When companies are seeking strategic growth initiatives or shareholder liquidity alternatives, they often consider options that may not fully maximize shareholder value. Utilizing a manageable amount of debt, however, to fund such initiatives can be a prudent way to accelerate growth and/or generate liquidity with more flexibility and greater long-term shareholder value. Whether to fund organic growth, acquisition growth or shareholder proceeds, the use of debt offers many advantages.

Types of Debt
Asset-based lending (ABL) facilities, or lines of credit, are based on a company’s collateral value, which is largely based on a discounted value of qualified receivables and inventories, and typically do not amortize.  Term notes are often based on the liquidation value of fixed assets and generally amortize over a fixed period of time (such as five years). These two types of senior debt are generally the least expensive for a company.

Second-lien, subordinated and structured credit facilities are utilized if more debt is required than is available through senior financing, subject to constraints for interest coverage and leverage multiples.  This type of debt is riskier and therefore more expensive than traditional senior debt financing. In addition, subordinated debt may be accompanied by equity warrants, which equate to a small percentage of a company’s overall equity value.

The type and amount of debt utilized to fund company growth or liquidity transactions is highly dependent on a number of factors, including:

• Type, quality and value of collateral
• Revenues and growth rate
• Earnings before interest, taxes, depreciation & amortization (EBITDA)
• Gross margin and EBITDA margin
• Stability of historical cash flows
• Existing debt obligations
• Industry and customer-specific attributes
• Other related factors

Organic Expansion
For companies that are expanding organically, a revolving line of credit or similar debt facility can provide the necessary working capital to support expansion efforts and reduce the constraints that growth has on operating cash flow. A credit line may also be used to fund entry into a new market that requires upfront capital but does not generate immediate positive net cash flow. A debt facility may allow a company to grow at a much faster rate than would otherwise be the case.  This higher growth translates into larger operating profits as well as greater shareholder value over a shorter period of time. Moreover, it allows a company to penetrate a market more rapidly, reducing competitive risks and increasing operating margin through greater scale.

Acquisition Growth
Companies seeking acquisitions can utilize various types of debt structures to fund a large portion of the total acquisition and related expenses. The use of leverage to fund acquisitions is common and minimizes the need to use cash on the balance sheet or more expensive new equity. The assets and cash flows of the acquiror and target may be combined to determine the total debt available to fund a transaction. Any remaining consideration required to fund the acquisition may be sourced from (i) the acquiring company’s cash balance, (ii) a subordinated “seller” note where the seller acts as a note holder, or (iii) new equity from the acquiror or a third-party. The total cost of the acquisition includes the upfront consideration paid to the target’s shareholders as well as the acquisition-related expenses incurred by the acquiror. Without the use of external debt, making an acquisition would be nearly impossible for many acquirors and would result in significantly higher overall costs, lower returns, and less shareholder value created.

Shareholder Liquidity
For private company shareholders seeking liquidity, there is an alternative to a traditional company sale. In certain cases, shareholders may be able to generate partial, upfront liquidity from their businesses utilizing a minority leveraged recapitalization structure, which allows shareholders to receive an upfront cash dividend. The dividend is funded through external debt, which is borrowed by the company and collateralized by the company’s assets and, in some cases, its cash flow. The overall debt structure can be customized based on the shareholder’s desired goals as well as the company’s collateral base and operating cash flow, among other factors. Moreover, the debt may be comprised of multiple tranches, each having its own unique amortization schedule, rate structure, etc. Such a transaction is predicated on the company’s ability to grow at stable profit margins in order to service the debt. Note: A derivative of the minority leveraged recapitalization is an employee stock ownership plan (ESOP), which involves a newly created trust acquiring all or a portion of the equity from shareholders using debt to fund the purchase.

Unlike a sale to a strategic or financial buyer, the minority leveraged recapitalization structure allows shareholders to participate in a majority of the future incremental value that is created. Compared to an equity recapitalization, the use of debt to recapitalize the company is significantly less dilutive as a result of the lower cost of capital and typically does not result in any initial loss of control. In addition, the transaction process is typically less obtrusive and can be completed more quickly.

