-depth industry knowledge and global contacts provide us with daily interaction with numerous acquisition targets for our buyers, as well as buyers for our sellers. Over the years the firm has put together a library of privately held company information. And while today the internet makes it easier to retrieve basic or published corporate information, our information delineates and describes the actual concerns and opportunities that corporate owners face daily. If what Napoleon said was true, and 90% of winning a war is receiving the right information, then Summit has already done its homework regarding a buyer’s ability to successfully acquire. In fact, since 1998 CSC Capital has mapped out this information in the firm’s nondescript “War Room.” Taken all together we call our services in the marketing phase for acquirers “Buyer Intelligence.”
Phase 4: Valuation
Attend Harvard Business School’s program in corporate restructuring and mergers and acquisitions and you will learn a lot about corporate valuations. Alpha they will tell you is used to measure performance on a risk adjusted basis, because as an acquirer you will want to know if you are going to be compensated for the risk taken; in other words a historical measure of an asset’s return on investment. And beta is a historical measure of volatility; how a asset moves versus a benchmark or index. It gets a lot more complicated if the reader wants to go there. However, in the “real” world of valuations you cannot value your company any more than a willing buyer is going to pay – period. And in Summit’s opinion history is just that – history. We contend that through a restructuring all corporate history can be proved ill-relevant.
But not to be mistaken, valuations are complicated but not in the alpha and beta sense, but rather in the financial and strategic sense. Most acquisitions are conducted in the middle market as an asset value purchase due to relatively low profit margins, so we will first discuss how we apply this valuation technique in the most detail; the second part is how we value companies for our clients based upon how earnings are deployed, or otherwise known as the intrinsic value approach, and the third part is how we value companies using a weighted average of typical cash flow analyses. Depending upon whether our client is an acquirer or seller and the specific purposes of selling, we determine which method or combination of methods produces the maximum benefit for our client and apply the valuation accordingly.
1) Asset Value
Asset values are determined by the amount of owner’s equity, less adjustments. Typically a standard practice in asset based valuations is to discount aged account receivables allowing for the possibility of bad debt, discount inventory allowing for the possibility of obsolete and/or inventory slippage, and discount unnecessary equipment. This asset value may be increased, depending upon the seller’s willingness to assume responsibility for present short and long term liabilities, rather than transfer them to the acquiring company. However, by calculating these standard reductions in assets does this now make the valuation method 100% valid? Not really! In many companies inventory and accounts receivables make up a large proportion of total assets, thus a correct assessment of its true economic value is essential. Generally a physical inventory is required to calculate total stock levels, and an aging report is needed to calculate collectable accounts receivables, specifically at 90 days to a 120 days. To most buyers as well as most mergers and acquisitions advisors, this is the point where such calculations correctly value inventory and account receivables. But is the valuation now 100% valid? Not exactly, as there is still more onion left to peal!
Account Receivables. Summit takes the position for our client buyers in asset purchases that aged account receivables at 90 days or over is no longer an asset at all. In fact it could become a liability as well as a misrepresentation of the profit and loss statement. Our reasoning is based on logic. First, a customer who is over the 90 day column, despite interest that may be charged is really not a reliable customer, and should probably be removed as a credit customer altogether. Second, the original sale to this customer has already been reported on the monthly and quarterly profit and loss statement as revenue though in fact this customer has generated no revenue for the company. Third, when this fathom revenue passes through the profit and loss statement it exaggerates the bottom line as well as cash flow which in turn falsely increases the overall value of the company. We take the position that any accounts receivable over 60 days is suspect, and must be evaluated on a customer to customer basis. Also extensive accounts receivable aging problems is more than just a customer unwillingness to pay on time issue, but demonstrates a weakness in the company’s credit policy or credit personnel. Summit valuations are not flexible on aged account receivables as an asset. Our strictness applies to notes receivable as well.
Inventory. A equally large proportion of the asset base of many companies, such as retailers, wholesalers, distributors, and manufacturers is also made up of inventory. Though not as immediately severe as incorrectly calculating bad debt as an asset, in an asset based purchase however, Summit believes that an acquirer should not purchase assets that have little or no business value. Companies seldom write visible inventory off and auditors rarely discount warehouse and store inventory levels on company balance sheets. In fact, to sellers high inventory levels typically leads to a misconception of real net worth; and this is rarely challenged because buyers can see and touch the materials. Even if one reviews inventory turn reports trying to assess accurate inventory levels, it can still be misleading. Normally the larger the company the larger the gap between inventory as an real asset vs. inventory as simply a carrying cost.
