Steve Miles

Tuesday, 31 January 2006 06:51

Choosing partners

In the past, only larger companies used external service providers (ESP) to provide temporary staff with specialized skills, develop custom software or assume responsibility for functions or departments, such as payroll or information technology (IT).

Times have changed. As competition heats up and firms in many industries consolidate, small- and mid-sized companies must compete with larger organizations, and must cut costs and streamline operations to remain competitive. Outsourcing certain business processes (i.e., application development and maintenance) allows mid-sized companies to gain the economies of scale — and cost savings and efficiencies — formerly available only to large firms.

How do you select an external service provider? What are the critical success factors and potential pitfalls of outsourcing?

Relationships, not transactions
A company’s approach toward outsourcing ultimately determines the engagement’s success or failure. If approached as a finite transaction, the engagement will experience difficulty. This situation occurs because firms rush to hire someone to solve a problem, or because price is given too much attention, at the expense of a clear understanding of needs, expectations, abilities, and roles and responsibilities. As a result, the outsourcing relationship is fraught with misunderstanding and contention.

In contrast, when approached as long-term relationships, outsourcing engagements are more successful. Taking this approach, firms not only evaluate vendor bids, but they examine and understand the entire problem, from beginning to end. They determine specifically what they need from the engagement and what abilities and value the vendor can contribute (beyond technical skills). They document roles, responsibilities, critical success factors and metrics first, and they evaluate price last.

Know yourself first
Early on, examine your needs. You must clearly understand what you need before you can explain it to prospective ESPs. What is the desired end result — a new software application? A three-year agreement to have some or all IT functions handled by an ESP?

Next, how will you measure success? By dollar reduction in costs? By percentage increase in processing capacity? What metrics are most important? Be specific.

What is your organization’s tolerance for risk? How critical, visible and time-sensitive is the project?

What roles and responsibilities do you see for the engagement? Which roles and deliverables will your firm manage? Which roles and deliverables do you expect the ESP to manage?

Once you clearly understand your needs, document the desired results, measures of success, responsibilities, and expectations. Use that as the basis for evaluating ESPs.

Evaluate on many factors
For each prospective ESP, document its strengths and weaknesses. Often a firm’s particular weakness may not be an issue if your firm is strong in that area, or if that weakness is not relevant to your needs. Knowing each ESP’s strengths and weaknesses will help you objectively evaluate vendors, and will help you understand and prepare for potential pitfalls or risks.

Ask the ESP for the names of other clients in your industry, or clients who had a project similar to yours. Contact those clients to discuss the ESP’s work, weaknesses, strengths, flexibility and results.

Evaluate the entire package of abilities and value the vendor can bring to the engagement. Outsourcing involves many different skills and expertise, not just technical skills.

Involve your IT department
Be sure to involve your IT department. IT departments have significant experience negotiating maintenance contracts, and can ask pertinent questions you may have overlooked.

Regardless of the ESP you select, remember that long after the project is complete, you will forget about $10,000 saved. Instead, you will remember the overall experience — the vendor’s skills (or lack thereof), capabilities, responsiveness, attention to detail, ability to deal with unexpected problems, flexibility and — most important — results.

Prepare for outsourcing success by understanding your needs, evaluating vendors objectively, and considering the entire value proposition.

Dave Miles is director of IT Solutions for CIBER in Michigan and Wisconsin, and can be reached at (248) 352-8650 or at dmiles@ciber.com. CIBER Inc., founded in Detroit in 1974, is a global IT consulting firm which builds, integrates and supports critical business applications in custom and enterprise resource planning environments. Visit www.ciber.com.

Monday, 02 February 2004 06:44

The leveraged recapitalization

Business owners who are considering a sale to achieve liquidity often overlook a viable and potentially attractive transaction alternative -- the leveraged recapitalization or "recap."

Through a recap, sellers can monetize a portion of their investment now and reduce their risk profile, while maintaining an ownership stake in the business and the opportunity to receive another -- and potentially even higher -- payoff down the road.

In a recap, the seller hires an investment banker to raise new debt and equity securities to finance a sale of a portion of the business (generally 30 percent to 80 percent), resulting in a cash distribution to the selling shareholders.

Recaps are appropriate for business owners who are bullish on the future value of their businesses, but may, for any number of reasons, desire some near-term liquidity. In this case, sellers may achieve substantial liquidity today, but retain equity that will be monetized in three to seven years when the financial sponsor leading the recap sells its position.

The combined proceeds realized by the sellers in the recap and subsequent sale often can exceed the value that would be realized in a full sale of the business through an auction today.

Recaps also can be used to create a "floor price" in an auction setting. If a full auction process fails to yield a price in excess of the expected value of a recap (a value that can be conveyed to auction participants at the outset of the process), the auction can be cancelled and a recap pursued.

Several market trends favorable to recaps will persist throughout 2004. First, strategic acquirers continue to focus on asset divestitures and internal profit improvement opportunities rather than on acquisitions to drive earnings.

Second, domestic institutional equity funds have billions of dollars in capital, causing them to pursue investment opportunities aggressively. Finally, credit markets eased substantially over the last six months of 2003, permitting the use of substantial leverage to finance a recap.

In short, strategic acquirers are not paying up, and the private debt and equity markets currently make recaps financeable at high valuations.

Structuring recaps

When structuring a recap, sellers and their advisers need to address three key issues:

* An acceptable and achievable valuation for the business

* An appropriate and achievable capital structure for the business

* The selling shareholders' desired ownership retention

For example, consider a company with greater than 10 percent revenue growth, high operating margins, a defensible market position in a strong industry, a leverageable balance sheet, manageable capital expenditures and working capital, and greater than $10 million of annual EBITDA. As illustrated, with a moderately leveraged capital structure, this company could pursue a recap at approximately seven times its EBITDA, or $70 million.

This valuation may exceed what a strategic acquirer is willing to pay and, at a minimum, this valuation should set the floor for an auction.

Assuming the business were debt-free at the time of the recap, the seller would receive a pre-tax cash distribution of nearly $62 million ($70 million less the $8 million reinvestment) and still own 30 percent of the company. In addition to the large cash distribution at close, the selling shareholder's retained ownership could be worth an additional $20 million upon exit in year five.

As business owners consider exits during 2004, the expected value of a recap should always be analyzed by sellers and their advisers. Depending on the sellers' need for liquidity and their desired ownership retention, an auction sale to strategic acquirers may still be preferable, but the expected value of the recap should represent the minimum acceptable bid in the process.

Steve Miles is a director at Brown, Gibbons & Co. mergers & acquisitions and corporate restructuring practices. Reach him at (312) 658-1600 or smiles@bglco.com.