Pepperdine survey: what rates of return do PE’s, VC’s, banks, and other financiers expect?

John K. Paglia and the Graziadio School of Business and Management at Pepperdine University is conducting their ongoing private cost of capital survey, a research survey pertaining to privately-held companies and the markets in which they raise capital. The survey “examines the behavior of senior lenders, asset based lenders, factors, mezzanine funds, private equity groups, angel investors, venture capital firms, business owners, investment bankers, business brokers, limited partners, and business appraisers.”

You can contribute to the updated survey by clicking here. Individual responses will be kept confidential, and participants will receive the survey results and a comprehensive outlook on private lending and investing, expected in four to six weeks.

If you have any questions or comments, email Paglia.

Large companies don’t want to disclose litigation contingencies to investors

businessvaluaton.com is following the story of the August 18th letter signed by a host of Association of  Corporate Counsel’s leading members.   ACC and many of their members believe that the proposed disclosure requirements about impending risks from litigation will alert the tort bar to insurance and other funds that can be pursued–delaying settlements and counterproductively inducing more litigation.

FASB had dropped this proposal in 2008, and recently reintroduced it, causing ACC’s response.  Some commentators feel that FASB, facing the twin threats of Bob Herz’ early retirement, and the increasing dominance of IASB, is struggling anyway–so now’s a good time to go on the offensive regarding fair value issues.

Among those signing ACC’s letter were its key officers, including Patricia Hatler, chief legal and governance officer at the Nationwide Mutual Insurance Company; J. Alberto Gonzalez-Pita, general counsel of HCP, Inc.; Jonathan Oviatt, chief legal officer of the Mayo Clinic; Michele Gatto, corporate services & chief legal officer at the National Life Group; and Bradford Smith, general counsel of Microsoft Corporation and chair of the ACC Board Advocacy Committee.

Will the outcome of this regulatory issue influence the way private business owners and investors look at the value of small businesses? At this time, bv.com believes the answer is “no.”   Disclosure standards in private deals remain the same;  if there is “known or knowable” litigation in the works, it better come out during due diligence, or there will be problems after the deal closes.

You’ll get a better price from ’strategic’ buyers now than you will from ‘financial’ buyers

Business owners and brokers can find 142 more current private company financials and market comps

A reminder of “the basics” in the on-going fair value debate

Going Concern’s Adrienne Gonzalez recently asked the question “does anyone care about fair value anymore?” Tired of reading IASB and FASB requests for comments, Gonzalez asked David Larsen (Duff & Phelps and a member of FASB’s Valuation Resource Group) for his current thoughts.

“David believes public opinion dominates the fair value argument and really doesn’t see what the big deal is,” comments Gonzales. “The goal is to make financial statements more readable.” Larsen is “a fan of transparency on the face of financial statements and more disclosures. Who doesn’t like that?” asks Gonzalez.

Click here for the full article.

Thinking of acquiring a business? A fairness opinion provides protection

If you’re in acquisition mode, there’s a small legal detail you may face–getting a fairness opinion.  During the recent BVR webinar on fairness opinions, Jeffrey Rothschild (McDermott Will & Emory) told the audience there are generally two different models of fairness opinions; one by Goldman Sachs and the other by Houlihan Lokey. The Goldman model is a very short fairness opinion, generally a page-and-a-half, while the Houlihan Lokey model is typically three or four pages. “Houlihan Lokey’s opinion will typically state quite clearly what it is not. Goldman’s will not do that,” says Rothschild.  “I think that the trend has certainly been towards Houlihan Lokey’s model in this area and not Goldman Sachs’.”

As a subscriber service, BVWire extracted this sample Houlihan Lokey fairness opinion from the SEC EDGAR database.

For the complete presentation on fairness opinions click here.

BV.com recommended by New York Times small business center

Owners looking to sell can benchmark their financial thinking by using Pratt’s Stats and other databases available from BV.com–as reported in the New York Times.

One way to increase the value of your business

by Dave Kauppi, CBI, principal at MidMarket Capital Advisors, LLC

At one point or another all business owners face the question how to transition ownership of their business to another party. It’s what we call Exit Planning and Strategies. This process can involve turning over the reins to a relative, merging the business with a larger company or perhaps selling the company to a new owner, to name a few options. Whatever you decide to do, having good people and systems in place that enable the company to run smoothly and with less direct activity from you, the owner, will dramatically impact the value of your business.

Investors are not looking to buy a job; they certainly don’t want to spend money for a company that requires their full attention to day-to-day operations. Instead they are looking to invest money in companies that have internal, systemic control over their operations and that function well without the owner present. Investors are looking for businesses that are profitable, organized, and with proven systems in place to all but guarantee a positive cash flow and an acceptable return on their investment.

What are you doing in your company that someone else can do?  For example, are there key customers you can turn over to a trusted employee?

A good idea to improve the value of your company is to develop an Operations Manual that details processes, procedures, key responsibilities, and proves you are not needed for a buyer to get the requisite return.  The Operations Manual would consist of three parts:

1. A current Organizational Chart
2. Job Descriptions for all exempt positions
3. Process Manuals.

The Org Chart will show the basic structure of the business by listing all the exempt positions within the company.

