FOUNDERS

INVESTMENT BANKING

A PRIMER ON HOW MIDDLE

MARKET COMPANIES ARE
BOUGHT AND SOLD

~ FROM THE PERSPECTIVE OF A SELLER ~

I NTRODUCTION

The steps to selling a middle market company1are generally not all that well
known,butthereisaprovenmethodologythat,whenfollowed,increasesthe
likelihoodofafirmobtainingapremiumvalueandgettingadealdone.Thereis
a large universe of potential buyers and investors. Owners of companies
typicallyseetheiruniverseofbuyersconsistingoffellowpartners,employees,
competitors, key customers, major suppliers, and perhaps local investors.
Whiletheseareallvalidoptions,professionaladvisorsarealsoabletotapinto
a vastly larger universe consisting of domestic and international public and
privatecompaniesaswellasprivateequityfirms.Thechallengeisnotfinding
potentialbuyers,butfindingtherightbuyerorinvestor.Attheoutset,itisnot
always obvious who the best buyer might be, and there is a high probability
thattheownerhasnevermetthebuyerbefore.Ittakesasystematicapproach
toidentifyandconnectwiththebestcandidates.
Letsfaceit.Mostofusareamateurswhenitcomestosellingourbusinesses,
since we tend to do it only once or twice. Institutional buyers2, on the other
hand,buyandinvestforaliving.Consequently,theyhavealotofexperience
getting deals done that are more in their favor. Financial buyers exist to buy
businesses for institutional and high net worth investors, and these shrewd
buyershaveinvestedover$2trillionbuyingcompanies.Strategicbuyershavea
preference for acquiring small to mediumsize firms and while these deals
happeneveryday,itisachallengefortheuninitiatedtogetintothismarket.If
you already know potential buyers because they are a customer, partner,
familymember,orcompetitor,youshouldaskyourselfiftheyarewillingand
abletopayfairmarketvalue.

How is fair market value determined? Lets first look at the definition of this
term.Fairmarketvalueisthemostlikelypriceatwhichabusinesswillchange
handswithinareasonableperiodoftimebetweenawillingbuyerandawilling
seller in an arms length transaction where both parties are motivated but
neither is under any particular compulsion to act. While this definition helps
somewhat,itdoesnotshedmuchlightonhowpriceisdetermined.Nordoes
this definition give much guidance on how owners can exert leverage when
dealing with professional institutional buyers and investors. The solution to
determining fair market value in a manner that also provides the seller with
leverage lies in making a market. How do you make a market? You make a
market by creating a competitive deal environment consisting of multiple
buyersandinvestors.

Middlemarketcompaniesaretypicallydefinedashavingannualrevenuesbetween$10million
and$500million.
2
Institutionalbuyersandinvestorsconsistofprivateequityfirms(i.e.,financialbuyers)and
largercorporations(i.e.,strategicbuyers").

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F IVE M AJOR
P HASES

Therearefivemajorphasestocreatingacompetitivedealenvironment:
I.
II.
III.
IV.
V.

PREPARATION&PACKAGING
BUYERRESEARCH&DEVELOPMENT
MARKETING&INVESTORCOMMUNICATIONS
ECONOMICNEGOTIATIONS&LETTEROFINTENT
DUEDILIGENCE&CLOSING

The PREPARATION & PACKAGING phase starts with an indepth analysis of the
companys business model, historical financial performance, and future
outlook. This information is then packaged into a set of documents that
conciselyandauthenticallytellsthecompanysstoryandformsthethesiswhy
the company would be a good acquisition or
investment.

The BUYER RESEARCH & DEVELOPMENT phase

systematically researches, identifies, and targets
potential buyers and investors culminating in a
specificlistofqualifiedbuyersandtheindividuals
tocontact.

The MARKETING & INVESTOR COMMUNICATIONS phase

directly engages potential buyers and obtains
indications of interest from the subset of firms
expressingastronginterestinthecompany.

The ECONOMIC NEGOTIATIONS & LETTER OF INTENT

phasestructuresandframesthedealculminating
inaLetterofIntent.

The DUE DILIGENCE & CLOSING phase allows the buyer to verify all the
representationsmadebytheseller,finalizesthedealstructure,andexecutesa
definitivepurchaseagreement.

Now lets dive into each of these phases in detail from the vantage point of
owners and CEOs who seek both a premium price and a high probability of
completingadealandarewillingtodowhatittakestoputtheircompaniesin
thebestpositiontoaccomplishthesetwinobjectives.

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P HASE I:
P REPARATION
& P ACKAGING

BUSINESS REVIEW

Phase I starts with an indepth 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
comparisontoindustryandcompetitorbenchmarksassessesthesustainability
of the companys competitive advantage. The areas that distinguish the
companyfromitspeersareidentified,aswellasthoseareasthatmayinhibit
future performance, by candidly appraising the companys strengths,
weaknesses,opportunities,andthreats.

