High Rock Blog

Optimizing for M&A and Growth

Buddy and I recently wrote a chapter in the 14th volume of Advances in Mergers & Acquisitions, published last month.  The book (and chapter) are a bit academic, but there’s some good content and ideas that might be of value as you think about M&A.

We find that private, middle-market companies that choose to implement mergers, acquisitions or growth strategies in today’s environment often face challenges when engaging with the capital markets, particularly when bridging the valuation gap between market values and owner values[1]. The chapter we wrote applies traditional corporate finance theory to the real-world dynamics of private, middle-market companies and outlines practical steps to shrink the value gap and increase transaction readiness.

For private, middle-market companies – those companies with annual revenues from $5 million to $1 billion – value creation is principally based on long-term, expected future cash flow. In practice, the activities that lead to value creation are nearly the same when preparing for a financing, a wave of growth or an M&A transaction. Owners of private companies tend to manage the business to minimize taxes and maximize the current cash benefit to the shareholders. While this approach makes sense in the short-term, it often over-weights decisions and strategies for immediate impact at the expense of what outside investors or lenders would consider long-term value creation. Many times, improving the realizable value of a company means shifting its approach and stance from one that is reactive to one that is proactive. Taking a proactive stance means, among other things, a company will tackle tough issues and instill disciplines like those on which an institutional investor would insist. A useful question for management to ask in readying their company for change is “What would a private equity buyer do to improve my business?” The answer to that question will likely provide keen insights and areas of focus, and is what we hope to provide in this chapter.

Essential to increasing the value of a company is increasing the amount and certainty of its cash flow while reducing the risk of achieving that cash flow. Optimizing the business should result in both a shift in the market value of the company towards the upper-end of valuation benchmarks and increase its alternatives (more buyers, cheaper capital, etc.) when engaging with the capital markets. Our discussion here hinges on those value levers most critical to the optimization of private, middle-market companies from the perspective of those in the capital markets, including institutional investors, lenders and buyers.

Keep in mind that strategic decisions need to be thought of and developed by aligning the company’s long-term growth strategy with the right leadership team, with the appropriate entity and organizational structure supported by scalable systems, and capitalized by the proper funding sources. Management must also consider changes to a company relative to its stage and life cycle within its specific market.

Calculating the value of a stream of cash flow can be viewed in mathematical terms by this simplified formula[2].


According to this equation, we can increase value by increasing the absolute value of the cash flow, reducing the cost of capital or increasing the rate of growth of the cash flow (or any combination of the three). Reducing the cost of capital is, in part, directly related to the risk of achieving that cash flow. To frame the discussion and apply some basic corporate finance concepts, we will look at value creation and optimization of a private, middle-market company as an exercise with three distinct types of value levers: (i) pursuit of strategies that increase the return on invested capital, (ii) pursuit of strategies that reduce the risk of investment in the company, and (iii) pursuit of tactics and strategies that ease the transfer and reduce the company specific risk of transitioning a business to new owners (whether transferred in part or in whole).

Certain businesses don’t generate positive cash flow in the early phase of their lifecycle but do create significant inherent value. From a buyer or investor perspective, these companies may have captured (or are capturing) a significant customer base or developing a technology that will eventually lead to relatively large and material cash flows. These core concepts still apply.

[1] Owner value is the value of the business interest to the current owner, considering
the entire stream of value including both financial and personal considerations that
accrue to his/her total economic benefit. The risk implied by owners to this value
stream is usually less than what the market would otherwise impute, which exacerbates
the valuation gap.

[2]There are variations of this formula that account for fast growth businesses, and
for those with negative short-term cash flow and positive long-term cash flow.


How Do I Know When the Timing is Right to Sell My Business?

This is a reprint from my interview with Divestopedia

Historically, at a high level, we know that the M&A market runs in cycles. Understanding the broad market as to where we are in the overall M&A cycle is step one. But, that’s not always the best indicator. That’s only one element of understanding when it’s right to sell. Determining when to sell should also take into consideration the specifics of the industry and what’s happening within a given industry. The best time to sell is when the industry trend is going positive at the same time that the M&A trend is positive.

So for example, if you have a Software as a Service (SaaS) company, you should consider the broad technology trends. Where does the company fit in the industry, and who are the other players in that space? You can begin to get a sense of if the timing is right and if the dynamics within that industry will value or appreciate what your company has to offer strategically as well as the core economics of the business.

Particularly if you think about the lower middle market, we tend to deal with this issue of the company has made investments that haven’t materialized or have been realized in the P&L. The business owners are always wanting to get paid for value that’s inherent in the business but isn’t showing up yet in the company’s cash flow. One of the best ways determine the right time to sell is to really articulate and understand that strategic component of the business and how it plays into a market trend in a positive way. When this is mapped out, you will be able to determine if you’re on the growth curve that buyer like to see; you’re not too early in it but you’re not at the very peak either. When you wait until you get to the peak, it may be too late to sell for maximum value.

