Disruptive Business Model for Lower Middle Market M&A Transactions - Position Paper
SBDG Disruptive Bus Model Position Paper
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Roy Y Salisbury
June 2021
The knee jerk reaction by some today is to assume a legitimate company cannot exist without the highest levels of regulation and oversight. Small Business Development Group, Inc. believes this blanket sentiment is false. In the last couple of decades, the largest public frauds occurred under the highest levels of regulation and oversight.
WASTE MANAGEMENT SCANDAL (1998)
Company: Houston-based publicly traded waste management company reported $1.7 billion in fake earnings. The Main players: Founder/CEO/Chairman Dean L. Buntrock and other top executives; Arthur Andersen Company (auditors). The company allegedly falsely increased the depreciation time length for their property, plant, and equipment on the balance sheets.
ENRON SCANDAL (2001)
Company: Houston-based commodities, energy, and service corporation. Stakeholders lost $74 billion, thousands of employees and investors lost their retirement accounts, and many employees lost their jobs. The CEO Jeff Skilling and former CEO Ken Lay Kept huge debts off balance sheets. Turned in by internal whistleblower Sherron Watkins; high stock prices fueled external suspicions. The company filed for bankruptcy. Arthur Andersen was found guilty of fudging Enron's accounts.
WORLDCOM SCANDAL (2002)
Company: Telecommunications company; now MCI, Inc. Inflated assets by as much as $11 billion, leading to 30,000 lost jobs and $180 billion in losses for investors. The CEO Bernie Ebbers allowed underreported line costs by capitalizing rather than expensing and inflated revenues with fake accounting entries. WorldCom's internal auditing department uncovered $3.8 billion of fraud; the CFO was fired, controller resigned, and the company filed for bankruptcy.
TYCO SCANDAL (2002)
Company: New Jersey-based blue-chip Swiss security systems The CEO and CFO stole $150 million and inflated company income by $500 million. The CEO Dennis Kozlowski and former CFO Mark Swartz Siphoned money through unapproved loans and fraudulent stock sales. Money was smuggled out of the company disguised as executive bonuses or benefits.
HEALTHSOUTH SCANDAL (2003)
Company: Largest publicly traded healthcare company in the U.S. earnings numbers were allegedly inflated $1.4 billion to meet stockholder expectations. The CEO Richard Scrushy allegedly told underlings to make up numbers and transactions from 1996-2003.
FREDDIE MAC (2003)
Company: Federally backed mortgage-financing giant had $5 billion in earnings misstated. The President/COO David Glenn, Chairman/CEO Leland Brendsel, ex-CFO Vaughn Clarke, former senior VPs Robert Dean and Nazir Dossani intentionally misstated and understated earnings on the books. One year later the other federally backed mortgage financing company, Fannie Mae, was caught in an equally stunning accounting scandal.
AMERICAN INTERNATIONAL GROUP (AIG) SCANDAL (2005)
Company: Multinational insurance corporation suffered a massive accounting fraud to the tune of $3.9 billion was alleged, along with bid-rigging and stock price manipulation. The CEO Hank Greenberg allegedly booked loans as revenue, steered clients to insurers with whom AIG had payoff agreements and told traders to inflate AIG stock price. How he got caught: SEC regulator investigations, possibly tipped off by a whistleblower. After posting the largest quarterly corporate loss in history in 2008 ($61.7 billion) and getting bailed out with taxpayer dollars, AIG executives rewarded themselves with over $165 million in bonuses.
LEHMAN BROTHERS SCANDAL (2008)
Company: Global financial services firm hid over $50 billion in loans disguised as sales. Lehman executives and the company's auditors, Ernst & Young allegedly sold toxic assets to Cayman Island banks with the understanding that they would be bought back eventually. Created the impression Lehman had $50 billion more cash and $50 billion less in toxic assets than it really did. In 2007 Lehman Brothers was ranked the #1 "Most Admired Securities Firm" by Fortune Magazine.
