Middle Market M & A: Handbook for Advisors, Investors, and Business Owners [2 ed.] 1119828104, 9781119828105

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ADDITIONAL PRAISE FOR MIDDLE MARKET M&A “As a business owner who has done several M&A deals, and as a former Chair of the Global Entrepreneurs Organization (EO), where I knew many business owners who did M&A deals, I found the information and practical advice in this book very helpful. We all read about the big deals that happen, but understanding the truths about small to middle market M&A is very different. Middle Market M&A is a great guide to navigating the entire process.” —­David Anderson Founder of several businesses, EO Arizona member

“It’s great to see a book recognize the middle market like Middle Market M&A does. Having owned and eventually selling a middle market company I sometimes felt we were, until now, the forgotten segment in the business world. This book is full of knowledge and insight and after reading it I no longer feel like the forgotten company owner!” —­Jim Baker Entrepreneur and author of The Adventure Begins When the Plan Falls Apart

“Whether selling to a strategic buyer or private equity firm, business owners and their advisors will find Middle Market M&A a go-­to resource as they think about and work through the deal process.” —­Rush Benton, CFA Senior Director of Strategic Growth, CAPTRUST

“Combining business, corporate strategy, legal, tax and accounting considerations and approaches involved in today’s middle market M&A transactions into a single, thorough, yet easily digestible format, I would consider the Middle Market M&A Handbook a “must have” desk side resource for today’s deal professional operating in the middle market segment.” —­Scott Bowers, Partner, Womble Bond Dickinson (US) LLP

“All business owners will eventually exit their company. For those that want to proactively plan and know their options, Middle Market M&A is the go-to guide for understanding the process and

gaining insights into how deals work and having an edge in getting the most value. Even if your exit is to the next generation, this handbook provides a perspective on value creation and making the succession and transition easier. Middle Market M&A should be a required read for every owner and entrepreneur.” —­Bill Buxton, Vistage Chair

“Having participated in middle market M&A over the past 25 years, I’ve learned how successful transactions hinge on many factors, beginning with the initial idea of a deal—­to getting it closed. This handbook provides a rare and unique overview of the spectrum of topics and concepts critical to understanding and optimizing the outcome.” —­Lanny D. Bynum, CPA Thompson, Price, Scott, Adams & Co. P.A.

“An owner’s business is often their largest asset. This handbook helps entrepreneurs and business owners properly consider their goals and objectives to enable them to present their company in an intentional manner to maximize the value of an asset they have often spent a lifetime building.” —­Terry J. Carlton, Managing Partner, Jordan Price Wall Gray Jones and Carlton, PLLC

“The new edition of this handbook for advisors, investors, and business owners on middle market M&A is an outstanding update for anyone involved in mergers and acquisitions. It is a comprehensive, well-­written, and stellar contribution to the M&A literature and to the M&A practice. It is a must-­buy for businesses, investors, and advisors, not only for middle market M&A but for anybody interested in the field more generally.” —­Professor Sir Cary Cooper, CBE Co-­editor, Advances in Mergers and Acquisitions Series Alliance Manchester Business School, University of Manchester, UK

“Whereas similar efforts barely manage to scratch the surface, the Middle Market M&A handbook represents a thoughtful and comprehensive treatise on topics of relevance to stakeholders across the transaction spectrum. An equally must-­have resource for serious M&A professionals and the clients they serve.” —­Michael C. Gillette Shareholder, Polsinelli PC

“For the M&A market, sellers, buyers, and advisors alike can find a lot of helpful information here. This highly readable guide is especially relevant for the middle market space, where mom-andpop meets the highly resourced, sophisticated worlds of corporate finance and private equity. This reference contains a detailed survey of M&A guidance including areas such as: reviewing seller’s goals and aspirations; understanding of market segments, types of buyers, and proper valuation; optimizing finance and capital structures; finding buyers; and structuring a deal so both sides can succeed. All of it is delivered in plain English, with practical thoughts on updated technology, ethical standards, and best practices. Well done!” —­Chris Hostetler Financial Advisor, Hilltop Wealth Advisors

“It is wonderful to see the second edition of Middle Market M&A, particularly in light of all the significant changes in this market over the past 10 years! As an M&A attorney, mainly on the sell-­side, I frequently point my clients to this resource so that they are more knowledgeable about the M&A process. I am confident that these clients who delve into the handbook have better outcomes and fewer surprises in their transactions.” —­Fred D. Hutchison Hutchison PLLC

“Great collection of the how-­to’s of M&A. No BS advice. Highly recommend.” —­Bharat Kanodia, ASA Founder and Chief Appraiser, Veristrat LLC Inc. Magazine contributor

“Having practiced corporate law for almost 20 years and teaching M&A to law students for the past 5, I have come to appreciate the complexity and nuance around M&A transactions. Middle Market M&A provides a well-­organized and thoughtful journey through all of the key elements of a middle market M&A transaction. I have found the clear and detailed presentation of the material to be accessible to both seasoned practitioners and novices alike, whether in the legal, accounting, tax, or investment banking profession.” —­Geoff Krouse, JD Assistant Dean for Alumni & Development and Senior Lecturing Fellow at Duke Law School; Of Counsel at Smith Anderson LLP

“This updated second edition of the Middle Market M&A handbook is a great resource for owners and advisors involved in the M&A process. It covers all the important topics in working through sell-­side and buy-­side deals, especially at the lower end of the market.” —­Brent Kulman Managing Director, Business Development, Five Points Capital

“As an entrepreneur having sold my landscaping business to a large industry leader, understanding the terms and concepts outlined in Middle Market M&A was highly valuable. This handbook is a great tool to have as you think about selling your company.” —­Don W. Long Best-­selling author, speaker, and transformational leader former; owner of Long Brothers Landscaping

“Often overlooked or discussed only as an afterthought, Marks and his co-authors have focused on an increasingly important part of the vibrant M&A market—the so-called middle market where indeed the most deals take place. This market is huge as are the implications for buyers of mid-sized companies, their founders and sellers, the myriad advisors, investors, and business school students. This book should be on the bookshelf of every one of those groups. This handbook provides not just an overview of the necessary elements for success in mid-market dealmaking, but is a rigorous and, importantly, up-to-date compendium of the broad range of issues that anyone dealing in this market will encounter.” —­Professor Scott Moeller Director, M&A Research Centre Bayes Business School (formerly Cass), City, University of London

“It is not a question of if, but when, you will sell your business . . .  and when you do, this handbook should be front and center during the process. Entrepreneurs are the best at growing businesses . . . the guidance in Middle Market M&A by these experts is what is needed to translate your hard work and passion into valuable business building and successful M&A!” —­Randy H. Nelson, Serial Entrepreneur Author of the Decision Series for Entrepreneurs

“Understanding how private businesses access capital for growth and successful owner transition is one of the most critical and least understood parts of the small- and medium-sized business economy. This second edition of Middle Market M&A is a must read for anyone who needs to master the ever-evolving dynamics of the private capital marketplace. There is no better reference book for equity investors, private company owners, and the advisors that unite them.” —­BRETT PALMER, President Small Business Investor Alliance (SBIA)

“A valuable M&A handbook. This edition of Middle Market M&A provides readers with a solid understanding of where the middle market and private capital markets currently sit while going into best practices from a sell-­side and buy-­side perspective. The technical section covers vital information and doesn’t just scratch the surface, but goes into detail that all M&A practitioners, whether they have 2 or 20 years of experience, will find beneficial.” —­Kison Patel CEO and Founder of M&A Science

