Selling: Do You Need a Fairness Opinion?
Much has been written about “fairness opinions” due to the financial manipulations among companies such as Enron, Tyco and others. The conflict in the use of fairness opinions was (and is) that an investment banking firm not only handled the sale of a company, but also got paid for doing a fairness opinion. For example, when the Bank of America decided to buy Boston’s Fleet bank, B of A paid the investment banking firm of Goldman Sachs $3 million as a retainer, $5 million for a fairness opinion, and was prepared to pay a success fee of $17 million if the deal actually was completed.
Keep in mind that a fairness opinion is prepared by one or more financial experts, or by a firm, to protect the shareholders; in other words, to assess whether or not the deal is fair to the real owners of the business. It also protects the officers and board of directors from shareholders who feel that their company is paying too much for the business being acquired. It is also apparent, from the example above, that the investment banking firm makes money, and a lot of money, through the entire purchase from beginning to end. They don’t have much of an incentive to really come in with a “fair” fairness opinion. However, regulators are looking at this obvious conflict of interest very seriously, and changes in the current regulations are almost sure to happen with full disclosure being only the first step.
So, how does all of this impact the privately held company? It is vital that an owner of a privately held company who has minority or family shareholders should also seek a fairness opinion. It may not have to be done by an investment banking firm and probably shouldn’t be prepared by the owner’s accounting firm, for the same reasons outlined above. A third party evaluation should be done to insure that a minority owner doesn’t come out of the woodwork and claim that the business was sold for much less than it is worth – at least according to the dissident shareholder.
A professional intermediary can be an excellent resource in the preparation of a fairness opinion for the privately held company. They can provide several valuation professionals and/or firms and also assist in the gathering of the necessary financial records. Generally speaking, a fairness opinion is prepared after the selling price is agreed upon. In the sale of a privately held company, the price may fluctuate throughout the negotiations, but a third party valuation can set the bar. And, it’s very possible that using a business intermediary to market the business will bring a price above the valuation, pleasing everyone.
What Do the Following Companies Have in Common?
This is just a partial list: Church’s Chicken, Uno Chicago Grill, Charlie Brown’s, Domino’s Pizza, Burger King, Cinnabon, Sizzler. The first response would be that they are all in the food business, and that’s correct. Now name the second thing that they all have in common? Give up? Well, they (and many others) have been purchased by private equity firms. And, apparently, this is just the beginning. The huge Dunkin Donuts chain is being sought after by two or three private equity firms.
Why the interest in restaurants from groups that most people associate with high tech? Many firms got burned during the dot com and high tech meltdown. Now these same private equity firms are looking at businesses that are stable, with more predictable earnings, and that are also very familiar businesses, time-tested and still have a lot of growth ahead.
One industry expert said in Nation’s Restaurant News, “What’s really driving this is the success of these deals, the numbers that the private equity companies are getting when they sell…” For example, he noted, “Restaurant Associates bought Charlie Brown in 1975 for $3 million and sold it to Castle Harlan seven years later for $50 million. Castle Harlan got almost three times that price – an appreciation of $90 million with the sale to Trimaran.”
If private equity and similar firms are now buying restaurants, what businesses are next? If you are the owner of a small growing company or chain of businesses – is a private equity firm in your future? A professional intermediary may be able to answer that question for you and if you are considering selling – they can also help.
Does Your Company Have Pricing Power?
If Starbucks raised the price of a cappuccino, sales most likely would not be affected. If your attorney raised his or her hourly rate, would you switch law firms? If a company or service firm does not have pricing power, then its value is less than it should be. Here are a few ways to develop or increase pricing power:
- producing a discernible branded product or service
- innovating with patent production such as Apple’s i-Pod
- providing such exceptional service that competitors are not able to replicate it
An interesting question for company management is – how should they set their prices? Sometimes the answer is that management figures out at what price the item can be sold and then works their costs backward. The more traditional way is to add up the cost of labor, material, and overhead plus an acceptable profit. But times have changed, and in many cases, the power of pricing has moved from the producer to the customer. Today, Wal-Mart tells most of their vendors what they will pay for certain items, and Ford tells their suppliers the same. On that basis, many companies are beholden to the Wal-Marts and the Fords of the world and do not have the benefit of pricing power.
A Seller’s Dilemma
When one sells their house, the best deal is usually the highest price. When one decides to sell their business, there may be other factors to consider. Many buyers are similar to the “overlooked” buyer described below, serious and qualified; and most sales of businesses are win-win transactions. However, there are a few exceptions, and sellers should consider them carefully, balancing their prerequisites to the goals of the buyer.
Selling to a Competitor – Many company owners think this is the best way to go. They read about the mega-mergers such as Bank of America and Fleet bank, or the pending deals such as Federated and the May Company Department Stores, and U.S. Air and American West. Consolidation may play a major role in large public companies; this is not the case in middle market companies.