HISTORICAL
FINANCIAL
ANALYSIS

The companys historical performance is assessed by reviewing and analyzing

financial statements (income statements/profit & loss statements, balance
sheets,statementsofcashflows)forthepast35years.Auditedfinancialsarea
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 earning 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
companys potential going forward. Furthermore, the structure of financial
statements makes it difficult to spot trends and mine salient data. A single
offyear or an unusual onetime event may disproportionately distort the
companysperformance.Understandingthesepatternsandtheimplicationsof
keyfinancialandmarketratiosisanessentialsteptodocumentingthehistory
ofthefirmandestablishingthecompanysfoundationofvalue.

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RECASTING
FINANCIALS

Publicly held companies like to please shareholders by showing the largest

bottomlinepossible.Privatecompanies,ontheotherhand,wanttomakeall
the money they can while showing the smallest amount of income that is
taxable.Tohelpbuyersandinvestorsbetterunderstandtheearningpotential
of the company, the next step is to recast financial statements as if your
companywasasubsidiaryofapubliccompany.ByadjustingtheP&Lstatement
to compensate for extraordinary spending or nonstandard accounting
practices,itisoftenpossibletoillustratehigherearningscomparedtohistorical
financialreports.Caremustbetaken,however,toensurethatalladjustments
arecredible,defensible,andproperlydocumented.Recastingisnotanexercise
in fantasy, but rather shows how your companys earnings would appear if
widely used management and accounting practices of public companies 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 highend automobiles, and
company loans at very favorable interest rates could be eliminated, which
wouldlowerexpensesandboostearnings.Recastingcutsbothways,however.
Ifacompanyhasunfundedorunderfundedobligations,insufficientinventory
levels,orinadequatecapitalexpenditurestokeeppacewiththecompetition,
then these savings should be recasted, which would increase expenditures
anddetrimentallyimpactearnings.
CommonadjustmentstoProfit&Lossstatementsare:

Sales:

CostofGoodsSold:

Costofsuppliesforinventoryitems

LIFOvs.FIFOaccountingadjustments

Depreciationandamortizationreclassification

Removenonperformingassets

Reclassifydepreciation&amortization

Operatingexpenses:

Adjustsalariestoindustrystandard

Familymembersonthepayroll

Nonrecurring(onetime/extraordinary)expenses

Discretionaryexpenses

Nonworkingfamilymembers'salaries

Perquisites(cars,clubs,insurance)

Flexibletravelandentertainmentpolicy

Adjustinterestexpense:

Interestexpense:relatedtodifferentcostofcapital

Removeinterestrelatedtononoperationalassets

Reclassifyinterestexpense/removefromoperatingexpense

Eliminateintercompany&relatedthirdpartytransactions
Cashtoaccrualbasedaccounting
GAAPrevenuerecognition

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CommonadjustmentstoBalanceSheetsinclude:

Assets:

Liabilities:

Removedebttoshareholdersadditionalequity

Fairmarketvalueofdebt

Longtermdebtsettlementperiodamortization

Optimizedebtincapitalstructure

Optimizeinternalgrowthcapabilities

Toomuch/notenoughdebt

Removenoncoreassets

Excesscashandinvestments

Aircraft

Boats

Luxuryautomobiles

Automobilesprovidedtoselectpersonnelasperks

Realestate

Lifeinsurancecashvalue

Nontransferableintangibleassets(brandnames,

patents)
Inventory

Lowerofcostormarket

Inventorynotonbooks
Adjustfixedassetstofairmarketvalue
Equivalentreplacement/currentbookvalue

Inmanycases,theoutcomeofrecastingincreasesacompanysvaluation
comparedtoexaminingfinancialstatementsbasedsolelyontaxreturns.

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M U L T I Y E AR
PRO FORMA &
VALUATION RANGE

Thenextstepbuildsuponrecastedfinancialsbyconstructingaproformathat
projectsrevenuesandexpenses,aswellasassetsandliabilities,overthenext
three to five years. The pro forma places the company in its best light and
reflects managements expectations for the future. As was the case when
recastingfinancialstatements,itisessentialtokeepassumptionsconservative
andcredibleandtoprovideindependentthirdpartyevidencewhenpossibleto
documenttherationalebehindanassumption.Sincetheindustryisthesource
of all profits, it is also important to forecast the growth rate for the industry
and to substantiate the companys relative performance in the industry (i.e.,
outperforms the industry, inline with industry performance, underperforms
theindustry)byanalyzingindustryperformanceratios.

The pro forma provides the mechanism to quantify growth opportunities

resultingfromstrategicinitiativesavailabletothecompany.Examplesofsuch
initiatives include expanding into new markets and geographies, rolling out
newproducts,andacquisitions.