Summit conquers this inventory valuation problem, by isolating obsolete and/or excessive inventory through analyzing and comparing product by product inventory sales by the purchasing date of the inventory. Such information is not readily available on many inventory control and procurement software systems, so we request that query reports be generated to provide this information. To be more precise these query reports should be generated by each warehouse and/or each point-of-sale location. While excessive inventory will be eventually sold, we calculate a carrying cost discount on our valuation, however for all obsolete inventory which is calculated as a individual item not sold in 90 days from purchase date, we eliminate the full dollar amount of that inventory from the asset base. For middle market acquirer’s this can easily be a reduction of millions of dollars off the valuation of a target company.
Equipment. Even if an acquisition candidate had recently an equipment appraisal conducted, Summit prefers to review the numbers and lists of equipment, though not for monetary accuracy, but rather for corporate necessity. Again like accounts receivable and inventory our valuation of equipment is based upon actual business needs and what is necessary to support current revenue levels. This is because often traffic and yard equipment, sales personnel vehicles and production equipment seems to accumulate beyond what is necessary to support sales. Summit likes to see the fixed asset equipment to sales ratio to be between 3 and 5 percent. We pay careful attention to what is an optimal amount of equipment. Typically, an “orderly liquidation value” is placed upon all necessary equipment, as it assumes exposure to the market. However, for excessive or unnecessary equipment if calculated as an asset at all, is normally valued as a “forced liquidation asset.”
Real Estate. Companies typically own either the land or buildings the business is located on, or the owners have created a separate real estate holdings company which leases the land and buildings to the business. In today’s environment often the land and buildings have been mortgaged up to pay for past operating losses so there is little real remaining value. In other circumstances the land and buildings are debt free, which may represent a large or small portion of a company’s value. Summit normally values real estate at its current fair market value for acquirers, using an outside real estate appraisal firm though the determination to acquire real property as part of the business acquisition is made on a case-by-case basis. For sellers real estate may be valued as having an intrinsic appreciating value due to its location as an long term investment. Sometimes real estate owned for decades is far more valuable than the business itself, due to the break-up value of the real estate for different commercial purposes.
2) Intrinsic Value
Recognizing that it is not the size of an equity investment that determines its value, but how earnings are deployed, Summit’s acid test of value is largely determined by a company’s intrinsic value. In our view, the value of retained earnings of a business is determined by the effectiveness with which those earnings are used. By intrinsic value, we mean, the discounted value of the cash that can be taken out of business during its remaining life. In order to calculate this it depends upon the estimation of both future cash flows and interest rate movements. Of course, book value is easy to calculate, but has limited use. Accordingly, earnings can be as pliable as putty when a charlatan heads the company reporting them. So too, with market price, at least for most companies.
Before the internet valuation era, it was common for investment bankers on Wall Street to value businesses using a calculation of cash flows equal to operating earnings plus depreciation expense and other non-cash charges. Summit believes that calculation is somewhat incomplete and a little generous especially for our acquisition clients. We contend that in order to arrive at the true intrinsic value, and average amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position must also be subtracted. Earnings are thus restated as operating earnings plus depreciation expense and other non-cash charges minus the required reinvestment in the business. For most companies the required reinvestment in the business usually exceeds the depreciation expense and other non-cash charges. Looking at value this way, a typical cash flow analysis as the method of determining value usually overstates economic reality.
3) Cash Flow Analysis Value
This analysis uses the three most common methods of valuing businesses and allows for the weighting of these methods: Capitalization of Excess Earnings, Multiple of Earnings and Discounted Future Cash Flow. It is common for small business valuations to include a fourth method, Liquidation even though it is given little weight. Summit believes the liquidation value method is unnecessary in the weighting of cash flow since for companies of all size because it assumes a forced sale. The weight given to each of the three methods is approximately 33% or 1/3rd of the weighted average.
Capitalization of Excess Earnings. This method is based on the idea that a portion of business earnings is due to a relatively safe rate of return on the equity in the business and that any earnings in excess of that amount are due to goodwill. In other words, this method involves capitalizing earnings above a normal rate of return to determine goodwill and adding that to the value of the assets of the business.
Multiple of Earnings. This method uses a “multiplier” based on a reasonable rate of return for the investment times the average earnings/cash flow of the business. Our use of this method assumes that the value resulting from use of the multiplier would include adequate tangible assets to generate the annual earnings or cash flow of the business.
