Category: Uncategorized

Selling a business? Why a Quality of Earnings Report Must be a Top Priority!

Business Buyers Will Always Check For This… It Could Be Costly

Blog Series 6 of 6

Author: Mark Mroczkowski

Acquisition transactions that are the most challenging tend to involve companies where the inventory was either under-managed or used aggressive inventory tax strategies.  Many variables affect the valuation of a business and the terms of a transaction; however, for product-oriented companies (such as manufacturing and distribution businesses), inventory valuation is probably the most overlooked economic consideration before executing a letter of intent. During diligence, inventory quality and accuracy can significantly affect the EBITDA, purchase price, working capital settlement, and even the buyer’s debt structure and capacity at closing.

In simplistic terms, inventory is not just a balance sheet account but a significant component of a company’s cost of goods sold, which largely determines business earnings.  The methods that management uses to manage inventory and determine its cost can either understate or overstate its earnings and EBITDA.  Inventory valuation also affects the balance sheet either positively or negatively, which significantly affects its borrowing capacity.  It is a good practice for business owners and their advisors to undertake the following before marketing a company for sale:

• Perform a complete physical inventory two months in a row.
• Perform a complete inventory aging analysis and inventory turnover rate.
• Update inventory reserves.
• Update the company’s cost roll and capitalized labor allocation to finished goods.
• Update the company’s inventory valuation and earnings based on raw materials’ market cost and purchased items.

Acquisition transactions are time-consuming, stressful, and costly.  It is better to address the valuation of inventory and its components before beginning a sale process to avoid what could be a deal-killing problem.

Business Buyers Will Always Check For This… It Could Be Costly

Blog Series 5 of 6

Author: Mark Mroczkowski

The business world often refers to earnings before interest, taxes, depreciation, and amortization, more commonly known as “EBITDA.” Public companies, private companies, business owners, investment bankers, lenders, valuation firms, and the mainstream business media constantly reference EBITDA and use it as a business term to negotiate value, define agreements, and reference cash flow.  However, EBITDA is not cash flow and may or may not approximate cash flow.  EBITDA is not a measurement recognized under Generally Accepted Accounting Principles (GAAP). The term EBITDA was created in the 1970s to demonstrate the cable television industry’s cash flow generation potential and was also used by leveraged buyout firms. Over time, this non-GAAP metric has taken center stage and is widely used to demonstrate a company’s financial health. Unfortunately, this metric ignores certain cash expenditures that must be paid, such as capital expenditures, debt service, taxes, and changing working capital requirements.  These cash outlays must be understood and adequately reflected in any cash flow analysis and company valuation.

Buyers care that a business under their ownership can: (i) reinvest in and expand its capital assets (capital expenditures), (ii) service its debt, (iii) give raises and bonuses to its employees, and (iv) deliver equity returns to its shareholders.

Business Buyers Will Always Check For This… It Could Be Costly

Blog Series 4 of 6

Author: Mark Mroczkowski

Adjusted or normalized Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) is one of the components determining a company’s valuation and establishing debt financing and its various loan covenants. Once Adjusted EBITDA is established through a quality of earnings analysis; it becomes the baseline for future performance measurement, incentives, and business compliance calculations. Arriving at this calculated number is more of an art than a science and involves increasing EBITDA for any non-recurring, personal, and extraordinary expenses run through the income statement that is not related to the future ongoing operations of a company. It is also important to adjust EBITDA downwards for other business expense increases needed or those expenses not previously captured correctly.

Non-recurring expenses are one-time, non-repeatable expenses incurred by a company that a potential buyer would likely not incur in the future. These expenses could include start-up costs for new product lines, facility relocation expenses, expenses related to discontinued operations, severance or termination expenses, recruiting, legal or consulting fees. Employee compensation, benefits, and bonuses are not considered an adjustment.

Personal expenses are shareholder-specific expenses unrelated to a company’s operations and expensed through the income statement.  These expenses could include cars, computers, travel, hobbies (e.g., country club dues or airplane costs), healthcare for non-employee family members, or other similar expenses. Such expenses must be well documented in enough detail to allow a reasonable person to substantiate the expenses.

Extraordinary expenses are one-time expenses or losses that arise from significant events that were not driven by the ordinary course of business. Examples include lawsuits, settlements cost, losses related to a customer bankruptcy, product recalls, warranty-related expenses, or natural disasters. Extraordinary expenses do not include ordinary business expenses such as inventory write-downs or bad debt write-offs.

Pro forma expenses also need to be reflected in adjusted EBITDA calculation to determine its profitability correctly. Owners’ compensation or rent expense to a related party needs to be adjusted to properly reflect the fair market value of a person’s wages or market rent.  Other necessary expenses that need to be included are accruals for vacation pay, bonuses, audit and tax fees, and salaries for essential employees required to be hired.

Calculating adjusted EBITDA to arrive at a business valuation is more of an art than a science. All potential add-backs must be well defined and substantiated to be considered in the calculation. Adjusted EBITDA must include all direct and indirect costs necessary to continue running the business after it is acquired.