The pro forma produces an integrated financial model for the company by
quantifying assumptions for future earnings. The Profit & Loss Statement
captures thepricing model and sales assumptions driving revenuesas well as
the corresponding cost structure necessary to develop, deliver, and support
productsandservices.TheBalanceSheetdocumentstheassetsusedtocreate
andsupportproducts,theworkingcapitalnecessarytoconductbusinessinan
orderlymanner,andthecapitalstructureofthefirm.TheCashFlowStatement
captures capital expenditures and demonstrates the companys ability to pay
itsbills.

The pro forma also provides the foundation for estimating your companys
valuation, known also as an enterprise value. Many factors and variables are
taken into consideration when determining a companys valuation. It is
importantnottorelyonsimpleformulasortouseindustryrulesofthumbto
valueyourcompany.Formiddlemarketcompanies,acombinationofvaluation

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methods are used with each method producing a valuation range. The four
mostcommonmethodsare:
1. DiscountedCashFlow
2. FinancialReturnModel
3. ComparableCompany
4. PrecedentTransactions

By estimating the most likely valuation range using each method, while also
taking into consideration industry conditions, the macroeconomic
environment,andothertimingfactors,itispossibletoderiveavaluationrange
foryourcompanybyevaluatingwheretherangesintersect.

HIGH IMPACT
MARKETING
MATERIALS

ThefinalstepinPhaseIiscomposingandproducingmarketingmaterialsthat
authentically and succinctly tell the companys story with a high degree of
impact. Phase III will use these materials to solicit interest from buyers and
investors.

The Anonymous Profile 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
alsomaybeincluded.Thecompanysidentityisnot
disclosedinthisdocument.

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The Confidential Information Memorandum

summarizes the companys strategy, operations,
industry trends and conditions, and investment
considerations. The CIM communicates whom the
company serves, the problem the company solves,
howthecompanymakesmoneydoingso,andhow
the company will grow. Key sections of a CIM
include an overview of the company, its history,
management team, market assessment (industry
size, drivers, trends, and growth estimates),
competitive environment, products and services,
customerbase,marketshare,compellingpointsofdifferentiation(proprietary
technology and methods, patents, source code, engineering, R&D) and a
financial recap analyzing historical performance and projecting future
performanceintheformofaproforma.

TheManagementPresentationisadynamic,hard
hittingpresentationrecappingthemostimportant
factorsforbuyerstoconsider.Thestructureofthe
presentationreflectsmanagementsapproachand
style and complements the Confidential
InformationMemorandum.

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P HASE II:
B UYER
R ESEARCH &
D EVELOPMENT

PROSPECT LISTS

PhaseIIfocusesonidentifyingasubsetoffinancialbuyers(i.e.,privateequity
firms)andstrategicbuyers(i.e.,largercorporations)thathaveaninterestand
the financialmeans to complete a transaction. The process starts with a very
largeuniverseofpotentialbuyersandinvestors.

The number of domestic and international public and private companies,

including and private equity firms, total over 700,000. By using a systematic
andsurgicalprocess,itispossibletowinnowthislistdowntoasmallsubsetof
firms most likely to express an interest to learn more about your company.
AnalysisperformedinPhaseIistappedtoidentifytheindustrysegmentsand
players who form the business ecosystem and value chains surrounding your
company. Identifyingcurrent participants in the industry, however, is just the
startingpoint.Itisalsoimportanttoidentifycorporationswhomaybeseeking
to enter an industry segment. On the private equity front, firms specialize in
certainindustriesandseekcompaniesofacertainsizeandsetofcapabilities.
The initial screening is critical. Casting too broad of net results in a poor use
everybodystimefilteringoutunqualifiedcandidates.Castingtoonarrowofa
net, on the otherhand, risks potentially excludingthe best buyer or investor.

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FINANCIAL BUYER
PROFILES

The method for screening private equity firms is different from the approach
used to screen strategic buyers. The initial screening concentrates on buyer
mandates, industry focus, company size in terms of revenue and EBITDA,
investmentsize,andgeographicpreference.

PrivateEquityGroups(PEGs)raisemoneyfrominstitutionalinvestors,suchas
pension funds, and qualified high net worth individuals and form a fund
structured as a limited partnership. These funds typically have a tenyear
horizon to give PEGs the opportunity to identify, acquire, grow, and sell
companies. Companies purchased by PEGs are referred to as portfolio
companies. In certain situations, PEGs will create platform companies and
acquire smallersized companies as addons to expand the capabilities of the
platform company as a whole. PEGs typically target the lifecycle stage of
companies in which they prefer to invest. For instance, some PEGs focus on
providing growth capital to early stage firms, others specialize in providing
expansion financing to established firms, while others target acquiring more
maturefirms.PEGsalsoliketotargetspecificindustriesgiventheirexperience
andexpertise.Finally,PEGsestablishguidelinesgoverninghowmuchtheyare
prepared to invest and the minimum size of company they are interested in
based on revenue and EBITDA. These criteria are used to perform the initial
screening. The next step is to peer more deeply into each PEG passing the
initialscreeningandisolatethosefirmsthatarethebestfitbasedoncurrent
investments (i.e., portfolio and platform companies already in the fund),
geographic preferences, investment size, industry focus, and track record for