BERNIE MADOFF SCANDAL (2008)
Company: Bernard L. Madoff Investment Securities LLC was a Wall Street investment firm founded by Madoff tricked investors out of $64.8 billion through the largest Ponzi scheme in history. Bernie Madoff, his accountant, David Friehling, and Frank DiPascalli the Investors were paid returns out of their own money or that of other investors rather than from profits.
SATYAM SCANDAL (2009)
Company: Indian IT services and back-office accounting firm falsely boosted revenue by $1.5 billion. The Founder/Chairman Ramalinga Raju falsified revenues, margins, and cash balances to the tune of 50 billion rupees.
As students of financial and investment history know, these are just a few companies with nefarious leadership that represented staggering losses for investors and employees. Each of these scandals was regulated by the SEC and maintained by top tier auditors to protect the investing public. In most cases it demonstrates that most companies and their respective management teams are honest hard-working people.
After many of the scandals we remember how the regulators adopted new rules, e.g., mark-to-market, to prevent firms from hiding troubled assets when a footnote would have been sufficient. The resulting unintended consequences of accounting changes sent everyone reeling. Regulators are again sharpening their pencils but what the unintended consequences will be remains to be seen. The merger of government and Wall Street, COVID-19 and bigger government is just the beginning of troubled times for all in the lower and middle market who need access to fresh capital - no matter the form or substance.
Small Business Development Group, Inc. (SBDG) trades on OTC Markets as a Current Information Pink under the symbol “SBDG”. Its mission is to be the best it can be as a publicly traded company and comply with regulatory requirements.
SBDG is a small business development company that acquires private businesses with owners seeking transition or growth. Its acquisition strategy is to target private seasoned companies with an identifiable track record of sales and profitability that supports its growth and profitability to result in a Registration on OTC, NASDAQ or NYSE via Spinout when qualified. As a Pink Sheet filer SBDG can make investments and acquisitions without costly compliance in conducting audits of the initial transactions prior to the readiness of the transaction.
The strategy allows the private company to raise growth capital while allowing SBDG and other stakeholders (including owners) to take profits in cash, debt, and in-kind off the table as SBDG shepherds it through the development and preparation for Registration and Spin Off5. The business model is designed to distribute a percentage of the shares of the Spin Off to SBDG stakeholders as a dividend.
An integral part of SBDG’s strategic business plan is to operate as a holding company with an industry agnostic approach to lower middle market merger and acquisitions. Rather than focusing on industry segments the strategy is to focus on best practices financial models based on fundamentals and operational methodologies.
IS NOW the time to be a BUYER? IS NOW the time to be a SELLER? IS NOW the time to PARTNER?
Three serious questions that are a direct result of the current economy. Business seller, buyer, and advisors are facing many problems today with respect to bringing a transaction to a successful conclusion. Values will be going down, financing is tough or non-existent, liquidations are on the rise, and seller and buyer are giving up. Business advisors in many cases are as stuck as buyers and sellers are. In many cases it’s the lack of being progressive and thinking outside of the box that impedes the sale. Buyer advisors are assessing valuations as too high based on financing - and seller advisors are responding the price is too low and require an all-cash sale to avoid risk. We think advisors are wrong and have lost sight of the goal - the completion of a successful transaction which must meet the goals of both sides with reasonable compromise. All sides should be looking for a win-win transaction.
Points critical to reasonable compromise include:
The need to use proper independent valuation methods not based on need or target price.
The realization that there are no cash buyer for the average lower and middle market deal.
The need to prepare a proper independent valuation and sales documents to save time and keep the transaction on track.
The use of seller financing as a value enhancement tool.
The need to mitigate risk for both sides (buyer and seller).
That partnering can achieve the goals and objectives for everyone.
That transactions may have buyer earning in and seller using a structured exit strategy.
Knowing when a recapitalization is better than a sale when planning.
