Mergers and Acquisitions For Dummies (25 page)

Striking the Right Type of Deal

M&A transactions are basically variations on a theme: How much of the company is being sold, and what is Buyer buying — stock or assets? The following sections delve into these issues.

Exploring the differences among buyouts and majority and minority investments

When Buyers make acquisitions, those purchases can take the form of a complete, 100-percent buyout (mainly for PE firms), a majority investment, or even a minority investment.

As the name suggests, a
buyout
occurs when 100 percent of a company is sold to another company. A buyout results in a change of control, and although 100 percent of the outstanding stock may be acquired to effect the transaction, it's possible for Buyer to acquire Seller's assets (instead of buying stock) and still have a buyout. In other words, buying 100 percent of the stock means you buy 100 percent of the assets, but buying 100 percent of the assets doesn't necessarily mean you buy any of the stock. Head to the following section, “Choosing an asset or a stock deal: What's Buyer buying?”, for more.

The new owners may allow the management of the acquired company to acquire the new shares either for a discounted price or as a part of some sort of stock option plan.

A
majority investment
is when Buyer acquires greater than 50 percent of the company. A
minority investment
is when Buyer acquires less than 50 percent of the company. Regardless of whether the transaction is a majority or minority investment, in most cases Buyer buys the stock of Seller. If the acquired stock is sold by an existing shareholder, that transaction is called a
recapitalization.
In this case, no new shares are being created; existing ones are simply changing hands.

If the acquired stock is the result of a new issuing, however, the money raised from selling those shares goes to the company. This setup is often called
growth capital
because the company retains the money for the purposes of facilitating growth.

Choosing an asset or a stock deal: What's Buyer buying?

One often-overlooked area of M&A is the question of what exactly Buyer is buying. Companies themselves aren't really sold, per se; instead, Buyer is acquiring either certain assets of the company (in an
asset deal
) or the company's stock (in a
stock deal
).

Buyers prefer asset deals over stock deals because the former are a lot cleaner logistically. The assets involved may or may not constitute the entire company and often include intangibles such as company name, domain names, customer lists, work in progress, sales pipelines, and so on.

Asset deals are cleaner because Buyer is essentially picking and choosing what she wants to buy. She picks the good assets and leaves behind the bad assets and some (or perhaps all) of the liabilities. Most often, Buyer does assume certain liabilities relating to working capital. A smart Buyer makes sure any assumed liability is
current
(or within terms).

The big perceived advantage for Buyer in an asset deal is
successor liability.
If Buyer acquires the stock, any past misdeeds of the company are a liability for the new owner. In some cases, an asset deal may help shield Buyer from the past misdeeds of Seller, but that's not always the case. Stringent representations and warranties (see Chapter 15) and an escrow account help mitigate this concern, but the risk never completely goes away.

The
assignability of contracts
(Buyer's ability to enforce contracts originally signed by Seller) is often in question with asset deals. Buyer may want to consider the risk of losing contracts as the result of an asset deal. The contract is with the company, not the assets!

Sellers usually don't like asset deals because those deals pose the risk of double taxation. Proceeds from the sale first go to the company, which may have to pay a capital gains tax on those proceeds. The remainder of that money is then paid out to Seller, who in turn may have to pay tax on that after-tax amount.

For that reason, Sellers prefer stock deals. In a stock deal, owners of the company's stock sell those shares to Buyer and in most cases face just one layer of tax (which is hopefully the capital gains rate). Unless Buyers want to increase the purchase price to offset the higher taxes of an asset deal (and some Buyers will do that), they need to get themselves comfortable with the possibility of stock deals.

Regardless of which side you're on, talk to your legal and tax advisors, who can advise you appropriately on a case-by-case basis.

Examining the All-Important EBITDA

In addition to being fun to say (I had a client who once referred to it as “EBITDA dabba do!”), EBITDA is a key M&A metric. Heck, it's a key metric in all things business.
EBITDA
is a measure of a company's profitability for doing what that company is supposed to do: selling a product or service. EBITDA effectively removes the profit-distorting effects of taxes, interest income, and expense and eliminates the effects of making capital investments in the firm. In other words, EBITDA is a measure of a company's financial performance if that company were in a bubble, sheltered from the real world.

