Chapter 8

Creating and Reviewing an Offering Document

In This Chapter

Taking an overview of the offering document

Relaying company info

Noting financial numbers

The offering document, also known as the confidential offering memorandum (COM), the information package (IP), and the deal book, is the main sales document in the mergers and acquisitions process. More commonly, it’s simply called the book. Everything a Buyer needs to make an offer (not close a deal) is in the book.

In this chapter, I introduce you to the who, what, when, and how of the offering document. In case you’re wondering about the where, that’s up to you! Write it where you’re most comfortable.

The Offering Document in a Nutshell

The offering document is the deal book, the almanac of fact, the atlas of numbers. The offering document is the bible of the company. As with any written document, it becomes dogma. In other words . . . it’s kind of important. Take care to draft a complete, honest, and accurate offering document.

The Seller writes the offering document (or, as is often more accurate, the Seller’s advisors do). Writing an offering document is a time-consuming process, so Sellers need to make sure the book-writing takes priority in their daily activities.

If advisors are handling the task, an employee (usually the CFO or some other high-ranking finance person) makes sure to provide the author(s) with all the necessary information. From the time all the necessary information is gathered, a well-written offering document should take 60 days to write.

Buyers don’t need to write an offering document. However, unless the company is well known and/or has a very detailed Web site, Buyer may want to prepare a quick one- or two-page overview of his company and investment thesis (a description of the types of companies he wants to acquire as well as his rationale for why those acquisitions make sense).

A well-written offering document spells out the value proposition for the Buyer. It includes an in-depth review of the company’s operations, finances, sales, marketing, customers, employees, facilities, and more. This collective information should be sufficient for an interested Buyer to make an offer for the company. (See Chapter 9 for more on how a Buyer makes that offer.)

I like to think of an offering document as a road map to value. Sure, Seller’s intent is to maximize the price Buyer pays for the company, but Buyer is only going to pay a price that makes sense from his view. Seller has to show Buyer where Buyer can realize value. And of course, Buyer has to confirm that value proposition! (Chapter 12 offers more info on valuation.)

Don’t include an asking price in the offering document. You want the other side to make the first move. If you as a Seller provide an asking price, you’ve merely set the maximum price. Buyers probably won’t be willing to pay more. Worse, if you give one price to Buyer A and Buyer B ends up paying more, Buyer A will rightfully be upset because Seller provided information that turned out to be moot.

Despite the fact that Buyers do far less work regarding the offering document — they just have to read it — few Buyers do actually go through it. Some Buyers (and I mean decision-makers) do actually read it closely, but many others merely scan the document and have a junior team member do the actual reading and provide a synopsis, quite often verbally during a meeting.

So why write a document most people don’t read?

First, writing an offering document often becomes an introspective journey for a Seller. The exercise reveals details about his company, the operations, what works, what can be done better, and what should not be tried again. In creating a roadmap of value for a Buyer, the Seller is able to understand his company, market, and industry.

In fact, during many of the sales processes that I’ve run, the Seller almost always remarks that although the exercise of compiling the book was a pain, it was ultimately worthwhile because he learned about his company. More than one has said, “If I knew then what I know now, this company would be bigger and better.”

Second, even though Buyers often don’t spend much time with the book prior to management meetings, they refer to it constantly as they craft offers. The offering document becomes a reference guide for the Buyer. The Buyer flips back and forth searching for specific bits of information as he contemplates what offer makes sense.

The following sections detail what goes into an offering document. The order that I list the offering document’s contents in isn’t set in stone. Don’t worry about following my list exactly; instead, just make sure your offering document addresses each of these areas.

Compiling the Executive Summary

Put your brain in the way-back machine and think about what your high school English teacher told you about writing a theme paper: Start big, narrow your focus, introduce the thesis, prove the thesis, and conclude by widening narrative. Your offering document should begin with an executive summary that follows that same rhythm. The executive summary is the big picture overview of the offering document. It includes the thesis, Seller’s rationale for seeking a deal, and some thoughts on the type of transaction Seller would find agreeable. The following sections delve into those parts.

