Buy Out Values – Hail the Willing Buyer

“How the hell did he come up with that number?” – quote from a new client reacting to his partner’s price to be bought out.

Almost every week, I get the chance to see a number of potential transactions among partners — mostly negotiating buying each other’s shares or debating what value to use in a buy-sell agreement. All different types of markets with the operative words being “fair value.” So I have been in the middle of this before and I have a solution that I have used, but it involves some education and “faith” by both parties if it is going to work. Let me explain.

Fair market value is used in a somewhat cavalier fashion in these type of deals but there is little focus on the key aspects of the definition of this term which is a value based on what a knowledgeable, willing and unpressured buyer would probably pay to a knowledgeable, willing and unpressured seller. Valuation experts use common tools to arrive at a number or range, but in the end, most importantly, you need a “willing buyer.” So what is the problem?

When you go to sell your business, the willing buyer may be a financial sponsor of some type (hedge fund, private equity, venture capital, etc.) or even your competitor or someone who wants to get into that market (often called a strategic buyer). Most of these willing buyers have another way to measure the results of their transaction. For example, I had a client sell a significant division of his company to a strategic for about 15 times earnings. This was a great deal for him, but the purchaser was public, selling at 25 times earnings; and my client’s ongoing $10 million in earnings increased the buyer’s market value by $250 million. Not bad. However, this does not translate into the private company market of “willing buyers.”

Using this example, if my client wanted to sell to his partner who wanted to continue to run this business for a long time and not sell, that partner would have to fork over all earnings (at current levels) for 15 years before he would see a plug nickel. What willing buyer is going to do that? Yet, it is a problem I confront quite often. So in this case, the “willing buyer” will only offer something a bit more reasonable from a pure cash-on-cash recovery basis – say 3 to 5 years. Many buy / sells I see have a price of 3 to 5 times EBITDA which gets you to the same place.

So I often suggest that the offer be based on projected cash flow for a 3 to 5 year period. I also suggest that a provision be added such that if the company is sold in say a 5 year period, there is some form of “claw back” – that the previous owners are paid in part as if they still owned some shares (all negotiated). The alternative is to wait for that outside purchaser to come along and prolong an important exit event. So while fair market value is a sacred term, please remember when in comes to partners, it is governed by the provisions of the “willing buyer.”

Change of Control – Revisited

Cardinal Ximinez: “Nobody expects the Spanish Inquisition! Our chief weapon is surprise, surprise and fear, fear and surprise. Our *two* weapons are fear and surprise, and ruthless efficiency. Our *three* weapons are fear and surprise and ruthless efficiency and an almost fanatical dedication to the pope.” – Monty Python “The Spanish Inquisition”

I have seen my fair share of situations where change in control provisions in agreements resulted in unintended consequences. Until recently, I thought their sole purpose was as the name implies and as Curly said in “City Slickers,” “One thing; just one thing.” But maybe as the Cardinal suggests, there is more than one thing. Let’s look a bit more closely.

Every smart business owner knows his most valuable assets walk out the door at the end of each day. Most owners like to retain key employees and enter into employment agreements that among other things, provide for incentives (many of which vest over a period of time) that are protected, should the owner or owners no longer be around. This standard solution is known in plain English as a “change in control” provision. What this normally provides for is the acceleration of any vesting or even liquidity provisions of any incentive provisions for the key employee in the event the current owner no longer has more than 50% (usually) of voting control in the company. Everything seems fair so far; what is the problem?

In case one, I was asked to consult with a company that had a key employee that was promised an incentive payment in the event of a change in control. That provision was triggered when the Company was sold to a “strategic” but the Company took the position that they had accepted a lower sales price in return for the key employee being offered a position with the acquirer, thus they did not owe the incentive. While both sides believed their case had merit, the ambiguity created years of turmoil until we helped to resolve it.

In the second situation, an acquirer had issued an LOI for the purchase of one of my clients. During due diligence, they realized that the resulting change of control provisions would substantially “enrich the lives” of all the key management members, and they were sufficiently concerned with their motivation after the deal that they almost walked away. Fortunately, a solution was crafted which all found acceptable.

