Thinking about stepping back from the business you built during your career or need to develop a succession plan? Want to make growth investments to strengthen your company? Perhaps you are ready to sell the business. You owe it to your family, yourself and your employees to know the options. There is a lot to consider. Your business is your life’s work, maybe even a big part of your identity of who you are. You have taken chances before, and you know that taking a chance backed by information increases the likelihood of a successful outcome. But you also know that timing is everything. As a privately owned manufacturer, rep agency or electrical distributor, if you are thinking about selling the business your options are clear:
- Stay on and continue to build the business and hand it off to an appreciative next generation.
- Stay on and create an ESOP, in effect handing off the business to your employees.
- Sell most or all of your business to a private-equity partner.
- Sell your business to a competitor or a large aggregator of businesses in the electrical industry.
These are all valid choices, but they each have their own advantages and disadvantages. From a value perspective, timing is an important factor. A less talked about consideration is your legacy. You have built a business, a brand that your employees, community and our industry have come to respect and depend on. How and who you sell your business to can put all of this at risk.
Often talked about behind closed doors is what I will call the “synergy case.” These are the changes a buyer may make to your business to reduce expenses and improve margins after you sell your business. Ironically, most sellers tend to believe this just happens when the buyer is a private-equity firm. This frequently not the case. Often, it happens when a competitor buyer takes over the reins of a business. It’s easy money for them to combine sales teams, integrate supply chains or eliminate duplicate functions or locations.
THE 2022 M&A MARKET
The M&A climate is as strong as it has ever been and is being driven by comparatively cheap money, competing forces looking for deals and a healthy end market outlook for electrical products.
Some private-equity firms that owned electrical businesses cashed in a number of their portfolio businesses in 2020 and 2021, enabled by the tailwinds of higher multiples at the exit. These firms have made solid returns for their shareholders as well as co-investors. Success builds success, and fundraising by private-equity firms has also been strong. They have money from businesses sold and new or additional money from investors in their funds. The number of new funds and the size of the funds means there is a strong desire to put money to work in good businesses they can help grow. These private-equity firms invest in private businesses to build growth, typically alongside the current owner of the business or at least the senior leadership team of a business they acquire.
Public and large private electrical companies are also keen to acquire. Many of these companies have made outsized profits for their shareholders, in large part due to higher margins from commodity price hikes and product shortages as well as from steady market volumes. This is in the face of what many consider to be a decent end-market demand. These potential acquirers are cashed-up and looking to make accretive acquisitions near, or adjacent to their core business to improve their competitive positions.
Other companies are positioning themselves for the expected boon from infrastructure spending and looking to acquire businesses that better position them for what is an anticipated period of growth. The combination of the competing interests of private-equity firms and strategic acquirers bidding for good businesses all but ensures the volume of M&A transactions will remain high, and that multiples paid by buyers for quality businesses will stay at or near the levels of 2021 for the foreseeable future. With that being said, the “party” for sellers of businesses will not go on forever. In recent months, I have spoken to many investment bankers, M&A brokers and private-equity players, and their general view is that this is the 3rd inning of a 4-inning game.
I like to break the complex into simple, and this analogy describes today’s M&A climate. I think of the current M&A market as being similar to the housing market in most states in 2006/2007, just before the 2008 financial crisis. During this era, the value of real assets declined sharply. I’m not suggesting this will happen with business values in the same way as it did to the housing market, but it’s probable that some of the frothiness currently in the M&A market will subside as money gets more expensive and buyers become more discerning or move to other industries.
TALKING MULTIPLES
In my 10-plus years of working in corporate strategy and M&A for U.S.-based electrical companies, I have seen typical multiples for a small- to medium-sized good manufacturing business increase from around 5 times to 6 times EBITDA to as it is now, to 8 times to 9 times EBITDA or higher.
In this simple example, a business with $5 million of EBITDA in 2012 would be worth around $25 million to $30 million, and that same business is now likely worth between $40 million to $45 million. This naturally varies depending on the type of business and whether it’s a distributor, agent or manufacturer. This may be an over-simplification of the valuation process, but it’s a useful rule of thumb. Valuation is more complex than it may seem on the surface, with several factors including sustainability of earnings being key. For this reason, I won’t go into any depth on valuation variables in this article.
GETTING READY TO SELL
Once you have decided to sell your business, two top priorities will be preparing your company’s financials for a sale to get the best value and evaluating potential acquirers. Don’t underestimate the time it will entail to prepare a business to make it “show ready” and to amass the data needed for a potential buyer to enable them to prepare a valuation, as well as being able to respond to questions during a later due diligence process. One way to do this is having an accredited CPA or accounting firm conduct a Quality of Earnings (QOE) report. This can also be done in-house if a business has sufficient bandwidth and capability. Naturally, the independence of an accounting firm adds credence to the information prepared and may end up shortening the total time of a transaction. In the shorthand, a seller QOE is a means of normalizing the underlying financial performance of a business. If it’s not done by the seller, it will almost definitely be done by a buyer.
Remember that the multiple times EBITDA methodology for establishing value is based on the belief that the EBITDA being valued (multiplied) is sustainable. In other words, the business will continue to make the same earnings after it has been acquired. This is the general understanding of both private-equity firms and competitors who may buy a business. It’s therefore normal in a QOE to consider both the one-off expense the business had in a valuation period, as well as any one-off commercial gain the business may have had in that same period that will also not likely repeat. The valuation period will typically be the last twelve months (called the “LTM” or “LTTM”).
Another consideration is capital gains tax, which may impact whether the business is sold as a “sale of assets” or “sale of shares.” Again, this work is best done by a CPA or your tax advisor, because there are different levels of ongoing risk associated with these two sale types. You must also consider who is in your business to bring into the circle of trust and how, or if, critical employees should be retained and engaged. Other considerations may be if these employees should be renumerated from the sale proceeds, and whether stay bonuses should be implemented to keep them engaged and in place during a sale process.
