How to minimize the risk in M&A transactions

David E. Shaffer, director, Audit & Accounting, Kreischer Miller

David E. Shaffer, director, Audit & Accounting, Kreischer Miller

Companies spend more than $2 trillion on acquisitions every year, according to an article in Harvard Business Review. Yet studies frequently cite failure rates of mergers and acquisitions (M&A) between 70 and 90 percent.

David E. Shaffer, a director in the Audit & Accounting practice at Kreischer Miller, says problems are often the result of poor planning. Companies are enticed by the opportunity to create synergies or boost performance and fail to consider all ramifications of an acquisition.

Smart Business spoke with Shaffer about ways to mitigate the risk and ensure a successful transaction.

Why is the M&A failure rate so high?

Many companies don’t establish a clear business strategy for mergers and acquisitions. Some questions that need to be answered include:

  • What are the goals of the merger or acquisition?
  • Do you want to leverage existing resources or create a new business unit?
  • What is the maximum price you are willing to pay?
  • Must the seller agree to some holdback of the price?
  • What happens to administrative functions and management of the target company?
  • Must key employees sign agreements to stay?
  • Will you negotiate between an asset purchase and a stock purchase?
  • Is culture important?

You should be proactive in identifying candidates for acquisition. Companies that have done many acquisitions tend to ignore requests for proposals because the sellers in such situations usually go with the highest price. They reason that the law of averages is against them and at least one competitor will overpay.

Instead, companies involved in many acquisitions prefer to target entities and establish a relationship before that stage in order to avoid a bidding war.

How should the due diligence process be conducted?

It’s important that you don’t take shortcuts in your due diligence. Hire professionals who are knowledgeable about the industry; they can negotiate better deals for you because they are not emotionally attached and can push harder for seller concessions.

Due diligence should address internal and external factors that create risk in the acquisition and focus on key factors driving profitability — employees, processes, patents, etc.

The more risk present, the more you should ask for holdback in the selling price. For instance, if much of the profit is derived from a few contracts, require that the contracts be renewed under similar terms if the seller is to receive the full purchase price.

M&A failures often result because buyers concentrate too much on cost synergies and lose focus on retaining and/or creating revenue. Client retention at service organizations is at significant risk following a merger or acquisition, according to a 2008 article from McKinsey & Company. Clients will receive misinformation, so it’s important that the acquiring firm step in quickly to assure clients that service levels will equal or exceed what they have been accustomed to expect.

What needs to be done post-acquisition?

It’s important to have a clear post-acquisition plan, including financial goals, with as much detail as possible. The quicker value is created by the acquisition, the better the result for the buyer.

Key post-acquisition steps to ensure a successful integration include:

  • Developing the organizational structure.
  • Developing sales expectations.
  • Identifying what processes and systems will change, and when.
  • Developing performance measures.

Finally, you also need to hold key management responsible for producing results.

David E. Shaffer is a director, Audit & Accounting, at Kreischer Miller. Reach him at (215) 441-4600 or [email protected]

Social Media: To keep in touch with Kreischer Miller, find us on Twitter: @KreischerMiller.

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How to prevent deal-breaking mistakes when selling your business

Brian Reed, partner, Transaction Advisory Services, Weaver

Brian Reed, partner, Transaction Advisory Services, Weaver

Selling a business is challenging. From vetting potential buyers to preparing financial statements to keeping negotiations on track — all while running your company — there’s a lot that can go wrong. In fact, almost no detail is too big or too small to affect the eventual outcome of merger and acquisition (M&A) deals. However, you can reduce the odds of a mistake by knowing where similar transactions have gone astray.

“It’s important to talk to owners who have successfully completed sale transactions and to work with experienced M&A advisers,” says Brian Reed, partner in Transaction Advisory Services at Weaver.

Smart Business spoke with Reed about common M&A mistakes and key items to resolve before closing a deal.

How might sellers hurt their chances before putting their business on the market?

You risk a letdown when you make overly optimistic future earnings projections or put too much weight on variable measurements, such as the sale prices of similar companies in stronger M&A markets. If you won’t budge from an unrealistic sale price, you could drive away an appealing buyer.

Work with a professional adviser to assess your company’s value as well as estimate an offering price the market can support. The two may not match because the price depends on contemporary economic, M&A market and sector conditions.

Where does timing factor into this?