The use of merger and acquisition techniques to create value where the value increase impacts the seller and buyer value proposition.
Spinout exit planning.
In today’s economic times thinking out of the box with creative financing is a must and it needs to be understood by all the parties involved. Companies must consider their options, however. Many transactions are predicated on a Leveraged Buy-Out (LBO) using debt sources such as traditional bank loans, SBA loans, factoring and hard money. Many companies are leery of adding debt or don’t qualify for additional debt monies to grow their companies. If they choose to raise capital through conventional sources such as bank financing, they may not be successful, or the level of funding needed may not be available. It is unlikely today that the needed lower to middle market financing will be found and if it is, will the terms be onerous and prevent the equity participation. The company may be required to seek out debt financing of US$5 million with an agency guarantee from a state or federal agency (e.g., SBA) as a first step. Unfortunately, this first step may also be, for some, the last.
SBDG uses its Soft-LBO model to acquire targets that involve partnering with a seller.
Soft Leverage Buy-Out (Soft-LBO)
The solution to complete a successful buy-sell transaction may be a partnership in the form of a Soft-LBO between a buyer and a seller. This process works well for upper small market and lower middle market companies with a value ranging from $2,000,000 to $20,000,000. The seller benefits in the same way as SBDG monetarily through increased value and the seller can run the spun off company if desired.
Why should any seller or buyer be willing to participate in this type of partnership?
The need of conventional capital which makes this process attractive to qualified companies.
Buyer can fund without overreaching.
Seller remains involved and have a claim to assets.
A company’s risk-to-reward ratio will be increased with continuity of operations.
Greater access to alternative capital resources, such as investors looking for passive investment income.
Risk mitigation for both the buyer and seller.
Reasonable assumptions based on seller’ needs, both financially as well as operationally, and buyer’ needs, weighed equally, creates a Soft-LBO opportunity, as follows.
Motivated and operationally qualified buyer with limited cash resources and limited borrowing based on the target acquisition’s valuation.
Motivated seller but expectations higher than the financial market’s willingness to fund.
How a Soft-LBO works?
Buyer and seller create a transaction in which a buyer can earn their way into the transaction by putting down a percentage of cash, providing working capital on a mezzanine basis, and taking a senior management position reducing the workload on the seller. The seller can protect themself during the process by staying involved and acting as the senior bank until paid in full. This “working transaction” is, in short, a partnership. The buyer has skin in the game, the seller has developed an exit strategy, and both have potentially increased the transaction value during a specific period. Now that the buyer and seller are partners, there are additional capital options that can involve private equity, subordinate debt, and even an acquisition strategy to build the company.
Part of the partnering process creates several immediate benefits:
Expansion of management resources and energy to build on the company’s successes.
Added financial resources to build the business that will result in creating added value.
The continuity of operations and the balancing of new and historical philosophies.
Jointly developed business strategies that take advantage of seller’ and buyer’ knowledge.
The ability to draw on financial options that may not have been available to the individuals.
The alignment of the seller’ and the buyer’ goals to maximize financial values for the participants.
The seller can recover or increase value by participating over time and strengthening the company’s future thus the value to the seller12.
The buyer will not be forced to over-leverage the business to try and satisfy the seller’ needs that puts many transactions at risk.
Two glaring issues buyer and seller face today are independent realistic valuations, availability of capital, regulatory compliance, and taxes. Independent realistic valuations are targeted to financial markets’ expectations. Business valuation is a mathematical process - not an emotional one or one based on perceived value. It does not matter what a buyer is willing to pay as a premium-to-market if they don’t have enough cash and or can’t access enough cash.
Buyer financing is not as simple as it once might have been. To be successful, financing needs to be tied to the buyer’s and the seller’s objectives with flexibility. If a buyer has enough cash and the seller will hold paper, the transaction has less to do with valuation. But once a third player is brought in the form of “other people’s money” to fund the transaction, the transaction becomes complex. For many reasons, the chances of completion become questionable, at best, without proper independent valuation.
