Archives for April 2011

Deal Algebra: Pre-Money and Post-Money Valuation with a Twist

April 29, 2011 By Ney

If someone buys 25% of your business for $2 million, it is easy to determine the value. If someone invests $10 million in your business for 50% it is a little bit tougher. How do you determine value if someone says, “I’ll pay you $ 2 million and I’ll invest another $10 million in the company and then we’ll both own 50%”?

Equity Purchase

Let’s start with the easy example. Say you sell 25% of your company for $2 million. That means your company is worth $8 million, correct? Not much algebra there.

Capital Investment: Classic Pre-money / Post-Money Valuation

Now let’s say that someone offers to invest $10 million in your company for 50% of the company. What is it worth then? Well, after the investment the company will be worth $20 million, but really the enterprise value of the company itself will be $10 million (the same value as before the deal), with $10 million of invested cash on the balance sheet. In venture-capital-speak, the pre-money valuation will be $10 million while the post-money valuation will be $20 million. Another way to look at it is that the owner did own 100% of a $10 million dollar company, and now owns half of $20 million company but he still owns $10 million of value.

A Mix of Equity Purchase and Capital Investment

Now here is the tough one. We recently had a buyer make a compelling offer to our fast-growing client: “I’ll pay you $2 million and I’ll invest another $10 million in the company to fund growth and then we’ll both own 50%” (By the way, I changed the numbers from the actual deal). It wasn’t until later that the question came up: “Um, what does that make the company worth?”. It was an interesting deal because no one actually cared but the attorneys and accountants – the seller and buyer were happy with the statement above.

The first cut at this may be, “Well, the buyer just paid $12 million total for half the company, so it’s obviously worth $24 million”. In fact, that is exactly what the attorneys said. Those guys are really bright on legal matters.

However, the day after the close the buyer would own half the company and therefore half the balance sheet, which now has another $10 million in cash on it. In other words, he would have 50% of the company and rights to $5 million in excess cash, which theoretically he could take home. So really, he paid only $7 million for half because he still “owns” $5 million. That would indicate it is valued at $14 million. In venture-capital-speak the pre-money would be $14 million, and the post-money would be $24 million. Or another way of saying it, the enterprise value of the core business is $14 million, with $10 million of excess cash on the balance sheet. This method, however, is really a short cut and doesn’t use much math.

Taking it even further, what is really going on with the ownership of the company? The owner is selling some of the company to the buyer for $2 million, however the buyer is also being issued new shares for the $10 million investment they are making. At the end of it all, including dilution, they both own 50%. How much of the company is the seller selling, and how many new shares should be issued? Now this is deal algebra.

To work this out I set up some equations with variables like shares sold, new shares issued, 50% ownership, enterprise value, etc. and solve them simultaneously. To make it easy I assumed 1,000 shares existed in the company although that wasn’t actually the case. One key constraint is that the share price for the shares sold and the shares issued is the same. In other words, the buyer is buying some shares from the owner, and some from the company treasury but is paying the same per share price for both.

For this example the owner would sell (143 shares) 14.3% of his company to the buyer for $2 million and $14,000 per share. 714 new shares would be issued, also at $14,000 per share. This would mean both the buyer and seller own the same number of shares at 857 shares.

The Actual Algebra – for Those that Care

For those that actually want to look at the math, here it is:

First, let’s assume 1,000 shares are originally outstanding. Then let’s say:

X = Shares sold by seller to buyer
Y = New shares issued to buyer
Z = Total amount of shares outstanding post-merger
P = Price per share

We know the buyer will own 50%, so I set up the equation:

X+Y = Z/2

We also know that the price per share (the same for both shares sold and newly issued shares) is:

P = 2,000,000/X (or X=2,000,000/P)
P = 10,000,000/Y (or Y=10,000,000/P)

Substituting these into the X+Y=Z/2 equation:

2,000,000/P + 10,000,000/P = Z/2 Or

Z * P = $24,000,000

Z is the total shares after the merger, so Z * P is the “post-money” valuation of $24 million. The enterprise value, or pre-money valuation, is always the post-money less the investment cash, so the pre-money would be $24 – $10 million or $14 million.

We also know that the pre-money valuation is the share price (which doesn’t change pre to post-money) times 1,000 shares:

$14,000,000 = P * 1,000

P = $14,000 / share

Using the equations above for X and Y in terms of P, we can easily calculate:

X = 2,000,000 / P = 143 shares are sold to the buyer (you can also think of this as 14.3% of the company is sold to the buyer for $2 million)

And

Y = 10,000,000 / P = 714 new shares issued to the buyer for his investment of $10 million

A quick check is now the seller has 1,000 – 143 = 857 shares. The buyer now has 714 new shares + 143 shares he bought from the seller = 857 shares. Dang, it worked.

There are obviously numerous ways of solving this, but that is how I did it. I have some cap table spreadsheets I dug out, but none of them could handle both an equity purchase and investment at the same time, so it really did come down to algebra.

If you got this far, do me a favor. I would be curious if anyone actually got any use from this algebra exercise. If you did, drop me a note at ney [at] compasspointcapital.com and let me know.