Other critical seller mistakes revolve around timing, whether internal or external. For example, selling at the wrong time, at the end of a market cycle, could mean fewer buyers and possibly lower offers. If your sector has experienced a recent wave of M&A deals, the buyer base could be depleted, and you may want to hold off.

Sometimes sales are spurred by internal circumstances, such as the retirement of a founding owner, but these situations shouldn’t rush the sale. If your company is not ready for the market, consider appointing an interim head to make preparations and screen potential buyers.

Sellers, particularly those selling for the first time, often greatly underestimate the amount of work and hours it takes to prepare for sale. Have you allocated enough time to implement strategies to maximize your sale’s value? Is your company ready to promptly and accurately respond to hundreds of specific buyer requests? If you haven’t assembled a team with the time and resources to handle these requests, it could bring your potential deal to a standstill and deter otherwise interested buyers.

How might housekeeping impact deals?

Housekeeping issues aren’t trivial. They include essential tasks such as ensuring that contracts and legal obligations are in order. Some items that can trip companies up are:
• Poor accounting. If your financial statements and records are not properly organized and presented, it reflects poorly on your management, and the due diligence process will likely take longer. Sloppy accounting errors could mean tax or legal issues after the deal closes.
• Neglecting key players. Buyers want to know that key employees will stay onboard once the sale is completed. Make sure your top performers are offered financial and other incentives to stay.
• Locking in contracts. Don’t renew an expensive vendor contract as you’re about to transfer ownership. Buyers don’t like long-term contracts they didn’t negotiate, particularly if they’ll be penalized for breaking them. Negotiate short-term contracts or push for favorable terms.

What are some common loose ends to watch for and resolve?

Leaving loose ends hanging won’t endear you to your buyer, as they could hinder integration and future profitability. Some common unresolved internal issues involve:
• Minority interests. Buying out minority investors or shareholders before a sale means the buyer won’t need to deal with their demands later.
• Employee controversies. An integration team doesn’t want to deal with open legal issues, for example, while trying to build a new culture.
• Copyright confusion. Make sure all patents, copyrights, trademarks and other intellectual property holdings are in order. If you’ve failed to verify and document ownership, you may risk the deal’s value.

Brian Reed is a partner in Transaction Advisory Services at Weaver. Reach him at (972) 448-6936 or [email protected]

Blog: To stay current on audit, tax and advisory issues that may impact your business, visit Weaver’s blog.

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How to review company information in the M&A process

Patricia A. Gajda, Partner, Brouse McDowell

Patricia A. Gajda, Partner, Brouse McDowell

Rachael Mauk, associate, Brouse McDowell

Rachael Mauk, associate, Brouse McDowell

When acquiring a company, it’s important that there are no surprises after an agreement has been signed. That’s why it’s critical to do your due diligence to ensure that there are no unknown problems that might arise after the closing.

“Companies that conduct a volume of transactional work — a lot of acquiring of businesses — understand the importance of getting information on the target company and assembling the proper team to review it,” says Patricia A. Gajda, partner and chair of the Corporate Group at Brouse McDowell.

Smart Business spoke with Gajda and Rachael Mauk, an associate at Brouse McDowell, about what areas to look at and the potential pitfalls in the due diligence phase of an M&A transaction.

What is involved in the due diligence process?

From a business, legal and financial perspective, you look at everything in the company that could have a risk or liability associated with it.

Usually the buyer will provide a list of documents for the seller to gather, including:
• Organizational documents.
• Financial documents, including three or four years of audited and unaudited financial statements, monthly statements, any audit reports, receivables, etc.
• Contracts with vendors, customers, etc.
• Real property information such as title documents, deeds, title insurance, zoning variances and leases.
• Permits and certifications.
• Environmental testing reports, remediation records, audit information.
• Intellectual property (IP) including patents, copyrights, trademarks, trade secrets, confidentially agreements, and licenses and software agreements.
• Employee information.

You also want to investigate the company to examine past and pending lawsuits, insurance claims, product liability questions, warranty information — how often there were product warranty claims — and delve into the history.

Due diligence can play an important role in determining the final transaction price. For example, if you find out the target company you intend to buy has a $5 million lawsuit pending against it, you will want to determine if and how that will negatively affect the company, even if you’re not going to take the liability for the lawsuit.

Are there things you find that might cause you to back out of a deal?

