M&A Trends: Tech & Government Contracting
Transcript of M&A Trends: Tech & Government Contracting
Page 1 Copyrighted Material. All rights reserved. The McLean Group, LLC
M&A Trends: Tech & Government
Contracting Deal Dynamics, Valuation, Drivers and Markets in an Era of Uncertainty
Presented by: Greg Boucher
Managing Director
The McLean Group
Direct: 410.799.2053
September 25, 2012
Page 2 Copyrighted Material. All rights reserved. The McLean Group, LLC
Speaker Greg Boucher, CMAP, CMEA, SBA
Managing Director
703.752-9022
Greg Boucher is a managing director in The McLean Group’s M&A practice.
He has more than 25 years of both industry and business consulting experience, and writes and speaks regularly on Exit
Planning and M&A, including teaching various M&A courses for The National Association of Certified Valuation Analysts & the
Middle Market Investment Banking Association. Since 2000, he has served private business clientele in strategic consulting
and mergers & acquisition services. Greg has strategic marketing, consulting and M&A experience in the construction, retail,
internet, telecom/broadband, technology, printing/lithographic, direct mail, government contracting, and moving and storage
industries.
Greg holds a Masters Certificate in Business Management from the A. B. Freeman Graduate School of Business at Tulane
University, and holds a BS in Organizational Communications from Missouri State University. He has held professional
credentials as a Certified Business Intermediary (CBI) and a Certified Business Councilor (CBC), and currently holds
professional certification as a Certified Mergers and Acquisitions Professional (CMAP), a Senior Business Analyst (SBA), and a
Certified Machinery and Equipment Appraiser (CMEA).
Mr. Boucher is a member of the Association for Corporate Growth and serves an executive role as Secretary for the Board of
the Maryland Chapter. He is a member of the Middle Market Investment Banking Association, the National Association of
Certified Valuation Analysts, the Society of Business Analysts, and the Mid-Atlantic Business Intermediaries Association, where
he served on the board for three consecutive years. Greg is a National Association of Securities Dealers (NASD) registered
representative (Series 7, 79 and 63).
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Selected Recent Advisory Experience
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Total US Deal Volume (TTM) lower than 2011
Source: FactSet, July 2012
Number of Deals Closed 2011 / 2012
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PE Investment off to a slow start in 2012
Source: Pitchbook
Number of Deals Closed (orange line) and Total Capital Invested by Year (blue bars)
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Add-ons Continue to Represent Half of Total
Source: Pitchbook
Add-on Deals as Percentage of Buyout Deals
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Healthcare and IT Large Share of Activity (26%)
Source: Pitchbook
Percentage of Deal Volume (count) by Industry
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IT Deals in Q1 & Q2 2012
Closed deals by Sector
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IT slowing down in 2012
Closed deals by Size
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Trends in Government
Contracting
Page 13 Confidential and Proprietary
76104
86 96
101
100
96
2009 2010 2011 2012
1st Half 2012 Summary
2012 Transaction Activity by Buyer Type
1st Half Activity in Perspective
For the first half of 2012, we are tracking 96
transactions closed in the defense and
government services sector.
Of these closed deals, financial buyers and
their portfolio companies accounted for
25% of the transaction volume.
Given the level of activity in the first quarter
and the expected increase in capital gains
taxes at the end of the year, we might expect
to see transaction volume similar to that in
2010 – However, it is uncertain exactly how
budget pressures and sequestration risk will
impact transaction activity for the remaining
three quarters.
1H
2H
177
204
182
?
Financial Buyers, 24
Strategic Buyers, 72
Page 14 Confidential and Proprietary
-50.00%
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
Defense Primes S&P 500 Index Government Services Middle Market Index
Capital Markets Overview
During the trailing 12 months ending September 14, 2012, the S&P 500 outperformed all of our custom indices. Over this time period the
market was in the negative from September 2011 until just before year-end 2011. Year to date, the S&P has trended upwards. During
this time period our Government Services Index suffered the biggest losses by falling nearly 25%. Our Defense Prime Contractor Index
and the S&P recovered beginning May 2012 to return modest LTM gains; however, our Middle Market index is performing poorly with
negative returns of -10.2%.