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Opus Advisory Partners professionals have significant experience in structuring and funding organic growth initiatives, acquisitions and shareholder recapitalizations.

Highly acquisitive companies as well as institutional private equity funds review numerous acquisitions on a recurring basis. But only a select number of target companies are ultimately pursued. This is because acquirors must have a high degree of confidence in the ability to create and realize future incremental value as a result of the acquisition.

Many acquiring companies ultimately ascribe value to acquisition targets based upon the projected risk-adjusted returns on investment. One of the most critical elements to enhancing returns is future growth in the acquired company’s business, principally through revenue and operating profit expansion. Acquirors must be able to expand a target’s operations either organically or through additional tuck-in acquisitions in addition to realizing revenue and expense synergies on a combined basis. Creation of future incremental value and strong return on investment are important facets of the decision matrix and depend on a number of factors such as:

• Growth in revenues and profitability
• Strong barriers to entry and industry-leading core competencies
• Minimal and fragmented competition
• Minimal customer concentration
• High-quality products/services
• Product/service diversification
• Strong reputation among customers
• Talented senior management and committed employees

The aforementioned factors greatly affect the amount of acquiror interest and ultimately valuation levels. Quite often the companies that exhibit such attributes are appropriately rewarded with relatively higher valuation multiples.

If planned and executed successfully, acquisitions can accelerate growth and shareholder value for acquiring companies seeking greater market share and/or further diversification of their businesses. As an alternative to organic growth, acquisitions can immediately strengthen an acquiror’s business through potential cross-selling opportunities, revenue diversification and expense synergies. But in order to maximize the chances of success, a detailed acquisition road map, which includes strategic growth, execution and integration plans, should be developed and approved by senior leaders.

Strategic Growth Plan

Once senior management and the Board determine that an acquisition strategy is desirable, a strategic growth plan that provides direction should be developed. The acquiror’s growth intentions, targeted investment size, timing and other factors will shape the rest of the acquisition process. Addressing the following key decision points, and many others, will help provide direction during execution and integration:

• What type of growth is the company seeking (expansion or diversification of current offerings)?
• What is the targeted range of revenues to be acquired (whether in one or more acquisitions)?
• What is the maximum amount that can be invested in an acquisition strategy?
• What are the goals of the key shareholders?
• What is the overall timing and exit strategy (if applicable)?
• What types of industry trends are expected over the next five years? Will there be consolidation?
• How does the company need to be positioned competitively over the next five years?
• What types of acquisition candidates are of greatest interest?
• How are competitors growing and what types of acquisitions are they making?

Knowledge of the above areas and others provides companies with a framework around which they can execute with greater efficiency. Beyond the scope of this paper, an outside advisor should help lead this process by providing detailed analysis that (i) educates management on industry and competitive trends, (ii) identifies growth opportunities, and (iii) analyzes whether shareholder value can be created and maximized. This will provide important decision-making clarity and shape the rest of the process. Moreover, it will significantly increase the chances of a highly successful acquisition strategy.

Deal Process and Execution

Once an acquisition strategy has been established, the next step is designing the execution plan, which is highly tactical by design but requires proper planning. In general, the execution phase should yield the highest quality candidates and widest range of alternatives for acquiring companies. Execution also requires meticulous evaluation and analysis of multiple acquisition candidates, often simultaneously, iteratively and in a time-sensitive environment. Included below are some of the key areas of emphasis:

• Research, identification and prioritization of acquisition/investment candidates
• Initial contact and relationship building with prospective acquisition targets
• Information gathering, including detailed discussions with senior management of targets
• Internal strategic assessment of prospective targets and acquisition rationale
• Detailed financial modeling/valuation (standalone and combined financial projections, pro forma adjustments, synergies, integration costs, etc.)
• Transaction structuring and buyout analysis (debt/equity mix, equity ownership, exit strategy, internal returns analysis, etc.)
• Sourcing of debt and/or equity capital (as applicable), including dissemination of detailed financial/buyout model and company-related information to potential lenders
• Letter of intent, detailed due diligence, and pre-transaction checklist (100+ total items)
• Definitive transaction agreements, negotiations and closing schedules

Embarking on the process of acquiring one or more companies is extremely rigorous, requiring organization and attention to detail. Moreover, detailed analysis is critical in determining synergies, valuation and transaction structure, among other variables.

