The Sm art Way To Buy a Money-Loser

Companies of all types and sizes can run into trouble in good times and in bad. But when the economy slows to current levels, numerous businesses often are left operating at less-than-optimal levels. The languishing economy and resulting credit crunch have weakened a number of companies, and the immense difficulties of trying to manage these firms through tough times has led a number of potential sellers to consider exiting. For the most critically ailing firms, bankruptcy looms as a stark reality. Other troubled companies may require extensive reorganization efforts to get them back on their feet. Few acquirers outside of the realm of distressed m&a or turnaround specialists consider tackling these most laborious restructuring projects. However, a growing number of buyers are mulling acquisition opportunities among down-but-not-yet-out firms that may provide the right acquirer with real economic and strategic values – companies ranging from startups that have not yet produced steady cash flows to historically profitable, older-line companies that have hit a bump in the road. M&a professionals are seeing increased interest in troubled firms from all classes of buyers. The stigma connected to troubled assets has almost disappeared, or at least has been significantly reduced, notes Frank Conway, National Managing Director of the Reorganization Services Group at Deloitte & Touche. His firm, he says, is working with Fortune 50 and Fortune 100 companies that believe they should at least do a “cursory examination” of stumbling or money-losing companies. “Whereas 10 to 12 years ago there were categories of buyers that would not go near assets like this, these companies are no longer off-limits to them,” he says. Currently, 90% of businesses worldwide are undergoing some form of restructuring, estimates Chris Oberbeck, Managing Partner of Saratoga Partners, a private equity investment firm based in New York. “We’ve left that era when people thought there was limitless high growth and have entered one in which many companies are experiencing flat-to-negative performance. In fact, a lot of companies would love to have flat performance now,” he states. Traditionally, the majority of LBO companies, private equity firms, and buyout funds have pursued healthy companies – businesses with positive cash flows, strong management teams, targeted markets, solid market shares, and tried-and-true products. But suddenly, investments in troubled companies have become “the thing to do in some circles,” notes Oberbeck, whose firm has expertise in underperforming companies, especially in the telecom industry. Michael Madden, a Partner at Questor Partners, says that his firm has been partnering with other sponsors and offering its turnaround skills in troubled-company situations. “We talk to companies with troubled units and say, Why don’t you ride with us on the upside? We will put in new money and do the heavy lifting for the next year and you ride with us and reap the benefits.’ So, in a way, it’s another version of an earn-out because they are getting the benefit of our turnaround skills and we get a built-in financing mechanism and less risk in terms of the original deal structure,” he says. Larry Graev, a private equity lawyer at King & Spalding and founder of a new merchant bank called The GlenRock Group, based in New York, notes that in slowing economies, interest in troubled assets generally grows. He says that his law firm has recently expanded its restructuring and reorganization business. While money-losing companies may appear to be unpolished gems that can be acquired at bargain prices, potential buyers often are stumped about how to assess and capture value in acquisitions of these kinds of firms. Even before considering such an acquisition, a buyer must determine whether the transaction makes economic sense, or whether the time, money, and effort required to improve the company would ultimately erode the value of the deal. Acquiring these kinds of companies often involves a complex process that goes beyond a seemingly attractive price. An acquirer should expect to devote more time than it would spend on an acquisition of a healthy company in thoroughly checking out the company, determining the right purchase price, and formulating a strategic plan to get the company back on track. Although due diligence is an essential element in all business transactions, it is the most critical element in buying a money-losing business, m&a experts say. A thorough once-over of the target should focus not only on finding the flaws in the company but also in unearthing potential value in the firm’s products, know-how, market share, customer base, and other assets and in determining turnaround probabilities. James Budyak, Vice President and Principal at American Appraisal Associates, says that early on in the due diligence process, the acquirer must figure out whether the target’s business model is viable. “That may be interpreted to mean, Is this business worth more dead than alive?'” he says. Key due diligence aspects to consider, he notes, include: 1. Customers, including a review of contracts; 2. Suppliers, including