The thesis

The thesis is your central argument — the value proposition for Buyer and the aspect of the deal you want to tout. When you’re selling a business, you need to have a thesis; you can’t maximize value in a transaction unless you provide Buyer with specific examples of the value she can gain. Seller’s thesis should be Buyer’s opportunity.

Highly profitable companies are often best sold based on multiples of EBITDA; the industry standard magic number is five times (5X) EBITDA. (Head to Chapter 12 for more on multiples and valuation.) It’s the easiest valuation technique for Buyer to understand (and obtain financing for).

In the following sections, you find some common examples of different possible theses. Take a look-see, think about your specific situation, and then consider what may be the best thesis to extract the most value for both you and Buyer.

You don’t need to limit yourself to a single thesis; feel free to pick and choose more than one.

EBITDA thesis

EBITDA is probably the most common investment thesis. Actually, EBITDA is a de facto default setting in the brains for most business people; you can say it’s hardwired into their brains, and for good reason.

EBITDA is a measure of profitability, and profits are the ultimate measure of a company. Bank loans are often based on EBITDA; maintaining a certain level of EBITDA is a condition of a loan. The business world is just plain mad for all things EBITDA, and therefore, EBITDA is simply a generally accepted business convention.

EBITDA theses come in a few flavors. They’re all similar because they use EBITDA as a basis for valuation, but they differ in the timing for the measurement of EBITDA.

Most recent complete year: In many cases, the valuation is based on the most recent year’s EBITDA. This method produces a static number; because deals take months to complete, Buyer may want to obtain financial updates to make sure the company suddenly doesn’t take a nose dive in terms of profits. However, the most recent complete year EBITDA can provide the basis for an offer.

Trailing 12 month (TTM): This thesis is based on the EBITDA for the trailing (most recent) 12 months; the valuation isn’t static like the most recent complete year figures, so it may fluctuate up or down depending on the continuing performance of the company.

Forward EBITDA: In this case, all or part of the valuation is based on the future performance of the company. Forward EBITDA is a good thesis when an earn-out or some other form of contingent payment is part of the deal because if Seller is asking for a valuation based on the future performance of the company, he should be willing to put his mouth where his money is.

Contribution margin thesis

With the contribution margin thesis, Seller is essentially telling Buyer, “Pay no attention to the lack of profits behind that curtain.” Instead of focusing on the bottom-line profitability, Buyer considers the effects (that is, benefits) of adding the Seller’s “contribution” to the Buyer’s existing operation.

What is contribution? Definitions vary, but essentially, contribution is sales minus direct costs for those sales. Direct costs include the cost of goods, as well as any sales or marketing costs in SG&A (selling, general, and administrative).

As an example, say a company has revenues of $40 million and is losing $2 million a year. Assume the direct costs associated with those revenues are $18 million. The gist of this thesis in this case is to say to Buyer,

“Look, we know our company as-is is unprofitable, but instead of taking the entire company, what if you only take the client relationships and corresponding revenue and move operations to your facility? If you do that and subtract only those expenses directly related to those revenues, you pick up $40 million in revenue and realize a $12 million contribution before your costs. I know you’d have other expenses, but how you run the business is up to you. What is that $12 million of contribution worth to your company?”

The key to this approach is the realization Buyer is already spending money on operations, and adding the acquisition’s contribution to the mix will have little or no impact on expenses.

Buyers are unlikely to pay the standard 5X multiple on a contribution margin, but 2X may be a reasonable amount.

Companies with thin profits (or losses!) are typically prime candidates for the contribution margin thesis because a company with thin profits or losses doesn’t fetch much if the valuation is based on the bottom line. Contribution margin focuses on something other than the bottom line and asks Buyer to pay based on that alternative.

However, companies with a product that clients view as a commodity aren’t suitable candidates for a contribution margin approach because their products aren’t considered different or unique, a situation that makes a contribution margin approach difficult. Buyer is unlikely to pay a premium for a company that’s a dime a dozen.

Gross profit thesis

Very simply, the gross profit thesis asks Buyer to value the business based on the gross profit (revenues minus the cost of sales). This thesis is similar to the contribution margin thesis in the preceding section and in some cases may be exactly the same. In this approach, a 5X multiple is probably out of the running, but a 1X or 2X multiple may be possible.

