Positioning a Business for a Merger or Acquisition

Part 1

Selling a business, in whole or in part, requires considerable strategic planning and preparation. Whether you are the CEO of a corporation looking for a new financial partner for a merger or acquisition, or the sole owner of a small business you have worked years to build and hope to find someone to carry on your life--s work, successfully closing a deal and putting together an optimal sale will depend on the steps you take to prepare for this unique event in the life of the business.

Validate Your Value Proposition

An M&A event is unique because it is outside the day-to-day operation of the business and will require additional effort and, potentially, the addition of dedicated resources to be performed effectively. You will need to plan for this additional effort. Whether you are looking for someone to acquire the entire business or just trying to bring on a financial partner that will leave you in charge of operations, you need to position the business to fully demonstrate its value proposition.

Your business should be positioned well ahead of the anticipated deal closing date. Ideally, planning will start at least a year ahead of your intended closing (and two years is not unreasonable) to capture and optimize your return. Of course, you may not be able to delay the closing for that long for many reasons, which will then constrain the activities you are able to take to prepare. The steps you take to position your business, and the extent to which you are constrained from taking those steps, will affect the outcome of the deal.

There is a school of thought that you should always operate a business as if it's for sale. I fully support that approach because it means paying constant attention to the optimization of the business' operating efficiency and paying close attention to its position in the market. This could potentially help limit your positioning activities. In practice, it may not be possible to do because there may be differences in the long-term versus short-term strategic approach you use when planning an exit. The argument is that continuing to emphasize a long-term strategy may enhance the value of the business, but are you ready to make the same capital commitments to a business when you're looking for a near term exit as one you intend to operate long term? You will very likely be trading near-term financial performance against long-term capital improvements. Unless there is a quantifiable value proposition improvement, it may not make sense to invest in long-term improvements. Strategic planning that includes the detailed development and maintenance of a road-map with key decision points for the business, including both near-term and long-term goals, is an important tool in making these decisions.

Set Reasonable Expectations

There are many reasons for seeking an M&A event, but some can best be described as "getting out from under."  If you're holding a fire sale and in a rush to exit, you probably won't achieve the same level of return as a business poised to move to its next stage of growth. It's important that you have a clear understanding of your goals and reasonable expectations of the businesses potential. More importantly, you have to be prepared to take the necessary steps and provide the needed resources to accomplish your goals. If you are holding a fire sale, though, don't be discouraged. Keep in mind that there are investors who look for fire sales.

Closing a good deal with the right investor takes planning and forethought. You may be an executive who regularly closes deals and moves from one business to another, or this may be the one time in life you make a deal to sell a business you've built from the ground up. You're preparing to enter a high stakes game that you may just be beginning to learn the rules too... and there are people who play the game all the time.

Given the stakes, don't be surprised if you find there are people who make up their own rules. Selling a business, whether you sell businesses frequently or this is an once-in-a-lifetime event, and whether you are looking for a strategic buyer or a financial investor, always includes an element of risk. This is a case of "let the seller beware." Given the stakes, it makes sense to seek professional help.

This is Not Like Selling Your Home

Some people mistakenly believe positioning a business is like staging a house. Staging a vacant house, by minimally furnishing it, is a marketing technique that allows prospective real estate buyers to envision themselves living in the home. Since your business is operating and not "vacant", a staging approach won't work. An investor wants to see products moving off the shelves and services being provided to understand how the business operates and you'll want the investor to see the business in operation to validate its value proposition.

For other people, positioning a business is about hiding the truth or somehow misleading potential investors about the shortcomings of the business. This is the "let the buyer beware" scenario. Hiding or falsifying information about the business is unethical and a fool's game that will be discovered in an effective due diligence and could end in litigation. Neither staging nor intentionally misleading is a good reason to position a business. Even problem businesses can be sold honestly to an investor looking for an opportunity to restore the business.

Even when you find yourself positioning a business for an asset sale, you will have work to do. The nature of business is that things can and do go wrong. Keeping a business at its peak operating efficiency is difficult. Markets change, major clients leave for reasons outside the business' control, and even nature disrupts the business' operations. Smart investors know this and understand that all businesses have warts somewhere. Investors will try to find the warts during their due diligence to help negotiate a better price. Be prepared to take the high road in negotiations by explaining, "We tried something. It didn't work and we moved on." Your goal is to be able to negotiate from a position of strength. You can't do this if you ignored an issue or tried to hide it. You should have already factored any issues in your valuation. "Yes, we introduced a loss leader product to see if we could sell into that market, but withdrew when it became clear our price wasn't supported." "It wasn't part of our normal operations." "We included the expense of our experiment as an adjustment when we calculate the EBITDA for the business."

It's More Like Selling Your Car

Actually, positioning a business is more like selling a car than selling a house. It's hard to keep the car clean, waxed and polished when you're driving around town, but when you know a potential buyer is coming by to see it, you will want to wash it and vacuum the floor mats. If you've been performing regular maintenance on the car you won't need to take the time to change the oil or do any of the other things that should be done as part of the normal maintenance.

