Fit to Be Sold
Getting your company's bottom line in shape for prospective buyers* * *
Before . . . after. Those were the words that held me in thrall as a 12-year-old leafing through my older sister's Glamour magazines. A beauty magazine staple, make-over stories were ugly duckling tales, pure and simple. The "before" picture featured an ordinary-looking, unsmiling girl. The "after" photo, several times larger and in color, showed the same girl, miraculously made beautiful. It was all a matter, the text assured us, of emphasizing your best features and downplaying your flaws.
That beauty tip is all you need to know about getting your company ready for sale. Oh, the merger and acquisition experts may say it more elegantly. Their before-after snapshots are financial statements, not photos. And they call it a cleanup, not a make-over. But the drill is the same: look your best by dramatizing your best.
There is one important difference, though. A company's most attractive feature is always its profitability. The bigger the bottom line, the better -- period. That obvious point, however, is typically the knottiest problem for private companies. It's not that these businesses are clunkers; it's just that owners rarely run their companies in a way that maximizes net income, since that only enlarges the tax bite.
As a result, a private business can do a lot to fatten up earnings before getting its after photograph snapped and shown to prospective buyers. In early 1987 that daunting task, and the uncertainty of what lay ahead, drove the controller of Metro Seliger Industries Inc. (MSI), a thriving direct-marketing services company based in Woodside, N.Y., to jump ship. The controller's youthful successor, senior vice-president and chief financial officer Mark Lewis, immediately set out to shear off extraneous costs. He also wanted to give prospective buyers a picture of what the company's past earnings would have been without those superfluous expenses, so he created a set of pro forma -- or reconstructed -- financial statements. The cost cutting boosted net income to an estimated $700,000 on sales of some $11 million. Here's the stunner: that was about two and a half times what net income had been.
Was it worth paying all that extra tax on the additional income? Absolutely. Buyers always base their price on a multiple of earnings or cash flow. KLP Group PLC, the British sales-promotion company that bought MSI in 1988, will ultimately pay between 8 and 10 times net earnings, up to $17 million, depending on how well MSI performs. So every dollar of earnings that Lewis carved out was worth at least $8.
Most of the expenses that Lewis was able to cut were accumulated over MSI's 65-year history. Once a Manhattan stationery supply store, the company gradually had expanded into printing, mailing, and computer and other direct-marketing services through a series of acquisitions. MSI probably had its strategic reasons for each purchase, but its accommodating attitude seems to have been just as important. Most of the adopted companies, says Lewis, "were struggling, looking for a home."
The capital structure and financial arrangements that evolved had the same casual quality. Founders and managers were shareholders; so were some top salesmen and ex-owners of acquired companies. Some were shareholders of the holding company that owned MSI; some weren't. Some salesmen kept receiving commissions after they left the company. Others once associated with MSI had "consulting" agreements.
None of this is a bad way to run a company or earn workers' loyalty. It all seems quite generous. But from a buyer's perspective, MSI looked discouragingly complicated. MSI had 10 owners. That alone could scare off a buyer (see "The Multiheaded Shareholder Monster," next page). It also had a welter of contractual obligations, which were a financial drain and a potential source of headaches.
Take Do-Best Printing Corp., a printing company that MSI had bought in 1985. As part of the purchase, MSI had agreed to give Do-Best's owners a three-year employment contract, followed by a three-year consulting contract and two years of commissions on Do-Best's preexisting sales. Altogether, the two contracts represented some $180,000 in expenses for MSI. By the time Lewis and the late Dan Silverman, then the CEO, president, and majority stockholder, had begun their cleanup, the first agreement was about to expire. They dispensed with the consulting contract by buying out the couple. The price? The present value of the monies that would have flowed to the couple over the next three years.
Similarly, four ex-salesmen continued to enjoy commission payments on sales that they had brought into the company -- MSI's insurance that they wouldn't try to steal the customers away. Normally salespeople at MSI earn 5% to 10% commission on their sales. The departees were still pulling in 2.5% to 5%. Most of them were bought out.
Lewis's other prime targets were discretionary expenses that amounted to unofficial compensation -- a classic profit eater in privately owned companies. For example, each year a portion of MSI's sales were made by a company called Whitfield Press. From those sales Whitfield booked a net profit of $50,000. And who owned Whitfield? None other than the offspring of certain MSI shareholders. Lewis and Silverman shut Whitfield's doors during the cleanup.