Job Descriptions list all the responsibilities for each position on the Org Chart.

Process Manuals list all the processes and procedures assigned to and performed by each position. Once an Operations Manual is in place, you have achieved a major milestone to building a business that can run without you.

Selling your company to management sounds like a good idea, but…

by Dave Kauppi, CBI, principal at MidMarket Capital Advisors, LLC

Many owners think that selling their company to their management team is a great way to reward loyal employees for years of service. This article discusses difficulties the owner’s exit planning team will have implementing a management buy-out and puts forth an alternative approach which accomplishes many of the same goals.

Showing gratitude to loyal employees is a noble desire that often leads to the exploration of a management buyout. The thinking goes: who better to buy the business than the management team that is familiar with the procedures, the customers, the suppliers, the industry and the intellectual property?

From a practical standpoint, however, unless the potential management buyout team already owns a meaningful percentage of the company, it is unlikely they have the financial resources to complete the acquisition. In addition, though these managers may be great employees, seldom will they have the risk tolerance to expose their personal assets in order to finance an acquisition.

Employees may at first naively think they will be able to secure financing to make the acquisition, but when they begin to peel back the layers, experiencing first-hand the detailed level of skepticism expressed by today’s financial institutions, their enthusiasm likely will begin to crack. Banks today are not going to finance an acquisition based on a competitive market price for the business. They will probably make loans based on a percentage of the asset value of the equipment, receivables and inventory that exceeds the company’s debt level. This will likely result in the buyout group getting financing at, perhaps, 40-50% of the investment value of the company.

Where does the remainder come from?

Mezzanine financing? Mezzanine financing offers a way for privately held companies to attain financing without relying on public markets and potentially ceding ownership of their company. It is a blend of traditional debt financing and equity financing. Like equity financing, mezzanine financing is an unsecured debt, requiring no collateral to be put up unlike traditional bank loans. Like debt financing, mezzanine financing is very fluid and does not necessarily involve giving up an interest in the company. When the management buyout team explores the effective rate of mezzanine financing – 12% interest rate with warrants that drive the cost to 25% – they usually eliminate that option.

Personal assets? When the banks start asking for personal guarantees, individuals drop out pretty quickly.

This process sometimes evolves to the owner being asked to settle for a purchase price closer to the secured financing level available rather than the market value of the company. On a company with a $10 million fair market value, this could result in a discount of $5 million or more. Is this what you want?

Unforeseen and unintended consequences occur once a very excited management team realizes that their dream of ownership has been knocked off the track. Many times key players will blame the owner for not acquiescing to the lower acquisition price; they can turn from loyal to disgruntled and may even leave the company. This can result in true erosion in company value. The original plan has blown up in the owner’s face. The exit planning team has to be aware of this possible scenario in advance and work to create solutions.

Another approach would be for the owner’s team to seek competitive bids from both strategic buyers and private equity groups. This process would give instant visibility to value that would presumably be far superior to the financing value of the assets minus liabilities. The owner could grant key employees a cash award based on years of service, salary, or other criteria of his choice. Of course, this deviates considerably from the employees-will-take-over ideal.

If the buyer is a Private Equity Group (PEG), the owner has another option that may be even more attractive to key employees and the owner. PEGs encourage sellers to invest some of their equity back into the business. They get to invest leveraged equity along with the PEG.

So let’s say that the selling price of the business was $10 million. The PEG would borrow $7 million and need $3 million in equity. If the seller invests $1 million of his (or her) proceeds back into the business, he would own 33% of the new entity. If the owner was planning on distributing $500,000 to employees, he could reinvest that $500,000 along with his $500,000 back into the business and he would then own 16-½% and the employees would own 16-½% of the new entity.

The employees will be highly motivated to stay and to perform at a high level for their eventual exit and cash out. The PEG gets to keep a performing management team in place that is highly motivated. The owner gets the investment value for his business because of the soft auction business selling process. Finally, the owner gets to reward his loyal employees with a powerful investment in their future.

The second payoff for the owner and a powerful payoff for the employees comes five years later when the PEG sells the company now valued at, say, $50 million to a strategic industry buyer. This second bite of the apple values the owner’s retained 16-½% stake at $8,250,000. The loyal employees cash out at that same level from the original $500,000 bonus, and a creative solution pays off for all.

Our thanks to Dave Kauppi and MidMarket Capital Advisors, LLC. for permission to use exit planning and exit strategies content and ideas on businessvaluation.com!

What’s your software company worth?

This Thursday June 24th, BVR’s Webinar Industry Spotlight Series presents “Software Company Valuation,” hosted by Mike Pellegrino (Pellegrino & Associates) and Robert Schlegel (Houlihan Valuation Advisors).  Schlegel and Pellegrino, a former software engineer and author of BVR’s Guide to Intellectual Property Valuation, will tackle the valuation challenges appraisers face when valuing software companies–and how owners can create more value. For more information or to join us, click here. CPE and CFA credits are available.

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