1 Year Relative Performance 3 Year Relative Performance
Historical LTM Median EV/EBITDA Multiple
Government Services Index: CACI, CSC, CUB, KBR, MANT, SAI, URS
Defense Prime Contractor Index: ATK, FLIR, GD, LLL, LMT,NOC, RTN
Middle Market Index: AVAV, CMTL, DRCO, ICFI, KEYW, NCIT, KTOS
6.3x
5.5x5.7x 5.6x
5.8x
5.9x 4.8x5.4x
5.5x5.4x
6.9x
5.8x 5.8x 5.7x
6.2x6.5x
4.1x
5.3x
5.9x
4.5x
6.5x
5.4x 5.4x5.2x
5.5x 5.9x
4.8x 4.9x 5.0x
5.4x
Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012
Defense Index Gov't Services Index Middle Market Index
-25.00%
-15.00%
-5.00%
5.00%
15.00%
25.00%
Defense Primes S&P 500 Index Government Services Middle Market Index
Page 15 Confidential and Proprietary
Capital Markets Overview
1 Year Relative Performance
Government Services Index: CACI, CSC, CUB, KBR, MANT, SAI, URS
Defense Prime Contractor Index: ATK, FLIR, GD, LLL, LMT,NOC, RTN
Middle Market Index: AVAV, CMTL, DRCO, ICFI, KEYW, NCIT, KTOS
-25.00%
-15.00%
-5.00%
5.00%
15.00%
25.00%
Defense Primes S&P 500 Index Government Services Middle Market Index
Page 16 Confidential and Proprietary
Capital Markets Overview
Historical LTM Median EV/EBITDA Multiple
Government Services Index: CACI, CSC, CUB, KBR, MANT, SAI, URS
Defense Prime Contractor Index: ATK, FLIR, GD, LLL, LMT,NOC, RTN
Middle Market Index: AVAV, CMTL, DRCO, ICFI, KEYW, NCIT, KTOS
6.3x
5.5x5.7x 5.6x
5.8x
5.9x 4.8x5.4x
5.5x5.4x
6.9x
5.8x 5.8x 5.7x
6.2x6.5x
4.1x
5.3x
5.9x
4.5x
6.5x
5.4x 5.4x5.2x
5.5x 5.9x
4.8x 4.9x 5.0x
5.4x
Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012
Defense Index Gov't Services Index Middle Market Index
Page 17 Confidential and Proprietary
Comparative Stock Price Performance
Defense Government Services Middle Market Index
Data as of Market Close Friday, September 14, 2012
(4%)
(3%)
(3%)
(2%)
(2%)
(1%)
(0%)
0%
0%
2%
2%
2%
3%
3%
3%
4%
6%
6%
8%
8%
15%
17%
(10%) (5%) 0% 5% 10% 15% 20%
Northrop
AeroVironment
NCI
URS
Kratos
Alliant
Comtech
Dynamics Research
Lockheed
FLIR
General Dynamics
Cubic
ICF
Raytheon
S&P 500
ManTech
L-3
CSC
CACI
SAIC
KBR
KEYW
Last 4 Weeks
(69%)
(64%)
(63%)
(46%)
(38%)
(29%)
(26%)
(25%)
(17%)
(16%)
(15%)
(8%)
(7%)
(7%)
(6%)
(6%)
3%
7%
10%
11%
19%
19%
(80%) (60%) (40%) (20%) 0% 20% 40% 60%
NCI
Dynamics Research
Kratos
ManTech
FLIR
CSC
Alliant
SAIC
AeroVironment
URS
KBR
General Dynamics
Cubic
CACI
ICF
L-3
Comtech
Northrop
S&P 500
KEYW
Raytheon
Lockheed
Last 52 Weeks
Page 18 Confidential and Proprietary
11 Trends We are Currently Watching
1. Budgets/Sequestration – At the top of everyone’s mind; materially influencing M&A
activity in the sector
2. Use of capital - Buyers continue to have substantial cash reserves and debt capacity;
M&A opportunities weighed against baseline share repurchases/special dividends.
3. Re-considering organic growth v. M&A – Organic growth in current environment
more difficult/expensive – buying market share is looking more attractive to some.
4. Strategic focus - Not seeing the attempted diversification into commercial markets we
saw during previous downturns.
5. Year-end close - Projected capital gains tax increase at the end of 2012 is contributing
to strong sell-side activity; there is an understanding that the buyer will gain leverage
the closer the closing date moves to Dec 31.
6. Small company burden - Budget pressures also contributing to sell-side activity;
tough for privately-held lower middle market companies to diversify risks.
Page 19 Confidential and Proprietary
11 Trends We are Currently Watching
7. Not over ‘til its over - Sellers are missing their numbers and buyers are scrutinizing
projections closer; greater risk of re-trade on economics/terms than we have seen
previously.
8. Finding opportunities - Bimodal distribution for valuations; hot areas are cyber,
intelligence, health IT, etc. but opportunities may be on the other hill.
9. ESOPS on the rise - Increasing ESOP activity driven by decreasing delta between
market M&A/ESOP values, increasing small business size standards and continued
scrutiny against set-aside work.
10. Active financial buyers - We are continuing to see very strong PEG activity; OCI
issues, uncertainty in market and fund timing are contributing to this.
11. Financing - Sequestration and budget pressures could lead to significant financing
issues the 2nd half of 2012 – when sellers are rushing to get deals done.
Page 21 Confidential and Proprietary
What Drives IT Company Business Value?
1. Quality of Revenues
2. Financial Performance (Gross & Net Margins)
3. Strong Balance Sheet
4. Management Team’s Depth and Experience
5. Work Force
6. Quality of Assets (tangible and intangible)
7. Proprietary Rights / Intellectual Property (competitive advantage)
8. Growth Potential (business/market)
9. Strength of Products & Services
10. Favorable Economic & Industry Conditions
11. Customer Base
12. Company / Brand – Identity & Reputation
13. Quality and Effectiveness of Sales & Marketing Efforts
14. Place in Market (Leader or Follower) – Barriers to Competitive Entry
15. Quality of Financial, Sales & Operational Records
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EBITDA Valuation Multiples
Government contracting value drivers are influenced by industry-specific qualitative factors. Valuation multiples can vary
greatly depending the Company’s attributes.
2x – 3x
8(a) and set-aside contracts
Significant % of subcontracts
Short-term contracts, weak
backlog
Less attractive service offering
(pure staffing, facilities mgmt,
etc.)