Where Does the M&A Advisor Add Value?

We surveyed private company sellers after their deal was done to gain insight into what was important to them and to better understand the selling process through their eyes.  While we are located in the Research Triangle Park area of North Carolina, we leveraged our national network of contacts to gain broad perspective in a variety of industries and states.  Below are a few statistics that might help you as you think about selling your company (or helping your client in the process):

Number of survey participants 63
Years in which companies were sold 2010 – 2014
Industries represented 18

As you can see from the chart below, companies representing the lower-middle and middle market participated, with revenues ranging from a few million dollars to nearly $250 million.



So where did the advisors add value?  That’s the chart below, ranking the area of value-add by highest or most value to lessor.  As you can see, the highest ranked areas were about the credibility attributed to the seller based on the advisor’s credibility coupled with leading the process and having an understanding of the transaction to negotiate on the seller’s behalf.  On a combined basis, these should enable the seller to achieve value that they might not otherwise have realized on their own.  Contrasting the value of legal counsel in the negotiating process, a M&A advisor should be able to assist in structuring the economic elements of the transaction to optimize the deal for you.  Surprising to many sellers is that “finding or identifying the buyer” is not on the top of the list.  It is important, and there should be solid process for understanding the logical buyer groups and who the key players are in each; however, actually contacting and get to the buyers is much easier in today’s environment than you might expect.  What is not so easy, is getting through their filter as a viable acquisition target ….in our view, this is why credibility of the seller ranked higher.


Two additional areas of value add are worth noting.  First, preparation for the sale process is so critical and relates directly to credibility.  A key concept above all is elimination of surprises to the buyer.  Surprises Kill Deals!  It is better to spend the time, understand the issues and opportunities specific to your company, and proactively prepare and address them at the right time in the process.  The second and last area of value add in this post deals with communication and negotiations. Private equity and strategics are the two main groups of buyers.  In both cases, management needs to preserve and build their relationship with the buyer as the process gains traction.  Invariably there will be tough issues to be communicated and tackled.  The M&A advisor should be able to run interference for management on the difficult and contentious issues, allowing the seller to preserve their goodwill in the relationship. Having a third party push on these deal points also gives the seller a fallback if the advisor pushes too hard.  After all, you can always fire the deal team …you can’t fire yourself as the seller.  So what you say is hard to retract.

I realize that this is self-serving, but we found in the comments, consistent feedback from experienced sellers indicating that they use a third part to facilitate their transactions.

M&A Advisor vs. Investment Banker vs. Business Broker: What’s the Difference?

Hiring the right team is always important, and no different when considering the purchase or sale of a company.  For owners in lower middle market businesses, it can be confusing when deciding on what type of advisor you need or who will really serve your interest.  Here’s a quick note on understanding the differences between business brokers, M&A advisors and investment bankers.

Business brokers typically work with smaller companies that will likely sell to an individual buyer (vs. a corporate or institutional buyer).  The process they use is very similar to that of listing a house for sale …and the terms they use are about the same.   In concept, business brokers sell companies that are income replacement for the owner/operator; and valuation is typically based on “sellers discretionary earnings”  (cash flow to the owner/operator).   Information is collected about the business and the company is advertised for sale on websites and marketed with an asking price.  The typical transaction is the sale of the company’s assets using template or standard forms.

M&A advisors and investment bankers are similar in their offerings, though there are some differences. To some degree, M&A advisors bridge the market gap between transactions that are clearly led by investment bankers (those where the deal size is greater than $150 million) and those led by business brokers (typically less than $2 million).  Investment bankers typically offer a broader range of services and work with larger companies …services like fairness opinions, public offerings, etc…  and those that might require formal licensing as a broker-dealer.  In practice, most lower middle market transactions do not require the advisor to be licensed under the securities laws, thus you find that most are not; however, this is a grey area and subject to specific facts and interpretation that will hopefully be addressed by the SEC and congress in the months to come.   In general, investment bankers are purely transaction driven and have minimum fee expectations (which tend to create a floor in the size clients that they serve).

M&A advisors tend to be somewhat consultative and might work with clients in the strategy and planning phases as they consider their exit or liquidity alternatives.  Both M&A advisors and investment bankers run a process to sell a company that is proactive and usually focused on creating a competitive and timed environment for the seller with the goal of optimizing the value and reaching the seller’s objectives.   Unlike the passive process used by business brokers, the actively managed process of M&A advisors and investment bankers tend to add value …and should pay for itself, not being a cost to the seller …rather an investment with an expected return.  M&A advisors and investment bankers typically buy and sell companies to/for other companies or institutional investors e.g. private equity funds.   The transactions involved at this size and stage of the market tend to be somewhat complex and require a level of sophistication and understanding in corporate finance not found at the lower-end of the spectrum.