It will depend largely on your motivation for acquiring the target company. You may be buying a company because they have the latest product, which you want to incorporate into your product line, only to discover that the target company doesn’t own the IP or the IP associated with the product was not protected. Alternatively, you might uncover product warranty issues that bring into question whether the product works, or review the financial records and find out it’s not a profitable line of business.

It’s not just attorneys who do the due diligence. A company will put a team together to look at the various segments of the business. Accountants will look at the financial statements and tax returns. If there are environmental issues, you might have an environmental consultant do additional testing.

What pitfalls do companies experience in doing due diligence?

They do not allow for adequate time for due diligence. A strategic buyer is generally familiar with the business, so it may think it already knows everything. Things can fall through the cracks, so leave enough time for adequate review, testing and follow up. The process can take from a few weeks to 30 days or more if it’s a complicated business.

Typically, due diligence is done simultaneously with negotiating the purchase agreement. It might result in a purchase price reduction because something discovered doesn’t add up to the price that was originally discussed. You might find there’s the potential for environmental liability and seek an indemnification for that specific item — due diligence can lead to specific requests in the purchase agreement.

Once you’ve completed the due diligence, you’re close to signing the transaction agreement and the purchase can go as planned.

Patricia A. Gajda is a partner and chair of the Corporate Group at Brouse McDowell. Reach her at (216) 830-6830 or [email protected] Rachael E. Mauk is an associate at Brouse McDowell. Reach her at (216) 830-6846 or [email protected]

FOLLOW UP: Pat Gajda and Rachael Mauk are based in Brouse McDowell’s Cleveland office.

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Business pulse: Private equity firms are hungry for quality companies

In a market hungry for deal flow, high-quality companies are in demand and valuation multiples are rising. Private equity firms continue to be active bidders at the table with the middle market being fertile ground for buying activity.

GF Data, which reports on private equity transaction activity in the lower middle market (deal values between $10 and $250 million), recently cited valuation statistics from 2012 that point to a market premium paid for quality, size and desirable industry, which, when combined, the sum of the parts can achieve a multiple of EBITDA in excess of eight times for a well-performing business, according to Private Equity Professional Digest.

PitchBook, another reporting firm focused exclusively on the private equity market, cited that more than a third of deals in 2012 had an EBITDA multiple of seven and a half times or greater, lending further support to healthy valuations in the marketplace.

With nearly $100 billion (private equity funds of $100 to $1 billion according to PitchBook) in uninvested equity capital, motivated sellers with companies that possess strong management, have shown solid performance and are in attractive industries can feel confident that the private equity radar is up for those businesses. With ample debt financing today, sponsors are open to a myriad of strategic options — from a dividend recapitalization to a partial or outright sale — for quality companies.

Local private equity firms were active in March. Linsalata Capital Partners completed its first acquisition of 2013 with Signature Systems Group, a New York-based manufacturer of specialty ground surfaces and coverings selling to more than 3,000 domestic and international customers. Signature’s founder and CEO reinvested alongside LinCap in the transaction. Financial sponsor Dubin Clark & Co. exited its investment in the sale. The sponsor completed two add-on acquisitions after purchasing the company in 2007.

Resilience Capital Partners acquired a majority interest in Memphis-based Aerospace Products International, a global aviation parts and equipment distribution and supply chain management firm. Its parent company, First Aviation Services, retained a minority equity interest in the company. The Cleveland sponsor completed five deals in 2012, including CR Brands, a manufacturer of branded and private label laundry and household cleaning products based in West Chester, Ohio, acquired from Juggernaut Capital Partners. ●

Andrew Petryk is managing director and principal of Brown Gibbons Lang & Co. LLC, an investment bank serving the middle market. Contact him at (216) 920-6613 or [email protected]

What to expect from the M&A market in 2013

Albert D. Melchiorre, President, MelCap Partners, LLC

Albert D. Melchiorre, President, MelCap Partners, LLC

Considering the uncertainty in the stock market, 2012 turned out to be a good year for mergers and acquisitions (M&A), and the outlook is even better for 2013, says Albert D. Melchoirre, president of MelCap Partners, LLC.

“Last year was pretty tumultuous, with the overwhelming European debt crisis, a slowdown in certain emerging markets, uncertainty about the presidential election and its potential impact from a capital gains tax perspective, and the fiscal cliff debate,” Melchoirre says. “But there were several factors that would indicate reason to be optimistic about the M&A market in 2013.”

