Reality Sets In

In 1999 or early 2000 at the height of the dot-com boom, this scenario may have ended with a happy outcome.  Venture Capitalists, having read all the publicity and anxious to get on the train, fund a Series A round based on generous pre-money valuations, little to no due-diligence and guidance that the money is to be used to expand hiring and spending at an even greater rate.  That was then - now we are in a different world.

Following the dot-com bust and two recessions between 2000 and 2009, most entrepreneurs understand that raising capital is now a significant challenge and not every company has a business model like Google, Facebook or Twitter – with the ability to command sky-high valuations and investor money.

Five Winning Strategies

Successful or not as an early stage company, consider these five winning strategies that will keep your company in the game through good and bad times:

• Stay focused on Revenue Traction – savvy investors demand and look at revenue traction as the most important metric in their decision to invest in early stage companies.  Consistent growth in revenue is more important than the immediate quest for profitability.  Investors aside, having revenue streams that are stable and growing will also be a satisfying affirmation of the value proposition embodied in your business model.  And, don’t be shy in thinking “outside the box” or in revisiting your business model to keep this notion alive and well at all times.

• Manage Cash Burn – this has to be more than just keeping head-counts or other expenses under control.  The management team has to pro-actively find ways to outsource work to lower cost centers, maximize their use of partner resources and even structure deals that provide customers the incentives to do some of the work.

• License the Technology – most early stage companies are unlikely to see customer or revenue traction from overseas operations if the primary focus of operations is the domestic market.  Unless you have a product or service that can immediately attract customers from around the globe, consider licensing the technology platform to an overseas partner – for one-time licensing fees and a royalty revenue stream – on a country or regional basis – and let your partner manage the headaches in that country or region.  If your business model supports it, consider licensing technology from another company before you build it in-house.

• Use Board Members for Strategic Work – a great way to manage the cash burn is to use Board members, especially with specific skills – legal, business development, technical – that can provide an assist in a pinch.  If necessary, compensate Board members with additional equity.  And, always use Board members to raise capital.

• Hire a great Investment Banker – to raise capital and to provide an assist with technology licensing among other tasks.  Hiring a banker can be a wise investment and free you to focus on your business. Fees are largely success based and in some cases equity participation may be included in the fee structure to reduce capital outlays. Investment Bankers with a good understanding of technology and finance can really make a difference in accelerating your success as an early stage company.

Case Study

Situation: Twenty years following the launch of ConArt, a manufacturer and erector of precast architectural and structural components, Mr. Lyle found himself seeking to sell his company during the height of one of the country’s worst economic and construction industry downturns in recent history.

Solution: Faced with an unusually difficult engagement, CFA prepared a detailed geographic and industry sector analysis, which was effective in presenting the fact that ConArt was not suffering from the effects of the construction industry downturn. Bolstered by the in-depth report, KT Capital Partners, a private equity fund, acquired a company that is strategically located and positioned to take advantage of a vast number of growth opportunities in Southeastern United States.

Akin to the underlying transformation in corporate objectives, the challenge with the project finance strategy is that the investment is made upfront while the anticipated benefits of the initiative are realized in the much longer term.  It is imperative to identify and prequalify sources of funds that can thoroughly understand the underlying changes being implemented by the prospective borrower(s) and project sponsor(s), and to achieve a comfort with the future cash flows arising from the collateral package of project investment or captive acquisition.

Originating and arranging long term financing in the current global credit environment is a daunting task when trying to get lenders comfortable with such a complex and flexible project financing strategy.  It is critical to create financing structures that include a collateral package of assets and contractual arrangements that capture a bankable flow of cash to service the debt, operating and capital expenses of project, while providing robust returns to the sponsors/company.  It is equally important that companies or project sponsors meet their objectives of keeping such capital intensive assets off their balance sheets and that the financing structure and terms limit or preclude recourse to their corporate balance sheets.