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successfully growing and exiting similar companies. From this evaluation, it is

possibletosegregatepotentialbuyersandinvestorsintotwocategories,TierA
and Tier B. Tier A firms have the strongest match based on publicly available
guidelines, proprietary research databases, and prior knowledge of the firm.
Tier B buyers and investors could still be viable candidates, but there are
several criterion that are not as strongly aligned when compared to Tier A
firms.ThefinalstepistouseatenpointscaletorankeachTierAfirmbasedon
overall fit and to provide a synopsis describing why the firm is a good fit. By
sortingTierAfirmsbasedonitsrank,itiseasytoidentifythefirmsproviding
thebestfit.

STRATEGIC BUYER
PROFILES

Searchingforstrategicbuyersrequiresdiligenceandcreativity.Employinga4
step iterative process is the best approach to systematically identify and
evaluatetargetcompanies.

Step 1: Evaluate forward and backward supply chain and

valuechainintegration.

Step2:Reviewmacrolevelacquisitionsacrossthebusiness
ecosystem.

Step3:Examinebusinessmodelsforcorporationsappearing
tobeagoodfittoidentifypotentialsynergies.

Step4:Compiletieredlistsandranktopcandidates.

Thesearchprocessisaniterative,ongoingprocessthatcontinuesthroughout
theMarketingPhase.Itisimportanttounderstandeachcandidatecorporation
frombothyourcompanysperspectiveaswellasfromthemarketsperspective
before finalizing the gotomarket list. Strong candidates are not always
readily apparent because they may not be in your industry segment, but are
looking for a company to acquire as the means to enter your segment.
Likewise,acorporationmaybeinterestedinemployingyouruniqueassetsor
technology in a different industry than the one you are currently in. For this
reason,itisimportanttoincorporatefeedbackcontinuouslyfromallcontacted
parties.Atthispointintheprocess,itisessentialtoguardagainstprematurely
disclosingthatyourcompanyisconsideringamarkettransaction.

Toachieveoptimalresults,thesearchprocessiscustomizedforeachcorporate
target. This customization requires developing an investment thesis for each
buyercategoryandincorporatingmicroeconomictrendsthatarefavorableto
your companys products, services, and capabilities. Researching and
understanding each corporations growth strategy and business model is
central to identifying potential synergies, which form the basis for
communications in the form of personal calls, tailored letters, customized
presentations,webinars,andfacetofacemeetings.

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TARGETED LIST OF
QUALIFIED BUYERS

The objective of this extensive screening process is to narrow down the

numberofqualifiedbuyersandinvestorstoamanageablelistcontainingboth
financial and strategicbuyers with a high likelihood of wanting to learn more
about your company and who also have the wherewithal and resources to
complete a transaction in a timely manner. To ensure that competitive
sensitivities are given proper consideration, the final gotomarket list is
reviewed and approved by you before contacting any potential buyer or
investor.

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P HASE III:
M ARKETING &
I NVESTORS
C OMMUNICA
TIONS

INITIAL CONTACT
CAMPAIGN

PhaseIIIdirectlyengagespotentialbuyers.Itstartswithanintensivecampaign
targetingspecificindividualsineachprivateequityfirmandcorporationonthe
gotomarketlist.Identifyingtherightpersontocontactataprivateequityfirm
is straightforward. For corporations, however, the preferred point of contact
may not be readily apparent and if they are, it still can be a challenge to get
them to engage. It is crucial to know what to say during the initial call to
stimulatetheirinterestandtoqualifyfurtherthatthefirmorcorporationisa
strong candidate. Tracking all communications (phone calls, emails,
correspondence)inaCustomerRelationshipManagementsystemisimportant.
Using a CRM ensures every potential buyer or investor is contacted and all
follow up requests are responded to and documented in a timely manner.
Following a methodical process helps build deal momentum, establishes a
sense of competitive urgency, and conveys to buyers and investors that the
searchisbeingconductedinaprofessionalmanner.

Duringtheinitialcontact,yourcompanysnameisnotdisclosed.Theonepage
Anonymous Profile is used to depict your companys characteristics. Indepth
discussions are only conducted after a Confidentiality Agreement has been
executed.

CONFIDENTIALITY
AGREEMENT

Executing a confidentiality agreement reduces the chance that customers,

competitors, and employees prematurely discover you are considering a
market transaction. Confidentiality agreements are legal instruments and
should be drafted by an attorney. At minimum, the agreement should define
themeaningofconfidentialinformation,howconfidentialinformationmaybe
used, who has access to confidential information, restrictions on attempts to
reverseengineerorcopymaterialsforanypurposeotherthanevaluatingyour
company,andremediesintheeventofabreachofconfidentiality.