So just when I thought the key provision in an employment agreement with an incentive was a change in control, I have come to realize that it should be accompanied by a well-defined “continued employment” provision so both the team member and the company do not suffer unintended consequences when there is a change in control. Negotiating them at the start when both sides are not under the pressure of an impending transaction is also very helpful. I am starting to see these provisions in some recent transactions and strongly encourage their use. As the Cardinal said, the two key provisions are…

Your Business Plan; Are You Making a Living or a Killing?

“Go ahead. Make my day.” Harry Callahan (Dirty Harry) – from the movie Sudden Impact

I get the opportunity to see a good number of business plans / pitch decks each week and I focus on the section of the plan I believe is most critical. While some may believe it is the management team or barriers to entry; to me it is the financial projections. So at this point, you have to be saying, “Of course; he is a CPA. What is so surprising about that?” The truth is, there is no other place in a pitch where one can get a better picture of the “directional indicators” of a plan. Please allow me to explain.

Years ago, a colleague of mind was tired of working the long hours at our firm and wanted to become his own boss. He bought a Basking Robbins franchise. He accomplished his objective; he still worked long hours but now he was working for himself. However, at the end of the day, all he did was replace salary with small business income; from a financial perspective he was still just making a living.

If you are doing a pitch before investors, remember they are focused on high rates of return; getting their money back in multiples of what they invest. They are looking at what we euphemistically call “making a killing” and they are looking for you to “make their day” by showing them how. So where does the projection fit in to all of this?

First, what is the size of the opportunity in your eyes? If your projections show that in five years, your revenues will be $5 – 10 million, you cannot make enough money to attract most investors. Please do not get me wrong; growing a business to this size is a real accomplishment and can be financially rewarding. It is just not a killing.

Next, does the financial model follow the plan? If the plan is a SaaS model with monthly subscription payments, revenue is simple; multiply the expected users by the planned fee and that should be revenue. So now I can see how many users you expect to have (market share) as well as the monthly payment (market price). I can also look at how you plan to get to that level of users.

Finally, are the projections logical? If your margin or operating costs are substantially different from competitors, do you explain why or are you just plugging numbers to provide a financial result some online advice indicated was what investors want to see? It is a simple logic test that many fail on a daily basis.

Shakespeare said, “The eyes are the window to your soul,” and I think your financial projections serve the same purpose as it relates to your plan. So after you get done “crunching the numbers” please step back to see what they really say. There is nothing wrong with creating a nice profitable business model that might allow you to make a very good living for a long period of time. I have had hundreds of successful clients who have followed that path. Just keep in mind how this approach has to “step up” if you are looking for that investor who wants you to make their day.

How Do I Learn To Be a Better Entrepreneur?

“God grant me the serenity to accept the things I cannot change,

The courage to change the things I can

And the wisdom to know the difference “ – The Serenity Prayer

I have had the chance to reflect on some articles about a recent survey conducted by The Alternative Board. The survey appears to be pretty robust.  They question some 500 entrepreneurs on very relevant topics.  My purpose here is not at all to take issue with the survey (I think it is great), but to focus more on my view as to what an entrepreneur can really learn and change based on these findings.

One principal finding of those surveyed appears to be that 60% would have raised more money.  While this sounds great, I have met only a handful of entrepreneurs (there are 4 leaf clovers) who have had the chance to raise more money but turned it down.

Another major finding is that 40% would have spent more time.  Now, I have been around entrepreneurs for 40+ years and when a bio break is a scheduled event, I am not sure how you accomplish this (unless someone comes up with a way to get more than 24 hours out of a day.)  I think for now we are all stuck with this model, so I’m not sure what can be learned to this point.

Let’s focus on what we “geeky accountants” call controllable costs.  The number one place entrepreneurs say they would have spent more time (and money) is sales and marketing.  Bingo!  In the plans I review, I often see a significant underestimation as to what it takes to get customers to see, understand and buy a product or service. The world is a crowded place and you need the dollars and a solid strategy to get (at least) your “15 minutes of fame.”