an examination of any favorable agreements; 3. Competition and market analysis; 4. Management team and other employees, including a review of employment contracts and special compensation issues; 5. Other significant intangibles; 6. Historical and forecast performance; and 7. The value of the company as a going concern versus the liquidation value of the company’s assets. In addition to the above issues, a buyer must fully understand why the company is losing money and how long is it expected to be in a negative cash flow position, says Richard Hitt, Managing Director of the Valuation Services Practice at KPMG Consulting Inc. In the case of a startup company, the firm may be making capital expenditures that exceed its revenues, Hitt notes. With most startups, the expectation is that after a certain period of time, they will become profitable from an earnings and a cash flow perspective, he adds. An acquirer eyeing a stumbling, established company needs to figure out the reason behind the company’s troubles – “whether it is something within the company’s control or some macro, economic factor beyond its control,” he says. “To the extent that the problem is something within management’s control, an acquirer would then look more closely at whether the company needs to make changes in management. If that is the case, one could become reasonably comfortable that the company could return to a profitable state after the changes have been made. On the other hand, the acquirer may not be interested in the management team at all – just the company’s products, customers, or other assets,” says Hitt. A money-losing business could possess significant intangible assets, such as customer lists or distribution channels, that are not present on the balance sheet, Hitt says. It is very possible that the company’s investors and shareholders do not recognize the value of those assets and that the company’s stock price, therefore, does not reflect that value, he says. A potential buyer should also carefully review the target’s tax position, he notes. “From the standpoint that the company has been losing money from not only an accounting or book perspective but also from a cash perspective, there could be significant tax attributes that can be realized by the buyer that may not be able to be realized by the seller,” he says. The jumping-off point for buying an ailing business is whether the deal makes economic sense. For the acquirer to create value, the deal price must be no greater than the stand-alone value of the company plus the value created by the acquisition synergies. But for any number of buyers of a particular company there could be just as many different values placed on the target based on the specific synergies and cost-savings that each of the potential acquirers might expect to achieve. Therefore, it is critical for the acquirer to carefully calculate the value of any synergies that it hopes to reap in the acquisition, keeping in mind any difficulties it might encounter in actually obtaining those synergies. “If you overpay for a non-troubled company, you are in the hole to start. But if you overpay for a money-losing company, you have two strikes against you,” says Van Conway, President of Conway MacKenzie & Dunleavy, a Birmingham, Mich.-based financial and management consulting company that specializes in underperforming businesses. Hitting on the right purchase price is key, he adds. He believes that if an acquirer determines the right price, has the right management team in place, and has a solid strategy for turning the company into a moneymaker, the deal would have about an 80% to 90% chance of being successful. If any of those elements are missing, the chance of success drops to about 50%, he says. In the current economic environment, companies are “heading back to the basics, like DCF,” says Gregg Smith, a Partner and Head of the Tri-State Corporate Finance Practice at Deloitte & Touche. In more competitive times, bidders were “backing into” their prices – deciding that they would be willing to pay “X” for a company then working to justify paying that price, he says. Frank Conway at Deloitte & Touche agrees, adding, “Now people are willing to pay something less than X’ on a relative basis. People are looking at these kinds of companies as potential value plays, but they recognize and plan for the fact that they will have to pump additional resources into the company after the deal closes.” In pricing a money-losing business, an acquirer probably would look at a broader range of alternative valuation approaches than it would in an acquisition of a non-troubled company, adds Tom Allison, a Partner at Andersen. “I think you would also see that the valuations that result from the different approaches would be all over the place, just because strategic acquirers might value a company on different bases. Additionally, if you have a competitive marketplace – or a lack of a competitive marketplace – that also drives the value of a lot of these businesses,” he notes. Colleague Terry Brown, a Managing Director at Andersen Corporate Finance, notes that normally buyers rely on a discounted cash flow (DCF) or other traditional