To demonstrate this premise, let us assume there are three key players within a given transaction: seller, buyer, and a funding source. First and foremost, a transaction cannot be completed without satisfying the funding source. Logically, the larger the transaction, the more difficult satisfying the funding source becomes.
Funding sources look critically at historical data including best practices financial models, operational methodologies, track record of sale, and profitability forecasts. Assuming the funding source can be satisfied allows the buyer and seller to take the next step. By combining the buyer and seller the financial resource option will be increased as part of the Soft-LBO process over their individual resources.
One example of a Soft-LBO transaction:
A buyer and seller enter into a Soft-LBO model purchase and sales agreement subject to a planned financing transaction based on an exempt security offering filed with the SEC and applicable state securities offices. This is a stock transaction of between 51% to 99% of the company in which the buyer is making an investment into the seller’s company and securing several purchase options on the balance of the seller’s ownership. The company issues equity securities through an exempt offering to satisfy a portion of the purchase obligations. The securities transaction is specifically tied to the structured financing of the company and a partial liquidity event for the seller. An additional balance of equity and debt is held by the seller making everyone more comfortable. In special circumstances, an asset transaction can be structured but tax implications can zap the value.
Consider the purchase and sales agreement represents a US$10 million transaction. The company structures the Soft-LBO with combined capital of US$10 million. An exempt equity offering through Regulation D nets $4.5 million, the seller holds $4.5 million senior debt and equity, and an additional $1.0 million is contributed by the buyer.
The Soft-LBO is where the flexibility and motivation of the seller come in. The breakdown of the US$10,000,000 buyout would be:
US$2.5 million in cash to the seller;
US$2.0 million in debt reduction;
US$4.5 million in the seller’ retention of equity and select secured debt; and,
US$1.0 in working capital for company operations.
This is a very simplified example that is not based on any specific transaction; it is strictly an example. The example provides, however, a reasonable picture of how a Soft-LBO could move a transaction along while at the same time benefiting the buyer and seller that were encountering significant barriers to closing the transaction.
Example of an alternative Soft-LBO transaction:
The seller and buyer form a new holding company into which the seller’s company will be placed as a portfolio company (NEWCO).
Assume that initially the company has a $10 million value proposition. The seller in this example sells 60% of the company to the NEWCO in the form of cash, debt, and equity. The seller receives $6 million for the 60%, retaining 40% value in the portfolio company, and receives a $2 million premium in the form of Preferred stock in the holding company, thereby increasing the valuation to the seller.
The buyer, who has partnered with the seller to grow the NEWCO, benefits from the value growth as well. The holding company does not get involved in the daily activity of the business. The holding company will be able to contribute additional capital necessary to grow the portfolio company (seller’s company) and provide a platform to make strategic acquisitions. The holding company is an investment-backed acquisition company (the seller, the buyer, and new money) with the goal of listing on OTC, NASDAQ, or NYSE. Any company that becomes a subsidiary of the holding company through acquisition will benefit from the valuation arbitrage resulting from the public process, enhancing the value of the Preferred stock shares held by the seller.
This strategy is to increase the seller’s company size over a period of up to five (5) years as new locations are opened and additional bolt-on acquisitions are made using capital deployed by the holding company and investors. During this transaction period of this example, the holding company growth increases its value proposition to $20 million. The seller receives 40% of this value, or $8 million in this example.
Upon exit and sale of the stock In this example, the seller walks away with $18 million from the sale of a company that was originally worth $10 million. In addition, the seller holds $2 million in Preferred shares, thereby realizing a $20 million return in value received, which is 100% greater than the initial valuation.
Key Points of a Soft-LBO:
Buyer and seller must be committed and willing to work together to complete the transaction.
A conflict resolution process must be put in place from day one.
Buyer must have risk capital to commit to the transaction.
Seller must be willing to hold a designated amount of debt and equity.
The transaction must assume a proper, customary derived valuation for the business.