“I have been doing mid-sized M&A deals for over 30 years and Middle Market M&A is the most comprehensive guide I have come across. The glossary alone, with its extensive definitions, could be a book itself. As the authors suggest, there is often an “asymmetry of knowledge” in the middle market because most entrepreneurs only sell their business once, whereas buyers can be frequent practitioners of the art. Readers of Middle Market M&A can minimize this disadvantage when armed with this impressively complete book.” —­Reed Phillips, CEO of Oaklins DeSilva & Phillips and author of QuickValue

“The authors and contributors to this second edition provide practical guidance in the planning and execution of M&A transactions for founder-­led and family-­owned businesses. Their experience and approach shine through in Middle Market M&A: Handbook for Advisors, Investors, and Business Owners.” —­Gerald Roach Firm Chair of Smith Anderson; corporate, securities, and merger and acquisition lawyer; and —Byron B. Kirkland, Managing Partner, Smith Anderson; corporate, private equity, and mergers and acquisition lawyer

“I am often asked whether there are any differences between a middle market deal and a traditional upper market deal. I just say ‘Read This Book.’ It has everything you need to think about in structuring, negotiating, and closing a middle market deal from the advisors I would hire to lead the deal.” —­Margaret Rosenfeld Chief Strategy and Legal Officer, Deltec International Group

“Middle Market M&A is a superb reference for C-­suite members and professionals serving the middle markets. The authors provide a unique perspective on how to structure transactions and manage organizations to maximize enterprise valuations. This book is full of terrific guidance for understanding and maneuvering within the middle markets, with clear and cogent advice on managing to a timely and certain closing and transaction.” —­Larry Robbins Partner, Wyrick Robbins

“Middle Market M&A is a must-­read and a valuable practical resource for anyone who spends all, or any part, of their day in middle market corporate transactions—­whether as an advisor, investor, buyer, seller, or student. It doesn’t matter whether you’re a veteran or a rookie, this book will help you navigate the always changing and challenging world of M&A. In fact, this is not just a book to read; it’s a book to use. Make notes in the margins, dog-­ear the pages, skip around out of order, keep it nearby as a handy reference, and refer to it often whenever you’re faced with old and new problems to solve. This is the one book to have in an increasingly overwhelming array of M&A resources.” —­Mike Saber Partner, Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan, LLP

“Middle Market M&A provides a comprehensive and approachable overview of merger and acquisition transactions. That is not surprising to me, as it reflects the real-­world insights and experiences of the writers in getting deals done.” —­Randy Whitmeyer Partner, Morningstar Law Group

Middle Market M&A

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Middle Market M&A Handbook for Advisors, Investors, and Business Owners Second Edition

KENNETH H. MARKS CHRISTIAN W. BLEES MICHAEL R. NALL THOMAS A. STEWART

Copyright © 2023 by Kenneth H. Marks, Christian W. Blees, Michael R. Nall, and Thomas A. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permission. Trademarks: Wiley and the Wiley logo are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries and may not be used without written permission. All other trademarks are the property of their respective owners. John Wiley & Sons, Inc. is not associated with any product or vendor mentioned in this book. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Further, readers should be aware that websites listed in this work may have changed or disappeared between when this work was written and when it is read. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic formats. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Names: Marks, Kenneth H., author. | Blees, Christian W., author. | Stewart, Thomas A., 1948- author. Title: Middle market M & A : handbook for investment banking and business consulting / KENNETH H. MARKS, CHRISTIAN W. BLEES, THOMAS A. STEWART, MICHAEL R. NALL. Description: Second Edition. | Hoboken, New Jersey : Wiley, [2023] | Series: Wiley finance series 6 x 9 | Revised edition of Middle market M & A, 2012. Identifiers: LCCN 2022027387 (print) | LCCN 2022027388 (ebook) | ISBN 9781119828105 (hardback) | ISBN 9781119828143 (adobe pdf) | ISBN 9781119828129 (epub) Subjects: LCSH: Consolidation and merger of corporations. | Small business—Mergers. Classification: LCC HG4028.M4 M377 2023 (print) | LCC HG4028.M4 (ebook) | DDC 658.1/62—dc23/eng/20220713 LC record available at https://lccn.loc.gov/2022027387 LC ebook record available at https://lccn.loc.gov/2022027388 Cover Design: Wiley Cover Image: © Yagi Studio/Getty Images

In support of doing God’s work, and for our families.

Contents

Preface xxiii Acknowledgments xxix PART ONE

Middle Market Overview CHAPTER 1 The Middle Market

1 3

Performance and Impact 4 Definition 5 Characteristics of Middle Market Companies 7 Ownership 7 Access to and Use of Capital 8 Organization 8

CHAPTER 2 Private Capital Markets

11

CHAPTER 3 Valuation Perspectives for the Private Markets

31

Segmented Markets 12 How Market Players View Risk 17 Capital Providers 17 Owners’ and Managers’ Views of Risk/Return 18 Buyers 20 Market Activity 26

Private Business Valuation Can Be Viewed Through Different Standards of Value Market Value Investment Value

32 34 37

xiii

xivContents Fair Market Value Fair Value Incremental Business Value Owner Value LBO Value Collateral Value Book Value Valuing Intangibles Why the Different Versions of Value? Valuation as a Range Concept Value Worlds and Deals

37 37 38 38 39 39 39 39 41 42 43

PART TWO

For the Business Owner/Operator and Entrepreneur CHAPTER 4 Transition, Succession, and Exit Planning A Decision Framework 1. Owner Ambitions and Goals 2. Industry Cycle 3. Business Cycle 4. Company Foundation A Team Approach

CHAPTER 5 Value Growth and Optimization

45 47

49 50 51 52 53 53

55

Increasing the Return on Invested Capital 57 Strategic Position 58 Customer Base 59 Cost Structure and Scalability 60 Working Capital 60 Human Capital 61 Reducing the Risk of Investment 62 Awareness and Planning 63 Growth Plans and Relative Position 63 Leadership Team 63 Predictability of Revenues and Earnings 65 Concentrations 65 Compliance 66 Keeping Current 67 Ease the Transfer of Ownership 67

Contents

xv

Financial Information 68 Contracts 69 Title to Assets 69 Corporate Structure and Attributes 70 Don’t Lose Focus on the Core Business 70 Summary 71 Formula Definitions 72

PART THREE

The M&A Practice and Processes

75

CHAPTER 6 Practice Management

77

CHAPTER 7 Sell-­Side Representation and Process

93

Primary M&A Advisors 78 Marketing the M&A Practice 80 Target Audience 80 Networking 81 Marketing and Advertising 81 Pretransaction Consulting 82 Valuation Services 82 Other Consulting Services 82 Becoming an Expert 82 Client Acceptance 83 Confidentiality 84 Client Engagement 84 Identification of the Parties 85 Scope of Service 85 Limitations and Disclosures 86 Fees—­Selling Advisor 86 Example Fee Structures 88 Termination and Tail 89 Buy-­Side Engagements 89 Licensure Issues in the M&A Business 90

