“A share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds.  This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund’s performance.”

Given the recent election results and ongoing debate about executive compensation in the midst of the current financial crisis, it should not be a surprise that the tax treatment of income associated with carried interests could be changed as early as 2009.

Under current federal tax law, the character of the income to the carried interest is the same as the income earned by the fund.  Therefore, if most of the profits of the fund consist of long-term capital gains, then the carried interest receives, in direct proportion to its allocated share of profit, the same tax treatment.  So with the substantial income earned by some of the managers of large private equity groups over the past few years, there has been a heated debate over this favorable tax treatment.  At the moment, with a few exceptions, the maximum federal tax rate on long-term capital gains is 15% while the federal tax rate on ordinary income is as high as 35%.

Without any amendments to the federal tax code, the 15% federal long-term capital gains rate is scheduled to expire on December 31, 2010 and, thereafter, move up to 20%.  Some members of the private equity community may believe that the substantial change in the capital markets and a higher capital gains rate in a few years will move this political issue to the sidelines.  With the promise for change by President-elect, Barack Obama, and a democratically controlled Congress, just about anything is possible with regard to changes in the federal tax code.

Let us also keep in mind that the current federal budget deficit problem does not appear to be going away anytime soon.  With Congress looking for new ways to increase tax revenue, it seems logical that ordinary income treatment will soon apply to a carried interest, just as it does for executive compensation reported on Form W-2.

Down economic cycles can offer excellent buying opportunities for well positioned companies but they may create funding challenges to getting a deal closed.  When credit is easy and senior debt lenders are liberal with leverage and terms, most buyers don’t need additional help in funding their deals.  In a down economy, it’s quite a different matter and mezzanine financing may be the solution.

Mezzanine financing is also known as subordinated debt and is junior to the security interest of senior debt while ahead of equity stakeholder rights.  Many of the features of a mezzanine loan are similar to a bank loan.  There will be provisions for interest payments, an origination fee, amortization terms, covenants, potential liens, default definition and remedies, and other items.  Additionally, mezzanine investors craft warrants into their structures to compensate for their risk as junior lenders.  Warrants provide the right to purchase equity at a later date.  Don’t worry, mezzanine investors don’t want to own your company so they will include “put” options, which when exercised, require the borrower’s company to buy-back the stock at a pre-determined price often tied to a valuation formula based on a multiple of the company’s earnings.  In short, it’s an in and out transaction designed to augment their return.

There can be considerable variance in the cost and terms of subordinated debt but a typical subordinated loan may include quarterly interest payments in the 11% to 14% range coupled with an equity kicker via warrants designed to boost the overall yield to a minimum compounded annual rate of return of 20% or more over the life of the loan.  The rate of amortization can also vary and may range from stepped amortization of principal to a balloon of the entire amount at maturity.  The term of the loan generally ranges from three to seven years.

During the first half of 2008, buyout firms and corporations raised $24 billion in mezzanine debt, a large increase over the same period in 2007, according to data from Dow Jones.  The number of providers has increased over the years and now includes a few public companies, in addition to many private funds and SBIC funds.  Because sources vary in focus and rates and terms can be complex, an investment bank may provide the most efficient and cost effective access to these funds.  Mezzanine debt may sound expensive when compared to senior debt but if it closes the funding gap on an attractively priced acquisition target, it may be an excellent choice. 
 

The Riegel case was decided based on certain language contained within the Medical Device Amendments of 1976 (“MDA”), which preempt state law claims for damages when a medical device has undergone the PMA process.  While this case does provide relief to manufacturers with respect to those medical devices that did receive pre-market approval from the Food and Drug Administration, it is important to note that medical devices which only meet the “section 510(k) process” (a section of the MDA describing the review process) do not get relief from state law injury claims.  This particular issue has already been decided by the U. S. Supreme Court in the 1996 case of Medtronic v. Lohr, and therefore, distinguishes Lohr from the Riegel case.

