Acquiring closely held family businesses
September 2011 | TALKINGPOINT | MERGERS & ACQUISITIONS
FW moderates an online discussion examining the issues surrounding acquiring closely held family businesses between Daniel Domberger at Livingstone Partners LLP, Mike Hinchliffe at Merrill DataSite, and Steven J. Daniels at Skadden, Arps, Slate, Meagher & Flom LLP.
FW: What methods can buyers use to source and target viable closely held businesses for acquisition?
Hinchliffe: Often, corporate finance advisers are engaged to find potential targets and start an evaluation process, but increasingly this initial research is happening in-house, as most companies are aware who their competition is or which competitors are on the rise. At a time when every company has its history, vision and values published on a website, this research is made easier. For an acquisition to have the greatest chance of success, particularly acquisition of a closely held business, there has to be synergy between the organisations involved in terms of core business, values and cultural fit, so it’s important to look for those. News aggregator websites, such as mergermarket, are also now much used for the purposes of keeping an eye on the market and singling out potential targets.
Domberger: Identifying targets can be relatively straight forward – especially if they’re active in the same market. You might be aware of them as competitors or channel partners or you may have seen them at trade shows. This gives you the opportunity to build a relationship with the principals first, which is often the key to gaining early traction. Targeting a company you don’t know can be hard: people aren’t always receptive to a cold contact from someone they’ve never heard of asking to acquire their business. It’s easier if they know you already and you’re active in the same markets, as a conversation can often evolve more naturally in the direction of acquisition. Of course, the easiest way can be to have a seller’s adviser contact you to say they have done this hard work for you, and are representing a perfect target, although the call may never come and this will probably be a competitive auction process rather than a one-on-one discussion.
Daniels: Identifying and executing on proprietary deal opportunities is more critical – and more challenging – than ever. Two reasons for this are the number of potential acquirers competing for acquisition opportunities and the fact that sellers continue to rely on formal auction processes. The proprietary sourcing model allows sponsors more time to evaluate targets and the absence of a competitive dynamic is helpful to maintaining price discipline. One principal method of executing on this strategy is the use of operating partners – individuals with industry-specific operating experience – as members of the sponsor’s deal team. These individuals bring knowledge of the relevant industry and a network of relationships that is critical to an effective proprietary sourcing model. While investment bankers also can provide industry contacts that aid in identifying deal opportunities before a formal auction process is commenced, the use of operating partners has certain clear advantages.
FW: How would you describe buyer and seller price expectations in the current market? What unique challenges arise when delivering valuations and fairness opinions on closely held businesses?
Domberger: There remains a gap between buyer and seller expectations, and this hasn’t been helped by the recent volatility in the markets, as declining share prices often constrain a listed acquirer’s ability to meet a seller’s value aspirations. Sometimes sellers come up with a target valuation by working out how much they need to maintain their current income levels. In this low interest rate environment, that can create a very significant expectation gap, as purchasers don’t look at it this way at all. It also ignores factors such as the differing tax treatment of income and capital, the balance of certainty and risk, and so on. Delivering valuations for closely held businesses can be tricky, as this is one area where beauty really is in the eye of the beholder. It’s not uncommon, in a sale process, to have one offer which is 50 percent higher than the others, or even 100 percent.
Daniels: During the height of the credit crisis and associated dislocations, transactions were hampered by the disparity in valuation expectations of buyers and sellers and the paucity of financing options. With the brief trend toward normalisation that occurred in late 2010 and the first half of 2011, valuation expectations appeared to be rationalising relative to the situation encountered during the credit crisis. The extent to which recent volatility will undermine this return to normality remains to be seen. At a minimum, financing options appear to have been impacted and this will no doubt impede some prospective acquirers and drive down valuations. In this environment, the real challenge in arriving at appropriate valuations and rendering fairness opinions seems to be the systemic volatility being experienced throughout the global economic system.
Hinchliffe: The gap in price expectation between buyer and seller, which has appeared since the global financial crisis, continues to be an issue. This arises particularly with closely held businesses, SMEs and family owned companies, who tend to value their company higher than buyers because of emotional ties. Both sides may just have to acknowledge that, to close the deal they want, both price negotiations and due diligence will take longer than they did five years ago.
FW: To what extent is the purchase process clouded by emotions and subjectivity attached to a closely held business? How can parties overcome this potential problem?
Daniels: One of the most challenging aspects of executing a private company acquisition from a non-institutional seller is overcoming the mindset of the closely held business owner.