Benchmarks and expectations must be determined up front.
Buyer and seller must be willing to see the transaction through to close, which can typically take 6 to 12 months to close.
If the holding company/portfolio strategy is employed, then:
The buyer and seller work together as partners to grow the company, thereby expanding its value proposition throughout the process until completion of the transaction;
The seller’s interests are protected by staying involved as senior management, receiving compensation for their work, and acting as the senior bank until fully paid;
The buyer’s interests are protected because they assume a primary management role as they earn their position in the transaction as their cash and working capital are deployed;
The buyer ultimately owns a larger, stronger, growing company with greater value than when originally purchased; and,
The seller receives a greater return on the sale than the original valuation could have supported, plus the seller has benefitted from a planned exit strategy.
All transactions are different, and each will be driven by its own set of valuations, analyses, market conditions, management skill sets, and other relevant circumstances. Soft-LBO’s takes time and specific financial resources to complete. It creates the opportunity to be successful in a market that has restricted conventional capital.
From an operating standpoint, buyer, and seller like this type of structure because it minimizes the risk related to an owner (seller) and respective expertise leaving the business entirely; and maintains operational continuity for successful growth (buyer). From a wealth planning perspective, it is a preferred structure because it allows a seller to take chips off the table immediately while continuing to grow with the stock that remains in the company. This is especially important for many business owners where most of their net worth is tied up in the value of their business. In many cases, the buyer is even willing and able to pay more for companies when this type of structure is in place, specifically because the management team risk is effectively eliminated.
The Soft-LBO transaction structure is becoming a much more common practice for transactions that can be structured on a staged exit for the seller. In the case of the holding company example above, it is assumed that the owner, or their children, are remaining in the business and will maintain management team continuity through the transaction. It is exceptionally good for a seller who doesn’t want to retire completely from their business, or for a seller who has children who can carry the torch after the initial sale.
A prospective seller might ask, “When is it most appropriate to pursue this type of deal structure?” The following analysis indicates suitable scenarios addressing both exit and growth strategies:
When the seller is not ready to walk away completely from the business and is willing to partner with the buyer to grow the business.
When a seller has children, who can remain with the business post-transaction and work with the buyer as a partner to grow the business. The children can cash in on the value of the stock they retain based on the future growth they facilitate. The original entrepreneurs (a parent in this case) take most, if not all, of the cash from the original sale.
When an owner or management team is relatively young and simply wants to take chips off the table via the transaction.
When an owner or management team needs help or an injection of capital from a new partner to finance the continued growth or expansion of the company.
There is little downside to this type of structure with a defined execution strategy.
The investing public is looking for opportunities in which to invest and, in some cases, participate in legitimate opportunities much closer to home than they have in the past. Yes, they are in most cases risk averse and that is why buyer and seller must construct a transaction that makes them comfortable, assures investors that everyone has skin in the game, and that the playing field is level for all parties.
Taking a transaction public through the Soft-LBO process and spinout of the entity is one exit strategy. The portfolio of NEWCO is spun out once it qualifies financially and operationally to meet registration requirements of OTC, NASDAQ, and NYSE.
Soft-LBO and Spinout
The parent company is required by the SEC to detail the spinout in Form 10 pursuant to Section 12(b), which contains a substantial information letter or narrative that outlines the rationale for the spinout, strengths, and weaknesses of the new company, and the outlook of its industry. A spinout, which is typically tax-free to stakeholders, can take up to 6 to 9 months to complete.
Spinouts can occur for a variety of reasons. The parent company might want to unlock the value of the embedded division, which might be growing at a different pace than the overall company. Usually, a trapped or constrained segment that's growing faster than its parent would be better off as an independent company.
A spinout allows the division being spun off to raise its own capital through issuing equity shares in the new company or debt in the form of bonds to fund the company's growth. The financing for raising capital might not be possible with the combined entity, but by separating out the profitable division, the spun-off division has a greater chance of attracting investors and banks.