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I N D E P T H
DISCUSSIONS

After executing the confidentiality agreement, the name of your company is

disclosedandtheConfidentialInformationMemorandumisshared.Thebuyer
profilesdevelopedinPhaseIIsteerinitialdiscussions,soitpossibletohighlight
quickly important facets of your company that should be appealing to the
specificbuyerorinvestor.Thecombinationoftargetingtherightfirmsfromthe
outset,craftingacompellingCIM,anddiscussingonpointthesalientfactorsof
high interest to a given PEG or corporation motivates them to pursue the
transactionandtoengageinternalteams.Thesediscussionscanbeextensive,
butyouandyourmanagementteamareshelteredfromthesecallssoyoucan
concentrate on running your business. The objective of these indepth
discussionsistoprovidesufficientdetailsandguidancesothebuyerorinvestor
can make an informed decision if there is strong fit between what they are
seekingandwhatyourcompanycanprovide.

INDICATION OF
INTEREST

An indication of interest is a nonbinding letter submitted by buyers or

investors who have a high degree of interest in seriously considering a
transaction. Indications of interest state the percentage of ownership sought
alongwithapreliminaryvaluation,expressedasarange,theyarepreparedto
pay subject to further discussions, negotiations, and due diligence. The
objective is to obtain multiple indications of interest as this is the path to
attainingnegotiatingleverageonbehalfoftheseller.

MANAGEMENT
MEETINGS

The stage is now set for you to meet with potential buyers and investors. By
employingasystematicprocesstoreachthispoint,youenterthesemeetings
understandingthemotivationsdrivingeachinterestedpartyandapreliminary
assessmentofhowyourcompanystacksupwithwhattheyarelookingfor.The
management presentation developed in Phase I is used to underscore your
companysgrowthpotentialandoperatingstrengthswhilealsomitigatingany
perceived weaknesses. These management meetings help to create an
environment for parties to get comfortable with each other and to establish
groundsforevaluatingafutureworkingrelationship.

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P HASE IV:
E CONOMIC
N EGOTIATIONS
& L ETTER O F
I NTENT

BUSINESS TERMS

The purchase price for which a company is sold represents a composite of

several factors, terms, andconditions.Some of these factors are economic in
nature dealing, for instance, with the present value of future cash flows, fair
market value of assets and inventory, and the perception of the economic
valueforintangiblessuchaspatents,sourcecode,brands,andgoodwill.Other
factors are legalistic and deal with indemnification, warranties, contingent
liabilities, and the like. Operational and organizational factors also weigh in
concerning, for example, specifying which employees remain with the
company,divestingordiscontinuingproductlines,andrelocatingoperationsto
a different office or city. Many of these terms and conditions are negotiable
andtheirrelativeimportancewillvarywitheachbuyerorinvestor.
Taxes will play a big part depending on what is being bought or sold. If the
transaction is a stock sale, then the seller potentially may realize several
advantages:

Proceedsaretaxedatlongtermcapitalgainsrates

Seller is not responsible for the companys liabilities going

forward

Taxes may be deferred depending on the structure of the

deal

Thebuyer,ontheotherhand,facessomedisadvantages:

Assetscannotbewrittenuptofairmarketvalue

Buyerassumescontingentandunknownliabilities

Goodwillisnotdeductablefortaxes

Anotherwayofstructuringatransactionisasanassetsale.Thereareseveral
advantagesforbuyerswithassetsales:

Goodwillisdeductibleforincometaxpurposes

Assets are writtenup to fair market value, which increases

cashflow

Contingentandunknownliabilitiesarenotassumed

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Theseller,however,facessomedisadvantages:

Proceeds may be taxed at ordinary income tax rates

dependingonthelegalstructureofthecompany

ForCcorpsthereisthepotentialofdoubletaxation

Sellerretainsliabilitiesandcontractsnotspecificallyassumed

Matterscangetcomplicatednegotiatingwhichmethodologies,standards,and
practices to use for determining the final purchase price. This is the realm of
experts and specialists, and it requires a multidisciplinary team of M&A
advisors, attorneys, and accountants who specialize in middlemarket
transactions to guide you through the deal process. For example, negotiating
whichliabilitiesareincludedorexcludedfromadeal,themethodusedtovalue
assets and remaining depreciation, providing sufficient funding for bonus,
profit sharing, andpensionplans, andappropriately valuing futurecash flows
based on current customers are all examples of business terms that have a
directeconomicimpactonprice.Theintegratedfinancialmodelconstructedin
PhaseIprovidesthefacilitytoquantitativelyanalyzetheeconomiceffectthese
variousbusinesstermswillhaveonyourcompanysvaluation.