Smart Business spoke with Melchoirre about those factors and his expectations for the M&A marketplace in 2013.

How was 2012 from an M&A perspective?

The number of domestic M&A transactions was down by 4.6 percent from 2011. However, the average deal size increased 13 percent — from $138 million to $156 million. From a private equity standpoint, fundraising increased 31 percent compared to 2011. That bodes well for future M&A.

It’s interesting to note that deal volume was up 56 percent in December compared to November.

What was the reason for the end of the year activity?

The primary driver was the capital gains tax increase in 2013. There was concern that if President Barack Obama was re-elected taxes were going to go up significantly. The M&A process typically takes six to nine months, so that started before the election outcome was known. But there was pressure to try to get something done before the end of the year.

Another situation driving transaction activity was private equity dividend recaps.  Many PEGS were going to the bank and taking out large dividends so the money would be taxed at the lower rates in 2012. They didn’t have enough time after the election to sell the business, so they paid out large dividends instead.

Because of the influx of closing activity in the fourth quarter of 2012, my sense is that 2013 will start out slowly. But I’m cautiously optimistic. When we look back at 2013, the numbers may be flat or down slightly because there isn’t enough time to make up for that lull.

Why are you ‘cautiously optimistic’ about the M&A market in 2013?

Some of the positive signs are the large amounts of cash reserves on corporate America’s balance sheets. The S&P 500 alone has over $1 trillion in cash, which is very strong. Combine that with favorable credit terms in the banking market and improved consumer confidence, and the elements are there for a solid year.

Another positive sign is more clarity with respect to the tax situation. Now business owners won’t be dealing with making decisions based on unknown, pending tax law changes. There’s something to be said for certainty. Uncertainty creates a tendency to be hesitant to make a move. When people know the rules of the game they can make decisions accordingly.

Do you expect corporate cash reserves to be utilized this year?

Absolutely. When you have corporate buyers sitting on these large cash reserves they have to deploy that capital in order to grow their business — there’s only so much equipment you can buy. When companies are sitting on trillions of dollars, one of the ways to accelerate that growth is through acquisitions. Cash is king and you can take advantage of opportunities in the market to grow and expand your business. And that cash will have to be deployed — the public markets will not let them sit on those reserves.

Last year, 75 percent of our sell-side deals were sold to strategic buyers who were sitting on a large amount of cash. Corporate buyers are acquiring competitors or complementary businesses through vertical or horizontal integration. With deals involving a private equity buyer, if they don’t have a portfolio company it would strictly be a financial play.

While I’m cautiously optimistic we’ll see more of the same activity this year, it looks like 2014 could be even better.

Albert D. Melchoirre is president of MelCap Partners, LLC. Reach him at (330) 239-1990 or [email protected]

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How using forensic investigative tools in an acquisition can detect fraud

Michael Maloziec, Accountant, Cendrowski Corporate Advisors LLC

Michael Maloziec, Accountant, Cendrowski Corporate Advisors LLC

Many companies undertake an acquisition using only a financial due diligence process. However, for a greater chance of detecting potential misrepresentations, companies need to incorporate forensic investigative tools into their standard due diligence process.

“Forensic techniques will help point out and isolate areas of potential fraud as well as any irregular or suspicious activity,” says Michael Maloziec, an accountant at Cendrowski Corporate Advisors LLC.

Forensic analysis during the due diligence process can uncover accounting improprieties that could overinflate the value of a target company. Performing these two services together will give increased assurance that projected performance is achievable, Maloziec says.

“Adding in forensic analysis is a crucial step toward assuring your acquisition is successful. It can allow you to see past ‘closed doors’ into areas you might not think to look,” he says.

Smart Business spoke with Maloziec about forensic techniques and their benefits during the acquisition process.

How large of a role can fraud play?

It’s huge. The Association of Certified Fraud Examiners Report to the Nations found a typical organization loses some 5 percent of its revenue to fraud each year. Even though that does not sound like a significant number, when applied to the Gross World Product, this figure translates to a potential projected annual fraud loss of more than $3.5 trillion.

What are some caveats to keep in mind?

Companies will always showcase their business in the best possible light. Managers will ‘polish the apple’ so to speak. Bear in mind the sales numbers might be misstated, which can overinflate the value of the company. Also, companies will not disclose everything, so it is important to proceed forensically during your due diligence process. Always be aware of potential manipulation in reserves and estimates. Reserves are one of the most common areas for fraud to occur because it is under management’s discretion. These caveats will help you recognize and point out areas that raise red flags.