Commodity-type services
Less attractive service
offering (IT staffing, facilities
mgmt, etc.)
Subcontractor
Commodity-type services
3x – 5x 5x – 6x 6x – 8x
> 50% prime contracts
Longer-term contracts
Stronger backlog
Some cleared employees
High % of OCONUS
contracts
High % of prime contracts
Long-term, unrestricted contracts
Strong backlog
Secret & Top Secret clearances
required
Customer within DoD, DHS, etc.
8x – 10x
Large prime awards
Long-term, unrestricted
contracts
Strong backlog and visibility
Highly-Attractive service
offerings
Cleared work
10x + Range of
EBITDA
Multiples
Mission critical capabilities
and entrenched IP
Unrestricted prime contracts
Highly cleared work
Intelligence/Health IT/Cyber
Government Contracting Value Drivers
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1. Lack of Customer Diversification
2. Contingent Liabilities
3. Inexperienced Management Team
4. Lack of Management Depth
5. Poorly Maintained Assets
6. High Operating Costs
7. Frequent Contract Renewals (bidding)
8. High employee turnover (Key employees not
locked into a contract – retention by bonus)
9. High Financing Costs
Risk Drives down Value
1. Lack of Customer Diversification
2. Contingent Liabilities
3. Inexperienced Management Team
4. Lack of Management Depth
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Consideration Affects Price
----
100 90 80 70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 80 90 100
Consideration
Offered
Non-Cash Cash
Valu
e R
an
ge
High
Low
Example of a
Transaction
SE
LL
ER
’S R
ISK
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A. Fair Market Value: An
appraiser’s formal
valuation (normally for
legal or IRS purposes)
B. Investment or
strategic value
(beauty is in the eye of
the beholder)
C. Dynamic
(Transactional)
Value (effective
auctions)
$0
$10
$20
$30
$40
$50
$60
$70
$80
Total Acquisition Valuation (millions)
Dynamic
Strategic
Fair Market
Multiple Realities:
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8. Being Represented by an unlicensed broker
9. Communicating your asking price inappropriately
10. Eliminating offshore buyers
11. Assuming the type of buyer
12. Waiting until management is ready to retire
13. Waiting for next year’s growth
14. Ignoring or over-emphasizing timing
1. Selling it without representation
2. Selling to a single bidder
3. The poorly constructed earn-out
4. Disclosing an insufficient amount of information in Offering Memo
5. LOI not thorough
6. Focusing on history and numbers instead of future opportunity
7. Mismanaging team, end runs
The Top 14 Seller Mistakes:
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Work toward a solution that is Win – Win
Divesting your company’s assets Without the bitter aftertaste
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Negotiating with a single buyer?
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MERGERS & ACQUISITIONS | CORPORATE FINANCE | MARKET
INTELLIGENCE | BUSINESS VALUATION | EXIT PLANNING
Greg Boucher
Managing Director
Direct: 410.799.2053
The McLean Group, LLC -
Headquarters
The McLean Group, LLC
7900 Westpark Drive, Suite A320
McLean, VA 22102
Tel: 703-827-0200
Fax: 703-827-0175
30
Scott Freed
Whiteford, Taylor & Preston, Business and Corporate Law
Scott is a partner in the corporate and M&A practice groups at Whiteford,
Taylor & Preston. Scott represents both private and public clients in a broad
range of transactions and corporate and securities matters, including equity
compensation programs, venture capital, financing transactions and M&A.
WTP is a Mid-Atlantic based business law firm with over 160 attorneys
serving their clients both regionally and nationally. Since 1933, WTP’s
attorneys have provided their clients with trusted representation and
guidance on issues critical to achieving their business goals.
D. Scott Freed | Partner
Seven Saint Paul Street | Baltimore, Maryland | 21202
t: 410.347.8763
Speaker Bio
M&A TRENDS: TECH &
GOVERNMENT CONTRACTING
Equity-Based Compensation Alternatives
Navigating Potentially Disruptive Legal and
Accounting Issues
Earnouts
September 2012
D. Scott Freed
Whiteford, Taylor & Preston
31
Equity-Based Compensation
Alternatives
Alternatives for granting equity awards to key employees:
1. Restricted Stock
2. Restricted Stock Units
3. Stock Options
Incentive Stock Options (ISOs)
Nonqualified Stock Options (NQSOs)
4. Stock Appreciation Rights
5. Phantom Stock
Awards may be used in whole or in part to carry-out a succession plan
32
Restricted Stock
A grant of shares of stock with limitations on transferability; may be subject to vesting requirements or other “substantial risk of forfeiture”
May be awarded for no consideration as a stock bonus or recipient may pay all or a portion of stock’s FMV
May be subject to repurchase restrictions that require the resale of stock to the company at some predetermined or formula price upon certain triggering events
Not treated as “non-qualified deferred compensation” (NQDC) under the American Jobs Creation Act (AJCA)
33
Restricted Stock
Tax Overview
Governed by IRC § 83 – taxation of “property” transferred “in
connection with the “performance of services”
Taxed upon vesting of the award (i.e., when stock is no longer
subject to a substantial risk of for forfeiture)
If no substantial risk of forfeiture, taxed at time of award
Substantial Risk of Forfeiture (IRC § 83)
Exists where rights in property are conditioned upon future
performance of substantial services by any person, or the
occurrence of a condition related to a purpose of the transfer
Section 83(b) election is available.