Discounted Future Earnings. This method calculates the sum of expected future earnings/cash flow of a business over a certain number of years discounted at the expected inflation rate. This method also assumes that the derived value includes adequate assets to generate the anticipated cash flow of the business.
Phase 5: Preliminary Negotiations and Letter of Intent
After a settlement of preliminary negotiations between the buyer and seller, the Letter of Intent serves to summarize the transaction to-date. It describes the parties involved, the capitalization plan, what will be acquired or sold, assets or stock, the purchase price, the overall structure of the acquisition both legal and financial, what security or collateral for deferred payments, guarantee of accounts receivable, key man agreements, what employment and/or consulting agreements are expected to be agreed upon, the non-compete agreements, the purchasing of real property facilities, what due diligence will be performed, representations and warranties, confidentiality agreements, broker obligation, non-negotiation with other parties agreement, corporate, capital gains, and sales tax issues, expense responsibilities, timing for completion of certain documents, press relations and so on. Though the Letter of Intent phase is a critical stage of the transaction, it will contain a provision that the letter is non-binding and that the parties are not obligated to consummate the transaction until a definitive agreement is executed. Once the Letter of Intent is executed a more investigative due diligence effort commences.
Phase 6: Assembling the Deal Team and Professional Due Diligence
Summit controls the entire mergers and acquisitions process from start to finish first supplying the traction at the beginning then ensuring that the momentum of the transaction continues until closing. However, between the Letter of Intent phase and the final negotiations and sales agreement phase, it is prudent to assemble an professional advisory team especially in legal, tax, and forensic accounting matters. It will be their task to perform professional due diligence to make sure that the acquirer is not buying punitive legal, compliance and tax concerns affecting the company under consideration. This specialized and largely investigative due diligence includes reviewing a number of documents before negotiations have commenced in earnest. Such documents include in part the Articles of Incorporation, bank statements, credit and customer agreements, corporate minutes, employment or union contracts, property and equipment liens, existing loan documents and current financing arrangements, ownership documents and contractual rights, policy manuals and benefit promises, environmental regulations, and tax returns and records. Further, an independent valuation of all assets and review of all liabilities may be deemed necessary. Failure to conduct appropriate due diligence by objective professionals is foolhardy. For example, if a business owner or stockholders are harmed as a result of the completed transaction, injured parties can sue for damages. More likely and damaging the acquiring company could be saddled with a undisclosed financial liability, environmental hazard, tax burden, or legal issue which could prove to be eventually fatal for the acquiring company.
Phase 7: Final Negotiations, Sale Agreement and Closing
After the due diligence phase, there could be certain legal and tax issues that need to be re-negotiated. At this point Summit works closely with both legal or tax counsel and the buyer and seller to finalize documentation approvals, not only managing the legal and tax issues but all on-going advisory and negotiations as well. While our objective at this juncture is to drive the transaction to a successful close, we will always represent our client’s best interest at all phases of the process, especially this last one.
Phase 8: Post-Closing Integration
This optional phase is for our acquisition clients only. The firm advises that shortly after closing CSC Capital Corporate Restructuring Group takes over from Summit and creates the enormous value that comes from the firm’s synergistic client services. The purpose of this phase is to restructure and integrate the once two companies into one holistic managed enterprise. Many acquisitions do not fare well after the deal, especially for the acquiring company. This is due to the fact that the acquiring company does little to integrate management, operations, budgeting, sales, purchasing, accounting, human resources, delivery and warehousing, computer systems, compensation, organizational and accountability structures into one functioning machine. Instead the once two competitor’s now under one ownership continues to operate as two distinct organizations with two distinct corporate cultures. Duplication of effort and manpower, unnecessary equipment and inventories, and the losses of economies of scale and of centralizing opportunities are the result. And with a debt service possibly higher such inefficiencies cause not only expenses to increase but the cost of goods sold to increase as well, resulting in lower margins and cash flow.
Indeed, the acquisition objectives of increased market share and penetration and the immediate growth of revenues are achieved. However, if the above mentioned housekeeping matters are not attended to, the increases in sales could eventually produce less profit, less cash, less efficiency and productivity, a lowering in morale, and a general feeling of malaise among all employees. A post-closing integration of the once two enterprises will change all that, allowing the acquisition efforts to continue into the future with amazing success.