Because EBITDA helps measure the company's underlying profit, banks and other sources of capital tend to use EBITDA when determining how much money they can lend. These institutions measure that amount in
turns;
one turn is equal to the business's EBITDA. For example, if the business is generating $3 million in EBITDA, one turn of EBITDA is $3 million. If a company is being sold for $15 million, the Buyer needs to come up with five turns of EBITDA.

Buyer doesn't necessarily come up with all the necessary turns from one lender. A senior lender may be willing to extend, say, two turns of EBITDA to Buyer ($6 million in this example). If Buyer gets a subordinate debt of one turn ($3 million) and chips in three turns itself, the acquisition financing is complete. (Flip to “Understanding the Levels of Debt” earlier in the chapter for more on senior lenders and subordinate debt.) Most acquisitions follow a financing model along these lines.

In years past, a Buyer may have been able to make that acquisition using less of its own money, but with the tightening of the credit markets in 2008 and the downturn in the economy from 2001 to 2010, most Buyers now find they need to put in more equity than in years past. As of the time of this book's writing, these estimations are accurate and are subject to change as the economy changes; as always, check with your advisors for your own situation.

Making Buyers' Return Calculations

Make no mistake: Buyers don't act solely because of feel-good business-book babble like “the right fit” and “synergy.” They make acquisitions for one simple reason: profit. Besides EBITDA (see the preceding section), Buyers measure profitability in various ways. The following sections present the main methods.

Return on equity

Return on equity,
or ROE for short, is simply the amount of income divided by the total amount of the company's equity. If the company has $1 million in after-tax income and $10 million in equity, the ROE is 10 percent.

ROE is a measure of how well a company is able to generate profits from invested capital. It helps Buyers measure each acquisition's profitability and continue to monitor whether acquired companies remain profitable enough. If the ROE is too low, management may decide that it can more profitably use the capital tied up in the company elsewhere and that selling the company is the best option.

Return on investment

Return on investment
(ROI) is similar to ROE (see the preceding section), except it accounts for the acquisition price and the sale price of a business. You calculate it by subtracting the sale price from the acquisition price and dividing that difference by the acquisition price; the result is a percentage. If you acquire a company for $10 million and sell it for $15 million, the ROI is 50 percent.

Internal rate of return

Internal rate of return
(IRR) is a favorite of PE firms and is the main metric investors use when comparing one fund to another. It's a discounted rate of return; that is, the anticipated future earnings of a company are discounted. A dollar today is worth more than a dollar next year, so the more time that expires, the lower the potential IRR. That's why PE firms are often very open to selling off a portfolio company sooner rather than later; keeping it may not be beneficial if the IRR is likely going to decline.

Financing a Problem Child

Not all companies go up for sale in the rosiest of circumstances. Sometimes, Sellers need to unload debt-laden or money-losing businesses. Working out financing for these so-called problem children is trickier than finding financing for healthy companies, but it's not impossible. The following sections present some problem situations and suggest ways you may be able to finance such deals.

Debt is greater than purchase price

When the external debt of a business exceeds the purchase price Buyer is willing to pay (known as being
underwater
), Seller is in a sticky situation. To accept the price means Seller literally has to write a check for the honor of selling his business. Short of getting Buyer to pay more (always an option worth trying!), Seller has a couple of options for selling his underwater company:

Ask Buyer to pay more.
Seller should explain the situation to Buyer; if Buyer is hot enough for the deal, she just may be willing to pay enough to cover all the outstanding costs and debts of the business.

Negotiate with creditors.
This situation is tricky because informing a creditor that a company is in financial trouble may cause that creditor to put place a lien on the business or force a bankruptcy on the company. The key is to not say the creditor will get nothing but rather that the creditor will get something. If Seller in financial straits can get major creditors to agree to accept less than the full amount owed, he may be able to extract himself from this precarious position without having to bankrupt the business.