A Primer on Middle Market M&A
By Marc A. Reich, Ironwood Capital Ltd.

When one thinks of mergers and acquisition ("M&A"), images of the large deals that are prominently featured in both the financial publications and the general media come to mind. But for every high profile M&A transaction involving well-known, publicly-traded companies, there are dozens of lower profile transactions done in the middle-market by privately-held companies in every industry. One thing is clear: the objectives of M&A, whether large or small, are generally consistent:

• to increase critical mass quickly;
  
• to increase product mix and revenues through cross-selling opportunities;
  
• to reduce operating costs by capturing "synergies" of the combined entity (i.e. enhanced purchasing power with vendors, elimination of duplicative overhead)
  
• to reduce cost of capital;
  
• to enhance access to the capital markets; and
  
• to increase shareholder value.
  

M&A--Considering The Opportunity
If there are so many benefits to an M&A transaction, why wouldn't all companies want to do it? The answer obviously has something to do with the vested interest of the parties and relative safety of the status quo, but is also almost always intertwined by the basic economic question: is the transaction financeable? Abiding by the time-tested adage: "cash is king", cash is still the preferred "currency" from the perspective of the "seller," though publicly traded companies often have the luxury of using their publicly traded stock to effect a sizable portion of the purchase price, with the gap then filled in by additional debt or equity. In transactions involving privately-held companies, however, the currency to effect the purchase is generally all cash, and the "acquirer" will have to do more leg work to secure a combination of bank debt, mezzanine debt and private equity to pay for the acquisition.

The decision for the seller to put their company on the auction block is both an economic as well as emotional one, and generally encompasses the following:

• desire by the owner to retire, especially if there is no family member interested in or qualified to run the business;
  
• belief that the company is at its maximum realizable value and, thus, an opportune time to "cash out";
  
• interest by a larger company to shed non-core businesses that do not fit into the strategic plan;
  
• the desire of a leveraged buyout group or a financial buyer to recapitalize the company in order to exit their investment, after having reached their investment horizon; and
  
• the sale of a company by an owner that is under financial duress due to the company being sold or other holdings.
  

M&A Terminology
Now, a sidebar discussion of terminology. The "M" in M&A, "merger", is really just a salve to make the owners or senior management of the target company feel that they will have a meaningful role in the combined entity (why do you think they are called "target" companies?). An overwhelming majority of deals are acquisitions where senior management disappears while employees from middle management down remain in place as long as the acquisition works. "Merger of equals" is a utopian concept. A "strategic buyer" is a buyer that sees the addition of a target company to its existing company as strategically important to the future success, growth and profitability of its existing business and expects to hold the company indefinitely. A "financial buyer" is often a leveraged buyout group that sees an opportunity to enhance the value of the target company by introducing better management, production processes, access to capital, strategy, and product positioning, all of which will bring growth, improved profitability and increased value, allowing them to "exit" the company at a significant profit sometime during an expected "holding period" of four to six years.

Determining Enterprise Value
The first step a business owner must take when contemplating the sale of their company is to assess and understand its enterprise value. The commonly accepted method in the investment community is to determine the enterprise value as a "multiple of cash flow" minus outstanding debt, where cash flow is defined as earnings before interest, taxes, depreciation and amortization, or "EBITDA". Companies tend to command higher or lower cash flow multiples based on a number of external and internal factors, ranging from industry and company growth rates, general market sentiments on the industry group as a whole, and the company's operating leverage and its sustainability. In arguing for a valuation, the most common approach is to look at privately and publicly-held companies in the same or similar businesses and see how they have been valued in recent M&A transactions or the public equities markets, if public. Privately-held companies are generally smaller than comparable publicly-held companies, thus more vulnerable to competitive and economic pressures, therefore the valuation of such companies are generally subject to a "haircut".

Approaching The Market
Next, the owner must determine how best to approach the market. In some instances, the owner will choose to run the sale themselves, sometimes involving the closest confidantes of the company, i.e. its legal counsel and accountant, or through family, friends and "country club contacts". In other cases, the owner will retain the services of a "sell side" M&A advisor, investment banker, business broker or other professionals regularly involved in effecting the sale of businesses. The former approach affords the owner more control of the process and saves them an M&A fee, but has the disadvantage of generally reaching a smaller audience. The latter approach is more expensive and puts more control of the process into the hands of the retained professionals, but has the advantage of achieving greater market penetration and, potentially, a better price. In either case, the owner has ultimate control since they hold the exclusive right to accept or reject all offers for their company.

Due Diligence
Once potential purchasers start to look at the company, its historical performance, management, market presence, production and distribution capabilities, future prospects and financial projections, the real action begins. The seller will attempt to justify a higher enterprise value through aggressive projections, while the potential purchasers will take a more conservative tack. A handful of potential purchasers will visit the company to conduct "due diligence" investigations, trying to move beyond the two-dimensional presentation of the company in the offering material and really learn what makes the company tick. After due diligence, those companies intent on moving forward will submit "letters of intent" stating the purchase price and the terms under which they propose to purchase the company. These letters generally contain a financing contingency and seek an "exclusive period" during which the seller will refrain from meaningful discussions with any other potential purchasers. The financing contingency makes the offer to purchase subject to the buyer obtaining the capital necessary to complete the purchase. Interestingly, letters of intent citing lower prices than offered in competing letters are often accepted. This is because the seller and their advisors feel that that bidder has the higher probability of successfully closing in a timely manner.

Capital Structure
The capital structure of a transaction is critical both to getting the deal done and to the future success of the deal. A typical deal will have three layers of capital with three distinct providers of capital, each with different pricing, priorities and idiosyncrasies. At the bottom (highest risk but also the highest expected returns) is equity. This layer is provided by the buyer and, if needed, outside investors, normally equity funds and small business investment companies ("SBICs"). Typical targeted internal rates of returns range from 35-45% based upon an ownership percentage in the company.

At the top of the capital structure is senior debt, typically provided by commercial banks and finance companies. This portion of capital has the least risk and, accordingly, the lowest returns. The senior lender normally only gets an agreed upon interest rate and possibly some upfront fees, and does not participate in the equity upside of the company. Banks generally have lower rates than finance companies, but tend to be more conservative in the amount they will advance in any given transaction. In any case, the underlying asset-base of the company generally has a lot to say about the size of the bank loan.

Mezzanine investors provide the tier of capital between the senior debt and equity. Mezzanine financing normally takes the form of subordinated debt with an equity "kicker" normally in the form of warrants to acquire a minority stake in the underlying stock of the company. The warrants enable the mezzanine lenders to participate in the equity upside of the company for about half of the all-in 25% expected internal rate of return targeted on their investment, the other half coming from an interest rate of 12-14% on the sub debt itself. SBICs are a major source of mezzanine financing for middle-market transactions.

Closing The Deal
If everything goes along as planned, the deal will likely close within 45 to 60 days, during which there will be periods of intense negotiation and stretches where the seller will need to simply wait for one or more of the capital providers to complete their due diligence and internal review processes. If not, the seller will accept a backup offer or simply pull the deal until market conditions improve.

Each M&A transaction is unique in its own way, but most follow the basic outline laid out above. The process is heavily impacted by overall economic conditions, the conditions present in the industry within which the deal is being done and the markets for senior debt, subordinated debt and private equity.

Mr. Reich is president of Ironwood Capital Ltd., a middle-market investment banking firm in Avon, Connecticut. He is also a partner in Ironbridge Mezzanine Fund LP, a Small Business Investment Company affiliated with Ironwood.

Copyright © 2002 by Ironwood Capital Ltd. All Rights Reserved.