The gross profit thesis may be a suitable solution for another problem: structuring an earn-out. See Chapter 12 for more on earn-outs and other contingent payments.

Top line revenue thesis

As simple as it gets: This thesis is a valuation based on top line revenue (gross revenue). Similar to the contribution margin thesis, Buyers probably won’t pay 5X EBITDA; a 1X multiple is usually a pretty strong valuation.

The top line sales thesis makes a great way to measure an earn-out.

Asset value thesis

Instead of basing the valuation on some sort of measure of cash flow, asset value thesis uses the value of assets. This type of valuation is another way to create value for a profit-challenged company.

When using asset value, do not use the depreciated value of assets, use the replacement cost of assets. Companies will have accumulated depreciation on their books. Add that back or do some research and determine the replacement value of those assets. Also, for those of you delving into cross-border deals, Chinese Buyers rarely look at cash flow as a valuation technique and instead prefer asset value.

Strong customer base thesis

This thesis moves out the realm of measureable accounting results and firmly places us in the touchy-feely, “gosh darn it, people like me” world of intangible valuation techniques. So burn some incense, put on your Ravi Shankar LPs, and dig it, man!

With this thesis, Seller is asking Buyer to consider the strength of the customers. Strength can mean both size/purchasing power of the customers as well as the point of entry to the customer — the higher up the corporate food chain, the more valuable the relationship. A Seller who has C-level contacts (folks with Cs in their titles, such as CFOs) has more-valuable customer relationships than a Seller who sells to low-level associates.

Recurring revenue thesis

A company with recurring revenue (revenue that automatically generates, such as that from fees or subscriptions) is often a more-desirable buy than a company where the sales force has to make new sales every year, month, or week. Many Buyers are often willing to pay a premium for that consistent revenue stream.

Just an old fashioned growth story thesis

This thesis is the ol’ venture capital, “we’re going to take over the world” story. Sure, the growth story deal often results in a flameout, but certain investors are willing to pay a hefty premium for a company that touts an incredible ability to grow.

I don’t recommend the growth story thesis for owners who want to retire or otherwise take some chips off the table. When an investor puts money into a growth story company, that means the money stays with the company to pay for growth! The ability for Seller to garner a premium by selling a growth story company and pocketing that money are extremely remote.

Synergies thesis

Otherwise known as the “You complete me!” thesis, the synergies thesis is a situation where 1 + 1 = 3. Two companies, perhaps in the same industry or closely related ones, have certain strengths and certain weaknesses that complement each other such that the result is greater than the sum of its parts.

For example, suppose two companies are in the auto parts distribution business. One company goes to market through a catalog, has a world-class distribution center, and a strong customer service department. However, competitors who are excellent Internet marketers are eating it alive. The second company is an ace at Internet marketing but lacks a customer service department and relies on a very expensive outsourced distribution center.

In this example, the second company may be willing to pay a premium to buy the first company to fill in its own weak spots. The two companies are stronger together than they are separately.

Deals with this thesis can be extremely tricky to negotiate. Most often, Seller needs to tailor a specific message to each potential Buyer; after all, not every Buyer needs the same weakness addressed. Don’t make up a story; just realize that different Buyers may view different aspects as the most valuable.

Seller’s rationale for seeking a deal

A well-written offering document should provide Buyers with information about Seller’s reasons for selling (I discuss common motivations in Chapter 2).

As Seller, communicating your motivation is important because doing so helps Buyer determine whether pursuing a deal makes sense. A Buyer who needs the Seller to stay on board to run the business is unlikely to bid if the deal involves the owner’s retirement.

When selling a business, don’t sound desperate when listing your rationale. Doing so gives Buyer the upper hand in negotiations because he knows you need to unload.

Seller’s deal guidance

The transaction guidance portion of the offering document indicates the type of deal that interests Seller — that is, how much structuring (notes, earn-outs, and so on) if any he’s willing to accept, whether he strongly prefers cash at closing, whether he needs or prefers an asset deal or a stock deal, and so on.