So what economic effect might the Riegel case have on medical device manufacturers?  Like so many other questions, this will depend on several factors, including the type of medical devices being manufactured and sold. 

The Food and Drug Administration provides for three different classes of medical devices – Class I, Class II, and Class III.  The Riegel case involved a Class III device – a balloon catheter used in connection with a coronary angioplasty procedure.  Class I devices are subject to the lowest level of review by the Food and Drug Administration and include such items as examination gloves and elastic bandages.  Class II devices, such as powered wheelchairs and surgical drapes, rise to a higher level of review relative to Class I devices.  Class III devices are critical for supporting and sustaining human life and include such devices as pacemaker pulse generators and replacement heart valves.  Logically, Class III devices are generally subject to a more rigorous review by the Food and Drug Administration.  Unless an exception is met, a new Class III medical device will be subject to the PMA process.  Due to the Riegel case, manufacturers of medical devices that have been subject to the PMA process will generally have less product liability risk in manufacturing and selling those approved medical devices. 

An immediate benefit to the manufacturer of approved devices might include lower premiums paid on products liability insurance coverage.  In addition, a lender might be willing to loan funds at a lower interest rate to a manufacturer of medical devices that have been subject to the PMA process.  And, very importantly, the reduced risk has an effect upon the value of the business model.

Business valuation professionals often refer to matters having to do with the discount rate when utilizing an income approach to value a business.  In a business valuation engagement, the “Ibbotson Build-Up Method” is often used in determining the discount rate.  Under this method, risk premiums are added to the safe rate of return (yield on long-term government bonds) and, ultimately, a discount rate is derived.  Bear in mind that the higher the discount rate, the lower the valuation of the business.  So a higher discount rate suggests a greater business risk to the buyer of the business, which intuitively makes sense.  After all, why buy a business that does not provide an adequate rate of return to compensate for the risk associated with owning such a business?

Under the Ibbotson Build-Up Method, one of the risk premium elements that are added is an amount for “specific company risk.”  It stands to reason that, with all other things being equal, a manufacturer of medical devices which is immune to state law personal injury claims has less business risk than a manufacturer of medical devices that can be subject to state law personal injury claims.  Therefore, the manufacturer which is immune to state law personal injury claims would deserve a lower discount rate, and higher valuation result.

Since the Riegel decision by the U.S. Supreme Court was fairly recent, moving forward, it will be interesting to observe the effect of this case on future mergers and acquisitions in the medical device industry.

When we reflect upon our deals that did not get done, or those that died between Letter of Intent and Closing, regardless of the specific reason, time killed all of these deals in some why or another.

Once a seller of a business makes his/her decision to sell the business, time does not move fast enough. Sellers imagine the worst: customers or employees learning of the sale; declining revenues; problems with the business; all these events happening the longer a deal takes to get done. Some of these fears are justified, others are not.

After a buyer makes the decision to make an acquisition, time does not move slowly enough. Buyers generally want as much time possible to arrange their financing, perform their due diligence, and learn the business they are about to acquire. Many buyers believe time is their ally.

We have seen buyers walk away from acquisition opportunities because they did not have the time to invest in the process; we have seen sellers lose patience with buyers who took too much time to make a decision.

The key to a successful deal is the delicate balance of timing and time; not unlike Goldilocks, we are looking for timing that is “just right.”

So what is the right amount of time? Unfortunately, specific timing depends upon each transaction. However, sellers should not expect buyers to close a deal within 30 days of acceptance of an LOI. Buyers should not expect sellers to be interested in a protracted closing taking more than 90 days from acceptance of an LOI.

Ultimately, deals are like dating; you have to know when to move fast, but you do not want to rush the process. Remember, time kills deals, so do not waste this precious commodity.

Asking for a referral from an existing professional service provider is the common way that most CEOs and CFOs begin their search for another service provider with a distinct specialization.   However, if the referral discussion focuses on a particular PSO firm’s isolated attributes, this does not necessarily correlate with the prospective PSO firm being a “good fit” within the context of all the PSOs serving the company. 