34
Stock Options
Represent a right to buy stock during a specified period at a
fixed purchase price
Types:
Incentive Stock Options (ISOs)
Non-qualified Stock Options (NQSOs)
Generally not deemed to be “property” for income tax purposes
(IRC § 83)
35
Nonqualified Stock Options (NQSOs)
No statutory limitations on option terms
May be granted to nonemployees (e.g., directors/ consultants)
No tax at date of grant or at vesting date(s)
Taxed at ordinary income rates upon option exercise
Capital gains treatment upon sale of underlying stock
Discounted stock options treated as NQDC under AJCA
36
Incentive Stock Options (ISOs)
Plan Requirements: Written Plan
Must specify aggregate number of shares subject to Plan
May limit all awards under omnibus plan or may limit ISO
awards only
“Net” share counting permitted (i.e., forfeited shares and shares
issued to satisfy exercise price can be reissued under Plan)
Must identify eligible Employees or class of Employees
Stockholder approval required within 12 months of adoption of Plan
No additional stockholder approval required for ISOs assumed
in a corporate transaction
ISOs are not subject to AJCA
ISO grant terms are subject to numerous special requirements
under the IRC.
37
Other Types of Equity Awards
Phantom Stock
Employee granted units equivalent to (but not actual) shares of Employer stock
Stock Appreciation Rights
Represent right to be paid spread between grant price and FMV of stock at exercise date
Restricted Stock Units Units representing shares of common stock settled by delivery of
shares at vesting or later payout
38
Equity Compensation –
Employee Tax Summary
NQSO ISO Phantom
Stock
SARs Restricted
Stock
Restricted Stock
Units
Grant Date No tax impact No tax
impact
No tax
impact
No tax
impact
No tax impact1 No tax impact
Vesting Date No tax impact No tax
impact
No tax
impact
No tax
impact
Ordinary
income1
Ordinary income2
Exercise
Date
Ordinary
income on
spread
No tax
impact3
Ordinary
income on
FMV of unit
Ordinary
income on
spread
N/A N/A
Sale Date Capital gain on
appreciation
post exercise
Capital Gain4 N/A N/A Capital gain on
appreciation1
Capital Gain on
appreciation
1 Assumes substantial risk of forfeiture exists and that recipient does not make a §83(b) election. 2 RSU may provide for deferral of payout after vesting – subject to AJCA deferral requirements. 3 AMT may be applicable. 4 Absent “disqualifying disposition.”
39
Equity Compensation –
Employer Tax Summary
NQSO ISO Phantom Stock SARs Restricted Stock Restricted Stock
Units
Grant Date No tax
deduction
No tax deduction No tax deduction No tax
deduction
No tax deduction1 No tax deduction
Vesting Date No tax
deduction
No tax deduction No tax deduction No tax
impact
Deduction equal to
compensation
recognized by
Employee1
Deduction equal
to compensation
recognized by
Employee
Exercise Date Deduction
equal to
spread at
exercise
No tax deduction Deduction equal
to compensation
recognized by
Employee
Deduction
equal to
spread at
exercise
N/A N/A
Sale Date No tax
deduction
No tax
deduction2
N/A N/A
No tax deduction No tax deduction
1 Assumes the recipient does not make a § 83(b) election. 2 Absent Disqualifying Disposition.
40
Basic Types of Exit Strategies:
41
1. Company Stock Redemption
2. Management Led Buyout
3. Third Party Sale
4. Sale to an ESOP
This Presentation is focused on a sale of target to a third-party
Buyer
M&A Risks for Seller
Disruption of business, loss of key employees, etc.
Loss of ownership/control
Confidentiality issues and risks
Unless an “all cash” deal, Buyer’s stock
Substantial costs and negotiation time
Earn-outs and contingent consideration
Escrow, holdbacks and indemnities
Failure to integrate and execute successfully
Affect on customers/suppliers if deal doesn’t go through
42
Preparing a Company for Sale
Buyer’s evaluation of target falls into four major categories:
1. Financial (e.g., accounting, financial systems and controls)
2. Business (e.g., products, customers, facilities, operations)
3. Legal (e.g., contracts, records, intellectual property,
compliance)
4. Other (e.g., environmental, HR, insurance)
43
Address Problems Early
Seller should conduct pre-go to market self-diligence
Consider/address poor earnings history
Incomplete/inadequate management team
Analyze/confirm business model or revenue stream
Market size/limited up-side
IP, Employment, Tax and other legal complications
Lack of competitive advantage/barriers to entry
Capitalization defects
Self-dealing/related party transactions
Deficient financial statements
Inadequate corporate infrastructure/accounting controls
44
Don’t Forget to Address
Opportunities
Reinforcing management depth and strength
Improving financial and IT systems
Confirming financial performance (audited financials are
recommended)
Strengthening sales and marketing infrastructure
Deepening customer and supplier relationships
Identifying potential growth initiatives
Strengthening any operations
Resolving contingent liabilities
45
Business steps to be taken
Standardize and document all company procedures
Eliminate liabilities or liens and resolve any outstanding litigation
Investigate transferability of leases and sales & supplier contracts
Perform maintenance on company equipment to ensure good operating condition
Secure key employees with employment contracts
Consider equity-based grants for truly key employees
Eliminate non-performing or non-contributing employees from the payroll
Establish a management team that can operate without the current owner
Reduce reliance on one or two large customers for the majority of sales
Spruce up the physical aspects of the business facility
Have clean, verifiable financial statements for the past three years
Financial statements should be audited if business has greater than $10 million in revenues
Reduce unnecessary inventory
Collect any outstanding receivables
Re-negotiate favorable key supply contracts
Reduce or eliminate owner adjustments on Income Statements
Ensure financial controls and procedures are established and followed
46
What is an Earnout?