Spinouts can also help the parent company by allowing it to focus on its core operations without the diversion of resources to a segment that could have different needs in various aspects including operations management, marketing, finance, and human resources.
The division being spun out may have been established to create an ancillary service such as software or some needed technology. While profitable, the technology division might not fit in with the industry of the parent company. As a result, it might be better to split them since the business plans and strategies of the parent company and the division might not align with each other.
A spinout could also occur if the division is not as profitable as the parent company. By creating a separate company, it removes the distraction of the struggling division. A spinout could allow management to sell off assets or look for a merger or buyout of the new company.
Parent companies often provide support for their spinouts by retaining equity in them or signing contractual relationships for the supply of products or services. In many cases, the management team of the spun-out firm is drawn from the parent company as well.
Investors are generally in favor of a spinout, as it makes business sense for a segment that has different needs and growth prospects to go it alone. The sum of the separated parts is usually greater than the whole for investors, as valuations over time have demonstrated.
The spinout process can be costly in terms of management time and distraction for several months. Management's focus may shift from running the company to executing the spinout. There can be significant transaction expenses to plan and complete a spinout.
There's no guarantee the spun-out division will be profitable by itself. A spun-out company could incur losses or poor earnings without the help of the parent. Conversely, removing a profitable division through spinning out, might leave the parent company with less revenue and vulnerable to poor financial performance. Although spinouts are typically a positive sign for a company, investors might not like what remains at the parent company after the spinout and sell its stock. Depending on the remaining value, the parent may become a shell company positioned to acquire other entities.
Examples of Spinouts
Spinouts are common, and investors have good reason to push for them. There are many notable spinouts including Mead Johnson Nutrition, which was spun out of Bristol Myers Squibb in 2009, Zoetis was spun out of Pfizer in 2013, and Ferrari was spun out of Fiat Chrysler in 2016.
Chipotle Mexican Grill
Chipotle Mexican Grill was spun out of McDonald's in 2006, and McDonald's reasons were "to push growth and devote more energy to its key businesses" as reported by the Denver Post. Chipotle's stock was offered at its initial public offering at $22 whereby 6 million shares were sold in 2006. As of the close of trading on June 7, 2019, Chipotle's stock was trading at $709.87 per share.
Delphi Technologies PLC
Delphi Automotive PLC spun out Delphi Technologies PLC, which became a $4.5 billion entity on December 5, 2017. The new company offers advanced propulsion systems, which according to the CEO, "the convergence of automated driving, increased electrification and connected infotainment, all enabled by exponential increases in computing power and smart vehicle architecture." Delphi Automotive became Aptiv PLC retained the powertrain business, the larger but slower-growing business. The spun-out Delphi Technologies PLC oversaw its own destiny.
Old Navy
Clothing retailer Gap Inc. (GAP) announced in early 2019 that the company would spin out the division of Old Navy as reported by CNN. Old Navy will be an independent company. The Gap stores, including other brands such as Banana Republic, Hill City, and Athleta, will be one company.
In 2018, Old Navy generated nearly as much revenue as all the other brands combined with its $8 billion in sales versus $9 billion in revenue from the Gap and the remaining stores. As a result of the spinout, Old Navy will be freed up to grow its brand under its own business plan and strategy according to senior executives at the company. The Gap and the remaining stores may consolidate since their sales have struggled to grow over the last few years.
Taking a company public through a Soft-LBO most often results in occupying either the nano or micro-cap markets.
Public Companies in the Nano and Micro Capitalization Space
Nano Caps: Understanding What They Are
Keep in mind that classifications such as large cap or small cap are only approximations that change over time. The exact definition of the various sizes of market cap can vary between brokerage houses. Technically a stock can be a nano cap without being a penny stock. If the float of available shares is low enough, the market cap will still be under $50 million even if the actual price of the shares is higher than the penny stock threshold.