Upfront Fees for Business Brokers and M&A – Should You Pay Them?

April 26, 2011 By Ney

If you are small business with earnings under $300K then you would probably approach a “main street” business broker to sell your business. It is industry standard practice for business brokers to not charge an upfront fee. Actually, in most states it is even more than that – it’s the law. In many states in which business brokerage is regulated under the department of real estate, brokers are not allowed to collect upfront fees that are a part of the sales commission. If they do charge an upfront fee, it has to be for a tangible product or service such as a formal valuation (not a 5 or 10 page “broker’s opinion of value”).

So that is pretty clear – if you are small and use a broker – no fee. It is also pretty clear that if your company has $1 million or more in earnings, you will want to use an M&A firm or investment bank and you will not only pay a upfront fee, you also may have to pay a monthly retainer (for very large companies).

But let’s talk about that middle ground, where it really isn’t clear what is what. In this space business brokers often call themselves mergers and acquisitions advisors and M&A advisors call themselves investment banks. Some high growth companies with $500K in earnings may well need a good M&A advisor because of the complexities of the business, while a car wash with $1 million in earnings could be sold by a no-fee business broker.

Here’s a couple of things to remember when considering whether you need to pay an upfront fee:

Like many things, you get what you pay for
However, be sure to ask what exactly you are paying for

What you want to pay for, and what it makes sense to pay upfront cash for, are products and services which help you sell your company and get the best price. This assumes you agree with the notion that professional marketing of your company increases the chance of getting it sold and with the best price. These services should ideally be performed (just ask) primarily by professionals, not the broker or dealmaker whose primary payday should be selling the company. Examples of items you should not mind paying an upfront fee for:

A professionally prepared selling prospectus (the book). By the way, there is a big difference between a professionally prepared book and a fill-in-blanks template that some firms use.
Sales and marketing materials. Executive summaries, photos, videos, blind web summaries, letters of introduction, etc.
Marketing research to uncover strategic and financial buyers. Good research entails using many resources and is very time consuming – and it consists of more than running a list based on SIC or NAICS codes.
Actual marketing costs of mailings, telemarketing, etc. (As opposed to a business broker that typically only pays for a web listing service.)

What you don’t want to pay for with your upfront fee are commissions paid to salespeople for signing you up. Some firms pay up to 50% of the upfront fee to salespeople to sign you up, and that is money that isn’t being used to prepare and market your company. What is worse, often those same salespeople are the ones that have complete authority to sign you up, creating an incentive to say all the right things to get the fee. However, they are not actually responsible for selling your company.

This business model has led to the rise (lots of new clients and fees) and eventual collapse (only sold a small percentage of clients) of some large M&A firms, most notably the Geneva Group. There are similar companies out there today, often using telemarketing and a seminar strategy.

The best thing you can do is ask directly about how the upfront fee and commissions work. Where does that money go and what is it used for? I was in Brazil recently and the prospective client really drilled me about fees and commissions. He was focusing in on the flow of money and where the incentives would be in my firm. That rarely happens in the US, but it should. Ask.

M&A Websites that Connect Buyers and Sellers

April 17, 2011 By Ney

In the last post I covered business-for-sale websites, which are fairly simple listings of businesses for sale, typically smaller businesses. For larger deals there are a few websites that go beyond a listing service, and they provide more powerful tools for sorting and searching to find the right buyer and the right seller.

The two M&A sites I’m familiar with are PEGBASE (www.pegbase.com) and AxialMarket (www.axialmarket.com). In both cases the business model is completely opposite of bizbuysell.com and the other business listing sites. For both of these sites the buyer pays to use the site, not the seller. Both consist mainly of private equity buyers, however Axialmarket also contains strategic buyers.

AxialMarket describes itself with the statements, “AxialMarket provides technology-enabled tools and analytics to help intelligently connect qualified buyers and sellers of privately held companies. Since 2007, AxialMarket’s deal management and deal origination platforms have been used by many of the most active lower middle market financial buyers, strategic buyers, and M&A Advisory firms to source, manage, and execute private M&A transactions across a broad range of industries, geographies, and transaction types. “ PEGBASE describes itself with the statement, “PEGBASE is a consistently formatted M&A Investment Opportunities clearing house that reaches key M&A players in the most efficient and useable manner”.

We have a very complete list of PEGs, but AxialMarket tends to be more up to date with what kind of portfolio companies the PEG’s own, and exactly what they are looking for. That is one of the benefits of charging a fee, the PEGs and strategics are not going to want to waste that money and will spend some time creating an accurate profile on the AxialMarket website. The downside is that because it is fee based, they don’t have a complete list of PEGs and definitely not a complete list of strategics. For example, for the lower middle market we typically find strategic buyers that are not specifically looking for an acquisition, but will take a look at opportunities presented to them.

I’ve been impressed with the Axialmarket interface. It shows you what types of buyers fit your opportunity, and you can easily filter different buyer types (such as PEG platform, add-on, etc.). You can “mouse over” a buyer and instantly see a profile.

Like the business-for-sale websites, sites such as AxialMarket and PEGBase are a great tool to use to help find buyers, but it shouldn’t be the only tool. We’ve found the best results come from using every tool – both technology based as well as traditional mail and telephone.

