It is a great time to buy, especially for buyers who can close for all or almost all cash in light of today’s choppy debt environment. It also is a great time sell because valuations in most sectors still are very high compared to historical averages. Although M&A transactions are substantially off in the large company segment, excellent opportunities still exist both to buy and to sell in mid-market and smaller company segments. There also are outstanding opportunities for acquiring selected assets, intellectual property and average and/or under-performing companies.

Enhanced shareholder value is best achieved by establishing a base line corporate valuation using all of the valuing techniques available. Next, FOCUS advises clients on the subjective drivers that may influence, enhance or detract from the straight financial analysis and conclusions. These subjective drivers are called the FOCUS 12 Value Drivers.

THE M&A PROCESS HAS CHANGED

Today, buyers and sellers are more cautious than ever before. Pre-LOI due diligence is lasting much longer prior to firm deal terms being agreed upon. There is much more focus on forecasted revenues and stable and growing customer bases. Integration planning on paper between buyers and sellers is taking longer prior to the execution of a Letter of Intent. Finally, management teams, while extremely important in all M&A transactions, are becoming much more critical to achieving success in the current M&A environment.

For buyers and sellers alike, the key to achieving a successful M&A transaction is to complete the financial valuation for the client and then to advise the client about the value components or Value Drivers which exist with the company. Over the years, the following FOCUS 12 Value Drivers have been used by the firm to advise clients about enhancing shareholder value once the financial analysis of the company is complete.

TWELVE VALUE DRIVERS RESULT IN GREATER CORPORATE VALUE

At FOCUS, when we assist a client organization in establishing a value or value range at which “we believe your company will sell,” we also carefully evaluate 12 specific Value Drivers as well as all of the financial metrics.

Value Driver #1: The Customer Base

The customer base of the company being acquired or being sold is extraordinarily important. What is the buying trend from these customers over the past five years? What is the extent of customer churn? How many new customers have been acquired annually over the past few years? What is forecasted revenue from these customers over a specific forecast period? How stable is the customer base? What is the profile of the customer base? Are the customers large, medium or small? How vulnerable are these customers to economic fluctuations and impacts? What is the revenue distribution of these customers over the entire revenue base of the company to be sold or to be acquired?

To provide an example of the importance of a company’s customer base, FOCUS recently completed a transaction assisting an educational software company client in its sale to an international educational software and publishing company serving the same education market segment. Our client had captured the top 300 college and university customers.

Our client’s service offering was a CRM-like enterprise application sold to colleges and universities on a “software as a service” model. Each year, subscription income to our client’s service offering was collected in advance and customer retention was 93%. While EBITDA was 22% of top line revenues, our client company sold for 15X EBITDA because its customer base was attractive in so many ways.

Value Driver #2: Recurring Revenue

One of the top Value Drivers to consider is the recurring revenue coming from the customer base of the company to be acquired or to be sold. Of total revenue, what percentage is recurring? This portion of total revenue is valued much higher than so-called "one-time revenue." Will the combination of revenues from the acquiring company and the acquired company create an opportunity for a higher recurring revenue percentage of the total when the deal is completed? Finally, is there an opportunity to change the business model of the acquired company to result in stronger recurring revenues?

In the example of the educational software company discussed above, 93% of revenues recurred each year. This revenue stream was valued much higher when compared to companies that must begin again each year with generating new one-time revenues.

Another great example of a product company that has transformed itself into a recurring revenue company is a firm that FOCUS currently is in discussions with to sell. This company sells, installs and maintains hardware devices worldwide that monitor refrigeration units. Not only does the company charge for its hardware products, but also derives over 60% of revenues from training, maintenance and support. In our analysis of the company’s financial statements, this recurring portion of the company’s revenues is valued higher that revenues resulting only from product sales. 

Value Driver #3: Product Integration

A major reason for making an acquisition is to acquire a new and complementary product line(s) so that the acquiring company can leverage its current distribution system and, therefore, increase revenues and gross margins. Great attention must be paid to technical platforms of different products. Even more attention and analysis needs to be completed on whether products are complementary or competitive. Product/market segment research often must be completed before a product integration advantage can be substantiated.

Value Driver #4: Gross Margin

At FOCUS, we believe this is most important line item on the P&L. In-depth analysis on paper needs to be completed to determine whether acquiring the target company ultimately will improve or degrade gross margins. Manufacturing processes need to be analyzed to accommodate more—and presumably complementary—product sets as well as items such as customer installation/training and service/warranty commitments.

Value Driver #5: Intellectual Property

“Intellectual property” is a catchall term meaning one thing to one person and something entirely different to another. Generally, at FOCUS, we use the term in its broadest sense when assisting a client with a transaction. Intellectual property certainly means trademarks, patents and copyrights but it also can mean a "developed process" such as a unique way to generate sales leads and then close sales using only the Internet. Accordingly, proprietary processes should be closely examined when evaluating a company for acquisition. Intellectual property and proprietary processes can add a lot of market value to a company that is for sale.

Currently, our firm represents a technology development company that has developed and patented a chip set that, when installed in a CCTV camera, can visually detect smoke and fire at the earliest stages—well before traditional smoke detection and sprinkler systems can set off a fire alarm. This company has no revenue, a very small management and product development team, and yet, this intellectual property is likely to sell for millions to one of the large security and fire protection companies. This is a perfect example of how intellectual property can provide a powerful strategic advantage to a strategic acquirer, while, at the same time, a detailed financial analysis of this asset can be very difficult if not impossible to measure.