D E A L S T R UC T U R E

Howadealisstructurediscritical.Itisnotjusthowmuchyougetpaidforyour
company that counts; its how much you ultimately put in the bank that
mattersthemost.Whichofthefollowingtwoscenariosisabetterdeal?

Option#1:sellfor$40million
o $25millionincash
o $7millioninrestrictedstockwithalockupperiod
o $5millionsellernote
o $2millionearnout

Option#2:sellfor$33million
o $33millionallcashupfront
o 3yearemployment/consultingagreement

Atfirstglance,option#1lookstobethewaytogo.Afterall,$40millionbeats
$33 million and you also get the bragging rights that go with the higher
number. But if the acquiring company falls out of favor and the stock price
plummets, and payments on the seller note are suspended to preserve cash
becauselinesofcreditaredryingup,andinternalaccountingtransferscreated
an operating loss eliminating the earnout since it was tied to profits versus
revenue,thenoption#2wouldstarttolookverygood.Ofcourse,itcouldgo
the other way: the stock could appreciate in value while also providing tax
benefits because gains are taxed at the capital gains rate, the

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interestrateonthesellernotecouldexceedwhatyouwouldreceiveinvesting
infixedincomesecuritiesprovidinganicestreamofmonthlyincome,andthe
company gladly pays the earnout because the acquisition exceeded revenue
targets.
Three broad categories can be used to influence the structure of a deal.
Recasting focuses on adjustments to EBITDA, valuing goodwill, employing
accounting standards, adopting realistic forecasts, addressing tax issues, and
otheritemsdirectlyaffectingfinancialstatements.
Sharing future risks allocates risk between both parties and addresses the
extentofprotectioneachpartyseeks.Trust,chemistry,flexibility,believability,
sharedvalues,andthedegreeandnatureofthepartiesinvolvementafterthe
saleallinfluencecredibilityandtheperceptionofthelikelihoodcertainevents
couldtranspireinthefuture.
Compensation concentrates on how you get paid. Several methods of
compensatingasellerareusedtosealadeal.

Cash:
As the saying goes, Cash is king. The benefits are readily
evident:zerorisk,instantliquidity,andtotalflexibilitywhenit
comes to structuring an investment portfolio. Without
planning,however,theordinaryversuscapitalgainstaxbite
maybedouble.Cashalsoeliminatesdeferredcompensation
strategies.

Gettingpaidtoworkafterthedeal:
There are two basic methods of getting paid to continue
workingafterthedealclosesemploymentagreementsand
earnouts.
Employmentagreementstypicallylastthreetofiveyears,but
theycanbeforshorterdurations.Compensationisusuallyin
the form of a base salary, incentive bonus, and company
benefits.Typicalprovisionsincludenoncompeteclausesthat
survive post termination, specific language addressing
conditions for termination, and perks beyond standard
company benefits. Compensation is taxed as ordinary
income.
Earnoutsareoftenusedtoclosethevaluationgapbetween
buyer and seller and typically span one to three years.
Compensationisbasedonperformanceandcanbeladdered.
Earnout targets can be indexed or structured as all or
nothing.Targetsshouldbetiedtorevenueinsteadofprofits.
Taxtreatmentcanbeeithercapitalgainsorordinaryincome
dependingonhowthedealisstructured.

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Gettingpaidnottocompete:
A noncompete agreement protects both the buyer and the
seller.Ifthenoncompeteisnotproperlydocumented,itruns
the risk of judicial interpretation in the event of a conflict.
Fourelementsmakeanoncompeteagreementvalid:
1. Itmustbeinthesametypeofbusiness.
2. There must be some form of paid
compensation or consideration, which is
treatedasordinaryincome.
3. Reasonablelimitsongeography.
4. Reasonableperiodoftime.

Gettingpaidwithstock:
There are different types of stock with various features and
restrictions: common or preferred; voting or nonvoting,
convertible or nonconvertible. If the stock is issued by a
publiccorporationandisregistered,taxesmaybedeferrable
until the stock is sold. If the stock is unregistered, Rule 144
appliesrequiringthestocktobeheldforoneyearorlonger
(in this event, it is important to request piggyback rights).
To guard against a substantial drop in market value,
protectivemeasuresusingstockcollars,puts,andcallscanbe
employed. Private company stock is more difficult to value,
notasliquid,andhypothecation,transfer,sale,orassignment
maybeprohibited.

Otherformsofpayment:
Seller notes help buyers fill financing gaps, which can drive
higher valuations. Typical terms are 1260 month notes at a
definedinterestrateusingapredeterminedamortizationand
paymentschedule.Thesenotesareusuallysubordinatedand
are not collateralized by specific assets. Principal payments
are taxed at capital gains rates while interest payments are
taxedasordinaryincome.