Selling Process Overview 93 Step 1: Preliminary Discussions with Seller 94 What Is the Transaction? 95 Value Expectations 95 Process 96

xviContents Step 2: Data Collection 97 Step 3: Industry Research and Identifying Buyers 100 Research Market Buyers 101 Step 4: The Marketing Book 101 Preparation 103 Seller Motivation 104 Financial Disclosures 105 Specific EBITDA Presentations 105 Balance Sheet Presentation 105 Other Financial Disclosures 106 Prospective Financial Presentation 106 Step 5: Marketing Process 106 Clear the List with the Seller 107 Initiate Contact with Buyers 107 Obtain Nondisclosure Agreements 108 Distribute the Book 108 Follow Up, Discuss, and Set Expectations 108 Step 6: The Auction Dynamic and Negotiations 109 Negotiated Sale 109 Private Auction 111 Public Auction 112 Step 7: Buyer Interest and Transaction Structure 113 Term Sheets 114 Indication of Interest (IOI) 114 Letters of Intent 114 Deal Structure 116 Asset versus Stock Structure 116 Other Tax Deferral Techniques 117 Step 8: Due Diligence 120 Step 9: Definitive Agreements 121 Step 10: Closing Process 122 Price and Valuation Changes 123 Terms and Conditions Changes 123 Third-­Party Challenges 123 Allocation of Risk 124 Other Preclosing Mistakes 124 Postsale Integration 124

CHAPTER 8 Corporate Development and the Buy-­Side Process

127

Why Acquire? 129 The Dismal Ds 130 Alternatives 131

Contents

xvii

The Acquisition Process 132 The Pipeline and Filter 133 Approaching the Target 134 The Balance between a Deep Dive and Locking In the Deal 135 Lower-­Middle Market versus Middle Market Deals 136 Valuation from a Strategic’s Perspective 137 Structuring the Transaction 140 The Bid 141 Due Diligence 141 Integration 144 Practical Tips and What Causes Deals to Fail 146 What Should We Acquire? 146 Why Are We Doing This? 147 Alignment of Interests 147 Recruit the Right Advisors Early 148 Allocate Enough Resources 148 Every Interaction Is a Negotiation 149 If It Can Go Wrong, It Will Go Wrong 149

CHAPTER 9 Buy-­Side Representation

151

Buyer Clients 151 Strategy 152 The Filter 153 Financing 154 Quality of Earnings 154 Coordination 156 Integration 156

CHAPTER 10 Technology in the M&A Process

Virtual Data Room Market Insight and Data Deal Sourcing and Exchanges Due Diligence Software Project Management Software Comprehensive M&A Software Supporting Tools Artificial Intelligence and Technology Trends Technology Providers

157

158 159 162 163 164 164 165 165 167

xviiiContents CHAPTER 11 Professional Standards and Ethics

Holistic Advice Ethical and Professional Standards Competence and Professionalism (Reputation) Best Practices (Activities) Ethics (Behavioral Boundaries) The Middle Market Standard

169

171 172 173 173 174 175

PART FOUR

M&A Technical Discussions

177

CHAPTER 12 Financial Analysis

179

CHAPTER 13 Market Valuation

195

CHAPTER 14 Deal Structure

213

Financial Reporting Motivation 179 EBITDA 181 Balance Sheet Analysis 184 Working Capital 185 Normalization 190

Reasons for Appraisal 196 Determine the Value Subworld 196 Calculate the Benefit Stream 197 Synergies 203 Determine Private Return Expectation 205 Specific Investor Return 206 General Acquisition Selling Multiples 207 Derive Value 208

Structural Priorities 213 Business and Economic Terms 214 Tax Structure 218 Legal Structure 222 Mergers 224 Initial Analysis of Both Entities 224 Strategic Rationale 225

xix

Contents

Valuation Modeling Understanding Cost, Operational, and Cultural Differences Developing the Integration Plan Deal Structure and Negotiations

225 226 227 227

CHAPTER 15 Financing Sources and Capital Structure

229

CHAPTER 16 Due Diligence

255

Perspective 229 Financing Primer 230 Capital Structure 230 Factors Shaping the Capital Structure 234 Basic Deals 237 Buyouts 237 Recapitalizations 242 Acquisitions 243 Sources and Types of Funding 245 Debt 246 Private Equity 249 Personal Guarantees 250

Due Diligence Process 256 The Diligence Team 256 Traditional Due Diligence 257 Financial Matters 258 Quality of Earnings Analysis 258 Balance Sheet Analysis 260 Ratio Analysis 260 Other Risks 261 Audited Financial Statements 261 GAAP Compliance 262 Tax Structuring and Compliance 262 Compensation and Benefits 263 Legal 264 Technical Due Diligence 266 Business Due Diligence 267

CHAPTER 17 Tax Provisions Used in M&A Tax Fundamentals Transaction Tax Basics

271

272 275

xxContents Asset Transactions Stock Transactions Stock versus Asset Sale Example Asset Transaction Details Buyer Tax Issues Detailed Tax Structuring Installment Sales Risk of Forfeiture Assets That Qualify for Installment Treatment Installment Planning Opportunity Partnership M&A General Partnership Doctrine Partnership versus S Corporation Partnership Gain Tracking Rules Purchase Price Allocation for Partnership Buyers Corporate M&A Issues Contributions to Corporations Stock/Asset Sale Election: Section 338 Mergers and Reorganizations S Corporation Issues Tax Glossary and Reference

CHAPTER 18 Legal Documentation

275 277 278 280 285 287 287 288 288 289 289 290 290 292 293 293 294 295 296 300 302

309

The Attorney’s Role 309 Preliminary Legal Documents 311 Nondisclosure and Confidentiality Agreement 311 Letter of Intent 312 Acquisition Agreements 316 Structure of the Deal 316 Stock Sale/Merger 316 Asset Purchase 317 Representations and Warranties 318 Qualifications to Representations and Warranties 319 Indemnification 320 Transaction Statistics 321 Consulting and Employment Agreements 322 Regulatory Compliance 322

CHAPTER 19 Regulation and Compliance

Protecting Investors: Securities Act of 1933 Exemptions under the 33 Act

323

324 326

Contents

xxi

Commonly Used Private Placement Exemptions 327 Keeping The Markets Honest: Securities Exchange Act of 1934 329 Requirements and Rules 329 Williams Act 330 Antitrust Issues and Laws You May Encounter in the Deal 331 Hart-­Scott-­Rodino Act 332 Transactions Involving Foreign Investors, Foreign Trade, and National Defense Matters 333 Other Regulatory Issues and Laws You May Encounter in the Deal 334 Bulk Sales Laws 334 The WARN Act 335 The Investment Banker’s Perspective 336 SEC Provisions Regulating Broker-­Dealers 336 M&A Brokers No-­Action Letter 338 Finders 344 Investment Advisers Act and Investment Company Act of 1940 345 FINRA Provisions for Broker-­Dealers 347 The Company’s Perspective 350 Process of Issuing, Selling, or Exchanging Securities for a Deal 351 State Blue-­Sky Laws 354 Considerations for Public Companies 355

CHAPTER 20 Cross-­Border Considerations

359

Is Cross-­Border M&A the Right Move? 360 Culture 361 Country Risk 365 Financial Risk 365 Market and Operational Risks 367 The Legal Environment 367 Labor and Employment 370 Negotiations 371 Due Diligence 372 Integration 372 Summary 375

xxiiContents

Glossary 377 Notes 417 About the Authors

423

About the Contributors and Reviewers

427

Index 445

Preface

D

eal markets go through cycles just as the broader economy does. The volume of deals flows or ebbs, influenced by interest rates, overall economic conditions, demographic or industry trends, the availability of capital, and other factors. These factors also affect the price of deals (i.e., the average multiple of revenue or EBITDA [earnings before interest, taxes, depreciation, and amortization] a buyer is willing to pay), which also rises and falls. The need for guidance is constant, however, whether the mergers and acquisitions market is bullish or bearish, whether it favors sellers or buyers. As you will see in this book, middle-­market capital markets, which are mostly private, are fundamentally different from public markets. Transactions are different in private markets. The participants—­buyers, sellers, and the advisors who help each party—­also tend to be different; many big investment banks do not do deals in the middle market, for example. Most sellers (and many buyers) are inexperienced—­selling a founder-­led business is almost always a once-­in-­a-­lifetime event. Acquisitions involving private companies are largely unregulated by groups such as the Securities and Exchange Commission. For all these reasons, the body of knowledge for middle market M&A differs in critical ways from what is taught in corporate finance classes and practiced by global enterprises, big investment banks, stock exchanges and their regulators, and others who are involved in deals that make headlines. Middle market M&A rarely moves markets or rates a mention on CNBC. But it makes all the difference to a founder and a founder’s family; it can lead to an infusion of capital that transforms the economic life of a community; it can give employees a whole new range of opportunity; it can create large fortunes; it can transform a niche player into an industry powerhouse. Or it can be bungled. If you own, operate, or advise a middle market company, one with $5 million to $1 billion in annual revenues, understanding middle market M&A is important for you and your clients when thinking about shareholder liquidity or selling or buying a business. How can you evaluate different options and opportunities? How can you improve the odds of getting a deal done? If you are the prospective buyer of middle market companies,

xxiii

xxivPreface how can you better understand sellers, and how can you make offers structured so that, once you close a deal, you can make it successful afterwards? Middle Market M&A: Handbook for Advisors, Investors, and Business Owners is a foundational reference for those advisors, leaders, and executives involved in the lifecycle and process of M&A transactions. This is the second edition of this book. The first, published in 2012, was based on the program for the Certified M&A Advisor® (CM&AA) credential originated and led by the Alliance of Merger & Acquisition Advisors (AM&AA). When it was published, the market for private companies was beginning to come back as the financial crisis of 2008 faded and the subsequent Great Recession slowly began to release its grip on financial markets and a long drought in M&A activity was coming to an end. This edition appears after a very different economic shock: the sudden stop-­and-­restart impact of the Covid-­19 pandemic. That event and its extraordinary human cost brought deal making to an almost complete halt in the first half of 2020. With employment and economic activity plunging, no one could have anything more than a gambler’s instinct for the short-­or long-­term prospects of a company or the true value of a deal. While ­Covid-­19 itself persisted (and persists, as of this writing), its impact on the deal market disappeared almost as quickly as it arrived. By the second half of 2020, middle market M&A activity was not just back, but at a record pace, and that pace continued into 2022, though we now face a potential recession. But while the volume of activity is back to (or above) “normal,” the nature of middle market M&A has changed in fundamental, structural ways. Some of these changes were sparked or accelerated by economic shocks, but others are the result of long-­term trends. Five stand out. First, middle market M&A has become a much bigger business. In 2021, the total global investment in middle market M&A was nearly $5 trillion, compared to just under $2.5 trillion in 2012. That is just the money that was put to work in deals. As of this writing, there is an estimated $1.3 trillion in “dry powder”—­capital held by private equity funds, family offices, pension funds, and others whose owners are looking for middle market companies. The recent jump in the number of deals may be partly driven by pent-­up demand after the Covid shock, but it has long-­term causes, too, including the massive intergenerational wealth transfer now underway as the Baby Boom generation retires and boomer-­owned companies come on the market. It is not just that the pool of capital has grown; a second major change is in who is providing the capital and who is making deals. A decade ago, institutional investors such as pension funds included private equity as a relatively minor part of their portfolio of so-­called alternative investments. Today middle market M&A is mainstream, not alternative, and there is

Preface

xxv

scarcely a pension fund that does not have a separate asset category for middle market private equity investing. In 2012, more than 75% of middle market M&A was with strategic buyers—­companies acquiring other companies to fit in or beside their existing business. Since then, the number of sponsor-­backed (i.e., private equity) deals has approximately doubled, and these account for nearly 40% of the total deals in 2021. For these financial buyers, as we call them in this book, the primary goal is to invest in a company that they will later sell. These buyers are not making acquisitions with the intent of integrating the target into a larger enterprise (although some are completing “add-­on” acquisitions as we describe in this book). Rather, these private equity investors intend to grow and develop their portfolio companies into stand-­alone valuable enterprises. Third, with the expansion of the industry has come an increase in professionalism, process, and standards. Ten years ago, this book was needed as a guide to a “Wild West” where best practices were only beginning to emerge and become known and where the quality of the advice available to middle market sellers and buyers varied enormously. To take just one example, a “quality of earnings” analysis (see Chapter 12) was rarely part of the due diligence process then; now it is routine. As the industry has become more professional, we have in this edition attempted to capture, codify, and update best practice, and in some cases expand it. The professionalization and standardization of middle market M&A will continue as the role of private capital in the U.S. economy expands. The number of U.S. publicly traded companies is about 3,500, half what it was at its peak in 1996. Initial public offerings are fewer and bigger. In 2017, according to Morgan Stanley,1 companies raised $3.0 trillion in private markets, twice as much as they raised in public markets. While private capital markets remain unregulated by and large, their sheer importance in the economy means that bankers, brokers, investors, and sellers will expect and demand more consistency and adherence to the practices this book describes. Fourth, the owners and managers of middle market companies are themselves becoming more skilled and professional. A decade ago, the middle market was the “neglected middle child” of American capitalism, largely ignored in academic research and business-­school curricula, not in the target market of those big advisory firms that do research as well as consulting, and mostly left to its own devices to discover and apply ideas to maximize enterprise value. While the knowledge gap persists, today’s middle market leader can be part of peer advisory groups for CEOs, CFOs, and others, which provide research as well as networking and can enroll in programs designed to help midsized companies scale up and help entrepreneurs build an operating system for their enterprises. For some middle market

xxviPreface companies, management expertise is provided by private equity owners—­ occasionally in operations and strategy, and certainly if they prepare for a sale or wish to make an acquisition themselves. Fifth, digitalization has transformed middle market M&A, at least in part, as it has so much else. There has been a proliferation of online, self-­ service tools for business valuation that owners, investors, and advisors can use. In the past decade, online marketplaces have arisen where companies, investors, and buyers can discover each other. Cybersecurity has become an important element of due diligence. And the whole transaction process has evolved as it has become more digital—­think of the use of virtual data rooms to secure confidential information, to take just one example. We added Chapter 10 about technology in M&A to provide a primer on the topic. Today, with capital more plentiful than target companies, the market is complex. The most attractive targets are in demand from strategic and financial buyers alike and can command prices that are extraordinarily high by historical standards—­so much so that private-­equity-­firm returns to limited partners are declining. The scarcity of these companies has driven buyers to consider smaller and earlier-­stage companies, or to develop a “platform strategy” of buying several lower-­middle ­market companies with the intention of combining them into one substantial entity, or to take partial positions en route to a complete acquisition. Often multiples for these smaller companies lag well behind, and some companies find no buyers at all. As buyers’ strategies have evolved, sellers have many more options to consider when thinking about liquidity, exit, or other transitions. And they have many more tools to use, as do sellers, advisors, and every other participant in the middle market M&A ecosystem. Thus, the quandary: How does a seller seek and achieve the best possible outcome? What is the typical middle market company to do to create a partial or complete exit for its owners? This challenge creates an opportunity for resolute leaders and executives as well as for innovative and trusted advisors. With more money at stake, more ways to buy and sell, and more professionalism on the part of buyers, sellers, and their intermediaries and advisors, the need for this book, we believe, continues to grow. Who generally wins at the deal table? The one with the most knowledge and experience! Historically, there exists an enormous asymmetry of knowledge, most often to the detriment of middle market company owners. Some experienced big buyers willingly admit to being bullies. That is why smart owners, investors, and advisors should arm themselves with any possible source of expert knowledge, reduce the asymmetry, and level the playing field. This handbook is meant to be a practical guide and reference for practitioners, owners and operators, buyers and sellers, and educators and

Preface

xxvii

students. The term M&A advisor is used throughout the text as a reference to the many professionals involved in the M&A process, including investment bankers, M&A intermediaries and specialists, CPAs and accountants, deal and transaction attorneys, valuation experts, wealth managers and investors, and consultants and business advisors. The intent is to provide a holistic overview and guide concerning mergers, acquisitions, divestitures, and strategic transactions for middle market companies. It covers pretransaction planning, deal execution, and post-­transaction considerations, and addresses the processes and core subject areas required to successfully navigate and close deals in the private capital markets. Middle Market M&A can be thought of as providing a horizontal perspective for the many participants in the process, which typically bring expertise in one or more vertical subject areas. The main content is divided into four parts, with Part One being an overview of the middle market, private capital markets, and private company valuation. In the first edition, this market perspective was heavily influenced by the work of Robert Slee, a co-­author, whose insights then continue to shape the discussion. Part Two, new to this edition, hones in on M&A from the owner’s perspective. It is written to help owners think through the issues of transition, succession, and exit planning from both personal and enterprise perspectives, and to help understand practical steps they can take that will enhance the value of their business to prospective buyers—­and its performance in the meantime. This part is not for owners alone, of course: successful advisors on both the buy and sell side know that understanding owners’ aspirations is a key to unlocking the best deals. Part Three focuses on the M&A processes and practice management. It addresses sell-­side, buy-­side, and merger processes and introduces a framework for professional standards and ethics. In keeping with the growth and professionalization of middle market M&A, this part has been considerably rewritten and expanded. Part Four delves more deeply into the technical subjects. Each chapter is a stand-­alone treatise on a specific topic. Together, they provide the supporting details to begin understanding the subtleties and intricacies in making a deal or transaction work. Keep in mind that this handbook is a guide. It is not intended as an endpoint in the search for understanding and clarity about M&A, nor is it a substitute for professional advice (from attorneys and tax specialists, for example); instead is a quick start to understanding the topics and processes and determining where more in-­depth knowledge and experience is required. The authors of this handbook are Kenneth H. Marks, lead author of the Handbook of Financing Growth; Christian W. Blees, chair of the CM&AA credentialing program and a key instructor in developing its content; Michael

xxviiiPreface R. Nall, CPA, founder of the Alliance of M&A Advisors and the MidMarket Alliance; and Thomas A. Stewart, former executive director of the National Center for the Middle Market at The Ohio State University. Although our names are on the title page, we also endeavored to generate and capture ideas, knowledge, and experiences from many industry and subject matter leaders to provide a holistic, practical, and balanced perspective. As you scan the list of contributors and reviewers involved in creating this edition, you will notice that the breadth and depth of experience, expertise, diversity, and backgrounds is vast, and we are deeply grateful to them for their help. M&A is a careful blend of art and science. On the one hand it is multidisciplinary, complex, and analytical. On the other, it is all about people, relationships, nuances, timing, and instinct. This dynamic produces opportunity coupled with conflict, ambiguity, and challenges, all supporting an exhilarating business ripe for those seeking to create or capture value. We invite you to send your comments, questions, and observations to us at: [email protected], [email protected], [email protected], and [email protected]. KENNETH H. MARKS CHRISTIAN W. BLEES MICHAEL R. NALL THOMAS A. STEWART

www.MiddleMarketMA.com

Acknowledgments

O

ne goal in creating this handbook is to present solid factual, researched, and experience-­based practical insights into the world of middle market M&A. Part of our approach to assuring the best work product possible was to augment the author team with subject matter expert inputs and to pepper their knowledge and wisdom throughout the text for accuracy and clarity. To that end, we would like to recognize and thank each of the reviewers of and contributors to this handbook, and express our sincere appreciation for their interest, time, insights, and contribution. A biography of each is in the back section. Mary Adams Mike Adhikari Darrell Arne James Bly Bryan H. Browning Austin Buckett John Carvalho Chris Dalton Champ Davis Mike Ertel Matt Evans Doug Farren Graeme Frazier Tim Friedman Michael Gillette Lisa Gross Shane B. Hansen David Henriksen William T. Hobbs II Diane Horton John (Buddy) A. Howard

Exit Planning Exchange Illinois Corporate Investments Blue River Financial Group Ernst & Young’s Family Enterprise ­Business Services Valuation Research Corporation BiggsKofford Capital Stone Oak Capital and Divestopedia FORVIS Davis Capital Transworld M&A Advisors MidMarket Alliance National Center for the Middle Market Private Capital Research and GF Data Resources PE Stack Polsinelli P.C. ALESC Warner Norcross + Judd MidMarket Alliance Private investor Tequity Advisors High Rock Partners

xxix

xxxAcknowledgments G. William Hubbard Eric Jones Terry M. Keating Stephen “Steve” Mariani Bill McCalpin Chris M. Mellen Scott Meza Eliot Norman Michael Painter Mona Pearl John Putnam D.M. (Doug) Robbins Ethan Saber John Saleeby Ari Salonen Chad Sandstedt Jerome M. Schwartzman Brent S. Solomon Brian Steffens Amalie L. Tuffin John Watts William B. Weatherford Bill Wiersema

Hubbard Business Counsel Gopuff Access Capital Diamond Financial Services DealWare Valuation Research Corporation Greenberg Traurig Transatlantic Partners Plexus Capital BeyondAStrategy, Inc. John Putnam & Company Robbinex High Rock Partners Darla Moore School of Business, University of South Carolina Midaxo TagniFi BDO Robert H. Smith School of Business, ­University of Maryland G2 Capital Advisors Hutchison PLLC Curtiss-­Wright Corporation FORVIS Miller Cooper

We are most appreciative to the teams at Dealogic, Pitchbook, and ­ rivate Equity Info for their help with supporting data, along with those P technology companies listed at the end of Chapter 10 for their insights in our technology survey.

PART

One Middle Market Overview

 

1

CHAPTER 

The Middle Market

T

he middle market is at once the most dynamic part of the U.S. economy and the least known. Smaller than the celebrated, multinational enterprises that participate in global markets, trade on public stock exchanges, are the subject of most academic research, and fill the pages of the Wall Street Journal, Fortune, Harvard Business Review, and other publications, middle market companies go about their business relatively undocumented and usually unheralded. The vast majority are privately held, so publications and broadcasts devoted to investment ideas ignore them. Academic studies are relatively rare. Most are too small to merit the interest of strategy consultancies like McKinsey and the Boston Consulting Group, whose publications about superior management practices focus on the multinationals that are their target market. At the same time, middle market companies get less attention than small business. The U.S. federal government (and states, following the federal lead) tracks small business performance through the Small Business Administration (SBA), the Bureau of the Census, and other entities. The SBA, now a cabinet-­level agency, advocates for small firms in Congress and in the deliberations of other cabinet departments and government agencies. It orchestrates the provision of counseling services that reach over 1 million entrepreneurs and small business owners annually. Because there are so many small businesses—­more than 30 million by the SBA’s count—­ they attract the attention of local and regional chambers of commerce and other groups. American Express promotes “Small Business Saturday” after Thanksgiving each year and “Shop Small” programs year-­round. And, of course, the small business that grows into a giant is the stuff of entrepreneurial American mythology. The Palo Alto, California, garage in which David Packard and William Hewlett founded HP was declared a California landmark in 1987 and was listed on the National Registrar of Historic Places in 2007.

3

4

MIDDLE MARKET OVERVIEW

The middle? Not so much. Only in the past decade or so has the U.S. middle market been given sustained attention by researchers, notably through the National Center for the Middle Market (NCMM) at The Ohio State University, surveys and analysis produced by RSM, a tax, audit, and advisory firm, an annual private capital markets study by Pepperdine ­University, and a few other entities. A handful of chambers of commerce, notably in Chicago, Cleveland, and Philadelphia, have created special programs for middle market companies. Several city business journals produce annual rankings and celebrations of local middle market companies. A Congressional Caucus for Middle Market Growth existed for half a dozen years before disbanding. But there is nothing in the American business landscape comparable to the support for and celebration of the German Mittelstand, the cadre of midsized family businesses Germans consider the core of their economy and the reason for its enduring success.

PERFORMANCE AND IMPACT Yet the American middle market is arguably as important to the U.S. economy as the Mittelstand is to the German. There are different definitions of the middle market (see the section further on) but however one counts, it produces about one-­third of private GDP, more than $6 trillion—­half again as much as the entire German economy and more than the economies of France, Italy, and Spain combined. The critical role of the middle market is not just a matter of its overall size. The resilience of these companies—­Dun & Bradstreet data show that almost 70% of middle market companies have been in business for more than 20 years, compared with only 26% of small companies—­makes them especially important to the communities in which they operate and the families whose members they employ. So does their growth. Although small businesses are the legendary engine of economic growth, on a net basis the middle market actually produces more growth, partly because fewer midsized companies fail, and partly because many small businesses are not built to scale (a neighborhood restaurant, for example). On average, middle market companies’ revenues grew 7.0% between the first quarter of 2012 and the end of 2019, according to the National Center for the Middle Market data, and added employees at a 4.3% annual rate. Both numbers are substantially higher—­about one and a half percentage points—­than the growth rates for large or small companies. As they grow, many middle market companies become big companies—­27% of large U.S. companies in 2010 had been middle market companies five years earlier. One can make similar observations about the importance of the middle market to employment. During the 2007–2010 “Great Recession,” about

The Middle Market

5

43% of small businesses went under, versus 18% for the middle market and 3% for big business. But the surviving middle market companies added 2 million jobs in 2007–2010, a period during which large companies reduced headcount by nearly 4 million.1 Beyond these economy-­wide effects, the middle market plays a critical role in the industry clusters that, as Professor Michael Porter has shown, are sources of national competitiveness and metropolitan-­ area vitality.2 Companies of this size are frequently tier-­one suppliers to global manufacturers, delivering parts and components or offering business services like logistics and distribution. Of particular relevance to readers of this handbook, they are often the source of new intellectual property that makes them acquisition targets for large businesses, a phenomenon widely observed in pharmaceuticals, life sciences, fintech, software, and other industries. A “barbell economy” made up of large and small companies does not fare as well as one with a robust middle market. The role middle market companies play in business ecosystems parallels the role they play in industry clusters. Middle market companies are rarely the “keystone species” in a business ecosystem, but they give it breadth and sustainability as suppliers to OEMs and providers of intermediary services. A business ecosystem like the tourism economy of Orlando or Las Vegas includes hundreds of middle market firms in the mix along with big companies like Disney and Southwest Airlines. The automotive ecosystem includes a full range of suppliers of parts and components, along with their suppliers, plus a downstream mix of dealerships, a large percentage of which fall into the middle market; a Brookings Institution study of the automotive industry in Tennessee showed that it depends on a supply base of 1,000 companies, all middle market.3 From a strategic point of view, the most successful middle market companies tend to have deep relationships with a few customers or suppliers, rather than shallow, transactional relationships with many. In some cases, this concentration is driven by big companies; for example, encouraged by Bath & Body Works (then part of L Brands), more than 14 suppliers have come together outside Columbus, Ohio, in an International Personal Care and Beauty Campus (inevitably nicknamed “Beauty Park”) that produces bottles, caps, pumps, and packaging—­an estimated 50% of the supplies the big company needs.4

DEFINITION Defining the middle market depends partly on statistics, partly on who is doing the defining, and partly on feel. NCMM defined the middle market as being comprised of companies with annual revenues between $10 million

6

MIDDLE MARKET OVERVIEW

and $1 billion, based on analysis of the U.S. Census Bureau’s 2007 Business Census, which showed that about one-­third of private-­sector GDP and employment was produced by companies in that range, with another third coming from smaller firms and another from larger enterprises. That definition has been broadly but not universally adopted. The idea that the middle market should be the middle third of the economy has obvious appeal and utility, but it is a moving target. First, GDP grew nearly 50% between 2007 and 2020, from $14.5 trillion to $20.9, which suggests that the sliders would be set differently today. Second, the definition was created by finding the middle third of the American private sector. In New Zealand, work by NCMM’s then-­partner GE Capital found that country’s middle market to consist of companies with revenues between $2  million and $50  million, in contrast with the U.S. middle market with its broader revenue range, described later in this chapter. Other parties have defined the middle market according to how they organize themselves to pursue middle market opportunities. Banks tend to define three market segments—­often called something like small business, commercial, and enterprise—­roughly according to how the bank believes it can serve them well and profitably. Technology providers and others do the same. At JPMorgan Chase, the middle market thus defined extends from $20  million to $500  million in revenue. Dealmakers such as investment banks, private equity firms, and the like are more likely to segment by transaction size, in part because they often rank themselves in their industries by the number and size of transactions they make. Some organizations define the middle by number of employees. ADP, whose core business is payroll services, segments its market that way: small (1–49 employees), midsized (50–499), and large (500 or more). Government organizations tend to count noses, too. Not to be outdone in a complex environment, the SBA sets the parameters for small business depending on revenue or headcount, plus industry—­so that retail bakers are small if they have fewer than 500 employees, but a small commercial bakery must have fewer than 1,000 employees, and makers of cookies, crackers, and tortillas 1,250. As shown in Figure 1.1, over 90% of U.S. and Canadian M&A transaction volume is with deals of less than $500 million in value, and about 70% of the volume is with those that are less than $150 million and averaging $47 million in transaction value in 2021. For us, the middle market for M&A encompasses businesses with revenues from $5 million to $1 billion, often subdividing it further into three segments as discussed in Chapter 2.

7

The Middle Market

100% Avg Trx $701M Avg Trx $269M

90%

70%

Deal Value

60%

$500M to $1.0B

50%

$150M to $499M Avg Trx $47M

Number of Transactions

80%

40% 30%

$5M to $149M

20% 10% 0% 2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

FIGURE 1.1  U.S. and Canadian M&A Transactions Data source: Dealogic 2022.

CHARACTERISTICS OF MIDDLE MARKET COMPANIES Hence the role of judgment—­or art—­in defining the middle market. It may be less important to define companies by size than by their characteristics, behavior, organization, and their interactions with customers, competitors, and capital markets.

Ownership The overwhelming majority of middle market companies are privately held. Within that privately held group, roughly a third are family-­owned businesses, 10 to 15% are substantially or entirely owned by private equity investors, and the balance is “other”—­a mix of entrepreneurial owners, family offices, partnerships, sole proprietorships, and so forth. Companies change hands, of course; that is the reason for this handbook. Thirty-­ three percent of middle market companies say they have undergone a major change in ownership (selling all or part of the company, bringing in a new investor, transitioning ownership within a family, etc.) in the previous five years.5 One change in ownership often leads to another; if

8

MIDDLE MARKET OVERVIEW

a private equity group buys a company, it typically sells again within a few years—­sometimes to another private equity firm group (thus restarting the process), sometimes to a strategic buyer, and sometimes to management. Private equity holding periods have been rising and averaged 6.9 years in 2018, according to the Cebron Group. These patterns were disrupted by the Covid-­19 pandemic, which made valuation very difficult.

Access to and Use of Capital Broadly speaking, middle market companies manage their capital conservatively. Individual or family owners, a large part of whose wealth may be concentrated in the company they own, are reluctant to dilute that equity by seeking outside investors and are leery about taking on debt. This is particularly true for lower-­middle ­market companies whose cash flow may be uncertain and—­perhaps more important—­where debt is often personally guaranteed by the owner. Personal guarantees mean that debt and equity carry the same risk for the owner, and can have a profound impact on the capital decisions for these companies. When one is investing one’s own capital—­or one’s mother’s—­prudence often trumps boldness. Smaller companies prefer to fund expansion from retained earnings rather than by borrowing. When they invest in innovation, established lower-­middle market companies are—­again, broadly speaking—­more likely to prefer “safe,” incremental innovations over risky, disruptive ones. Upper-­middle-­market companies are less likely to guarantee debt personally, more willing and able to use their balance sheets and relationships with capital providers strategically, and more likely to take on innovation risk in pursuit of greater reward.

Organization As companies grow, they become more complex. A small business may be run by an entrepreneur, their family, and a handful of employees, each of whom wears many hats. When specialized knowledge is required, the small firm goes outside, retaining a lawyer or tax accountant. Small business may have experts, but they rarely have corporate functions—­there is no department of human resources, marketing, or even finance. There’s a computer guy to maintain the systems, but not an IT department. The middle market is where functions appear. Somewhere in the lower-­ middle market revenue range, a recognizable finance team appears; sales becomes a department, not just a sales leader and a few commission reps; people are put in charge of procurement, operations, and distribution. At first, those functions are skeletal. The Society for Human Resources Management says that as a rule of thumb a company has one dedicated HR staffer

The Middle Market

9

for every 75 full-­time employees, which means that even a 300-­person company will have an HR department of four—­enough to manage basic tasks of pay and benefits, hiring, and compliance, but not enough to staff expertise in fields such as learning and development, executive compensation, succession planning, performance reviews, or diversity, equity, and inclusion. (Consequently, data show that middle market companies are more likely to fill skills gaps by hiring from outside than by developing from within.) In the core of the middle market, functions are much stronger, though still not deep. A middle market company might employ specialists in financial planning and analysis—­but just two or three, not dozens or hundreds as large companies do. However, at the upper end of the middle market, functions are robust and the companies have more business management sophistication. In the core and upper middle market, divisions appear alongside functions: divisions for different products, services, or geographies, perhaps with separate P&Ls. When functions and divisions meet, the result is a matrix, a complex organization in which different parties each vie for their share (or more than their share) of CEO attention and investment resources. Management becomes more professional as these companies functionalize and divisionalize. Decisions that were made informally now go through processes. Accounting, which in the lower middle market has been done primarily to prepare tax returns, becomes more descriptive and useful for tracking business performance. People begin to complain about “silos” between departments. Family businesses may bring in outsiders to fill key management roles. Often the first act of a private equity buyer is to upgrade functions—­particularly finance—­by bringing in an operating partner to push for efficiencies or installing functional leaders from their own talent bank. Governance, too, matures as companies grow. Small businesses often have no established governance; there’s the owner, a kitchen cabinet of friends and family, and a triumvirate of advisors—­lawyer, banker, accountant—­who offer counsel but have no formal responsibility. Over time and as companies grow, they appoint boards whose role may initially be advisory but that often take on fiduciary duties; they may also create other governance bodies, such as family councils whose powers and duties are explicitly defined; and the roles of outside advisors may be strengthened, for example to include preparing audited financial statements according to GAAP. These growth inflections—­the emergence of functions, divisions, processes, and professional management—­are what really describe the middle market landscape. Small businesses have not experienced them yet. For big business, they’re old hat. The middle is where they emerge, and the decisions that a company’s owners make about them will determine the company’s prospects for growth, enduring success, reduction of business specific risks, and ultimately the enterprise value. Management expert Jim Collins likens

10

MIDDLE MARKET OVERVIEW

middle market companies to adolescents, charting directions and making decisions that will define them: “I’ve always thought that there’s a journey and a progression in a company’s story. You start with an idea and then turn an idea into a business. Then you turn a business into a company. Then you turn a company into a great company, and a great company into an enduring great company. The midsection of that chain—­the shift from a business to a company and then to a great company—­that’s your mid-­market stage.”6 The special characteristics of the middle market—­its relative public obscurity; its dynamism; its ownership, governance, and attitude toward capital; its role in industry structures and economic ecosystems; and its own internal management processes and maturity—­all explain why middle market M&A is a discipline of its own. It has a unique body of knowledge and there is a distinctive art to employing it.

2

CHAPTER 

Private Capital Markets

A

fundamental premise of this handbook is that there is a difference between the deals, transactions, and financings in the middle market and those in the large-­company, traditional-­corporate-­finance public market. As indicated in the Preface, the focus of this book is the middle market, primarily composed of private businesses. Chapter 1 described the middle market landscape—­the definitions, scope, economic impact, and general characteristics of middle market companies. The purpose of this chapter is to set the stage for the balance of the discussion in this handbook by describing how these companies interact with the financial services, particularly with respect to M&A, by providing an overview and perspective of middle market and private capital market activity. A capital market is a market for securities (debt or equity) where businesses can raise long-­term funds. Since the 1970s, public capital markets—­by which we mean companies that trade on a public exchange and have a float of more than $500 million—­have received much of the attention from academics in the literature and press. For many years it was assumed that insights and ideas about public markets could be applied in the private markets, but in recent years this assumption has been challenged by research studies showing that the two are different in many meaningful ways and across the whole spectrum of financing activities and capital transactions.1 At a macro level, middle market mergers and acquisitions (M&A) activity is currently driven by the aging population of business owners, significant availability of private capital, and the need of publicly traded companies for revenue, earnings growth, innovation, and talent. As a backdrop in general, M&A is influenced by capital availability, liquidity, trends in the economy and industries, and motives of the players, which vary in each market and for each transaction. Whether one is a buyer, seller, M&A advisor, investor, or lender in the middle market, it is important to understand the market differences and dynamics.

11

12

MIDDLE MARKET OVERVIEW

A number of factors differentiate the public and private markets: Risk and return are unique to each market. Liquidity within each market is different. ■■ Motives of private owners are different from those of professional managers. ■■ Underlying capital market theories that explain the behavior of players in each market are different. ■■ Private companies are priced at a point in time, while public companies are continuously priced in the stock market. ■■ Public markets allow ready access to capital, whereas private capital can be more difficult to arrange. ■■ Public shareholders can diversify their holdings, whereas shareholders of closely held businesses have few opportunities to create liquidity or to reallocate their ownership in a private company. ■■ There is little “retail” market for shares in private companies; transactions usually involve buying or selling large stakes or the entire company. ■■ Private markets are inefficient, whereas public markets are fairly efficient. ■■ Market mechanisms have differing effects on each market. ■■ Costs of capital are substantially different for each market. ■■ The expected holding period for investors is different. ■■ The role of institutional investors is different. ■■ The transaction costs of buying versus selling a business are different. ■■ ■■

The differences between public and private capital markets are important because acquisition pricing and behavior vary by market, or more specifically, by market segment. Further, much of what is taught in traditional corporate finance is not easily applied, and is not appropriate to apply, to the private capital markets and to many middle market deals. Last, a clearer understanding of market behaviors, drivers, processes, and dynamics will enable those on all sides of a transaction to put greater focus on creating value and meeting the strategic objectives of owners and shareholders.

SEGMENTED MARKETS The private markets contain numerous marketplaces. For example, there are different submarkets for raising debt and equity and for transferring business interests. Markets are also segmented by company size and by ownership type. This handbook consistently uses the collective term markets to describe activity within the private capital markets, rather than attempting to describe particular submarkets with a confusing array of terminology.

13

Private Capital Markets

While there are no definitive size boundaries, as we discussed in Chapter 1, Figure 2.1 depicts market segmentation by size of business.2 Small businesses with annual sales of less than $5  million are at the bottom of the ladder. There are more than 5 million small businesses in the United States and together this group generates approximately 15% of the U.S. private-­sector gross domestic product (GDP). These businesses generally are handled by the business banking group of community or smaller regional banks and are almost always owner managed. These businesses have limited access to the private capital markets beyond bank loans, assistance from the Small Business Administration (SBA), and business brokers. Capital access improves as the business moves into the upper segments. The entire middle market generates roughly 40% of the U.S. private-­ sector GDP. The lower-­middle market segment includes companies with annual sales of $5 million to $150 million. The lower-­middle market is the main province of the private capital markets as described in this book. These companies generally have good relationships with local or regional banks, or with regional leaders of national commercial banks. They may deal with investment banks when a transaction happens or use business brokers, but many times they engage with middle market M&A advisors. Companies in this segment have a number of unique characteristics: ■■ ■■

There is owner management. Owners have virtually unlimited liability and personally guarantee the debt.

Small Companies

Lower

Middle Market Middle

Upper

Large Companies

POPULATION

5.6MM+

4,000+

400,000+ GDP

15%

45%

40%

V A L U A T I O N

2–3×

12×+

4–11×

5

150

500

1,000

Revenues ($millions)

FIGURE 2.1  Segmented Capital Markets

Untitled-18 13

8/18/2022 7:37:40 PM

14

MIDDLE MARKET OVERVIEW

Owners typically have most of their personal wealth tied to the business. A vast majority of these businesses will not transfer to the next generation of the same family. ■■ Access to capital varies greatly, is situation dependent, and is difficult to prescribe. ■■ The enterprise value (EV) of the company can vary widely from year to year. ■■ As a practical matter, lower-­middle ­market companies are more likely to be sellers and much less likely to be acquirers in an M&A transaction. ■■ ■■

The middle-­middle market includes companies with annual sales of $150  million to $500  million. They are serviced by regional investment banks and draw the attention of the bank’s top lenders—­their corporate bankers. Generally, capital market access and efficiency improve at this level as the sophistication and robustness of the business increase. Companies with sales over $150 million begin to have access to nearly all capital market  alternatives in some form, though selectively and usually at a higher price than larger companies pay. The upper-­middle market is comprised of companies with sales of between $500 million and $1 billion. These companies have access to most of the capital market alternatives available to the largest public companies. This group of companies attracts the secondary attention of the largest Wall Street investment banking firms; the largest regional bankers also take notice. In this tier, capital is accessible and priced to reflect the riskiness of the borrower. Some of these companies are publicly held, but they are increasingly likely to be in private hands, part of a trend that has seen the overall number of U.S. public companies decline from a peak of more than 8,000 in 1996 to below 3,500 today. The large-­company market, which is almost entirely composed of public companies, is estimated to generate about 35% of the U.S. private-­sector GDP. Large companies have the complete arsenal of capital alternatives at their disposal. Many use discounted-­cash-­flow techniques to make capital decisions because they can fund projects at their marginal cost of capital. Those that are private have most of the financial capabilities of public companies. Wall Street bankers focus primarily on these companies. This segment of the market is where the finance theory, research, and rules of traditional capital markets were developed and typically applied. Each market segment yields information and liquidity, which form the basis for particular investor return expectations manifested by acquisition multiples paid for companies within it. Acquisition multiples based on EBITDA (earnings before interest, taxes, depreciation, and amortization) represent capital structure decisions. The reciprocal of EBITDA multiples

Private Capital Markets

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yields an expected return on total capital. For instance, equity investors traditionally require 30 to 40% compounded returns from small businesses, 20 to 30% from investments in the middle market, and 10 to 20% from investments in large companies, which implies lower acquisition multiples in the middle market than in the large-­company market.3 Some funds define their targets in terms of the difference between private-­ market investment returns and those attainable in the public markets—­ for example, aiming for a return 2.5 times greater than they could get in public markets. Markets segment by investor return expectations because players within a segment view valuation parochially. The relationship between investor return expectations and valuation is straightforward: Greater perceived risk requires greater returns to compensate for the risk. Using a capital market–determined discount rate is another way of looking at this risk/ return relationship. The discount rate then is the expected rate of return required to attract capital to an investment, taking into account the rate of return available from other investments of comparable risk. Risk is the largest determinant of return expectations, but not the only one. A surfeit of capital (such as we see at this writing) may drive investors to accept lower expected returns; also, the possibility of greater reward may increase multiples regardless of the risk of an investment. Calculating the reciprocal of a selling multiple is a shorthand method for determining the capitalization rate or, once we account for assumed long-­term growth, the discount rate. EBITDA acquisition multiples for the lower-­middle market typically fall between 4 and 10 times. Expressed as a reciprocal, this roughly corresponds to a 10 to 25% capitalization rate, or assuming a long-­term EBITDA growth rate of 2%, a discount rate (investor return expectation) of 12 to 27%. Return expectations can be expressed as discount rates and can be tested. Assume a buyer uses a capital structure in an acquisition with 30% equity, carrying a 30% return expectation, and 70% debt, which costs 9%. The discount rate implied in this capital structure is about 15%, within the return range cited above. Thus, as Figure  2.1 implies, there is a correlation between investor return expectations and pricing. Although much of Figure  2.1 is definitional, support for these findings can be found in several private company transactional databases.4 Since a number of factors form boundaries in the capital markets, appraisers must correctly identify the segment within which the subject will be viewed. Characteristics need to be weighed in their totality. For example, some companies have annual sales of $3 million, but meet other criteria that may allow them to be viewed as lower-­middle market entities. On the contrary, companies with sales over $5 million may be viewed by the

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MIDDLE MARKET OVERVIEW

markets as small businesses if they don’t have certain characteristics. An incorrect assessment will lead to improper valuation. Table  2.1 provides criteria appraisers can use to define the segment within which their subject should be viewed.5 Some criteria warrant further explanation. Owners significantly influence the segment in which their company will be viewed. For instance, if an owner decides to personally manage every aspect of the business and desires to achieve only a good lifestyle from the business, the market will probably view it as a small business. Conversely, owners who strive to create company value and build a functional organization with professional

TABLE 2.1  Defining Characteristics by Segment   Characteristic

  Small Market

Lower Middle Market

Middle Middle Market

Revenue size EBITDA size

< $5 million