How can you protect yourself from fraud?

One method is to look behind the numbers. You should always carry a certain sense of forensic skepticism and never make assumptions during any part of the due diligence process. Be sure to ask questions that will dig into transaction details and note any instances that provoke uncertainty. Don’t forget about applying simple common sense. Ask yourself, ‘Do the numbers flow with the current business plan that is set in place? Do management’s representations make sense?’ You can also utilize a number of analytical tools to spot any anomalies.

What analytical tests should be performed?

A great way to start would be to forensically analyze the financial statements over the past few years. During analytical testing, it is important to review current and past events in order to isolate anomalies from known events. You can utilize a variety of different ratio analyses, which can be an excellent tool in detecting red flags. Ratio analysis measures the relationship between various financial statement amounts and tracks how past numbers are trending with current results. To gain some perspective, compare company financial information to similar industries that hold the same standards, such as size, geography or sector. There are also numerous computer software programs that will assist in narrowing the scope and provide the capability of recognizing potential fraud.

How should a company approach this issue?

Start by assessing the business processes. Processes provide guidance to employees and assure accurate reporting. Acquirers need to review and understand the capacity and capability of their target organization. As part of the due diligence process, the acquirer should examine the current processes and identify any weakness or holes that could allow for erroneous or unauthorized transactions. A great method to gain insight would be to perform an internal risk assessment, which can help identify industry risks that might not be so obvious. This allows managers to zero in on areas that might be susceptible to potential fraud before they become a problem.

Michael Maloziec  is an accountant at Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or [email protected]

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How to normalize your company’s historical earnings

Albert D. Melchiorre, President, MelCap Partners, LLC

Personal and one-time expenses can make getting a true picture of a company’s earnings history difficult, particularly in smaller family businesses. This presents challenges when marketing the business for sale, as the buyer and seller need an accurate representation of how the business has performed. Normalization adjustments are the solution.

“Normalizing a company’s historical earnings means adjusting them to eliminate personal or one-time expenses that are not essential to operating the business in normal course. Normalization allows the seller to show true operating earnings on a historical basis, without being penalized for showing nonessential expenses running through the business. This also allows the buyer to get a true picture of the operating earnings for purposes of determining value,” says Albert D. Melchiorre, president of MelCap Partners, LLC.

Smart Business spoke with Melchiorre about how this process impacts the merger and acquisition (M&A) process.

What are some common adjustments used in normalizing historical earnings?

The use of normalization adjustments, which are sometimes called addbacks, is often as much an art as it is a science. An experienced M&A adviser is essential for determining what are appropriate and supportable addbacks before the business goes on the market.

Some common normalization adjustments include: elimination of personal automobile or travel expenses, excess rent expense, excess or above-market salary or other compensation paid to the owner, as well as excessive or one-time professional fees.

In the case of normalizing excessive professional fees, the seller needs to consider if the services provided by professionals were absolutely essential for normal business operations.

What does the amount of adjustments say about the seller and his or her business?

Use of normalization adjustments ultimately has a direct impact on the value of the business, but it also sends a message to prospective buyers.

While a seller does not want to leave any value on the table by missing legitimate addbacks, it can be the case that being too aggressive in their use can cause a prospective buyer’s guard to go up. It is an important balancing act for the seller to try and be aggressive enough to legitimately maximize the company’s value while also maintaining credibility and building trust with the prospective buyer.

The M&A adviser should be able to uncover solid addbacks while vetting out those that are questionable or unsupportable before going to market.

Should I consider possible synergies with buyers when normalizing earnings?

Financial buyers, such as private equity groups, may or may not currently own a business that is similar to the seller’s business. To the extent there is a strategic fit, the seller may think about all the cost savings that can be realized by the buyer if the businesses are combined. In doing so, the seller may make assumptions about these anticipated cost savings and include them.

While these savings may be legitimate, sellers should realize that buyers are reluctant to pay for the synergies that they bring to the table. It’s also important to remember that each buyer is different, and in order to submit a uniform presentation of normalized earnings, these types of synergies should most often be excluded when marketing the business.

It is a good idea to discuss these types of synergies with your M&A adviser to get a sense of the flexibility that a strategic buyer might have during the bidding process, as well as how to convince the buyer to pay for some of the synergies this could potentially bring in order to successfully land the deal.