Post-Deal Integration

Most companies are realizing better results from their acquisition strategies primarily due to their integration efforts. Successful integration following transaction completion is critical, but much of the planning should occur well in advance of closing in order to minimize risks and fully exploit all opportunities. And implementation of the plan should begin prior to closing once the deal has reached a high level of certainty.

Since no two acquisitions or companies are the same, the integration plan is customized based on the unique issues, challenges and opportunities of each transaction. Listed below are some of the important aspects of executing upon such a plan:

• Focus on the largest profit opportunities first—e.g. cross-selling opportunities, customer integration, and expense synergies—that will make the most meaningful difference
• Determine key management changes and finalize the reporting structure in order to eliminate people-related issues that otherwise are a detriment to integration
• Assign key managers from different areas to a newly formed integration committee, which oversees integration on a day-to-day basis and is responsible for meeting key milestones, resolving issues, recognizing profit opportunities, reporting to senior management and the board, etc.
• Go above and beyond to deliver consistent and positive communications to customers and solicit their feedback in order to get in front of potential issues early
• Maintain strict focus on both the base and acquired businesses to ensure that key personnel are focused and motivated to execute as they have been historically (“business as usual”)
• Stay on plan—thoughtfulness, execution rigor and timing are key aspects of maximizing integration effectiveness and send employees a powerful message as to the company’s commitment
• Recognize that integration takes time and employees of both companies will need to embrace the various change that affect them both directly and indirectly
• Deliver a consistent message about the newly combined company culture and communicate it clearly internally with employees

Such planning involves the creation of a 180-day action plan that includes action items, assignments, key milestones, etc. across multiple operational areas. Lack of strategic direction or mismanagement of the integration process can lead to issues such as customer confusion, poor performance in both the base and acquired businesses, and the loss of key people. Competitors take advantage of these types of opportunities to take market share.

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The risks associated with internally managing an acquisition process are extremely high and could result in lackluster results or outright failure. Working with a seasoned advisor that is involved in each of the three phases of an acquisition growth strategy is highly recommended.

Opus Advisory Partners provides advice to shareholders, boards and senior management on corporate growth strategies, including all aspects of mergers & acquisitions.  Opus employs an institutional investor mindset to the evaluation, structure and integration of transactions when working with clients to achieve “best practices” results.

Shareholders of closely held companies, as well as parent corporations of publicly held divisions, often seek advice as it relates to corporation valuation and the value of their holdings.  While determining the value of a corporation is a complex analytical exercise, there are a number of qualitative factors that indirectly affect value as well as the interest level by prospective acquirors or investors.

Valuation is based on a number of different methodologies that are dependent on the unique financial metrics of a subject company, valuation metrics of similar companies, and industry-specific characteristics, among other factors. But equally as important as the analytical exercise of determining value are the qualitative factors that influence it. Listed below are selected factors that often influence whether companies receive discounted or premium valuations:

• Company Revenues and Operating Profit. Companies with larger revenues and operating earnings before interest & taxes (EBIT) typically command higher valuation multiples.
• Customer Concentration. Minimal customer concentration significantly reduces the risk of lost revenues and operating margin degradation and bolsters valuation levels.
• Industry Growth and Competitive Dynamics. Positive industry growth and competitive fragmentation improve a company’s growth prospects and have a positive impact on value.
• Product/Service Line Diversity. A diversified line of products or services often increases customer retention and reduces risk of lost revenues.
• Reliance on Suppliers/Inputs. Minimal reliance on suppliers reduces overall business risk.
• Regulatory Limitations. Industry-specific regulatory oversight or risk of industry-related legislation may have an adverse effect on a company’s risk profile.