Routine maintenance should be done on a periodic schedule... and you should have those records to show a buyer. A car buyer may look at the dipstick to see that the car has clean oil, but showing the receipts for the regularly scheduled maintenance you've performed adds value. Showing the records for the normal operation of your business is also a primary way to demonstrate value. You want to demonstrate that the business has been maintained. If the car's oil is dirty or the level is low, the buyer is likely to try to use this to negotiate a lower price. The same is true for a business. If your business uses specialized equipment, showing maintenance records for that equipment or a regular upgrade of your software says a lot about the value of your business.

If the business is operating well but starting to show its age, you may want to improve its value by updating the software to the latest version or installing the latest machine tools. To continue the car analogy, you might improve the curb appeal of the car by adding a new set of tires to get more value.

Effective positioning means you are prepared to make the tradeoff between the expenses of an upgrade against your sale price and keep a potential investor from negotiating the price down by saying it will cost them to do the upgrades. Positioning needs to be performed with your anticipated negotiating strategy in mind well before you get to the deal table.

Prepare to be Prepared

It takes committed resources to correctly position a business. Collecting your records in preparation for due diligence, recasting your financials to identify valid financial adjustments, identifying potential strategic partners, reviewing the legal structure and ownership of the business, writing a business plan that will serve as a marketing brochure for the business and on, and on... If your business is going to operate at its most efficient, your staff will be busy and may not be available for these additional duties, and you will not want to expose your exit to your staff. You need to consider bringing on a team that is committed to the success of the sale.

Read more in part two of this series where we explore some of the specific steps you will need to perform in order to effectively position your business and improve its value proposition.

Part 2

In part one of this three-part article, we discussed the reasons for positioning a business prior to an M&A event. Here we will discuss some of the critical steps that should be included in the positioning process. Whether you are seeking a full exit or looking for a capital partner who would leave you responsible for continuing the businesses operations, these activities are intended to shorten the sales cycle and improve the business' value proposition.

Let's start with an assumption: any time you fail to thoroughly answer an investor's due diligence question, you will appear unprepared, and that lack of preparation will lower the business' value proposition because it can put you at a disadvantage during negotiations. You may have built a great business that is growing quickly, but if you're not prepared to definitively explain your business model, you risk the investor not understanding the business' true value. Or if they do understand the value proposition, they'll think you don't understand the true value of the business and offer you a lower price as a result.

Step #1: Operations Assessment

You must enter the M&A process from a position of knowledge and strength. You accomplish this by performing an operations assessment to identify potential risks, allowing you to negotiate from a position of strength rather than ignorance, and an investor will not be able to use this as leverage.

For instance, if an operations assessment indicates a weak sales organization, an investor will likely use this and lower their offer because of the presumed expense to solve the problem. By understanding the weakness, you can convert this to a position of strength by looking for an investor seeking to merge the business into a group with a strong sales team who is more likely to understand that your value proposition is in the strength of your product, not your sales team. You'll be prepared and ready to show that you have already factored the sales risk and you will have turned a negative into a positive. An independent operations assessment can be a valuable positioning tool.

Step #2: Business Model Analysis

The next step in positioning needs to be an analysis of the business model so that it can be clearly explained to a potential investor. This requires understanding, not only of the strengths of the business, but its weaknesses as well. Telling a prospect that they may want to make an additional investment to improve sales can be a tough conversation, but you may want to show that there is greater potential than the current financials indicate and be able to show the upside without sales looking like a negative. If you appear unaware that sales is a weakness, you are responding from ignorance and have no negotiating position. The goal is not to be surprised by an investor's findings.

Step #3: Review and Recast Financials

The third step in positioning is to review your financials and recast them to present a realistic valuation of the business. Recasting of the financials is needed to determine what the normalized expenses and income are for the business and making adjustments to the financials to move any expenses or income that will not be normal to the continuing business. Recasting moves these expenses and income below the profit line, meaning a new owner would not incur the same expense or income. These are the Adjustments in calculating your EBITDA.

Small and startup businesses are notorious for expensing personal items. Does the president receive a company car as a benefit? If so, that car expense will lower the EBITDA if it is not moved below the line. This is a value proposition discussion, not a tax discussion. Remember, you will be negotiating a multiple of EBITDA to determine the value of the business, so you will want to eliminate that expense from the calculation. The same is true on the income side. Did you spin off an asset or offer a product that you received income from but which will not be part of the continuing business? That income needs to be reflected as an income adjustment.

This is a good time to have your CFO or CPA review what items have been capitalized versus expensed and the value of deferred sales. Small, valid changes can have a large effect when a multiple is applied, so decisions about these items need to be considered well in advance. This is one of the more critical areas that should be considered when you are considering long-term versus short-term strategic path analysis.