MSI also had given 24 employees company cars, sometimes in lieu of a raise. The company not only shouldered the cost of the cars, but paid for their insurance as well. The shareholders agreed that nearly half of those cars could be eliminated. To make the move more palatable to the employees who'd been using the cars, MSI gave them raises equivalent to the amount of the monthly car payment. The employees had to pay tax on their extra income, but MSI saved on insurance -- which had been about half as much as the cars had cost.
While Lewis's expense cutting produced dramatic results in MSI's earnings, it extracted a big price. Buying out the individual consulting contracts cost an estimated $400,000 -- nearly as much as was saved. But, of course, that's just a onetime charge. MSI will benefit from the resulting savings year after year, and that's what prospective buyers are willing to pay for.
Preparing the company for sale had other, more subtle ramifications, too. Before a sale is contemplated, says Stephen Blum, the KPMG Peat Marwick partner who worked with MSI, "an owner knows where he plans to take the business, but he often hasn't put it down on paper." MSI fit that generalization to a T. Until its managers began participating in the cleanup, says Lewis, "there were no business plans, no budgets -- except when the bank required them."
Now, there's a much keener appreciation of MSI's budget, even though the managers are no longer owners. Of course, that has a lot to do with the annual earn-out payments they'll get through the end of fiscal 1992. If MSI performs as well as possible, they'll receive payments equal to the ones they got when the deal was closed -- totaling as much as $17 million. That leaves little doubt that MSI's make-over will have lasting results.
THE MULTIHEADED SHAREHOLDER MONSTER
How MSI defanged it
If you were a prospective buyer, how would you like to negotiate with this gang?
There's a dissident shareholder with 2% of the company who thinks his shares are worth much more than you're offering. Another shareholder thinks the company should go public, not sell to you. And the CEO and majority shareholder initiated the sale knowing he could get much more for his shares by selling to you than if the company bought them back when he retired.
In the end, Metro Seliger Industries Inc. (MSI) was able to present a unified shareholder group to KLP Group PLC and other prospective buyers. But behind the scenes things got a bit sticky, says CFO Mark Lewis. Here are the key ownership problems MSI faced and how it solved them:
The dissident shareholder. This was probably the easiest to solve; MSI bought him out. The company ended up paying him 150% of what he would have gotten for his shares from the sale, but it was worth it. "He could have blocked the sale, brought a lawsuit, and made things very difficult," says Lewis. It's better to buy out minority shareholders well in advance of a sale, if possible.
Unification drive. Most of MSI's shareholders were former colleagues, some of whom had worked together for 30 years. So it wasn't too tough to get everyone to agree to the sale and sale price. Still, to give the other shareholders an extra incentive, the late CEO, Dan Silverman, gave away some of his own proceeds. Entitled to 43% of the earn-out, Silverman agreed to take 3% less, so that other shareholders (and one nonshareholder) would have a bigger share in the total sale proceeds.
Separate and unequal. A manager's share of stock didn't necessarily relate to his importance to the company. For example, some MSI salesmen who had been given stock as an inducement to stay at the company weren't key decision makers. This is a common problem. Solution: four shareholders got a portion of KLP's down payment that was proportionate to their stock holdings, but they won't participate in the earn-out payment. This, of course, was a controversial decision. "It bothered me," recalls salesman Walter Gordon. "I thought everybody should have the same deal." On the other hand, he says, "I was ecstatic to be able to sell the company."
TAKING STOCK OF INVENTORY
Do away with the deal killer
No cleanup is complete without a close look at how inventory is valued. MSI was regularly audited, so no adjustments were necessary. But the number that private, unaudited companies pin on inventory sometimes covers a multitude of sins. No one likes to talk about it, but a lot of companies manage their taxable income by the value of their inventory. That value at year end determines a company's cost of goods sold for the year. And that expense, of course, dramatically affects earnings.
It's essential to assess inventory properly before putting a company up for sale. No well-heeled buyer will plunk down his money until he's checked out everything -- especially inventory -- thoroughly. If you've got a lot of unsalable goods on the books, a buyer is likely to get leery of the whole deal, wondering, What else is wrong here?