In the ever-evolving landscape of mergers and acquisitions, middle market transactions continue to play a pivotal role. To shed light on the intricacies and challenges of navigating these deals, Empire Valuation participated in a panel of experts from the due diligence, legal, and valuation world of transactions. The discussion covered a wide range of topics, from due diligence and capital stacks to deal structuring and valuation. A few key highlights included the increasing trend of hybrid deal structures, how to prepare a business for sale, and the increased use of Reps and Warranties insurance over the last few years.
Due Diligence: A Cornerstone of Success
Due diligence is a critical step in any M&A transaction. The due diligence process has become increasingly complex and time-consuming, with growing emphasis on areas like data privacy, intellectual property, and ESG factors, and they tend to be longer due to increased scrutiny. A common example of issues that can arise during the process, especially for privately held companies or family-owned businesses, is “who is the actual owner of the IP that the seller is using?” There have been cases that at the last minute, it was discovered that the selling company does not own the IP and the deal needs to be restructured to include the IP that the company uses and it may be held by another related-party entity that was not originally part of the transaction. Another increasing area of focus is data privacy and the cybersecurity assessment of the target company’s operations. In an increasingly tech-driven and interconnected world, it is imperative to evaluate the target company’s cybersecurity practices and vulnerabilities to be able to prepare accordingly when negotiating the transaction.
Structuring a Transaction: The Capital Stack and Hybrid Structures
The capital stack, which represents the various sources of financing used to fund an acquisition, is a critical component of any deal. A well-structured capital stack can significantly impact the acquisition strategy and overall deal success; therefore, it is essential to carefully consider the mix of equity, debt, and other financial instruments based on the target company’s financial profile, the acquirer’s risk tolerance, and the prevailing market conditions. Rising interest rates can increase the cost of debt financing, impacting the overall cost of the acquisition and debt covenants can also impose restrictions on the target company’s operations, which can affect its flexibility and growth potential.
In light of the above considerations, deal structuring has evolved in recent years, with a growing trend towards hybrid structures that offer greater flexibility, risk-sharing, and alignment of interests between buyers and sellers. Rollover equity, earnouts, and seller financing are becoming increasingly popular in middle market transactions.
These hybrid structures can be beneficial for both buyers and sellers, as they provide a way to bridge valuation gaps, incentivize performance by maintaining an ongoing stake in the acquired company and allow deals with buyers that have limited access to capital or want to preserve their financial flexibility.
More specifically, earnouts (or contingent consideration) can be a valuable tool in M&A deals. However, they require careful planning, structuring, and negotiation. It is essential to define the contingent events clearly, allocate risks fairly between buyers and sellers, and consider the potential accounting implications. If you are considering earnouts as part of a transaction, conducting sensitivity analyses to assess the impact of different scenarios on the valuation of the contingent consideration can be highly beneficial, as it will give you further insights of the expected overall purchase price and what the potential impact on the target company would be. Lastly, having a dispute resolution process outlined in the agreement, in case the parties disagree on the events occurring and estimates, will greatly aid in preventing future complications.
Maximizing Value: How to Prepare Your Company for Sale
Preparing a company for sale involves more than just financial readiness; it is about presenting a compelling value proposition. It is important to understand the buyer’s perspective and their strategic goals and see how your company fits their plans. Then, develop a compelling narrative highlighting the company’s unique value proposition and present a well-defined growth strategy that demonstrates future potential.
Furthermore, to maximize valuation, companies should focus on their financial health, improving their financial performance, cleaning up their balance sheet by eliminating information not pertinent for the purpose of a sale (e.g., assets and liabilities not related to their main operations), and optimizing cash flows by improving collections and managing working capital efficiently.
Lastly, effective leadership and a solid succession plan would be strong assets to ease any concerns from the buyer’s side for a smooth transition and continued success of the company.
Having the right advisors by your side
Navigating middle market transactions requires a deep understanding of the complexities involved. Whether you are selling or buying a business, due diligence, deal structuring, and valuation concerns are always going to be part of the process. Having trusted advisors by your side to guide you through the challenges and pitfalls, to protect your interests and advise you on the process can make or break the deal.
We are here for any valuation support you may need, with our pre and post-deal advisory and reporting services.
Ioanna Fokianou is a Senior Manager at Empire Valuation Consultants, where she has worked since 2015. Ioanna has worked with publicly traded and closely held companies, as well as private equity firms and hedge funds, and has been involved in numerous valuations related to debt and fixed income securities, intangible assets, and equity interests across a variety of industries and worldwide locations. Ioanna’s expertise includes preparing valuations for the purposes of fair value measurements, business combinations, and intangibles – goodwill and others, for financial reporting and SEC reporting purposes, among other. Ioanna received a BS degree in business administration from the Athens University of Economics and Business, and a BS degree in accounting and finance from DEREE-The American College of Greece, and earned an MBA from NYU’s Stern Graduate School of Business.