Step #4: Prepare a Pro Forma

The next step is preparing a realistic pro forma. Your financials show the past performance of the business, but the value proposition of a business exists in a continuum between the past performance and the future performance of the business. It is a projection of financial performance for at least the next three years. The pro forma should be based in fact and not appear like a game of liar's poker. If the business has been self-sustaining and has grown 15% annually in the prior three years and you are projecting a continuation of that growth over the next three years, you have a pretty sound basis for your projections. If, however, you're projecting more than 50% growth annually over the next three years, you have some explaining to do! If you can show the current growth track modified with additional investment and show the potential income change, you will create a strong negotiating position for a higher multiple. If the business generates monthly recurring revenue then the value proposition should be based on an annualized multiple of the December revenue rather than simply using the actual January to December revenue.

Read more in part three of this series where we explain the final three steps you will need to perform in order to effectively position your business for sale and improve its value proposition.

Part 3

In part two of this three-part article, we discussed the following critical steps that should be included in the positioning process: operations assessment, business model analysis, financials review, and preparation of a pro forma. Here we will discuss the final three of these critical steps. Whether you are seeking a full exit or looking for a capital partner who would leave you responsible for continuing the businesses operations, these activities are intended to shorten the sales cycle and improve the business' value proposition.

Step #5: Create a Business Plan

Now it's time to create your business plan. The business plan is the "book" that is handed to serious prospective investors. It is important because it is the takeaway they will likely take back to their board. The investment banker or broker you engage will write a plan as one of their services. Don't wait for them! Creating a draft version tells them how you see the business, including the market you sell to and your competition. If your business model is unique, this is how you will convey that advantage. Your banker or broker will do their own analysis and write their own version, but they will start with what you provide them. This exercise forces you to put your thoughts on paper, which helps to focus your story.

Step #6: Prepare for the Due Diligence

Positioning is also the time to start preparing for the investor's due diligence. Due diligence includes three facets: financial, legal and operations. In general, financial due diligence focuses on the past performance of the business, legal due diligence focuses on the current legal status of the business, and operations due diligence focuses on the future performance of the business.

Operations due diligence is where the most mistakes are made. Until I published my book, "Operations Due Diligence: An M&A Guide for Investors and Businesses" (published by McGraw-Hill), most investors could not correctly say what constituted an effective operations due diligence. ("Operations Due Diligence") was also the subject of another two-part article: The 9 Critical Areas for Effective Due Diligence.)

Collecting the documents needed to support due diligence can be a daunting task. In the past this was a paper collection, but today your due diligence collection is more likely to be an online virtual data room (VDR). When there are multiple investors looking at the business this is an advantage because it cuts your paperwork production. It can also be a huge disadvantage because VDR repositories can be searched easily, meaning it is more difficult to hide the needle in the haystack to keep it from being discovered.

The ownership of many businesses gets cloudy over time. This is particularly true during the startup phase. Entrepreneurs are notorious for promising their chief engineer part of the business in return for getting their first product delivered, but they are terrible at putting it in writing. When it comes time to bring in an investor, those promises are often forgotten by the entrepreneur, but not by the engineer. Startups are not the only problem. The failure to put tight, limiting terms on options can lead to surprises when someone decides to exercise some old options now that the business is about to expand. Investors, of course, won't accept this type of dilution. Cleaning up the ownership of the business is a time-consuming task that requires some forthright conversations that can be difficult with people you still depend on.

Step #7: Cleanup the Ownership

Cleaning up any outstanding legal issues is an absolutely critical positioning task. It goes without saying that any outstanding litigation must be brought to a close. There are also many types of contractual agreements that need to be reviewed. Many third party agreements include terms that require notice of any significant ownership change. This is VERY prevalent with software businesses where critical third party components are used. Once the third party is notified, and they know you are facing an M&A event; they will use this clause to renegotiate the price of their product. Your business model will take a big hit because it forces you either to increase development cost and product pricing or lower earnings. This has become an all-too-common form of legal extortion! If the product is being updated regularly then these negotiations should start early. Or, better yet, be aware this has become a common practice and never allow these terms when you enter into third party agreements. It will take time, but all agreements and contracts must be carefully reviewed as you position the business.

Step #8: Create a Hard Asset List

Creating a hard asset list can be time consuming and difficult to maintain, but this is also an important positioning step if you haven't maintained a current asset list. It will not only save you time when you're trying to close a deal, it can save you some embarrassing mistakes. This is particularly true if you are only spinning off part of the business. You must identify what hard assets are included in the deal and what remains behind.

There are many other less critical activities not mentioned here. Deciding to find a financial partner or to exit your business is not a light decision. It should always be made with plenty of forethought, according to a plan, and not when your back is against the wall. You must perform these activities before entering into the sales process. You never want the sharks to smell blood in the water. Positioning your business is not a passive activity. Make your decision early and drive toward it.


Author: Jim Grebey