Value Driver #6: Human Capital

Today, this area is being evaluated to a much great extent than ever before. During the late 1990s, a common approach was to acquire a company, assume that management and other key employees would stay for a while and then, the acquiring company would expect to augment or replace management as employment agreements expired. Today, buyers look for situations where management wants to stay for the long term. Post-sale integration failures of the past are largely the result of management departing after the deal is closed. When valuing a company that is for sale or valuing a company to be acquired, a close look at the human capital of the organization is an absolute necessity.

Value Driver #7: Management Experience and Expertise

This Value Driver is closely aligned with Value Driver # 6: Human Capital, with the following differences: Does the management team of a company being sold have substantial knowledge of a specific product, process or market segment that is a necessary requirement of the acquiring company? Can the managers of the company to be acquired add value to the current management team? Will this new management team give the organization the capacity to grow to the next level?

Value Driver #8: General and Administrative Leverage

Almost as important as Value Driver # 4: Gross Margin is the general and administrative (G&A) leverage when combining the acquiring company and the company to be acquired. Again, careful planning is necessary in this area prior to the LOI stage. Buyers tend to overestimate the cost savings of combining companies at the G&A line. Also, transition costs often are underestimated, if not overlooked altogether. “Valuing the synergies” is a catch phase in today’s M&A environment and, while synergies do carry value, we advise our clients not to include this analysis in the offer price.

Value Driver #9: Distribution Leverage

Potential buyers frequently say, "I want to buy a company where I can drive the products from the acquired company through my existing distribution system." While this concept is sound, there are pitfalls. Buyers need to be certain that end user customer requirements are complementary to this strategic approach.

Demand should be measured through effective market research. Sales and dealer training costs need to be taken into account, and product installation and customer service expense of the new products needs to be analyzed. These are just a few of the items about this Value Driver that need to be studied. Distribution leverage is an exciting concept and a top Value Driver, but a hard look at implementation details is critical.

Value Driver #10: History/Reputation and Operating Tenure

In the heat of an M&A transaction, this Value Driver often is overlooked. It has to do with the stability and constancy of the business being acquired. The fact that the company to be acquired has been in business for some time does matter and does have value although it is very hard to measure. An in-place management team that has operated together for some time is a highly valuable commodity. Many venture capital firms—as is commonly known—place a very high value on “serial entrepreneurs” who have had successful exits after working together closely for a period of time.  

The fact that customers have been with this company for a period of time does matter and, once again, the fact that the company is operating with the same management team in place is a positive factor. While there are other factors with this Value Driver, company history, reputation, management tenure and continuing operations are very important to the contemplated transaction.

Value Driver #11: Sales and Marketing Effectiveness

When FOCUS is advising clients, this Value Driver is at the top of our list. All too often, buyers concentrate on exotic product sets, exciting technology (that someday could be turned into a product) or new markets and customers. One key and very important element of a successful buy-side or sell-side transaction is to determine whether the company to be acquired or sold has developed an effective and "least cost" sales and marketing model.

When was the model developed? How long has the model been in place? What are the statistical results of the sales and marketing model over time? Is the model scalable through the forecasted period? If the answers to these and additional questions are positive, chances are excellent that a successful acquisition or company sale will occur.

Value Driver #12: Barriers to Competitive Entry/Competitive Differentiation

Barriers to competition are becoming more difficult to identify, as many companies are reluctant to file for patents even if a technology or process is evaluated to be "protectable." Buyers must look for effective barriers to competition when evaluating a potential acquisition through competitive differentiation.

Does the company have a "first mover" advantage in a particular market or market segment? Does the company to be acquired or sold have significant product features that would provide a real product advantage when compared to competition? Does the company to be acquired or sold have a significant technological edge that affords a 12- to18-month product roadmap advantage? These are a few of the questions that should be asked and thoroughly and objectively answered when looking for a competitive advantage Value Driver.

Conclusion

In today's tough M&A environment, the investment banker must, of course, analyze the numbers and make solid recommendations based on that analysis. It also is more important than ever to concentrate on these FOCUS 12 Value Drivers when advising clients on maximizing value during the transaction process.

The late 1990s called for buying a company and then “making it work.” Today's environment dictates careful study and analysis of the financials within the context of the above FOCUS 12 Value Drivers prior to establishing value, setting a purchase price or price range and executing a Letter of Intent to acquire or sell.

About Marshall Graham and FOCUS, LLC

Marshall founded FOCUS in 1982 after a successful corporate career at IBM and Xerox Corporations. Today, FOCUS has over 40 investment banking professionals located in company offices in Washington, DC; Atlanta; Chicago and San Francisco. Most of the firm’s investment banking staff have extensive operations backgrounds as well as financial transaction experience.

The firm serves domestic and international buyers, sellers and investors and specializes in companies with revenues of between $5-300 million. FOCUS has a large research staff and a defined transaction methodology which results in a very high engagement success rate.

For more information about FOCUS, please visit the firm’s website at www.focusbankers.com. To contact Marshall Graham directly, please email him at graham@focusbankers.com or phone him at 202-470-1964.