A final major finding: A total of 42% of those surveyed would have sought out better coaches and mentors. There is a lot written on the preponderance of male entrepreneurs and I think it is in our DNA to figure it out for ourselves.  Yes, that old image of not stopping to ask for driving directions when lost (thank you GPS) is alive and well.  My female clients have always been more collaborative and, I think, more effective in getting solutions to problems by involving others.  Just understanding that good help is worth its weight in gold is a great first step.  There are so many knowledgeable resources today it is almost foolish not to take advantage of at least some of them.

So, what lessons can we learn from these findings?  I think the key takeaway is to take the opportunity to learn from those who have gone before us and work on understanding what we can and cannot change and adjust our approach to make sure we are doing our best to take our businesses to the next level.

Caution – Those Equity Promises Can Really Hurt

 “Nudge, nudge, wink, wink; say no more, say no more” – from a skit by Monty Python’s Flying Circus

My partner and I have been making the rounds in a series of Lunch & Learns at various co-working spaces around NYC.  Our normal fare is to discuss the pertinent accounting and tax issues startups and early stage growth companies face (after all, we are CPA’s) but we also discuss ownership issues and in particular equity splits or as it is commonly known, how to “divvy up the pie.”  This topic seems to dominate the conversation (it seems to be more popular than tax credits) and we are always intrigued by the questions and issues that get raised.  It is clear to us there is more education needed in this area and this blog is just one small attempt to fill this void.

It is important to emphasize the basic fact that if you give someone something of value, even if it is not cash, there are usually tax consequences to the individual.  Reducing this to its simplest form, what did you give and what was it worth?  This is one of those “says easy, does hard” moments.  So, let’s look at an example.

Joe has started to develop a social media app and is in the early stages of proof of concept.  Joe works on this for a month or so and realizes he needs technical help.  He recruits in Jane, a tech pro who really accelerates the app development.  Joe appreciates her contribution and tells Jane he will give her 10% of the Company (for those of you following, that is the wink, wink; nod, nod part.)  A few months later, Joe and Jane present their concept to an angel who invests $100k for 10% of the company.  A couple of months after that, another investor approaches ready to write a big check.  He asks us to do some diligence, part of which is reviewing the cap table.  We see Joe at 90% and angel at 10%.  We ask about Jane since she appears to be a key player and find she was promised 10% but there is nothing issued or in writing.  You know what then hits the fan.  The investor now wants to know what other promises were made.  When someone invests, there is one thing they want clear – who owns what before and after the deal.

So, this has now created a credibility issue.  In addition, Jane now has a problem.  If she is to get her 10%, she can only get it at current value.  And, what about vesting; does she get credit for past time and effort?  There is nothing worse than getting a big tax bill with no cash to pay the tax and that is what is going to happen to Jane. The plan to give her an incentive has just become a disincentive plan.

So, I will state this as simply and strongly as I can.  If you decide to either give equity or have a partner invest in your Company, please get the right professionals involved to make sure it does not become a painful experience and that it accomplishes what you want it to.  With that, I will “say no more, say no more.”

Due Diligence and Early Stage Companies

“Surprise, surprise, surprise” – from Gomer Pyle USMC – played by Jim Nabors

I have had the privilege of being involved in due diligence activities (both buy side and sell side) for dozens of companies of all sizes. I had the chance to blog (November 2013) about being prepared for due diligence citing one of my favorite Monty Python sketches, “No one expects the Spanish Inquisition.”  That wasn’t just some pithy quote – a number of my clients used that analogy when describing the diligence process they were going through. However most were established companies with some history for a buyer to digest.