EBITDA is Not Cash Flow

The business world often refers to earnings before interest, taxes, depreciation, and amortization, more commonly known as “EBITDA.” Public companies, private companies, business owners, investment bankers, lenders, valuation firms, and the mainstream business media constantly reference EBITDA and use it as a business term to negotiate value, define agreements, and reference cash flow.  However, EBITDA is not cash flow and may or may not approximate cash flow.  EBITDA is not a measurement recognized under Generally Accepted Accounting Principles (GAAP). The term EBITDA was created in the 1970s to demonstrate the cable television industry’s cash flow generation potential and was also used by leveraged buyout firms. Over time, this non-GAAP metric has taken center stage and is widely used to demonstrate a company’s financial health. Unfortunately, this metric ignores certain cash expenditures that must be paid, such as capital expenditures, debt service, taxes, and changing working capital requirements.  These cash outlays must be understood and adequately reflected in any cash flow analysis and company valuation.

Buyers care that a business under their ownership can: (i) reinvest in and expand its capital assets (capital expenditures), (ii) service its debt, (iii) give raises and bonuses to its employees, and (iv) deliver equity returns to its shareholders.

Business Buyers Will Always Check For This… It Could Be Costly

Blog Series 3 of 6

Author: Mark Mroczkowski

Valuing and financing a company is more complex than using a discounted cash flow model or market comparable EBITDA multiples. Debt compliance plays a significant role in valuing a company. Fixed-charge coverage ratios, leverage ratios, weekly or monthly borrowing base calculations, and capital expenditure caps all play a part in determining how much debt can be borrowed and how much equity is needed to close a transaction.

As a buyer, modeling a transaction’s capital structure goes beyond calculating the projected IRR of an investment. Instead, a buyer needs to understand the monthly working capital requirements of a business, its after-tax cash generation capabilities, and its liquidity. Businesses that are seasonal, cyclical, and have high working capital requirements, tend to be valued less because excess free cash flow is less, if not zero. A  buyer must know if available revolving credit lines can support growth, seasonality, or illiquidity. Buyers must also know if a business can make its interest, principal, and capital expenditure payments in an expanding or contracting market.

Buyers typically use a combination of revolving/asset-based debt, senior debt, and subordinated debt to fund transactions. Each type of debt has specific terms, costs, and covenants that must be met to avoid a credit default or a liquidity crisis.

Revolving or asset-based credit financing uses a company’s accounts receivable and inventory as collateral for the loan amount. It establishes a borrowing limit based on the assets’ quality, age, location, salability, and liquidation value. These items affect a company’s borrowing capacity because “advance rates” on “eligible” accounts receivable and inventory determine how much a company can borrow. For example, the company may have a revolving/asset-based credit facility of $10 million. Based on the accounts receivable characteristics and inventory characteristics, the company may only be allowed to borrow half of that amount or less. Revolving/asset-based credit is not permanent capital and is subject to limitations and quality restrictions. Having a credit line does not mean you have unrestricted access to it, nor can you use it to finance an acquisition.

Both senior debt and subordinated debt are considered long-term debt supported by all the company’s assets, whether tangible or intangible, as well as a pledge of the company’s stock. Typically, senior debt lenders provide the revolving/asset-based credit and have a first lien on all the company’s assets. In contrast, subordinated lenders are typically uncollateralized and considered to have a second lien on all the assets and stock. Commonly, the amounts loaned are more than what the lenders could recover in an orderly liquidation. The lenders monitor the business’s liquidity and cash flow generation capabilities with various financial ratios and restrictions, such as fixed charge coverage ratio being greater than 1.15, senior debt ratio not exceeding 2.50, total leverage ratio not exceeding 4.00, and many others. These ratios are based on the company’s negotiated adjusted and projected EBITDA for the business (please see April’s perspective Adjusting and Normalizing EBITDA for more details). For future years, the financial ratios become more stringent (increases or decreases based on the ratio), thereby holding a buyer accountable for the representations and projections that the business can generate the cash needed to meet all operational, tax, and debt obligations.

In summary, a buyer’s diligence of a company’s historical profits, quality of assets, and projected earnings provided by a seller affect the amount of debt a buyer can borrow, the amount of equity to be invested, and the potential equity return (IRR) on invested capital.

Business Buyers Will Always Check For This… It Could Be Costly

Blog Series 2 of 6

Author: Mark Mroczkowski

Buyers consider many things when looking to acquire a business, and real estate is an essential factor. Buyers first consider whether the company owns or leases the property and seeks to understand each’s pros, cons, and valuation impacts.

Lease vs. Own

Owning property as a business owner is not the same value proposition as owning a home. There are pros and cons to owning that need to be thoroughly weighed before deciding how to structure a business transaction. The positives are simple: you have more collateral to support the borrowing capacity of the business, and as you pay down the mortgage, you build equity value in what you hope is an appreciating asset.  Owning the property also gives you flexibility in customizing the space and potentially expanding it without landlord approvals.

