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Archive for August, 2008
M&A Basics
There is a general process that holds true for M&A processes. For purposes of this discussion, we will be taking the potential buyers point of view. This walk through is of course a simplified, high-level walk through but it should provide a useful base. We will be adding more details and examples around the M&A process soon. If you are already familiar with the M&A process, then skip to the businesses for sale. The M&A process can be broken up into a couple segments as shown below. The M&A process includes several documents including:
- Non Disclosure Agreement (NDA)
- Engagement Letter
- Indication of Interest (IOI)
- Letter of Intent (LOI)
- Purchase Agreement (APA, SPA, PA)
- Escrow Agreement
- Senior Management Agreement (SMA)
- Source the Deal. Potential buyers must source deals so they have targets to acquire. To source deals, investment professional utilize several channels including intermediaries, investment bankers, family and friends, etc.
- Execute NDA. Once a deal is sourced, a Non Disclosure Agreement (NDA) should be executed before any information is exchanged.
- Information Exchange. Receive basic information from target, including financial statements, customer concentration, etc.
- Evaluate Investment. Now, the deal must be evaluated against the investment criteria set forth. Does the deal meet your investment objectives? If not, this is the end for this particular process. If the deal does, we proceed to the next step.
- Submit a Letter of Intent (LOI). This document provides an initial indication for the target. If your initial indication is sufficient, you will proceed to the next step.
- Conduct due diligence. This is a catch-all for all the analysis that you have to perform to get comfortable with the deal. Areas of due diligence include the following below. If the due diligence all checks out, you will proceed to documentation.
- Financial Due Diligence - typically, a buyer will hire accountants to perform detailed financial due diligence. The accountants verify the process and procedures of the target’s accounting controls and ensure the accuracy of the financial statements. In addition, the buyer often has the accountants analyze the financials of key clients.
- Business Due Diligence – the buyer usually has its own managers and operators conduct the business due diligence.
- Insurance Due Diligence - buyer has insurance benefits provider review the target’s current benefits and insurance plans. The insurance benefits provider may identify some areas for cost savings or identify potential issues that could lead to increased expense later.
- Legal Due Diligence – buyer has its lawyers review the target’s existing customer contracts, supplier agreements, employment agreements, any intellectual property, patent wards, etc.
- Technology Due Diligence - If the target has a large technology component to it, the buyer will review the target’s existing technology (either uses someone in-house or hires a consultant). This is to verify that the technology is legitimate and worthy of the consideration the buyer has agreed to pay.
- Customer Due Diligence – A target is generally extremely apprehensive to have its customers talk with potential buyers until the target is 100% certain the transaction is going through. Therefore, customer due diligence usually doesn’t happen until just before the transaction closes. Obviously, this will vary depending on buyer and target, etc.
- Legal Documentation of Transaction. Documentation is the legal documentation of the transaction and includes all associated agreements with the closing. Generally, documentation begins during the due diligence once it seems likely there are no issues. The reason the buyer waits is to avoid large legal bills resulting from the documentation. The key documents include the following below. Sometimes deals may fall apart during the documentation phase.
- Purchase Agreement - outlines all aspects of the transaction in painstaking detail – who is getting paid what, how much, when, employee roles and compensation, etc. We will be providing a detailed walk through of an purchase agreement soon.
- Escrow Agreement – outlines how much of the transaction consideration is being held back and for how long. It’s typical for buyers want to hold back part of the transaction proceeds and deposit it into a bank account to earn interest while waiting for one full audit cycle. This is done to help protect the buyer against any issues that may arise post-closing. Again, amounts may vary widely depending on the size of transaction, customer concentration, if the owner is going to be continue to be involved.
- Senior Management Agreement (SMAs)- a buyer will want to execute SMAs with key employees of the target. This is to ensure that they are incented and fully aligned with the buyer and cannot leave to help a competitor.
- Stock Option Plan – legal documentation of a company’s stock option plan.
- Equity Option Award - outlines the number and vesting schedule for equity options for plan participants. Again, buyers use equity option awards to incent and retain key employees.
- Closing and Transfer of Funds. If no issues arise during documentation, the deal is completed. Now, the hard work begins as the buyer must now operate the new company effectively to earn a good return on its investment.
Documents & Terms
There are several documents that you should be familiar with if you are involved in buying or selling a business. These include those mentioned above (NDA, IOI, LOI, APA, SPA, SMA) as well as others. View are overviews of merger and acquisition documents and terms that are used to buy or sell a company.