valuation techniques to zero in on an appropriate purchase price. Yet, in situations in which the target is losing money and has no cash flow to evaluate, setting the right price can require using a traditional methodology as a base and supplementing that analysis with evaluations of what the assets are worth to the acquirer. “The acquirer might rely heavily on determining the value of acquisition benefits – taking a look at the potential for cost-savings, revenue enhancements, or other value that it can bring to the table. It’s really an art, not a science,” he says. Mark Brattebo, a Managing Director at Milwaukee-based Valuation Research Corp., says that a well-executed market approach or DCF approach is a good starting point for estimating the value of a money-losing firm. He adds, though, that there is a school of thought that traditional valuation methods can fail to accurately capture the economic value of investments in an environment of uncertainty and change. A state-of-the-art technique called the real options methods was developed to quantify the effects of risk and uncertainty beyond the traditional valuation models. “For a while, this real option theory gained close to widespread acceptance, but I think it was a bit oversold in terms of the precision it could bring to valuations of money-losing businesses,” he says. Pharmaceutical companies use the technique to value certain research and development projects, which may include a money-losing phase, he says. But the method was taken a step further and applied to corporate valuations, he adds. “It clearly produces higher values than a DCF. People were looking for a technique to justify already high prices and people started applying this theory. I think there are sentiments now that it was really oversold in a lot of corporate valuations,” he remarks. Valuation and investment banking professionals generally agree that traditional valuation techniques are best for nailing down a purchase price for a money-losing business. Most likely, though, the evaluation will require a combination of subjective and analytical modifications to the more traditional pricing methods. A good way to value a money-losing business that appears to be losing on an EBIT or EBIT-DA basis, notes Budyak, involves focusing on the company’s gross margins or product contribution. The target may be losing money because it doesn’t have the critical mass to cover SG&A expenses, for example. The potential buyer may have the required mass in order to make the acquisition of the company successful. In this case, Budyak adds, the acquirer’s valuation model “would not include all of the operating expenses but may stop at some product contribution basis because the buyer may be able to leverage off of its own existing assets,” he says. Additionally, says Budyak, methods for valuing a money-losing business have to be “sensitive to the consensus” of what willing buyers in the industry would pay. Appraisers, he notes, try to mimic the market – “putting a price on something that reflects a reasonable range of value for something that is not observable (priced) from the marketplace.” If a company has negative earnings, methods that focus on price-to-earnings, such as price-to-EBIT or price-to-EBIT-DA, might not be applicable, he adds. Instead, he says, an acquirer could consider using a comparable company or guideline company method, which is part of a market approach, to include calculations of price-to-revenue multiples – especially price-to-revenue multiples for businesses that are similarly unprofitable. A company may possess value if it has a strong market share or other assets that could be attractive to a buyer that could realize synergies in an acquisition of that company, he notes. Additionally, a firm can have value if its earnings trough is not indicative of its potential, he adds. Price-to-revenue multiples should be carefully selected, Budyak says. In general, price-to-revenue multiples are impacted by three elements: growth factors, risk factors, and profitability factors. All earnings-based market multiples, he says, have inherent growth and risk factors, but the price-to-revenue multiple also takes into consideration the profitability factor. “If you have negative profits, that would suggest that the price-to-revenue multiple would be lower in comparison to profitable companies. But if you are able to identify in your comparable company analysis money-losing firms that are publicly traded and can derive the price-to-revenue multiples of unprofitable companies, this may provide the basis for an indication of what the money-losing firm might be worth based on what people are willing to pay for stocks of money-losing entities. But one must acknowledge that share prices from public exchanges are typically thought to be a minority indication of value, and warrant consideration of a control premium for transfers of majority or 100% interests,” he says. Since market multiples are “very powerful, single-point estimates of value,” Budyak says that he also likes to consider the DCF valuation method. With a money-losing business, he notes, the company’s specific circumstances will dictate whether it