Typical terms of an offer. Most transactions in the United States are cash-free, debt-free and with a normal level of net working capital (NWC). The last is frequently a surprise for first-time sellers but is logical when explained. A buyer is buying a business as a going concern. They, therefore, expect on Day 1 to be able to operate the business without needing to inject additional cash. There are several mechanisms to determine NWC. The most common is an average of the last 12 months’ NWC balance where any differences between the value of NWC at close and the actual is determined by a third party. This is done sometimes after the transaction closes, and then “trued-up.” This means that if a seller delivers at closing more than the average NWC value, they would receive the difference as a one-time payment. In the inverse, if the NWC at the close is found to be less than the 12 months average the seller would refund that amount to the buyer.
The other term — cash-free — may seem contradictory. Cash-free typically implies “surplus cash” in the company’s bank account. This can be removed by the seller at the close. Surplus cash is not cash balances required to service current liabilities including, for example, supplier payments. That’ an element of the going concern principal.
CHOOSING A BUYER
Who is the best next owner of your business? As mentioned earlier, and assuming that there isn’t an obvious successor owner in the business, or you are not prepared to create an ESOP, there are two real options. Let’s look at each of them.
Private-equity firm. I have heard anecdotally that many businesses receive calls from private-equity business development executives asking, “Would you consider selling your business?" The first thing to understand is that private-equity firms are very selective buyers. They have a high degree of accountability to individuals and others that have invested in their fund. I realize this may seem odd given the frequency of them reaching out. When it comes down to it, a private-equity firm’s decision to invest will be based on many factors, many unique to each firm. These factors include a potential acquisition’s alignment to their investment thesis and size of the business EBITDA. Private-equity firms have a mandate for different size transactions and different end-markets). For any private-equity transaction to be complete, it will need to be internally tested by an independently minded investment committee, which will have the final word. While not the same, an investment committee can be considered in function as being like a board of directors. Now let’s look at some advantages of becoming a private-equity owned business.
Succession flexibility. Private-equity firms are always agreeable to a seller taking the bulk of the sale proceeds “off-the-table,” and encouraging of a roll-over of some equity, perhaps 2% to 10% of the total enterprise value (TEV). This may allow the seller to stage his or her departure from the business, if, at all, and benefit alongside a private-equity partner when they exit down the road. Alternatively, in circumstances where a business owner wants to retire but has a family successor, a private-equity firm will typically back and develop that individual or individuals. Equally, where a seller wishes to retire but has a management team in place, they will also generally be accommodating and if necessary, add a human resource to back-fill the owner’s capability.
Future growth of the business. In circumstances where growth is the order of the day, a private-equity buyer` is an especially good consideration. They typically have a bench of industry experts on call that are available to help with advice and decision making. Future growth can take many forms including, investment in capability, growth through bolt-on M&A, geographic expansion, or investment in systems.
Legacy. Private-equity firms invest in businesses for growth. They recognize there is value in the heritage of the business, as it has been established under one or more generations.
PRIVATE-EQUITY PITFALLS
There are more than 4,500 private-equity firms in the United States, and it comes down to finding the best partner that suits a seller’s particular circumstance. A good private-equity partner in my view, is one that believes in the mission of the business, has an affinity for the industry, and intuitively understands that the private-equity team and the business perform different functions in the partnership.
Because private-equity executives have rarely run an industrial business, they rely on data to get comfort that the business is performing to their model. Supplying this data can be time-consuming and dare I say even frustrating with the wrong partner.
Generally, it makes sense to take the time to meet several private-equity groups to understand their exit thoughts, noting that different private-equity firms have different hold time ambitions. This is particularly true of family office firms that look to hold for longer periods. Speak to other business owners that have partnered with these firms about their interaction and how their deals panned out.
Selling out to a competitor. One advantage of selling to a competitor may be the speed of the transaction. A buyer who may be a direct competitor or an adjacent industry player will usually come to the table with a good industry understanding. This can make the acquisition process faster, as there isn’t the need to work through some of the industry-specific understanding
Purchase price. Some people think an industry player will automatically pay a higher price because of synergies that may stem from an acquisition. While it can be the case that there may be opportunities to achieve synergies, few industry buyers will be prepared to pay for these. That said, in a competitive process strategic buyers can leverage these potential synergies to push up the price.
Career opportunities for employees. It’s true in theory that when a smaller privately owned business is acquired by a larger player it may provide employees with more opportunities for career progression. This, like most considerations, is highly dependent. These dependencies are cultural, and skills capability related. Also, employees in the acquired business must be willing to align with the culture of their new employer. My personal experience from acquiring many businesses is that the dream of employees from an acquired business flourishing under a new owner is rare.
Pitfalls of selling to a competitor. There's a commercial risk in sharing confidential information with a close or adjacent competitor, as nothing is certain with M&As. I have seen deals that almost got to the finish line and then fell over. Confidentiality agreements provide some security in this circumstance, but as M&A deals inevitably involve large numbers of employees and advisors nothing is certain. The other risk consideration, particularly in situations where the owner and senior management from the seller business join the leadership of the acquirer, is the difference in culture, organizational status as well as business priorities and rules. This risk is further amplified by the requirement of most employees that come from the acquired business to sign a non-compete and /or a non-solicitation agreements that form part of the transaction documents. These agreements may effectively lock out an individual from working in the industry they know for many years.
In summary, there is a lot to consider when selling a business, from the work, time and cost needed to get the process started, to determining the best next owner of a business that has likely been built over years if not decades.