Many owners of middle market firms look at these mega-deals and think it might work for them. However, upon further consideration, they realize that by disclosing a lot of confidential information to a competitor, their business could suffer irreparable damage if the deal would fall apart – and many do.
Selling to a Strategic Acquirer – This may bring the highest price, but there are several reasons why this may not be in the company’s best interest. Many owners have worked with key employees for years and would not like to see them replaced. The strategic owner might not only replace members of management, but might also move the company to another part of the country.
Selling to a Financial Buyer – This buyer may not be willing to pay the seller’s price and is usually buying a company with intentions of selling it at a profit in three to five years. This leaves the company and its employees in limbo waiting for a new owner to take over.
Other Buyers – The employees may decide to buy the company (ESOP). However, this usually means a long-term payout for the owner. An individual buyer may come along such as a Warren Buffett, but what are the chances? A key member or members of management might decide to purchase the company, but generally they won’t pay the price. If a sale is not consummated, the key management member(s) will most likely leave.
The “Overlooked” Buyer – There are many individuals who want to own their own company. They might be former executives of major companies who want to do something on their own. Some buyers have access to large amounts of investment capital. There are many qualified individual buyers in the market place. Russ Robb, the editor of a leading M& A newsletter, M&A Today, has written a book, Buying Your Own Business, for those individuals interested in buying their own company. This book has sold over 20,000 copies, which indicates the large number of people who are interested in buying a company.
There Is No Magic Answer – Selling a company comes with no guarantees. When Badger Meter Company, a public company headquartered in Milwaukee, acquired Data Industrial Corporation based in Mattapoisett, Massachusetts, this appeared to be a marriage made in heaven. Their respective product lines fit like a glove, their corporate cultures seemed compatible, and sales expansion by cross-selling was evident.
This strategic acquisition would have been fine except for one change. The parent company moved Data Industrial’s operation to Kansas, and every employee’s job was terminated. However, one should not construe that all acquisitions by strategic or competitive acquirers end up in a similar fate. Furthermore, for price considerations, the seller can draft restrictions in the Purchase & Sale agreement to prevent the transfer of the business, at least for a specified time period.
Certainly selling to the overlooked type buyer doesn’t guarantee all of the seller’s concerns, but knowing the interests of some of the various buyer types can help insure that the goals of both buyer and seller are met. Sellers should determine their goals prior to attempting to sell their business. A consultation with a professional intermediary is a good start to this process.
What’s Your Business REALLY Worth?
A recent article in INC magazine titled”Street Smarts,” by Norm Brodsky (his column is worth the price of the magazine) addressed the subject of the title above. However, in the very first paragraph of the article, Mr. Brodsky stated, “Unfortunately, most of them [business owners] have grossly inflated notions of what their companies are worth.” Mr. Brodsky is not one to mince words. Some of his examples were: “One company had lost money on sales of about $60 million, and yet its owners thought it was worth between $50 million and $100 million … Another company had a net profit of less than $335,000 on sales of about $6.5 million – and still the owners somehow came to believe it was worth between $100 million and $200 million.”
Mr. Brodsky feels that the reason for this is “… our egos can get us in trouble when it comes to putting a dollar value on something we’ve created. We generally take the highest valuation we’ve heard for a company somewhat like ours – and multiply it.”
He goes on to point out that prospective acquirers are more concerned about profits, especially Free Cash Flow, than sales. Too many company owners use some rule of thumb based on sales. He also points out that company owners tend to use a comparison of a similar business across town that sold for some multiple of sales and then apply it to their company. There are so many variables of how sales (and subsequently earnings) are generated that no two companies are ever alike.
Business owners tend to forget the negatives of their business; e.g., sales from just a few customers, lack of contracts with customers and suppliers, lack of product diversity, out-dated equipment, etc. Also, as Mr. Brodsky points out, “Before you try to sell, make sure you know what buyers want.”
Turning to another expert voice, here is some good advice from Allen Hahn, Senior Vice President of Valuation Research Corporation: “The level of EBIT or EBITDA used for negotiating a purchase price is the ‘normalized’ level that will be available to the new owners from the assets acquired. Often times this requires elimination of unusual, inappropriate or non-recurring expenses. Buyers will typically consider a company’s last twelve months of financial performance. However, projected results may be more relevant if a structural change has recently occurred in the business (loss of a key customer, acquisition, etc.) that renders historical results less meaningful.”
What does all of this mean? It means that owners should disregard rules of thumb based on what the company across town sold for; it means that owners should not use a multiple based on what the business did four or five years ago, or what they think the business will do next year.
Business owners should first put their egos aside, then look long and hard at the company’s cash flow, realistically assess the negatives (and positives) of their business and “make sure you know what buyers want.”