Types of Review of Financial Statements
There are several different tasks an accounting firm or auditor performs for a company. When you are considering buying or selling your company, you should want audited financials as these are the most detailed and provide the most comfort in terms of the financials. View our explanation of the types of review of financial statements.
Encouraged by a proposal recently made in the Wall Street Journal by Richard Thaler and Cass Sunstein called Disclosure Is The Best Kind of Credit Regulation, we at TransFS took a few nights and developed a demo version of the kind of system proposed.
Basically the proposal is that, instead of all the silly fine-print and hidden fees, financial services companies would be required to provide an electronic file to their customers showing them exactly what kinds of fees and rates they could be charged in each situation (example – what happens to my rate if I pay late) and exactly what fees and rates they paid over the past year.
Instead of reading the electronic file itself, consumers would upload it to web-based services that would parse the file and provide analysis. Such web-based services would likely be anonymous and free. Since the data format would be published widely, anyone with the technical know-how could create such a web-based service. Here is a screencast of what such a system might look like ( A larger version of the screencast is available here ).
The example is for a consumer credit card, but this kind of system could work for almost any financial product, including checking accounts, insurance, credit card processing, mortgages, etc.
Recently, Richard Thaler and Cass Sunstein, colleagues of ours at the University of Chicago and the authors of a recently published book called Nudge, wrote an op-ed in the Wall Street Journal entitled Disclosure Is the Best Kind of Credit Regulation.
We at TransFS think that Thaler and Sunstein’s proposal is a very good idea that would make financial services work better for everyone.
The premise of the article is that, while some financial services companies have behaved very badly in the recent past by not fully disclosing fees and rates to their customers, the best way to deal with the problem is not to limit the rates and fees that can be legally charged, but rather to set stricter rules for disclosure.
Everyone, including the Fed, is well aware that in banning activities that have caused justified ire in some quarters, the regulator is playing a game of whack-a-mole. If some method of making money is eliminated, lenders will find a new way in the near future. Merely by making market pricing more transparent, better disclosure can make consumers better shoppers, enabling them to be their own regulators.
One challenge of this approach is that financial products can be so complicated that even when fees and terms are fully disclosed they can be difficult to understand. Thaler and Sunstein propose that the disclosure be provided electronically so that web-based tools can help customers make sense of their situation.
The Fed can substantially improve its proposal by requiring credit issuers to disclose relevant information electronically in a standardized, machine-readable format…issuers would be required to make available to users two secure electronic files. The first would be essentially a spreadsheet that listed all the ways in which a customer can be charged… The second file would be a list of all the actions the customer made in the past year that incurred a charge…To be sure, most consumers would not read these files in any detail. Instead we anticipate that new third-party Web sites would compete for the business of distilling the information in the files. The Web sites would serve three purposes. First, they would translate the information into plain English. Second, they would explain to consumers how they could save money by changing their behavior. And third, they would point consumers to alternative providers that, given their past behavior, would provide a better deal…None of these functions is being adequately provided now, and for one simple reason: The precise details of the terms being offered are not easily available.
We think this is quite a sharp idea. At TransFS we are able to provide something similar to what Thaler and Sunstein propose, but it requires a significant amount of reverse-engineering and we are only able to do it in small niches of financial services (like credit card processing) where we can find financial services firms to partner with that are willing to provide more transparency than otherwise available in the industry.
For example, the credit card processing calculator, which is already a useful tool that helps customers 1. make sense of their fees, 2. figure out if there are ways they could save money and 3. compare their fees to those available from other providers, could be made better if Thaler and Sunstein’s proposal were adopted for the credit card processing industry. First, it would be easier to use – we wouldn’t need to ask questions of the user about their credit card processing situation, we could extract it all from an existing data file. Second, it would be more accurate since we wouldn’t have to depend on the accuracy of the answers to the questions we ask the user.