Albert D. Melchiorreis president of MelCap Partners, LLC. Reach him at (330) 239-1990 or [email protected].

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How to ensure you’re picking the right M&A adviser for your needs

Albert D. Melchiorre, President, MelCap Partners, LLC

“This year’s election is critical to the future success of our country,” says Albert D. Melchiorre, president of MelCap Partners, LLC. “The selection of the next president of the U.S. should be based on experience, track record and shared values. So too should it be with the selection of your M&A adviser.”

He says much like each election is pivotal to the country’s progress, selling your business will have grand implications on the rest of your life, so it’s wise to put the transaction in the hands of an expert.

“It’s a very involved process with many risks,” he says of the merger and acquisition process. “Making a mistake could result in a bad transaction, which is why it’s important to find help.”

Smart Business spoke with Melchiorre about the role of an M&A adviser and what qualifications to look for when
selecting one.

What is an M&A adviser, and what is his or her role in merger and acquisition transactions?

An M&A adviser is a financial adviser who has experience in completing merger and acquisition transactions. The role of this adviser is to represent the interests of the business owner in achieving their goals and objectives through either a merger or acquisition transaction. This adviser also quarterbacks the deal team, which typically includes attorneys, accountants and other advisers who help to successfully compete a transaction.

What does the resume of a qualified M&A adviser contain?

An experienced adviser should have a relevant and proven track record of successfully completing transactions in your field of business. They should also have an applicable education, as well as the proper financial securities license to complete the transaction. Additionally, look for an adviser who has the relevant industry experience necessary to understand the nuances of your industry.

There are a few ways to qualify potential advisers. One way is through a referral from the seller’s trusted advisers. Many M&A advisers are fairly transparent in their experiences, so you can conduct an initial screening by visiting their website to see the number of deals they’ve completed. Also look to see if they have experience in the industry in which you do business and that they have qualified personnel at the firm.

While you’re really hiring a firm, it’s equally important to choose the right individual. You can have a firm with a well-known name that has been through many deals, but you still need to know that each individual within the team is qualified to handle your transaction. You don’t want an inexperienced adviser on your deal.

How does a company decide whether an M&A adviser will help facilitate its sale?

In a sale transaction, one role of an M&A adviser is to help business owners achieve their goals and objectives, but also to maximize the value of their business. An experienced adviser can bring the appropriate parties to the table and create a competitive environment where that can take place.

There are many aspects to completing an M&A transaction. Having an adviser who can expect the unexpected will help you navigate through the land mines associated with completing the deal. This will likely be the most significant liquidity event you’ll ever face, and your adviser should treat it as such. Business owners in the middle market will only sell their company once, so it’s important that they’re hiring an experienced adviser who has a record of facilitating and closing transactions.

What are the risks of negotiating an M&A transaction without an adviser?

You should have an experienced deal team to ensure you’re not being taken advantage of through the terms and conditions of the deal. They can also help maximize the value of the transaction, while lessening the risk of not getting a transaction done.

It’s a very time consuming process that involves highly confidential information. As a deal is pursued, there is the risk that customers and employees could find out about the sale too soon, or a buyer could be brought to the table who is not serious, which is a concern when you’re talking to a competitor. An experienced adviser can make sure confidential information is properly disclosed and facilitate its secure transfer.

When do you bring in an adviser?

Bring in your M&A adviser at the forefront, before you even embark on the process. You need to make sure you’ve taken the steps necessary to prepare yourself for an appropriate sale and get a sense of whether your goals and objectives are achievable in the current market. Right now may not be the time to sell your business, but there may be some steps you can take to make a future sale both successful and efficient. A qualified adviser can present you with the best options and advice to achieve your goals.

On the buy side, an M&A adviser can help by assessing the value of the company you’re considering to ensure the offer is competitive. Your adviser can help you determine how you’re going to finance the acquisition and can also assist you with your due diligence as the process is closing.

An M&A adviser can make the initial contact with the company you’re interested in acquiring to gauge its interest. He or she can be there earlier in the process to help determine and develop your acquisition criteria, and use it as a basis for the search process by identifying companies through other intermediaries that may have companies for sale. Your adviser can also help you develop a list of suitable acquisition candidates and initiate contact with them.