The downside to owning is that it requires additional equity capital to acquire an asset that produces a lower IRR than the business, thereby lowering the overall rate of return on the total investment. When selling the company in the future, the next buyer may not want to purchase the real estate. The business could have out-grown the current space, or the location may be inconvenient or unattractive to the labor pool required by the company.  All these factors need to be evaluated when considering owning real estate.

Leasing a facility comes with its own set of positives and negatives. As a lessee, the business is not necessarily tied to its facility long-term and has the option to renew its lease or move to a newer location better suited for its needs.  Additionally, the business has limited liability for capital expenditures associated with the normal aging and wear and tear associated with an older property.  Leasing’s negative aspects are that the landlord may not renew the lease or escalate the rent, thereby making renewal cost-prohibitive and forcing the business into an unwanted relocation. Moving a business is challenging, disruptive, and costly.

Types of Leases

There are three main types of leases: Non-Triple Net (or Gross), Triple Net, and Absolute Triple Net.

The Non-Triple Net (or Gross) Lease is a lease agreement between the lessee and lessor where all costs and expenses of the lease are included in the monthly base rent.

A Triple Net Lease requires the lessee to pay the base rent and its proportionate share of the real estate taxes, building insurance, and basic repairs and maintenance to the building.

The Absolute Triple Net Lease has the same stipulations as the Triple Net, except the lessee is responsible for virtually all structural repairs to the building and surrounding property. The lessee has the responsibility of an owner but without the benefits of ownership.

Terms of Leases

Whether a buyer is assuming a lease as part of a transaction or renegotiating the lease terms at the expiration, there are six essential items to consider.

Annual Increases. Understand the magnitude and timing of any increases to rent. Look for comparable market terms in the area.

Taxes. Understand the assessment of the property and verify the business is not paying an overburdened tax bill.

Common Area Maintenance (“CAM”). These charges typically include costs to maintain the building like landscaping, snow removal, janitorial services, common area utility costs, and general repairs to the building shared by all the tenants. However, a lessor may include additional items into this category, such as cost-sharing on roof repair and replacement, HVAC systems, capital improvements, lighting, plumbing, or electrical wiring.

Expiration and Renewal. Understand when the lease ends and how it will affect the business. If the business needs flexibility, it should look for a short-term lease. If the business needs a guarantee of longevity in the building, then look for renewals with longer-term provisions.

Tenant Improvement Funds. These are funds given to the lessee to improve or potentially fully build out space in the desired fashion. Typically, this will increase the value of the lessor’s space, so they should be amenable to most changes. These funds are usually given at the renewal or start of a lease and include new carpet, paint, and office buildouts.

Indemnification. This provision is required before acquiring a company that leases the building from a related party. The seller of the business (or related party) needs to indemnify the buyer from any material problems with the building or property.

There are many factors to consider in the lease versus ownership debate. Many buyers prefer to rent instead of owning real estate because it creates a less complicated transaction.

Business Buyers Will Always Check For This… It Could Be Costly

Blog Series 1 of 6

Author: Mark Mroczkowski

A crucial red flag when evaluating a new acquisition target is a lack of customer diversification. Companies with customer concentration greater than 20% of total sales may pose a significant problem for a buyer.  The nature of the relationship between the company and its large customer(s) needs to be thoroughly vetted before finalizing a purchase price and capital structure. The buyer must weigh all the positives and negatives discussed below.

Positives

Having one or several large customers can be beneficial with the right circumstances. If a company has a patented product integral to its customer’s success, there is a lesser risk of losing that customer. A company and customer could also have a special relationship between principals that would be difficult for competitors to usurp. Most importantly, if long-term non-cancellable contracts are in place, there is generally a lower turnover risk.

Risks

Unfortunately, the risks surrounding customer concentration usually far outweigh the benefits. Typically, any loss of business from a major customer will be magnified. A customer that accounts for 20% of sales may account for 30% or more of profitability due to overhead absorption and production efficiencies.

Suppose the company’s products are commoditized or have limited differentiation from its competition. In that case, a change in procurement agent or ownership of the customer could drastically change its purchasing levels. The new procurement agent may not like the salesperson or has a better relationship with a competitor. When a new owner steps in, the customer may want to re-bid all vendors, and a competitor with a lower price point could prevail.

The strength and position of the customer also will impact the company. If the customer’s business slows down, so will its purchases. Business loss from a large customer is likely to impact profit margins more than losing business from smaller customers.

If the company’s product or service is re-engineered or becomes obsolete because of changing times or technology, the company’s.earnings will suffer greatly.

For potential acquirers, customer concentration is one of the critical filters when processing potential acquisitions. Buyers typically won’t pursue any deal with customer concentration greater than 20% unless it displays one or more of the positive aspects listed above. Even so, any offer made for a company with customer concentration will usually come with an earn-out predicated on the future profitability of the largest customer(s).