In sum, project finance is usually based on non-recourse or limited in recourse structures to the balance sheet(s) of corporate sponsors, whereby project debt and equity (and potentially leases) used to finance the project are paid back from the cash flow generated by the project, with the project’s assets, rights and interests held as collateral. In other words, it’s an incredibly flexible and comprehensive financing solution that demands a long-term lending approach not typical in today’s credit strapped marketplace.

Many project financings require credit enhancement due to the overwhelming asset class size and capital expenditure, the heightened political or credit risk in certain emerging market countries, and/or local or regional financial institution capacity to provide debt service on such projects. This entails working closely with established local and foreign relationships in government agencies and multilateral organizations to fortify the creditworthiness of a project and related asset classes. It is critical to be closely advised on the required political risk insurance, bank guarantees, public debt and equity participation, among other vehicles to provide credit enhancement for projects.

Advisors and project sponsors should work with local, state and federal government agencies as well as multilateral agencies and development organizations to support their projects. For more information, please refer to my article on Project & Public Finance Strategies (PDF) or leave a comment here.

Several CFO’s have recently asked me “When will the capital markets “return to normal?”  My answer is:  Not this year.  Therefore, if you are a C-level executive that wants to obtain funding for your company, you might consider leveraging your company’s top-line gross revenues with a new form of financing structure from Entrex, Inc., based in Chicago, and Bank of New York/Mellon, and made available to you through your corporate finance investment banker.

The current reality is that talk by traditional banks about low interest rates is not solving your cash flow needs, particularly when stricter lending requirements have reduced the amount of your working capital line or term loan.  Also, selling or giving up equity at a today’s reduced valuations is not attractive, which explains why raising equity capital in the types of private placements typical a few years ago, are not getting done.  As a result, unless your company is distressed (and, therefore, attractive to vulture investors), then you are most likely frustrated with your inability to access capital for growth and recapitalizations.

One attractive and innovative financing solution that middle market companies might consider is obtaining lump sum capital in exchange for giving the investor a monthly fixed percentage of the company’s top-line (GAAP) gross revenues for a finite period of time, or perpetually. Traditionally known as royalty based financing, this form of financing is accomplished by a company issuing securities known as Top-Line Income Generation Rights Certificates (aka TIGRcubs™) under a license from Entrex, Inc.

For private and public companies with positive cash flows, annual revenues between $5M - $250M, relatively strong gross margins, and promising future revenue growth, TIGRcubs™ appear to be a well-suited corporate finance solution. The main advantage for companies issuing TIGRcub™ securities is that there is no equity ownership dilution to the current shareholders.

This top-line focus to derive investor returns elegantly avoids today’s awkward company valuation discussions, the difficult analyses associated with estimates of future EBITDA results, and the liquidity discount often applied to illiquid private equity valuations. Instead, investors, who receive a fixed percentage of the company’s variable gross revenue, truly become aligned in promoting company growth.  Variable payments enable companies some relief if cash flow drops, at a time when they need it most.

Entrex, Inc. is institutionalizing this form of financing, and intends to operate a secondary exchange for trading of TIGRcubs™, which should cause more institutional investors to make allocations to this type of security.  However, for companies interested in issuing TIGRcubs™, the first step is to begin working with an investment bank (namely, Corporate Finance Associates) which is specialized licensed by Entrex, Inc. to sell TIGRcub™ securities, and who can show you a spreadsheet comparing the cost of capital for issuing TIGRcubs™, versus issuing other forms of securities or taking on additional debt.

Download my article titled Obtain Financing By Leveraging Your Company’s Top-Line Revenues to learn more about how TIGRcub™ financings are now getting done in the new economy, or for more information visit: financing options for middle market companies.

Under section 368(a)(1)(A), the Internal Revenue Code defines a type A reorganization as a “statutory merger or consolidation.”  Besides meeting the definition of a statutory merger or consolidation, there is a continuity of interest requirement.  As provided by the treasury regulations, this requirement will be met if at least 50% of the consideration received is stock (under case law, 40% stock consideration will meet this requirement).