I don’t recommend providing a price in the book. Doing so places a ceiling on the valuation, and Seller runs the risk of leaving some money on the table. Also, providing a price may inadvertently provide Buyer with the wrong guidance. A Buyer who submits an offer by matching the listed price will be rightfully upset if the company is sold to someone who submitted a higher bid. The snubbed Buyer may have been willing to submit a higher bid but decided to follow the guidance of Seller.

Presenting the Company’s Background

After the executive summary provides the rationale for seeking a deal and provides some rough ideas on what a deal would look like (see “Compiling the Executive Summary” earlier in the chapter), the next section of the offering document provides basic information about the company: past, present, and future.

I call this section the B and B section: the basics and the bragging. Learning the basics helps Buyer understand the company and whether it’s a right fit. It’s much like dating.

As for the bragging, Seller’s touting the company’s achievements gives Buyer something to brag about post-sale. Perhaps more importantly, the representative for Buyer may need to get final approval from someone higher up the food chain, and being able to brag about the great accomplishments of a target helps with that internal sales pitch.

When I say “bragging,” I’m not suggesting you take license and devolve into full-blown Seller hyperbole! Subjective comments aren’t readily provable and more often than not make you sound like a huckster. Instead, focus on making accurate and objective comments about your business. Quiet confidence and actual results go a long way toward getting Buyer to make a deal.

The company’s past and present

An accurate assessment of the company’s history (good, bad, or in between) is a necessary part of the offering document. Having a solid understanding of where a company came from and how it developed can help Buyer understand the company.

Consider the following questions as you write this section of the offering document:

How was the company founded, and how did it grow? Is it still growing or has it run into some recent challenges?

What are the great successes and the problems, and how did the company overcome those problems?

What is the company’s current situation?

Providing a timeline is a great visual tool and a quick way to point out key events in a company’s history: new products, financial milestones, past acquisitions, and so on.

Ownership and legal entity

Who are the owners, what do they own, and how much does each owner own? Okay, that sounds like a tongue twister, but furnishing ownership information to Buyer is extremely important because most offers actually reference the ownership.

Another important consideration is what type of entity the company is. Is it an LLC, S-corp, or C-corp? Should any other affiliated or related entities be a part of an offer (or should they not)?

If Buyer is buying the stock of Seller’s company, Buyer needs to understand what entity owns what assets. For varying (often tax-related) reasons, a company may be comprised of two or more related entities. Buyer needs to make sure the stock he is buying actually has title to the assets of Seller’s business.

Employee info and benefits

A company with products and customers isn’t a company unless it can sell, service, account for, and otherwise take care of those customers and run the business. Because droids and clones are still a few years away, most companies have to use this creature called people. Perhaps you’ve heard of it.

For many (if not most) companies, the largest, single expense is personnel, so not surprisingly, a discussion of people, pay, and job duties is mandatory in the book. A book should list the total number of employees, the headcount per department, and provide a salary and wage ranges per employee, department, or employee type. It should also include bios for the key employees, which typically includes the executives, key managers, and perhaps certain other employees (such as sales and product development).

Including an organization chart is often a good idea. Specific names don’t need to be divulged in the offering document. Instead, listing the employee’s title is sufficient.

An offering document should provide detail on the health plans, retirement plants (401k and the like), and vacation, sick day, and holiday policies. These plans may or may not match with Buyer’s company, so Buyer needs time to plan accordingly and make adjustments if warranted.

Vacation can be a small but serious sticking point when buying a company. If Seller owes employees a certain amount of vacation time, Buyer may insist that the value of that vacation time be deducted from the sale price. The logic is if the employees used that vacation time prior to the close of the sale, Seller would have to pay for that time off. You can find the value of this vacation time lurking on the balance sheet in the liabilities section, most often called “accrued vacation” or something similar.

Locations of offices and facilities

The offering document needs to list all distribution and manufacturing facilities, including square footage as well as the number of employees at each location. Buyer may need this information as it considers how best to integrate the acquisition and the parent company.

Many salespeople work remotely. Seller should list any and all remote workers, the city where each person resides, and a description of the person’s duties and/or sales territory.