Royalties are typically best suited for productdriven

businessesandcanbeusedduringnegotiationsasatradeoff
for goodwill. Royalties may qualify for favorable tax
treatments.

Warrantsgranttherighttobuystockfromanissueratapre
agreed upon price and are an effective tool to align
incentives.

FoundersInvestmentBanking
2012

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LEGAL TERMS

Afterframingthebusinesstermsanddealstructure,itistimetodelveintothe
various legal issues associated with the transaction. The legal focus in this
phaseisondraftingandexecutingaLetterofIntent(LOI).TheLOIwillserveas
thefoundationfortheDefinitivePurchaseAgreement,whichisdraftedduring
Phase V and covers standard covenants, representations, warranties, closing
conditions,andprovisionsforindemnificationandsurvival.Atthisjuncture,the
partiesconcentrateondefiningthelegalaspectsofthedealandresolvingany
unusualorextraordinaryitemswhichmaysurfaceduringduediligence.

GOOD FAITH TERMS

Good faith terms form a bond of trust between the buyer and seller that all
partieswillrepresentfairlyandaccuratelywhatisbeingboughtandsoldand,
baring unusual and unforeseen circumstances, the parties commit to
completingthetransactioninareasonableperiodoftimeconsistentwiththe
termsoftheLOI.

LETTER OF INTENT

TheLOIdocumentsthebusinesstermsthathavebeenagreedto,describesthe
transaction, states the purchase price and compensation structure, and cites
other key terms and conditions, such as confidentiality provisions, continuing
to operate the company in much the same manner as it has been, and the
sellermakingavailableallinformationnecessaryforthebuyertocompletedue
diligence.An important provision ofthe LOI is grantinga period of exclusivity
duringwhichtimetheselleragreestodiscontinuenegotiationsandnotenter
into any agreement with another party. It is imperative at this point in the
process to have available quantitative and qualitative analyses to equip
shareholderstomakeafullyinformeddecisiononwhichbuyerorinvestorto
choose for negotiating the Letter of Intent. It is important to maintain
competitive pressure by keeping other interested parties as stalking horses
toassistinnegotiatingfavorabletermsandconditions

By implementing a wellstructured competitive deal process, it is possible to

movesystematicallyfromthemanytothemostinterestedtotheone.

FoundersInvestmentBanking
2012

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P HASE V:
D UE D ILIGENCE
& C LOSING

DUE DILIGENCE

Throughout the deal process, the seller makes representations and sets
expectations about the nature of the company. Due diligence provides the
buyer the opportunity to verify all that has been communicated, clarify any
pointsofconfusion,andvalidatethattheoperationsofthecompanyareinline
withwhatthebuyerisexpecting.Duediligenceevaluatesboththebenefitsand
therisksoftheacquisitionorinvestmentbyexaminingthepast,present,and
predictablefuture.SellersshouldstartpreparingforduediligenceinPhaseI.
Duediligencetypicallycoversfourbroadareas:
1.

2.

3.

4.

FinancialStatementsreview:examinestheassetsandliabilitiesonthe
balancesheetbyverifyingtheirexistenceandcurrentvalue;assesses
the income statement to appraise the general health and soundness
ofthecompanysoperations.
Management and Operations review: evaluates the companys
practices, procedures, and controls; assesses key staff members
critical to ongoing success; analyzes revenue streams, customer
concentration, and health of customer relationships; analyzes
products,services,andkeytechnologiesandmethods;reviewsquality
andstabilityofkeysuppliers.
Legal,HumanResources,andRegulatory&EnvironmentalCompliance
review: examines pending or potential litigation or other legal
problems; identifies current or potential human resources issues;
verifiescompanyisincompliancewithregulatoryandenvironmental
lawsandregulations.
Transaction review: verifies all documentation associated with the
transactionisinorder.

The scope of due diligence varies depending on the size and scale of the
company. Experienced buyers will agree to complete due diligence within a
specifiedtimeperiodandwillprovidethesellerwithachecklistofitemsthey
want to review. Many of these items are standard requests and can be

FoundersInvestmentBanking
2012

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preparedinadvancetoexpeditecompletingtheduediligencestep.Examples
oftheseitemsinclude:

Documents
o

o
o
o
o
o

Companymanagement
o
o
o

Relativeprofitabilityofproductsandservices
Ownershipofcompany
Governanceinformation

o Litigation
Contracts
o
o
o
o
o
o
o
o
o
o
o
o
o

Corporatedocuments

Certificateofincorporation

Bylaws

Minutes
Financialstatements

Taxreturns

Assets

Receivables

Pension

ESOP
Environmentalreports
Marketstudies
Productdescriptionsandplans
Keyintangibles
Keytangibles

Mortgages

Titledocuments
Insurancepolicies

Supplyandsalesagreements
Employmentandconsultingagreements
Leases
Licenseandfranchiseagreements
Loanagreements
Shareholderagreements
Sponsorshipagreements
Laboragreements
Goldenparachutes
Deferredcompensation
Poisonpills
Securityagreements
Salesandproductwarranties

Outsidesources
o
o
o
o
o
o

Marketandcapitalinformation
Liensearch
Creditchecks
Backgroundchecks
Patentandtrademarksearches
Assetappraisals

These documents are typically stored in a virtual data room, which

facilitates 24/7 access and reduces the amount of work that has to be
performedatthecompanyslocation.

