2017 Exit Academy. Evaluating Alternatives and Valuation

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Kristina Small
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1 2017 Exit Academy Evaluating Alternatives and Valuation

2 Sales Critical Issue Where is Company in Its Lifecycle? Introduction Growth & Adoption Penetration and Maturation Consolidation and Decline Debt / Equity Recap Cash Generation - Disinvestment Investment & Acquisitions Start-up and Cash Burn Shareholder Returns & Diversification Time 2

3 Explanation General Benefits Other Considerations Potential Strategic Alternatives Status Quo Plus Acquisitions Staying the course Management focuses attention on existing business plan Regain level of operating momentum and grow incremental value Maintain focus on executing existing plan Mitigates integration risk to the business No change in ownership / capital structure Viability in light of changed market dynamics Opportunity cost of equity in business Need to maintain excess liquidity for acquisitions Internal Recap Manage for Cash Focus of Company operations toward cash generation and distribution Execute modified capital structure by distributing surplus cash, using bank line to fund working capital Implement specific changes to past practices medical co-pays, bonus Puts to work surplus equity in business Improve returns on equity and overall shareholder wealth Puts additional discipline around cash Improves cost of capital substitutes inexpensive bank credit for valuable equity Cash distributions versus redemption of shares Ability to manage month-to-month cash needs Preparation for downstream MBO/ESOP/LBO Internal Buyout (MBO/ESOP) Use available leverage to execute a share redemption Given projected equity value and leverage capacity will be multi-stage Transfer ownership over time to employees and/or mgmt Owner/company financed Partial liquidity for shareholders Retain benefit of future upside Large overhang of available private equity capital Potentially offsets other benefits bonus payments Potentially tax favorable Typically lower valuation for internal transaction If equity recap, adds governance complexity Use bulk of available debt capacity Estate planning / tax considerations Sale/Recap Strategic or Private Equity Sale of a controlling interest to a strategic or financial buyer Typically sale of more than 70% for private equity sale Full or majority liquidity for shareholders Potential to retain some benefit of future upside Large overhang of available private equity capital Meaningful risk diversification If equity recap, adds governance complexity No new cash coming into business Estate planning / tax considerations 3

4 Long-term Liquidity Alternatives & Resulting Valuation Implications? Least Liquidity Most Maintain Autonomy Control Loss of Control Leveraged Recapitalization MBO/ESOP Private Equity Recap Sale to Strategic Buyer Key Issues Debt recap No new cash Retain 100% ownership No transition Owner/ co. financed Installment sale Adds leverage Need right mgmt 80% liquidity Mgmt stays Leveraged 2 stage 100% liquidity Mgmt transition 2-3 buyers Valuation Implications N/A 5.0x 5.5x EV/EBITDA 5.0x 6.0x EV/EBITDA 6.0x + EV/EBITDA 4

5 Leveraged/Debt Recapitalization Summary Considerations Benefits Continue to execute business plan with little management distraction. Achieve partial liquidity without diluting ownership, provide level of financial safety net. Current shareholders retain all future upside. Current management maintains complete control. Higher degree of confidentiality and certainty of execution relative to partial or full sale Preserves flexibility to pursue ultimate exit strategy (completely pre-payable capital structure). Internal discipline of managing capital aggressively Shareholders earn favorable return on capital versus cash/debt costs, and retain option to lend back to company in emergency At shareholder option, potential leverage in event of distress Considerations Ability to fully satisfy shareholder liquidity objectives. Reduces financial flexibility for future acquisitions or growth investments. Ability to operate in leveraged environment. Revolver capacity / working capital needs. Forego opportunity to maximize value and liquidity in current M&A and private equity market. Uncertain bank receptivity of if leverage pushed beyond asset support Maintaining asset coverage, and below 2.0Xs EBITDA Appropriate availability to meet working capital needs and execute strategic add-on acquisition 5

6 Summary Considerations Financial Sponsor Transaction Benefits Considerations Provides substantial liquidity for existing shareholders. Equity rollover provides opportunity for existing shareholders to capture upside. Ongoing management role and meaningful equity participation for current executives. Potential to introduce additional expertise and strategic resources. Brings credibility, helping to attract outside capital and resources. Capitalizes on favorable conditions in the leveraged finance markets. Potential to achieve attractive valuation given current private equity overhang. Could preserve existing culture. Identification of sponsor for appropriate fit. Potential to give up significant, and possibly majority, voting and economic control. Agreement on valuation and tax implications to both parties. Investment horizon and exit strategy are critically important to buyer. Corporate governance requirements of new investors (i.e. covenants, minority protection provisions, board members). Ability to operate in leveraged environment. M&A process is time intensive and potentially distractive to management. 6