In addition to the aforementioned factors, valuation is affected by ownership aspects such as the marketability (or lack thereof) of a company’s stock on a freely tradable market as well the control or influence with respect to corporate governance.

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Opus Advisory Partners provides valuation and fairness opinion services to boards, shareholders and senior management of companies and divisions. In addition, our firm provides advice on a range of transactional, financial and strategic advisory services that include valuation as a core component.

Many companies are facing challenges in growing their businesses organically. We expect this trend to continue for the foreseeable future principally based on weakened economic growth (domestic and worldwide) and increasing competition primarily due to disruptive technologies, as well as other factors. For publicly held companies, in particular, there is significant, ongoing pressure to generate continued increases in shareholder value as well as stock price appreciation.

Alternatives such as share buybacks and increased cash dividends are short-term strategies that have recently worked to buoy share prices. Over time, however, these financial engineering methods break down and companies often find themselves in a competitively weaker position. Companies with a successful track record of growth and long-term share price appreciation have instead focused on generating recurring growth in profits through a mix of internal and external (acquisition) growth initiatives.

Buy vs. Build

Most companies evaluate growth initiatives on a recurring basis and often look organically to initiate growth through new products/services or extensions of existing offerings. Senior management may believe that organic growth is simpler and less expensive than finding the “perfect” acquisition candidate. In addition, internal expansion may come with more personal recognition, promotion opportunities and compensation upside to senior management personnel. But the ramifications of this singular strategy may result in a more time-consuming, challenging and costly outcome with potentially more risks.

Conversely, a diversified growth strategy that includes both organic growth and targeted acquisitions can quickly and effectively generate profitable growth and incremental value. Acquisition targets do not necessarily need to be large in order to be considered.  In fact, the acquisition of a smaller target still provides immediate benefits in addition to its own organic growth potential and cross-selling opportunities. Irrespective of the specific strategy or deal size, an acquisition will likely result in immediate increases in revenues and profitability, dedicated personnel and stronger overall growth potential.

Some of the largest publicly traded companies have a successful track record of growing shareholder value because they generate growth and maintain strong margins while staying competitive. And that combination has repeatedly come from making strategic acquisitions as well as simultaneously growing organically (in the base and acquired businesses).  Of the 500 companies that make up the S&P 500 Index, 97% have successfully closed acquisitions.  Moreover, 72% of the S&P 500 have made acquisitions in the last 24 months. Given the availability of inexpensive debt financing, excess cash on balance sheets, and the efficiency associated with buying versus building, we expect this trend to continue.

Synergies and the Compounding Effects on Profitability

Most acquiring companies are able to generate cost synergies by eliminating duplicate or unnecessary operating expenses of the target, thus increasing overall profitability. Overlapping internal support functions and sales roles may provide the greatest opportunity for expense savings. In addition, the ability to cross-sell products/services across multiple customers can result in accelerated growth and incremental profits. And the incremental gross profit attributable to these revenue synergies often comes at no additional operating expense. The compounding effect of this incremental growth in future periods translates into acceleration of revenues, operating profit and shareholder value.

Transition and Integration

Critical to the success of any acquisition is the planning, transition and integration of the target’s business within the acquiror’s infrastructure, from a practical and cultural perspective.  A 180-day plan should be instituted to ensure the following:

• Best practices among both organizations are implemented
• Senior management and employees work collaboratively
• Cross-selling opportunities are maximized
• Infrastructure changes and expense reductions are appropriately realized
• Challenges are immediately identified and solved

Working with an Acquisition Advisor

Choosing to partner with an advisor that has experience in evaluating and executing acquisition opportunities not only greatly improves success but it creates opportunities. An experienced advisor can add tremendous value across multiple disciplines:

• Leading all elements of the acquisition process including acquisition growth strategy, execution, analytical support and integration
• Assessing a market and competitive landscape to determine opportunities for growth
• Identifying and connecting with high-quality acquisition candidates
• Managing and performing detailed due diligence (financial, market/competitive, operations, etc.)
• Providing detailed financial modeling and valuation analysis that accounts for pro forma combined results, upfront costs, integration costs, synergies, etc. on a risk-adjusted basis
• Utilizing a structure that minimizes cost of capital, and if needed, raising the requisite debt financing from various sources
• Assisting with board-level communications, including investment committee memoranda and full presentation materials

Senior executives have the ability to own significant equity stakes in the companies they run whether at privately held companies or divisions of public companies. Such executives are able to acquire (or “buy out”) the ownership interests of the corporate parent, owner/CEO or other shareholders as a result of a corporate sale or divestiture. This type of transaction allows senior managers to run and grow their business as direct equity holders, sharing in the rewards of the incremental future value they create. Through some creative transaction structuring techniques, senior management can acquire a company with a very small upfront equity investment.

One of the perceived challenges of a management buyout is funding the transaction. Most management teams, on their own, do not have the available resources to acquire a company or division from its owner. Likewise, most parent corporations or owners are not willing or able to accept consideration less than fair market value. However, there are ways to creatively structure a transaction that not only satisfies the owner’s valuation expectations, but also accommodates meaningful and potentially lucrative equity ownership opportunities. Additional structuring techniques can be employed to minimize the burden of raising outside capital to fund the deal.

Senior management team members should actively position themselves as potential acquirors for the businesses they run by having ongoing dialogue with company owners or the parent corporation. Because of their tenure at the company or division, management may receive favored treatment either (i) before a formal decision has been made to divest or sell, or (ii) as part of a formal process.

Given the complexities, risks and timetable associated with a management buyout, working with an advisor that has buyout experience and strong relationships with capital providers is critical to maximizing probability of success. Care must be taken to structure the transaction, as well as build a sophisticated acquisition model and determine the optimal capital structure, among many other factors.

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Opus Advisory Partners actively works with senior management teams in all aspects of the management buyout process.  In addition, Opus can co-invest alongside senior management in the transaction and position the management team to rapidly generate incremental value.

If you were considering the divestiture of one of your lines of business but then learned that a small acquisition would drive significant growth over the next 18 months, would you still exit or instead put the transaction on hold to take advantage of gaining new market share? If you decided not to divest a lackluster division, but later found out that there were significant headwinds negatively affecting growth opportunities and profit margins, would you still weather the storm or instead divest the division and redeploy the funds internally?

Corporations, boards and shareholders sometimes struggle with determining the strategic direction of each of their lines of business.  The same is true for owners and shareholders of closely held, stand-alone companies.  Some lines of business may no longer be strategic, or may be increasingly difficult to grow profitably given their unique characteristics, and therefore it might be time to consider an exit.  Other divisions might need to be repositioned or even expanded to exploit growth opportunities within a very short window of time that could transform the entire company.

This multi-faceted decision matrix is an ongoing challenge for corporate leadership.  Personal emotion and conflicts of interest, as well as the inability to quantitatively and qualitatively assess each available alternative, make such strategic decision making difficult. But the most successful companies are always evaluating their businesses introspectively, including whether to expand, enhance or exit operations.  Expanding the business can create value.  Enhancing the business can unlock value.  And exiting allows shareholders to realize immediate value, the proceeds of which can be distributed or redeployed internally. Determining the course of action is highly dependent on answering the following question: Which option will maximize shareholder value on a risk-adjusted basis?

Companies often face a dilemma when determining their future direction—either grow aggressively to increase value, or exit now to maximize current value.  Investing in the future through efficiency enhancements, organic expansion and acquisition growth can lead to greater profits and margin expansion, resulting in greater long-term value and more attractive exit options.  These alternatives should be analyzed to determine if the incremental value created is worth the risk of giving up the proceeds from a near-term exit, among many other factors.