Basic Definition: An earnout is a risk-allocation mechanism
used in an M&A transaction whereby a portion of the purchase
price is deferred and is paid out based on the performance of
the acquired business over a specified time period following the
closing.
47
Reasons for Use of Earnouts
Valuation Bridge: Earnouts can bridge the business valuation
gap between Seller and Buyer.
Financing Tool: An earnout can serve as a financing device for
a Buyer by permitting Buyer to pay for a part of the acquisition
with future profits of the target business.
Incentive-Based Compensation: Earnouts can also can be a
form of incentive-based compensation for Sellers who are
continuing as employees.
Early-State Companies: Earnouts are often used for
companies with little operating history but significant growth
potential (which are not easily valued).
48
Key Structural Considerations
Principal considerations when negotiating and drafting an earnout:
1. The definition and scope of the target’s business subject to the earnout.
2. The selection of the performance benchmark.
3. Measurement of the target’s performance relative to the benchmark.
4. The determination of the payout structure and form (cash, equity, debt or
a combination) and establishment of the earnout period.
5. Post-closing operation (i.e., the allocation of operational control between
buyer and seller and the level of support, if any, that buyer will commit to
assist the target business in achieving its earnout objectives)*.
6. Dispute resolution.
*Courts have held that the covenant of good faith and fair dealing will require buyer to operate the
business to maximize the likelihood of an earnout payment absent specific agreement on this point
(DE law)
49
Defining the Target Business
Clearly define the scope of the target business subject to the
earnout.
Where Target will be integrated into Buyer’s existing
business, the performance of the business may be more
difficult to track and special accounting allocations may be
required.
Matters to be addressed include: (a) the defined line of
business, (b) whether geographic or product expansion will
count toward the earnout and (c) sales to common
customers.
50
Performance Metrics
Financial Metrics: The most common financial metrics are (i)
revenue, (ii) net income, (iii) EBITDA and (iv) earnings per
share.
Non-Financial Targets: In some situations, non-financial
metrics are more appropriate because there is historical
information to use as a basis for financial projections.
51
Accounting Principles
Accounting Principles
Establish appropriate accounting principles for measuring
the performance metric.
Reference to GAAP in and of itself is usually not sufficient.
Parties should, at a minimum, stipulate that GAAP will be
applied consistent with either Buyer’s or Seller’s historic
practices.
Some specific accounting matters to be considered include
(i) use of cash or accrual revenue basis, (ii) revenue and
expense allocation, (iii) timing of revenue recognition, and
(iv) treatment of acquisition expenses, non-recurring items,
intercompany transactions and uncollected receivables.
52
Payout Structure and Earnout Period
Structure Alternatives
Installments vs. lump sum
Percentage of earnout payment upon partial satisfaction
of benchmarks vs. all-or-nothing approach
Earnout conditioned on participation by Seller in acquired
business
Cap on earnout payments
Setoff of indemnification claims
Adjustments based on subsequent performance (e.g.,
carry back/carry forward of EBITDA from one
measurement period to other measurement periods)
53
Payout Structure and Earnout Period (cont’d)
Earnout period: Period over which performance metrics are
measured.
An earnout period that is too short risks performance
distortion by short-term factors Sellers generally seek a
shorter period in order to receive full payment sooner and
mitigate risk.
A longer earnout period allows Buyer time to better evaluate
the target business.
Earnout period may accelerate upon specified events that
negatively impact ability to achieve earnout targets (e.g.,
Buyer’s subsequent sale of acquired business, bankruptcy or
change of control).
54
Post-Closing Operation of Acquired
Business
Allocation of Control over Operations
Seller may request a level of control over the operations of
the acquired business (e.g., approval rights over major
decisions).
Seller may request restrictive covenants that limit how the
target business may be operated.
Buyer may be required to operate the target business
consistently with how it was operated prior to closing.
The parties should address the treatment of Buyer's existing
competing businesses and after-acquired businesses.
55
Post-Closing Operation of Acquired Business (cont’d)
Level of Support
Requirement that Buyer use specified efforts to maximize the
earnout.
Buyer's objective is to operate the acquired business in its sole
discretion without regard to the earnout.
Buyers will seek language in the acquisition agreement that (i)
gives Buyer absolute discretion over operations and (ii)
disclaims any obligation (express or implied) to support the
target business or achieve the earnout.
56
Disputes and Resolution
Financial statements and earnout calculations are typically
prepared by Buyer and its accountants.
Seller is afforded opportunity to review and challenge the
financial statements and earnout calculation.
Arbitration procedures should be established in advance to
resolve future disagreements concerning the earnout
calculation in a fair and expeditious manner.