Albert D. Melchiorre is president of MelCap Partners, LLC. Reach him at (330) 239-1990 or [email protected]

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How a working capital hurdle in an M&A transaction can protect a buyer’s interests

Tom Vande Berg
Partner, Transaction Services Group
Crowe Horwath LLP

The purchase price in the majority of merger-and-acquisition transactions is calculated using a common formula: Multiply the target company’s earnings before interest, taxes, depreciation and amortization (EBITDA) by an agreed-upon multiple.

However, Tom Vande Berg, a partner with Crowe Horwath LLP’s Transaction Services Group, says a seller can juggle a company’s assets and liabilities before the deal is finalized in ways that reduce its future cash flows without affecting its EBITDA.

“This can lead to the purchase price staying the same, although the company’s future cash flows could be considerably different than what the buyer expected,” he says.

This is where a working capital hurdle can be used to protect the buyer’s interest in future cash flows.

Smart Business spoke with Vande Berg about working capital hurdles and how they can positively affect M&A transactions.

What is a working capital hurdle?

A working capital hurdle is a predetermined amount of working capital built into the purchase price of a business. It can be a specific amount or set as a range, and it can be adjusted up or down based on the actual working capital at closing. Working capital hurdles help protect the buyer from changes in the targeted company that don’t show up in EBITDA but that have the potential to reduce expected future cash flows.

The adjustment typically is dollar for dollar, but it could be derived from a tiered structure in which the purchase price would change by a predetermined amount based on available working capital when the deal closes.

What is the benefit of working capital hurdles?

A working capital hurdle attempts to include in the transaction the normal working capital needed to run the business. Without the protection of a working capital hurdle, the buyer could end up with less future cash flow than bargained for because it is possible for a seller to maintain its EBITDA but not deliver the promised mix of assets and liabilities.

A working capital hurdle also has noncash-flow benefits such as increasing the likelihood the seller will maintain normal course business relationships.

Assuming cash is excluded from the definition of working capital, a seller could manipulate its assets by aggressively collecting accounts receivable. If receivables are reduced ahead of the transaction, the buyer will not receive the expected future cash flow from them.

A seller also could liquidate inventories by reducing production and inventories for sale. When the buyer then takes over the company, it will have less inventory to sell and will need to incur higher-than-expected costs to rebuild inventory levels. Another possible detrimental action by the seller is slowing payments of accounts payable, which will leave the buyer facing higher-than-expected obligations when the company is acquired.

A working capital hurdle can pre-empt certain noncash-flow issues, such as any ill will that might develop among vendors if a seller stretches accounts payable ahead of closing. It can also help a buyer deal with other issues that affect a deal’s bottom line.

For example, consider a target company that does not maintain an accounts receivable allowance for bad debt. Say the buyer finds that the company should have reported an allowance throughout the year preceding the transaction. Adjustments made by the seller to provide for the allowance at the beginning and ending dates of the analysis period will make it look as if there was no net income effect, and both the EBITDA and the purchase price will not change. However, the balance sheet could overstate the asset balance for accounts receivable, which means it has also overstated working capital. Hurdles can include adjustments for such overstatements and would result in a lower purchase price.

Sellers can also benefit from a working capital hurdle, as it can create a higher purchase price for delivering working capital above the hurdle.

How is the amount of a hurdle determined?

Most often, a hurdle is calculated based on the average monthly adjusted working capital over 12 months. The asset or stock purchase agreement might, for example, define working capital as current assets (excluding cash), less current liabilities (excluding debt), less items that are excluded by definition in the purchase agreement plus/minus pro forma or due diligence adjustments determined during the financial due diligence analysis.

However, a 12-month analysis is not always appropriate because, for example, it might not reflect the company’s current working capital needs if it is experiencing substantial growth. If revenue has grown 75 percent in the second half of the year, it is likely that the working capital at closing will be higher than a hurdle calculated on a 12-month average, which would drive up the purchase price. In this case, the hurdle might best be calculated based on the most recent three or six months.

It is also important to note that 12-month hurdle calculations generally factor out seasonality, but working capital levels could swing significantly depending on whether the purchase is made in or out of season. During a peak-season purchase, working capital is likely to be higher than average, leading to a higher purchase price, while the opposite is true for an off-season purchase.

Like most points in an M&A transaction, the hurdle amount is open to negotiation.  However, the existence of the hurdle should usually be non-negotiable.