In this setting, it is often difficult for sellers to accept the valuation implications of flaws identified during the diligence process. In addition, sellers may not recognise the integration issues that their business methods may pose to a larger, institutional buyer. For example, the absence of appropriate financial statements, accounting controls and forecasting tools may hamper a buyer’s ability absorb and integrate the acquired business. From the perspective of the seller, there is often a certain amount of cognitive dissonance regarding the quality of the business, and this may be coupled with an emotional attachment that impedes the seller’s ability to negotiate rationally. It is important in this context to stress empirical data when addressing valuation issues, particularly when valuations are being adjusted based on diligence findings. Outside advisers can be helpful in this context by providing a buffer between the principals.
Hinchliffe: Closely held businesses have a relatively small group of shareholders, which can be a blessing and a curse to suitors. These shareholders have time, money and emotion tied up in their business, a potent cocktail, making them naturally averse to any buyer who doesn’t appear to fully appreciate the asset they are trying to acquire. The shareholders will also have personal relationships and a deep sense of responsibility to management and staff within their business, which may make negotiations around consolidation or reorganisation problematic. But this is balanced by the benefits of working with a small group of passionate owners who know their business, good and bad, and come in manageable numbers. Buyers can assign representation to forge personal relationships with each individual; then address their concerns on a personal level, achieving quicker decisions and reaping the benefits over the short-term and into post-acquisition.
Domberger: Individual shareholders selling a closely held business are frequently making personal decisions, rather than purely commercial or financial ones. They’re also making decisions which will have far-reaching consequences for them, their families and their employees. So there’s more pressure on them not sell badly, which can make it challenging to bring the parties together. A constructive dialogue is the key to overcoming this and again this is easier if the purchaser already has a relationship with the company, and is aware of some of the potential sensitivities. A purchaser should also be aware of first impressions and the messages it’s sending a target – a low-ball opening valuation might make a target think you don’t see the value in the business or that you are not serious, and might be the end of the conversation.
FW: What advice would you give companies on undertaking a successful due diligence process to manage risk in the deal?
Hinchliffe: Due diligence is demanding, involving aggregating; organising; indexing; duplicating; disseminating; and making hundreds, even thousands, of documents available for review. In the past this was done in a paper-based environment, with documents presented in a physical data room for buyers to trawl through. This is time-consuming, costly and inefficient. Also, with multiple parties involved in gathering content, the risk of incomplete disclosure and subsequent post-transaction liability is a threat. Virtual Data Rooms have transformed due diligence, making it an efficient, online process that reduces cost, eliminates complexity, adds security and accelerates transaction cycles, while attracting and enabling the right volume and type of buyers to the process.
Domberger: The key to due diligence, for a seller, is always preparation. If you can have the core information ready, you can focus on reassuring the purchaser on the more important strategic and commercial questions it has, rather than running around trying to pull together volumes of information at short notice and under pressure. This is particularly important in closely held companies, because the main shareholders might be the only people in the company who know what’s going on, and they can’t ask others in the business to help prepare information without giving the game away. A second critical aspect is to be up-front about potential issues. If you try to hide an issue, it will almost certainly come out eventually, and this will be much more damaging to the relationship than an open dialogue at the beginning.
Daniels: My principal advice would be to take the time and spend the effort necessary to perform appropriate diligence. This includes retention of all appropriate subject matter experts needed to fully evaluate a target. In addition, buyers need to be disciplined about the timetable for completing diligence. Often negotiating developments will put pressure on the diligence timetable and cause buyers to truncate their advisers’ efforts. This can be short-sighted depending on the situation. Accelerating the deal process in order to sign a transaction that has not been fully vetted through appropriate attention to business, legal, regulatory, tax, accounting and other diligence matters can result in significant buyer’s remorse.
FW: Are there any specific legal issues and requirements involved in the acquisition of a closely held business, which buyers need to consider?
Domberger: You should be alive to any shareholders’ agreement, which might govern decision-making in unusual or unpredictable ways. Knowing whether one shareholder can force others to sell is often very useful information, because you know who you’ll need to convince.
It’s not uncommon for tax planning to become more important when you’re dealing with a closely held company, as individual shareholders may be more focused on their net proceeds than the headline value.
Daniels: Among the many legal issues that arise in the context of a private company acquisition, buyers should pay specific attention to the company’s capital structure and equityholder arrangements. In particular, there are often tensions and competing obligations in the terms of preferred equity and convertible debt arrangements and in the agreements entered into among equityholders and other constituencies regarding their rights vis-à-vis one another.
FW: In your experience, what are some of the recurring challenges that arise when integrating a closely held business into the buyer’s existing operations? What are some of the options that buyers can utilise to empower and incentivise employees during the sale and purchase process, to assist integration?