Real estate

If Seller owns the real estate where the facility is located, she may be interested in selling the business but retaining the property and having the new owner pay rent. This situation is very common and in many cases is Buyer’s preferred method. If Seller wants to sell the land as part of the deal, that sale is usually a separate deal.

Use a real estate agent to sell land or real estate; M&A intermediaries (investment bankers or business brokers) aren’t usually licensed real estate agents.

Technology

Buyers need to know Seller’s computer systems, software, phone systems, Web sites, domain names, and anything else technology related. After all, if Buyer is going to someday run Seller’s business, Buyer needs to know how Seller runs it.

Legal disclosures

Major areas of legal disclosure include safety, environmental, and tax issues. The company should mention any lawsuits to which it’s a party. Unless a company has specific issues to disclose (and it should disclose any and all issues), this section is a very quick read. Essentially, Seller says, “Ownership has no knowledge of any problems” or “Ownership believes it’s in compliance with . . . .”

Sellers should speak with their legal advisors about proper wording of any legal disclosure.

Sharing the Go-to-Market Strategy

An offering document isn’t just all numbers and accounting and EBITDA; a good deal book needs to describe the company’s go-to-market strategy, commonly called sales and marketing. The following sections focus on some considerations to keep in mind when creating or reviewing the sales and marketing section of an offering document.

In addition to providing information about sales and marketing, a good offering document should provide the Buyer with information about the sales by product line and/or sales by customer, though it shouldn’t use specific customer names at this juncture. See the later section “Customer names” for more on the to-name-or-not-to-name issue.

Description of market and products

A company exists to sell a product and/or offer a service, so the offering document should reflect careful attention to the explanation of the selling company’s product/service, customers and suppliers, and sales and order processing. The following sections outline some basic questions Seller needs to answer regarding each of these categories.

Product/service

I doubt Sellers are shocked to find that Buyer is interested in buying the company because of its products or services. With that in mind, the offering document needs to provide plenty of information about products and services, including answering the following questions:

What is the product or service? What does the company sell? The offering document should provide details about this most basic aspect of the company. You may think this information is something Buyer should already know, but remember that Buyer likely has multiple decision-makers, and some of the people reading the offering document may not have been involved in the early discussions and therefore may not know anything about the company.

What is fueling growth? If sales are stagnant (or falling), what factors cause that? Providing Buyer with some insights as to market trends and challenges is important in helping Buyer understand the value drivers for a company.

Is any portion of the revenue recurring? Recurring revenue is often the holy grail for acquirers. A company with high percentage of revenue that recurs month after month or year after year may be able to garner a higher valuation than a company that starts each month at zero.

You may also hear that a company scales very well. Scale can mean recurring revenue; in other words, after a salesperson has made a sale, she doesn’t need to go back and sell that same customer again and can instead focus on winning new customers. Scale can also mean very large sale prices. For example, a company that sells $1 million pieces of equipment probably scales better than a company selling a $10 widget.

Does the company experience any seasonality? In other words, are sales stronger during certain parts of the year and weaker in others? Buyer needs to know about seasonality so that it can plan accordingly. For example, companies with extreme seasonality may need a credit line. The company will tap the credit line during the slow season(s) and pay off the line during flush times.

How many product offerings does the company have? If the company offers a physical product (as opposed to a service), how many stock keeping units (SKUs) does it sell? A stock keeping unit is simply a number assigned to a specific product; the more SKUs a company has, the more different products it can offer its customers.

A high number of SKUs can be a warning sign for Buyer because too many SKUs may mean the company is spread too thin or is stocking a lot of slow-moving inventory. Slow-moving inventory can be a waste of cash. Too many SKUs can also be an opportunity for Buyer because Buyer may be able to eliminate this slow-moving product and improve the efficiency and profitability of the company. What constitutes too many SKUs depends on each specific industry and each specific company.

Customers and suppliers

Having products and services without customers to buy them makes no sense, so as Seller, you want to give some information about customers in the offering document. Additionally, you need to provide some detail on your vendors and suppliers; you have to get those products or raw materials from somewhere! Here are some topics to consider in this section of the offering document:

Who buys the company’s products/services? Because a company is a pipe dream until it has actual paying customers, Seller needs to describe its customers to Buyer. Depending on its needs, Buyer may want access to new customers or to be familiar with the customers.