Largest Credit Card Issuers
While many smaller or local banks still issue credit cards, the majority of credit cards are issued by a few very large banks. That means that the banks below are collecting the majority of interchange payments – it is ultimately these banks that businesses are paying with their credit card processing fees.
| Credit Card Issuers Ranked by Receivables | |||||
| Rank | Organization name | Location | 12/31/2006 | 12/31/2005 | % Change |
|---|---|---|---|---|---|
| 1 | Bank of America | Charlotte, NC | $170,736,623,000 | $60,790,331,000 | 180.9% |
| 2 | JPMorgan Chase & Co. | Wilmington, DE | $146,100,000,000 | $138,900,000,000 | 5.2% |
| 3 | Citigroup Inc. | New York, NY | $111,600,000,000 | $113,700,000,000 | -1.8% |
| 4 | Capital One Financial Corp. | McLean, VA | $53,623,680,000 | $49,463,522,000 | 8.4% |
| 5 | Discover Financial Services Inc. | Riverwoods, IL | $47,384,674,000 | $46,936,000,000 | 1.0% |
| 6 | American Express | New York, NY | $37,368,000,000 | $34,159,000,000 | 9.4% |
| 7 | Washington Mutual Bank | Seattle, WA | $23,501,000,000 | $19,973,000,000 | 17.7% |
| 8 | Wells Fargo Bank | San Francisco, CA | $20,870,868,363 | $17,392,978,230 | 20.0% |
| 9 | HSBC Credit Card Services | Salinas, CA | $18,260,017,000 | $26,200,000,000 | -30.3% |
| 10 | USAA Federal Savings Bank | San Antonio, TX | $8,877,491,000 | $8,877,491,000 | 0.0% |
Source: Card Industry Directory
Interchange
Credit card processors don’t get to keep the majority of the money they collect from their customers. Most of it gets passed along to the banks that issue credit cards (list of largest credit card issuing banks). The amount that is passed on actually varies depending on the traits of each individual transaction. The rules that define how much each transaction costs are defined in these documents: Mastercard Interchange and Visa Interchange.
The important variables that determine the interchange rate for a transaction are:
- Kind of card (rewards cards are more expensive, debit cards are less expensive, business cards are more expensive)
- Type of transaction (cheaper if the card is swiped through a terminal in a face-to-face transaction, more expensive if done over the phone or internet)
- Industry of the business (some businesses that have historically gotten paid mostly with checks, like utilities, insurance companies and supermarkets get lower rates to encourage them to accept cards)
- Size of transaction (smaller transactions are given a lower rate, to make it affordable for businesses like coffee shops to accept credit cards)
Credit card processors make money by charging their customers more than the interchange rate for each transaction.
Unless you have an interchange-plus arrangement with your credit card processor, it can be hard to figure out how much of the money you are paying goes to interchange and how much the processor keeps. Our free and easy to use tool, the credit card processing calculator can help you figure that out.
Stock Option Plans Overview
In a previous post, we mentioned that there are basically two types of options plans (i) incentive stock option pans and (ii) non-qualified stock option plans.
Before explaining these option plans in more depth, first we want to reiterate the importance of stock option plans. These plans allow employees to share in the financial upside for a company and helps to ensure that employees are aligned with business from a medium and long-term views. In addition, by using stock options to compensate employees versus cash payments, companies help to generate more cash flow, which could be reinvested in equipment, technology or even hiring additional employees.
Stock options are commonly used in startups and venture capital companies because these companies generally don’t have much cash. Further, people work for startups and venture capital companies because they are seeking higher reward for taking more risk. In addition, people oriented businesses like consulting firms or investment banks also use stock options prevalently.
Stock options are normally subject to vesting requirements (see definition below) and certain other conditions. If you are looking at business for sale, you should review the company’s current stock option plan (if it has any) and if you need to make any changes. If there is no option plan, you should need to decide whether one should be put in place.
Incentive Stock Option Plans
A company allows its employees to buy a certain number of shares at a fixed price over some specified period of time. This fixed price is commonly referred to as the grant price. Incentive stock options are subject to special tax treatment.
For example, a company may grant an employee the right to buy 1,000 shares at a $1.00 per share over the next two years. In this example, the grant price would be $1.00.
Non Qualified Stock Option Plans
Non qualified stock option plans are commonly referred to as NSOs. These plans are similar to th incentive stock option plans except for taxation. For NSOs, the employee must pay a stock option tax whether he sells the shares or holds them upon exercise.
Definitions
- Grant Price, Exercise Price, Stock Option Price) - price that an employee receives the stock options. Basically, this is the cost basis for the employee.
- A good example would be a public company. Let’s assume a company grants an employee options at a price of $50 and the company’s stock is trading at $60. The grant price is $50. This is obviously good for the employee since the stock price is above the grant price. However, this is not always the case, which leads us to our next point.
- Underwater Options - when the grant price is below the current value of the stock.