Tom Vande Berg is a partner with Crowe Horwath LLP’s Transaction Services Group. Reach him at (214) 777-5253 or [email protected]

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How the furious consolidation of the U.S. health care industry might impact your health plan

Chris Pritchard, National Health Care Practice Leader, Moss Adams

With assistance from the Patient Protection and Affordable Care Act (PPACA), millions more Americans will now have basic health coverage and will be seeking services possibly resulting in billions of dollars flowing into the US health care marketplace. The health care industry has begun reacting to this new legislation and expected inflow of insured Americans, by moving rapidly toward a “bigger is better” model, says Chris Pritchard, national health care practice leader at Moss Adams.

“A key concept that consumers of health care services will deploy and one to which the health care market is reacting to is the concept of consumerism. Consumerism embodies the process through which consumers consider at a minimum three basis purchases attributes when choosing which health care services to buy. The three attributes consumers will consider at a minimum are cost of the services being provided, the quality of the services being provided and access to the required services needed,” says Pritchard.

To meet demands for better quality of care for less, Pritchard says health care providers have begun to merge and are creating affiliations to improve quality statistics, take advantage of cost synergies and provide for increased capacity to improve access to services being purchased by the public.

Whether it is the government, an employer or an individual, that entity is trying to get the highest quality in the quickest time for the least amount of money.

Smart Business spoke with Pritchard about how this transformative consolidation has positive and negative ramifications for employers and employees.

How is the concept of consumerism impacting health care?

Health care organizations know the importance of consumerism. States have departments that monitor quality, cost and access, while independent regulatory and watchdog agencies do the same. Health care providers themselves publish favorable quality of care, price lists and access time statistics on their websites for public consumption and consideration in their pursuit of services.

Consumerism will also be a factor with the state-based health insurance exchanges set to begin in 2014. Participating insurance companies will offer benefits in the exchanges, and employers and or employees will make their purchase decisions using cost, quality and access to purchase coverage. California has one of the largest groups of uninsured people, especially when considered on a per capita basis, so these exchanges will likely have a large effect. Employers have the choice of providing high-quality benefits to their employees as a retention and recruiting benefit, or they can choose to not provide benefits at all and have their employees participate in state exchanges to purchase health care coverage.

What are some examples of health care consolidation?

The health care marketplace is making substantial moves, as the number of transactions — health care affiliations, combinations or acquisitions — are up tremendously compared to previous years. Large private equity funds have put billions of dollars in play to reap the benefits of these mergers and acquisitions. In addition, on the quality side, community hospital providers that don’t have a higher quality score are looking for health systems or academic medical centers that do have high quality scores and available financial resources with which to affiliate or merge. That, in turn, helps attract additional patients. There is also the idea that the larger an organization gets, through economies of scale, the higher the probability of achieving cost synergies.

Physician groups have been an area of focused consolidation. They are primarily the gatekeepers of referrals, so organizations that can control physician groups can then control referrals into their organization and the associated revenue streams.

What are the possible negative implications of consolidation?

The potential problem is that health care organizations could get so large that eventually they have geographic leverage over the federal, state government payors as well as the local communities. Employers could potentially face higher costs because of the geographic control these organizations will have on the marketplace pricing of services.

In the early 1990s, a similar phenomenon transpired where mega health systems merged to a size where the Federal Trade Commission and or the Justice Department moved to break up these groups because they had too much control over the marketplace. There are investigations under way in California today to ensure that those grouping together won’t have the opportunity to raise prices and create a monopoly. So far, most of the mergers, affiliations and consolidations have gotten through the anti-trust laws, but at some point, the groupings are going to run into that.

Will this larger block of insured’s lessen the quality of care that employers and their employees can expect?

The quality of care won’t likely change because health care providers are or will be partly reimbursed based upon quality measures. The issue is likely going to be access — whether they can continue to provide access with a large base of users coming in. Organizations are strategically trying to make their waiting rooms larger or are looking at the concept of concierge service to make patients feel like they are being taken care of.

An employer and its employees will need to decide what is more important. If insureds can’t obtain access, they may decide on a plan with lower quality and better access, or they may be willing to pay more for both high quality and access.

Consolidation isn’t likely to stop any time soon, even if the political climate changes and PPACA is repealed or amended. The funding for certain aspects of health care reform may differ with changes in Congress or the presidency, but regardless of what happens, the industry will continue down this M&A path.

Chris Pritchard is the national health care practice leader at Moss Adams. Reach him at (415) 677-8262 or [email protected]

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