Up until just a few years ago, a statutory merger or consolidation was limited to domestic transactions that are subject to the corporation laws of a state, a territory, or the District of Columbia, which are part of the United States.  In 2005, proposed regulations were released that expand upon the statutory merger or consolidation requirement.  The proposed regulations disposed of the requirement that only domestic transactions will qualify.  As long as the statutory merger or consolidation satisfies the criteria that are often found in domestic statutes, then a foreign transaction will qualify.  Since many foreign jurisdictions do have merger statutes in place, this change in the federal tax law opened the door to favorable tax treatment for cross border transactions.

In 2003, regulations were issued that expanded upon the type of entity included in the definition of a statutory merger or consolidation.  Before 2003, an entity had to be a corporation.  Under the regulations, subject to various restrictions, a limited liability company can be a party to a merger transaction in a type A reorganization.

As with any material transaction involving tax consequences, it is wise to seek counsel from a competent tax professional before entering into a merger or acquisition transaction.

Press Release on PR Leap

Sound working relations with employees are an important component of every business. While confidentiality can be a far greater perceived problem with regard to employees than an actual problem, with proper planning it is possible to minimize the risk of untimely disclosures.

While confidentiality is an important consideration, employees generally do not jump ship upon learning that a business is for sale; however, proper timing as to when to share such information can contribute to a smooth transaction and reinforce the buyer’s willingness to proceed to the closing table.

Although buyers are generally not introduced to customers or suppliers until the final stages of due diligence and the sale appears to be imminent, buyers will insist upon meeting and interviewing the seller’s management team during due diligence. In most businesses, the company’s management team is crucial to the ongoing success of the business. For this reason we like to discuss with business owners the pros and cons of including key members of the management team in the sale process from the beginning.

Keeping important members of your management team in the dark could cost you the deal. Most key members of a management team invest their time, energy and effort to help build the company they work for and it becomes a major factor in their lives. They feel they have earned the right to know about major corporate initiatives, even if it makes them nervous. All too often we have witnessed business owners hastily call a “damage control” meeting when employees become suspicious that the business is being sold.

When the management team is informed of the owner’s interest in selling the company, the focus of the discussion should not be on the seller’s plans for retiring or moving on to a new opportunity, but on how the sale will benefit the future growth and prosperity of the company. The seller needs to convey to the management team their jobs are safe and the buyer will provide the company with added financial resources, management expertise, or incentive to grow that the seller may not currently possess. Such a discussion validates the contributions key managers have made to the company, and avoids possible feelings of betrayal or resentment.

It is seldom that we encounter a senior management team that has not been a key element in the success of a business. From our experience, the properly timed sharing of information about plans to sell a business is more likely to keep the management team intact through the closing.

His point was that professional buyers are in the market everyday and need very little assistance in evaluating opportunities.  The individual buyer, no matter how sophisticated they think they are, is not in the market on an ongoing basis and therefore, will be less proficient and therefore a more risky prospect.

With that introduction, since joining CFA I no longer deal with individual buyers.  My concentration tends to focus on recapitalizations (recaps) where I represent a business owner that is looking to sell part of their business to gain some liquidity and continue growing their company aggressively with a financial partner over the next several years before ultimately selling. This financial partner is almost always a Private Equity Group.

There are several things I like about the Private Equity Groups.  First and foremost they have money (although there are a few exceptions).  Secondly, they are compensated primarily through equity stakes in transactions completed. Therefore they have a tendency to not waste their time or mine. While they may not always be able to specify what they are looking for, they are very competent at deciding quickly if they like an opportunity or not.

My approach to targeting prospective buyers starts with my knowing the Private Equity “players” that tend to concentrate on energy transactions. I like to keep my targeted group to a relatively low number (25) so that I can interact with them one-on-one to determine their interest — including who will be in the final five or so that gets to meet my client.  I can tell a lot by the questions they ask (are they knowledgeable) and by the obstacles they raise (are they positive) in discussing my client.

The last and certainly most important of the criteria is the chemistry between my client and the prospective buyer. Certainly their price has to be competitive, but the chemistry, normally solves this issue.