Often an independent accountant serves as the arbitrator.
2019070V2
57
From P&L to Portfolio Bernstein.com
Speaker Bio
58
Rick Monfred
Bernstein Global Wealth Management
Rick is a Financial Advisor with Bernstein Global Wealth Management.
He advises individuals, families, corporations and nonprofit entities in
the Baltimore/Washington area regarding investment strategies. Using
Bernstein’s proprietary wealth forecasting analysis, Rick provides a
roadmap for owners experiencing a liquidity event in connection with
the sale or recapitalization of their business.
Rick Monfred Bernstein Global Wealth Management (O) 202-261-6753 [email protected]
From P&L to Portfolio Bernstein.com
A Holistic Approach to Pre-Transaction Planning
59
Determine when (and how) to sell the business
Analyze the impact of the deal structure on the owner’s ability to meet lifetime financial
goals and objectives
Explore advantages of wealth transfer planning pre-transaction
From P&L to Portfolio Bernstein.com 60
Quantifying the Opportunity: The Wealth Forecasting System SM
Based upon the current state of the capital markets
Prospective returns
Forecasts returns for 30+ asset classes and 16 different planning vehicles
Tracks wealth of G1, G2, G3 and charity after income and transfer taxes
Family Profile Data
Wealth
Forecasting Model
Probability
Distribution
Financial Goals
Assets
Income Requirements
Risk Tolerance
Tax Rates
Time Horizon
Dis
trib
ution o
f 10,0
00 O
utc
om
es
Simulated
observations
based on
Bernstein’s
proprietary
capital markets
research
5%
50
90
10
95
Scenarios
Allocation
Deal
Terms
Source: AllianceBernstein
See Notes on Wealth Forecasting System at the end of this presentation for further details.
From P&L to Portfolio Bernstein.com
Evaluating What You Need and What You Want
61
How much?
To whom?
How quickly?
What techniques?
Excess Capital
Amount that can be
transferred
How much do you spend?
What is your age?
What is your risk tolerance?
Core Capital
Amount to ensure spending
needs are met
Calculated at 90% level of
confidence
Charity
Capital for Next
Venture
Extra Spending
Children and
Grandchildren
Personal Reserve
Lifestyle
Spending
From P&L to Portfolio Bernstein.com
How does their risk tolerance affect their decision?
Which offer should the couple take so that they can retire confidently today?
Case Study: Retiring Securely
Married couple, age 60, wants to sell their technology company and retire
Investment assets of $1.25 million of which $250,000 is in a qualified retirement plan
Currently spending $240,000 per year
Evaluating two term sheets:
(More Upfront) The first provides $10 million total—$8 million upfront and an annual earnout of
$400,000 for five years
(Less Upfront) The other provides $12 million total—$4 million upfront and an annual earnout of
$1.6 million for five years
62
From P&L to Portfolio Bernstein.com
$12.6
$9.5
$8.2 $7.7
0/100 20/80 40/60 60/40
$4.5 Mil. (Less Upfront)
$7.7 Mil. (More Upfront)
Current Assets**
What Is the Couple’s Core Portfolio?
63
Amount Needed to Fund Core Portfolio Today Spend $240,000 (Real)
($ Millions)*
*Based on Bernstein’s estimate of returns for the applicable capital markets over the applicable time horizon. Data do not represent past performance and are not a promise of
actual or a range of future results. Core capital calculated at 90% level of confidence assuming adjusted joint life expectancy. Variations in actual income, spending, applicable
tax rates, life span and market returns may substantially impact the likelihood that a core-capital estimate will be sufficient to provide for future expenses.
**Current assets are the sum of the beginning portfolio assets plus the after-tax sale proceeds in the first year of the analysis. A combined 19.25% state and federal capital gains tax
rate was assumed.
***“Asset Allocation” refers to the proportion of assets invested in stocks and the proportion invested in bonds over the next 35 years. Assumes globally diversified stocks (21% US
value, 21% US growth, 21% US diversified, 7% US small and mid cap, 22.5% developed international and 7.5% emerging markets); bonds are assumed to be intermediate term
with municipal bonds in the taxable portfolio and taxable bonds in the tax-deferred portfolio. See Notes on Wealth Forecasting System at the end of this presentation for further
details.
Source: AllianceBernstein
Asset Allocation (Stocks/Bonds)***
From P&L to Portfolio Bernstein.com
What Is the Couple’s Investment Risk?
42%
32%
69%
93%
2% 2%11%
46%
2% 2% 2%
12%
0/100 20/80 40/60 60/40
10% Loss 20% Loss 30% Loss
64
Probability of Peak-to-Trough Losses over 40
years*
Data do not represent past performance and are not a promise of actual or a range of future results.
*Data indicate the probability of a peak-to-trough decline in pretax, pre-cash-flow cumulative returns of 10%, 20% or 30% over the next 40 years. Because the Wealth Forecasting
System uses annual capital markets returns, the probability of peak-to-trough losses measured on a more frequent basis (such as daily or monthly), may be understated. The
probabilities depicted above include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years.
**“Asset Allocation” refers to the proportion of assets invested in stocks and the proportion invested in bonds over the next 40 years. Assumes globally diversified stocks (21% US
value, 21% US growth, 21% US diversified, 7% US small and mid cap, 22.5% developed international and 7.5% emerging markets); bonds are assumed to be intermediate term
with municipal bonds in the taxable portfolio and taxable bonds in the tax-deferred portfolio. See Notes on Wealth Forecasting System at the end of this presentation for further
details.