FoundersInvestmentBanking
2012

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FINALIZE DEAL
STRUCTURE

Any remaining adjustments to structuring the deal are finalized at this point.
Common adjustments include balances for working capital, receivables,
payables, and other current assets and liabilities. Resolving any material
findings or surprises emerging out of due diligence may also affect the
structureofthedeal.

DEFINITIVE
PURCHASE
AGREEMENT



EXECUTE
AGREEMENT



DISBURSE FUNDS

The Definitive Purchase Agreement is the binding legal contract specifying all
terms and conditions of the transaction. All the elements in the LOI are
incorporated as well as the legal clauses and provisions attorneys from both
sidesbelievearenecessaryforthedeal.

The deal is not complete until both parties execute the Definitive Purchase
Agreement. All hands remain on deck until financing is secure and the
DefinitivePurchaseAgreementissigned.

The best part of the process is disbursing the proceeds from the transaction
accordingtothetermsoftheDefinitivePurchaseAgreement.Proceedsfrom
thesaleofmiddlemarketcompaniestypicallyareintheseventoninefigures.
Prudentownersprepareforthisdaywellinadvancebyworkingwithamulti
disciplinary team of wealth management advisors consisting of certified
financial planners, trust and estate attorneys, tax attorneys and accountants,
chartered financial analysts and portfolio managers, and insurance and
philanthropicspecialists.Planningforandaddressingyourpersonalobjectives
areofequalimportancetoplanningandaddressingyourcorporateobjectives.
Somesituationsaremorecomplexthanothersareandnotwocasesarealike.
Succession planning in particular requires careful forethought, consideration,
and coordination. Managing this level of wealth requires both customizing a
plantoyourspecificsituationandformingateamoftrustedadvisorswhowill
continuously place your interests ahead of theirs when the time comes for
implementingtheplanandmanagingyourwellearnedwealthfortheyearsto
come.

Thedealisnotcomplete,however,untiltheinkisdryandthemoneyisinthe
bank.Followingthroughtothecloseisessential.

FoundersInvestmentBanking
2012

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T HE S TEPS O F
A C OMPETITIVE
D EAL P ROCESS

It takes a lot of work, energy, and skill to plan and execute a successful
transaction.Itisfairtoaskifallthesestepsarenecessary.Butwhichofthese
can youafford to skip? Unlocking the economic value ofyour company while
ensuringasmoothandorderlytransitiontoaqualifiedbuyerorinvestorthat
youselectbasedonbothyourcorporateandpersonalpreferencesisanevent
fewpeopleearntheprivilegetoperform.Givenallthatisatstake,followinga
proven methodology managed by a team of experienced advisors who
specializeinmiddlemarketcompaniesmakesalotofsense.

Workingwiththerightteamofadvisorsisthebestapproachtoaccomplishing
the twin objectives of obtaining a premium price with a high probability of
gettingadealdone.

FoundersInvestmentBanking
2012

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A BOUT
F OUNDERS
I NVESTMENT
B ANKING

Founders Investment Banking is an independent investment banking firm,

headquartered in Birmingham, Alabama, that is committed to providing
customized corporate finance solutions for our clients. Our comprehensive
range of complementary, valueadded services include merger & acquisition,
capital market, strategic financial, and real estate investment advisory. We
continue to build our reputation by delivering creative and sophisticated
solutions, providing a superior level of customer service and personal
attention, producing a track record of successful results, and conducting
ourselves every day with the highest degree of personal and professional
integrity.
At our core, our professionals are dedicated to connecting our clients to the
broader capital markets, both domestically and internationally, to accomplish
theirpersonalandstrategicobjectives,withanemphasison:
o
o
o

AchievingGrowth
BuildingValue
RealizingLiquidity

TolearnmoreaboutFoundersordiscusswayswemightbeofservice,please
contact:
DuaneDonnerat2059492043(ddonner@foundersib.com)
GeorgeMyersat2058217437(gmyers@foundersib.com)
ZaneTarenceat2055034013(ztarence@foundersib.com)
orvisitourwebsiteatwww.FoundersIB.com.

FoundersInvestmentBanking,LLC
LakeshoreParkPlaza
2204LakeshoreDrive,Suite425
Birmingham,Alabama35209
205.949.2043(office)
205.871.0010(fax)
www.FoundersIB.com

FoundersInvestmentBanking
2012

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