The effectiveness of the PSO vetting process (the so-called “beauty contest”) can be improved by inquiring whether the referring firm (e.g., an accounting firm) regularly conducts business with the referred firm (e.g., an investment bank).  If a formal Strategic Alliance is found to exist between the PSO firms, then established methods and processes help ensure that the PSOs provide complimentary resources, expertise and advice, in order to deliver collaborative solutions to the client company.  

In the investment banking industry, a notable number of national and international firms (including Corporate Finance Associates) have formalized the process of making cross-referrals with other PSOs under written Strategic Alliance Agreements.  As such, these investment banks are better qualified and positioned to deliver a coordinated package of services to their clients.  Astute CEOs and CFOs leverage these alliance relationships for their company’s benefit.           

Therefore, when hiring, or requesting a referral from, an investment bank, the CEO or CFO often asks:  “Does your investment bank have an alliance with the following service providers?”:

• Wealth Management / Financial & Retirement Planning Firms – Investment banking firms specializing in business sales, mergers, acquisitions, and divestitures, have alliances with wealth managers providing estate planning, trust administrations, and who manage the money generated from a liquidity event. 
• Other Investment Banks (with distinct specializations) – M&A investment banks (such as Corporate Finance Associates) often have alliances with other investment banks specializing in corporate finance matters, or that conduct business in other countries.  
• Consulting Firms – Investment banks which have sets of bankers working in Industry Practice Groups, are typically well-coordinated with other management consultants, environmental consultants, and specialists in particular vertical industries where clients also focus their business.  
• Law firms – M&A investment banks have relationships with specialized lawyers and law firms that know how to prepare Purchase and Sale Agreements, including critical terms, such as representations, warranties, indemnifications and earn-outs.
• Accounting Firms – Investment bankers have quality relationships with Big 4, regional and local accounting firms, which have experience in providing valuations, due diligence, post-merger integration and minimizing the adverse tax consequences of selling a business.

Corporate Finance Associates (CFA) is a M&A investment bank that regularly receives referrals from, and makes referrals to, its’ strategic alliance PSO partners.  Importantly, CFA’s clients are the key beneficiaries of the synergies which CFA enjoys with other PSOs.  If you are interested in learning more about how alliances between CFA and other professional service organizations will result in collaborative benefits for your organization — let’s talk.

As a middle market investment banker and exit strategy advisor, I have recently observed an overriding temptation in business owners to simply ride out the current storm and wait for the next wave of M&A activity—the next valuation peak—and then return to their thoughts to selling their business.  The problem is, if they wait until the next wave comes, it will be too late to maximize their opportunity, and they risk missing it altogether (again!).

My advice to middle market business owners is this: don’t just wait for the next wave to arrive. Expect it and prepare for it.  If the market is soft for your business right now, it’s the perfect time to prepare for the time your market comes back.  Allocate a portion of your workweek (say 20%) on activities that will enhance both the market value and the marketability of your business in the future.

What am I talking about?  Here are six “Value Builders” that we recently identified for a client and which are common in privately held businesses.

1. Management Succession: begin transfer of knowledge and responsibilities to key employee(s);
2. Business Plan: create a  written business plan focusing on growth opportunities and assuming no capital constraints;
3. Website Enhancements: upgrade company’s website to ensure a very positive first impression to customers and potential buyers;
4. Corporate Structure: discuss with company’s CPA alternative corporate structures that could yield favorable tax and/or marketability results;
5. Financial Reporting Upgrade: invest in CPA- reviewed or audited financial statements;
6. Corporate Contingency Plan: memorialize in writing a contingency plan for the business, clearly stating the owner’s intentions in the event of an unplanned event (death or disability).

Begin by determining your company’s unique Value Builders, creating a list of not less than 20.  Prioritize each Value Builder based upon (i) cost, (ii) ease of implementation, and (iii) impact.  Begin working the top priorities immediately.