Which is the Best Business-For-Sale Website?

April 6, 2011 By Ney

Building a website that puts business buyers and sellers together, then charging a subscription fee for the service must be fairly easy to do. Why else would there be over twenty sites doing it, with more appearing each year? The fact is, it isn’t necessary for buyers and sellers to hit all the sites. Here is why.

Let’s think about that from the point of view of a business buyer. A serious buyer is going to start looking for businesses, and very quickly they are going to find out that the place to look is on the web. No one uses newspaper ads or journal ads any longer for small businesses (although we still do for larger ones). A few quick searches on the web, and they are likely going to wind up on one of the top sites. The top sites are at the top of the Google natural rankings and the top sites also advertise more heavily than the other sites. Really, it is pretty tough not to end up on the top sites within a few days of starting your search.

I’ve done some searches for clients, and as a “buyer” I’ve also realized pretty quickly that the same businesses are listed on many sites, and the common denominators are the top sites.

So what point is there for a broker or M&A advisor to market their clients on 20 sites? Not much, except being able to tell your clients you are marketing on 20 sites. In my opinion it is better to get on the top sites but also use other marketing channels, even good old US Mail and the telephone, to find buyers.

Now there are some differentiation features of some of the websites. For example, mergernetwork.com is for larger companies, businessesforsale.com has better exposure to international buyers and bizben.com is a great site for California businesses.

So which are the best? Well, I wouldn’t just advertise on one or just do your searching on just one, you do want to pick a few – but you don’t need 20. Bizbuysell is owned by the Wall Street Journal and they also purchased Bizquest.com so they are definitely the heavy weight in the industry. You definitely want to use them as a business buyer or seller. Businessesforsale.com has a bit more traffic than bizbuysell.com; however, they are ranked number one in the UK and Australia and much of their traffic is generated there. Here are some traffic stats from web traffic stats company Alexa. I’ve compared to Bizbuysell a dozen of the top sites.

The above chart measures the traffic of Bizbuysell.com vs. Businessesforsale.com as well as mergernetwork.com, bizben.com and bizquest.com. Although businessesforsale.com is ranked a little higher than bizbuysell.com on the Alexa ranking site, I would rank bizbuysell.com higher in the US for US companies. If a company could be acquired by an overseas company then businessesforsale.com would certainly be a place to advertise.

The above chart again graphs bizbuysell and businessesforsale.com for reference, and compares them to businessbroker.net, businessmart.com and acquireo.com. None of these sites generate the web traffic that bizbuysell and businessesforsale.com do.

Birds, Rain and Wind – Flying to Visit Business Owners

April 2, 2011 By Ney

Another business trip to Southern California, this time to see a prospective new client and meet to discuss a serious letter-of-intent with a current client.

The weather was going to be marginal, so Graeme drove to Placerville so I wouldn’t have to do an approach into Auburn or Truckee to get him. This way I could launch into low weather and fly into clear weather as we flew south. But I didn’t get off the ground before we had a bird strike. I didn’t feel or hear it, but I clearly saw it coming and there wasn’t anything I could do. Fortunately it was small bird, but I did abort the takeoff, shut down and inspect the propeller. I also had to clean the windshield and pull feathers and stuff off the wing.

We only had short bit of flying in rain before we broke out and had a dramatic flight with lots of different layers of clouds. We had a meeting in San Diego, then a meeting at Santa Monica airport with Jerry. You may have noticed I don’t have many aerial shots of cities. For one, they don’t have the same allure to me as the mountains, and two, I’m usually too busy flying to take photos. Especially in the LA basin, where I don’t have a brain cell to spare while flying, watching for traffic and trying to stay on the ever-changing IFR routing they give me.

So this time I gave Graeme the camera, and he got some excellent shots of the LA area.

We then spent the night and headed out to Las Vegas for a quick meeting before heading home. I almost canceled because the winds were expected to be 50 mph by the afternoon. So we flew in early and expected to be out by 12 or 1 pm. It was calm when we landed, but by 11:00 am I was looking out the window and saying, “we really have to leave. “. Everyone would keep talking. I just had to interject, “I’m sorry, but I mean it. We really have to leave.”

We took off in a 35 knot wind, with a 20 knot crosswind component. I had the control wheel cranked over and rudder mashed. Everything was fine until the last few seconds before taking off, when the plane plane started going sideways. Luckily we were in the air by the time we ran out pavement or hit a taxi light. As we took off, as planned, one wing dipped significantly and we swung into a sideways crab down the runway.

As we got in the air we could see a massive dust storm approaching Las Vegas. I wish I could have gotten a photo, but I was extremely nervous trying to get above the Red Rocks area so we wouldn’t get slammed by a rotor. We did get one good drop and we both hit our heads. Later I asked Graeme if that scared him, and he said not really, it was that sideways takeoff that did. Luckily that was it, and soon we were at 12,000 feet where it was extremely slow going, but safe. For once I took the very long way home, over by Edwards Air Force base, into the Central CA valley, then up.

The first photo is mine, the others were taken by Graeme.