Using An Investment Banker
In Merger/Acquisition Transactions
by Robert Kleiman
One of the most important development on the U.S. business scene in recent years has been the increase in middle market merger and acquisition activity of a strategic nature. Large firms are attempting to consolidate smaller competitors in the same line of business or vertically integrate forward to the ultimate consumer or backward to a supplier. As a result, family controlled enterprises may be subject to acquisition overtures from expanding competitors.
Alternatively, family controlled corporations may desire to take a pro-active approach and augment the size and scope of their operations through purchases of other entities. Finally, many family controlled entities may not have a successor to the founder chosen, and accordingly these firms may put themselves up for sale.
Purchases and sales of operating businesses are normally handled by investment bankers. Investment bankers are corporate finance specialists who are comfortable with interpreting financial statements and appraisal techniques. Such financial knowledge is indispensable in determining the appropriate value for a business and successfully negotiating merger and acquisition transactions.
Family business owners who desire to sell or purchase a business are advised to use a business broker if the business is worth less than $2 million and an investment banker for larger transactions. Middle market, or regional investment banking firms, typically are not interested in advising on transactions below the $2 million threshold. Only if a transaction exceeds $10 million are the major national Wall Street firms such as Goldman Sachs & Co. or Morgan Stanley likely to be interested.
Evaluating the Investment Banker
Investment bankers services range from finding an appropriate buyer or seller, pricing and structuring the transaction, assisting in negotiations, and raising financing. Experienced deal makers can separate serious buyers from perpetual shoppers and can help resolve doubts and disagreements among both parties. Experienced investment bankers can assume the cost of marketing the sale of the company, attract more prospective buyers than a seller, reduce the burden of screening and qualifying prospects, and prevent negotiations from breaking down.
Investment bankers can be found through classified advertisements in financial and trade journals and personal recommendations. The seller should thoroughly investigate the investment banker handling the transaction. Beyond the obvious inquiries–how many transactions has the investment banker completed?; what is his or her background?; can he or she provide references?–there are a few other areas the seller should investigate.
First, if an investment banker has dealt specifically in the industry of the company for sale, that’s a plus. Second, an investment banker who can document a successful track record of sales to engagements is preferable to one that can’t. Third, it is useful to determine how frequently the investment banker’s initial estimate of the price correspond to the eventual sales price. Where a wide divergence is common, the investment banker is likely to be misleading the seller about the true value of the company and wasting prospective buyers’ time. Business owners are advised to ask for proposals from several firms and choose the investment banker that best suits their needs.
Inappropriate financial advice can harm either the buyer or the seller. Overly eager acquirers may end up paying more than the fair market value of the company being acquired. With respect to the sale of a company, investment bankers may pretend to have ready buyers in order to persuade owners to retain them to sell their businesses. Then, they never find an acquirer. Or, eager for business, investment bankers may promise so high a price to the seller that it stifles buyer interest. As a result, many businesses listed by investment bankers are never sold.
Good investment bankers can be the key to structuring the elements of a deal–advising a stock or assets sale, for example, and mediating disputed points. Some even help out in finding sources of financing.
Another potential problem relates to client confidentiality. Eager for a quick sale, an investment banker may resort to wholesale distribution of marketing information and risk breaching confidentiality. Investment bankers should get clearance from sellers before sending company information to prospective buyers. And, investment bankers and any prospective buyers should sign nondisclosure agreements. Otherwise key employees might send out their resumes, customers might become skeptical about the continuity of the enterprise, and competitors could spread rumors about the firm’s financial strength.
Sellers should find out how investment bankers qualify potential buyers. Careless investment bankers may guide unqualified buyers through a seller’s facility, regardless of whether they can afford the business. Or they may convince buyers to over spend. Overextended buyers–or those who overpay for a business–may have trouble making payments after a sale and may even default. If a sale is consummated at an exaggerated price, it can boomerang against the seller in seller-financed transactions. Seller financed deals are commonplace in the sale of small and midsize family businesses because the buyer is often short of funds.
Pricing the Business
One of the investment banker’s most important jobs is pricing the business. There are a number of ways to evaluate fair market value, but the seller mustguard against unrealistic expectations. One method to establish the market value is to compare the asking price with the market value of similar businesses that have recently sold.
Often, a company’s worth is calculated asthe firm’s earnings times a multiplier for comparable businesses in that industry. If, however, the multiplier is derived from businesses that are more solidly established than the company for sale, the buyer would insist on a higher rate of return for the risk, and thus a lower price. Owners preparing to sell shouldmaximize net income in the year prior to sale, even though this will increase tax liability.
One type of sale is the cash sale, which is quickest but does not generally produce the largest payment. The seller may get a higher price if he finances part of the sale, but this involves exposing himself to the risk that the buyer will be unable to pay or will go out of business. Another option is the earn-out agreement, in which the final price is based upon future events. The seller remains in the business to share in the company’s profits for several years after the sale.
Transaction fees for merger and acquisition transactions are typically based on the Lehman formula. The fees are based on the size of the transaction and decrease in a step like fashion and are paid at the completion of the deal. Investment bankers charge advisory fees of 5% on the first $1 million; 4% on the next million; 3% on the next million; 2% on the next million, and finally 1% on the amount of the transaction in excess of $4 million. Thus, on a $10 million transaction, the investment banking advisory fees would total $200,000. In more complex transactions, deal makers may charge 1.5 times Lehman. In this case, the fee on a $10 million transaction would be $300,000 (1.5 x $200,000).
In addition, investment bankers generally charge sellers upfront fees for preparing a company’s strategic profile and appraising its value. Upfront fees may also be charges for an acquisition profile analysis to initially identify potential acquisition candidates. These consulting fees can amount to $20,000 plus for a detailed valuation report.
Generally, the consulting fees are non-refundable if the firm which retains the investment banker does not consummate a transaction. Investment bankers generally will agree to deduct the packaging costs from their commission if they close the sale. If the investment banking firm needs to raise debt or equity capital to finance the transaction, separate underwriting or placement fees also will be applicable.
Dr. Robert Kleiman is the Director of the Oakland University Center for Family Business