We have now been through quite a few due diligence exercises with very early stage companies. Many think it is a quick process; just answer a couple of questions and then wait for the check to clear. But surprise, surprise, surprise it is a bit more intense than you would expect. Compound this with how off point many of the diligence requests are and the process really gets convoluted.  I recently became involved with one startup that was being acquired and had been in business a little over two years. The potential purchaser’s diligence team requested the last 5 years’ tax returns and the entrepreneurs (taking the request literally) were in the process of getting together their personal tax returns for the earliest three years.

So, what do (or should) investors focus on when doing diligence on an early stage company? I would highlight five areas:

Management team – we always suggest looking at the team both current and future. Do the key leaders know what they have and what they need to get to the next level?

Dashboard report – what has the team laid out in terms of what they are focused on? Burn rates, the competition, a detailed plan to get from MVP to sustainable product and KPI’s are all key aspects to assess.

Traction – I do not just mean unique visitors to a site but customers or near term prospects who will buy your product or service. If you are selling to end users, it’s easy – how many swipes do you get and what is the trend. If you are selling enterprise level software, the sales cycle is longer and the question is how well do you know the status of each pursuit?

Equity – a complete cap table including options, promises and any “winks and nods” for future equity. If there is no equity plans covering employees or future key team members, that is also a red flag

Owners’ mindset – just like mature businesses I often see deals crater over sellers’ remorse. While subordinated notes have allowed all parties to “kick this can down the road” are owners ready for partners or to sell outright?

CPA’s are often retained to complete due diligence but for accountants used to financial data analysis, this type of diligence is not comfortable.  Other than tying down revenue, there is little they feel they can do. So, if you are in a potential deal and sense the acquisition deal team has the wrong focus, don’t be afraid to let the purchaser/investor know.  For many, this is still somewhat virgin territory.  Be prepared.

Myths About Startup Equity

“Mr. Fuji as everyone knows, is a fountain of misinformation.” Quote from the late great Gorilla Monsoon a star from the World Wrestling Federation.

Here in the New York Metro area, we get the chance to hold sessions with loads of startup companies.  From incubators to accelerators to coworking spaces, we get the opportunity to meet with some of the best and brightest minds especially in the tech space. Their ability to question everything and absorb a multitude of ideas and observations is second to none and a unique skillset that many of us admire.

We are accountants and consultants and so topics we present tend to center around accounting and taxes. While I would love to think those attending are mesmerized by our subject matter, I have come to believe it is the free pizza and soft drinks which attract them. However, there is a subject we cover that seems to draw a bit more of a response than the equivalent of sitting through a root canal – – and that subject is equity. How to split up the pie; techniques to use to share ownership and pitfalls to avoid seem to get attendees to perk up. Like most things in life, when deciding on equity sharing, a bit of advanced planning helps; but who has the time when one is creating their MVP, trying to drive the community to their product or preparing for a Demo Day.

Unfortunately, we have heard a few myths over the last couple of months and I thought it best to take some time to clear the air a bit.

  1. “You can wait to issue equity” – actually when you issue equity is completely up to you; the value you have the use in the transaction is the issue. Just keep in mind assuming the value of your entity increases over time (or else why would you give up your life for it) the higher the value, the more difficult this task becomes.
  2. “Founders can always get shares at discounted rates” – one of the better tales we have heard. Founders’ shares only have minimal value before you raise financing and there is no near term proof of value (usually by some outside party.) However, once funds are raised, you may get more shares as a founder but the new (and usually higher) value has to be taken into account.
  3. “We don’t need no stinkin’ valuations” – unless you are in a clear founders’ shares startup situation or use the value of a recent transaction, yes you do need a valuation (referred to as a 409a as this is the IRS regulation that governs.) Without it, your tax exposure can make you the next Leona Helmsley.
  4. “I can always file an 83b” – as long as it is filed within 30 days of receiving the equity, it uses an appropriate value and you pay any related tax, yes you can. After that, you can’t put that genie back in the bottle and you are on your own.
  5. “Who cares if my company is an LLC or C Corporation?” Almost every investor does; and most prefer C Corporations.

Equity issues are complex and costly so please consult with your attorney and accountant before completing any equity transactions. Relying on a myth can cost you dearly.