Of course, penny stocks aren't even necessarily penny stocks. The definition of a penny stock was formerly a stock trading for under one dollar-per-share, but the Securities and Exchange Commission has moved that up to count all shares trading below five dollars-per-share. In short, these definitions are fluid at the best of times.
For example, if there is enough global growth and increased investment across the world, the nano cap of the future may be redefined as $100 million or more.
Micro-Caps: Understanding What They Are
A micro-cap is a publicly traded company in the U.S. that has a market capitalization between approximately $50 million and $300 million. Micro-cap companies have greater market capitalization than nano caps, and less than small-, mid-, large- and mega-cap corporations. Companies with larger market capitalization do not automatically have stock prices that are higher than those companies with smaller market capitalizations.
Nano & Micro-Cap Companies: Risks and Rewards
Investors looking to invest in nano-cap companies should be aware that these small firms are often associated with a remarkably high risk of failure. Small cap stocks, which start at $300 million in market capitalization and go up to $2 billion, are considered a risky place for investors to dabble to capture aggressive growth.
Nano and Micro-caps ratchet up that risk versus reward even more. Short-term returns in the double and triple digits do happen in nano and micro-cap stocks, but so do a lot of outright failures. On top of the legitimate failures, there is no shortage of pump and dump schemes. Nano and micro-cap stocks are prone to these problems because they are not as rigidly regulated as larger cap stocks that trade on exchanges like the NYSE or NASDAQ. Some nano cap stocks will have reporting gaps, unaudited documents, and other red flags that should discourage even the most risk seeking of traders.
Avoiding Pump-and-Dump Schemes
The nature of a publicly traded company, no matter the exchange, is being vulnerable to pump-and-dump schemes.
Transaction Value
Before any purchase and sale transaction can move forward to completion, an agreed enterprise valuation must be derived. This only makes sense since both buyer and seller must come to a common understanding of the factors that determine the value and then reach agreement on the sale price, payment method and timing, as well as other related matters. It becomes apparent to both sides there are several valid ways to determine the valuation, that each of these methods will probably establish a different valuation, and that all parties will not necessarily agree with the valuations determined.
There are several methods that can be used to value a transaction. The three below are commonly used by brokers and advisors to value private business:
Multiple of EBITDA
The first is the EBITDA valuation method, which relies on a multiple of EBITDA to arrive at a company's enterprise value. It can also be thought of as the total market value of a company's expected cash flow stream.
Enterprise Value (EV)
EV is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization. It includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet.
Discounted Cash Flow
A discounted cash flow model is a type of financial model that values a company by forecasting its cash flow and discounting it to arrive at a current valuation. The discounted cash flow model has the distinction of being widely used both in academia and in practice.
From these simplified definitions it can readily be seen that each will, as previously stated, most likely result in different valuation figures. Add to that the propensity of the seller to have deeply held emotional attachments to the business they built during long years of hard work and risk-taking. It is not difficult to understand why many transactions fail due to the inability of both sides to reach agreement over valuation. Additionally, even with the best of intentions, advisors can make the valuation process more complex through data and positioning.
Arbitrage Valuation
Arbitrage valuation is a Soft-LBO valuation mechanism. An understanding of arbitrage and how it may apply to a specific transaction is often a way to bridge these differences between buyer and seller over the transaction value, in that arbitrage provides a tool to support a higher selling price than a buyer might otherwise be willing and able to justify.
The arbitrage value proposition is a simple concept: increasing the value of a company between buying it and selling it prior to improvements. The textbook definition of arbitrage is buying a commodity on one exchange and selling it on another simultaneously and at a higher price, pocketing the spread. This assumes that the market for the commodity is less than perfect, with buyer and seller of different capabilities and knowledge accounting for the price disparity. Such information leads to transaction markets in which the most astute participants stand to pull greater profits than in more efficient markets. Private markets, absent of exchanges, are particularly imperfect and thus ripe for arbitrage opportunities, although less straight-forward and concrete than the commodity example. It is primarily a tool of private equity but is also used by strategic buyer.