Source: AllianceBernstein
Asset Allocation (Stocks/Bonds)**
From P&L to Portfolio Bernstein.com
94% 96% 96% 98%
40/60 60/40 40/60 60/40
Both Deals Meet Spending Plan—If They Get 100% of Earnouts
65
35th Year—Probability of Maintaining Spending* Spending $240,000 (Real)
100% Earnout**
Asset Allocation (Stocks/Bonds)***
*“Probability of Maintaining Spending” represents the probability of having assets greater than $0 at the end of the 35th year. Based on Bernstein’s estimate of returns for the
applicable capital markets over the next 35 years. Data do not represent past performance and are not a promise of actual or a range of future results.
**Assumes the couple receives each annual payout in its entirety as described previously.
***“Asset Allocation” refers to the proportion of assets invested in stocks and the proportion invested in bonds over the next 35 years. Assumes globally diversified stocks (21% US
value, 21% US growth, 21% US diversified, 7% US small and mid cap, 22.5% developed international and 7.5% emerging markets); bonds are assumed to be intermediate term
with municipal bonds in the taxable portfolio and taxable bonds in the tax-deferred portfolio. See Notes on Wealth Forecasting System at the end of this presentation for further
details.
Source: AllianceBernstein
More Upfront
Less Upfront
From P&L to Portfolio Bernstein.com
If Earnouts Are Less Certain, Asset Allocation Can Help
66
35th Year—Probability of Maintaining Spending* Spending $240,000 (Real)
60% Earnout**
*“Probability of Maintaining Spending” represents the probability of having assets greater than $0 at the end of the 35th year. Based on Bernstein’s estimate of returns for the
applicable capital markets over the next 35 years. Data do not represent past performance and are not a promise of actual or a range of future results.
**Assumes the couple receives an earnout of only $240,000 per year in the “More Upfront” scenarios and $960,000 per year in the “Less Upfront” scenarios.
***“Asset Allocation” refers to the proportion of assets invested in stocks and the proportion invested in bonds over the next 35 years. Assumes globally diversified stocks (21% US
value, 21% US growth, 21% US diversified, 7% US small and mid cap, 22.5% developed international and 7.5% emerging markets); bonds are assumed to be intermediate term
with municipal bonds in the taxable portfolio and taxable bonds in the tax-deferred portfolio. See Notes on Wealth Forecasting System at the end of this presentation for further
details.
Source: AllianceBernstein
91% 94%
84% 89%
40/60 60/40 40/60 60/40
Asset Allocation (Stocks/Bonds)***
More Upfront
Less Upfront
From P&L to Portfolio Bernstein.com
0
23
45
68
90
$3.3$1.1
What Is the Impact on the Couple’s Future Wealth?
67
$45.9
$14.1
$26.7
$8.7
$62.5
$20.5
$36.9
$13.5
Range of Wealth Values, Year 35* After Taxes and Cash Flows, Nominal
60% Earnout**
$ M
illio
ns
*Based on Bernstein’s estimate of returns for the applicable capital markets over the next 35 years. Data do not represent past performance and are not a promise of actual or
a range of future results.
Asset values represent the estimated market value; if the assets were liquidated, additional capital gains or losses would be realized that are not reflected here.
**Assumes the couple receives an earnout of only $240,000 per year in the “More Upfront” scenarios and $960,000 per year in the “Less Upfront” scenarios.
***“Asset Allocation” refers to the proportion of assets invested in stocks and the proportion invested in bonds over the next 35 years. Assumes globally diversified stocks (21% US
value, 21% US growth, 21% US diversified, 7% US small and mid cap, 22.5% developed international and 7.5% emerging markets); bonds are assumed to be intermediate term
with municipal bonds in the taxable portfolio and table bonds in the tax-deferred portfolio. See Notes on Wealth Forecasting System at the end of this presentation for further details.
Source: AllianceBernstein
40/60 60/40 40/60 60/40
Asset Allocation (Stocks/Bonds)***
More Upfront Less Upfront
5%
10
50
90
95
Level of
Confidence
From P&L to Portfolio Bernstein.com
Case Study: Excess Planning—Client Situation
68
Married couple, age 57, with two children ages 21 and 18; The couple is a 50% owner
of a private, family S-corporation, valued at $40 million
In addition to the business, the couple has investment assets of $920,000; with
$260,000 in qualified retirement plans and $100,000 in section 529 college savings
plans
The couple receives the following pretax income:
$1.4 million in business distributions
$150,000 in total salary, adjusted each year with inflation
The couple spends $225,000 per year, indexed for inflation. Additionally, their daughter
begins college this year ($40,000 per year, indexed by inflation, plus 2% for six years).