can be modeled under “an optimistic case, a base case, or a downside case.” In acquisitions of money-losing firms, Budyak recommends that a potential buyer do an expected value analysis of each of the three possible scenarios in estimating a purchase offer price, he says. “It’s one thing to base the value of the business on a going-concern premise, including recognition that the money-losing business has a seemingly viable business plan and a workout period to get to profitability. But because there is the possibility that its underlying assets may be worth more or less than the going-concern value, it would be useful for an acquirer to have a liquidation number in the back of its mind as it goes through these various approaches and considers an offering price,” Budyak adds. While the DCF method may be the most “analytically pure” way to value a going concern, it can be extremely difficult to apply even in an acquisition of a non-troubled company because it is always difficult to forecast future cash flows, says Andrew Miller, Managing Director and Head of the National Distressed Company M&A Practice at Houlihan Lokey Howard & Zukin. Therefore, it is nearly impossible to apply to a troubled-company deal, because forecasting future cash flows is even tougher in that kind of situation, he adds. “If an acquirer were to do a DCF valuation on a troubled company that has cash flow losses, with sometimes a hockey stick turnaround in its cash flows, the buyer may find that there is no value in the interim cash flows and that, therefore, all the value is in the terminal value, which is very often valued using some type of Gordon growth formula or a market multiples approach. So why not just apply a market multiples methodology to some kind of current representative levels as opposed to trying to do that five years out, which is really all you’re doing in larger part in a DCF method,” he states. But even applying a market multiples approach to a troubled-company valuation can be tricky, Miller adds. When doing a market multiples analysis, the acquirer would look at comparable companies or representative transactions from comparable companies in trying to figure out the appropriate multiple for the firm it is trying to value, he says. In assessing the multiples, the acquirer would have to keep in mind that the comparable companies will have different growth characteristics, different balance sheets, and different levels of health, and would have to take all of those factors into consideration when assessing the appropriate multiple for the target company, he notes. “The problem is that those multiples probably assume a normalized balance sheet, and a buyer might have to make certain corrections even if it uses a multiples method.” Additionally, Miller states, even if an acquirer can determine what the right multiple is for the target company, it will still have a tough time figuring out what the right representative levels are. “For example, you may figure out that the right multiple is six times EBIT-DA. However, that is only good if the company has EBIT-DA or operating cash flow to apply the multiple to. If the company has negative EBIT-DA, that may send the buyer off to look at revenues multiples. But they are very tricky and for most industries are a poor indication of value, because they don’t necessarily bear a perfect corporate correlation to operating cash flow,” he remarks. The experts say that a money-losing business may seem easier to value than a non-troubled company because there may be less comparable company analysis that can be done if the buyer is unable to identify comparable companies that are similarly unprofitable. But it is actually at least as difficult, if not more so, to value a troubled company as it is to value a healthy company because of the uncertainties in the business and the need to do an expected value analysis of each of the three possible scenarios – optimistic case, base case, and downside case – in estimating the purchase price. While figuring the right purchase price is critical in these types of acquisitions, Frank Conway notes that savvy buyers are putting as much emphasis on their postacquisition plans as they are on the up-front work of due diligence and valuation. “The closing date is generally not the defining moment anymore. Also, an acquirer should have a Plan B and Plan C in mind if the original business plan does not work out. That’s where I see that the prudent acquires are. They are coming up with alternative plans. The Plan B aspect of this kind of deal should not be underemphasized,” he says. The key in acquisitions of money-losing businesses, he adds, is to have “rational, reasonable assumptions and to stay in a safe-harbor sort of mode when you focus on return on capital, return on invested equity, and cash flow generation.” “Those three hot buttons’ are situations that our savvy clients already recognize, and they won’t depart from that. I think the notion of value investing is back. But you must factor into your analysis the notion that you’ll have a much more labor-intensive, management-intensive, and probably capital-intensive pool of assets to work with after the acquisition.”