A seller may take umbrage at their business being considered a commodity, but the selling and buying of private businesses is an imperfect market as are many commodity markets, thus meeting the core requirement for arbitrage, which is the capability of realizing a profit from a valuation differential. Knowledge of the method can help both buy-side and sell-side advisors win fair prices for their clients.
Below are three instances of a value arbitrage strategy:
Acquisition to grow
Size and scope matter. The larger of two otherwise identical companies will usually sell at a higher multiple for no other reason than the fact that it is larger. If companies with $5M in EBITDA sell at 5x earnings, and companies with greater than $20M EBITDA sell at 7x earnings, it follows that a company with $20M in EBITDA can hypothetically acquire a $5M EBITDA company for $25M and automatically be able to sell that company, as part of its whole, for $35M. This is multiple-of-EBITDA arbitrage. Some strategic buyer and private equity portfolio companies build strategies around rolling up industries solely for the purpose of increasing aggregate EBITDA and are then able to sell the whole company for a greater value than the sum of its parts.
Repositioning the target in a more buoyant industry
Assumed profitability growth is another driver of company and industry valuation multiples. If a consensus of buyers thinks the smartphone market will grow faster than the windowpane market because of bullish views on the middle class and bearish views on construction, then they pay more per share of a smartphone manufacturer’s earnings than those of a window manufacturer, say 7x and 4x, respectively. A manufacturer of windows may also have the capabilities to turn glass into something useful for smartphones, say their screens. Thus, a financial buyer could purchase the window manufacturer at 4x EBITDA, tweak the strategy and business plan, and flip it back into the market as a smart phone play at 7x EBITDA. Likewise, a smart phone company could buy the window company at the 4x, fit it into the business model, and capture the spread when it sells itself at 7x.
Rolling a private company into a public company
If a public company trading at 20x earnings buys a small private company for 10x earnings, the earnings of the latter automatically trade at 20x as part of the whole entity, given that the transaction is small enough not to be scrutinized. When the public company reports earnings the first time after making the acquisition, the tranche of its earnings from the acquisition naturally trades at the same multiple as the whole entity, 20x instead of 10x, completing the arbitrage.
Small Business Development Group, Inc. Summary
SBDG believes the Soft-LBO business model will be disruptive in small and medium sized M&A transactions involving private companies owned by baby boomers. The largest transfer of wealth has been the baby boomers selling their private businesses. There will never be a new baby boomer generation and the transfer is acceleration in the final stretch of them aging out. The Government sees this as a windfall for them in taxes “the tax man cometh.”
The business model has three pillars:
Seller partnering with SBDG and its affiliates Special Purpose Vehicle (SPV) using a Soft-LBO deal structure.
Planned exit for the seller.
Growth of the new entity.
These pillars are not new and have been used by some of the biggest financial investors for years.
The SBDG model takes steps to mitigate risk and rewards its stakeholders. The model is designed to share the wealth with its stakeholders increasing the value proposition through arbitrage from private to public, providing the needed stakeholder base to become public and distribute dividends in-kind on registered shares it receives from a sponsored spinout to its stakeholders. A well-run company with good management that practices proper fundamentals of transparency, and best practice financial and operational controls can be a good investment. The opportunity for buyer, seller, and investors to make a greater ROI cutting the Wall Street middleman out of the equation.
Some of the largest financial scandals have taken place in the most regulated environments on Wall Street as noted in the opening statement. It is not possible for regulations to protect investors from management and people in general who have nefarious motives. An appropriate quote reads, “A lock keeps the honest person honest.” No one should be fooled or blinded as regulation is not prevention, it is to punish those who are willing to break it. Most managers of public companies are honest hardworking individuals looking to be successful. There are many reasons why businesses fail and not even the best of management identify prevention to prevent failure. A glaring case in point is the COVID Pandemic.