What is the demographic of the customer? Are the customers businesses or consumers? Is this demographic growing or shrinking? What sort of macroeconomic factors affect these customers?

Where does Seller fit in its sales channel? An offering document should describe a company’s sales channel. Is it a supplier of raw materials, a manufacturer, a distributor, or a retailer? Does it offer a service to other companies or consumers? In other words, where does the company obtain the materials used to fabricate its end product? Who does the company buy from, who does it sell to, and who do those customers sell to?

Does the company have any customer concentration issues? Flip to the section “Income statement basics,” later in this chapter, for more on customer concentration.

If a customer that accounts for a big chunk of revenue is a large company (say, Fortune 500 size), you may be able break out the specific divisions and the corresponding sales to substantially lower the concentration issue.

Sales and order processing

Products and services are wonderful. Suppliers and vendors are great, too. But all of those products, services, and raw materials don’t amount to a hill of beans without the ability to sell them. Buyers want some detail on sales information, so the offering document needs to cover the following:

How does the company go to market? Does it utilize a direct sales force, e-mail, Internet, other social media, catalog, and/or word of mouth?

Who are the key salespeople? What are their backgrounds and experience?

How are orders taken: phone, fax, e-mail, or in person? Does the company have a dedicated customer service department?

What are the company’s terms of sale? How does the company get paid: credit card, cash, check, or wire transfer?

What is the average transaction size?

Customer names

As Seller, should you provide customer names in the offering document? Yes and no. In other words: It depends. I provide both sides of the argument here; read both bullets and pick the option that best suits your situation:

No: Customer names should not appear in the offering document because they’re a highly sensitive bit of information, especially if Seller’s direct competitors are reviewing the offering document.

Yes: If Seller’s Web site or existing materials list customers or if the names of certain customers are otherwise public information, specifically mentioning those customers doesn’t hurt, especially if the customers are of the large and extremely well-known household names.

Whichever argument you follow, providing a full customer list in the offering document isn’t a good idea because you should disclose detailed customer information (name, amount of annual purchases, and so on) only after you’re reasonably certain Buyer will close a deal. For this reason, I always recommend Sellers wait until near the end of due diligence before providing the full, detailed customer list to Buyer.

Info about competitors

The offering document should also include information on Seller’s competitors. Seller needs to demonstrate to Buyer that it understands the competitive landscape. Additionally, this information may help a Buyer who’s new to Seller’s specific industry get an overview of the main competitors and assess the competitive risks.

In addition to listing competitors, the offering document should provide some insight into each competitor’s relative strengths and weaknesses, revenue size, and percentage stake (roughly) of the market.

Note: If one of the listed competitors is also reviewing the offering document, that competitor instinctively goes to the competitor section and corrects, contradicts, or otherwise chuckles about whatever the entry says. No matter what Seller writes, the competitor will take some sort of umbrage with it. Wouldn’t you?

Doing the Numbers

Numbers don’t necessarily speak for themselves, and Buyers don’t want to have to translate them, so you as Seller should take care to present your financials in the offering document in the best light possible, as the following sections demonstrate.

You can’t get around dealing with accounting and financials in the offering document, so make sure whoever is compiling this part of the offering document has strong accounting skills.

Historical financials

I recommend an offering document have at least three years of historical financial results; five years is much better.

An offering document with three to five years of financial results helps Buyer better understand the recent trends of the business. Some of the key historical financial aspects include

Are sales increasing or decreasing? What about profits?

Is the company maintaining its gross margin?

Are any operating expenses getting out of control?

How much working capital does the company have?

Does the company collect accounts receivable in a timely fashion and pay its bills on time?

Does the company have long-term debt, and will that debt get in the way of doing a deal?

Make sure you include a full set of financials: income statement, balance sheet, and cash flow statement.

When presenting financials, present the numbers down to an EBITDA calculation. If the company has substantial add backs (nonrecurring, one-time only, or owner-related expenses), include those add backs in the historical and current financials. Make sure you provide details of what exactly those add backs comprise.