- Let’s go back to our public company example. However, let’s now assume the grant price was $70 and the stock is still trading at $60. Clearly, the employee does not want to exercise the options since he or she will be down $10 per share right off the bat.
- Vesting Schedule – generally, while employees may be granted stock options, these options are still subject to a vesting schedule. This means that the employee doesn’t own the options until the vesting requirements are met. Vesting requirements could be time and/or performance based.
- For example, let’s assume at the end of 2008, an employee was granted 1,000 options. These options are subject to vesting over the next four years with 25% vested per year. This vesting schedule means that at the end of 2010 (year 2), the employee has 50% vested, or 500 options.
- If an employee leaves or is terminated, only the vested options are able to be exercised and are generally subject to other conditions.
There are several terms and definitions you should know if you are evaluating a businesses for sale . In order to buy or sell a company, it is critical that you understand the rationale for each legal document as well as terms that are commonly used.
Document Definitions
- Non-Disclosure Agreements (NDAs) – a confidentiality agreement between two parties. This basically prevents one of the parties from disclosing the information specified in the agreement. This helps to ensure proprietary and sensitive material is kept confidential.
- Engagement Letter- outlines the scope of work that a service provider / vendor will provide to the client, including the type of work that will be performed, how much work will be performed, the payment method for the work (hourly vs. fixed fee), and the timing of the payments. In addition, an engagement letter defines the deliverables that the client wants to receive.
- Indication of Interest (IOI) - this is a letter that the Buyer sends to a purchaser. It basically gives an offer range for the business as well as ownership percentage the buyer is seeking.
- Term Sheet- This is basically a one or two-page document that provides a little more detail to supplement an Indication of Interest (IOI).
- Letter of Intent (LOI) – A letter of intent is the preliminary agreement entered into between a buyer and a seller. This document summarizes the transaction terms and conditions that have in principle been agreed to by both parties.
- Stock Purchase Agreement (SPA) – agreement by which the owners of a company sell their shares of stock to a buyer. Basically, a SPA details the terms of the transaction (who receives what, how much and when; legal conditions and/or issues). Here’s a more detailed explanation of a Stock Purchase Agreement.
- Asset Purchase Agreement (APA) – agreement by which the assets of a company are sold to a buyer. Basically, an APA details the terms of the transaction – who receives what, how much and when; legal conditions and/or issues. Here’s a more detailed explanation of an Asset Purchase Agreement.
- Escrow Agreement - ensures parties fulfill contractual obligations and helps mitigate disagreements. For example, a buyer typically escrows part of the purchase price to protect itself in a transaction. The escrow is typically released after one and/or two audit cycles. Basically, a buyer wants to make sure it is buying a sound business. Here’s a more detailed explanation of an Escrow Agreement.
- Senior Management Agreements (SMAs) - an employment contract between a company and its key executives. This formalized a Company’s relationship with its senior managers. SMAs outline such things as base and incentive compensation, employees’ roles and severance terms. Basically, this spells out the terms of employment for a respective employee.
- Stock Option Plans – stock option plans govern employees receiving ownership (or right to exercise option for ownership) in a company. Business owners use stock option plans to retain and motivate workers because options allow workers to participate in the upside. We believe Google employees are quite happy it had a stock option plan! In addition, business owners receive tax savings, which helps cash flow. There are two types (i) incentive stock option pans and (ii) non-qualified stock option plans.
Some Common Terms
- Deal Fees- Generally related to a financial advisor and outlines the scope of work that a financial advisor will perform for the client and specifies how the financial advisor will be compensated. For example, financial advisors typically earn a fee that is equal to 2%-5% of the total deal price. This fee may be more or less depending on certain characteristics (nature of the deal, complexity, etc).
- Earnouts - payment(s) contingent on some future financial or measurable target. For example, a buyer may agree to pay the owner of a business an additional $5 million the year following an acquisition if earnings grow by at least 20%. Depending on the complexity on a transaction, earnouts can be either straightforward and easy to understand or very complicated and hard to quantify the real value. Some examples will help you to better understand how earnouts work.
Some Deal Terms – (more to come)
- Price - how much are you paying / receiving?
- Timing of Payments – when are payments paid or received?
- Conditional Payments - are any payments contingent (commonly referred to has earnout payments). For example, is part of the compensation based on company achieving a certain amount of revenue by the end of next year? two years from now?
- Management Roles / Retention – is the transaction contingent on the an individual being given certain duties or being retained prior to the closing?