Acquisition Financing

In 2012 we published our book on mergers and acquisitions ….it is called “Middle Market M&A: Handbook of Investment Banking & Business Consulting“.  One of the topics we address is financing acquisitions and various ways to thinking about getting deals done.  In the middle market, funding strategic deals is often a mix of senior debt coupled with mezzanine and some type of seller financing (i.e. seller note or earn-out).   If your company, as the buyer, is a lower middle market business itself; a key to being credible in the negotiating process is having evidence of financing before you enter discussions.  This essentially means building an acquisition strategy and plan, then obtaining buy-in from lenders and investors before going to market.  An advantage of this approach is having the experience and support of your financing sources early-on and in due-diligence.  Overall this helps improve the likelihood of a successful transaction.

The Value Gap

Our team at High Rock Partners is constantly listening to clients and observing market trends.  In a short video, we captured our view of the quandary of emerging growth and middle market company leaders.  The need and case for focusing on value creation has never been more prominent than it is now …businesses must pursue strategies to become stronger …not just to lead, but to survive and thrive.  Here’s a link to view the video  http://vimeo.com/53096085 The snippet ends by talking about our framework and tools to create value for shareholders; it is called Strategy Navigator™.

Also, here’s a link that talks about the Value Gap on Divestopedia.com

Unitranche Financing

In recent months, I’ve had clients ask about “unitranche financing” ….what is it, what is different, when would you use it and where do you get it?  The definition that we use in the Handbook of Financing Growth is –

“A hybrid senior loan product that blends first and second lien debt, and in some instances mezzanine, into a single tranche.”

A tranche is a round or an installment of funding.  A company typically seeks to maximize its borrowings with lower cost senior (or first lien) debt and then add debt that is increasingly more expensive as the lien position decreases. It is similar to the concept that a mortgage on a house is the cheapest because it has the deed of trust in first lien position in the event of default.  If you then get a second mortgage or equity line of credit, it has a second lien on the property and is a bit more expensive.  Lastly, if you obtain unsecured debt like a credit card …it is the most expensive.  In business, the unsecured debt is usually called subordinated debt or mezzanine financing.

Historically, each type of debt comes from a different funding source.  A business would get senior debt from the bank, junior debt from a hedge fund or specialty finance company, and subordinated debt from a mezzanine lender or growth equity investor (mezzanine is a hybrid debt and equity).

In the market now, there are lenders that have combined all of the levels of debt for a company into a single financing resource (and set of documents) call “unitranche financing”.  This can make a lot of sense when a company needs to get a deal done quickly and with a single lender ….eliminating the negotiations and costs among multiple parties.

The Public Option for Growth Capital

Last week at our local NFA chapter meeting I listened intently to Raymond King of the Toronto Stock Exchange share his insights into the market from the Canadian perspective.  What really caught my attention is the creativity and progressiveness that the TSX has applied in filling the need for late stage venture and growth funds in their country (and how it can be available to foreign businesses too, i.e. those in the U.S.A.).   The TSX has a  platform called the TSX Venture Exchange that enables revenue generating companies that are within a year or two of profitability to raise growth financing in the equity markets …you’ll need to raise $5 million plus for it to make sense.  I was also impressed with the breadth of sectors and industries supported.  For example, the TSX has the largest clean technology public market in the world.

Here’s a copy of the September 2010 presentation with significant background about the Toronto Stock Exchange and the TSX Venture Exchange.

M&A Activity Up; Private Equity Still Cautious

How is your deal activity this summer? I met with Mia Saini of Forbes and had a discussion about the M&A markets. She posted the dialog on her blog Money with Mia ….here’s our video on Forbes Video Network™ about M&A activity.

I also spoke with the folks at GE Capital this summer …and had a chance to share an article that we titled  “Exits & Acquisitions” in their CapitaLens™ newsletter.


Last week we held our monthly National Funding Association meeting in Raleigh. Our guest speaker was Bill Hobbs, Managing Partner of Carousel Capital. Carousel is a buyout fund purchasing companies with at least $3 million of EBITDA located in the Southeast US. In addition to the industry trends and observations, Bill highlighted a phenomenon somewhat unique to our times; we’ve seen the same. That is, valuations for well run and good performing middle-market companies are strong and funding is available. Otherwise, valuations are depressed and deals tough to do …in many cases there’s no deal to be done. This makes sense given the back-drop of historically high dry powder in the coffer’s of private equity funds searching for deals to invest in. In fact, there is the greatest amount of overhang and pent-up capital ever for middle-market transactions.