The add back machine: What’s legit and what’s not

An add back, for the uninitiated, is an expense that is added back to the profits (most often EBITDA) of the business for the express purpose of improving the profit situation of the company. It’s a bit of alchemy; when you toss in enough add backs to the profits of a company, you turn EBITDA into the mythical “adjusted EBITDA.”

The theory behind these add backs is that these expenses are purported to be extraneous, one-time, and/or “owner’s” expenses. In plain English, these add back expenses will either go away once the company is in the hands of the new owner or won’t be incurred again.

Some legitimate add backs include the following:

Adjustments to owner’s compensation: Many owners of closely held companies, especially successful and highly profitable ones, give themselves outsized salaries and bonuses. Nothing is wrong with that, of course, but an acquirer is unlikely to pay that kind of compensation to the new president (and other execs). For example, if a reasonable salary for the president of a certain-sized company is $150,000 but the owner of such a company paid herself $500,000, a legitimate add back would be $350,000. This add back means EBITDA would improve by $350,000, thus improving the potential valuation for Seller and providing a roadmap of greater profitability for Buyer.

Taxes and benefits: If making add backs for adjustments to owner’s compensation, make sure to add back the corresponding taxes, too. If an owner and/or other employees are leaving the company post-acquisition, the benefits these people were paid may be appropriate add backs, too. The main benefit for most owners is insurance. If the owner won’t be replaced, the full amount of insurance can be added back; if the owner will be replaced, the replacement insurance package may not have all the bells and whistles of Seller’s plan.

Severance and lawsuit settlements: Severance payments and lawsuit settlements may be cause for further due diligence on behalf of Buyer, but these payments can be another example of a legitimate add back, assuming these sorts of payments are truly rare and unusual for the company.

Personal expenses: Running personal expenses through the company is a common occurrence in closely held companies. These companies often practice the so-called Family Accepted Accounting Principles, or FAAP (to use some slang), in addition to (or in replacement of) Generally Accepted Accounting Principles (GAAP). If an acquired company does utilize FAAP, these personal expenses are a legitimate add back because the new owner won’t continue to incur these expenses. Note: FAAP is firmly a gray area for taxation, so speak with your accountant as to the proper treatment of these expenses.

Disclaimer: Mergers & Acquisitions For Dummies doesn’t suggest owners should engage in FAAP. Instead, the author realizes these expenses are often included in a closely held business’s income statement.

Personal expenses may include the following:

The clubs (hunting, country, health, and so on)

Owner’s car expenses (monthly payment, insurance, gas, and so on)

Family members on the payroll

Travel, meals, entertainment for personal use, not business purposes

Any other expense that is personal in nature and not a business-related expense

So, what add backs aren’t legit? This group is a little more difficult to quantify because types of expenses are virtually limitless. Instead, apply a simple two-part rule of thumb:

If one-time-only expenses show up on a company’s income statement year after year, they aren’t one time; they’re recurring and therefore not a legitimate add back expense.

If the company will incur add back expenses post-acquisition, they aren’t legitimate add backs.

Buyers, pay close attention to Seller’s add backs. Don’t be afraid to challenge Seller as to the legitimacy of the add back. And Sellers shouldn’t try to add back expenses that will not go away post-closing. Add backs that aren’t legitimate are expenses that the company will continue to incur, even after a sale transaction.

Financial projections

Ideally, an offering document should have five years of projections. I know that’s a lot of work, especially when projections are taken with a grain of salt, but Buyer should be able to get a good sense of where you think the company is headed.

Your projections should include a narrative explaining the assumptions you used to create them. For example, explain your rationale for revenue increases and how expenses are related to those revenues. Achieving the projected numbers is imperative, so you’re much better off to project low growth and beat that projection than to project rapid growth and fall short. You’re sure to create problems for yourself if you pad your projections to an unobtainable level. Not achieving those higher projections often leads to a lower sale price. Plus, Buyers are on the lookout for overly rosy projections and may discount projections that the historical financials don’t support. (See the preceding section for more on historical financials.)