Daniels: Workforce issues and employee morale problems can arise if integration is not handled in a crisp and coordinated fashion, with attention to appropriate incentives. In a sales force driven business in particular, missteps in this process can fatally destroy value. Simple differences in corporate culture and approach can exacerbate integration problems in ways that buyers may find difficult to foresee at the contract stage. For employees needed on a transitional basis only, stay bonuses and interim consulting arrangements can be effective tools for integration retention. For employees expected to remain with the combined company long-term, it is critical to develop and design an appropriate package of salary, incentive compensation and others perquisites, including equity compensation.
Hinchliffe: Even in small businesses there are complexities and challenges to be faced when working on integration – the challenges are the same as those encountered on a multi-billion pound transaction, just on a smaller scale. Improved electronic document management processes have enormously helped integration processes, big and small, giving all parties access to important communication tools before, during and after transactions have taken place.
Domberger: One of the biggest issues can be that the senior individuals in a closely held company aren’t used to reporting to superiors, but are accustomed to being their own bosses. It can be a difficult change of mindset for a seller who has to come back in to the business the day after the deal, to find everything’s the same except he or she is no longer in control. If the buyer wants the shareholders to remain, incentivisation becomes critical. This doesn’t just mean money – a broader role or remit within the purchaser’s group can often be just as effective. The earlier you start these discussions, the less painful the transition will be.
FW: Overall, how important is it to engage external advisers to guide the transaction process?
Hinchliffe: Different companies will have different approaches to managing M&A opportunities. Some organisations will use in-house teams that manage everything from sourcing, valuing and managing transactions through to post-acquisition integration, while others will see these as separate processes and bring in experts along the way. It’s likely that smaller businesses won’t have an in-house resource or capability and will feel that third party objectivity, industry knowledge and experience are critical, so they will engage external advisers. Certainly it is important for a seller not to tie up valuable resources in attempting to run the electronic due diligence process by some internal means, when advanced and good value technology is available off the shelf.
Domberger: Having a good adviser is key. For shareholders in a closely held business, the exit is one of the most important things they’ll ever go through. They may think they can negotiate a deal themselves, but a transaction like this is quite different to other commercial agreements, and it’s an area where experience really counts. A good adviser will know what’s normal in the market, and be able to advise when a counterparty is taking an inappropriate position which might sound acceptable but shouldn’t be. They can be helpful in suggesting different approaches to apparently deadlocked situations which might otherwise kill a deal. They can also act as a very useful buffer, playing the bad cop to your good cop so you can maintain your relationship with the other side; after all, you’ll have to work with them after the deal is done, and falling out over the negotiations isn’t a great start to a relationship.
Daniels: Proper use of outside advisers is critical to deal execution. The timing of when it is appropriate to bring outside advisers into the process varies, however, depending on whether the buyer is strategic or financial and, if strategic, whether the buyer has significant transaction experience. Decisions are often made at an early stage in the process regarding structure and deal terms, and these decisions may be difficult to revisit or modify later if outside advisers are not involved early enough in the transaction process. Similarly, once the business rationale for the acquisition has been established and a decision has been made to move forward, outside advisers in accounting, legal, tax and regulatory matters, among others, are critical to a successful due diligence process.
Daniel Domberger is a director at Livingstone Partners LLP, with a specific focus on the technology sector. Having studied in Australia, Mr Domberger graduated from Oxford University in 2000. He then moved to the US to work as part of Tyco Electronics Corporation’s in-house M&A team. He has advised on numerous M&A transactions for owner managers, large corporations and Private Equity houses. He can be contacted on +44 (0)20 7484 4700 or by email: firstname.lastname@example.org.
Mike Hinchliffe is a sales director at Merrill DataSite, and has been with Merrill Corporation for over 10 years. He was responsible for execution and launch of the first DataSite Virtual Data Room projects in Europe, while he was based in Paris, and has global expertise in his field. Since returning from Paris to London in 2004, he has worked on hundreds of M&A transactions with major law firms, corporate businesses and investment banks. He is currently responsible for sales coverage in the UK and Benelux. Mr Hinchliffe can be contacted on +44 (0)20 7422 6256 or by email: Mike.Hinchliffe@Merrillcorp.com.
Steven J. Daniels is a partner at Skadden, Arps, Slate, Meagher & Flom LLP. Mr Daniels has a broad-ranging corporate practice, focused primarily on M&A, private equity transactions, and securities law matters. He also advises clients, as well as attorneys throughout the firm, in matters relating to Delaware law, including fiduciary duty and corporate governance issues. He has represented numerous public and private companies and investment funds in connection with negotiated acquisitions and dispositions in distressed and traditional settings. He is regularly included in Chambers USA: America’s Leading Lawyers for Business. Mr Daniels can be contacted on +1 (302) 651 3240 or by email: email@example.com.
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Livingstone Partners LLP
Steven J. Daniels
Skadden, Arps, Slate, Meagher & Flom LLP