7 General Structure Structural Features of Sponsor Investments Investments by financial sponsors can take a variety of forms with the sponsor s ultimate objective being striking the balance between risk and reward. Sponsors will typically seek to invest through some form of a Preferred Stock Security. Preferred stock enables investor to limit downside. Proposed security would likely PIK and accrete to greater ownership over time. Restrictive Covenants Voting Rights Board of Directors Information Rights Forced Exit Sale of company / sale of major assets / merger / fundamental corporate change / special dividends. Super-majority on major issues not covered by a restrictive covenant and, potentially, on other large issues such as a major acquisitions or capital expenditures. Expect to have board representation and will want input (and potentially veto rights) on the selection of outside industry / expert board members. Likely on a monthly and quarterly basis. Financial and operating information. 3-5 year redemption feature so that private equity investors can achieve a liquidity event. May be in form of Put Right to company (or current owners) or call structure to provide current owners ability to buy investor out. Ability to force a dividend recapitalization after a certain time period if the Company is performing well and has low leverage. Registration Rights Piggy-back registration rights and, potentially Demand rights (however less of an issue if there are other adequate exit mechanics). Tag along / Drag along Rights Tag-along rights for the private equity investor in any sale by the current owners. Drag-along rights may be put in place to force a liquidity event. Economics Typically target an all-in IRR in the +/- 20% range. Anti-dilution provisions. May seek advisory fees on acquisitions and ongoing management fees. 7

8 Sale of Company Summary Considerations Benefits Considerations Likely most attractive valuation, as strategics will pay a premium for synergies and enhanced competitive position. Potential for lower leverage and no financing risk. Maximize business plan by leveraging existing strengths and addressing any key weaknesses of each partner. Enhanced proprietary information and opportunity to improve core competencies. Impact on employees, community, and other constituents. Ongoing role of executive management. Loss of autonomy / control over strategic direction. Shareholder rights and veto issues. Shareholders forego future upside. Possible confidentiality issues / competitive sensitivities. Potential change in culture. Depth of strategic buyers very limited 8

9 MBO ESOP Internal Sale MBO vs. LBO Transaction Mgmt team buys out owner shares over time Company borrows $$$ to fund share redemption from current shareholders Mgmt team earns shares as comp/buys shares Mgmt team ownership expands over time Transaction Employees buy out shares over time Company borrows $$$ to fund share redemption from current shareholders Employees earn shares as comp or buy shares Opportunity Minimize up-front due diligence Maintains legacy, control for significant period Provides liquidity over time Reduces bonus comp in exchange for shares Opportunity Tax favored borrowing and company contributions, potential for tax deferred rollover Minimize up-front due diligence Reduced bonus/401k in exchange for shares Does not necessarily require family mgmt to depart Challenges Conflict-of-interest issues Will take 5-8 years to execute Is there qualified leadership to execute? Willingness of buyer to take buyers risks Leveraged, precludes other strategic moves Need to add corporate governance, provide minority shareholders rights, limit discretionary distributions Challenges Does ownership incentivize employees? Will take 5-8 years to execute Need to provide redemption for retiring shareholders make-market in equity Significant fiduciary duty to ESOP shareholders Subject to annual valuation and equity price variation May preclude other paths 9

10 ESOP Fundamentals Benefits of an ESOP 1. To buy the shares of a departing owner. Owners of privately held companies can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to buy out an owner's shares, or it can have the ESOP borrow money to buy the shares (see below). Once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain. 2. To borrow money at a lower after-tax cost. ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible. 3. To create an additional employee benefit. A company can simply issue new or treasury shares to an ESOP, deducting their value (for up to 15% of covered pay) from taxable income. Or a company can contribute cash, buying shares from existing public or private owners. In public companies, which account for about 10% of the plans and about 40% of the plan participants, ESOPs are often used in conjunction with employee savings plans. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level. 4. To align employee and shareholder interests. Companies that are wholly or partially owned by the employees can be more productive and valuable. Employees take pride of ownership of the company, and an ownership culture can be created. 5. To retain talented employees. ESOPs are often structured with a vesting schedule, so that employees leaving prior to vesting lose their interest in all or part of the ESOP, thus aiding retention of valuable employees. 10

11 VALUATION OVERVIEW Capital Market Factors Economic expansion or recession Liquidity and availability of debt State of the M&A markets Company Factors Financial performance/profitability Competitive positioning Growth prospects Uniqueness of products or services Depth/quality of management team Customer concentration Size and scale of operation Industry Factors Mature or growing Consolidated or fragmented Competitive dynamics (price driven, capabilities, reputation, etc.) Valuation Shareholder Factors What is driving the decision to sell? Public or private Intentions post-closing Involvement in day-to-day operations 11 11

12 VALUATION OVERVIEW 12 12

13 2017 Exit Academy Program Topics Case Introduction and Value Drivers Realistic Strategic Alternatives & Sale Values Ownership Transition & Liquidity Alternatives Without a Sale Building Value; Going from A to Z Dealing with Family Dynamics in the Transition Process The Investment Banking & the Real Selling Process Due Diligence and What is Cash Flow? Legal Documents; The Good, the Bad, & the Ugly Planning for Life after Closing; Wealth & Career (Life) Transition 13

Introduction. PEs: the invesment process and the Value Creation

Introduction. PEs: the invesment process and the Value Creation Introduction PEs: the invesment process and the Value Creation 1 Contents - Introduction - PE Stages and Investment Process - Initial Strategic Definition: Types of deal and PEs - Deal Sourcing - Initial