Another important figure in the projections is CAPEX. CAPEX (short for capital expenditures) occur when a company makes some sort of investment in itself. Instead of immediately expensing the expenditure, thus reducing profits by the full amount of the investment, a company may be able to capitalize the expenditure and write off the expense over a period of time. Examples of CAPEX include anything that will be used for a long period of time: computers, software, furniture, improvements to the facilities, manufacturing equipment, and so on.

For example, say a company pays $1 million for a piece of equipment with an expected useful life of ten years. Writing off the full cost of the equipment in year one doesn’t make sense because the equipment will be used for nine more years. Instead, the company writes off the amount of the equipment used each year, or $100,000 per year. This write-off is called depreciation.

Because annual capital expenditures are not captured in the venerable EBITDA calculation, Buyers should take a close look at a company’s CAPEX needs to fully understand the true cash flow of the business.

Balance sheet basics

One of the most important figures from Seller’s balance sheet is the company’s working capital. For the purposes of M&A, working capital commonly means current assets minus current liabilities. Typically,

Current assets = accounts receivable + inventory + prepaid expenses

Current liabilities = accounts payable + short-term debt + current portion of long-term debt + accrued (unpaid) expenses

For the purposes of M&A, you don’t include cash and equivalents in this calculation. However, for accounting purposes, you do include them.

Working capital is important because it represents the liquidity of the company. All current assets should be convertible into cash within 30 days, and all current liabilities should be able to be paid within 30 days.

Buyers, eye the balance sheet carefully to see whether the company you’re looking to acquire is sufficiently undercapitalized, has a reasonable reserve against bad (uncollectable) accounts, and has its current liabilities all within terms. If any of these items are remiss, you may be taking over financial trouble.

Depending on the nature of the business, working capital may have some seasonality. For example, retailers typically have very strong fourth quarters as their sales are driven by the gift-giving season. Other companies experience peaks in late summer with the back-to-school season. As Seller, you want to spell out how this seasonality affects working capital so that Buyer gets a more accurate view of your company’s situation.

Income statement basics

The selling company’s income statement contains lots of important information for the offering document; check out the following sections for some notable income metrics.

Be sure to distinguish in the book which party gets any cash on the books. In most cases, cash belongs to Seller. If a company has $500,000 in cash and is selling for $5 million, Seller receives $5.5 million (before taxes, expenses, and advisor’s fees, of course).

Recurring revenue and customer concentration

Recurring revenue is always a plus for a company, and Sellers are wise to mention the amount of recurring revenue in the offering document because it may increase Buyer interest and therefore the offer price.

Another metric, customer concentration, is the opposite of recurring revenue. If a company has highly concentrated sales (large amounts of sales with one customer or a small number of customers), Buyers may be less inclined to pursue a deal or offer a high price. Customer concentration is a bit of a slippery eel to grasp and define, but generally speaking, if a single customer accounts for more than 20 percent of revenue, or if a small number of customers (three to five) accounts for more than 50 percent of revenue, the company may have a customer concentration issue.

If Seller doesn’t have a concentration issue, that’s a key selling point definitely worth mentioning, if not touting, in the offering document. If Buyer cannot ascertain any customer concentration issues (after reading the offering document), Buyer should make a point to ask Seller about customer concentration during a follow-up phone call or e-mail.

If you do have a customer-concentration issue, try to mitigate that issue. For example, if a single customer accounts for 40 percent of revenues but is a large, multinational conglomerate with multiple decision-makers in multiple offices, point out this distinction to Buyer. In this example, you can argue that 40 percent of revenue is not under the control of a single decision-maker, thus mitigating some of the risk of the concentration.

Gross profit, gross margin, and SG&A

Gross profit is the amount of revenue that remains after the cost of producing sales is subtracted. For example, if sales are $100 million and the cost of goods sold is $40 million, the gross profit is $60 million. Gross margin is the percentage calculation of gross profit. In this example, the gross margin is 60 percent.

Contrary to popular usage, gross profit and gross margin aren’t interchangeable. Any time you see the word margin, that means percentage. Far too many businesspeople refer to gross profit as gross margin, saying, “The company has $10 million in gross margin.” