Growth

Rich and Co.

Independence and Reality Check on M and A Markets

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Let us share our experience from the front lines of the M&A markets now for RIAs and third-party administrators serving retirement plans (TPAs). Let us share our POV about maximizing the value of your life-long investment in your business

  • Take Away – You will receive the biggest total return from your lifetime investment in your business by maximizing the growth of the business for the next 2-5 years.
  • Bottom line, there appears to be no way to avoid funding growth and/or cutting expenses to optimize the payout to you.

We are hired by our clients, both buyer and sellers, to maximize the return on their investment. This actually makes everyone’s goals the same in most transactions.

Goals
Sellers want the most payouts. Buyers want to generate the most net revenue and ROI. So unless a seller takes a onetime payment, sellers and buyers have the same revenue/accounting goals.

The main variable is liquidity/discount preferences. Some clients have sooner or later preferences. However, generally everyone’s time frame is 2-5 years as the first priority.

Buyers sometimes look longer. Sellers also must now fund longer retirement periods for themselves and their families. Employees have the longest time frames looking for decades of employment. Realistically wives and children have longer time frames then husbands. Guys die earlier.

The Numbers are Standard
Most transactions are pretty generic and follow standard accounting assessments. The numbers of these transactions are transparent. Everyone is very good running the numbers. The larger multiple expectations set by “roll-up” models, that hoped for out-sized financial returns, are no longer being offered – realistically.

The business you have built is then a platform for proving out net revenue projections, increased hopefully, on which you will be paid. Since this is a “net” number, cost reductions help your payout as well.

The revenue numbers are normalized going back as far as possible. Of course, there are extrinsic effects on both past and future numbers. The future increased costs from new regulation are a factor as is the natural shrinking/growth of some markets. So too the abnormal disruption of the financial market meltdown and special restatement and one-time revenue projects are normalized.

Counter-balancing negative effects are marketing efforts to optimize channels of distribution, efficiency and new products/services. Whatever can be done, or is now being done, to get more top line and bottom line revenue is the key factor.

Alternatives to Sale
Keep Taking a Salary — The owner can continue to take a salary from the business, as another alternative. However, that likely just subtracts value from the purchase price unless accompanied by greater revenues. The trade off then becomes shorter-term payouts, as salary, vs. longer term sharing in growth on a preferential basis.

If the owner staying involved can raise the revenue curve (smoothly) then the equity in the business is increased and there will be more to payout in a sale. However, if the revenue growth stays flat or drops with the owner’s salary constant, especially now after the crisis effects are mainly past, it can hurt the price.

Also, our experience is that taking a 2-3 year payout with post-transaction profit sharing, taking advantage of you ability to still contribute, and then reinvesting those proceeds in a diversified portfolio to fund you and your family’s retirement expenses is best.

The longer an owner waits, the more uncertainty may accrue given the regulatory, business expense and market environments we can project with information we have now. One example, the fee disclosure rules will likely damage profitability and marketing opportunities.

ESOP — Let me share some experience on an ESOP. It is actually best to assure management continuity and reward employees. I have not seen it maximize the pay-out for the owner(s). Additionally, it does burden the business and management with debt so usually demands cutbacks in expenses and compensation, immediate term.

An ESOP also may limit your flexibility in valuation since you are required to get an independent valuation, by the lender/bank, and limited to that number. Generally, that valuation is 1x revenue.

For example, on a $5mm gross revenue firm, it is likely:

  • Your valuation will be $5mm
  • You will be able to fund a 30% payment, or let’s say $1.5mm
  • Debt service will then be $330k p/yr. for term of loan and include interest
  • This will need to be paid before additional payments to you can be made
  • You will likely also have to personally guarantee the debt
  • You may be faced with an extended payout period of 10-15 years.

So the business again is faced with needing growth to serve this debt. Growth or expense cuts.

This is not always optimal for firms. Growth to service the debt, again, seems key. If the employees are young and willing to defer pay to service the debt and fund growth — it can work. If not, there are many examples of firms with older principals and employees, the debt burden can force intractable conflicts between debt service and compensations and investments.

Bottom line, there appears to be no way to avoid funding growth and/or cutting expenses to optimize the payout to you.

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Written by Rich and Co.

July 3, 2012 at 8:16 pm

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