The key is to work on something now, so when the next wave comes, it will be yours.

• How critical to your business’ survival is succession planning?
• Have you done anything about formalizing a succession plan?

The results were extremely interesting. More than 95% of the respondents said a succession plan was critical to the long-term survival of their business, but a staggering 85% had not done anything to formalize their succession plans.

This survey reinforces information we learned first-hand several years ago when leading a continuing education course for Certified Financial Planners (CFPs). The subject of the course was “Succession Planning for Business Owners.” With more than 200 CFPs in attendance, we asked how many of their business-owner clients had formalized their succession plans. Less than 5% of those in attendance had clients who had formalized their succession plans. More startling, the CFPs in attendance reported less than 20% of their business-owner clients had even discussed their goals for succession, let alone put these goals in writing.

We all know the old saw, “A failure to plan is a plan for failure.” We also know most people do not like to face their own mortality (why is it people say, “If I die” and “When I win the lottery,” isn’t this fractured logic?). The reality is, every business will change hands at some time…it is inevitable.

Everyday, the Wall Street Journal and the business section of your local newspaper are filled with stories of Private Equity Groups (PEGs) acquiring…and selling…businesses like yours. Interestingly enough, PEGs never make an acquisition without defining their exit options…before they make their investment!

Take a tip from PEGs, professional business acquirers, and plan for your own exit from your company. As a business owner, you owe it to yourself, your shareholders, your employees, your customers/clients and your suppliers, to start examining your exit options. If you are not proactive about this process, the process will control you…and you just might not like the results.

“I will sell if I receive the right offer, but I don’t want to market the business!”

Despite its obvious flaws, the above statement reflects the position taken by a surprising number of business owners. In fairness, marketing your business is time consuming and may jeopardize a hard-earned market position if “word gets out”, so the position is understandable. It just doesn’t make a lot of sense!

The “strategy” is flawed because it results in a reactive positioning, yielding all control to the buyer. It suffers from two serious deficiencies:

• The seller does not select the buyer, the buyer selects the seller and the seller has no frame of reference to employ to determine if the buyer or the offer is really any good
• The seller accepts that the business will be “ready for sale” the day the buyer happens to show up

There is a better way. Hire a professional firm to market the business (use of a professional firm will mitigate the time burden and professional knowledge and experience will benefit the process and the result) and plan the sale by assessing, with the professional firm’s help, how the business’ value can be increased, then executing that plan ahead of a sale. An experienced firm will know how to maintain confidentiality to the greatest extent, thereby mitigating against the risk of a premature information release to the market.

If the question is: “Can I make my business more valuable?”, then the answer is another question: “Can you decrease the risk that your business could fail after a sale and/or can you increase the potential for business growth?” You will be amazed how much value can be added to valuation by, for instance, addressing weaknesses in management, customer concentrations, marginal or unprofitable product lines, … and many, many more.

Example: A buyer assessing risk by using a discount rate of 33% might pay $30 million for a business earning $10 million. That same buyer, if persuaded that certain risks can or have been mitigated, might lower the discount rate to 30%, increasing his valuation to $33 million.

So, unless your business is already “perfect”, do put some thought and energy into “preparing for a sale” and don’t sell to the buyer who happens to come looking unless you have invited offers from a number of other buyers or have expert opinion on the fairness of the sole offer.

Corporate Buyers Should Answer 5 Key Questions When Preparing a List of Acquisition Criteria

Corporate buyers appreciate that acquiring another company is an effective way of achieving growth, which can compliment organic growth. However, before proceeding with any acquisition process, research in the area of Pre-Acquisition Best Practices has shown that 5 key questions should be considered by acquirers.

By answering these fundamental questions, a corporate buyer is then more readily able to detail a List of Acquisition Criteria. In turn, the List of Acquisition Criteria shapes the buy-side mandate given to an investment bank, which will then proceed to systematically contact both sellers that are actively for sale, as well as the much larger group of off-market target sellers.

