How Middle Market Companies Valued And Sold – Phase 1: Preparation & Packaging
By: Duane Donner
As we discussed in this previous blog, over the next several weeks we will continue the topic of how middle market companies are valued and sold. In this section we will focus on the first phase in the process, Preparation & Packaging.
Preparing your company for a sale and positioning it
in the most positive light requires knowing what buyers
are looking for and how they think.
Phase I starts with an in‐depth analysis of your company. The first step is to conduct a thorough review of the business and to begin constructing a company profile. An assessment of market and industry drivers reveals the source of revenues and profits and the potential for future growth. A comparison to industry and competitor benchmarks assesses the sustainability of the company’s competitive advantage. The areas that distinguish the company from its peers are identified, as well as those areas that may inhibit future performance, by candidly appraising the company’s strengths, weaknesses, opportunities, and threats.
Historical Financial Analysis
The company’s historical performance is assessed by reviewing and analyzing financial statements (income statements/profit & loss statements, balance sheets, statements of cash flows) for the past 3‐5 years. Audited financials are a definite plus, but they are not required. While it is commonplace for private companies to seek to minimize taxes and maximize personal benefits, this approach tends to understate the earnings potential of a firm. Historical financial statements, consequently, often have several limitations when it comes to portraying a firm in its best light. For instance, earnings may have been suppressed due to tax minimization strategies and since financial statements only deal with the past, they seldom do a good job illustrating a company’s potential going forward. Furthermore, the structure of financial statements makes it difficult to spot trends and “mine” salient data. A single off‐year or an unusual onetime event may disproportionately distort the company’s performance. Understanding these patterns and the implications of key financial and market ratios is an essential step to documenting the history of the firm and establishing the company’s foundation of value.
Publicly held companies like to please shareholders by showing the largest bottom line possible. Private companies, on the other hand, are not as concerned with the timing of profits, and often want to make all the money they can while showing the smallest amount of income that is taxable. To help buyers and investors better understand the earnings potential of the company, the next step is to recast financial statements by adjusting the P&L statement to compensate for extraordinary spending or non‐standard accounting practices. These adjustments provide a clearer picture of the company’s true financial performance and most of the time result in higher earnings compared to historical financial reports. Care must be taken, however, to ensure that all adjustments are credible, defensible, and properly documented.
Recasting is not an exercise in fantasy, but rather shows how your company’s earnings would appear if widely used management and accounting practices were employed. For example, excess compensation that is well above the industry average could be restated by reducing salaries to be more in line with the industry. Likewise, country club dues, leases for high‐end automobiles, and company loans at very favorable interest rates could be eliminated, which would lower expenses and boost earnings. Recasting cuts both ways, however. If a company has unfunded or under‐funded obligations, insufficient inventory levels, or inadequate capital expenditures to keep pace with the competition, then these “savings” should be recasted, which would increase expenditures and detrimentally impact earnings.
Multi-Year Pro Forma & Valuation Range
The next step builds upon the re-casted financials by constructing a pro forma that projects revenues and expenses, as well as assets and liabilities, over the next three to five years. The pro forma places the company in the best light and reflects management’s expectations for the future. As was the case when recasting financial statements, it is essential to keep assumptions conservative and credible and to provide independent third-party evidence when possible to document the rationale behind an assumption. Since the industry is the source of all profits, it is also important to forecast the growth rate for the industry and to substantiate the company’s relative performance in the industry (i.e., outperforms the industry, in‐line with industry performance, underperforms the industry) by analyzing industry performance ratios.
The pro forma provides the mechanism to quantify growth opportunities resulting from strategic initiatives available to the company. Examples of such initiatives include expanding into new markets and geographies, rolling out new products, and acquisitions.
The pro forma produces an integrated financial model for the company by quantifying assumptions for future earnings. The profit & loss statement captures the pricing model and sales assumptions driving revenues as well as the corresponding cost structure necessary to develop, deliver, and support products and services. The balance sheet documents the assets used to create and support products, the working capital necessary to conduct business in an orderly manner, and the capital structure of the firm. The cash flow statement captures capital expenditures and demonstrates the company’s ability to pay its bills.
The pro forma also provides the foundation for estimating your company’s valuation, known also as an enterprise value. Many factors and variables are taken into consideration when determining a company’s valuation. It is important not to rely on simple formulas or to use industry “rules of thumb” to value your company. For middle‐market companies, a combination of valuation methods are used with each method producing a valuation range. The three most common methods are:
- Discounted Cash Flow Analysis
- Comparable Companies Analysis
- Precedent Transactions Analysis
By estimating the most likely valuation range using each method, while also taking into consideration industry conditions, the macroeconomic environment, and other timing factors, it is possible to derive a valuation range for your company by evaluating where the ranges intersect.
High Impact Marketing Materials
The final step in Phase I is composing and producing marketing materials that authentically and succinctly tell the company’s story with a high degree of impact. Phase III will use these materials to solicit interest from buyers and investors.
The Anonymous Profile (or teaser) is a one-page overview of the company sent to prospective buyers and investors to gauge their initial interest. This profile provides a brief description of the company, its industry and product offerings, points of key differentiation, and highlights of compelling accomplishments. A financial recap and pro forma also may be included. The company’s identity is not disclosed in this document.
The Confidential Information Presentation (CIP) summarizes the company’s strategy, operations, industry trends and conditions, and investment considerations. The CIP communicates whom the company serves, the problem the company solves, how the company makes money doing so, and how the company will grow. Key sections of a CIP include an overview of the company, its history, management team, market assessment (industry size, drivers, trends, and growth estimates), competitive environment, products and services, customer base, market share, compelling points of differentiation (proprietary technology and methods, patents, source code, engineering, R&D) and a financial recap analyzing historical performance and projecting future performance in the form of a pro forma.
The Management Presentation is a dynamic, hard‐ hitting presentation recapping the most important factors for buyers to consider. The structure of the presentation reflects management’s approach and style and complements the Confidential Information Presentation.
In the next blog we will be discussing the third phase, which is Buyer Research