The couple will pay expenses that exceed the college savings plan
The couple anticipates wedding expenses of $50,000 upon their daughter’s graduation
From P&L to Portfolio Bernstein.com
Case Study: Excess Planning—Business Facts
69
The couple will sell 30% of their ownership in the business in five years, which is taxed
as a long-term capital gain with a cost basis of zero (30% of the business distributions
stop). The remaining 70% of the business interests are sold in Year 10 (business
distributions stop entirely along with the couple’s salary)
We examined the following growth scenarios for the business:
5% Annual Growth: The $1.4 million business distributions remain flat and the value of the
business interest grows 5% annually
10% Annual Growth: The $1.4 million business distributions increase by 5% annually and the
value of the business interest grows 5% annually
18% Annual Growth: The $1.4 million business distributions increase by 10% annually and the
value of the business interest grows 8% annually
From P&L to Portfolio Bernstein.com
No Wealth Transfer: Distribution of 40-Year Family Wealth*
40/60 Portfolio for G1 After Spending and Taxes in Typical Markets (Nominal)
Bernstein is not a legal, tax or estate advisor. Investors should consult with professionals in those areas as appropriate before making any decisions.
*Median results. Assumes the grantor’s assets are invested 40% globally diversified stocks and 60% intermediate term bonds. Assumes that the spouses die in the same year, and
that $5 million, indexed for inflation, per person, is exempt from estate taxes less any gifts made during life. The remaining estate is taxed using a 35% estate tax rate. See Notes on
Estate Transfer and Taxation at the end of this presentation for further details. Based on Bernstein estimates of the range of returns for the applicable capital markets over the
duration of the analysis. Data do not represent past performance and are not a promise of actual or a range of future results. See Notes on Wealth Forecasting System at the
end of this presentation for further details.
Source: AllianceBernstein
Family $93.1 Mil.
Family $99.2 Mil.
Family $129.1 Mil.
Government $37.9 Mil.
Government $57.8 Mil.
Government $41.2 Mil.
$131.0 Million $140.4 Million $186.9 Million
Probability of Meeting Spending over 40 Years
>98% >98% >98%
5% Annual Growth 18% Annual Growth 10% Annual Growth
70
From P&L to Portfolio Bernstein.com
You’re Kidding, Right? There Has to Be a Better Way
71
Couple makes an $8 million gift of interests in their business to an irrevocable grantor
trust for the benefit of their children
Pro: Couple has a combined $10.24 million applicable lifetime exclusion in 2012 and can
comfortably make gifts without jeopardizing their core portfolio; immediately removes the present
value of the growth of the business from their estate
Con: Uncertainty about future gift and estate tax policies
Other Strategies to Consider:
Discounted sale to children or a trust for their benefit in exchange for a promissory note
Pro: Uses little or no gift tax exclusion and requires little to no gift taxes to be paid; the applicable
federal rates are near historic lows
Con: The principal value of the note remains in the grantor’s estate
Discounted transfer to a grantor retained annuity trust (GRAT)
Pro: Requires no gift tax exclusion to be used when GRAT is zeroed out; Section 7520 rates are
near historic lows
Con: Mortality risk; frequent valuations required
From P&L to Portfolio Bernstein.com
Gift/Estate Strategies Benefit from a Discount
72
Capitalize on the valuation discount, due to illiquidity and lack of control
Assuming transfer of a minority interest. Bernstein does not advise on the value of any discounts; information on discounts was provided by clients’ tax and legal teams.
Source: AllianceBernstein
Grantor
Value of Gift for
Transfer Tax Purposes Discount
$8.0 Million
$6.0 Million
$8 Million
Pre-
Transaction
Gift
$5.2 Million 35%
25%
0%
The couple’s deal team advises them to use a 25% valuation discount, due to illiquidity and lack of marketability
From P&L to Portfolio Bernstein.com
Planning: Distribution of 40-Year Family Wealth*
73
40/60 Portfolio for G1; 80/20 Portfolio for G2** After Spending and Taxes in Typical Markets (Nominal)
Bernstein is not a legal, tax or estate advisor. Investors should consult with professionals in those areas as appropriate before making any decisions.
*Median results. Assumes G1 assets are invested 40% globally diversified stocks and 60% intermediate-term bonds, and G2 assets are invested 80% global stocks and 20% bonds.
Assumes that the spouses die in the same year, and that $5 Million, indexed for inflation, per person, is exempt from estate taxes less any gifts made during life. The remaining
estate is taxed using a 35% estate tax rate. See Notes on Estate Transfer and Taxation at the end of this presentation for further details.
**G2 portfolio is assumed to be an irrevocable grantor trust for the first 10 years, at which time the trust pays its own taxes. Based on Bernstein estimates of the range of returns for
the applicable capital markets over the duration of the analysis. Data do not represent past performance and are not a promise of actual or a range of future results. See
Notes on Wealth Forecasting System at the end of this presentation for further details.
Source: AllianceBernstein
Family $236.5 Mil.
Government $4.1 Mil.
$171.7 Million $183.7 Million $240.6 Million
Probability of Meeting Spending over 40 Years
93% 94% >98%
5% Annual Growth 18% Annual Growth 10% Annual Growth
Family $183.7 Mil.
Government $0.0 Mil.
Family $171.7 Mil.
Government $0.0 Mil.
From P&L to Portfolio Bernstein.com
How Bernstein Can Help
74
Give clients comfort and confidence to proceed with the transaction
Simplify and ease implementation
Help clients choose between competing offers with different deal terms
Provide our unique ability to model deal terms, personal wealth planning and wealth
transfer strategies in an integrated and customized analysis
AllianceBernstein.com/go/SellingABusiness