Excerpts from a CEO Exclusive Radio interview featuring Jonathan Wilfong, Regional Managing Partner, Southeast; Healthcare and Life Sciences Team Leader; and Energy Co-Team Leader, FOCUS Investment Banking LLC*
Q: In 2015, we heard a lot about how favorable the market was for acquisitions. What’s happening with deals in investment banking now?
WILFONG: Indeed, 2015 was a very robust year for deals in the lower middle-market space which FOCUS defines as companies that do up to 250 million in revenue. This activity was driven by a couple of factors:
- Historically low interest rates—almost all acquisitions have a leverage component, so the cost of funds is a key driver.
- Availability of a tremendous amount of private equity money as part of investment strategies—many pension funds, employee funds, and high net worth individuals have alternative investments, usually in the form of private equity investments.
It also was driven by the fact we’ve experienced several years of very positive results by what we call strategic acquisitions. Companies that are in the business—and may enjoy good profits—have accumulated significant cash reserves.
With these historically low interest rates, there’s not much return on cash sitting in corporate coffers, so there is a real incentive to go out make acquisitions.
At FOCUS, we rarely help people with traditional bank debt. Coming out of 2008, banks are used to a very structured, straightforward loan. You can get a car loan. You can get a secured revolving loan.
But, for any other type of activity, there are tremendous numbers of lenders. I get a call every day from alternative financing sources. Now there are the direct lenders who work with small businesses, making merchant advances against credit card receipts.
So, there has been a real shift in the industry with people moving away from the banks, the regulation, the paperwork, the approval process, and the lack of decision-making by banks on anything other than a standard loan. And, it has driven a tremendous number of what we call alternative financing vehicles.
Q: For a middle-market business owner looking to sell, strategic buyers are often going to be a great option. How does a CEO position himself or herself for a strategic buyer?
WILFONG: Strategic buyers will pay a higher multiple of earnings or EBITDA—earnings before interest and taxes. Sometimes, that’s not the case when private equity groups want to acquire what they would call a platform company. I look at strategic buyers in two ways:
- If a strategic buyer wants to buy a company as a standalone or as an operating division, a lot of importance is placed on management, leadership, the employee base, their procedures, and systems.
- If a strategic buyer is buying a company to absorb their customer base, they are not as concerned about management. They’re going to fold it into an existing operation, so you look more towards customer “stickiness.”
So, when FOCUS is advising a company, we put together an offering memorandum or information memorandum, and include the degree of customer stickiness. By that I mean if they have major relationships, prepare a graph that shows how long they’ve kept those relationships. If they don’t have people who are repeat business, you want to demonstrate you have a customer base—so, it’s important to have that type of information.
Q: What kind of timeline does a CEO have to put together to produce this really good report and paper trail?
WILFONG: That’s easy. They should have it from day one, because it would have helped them in managing the business. But we know that’s not usually the case. So, the entrepreneur or business owner is worrying about working capital, is driving his customers, is driving his staff, etc.—and making payroll. So, accounting and finance and reporting usually are not a high priority to most middle-market business owners.
Business owners should be looking at two or three years before planning the sale of a company—not the week before they decide they want to sell it by the end of the year.
Middle-market business owners need to start thinking several years in advance of a sale. In fact, the longer the better—it’s a long process. The typical sale process is seven to nine months. I’ve seen sales as short as four months and as long as 18.
But clearly, business owners need to look as far ahead as possible. If your corporate structure is a C corporation, immediately call your CPA if you have less than 35 shareholders—I’ve never seen a private business that had more—and ask them convert you to either an LLC or an S Corp.
The C corporations structure is absolutely the worst possible thing you can have as a business owner of a closely held business, because if you do have a sales transaction, you are going to pay two levels of tax both at the corporate level and then when you take the money out of the corporation at your personal individual level.
Q: In positioning a company for a strategic buyer, you say to make sure your numbers are together, and show a track record with customer relations—plus focus on your management team so a buyer can find some good people who will be left behind.
WILFONG: Often, middle-market business owners run their business with kind of an iron fist. They don’t let their people develop. That is unattractive to a strategic buyer or to a private equity group looking at that company to be a platform investment.
If I want to have a division in Alabama and they’re going to report to the folks here in Atlanta and they are going to be a division, I want good, solid people. If I have a business owner who hasn’t developed those people in place, the attractiveness to a strategic or private equity group is not nearly as great.
Q: Why is it so difficult to get middle-market CEOs to actually develop exit strategies?
WILFONG: It’s a very emotional thing—their identity is in the business. Ultimately, every business is going to turn into cash at some point, and that can be favorable or unfavorable. How you manage that is an important part of any business owner’s career.
If you can set objectives and outline strategies and monitor what’s happening as you go along, these techniques can go a long way to help design the exit strategy. I tell business owners to run their businesses as if they are going to sell it tomorrow—that sounds radical, but the result is a business owner will have a good business they can walk away from.
Q: You said something about “pre-liquid wealth” that sounds like an oxymoron. If it’s not liquid, is it really wealth?
WILFONG: Certainly. Ninety percent of the wealth in this country is not liquid—it’s in farmland, it’s in business, it’s in real estate, it’s in intangibles, etc. People concentrate on the stock market and cash and bonds but most of the wealth in this country is not liquid so we refer to it as pre-liquid.
At FOCUS, we concentrate on how best to handle that pre-liquid wealth. At the stage when it does become liquid, will it provide the wealth the middle-market business owner hoped to attain?
* Broadcast February 2, 2016 on CEO Exclusive Radio, Atlanta, GA; Host Soyini Coke.