Trying to comprehend all of the various options in addition to understanding how to maximize value is challenging.  It requires utilizing market/competitive analyses and sophisticated valuation and transaction structuring to quantify and evaluate each of the alternatives.  A strategic assessment of corporate finance options can provide companies, boards and shareholders with a blueprint to objectively evaluate their future on a risk-adjusted basis.  Moreover, the assessment provides an action plan that can be immediately implemented.

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Opus Advisory Partners works closely with boards, management teams and shareholders to evaluate their strategic options and maximize value on a risk-adjusted and conflict-free basis.  Our firm also provides execution advisory services to companies seeking to institute specific initiatives.

Compared to a traditional company sale, an employee stock ownership plan (ESOP) may provide a more flexible and economically attractive solution for company owners or shareholders seeking liquidity. In a leveraged ESOP transaction, the ESOP (newly formed or existing) purchases the stock of one or more shareholders through newly funded company debt within a tax-advantaged structure. Funded debt can be structured to minimize taxable income (maximizing corporate tax deductions) using multiple debt tranches, customized amortization and warrants.

Compared to other transaction alternatives, the ESOP structure may be more advantageous for a number of reasons, including:

• Compelling Tax Benefits. There are notable individual and corporate tax advantages for selling shareholders, the company and employees:
  • Depending on how the transaction is structured, selling shareholders may be able to indefinitely defer capital gains taxes on their transaction proceeds, resulting in an upfront savings equal to the capital gains tax rate and potentially higher. In every case, the transaction is structured as a sale of stock versus a sale of assets.
  • For corporate tax purposes, a company is able to deduct, within certain limits, principal payments on ESOP-related debt, as well as certain dividends paid to the ESOP. In essence, a company is utilizing pre-tax dollars to reduce its debt balance, albeit at a more accelerated pace, and to pay dividends. Interest on ESOP-related debt is also tax deductible.
  • Because the ESOP is a defined contribution plan, similar to a 401(k) retirement plan, employees’ ESOP ownership interests in the company grow on a tax-deferred basis.
• Structuring Flexibility. Shareholders determine how much equity they wish to sell to the ESOP as well as the requisite timing—either upfront or over time depending on desired goals, debt structure limitations, and company cash flow projections. Owners often choose to sell between 30% and 100% in the initial transaction. A non-ESOP equity incentive plan may also be implemented specifically for senior management as part of the overall transaction.
• Owner/CEO Benefits. Unlike other transaction structures, an owner/CEO may retain day-to-day control of the company if he/she chooses, irrespective of the amount of equity sold. If not already in place, a board is typically formed and members are chosen at the discretion of the owner/CEO.
• Simplified and Expeditious Transaction Process. Depending on the complexity, the ESOP process may take between three and four months to complete. Confidentiality and due diligence issues that often occur in a traditional sale process are eliminated.
• Employee Ownership. Implementation of the ESOP allows employees to become indirect company owners at no upfront cost. Studies have shown that employee-owned companies often outperform their peers as a result of having an ownership interest.

While there are many advantages to an ESOP structure, there are a number of considerations worth noting.  The valuation ascribed to a company as part of an ESOP transaction is determined by an unaffiliated, independent third-party appraiser. This valuation will serve as the basis for how the transaction is structured and directly impact the proceeds of selling shareholders.  Additional annual company valuations must be completed at a nominal cost in order to calculate the value of ESOP holdings. In addition, a company must hire an independent trustee/fiduciary that represents the interests of ESOP participants.  A Company must also plan for its repurchase obligation, which is the Company’s future obligation to repurchase vested shares from departing employees upon retirement, death, disability or termination.

These considerations are manageable but must be evaluated within the overall context of the transaction.  For many companies, the advantages of an ESOP structure outweigh the considerations, which is why this structure is gaining in popularity among owners and shareholders seeking liquidity, especially in a rising tax rate environment.

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Opus Advisory Partners advises company owners on the initial feasibility as well as the structuring, financing and implementation of an ESOP.  Our firm also analyzes and compares the various exit liquidity options available to owners, providing decision-making clarity on how to maximize value and after-tax proceeds on a risk-adjusted basis.