• Acquisition Purpose. First, what is the purpose, motivation or intent that causes an acquirer to undertake buying another firm? Acquisitions are often employed by acquirers to achieve economies of scale, to expand existing product/service lines, or to penetrate additional markets. These goals are a reflection of the broader corporate strategy for how you want to grow your company.

• Determining Fit. Second, what information needs to be obtained in order to make a precise evaluation of a target firm? Advisors use buyer due diligence checklists to ask for documents from the target seller, after the buyer signs a Confidentiality Agreement. However, proper analysis of this information is aimed at determining whether the target will integrate well with the acquirer, both from a “synergistic fit” and “operational fit”. Strategic fit is the degree to which the target firm complements the parent’s strategy and thus makes identifiable contributions to the financial and nonfinancial goals of the parent. Operational fit involves matching administrative systems, corporate cultures, and demographic characteristics.

• Defining Value. Third, how would an acquisition create value? Value can be defined as the worth of an acquisition, resulting from the anticipated synergistic benefits of combining the acquirer and target company. Synergy will be realized when cash flow is increased, through either increased sales or reduced costs, which ultimately leads to an increase in shareholders’ wealth. In short, what cash flow metrics establish value?

• Deal Pricing and Financing. Fourth, how is price determined, and how will the buyer fund a deal? Typically, multiples of EBITDA within the same industry, establish the benchmark for pricing a deal. However, a buyer also needs to define those aspects for which a premium above average industry multiples will be paid, or when the buyer will insist on a discount from those averages. Also, determining how you might fund a deal, and establishing your funding capacity, as evidenced by a letter from a debt or equity source, will strengthen an anticipated Letter of Intent to buy.

• Approaching the Seller. Fifth, what approach to acquisition should be utilized? Approach is the variety of procedures used to persuade the target firm to accept and finalize an intended acquisition deal. A bidder’s acquisition approach includes the manner of acquisition (i.e., merger vs. tender offer), the method of payment (i.e., cash vs. stock), and the type of acquisition (i.e., related vs. unrelated acquisition). Advisors help buyers by conducting this process confidentially.

As a corporate buyer, summarizing your answers to these 5 questions in a List of Acquisition Criteria will establish the framework for evaluating whether an acquisition is a good deal. Detailing your Acquisition Criteria is also the first step towards enlisting qualified advisors to act as your outsourced acquisition team. Based on such well-defined acquisition criteria, investment bankers working on your behalf can then proceed to systematically qualify target sellers and initiate the due diligence process.

In 1997, as part of the Taxpayer Relief Act of 1997, a new section 1045 was added to the Internal Revenue Code that provides for the rollover of gain from the sale of QSB stock.  In the following year, the IRS Restructuring and Reform Act of 1998 provided some amendments to section 1045 including the expansion of the gain rollover treatment to additional taxpayers, other than corporations.

Just last August 2007 (with corrections made in October 2007), final regulations were issued by the Treasury Department with respect to the application of section 1045 to partnerships and these regulations include some interesting examples.

So what is QSB stock?  Section 1202(c) of the Internal Revenue Code provides us with the definition, which includes:

• It is stock of a C corporation (i.e., not an S corporation).
• The stock was originally issued after August 10, 1993.
• The stock was acquired at its original issue in exchange for money, property other than stock, or compensation for services provided.
• The corporation must not have more than $50 million in gross assets (measured by adjusted basis) at any time on or after the original issue date of the stock.
• The corporation did not redeem more than 5% of the outstanding stock over the periods described in section 1202(c)(3).
• At least 80% of the assets of the corporation must be used in the active conduct of a qualified trade or business as described in section 1202(e)(3).

Under the appropriate facts and circumstances, the section 1045 rollover of QSB stock provides another useful strategy for deferring income taxes.  As with all significant transactions, you should seek advice from a qualified tax professional in connection with any contemplated business sale.