In summary, my screening process includes:  money, knowledge, interest, and chemistry.

While these guidelines will certainly apply to an individual buyer in a “brokerage” transaction; individual buyers are far more difficult to screen. Eliminating unqualified buyers is a key skill that an intermediary brings to his client. This skill ultimately saves the client valuable time.  At the end of the day, when a business owner thinks about selling his business it is critical that they keep their eye on the ball (i.e. continuing to run their business profitably) and minimize any distractions.  This time saving skill that an intermediary provides in only allowing qualified buyers to meet with business owners is “priceless”.

With changes in the economic climate and the halt in highly leveraged lending, companies that were patient during the M&A boom are now poised to make strategic acquisitions that can strengthen current operations, increase market share, decrease customer concentration, add new product lines and position them for significant future growth — all without the heightened competition experienced over the last five years.

Less competition from financial buyers: The window has closed for the highly leveraged transactions popular with Private Equity Firms during the M&A boom of the last few years. With these financial firms reassessing their approach and struggling to raise debt, it removes them from the market and/or diminishes their buying power.

Healthy companies have a better balance sheet and better banking relationships: Quite simply, companies that were patient will be rewarded for keeping cash high and debt low. Banks, some that are frozen to new lending, look for ways to cultivate existing relationships with healthy customers.

Opportunities to buy or merge with competitors: Companies facing mounting debt, loss of a key customer or other financial or operational “hiccups” need equity and/or a strong partner. Companies that did not move fast enough to fix these problems can be acquired at attractive valuations, or in some cases, 363 sales and/or through a bank workout.

Current economic climate has paved the way for creative deal structures: The market is realizing the need for creative ways to successfully complete a transaction. Seller financing, earn-out structures and other vehicles for contingent payments tied to future performance are key to getting deals done in a market with restricted credit.

Acquisitions always have risk attached and in a slumping economy the risk is greater. However, by continuing to be patient, keeping within your comfort level, and hiring an experienced M&A advisor, attorney and accounting firm, a well planned acquisition can take your business to the next level and generate growth for years to come.

In its Q4 report GFDR identified several trends regarding the current state of the market that lower middle-market business owners will want to take note of:

1. Average multiples on buyout transactions dropped from the mid-6.0x range in the first half of 2007, and have remained in the 5.8x - 6.0x range since.  Valuations have held up particularly well in the $50 million - $100 million TEV tier, where companies appear to benefit from being large enough to mitigate at least some of the risks relating to scale, but still small enough to get financing in the current credit market.
2. To measure the extent to which good companies have begun to accept reduced valuations, 200 buyouts completed since 2003 were examined.  All the firms analyzed exhibited “above-average” financial characteristics, which is defined as trailing twelve months (TTM) EBITDA margins and year one projected revenue growth both exceeding 10 percent.  The 12 such transactions completed in the fourth quarter of 2008 traded at an average of 5.9x, compared to a historical average of 6.2x and averages in the low to mid-6.0x during the recent market peak of 2006 through mid-2007.
3. Debt spreads widened, as the 90-day LIBOR interest rate (a benchmark for commercial lending) dropped from 4.1 percent on September 30 to 1.4 percent at year end.  Average initial pricing on senior debt declined only slightly (from 7.4 percent to 7.2 percent), causing the average spread on senior debt to jump from 4.3 percent to 5.8 percent. Spreads on subordinated debt also increased.
4. Among industries, health care services remained particularly active, with valuations averaging about 7.0x in the last six months of 2008.

In his commentary, Andrew Greenberg, CEO of GFDR notes that the transaction volume both before and after the financial industry meltdown came into full effect in the fall is comparable and evidence suggests that lower middle market (deals valued below $100 million) are likely to continue at the same level. CFA is one of over 100 firms that report transactions to GFDR.

In a period of mostly bleak business news it is good to see that in the lower middle-market there is a degree of steadiness for businesses that are making plans to transfer ownership. While these are challenging times, each business is unique and we believe now is a good time to initiate the process of finding a quality buyer or investor. Do you agree or disagree?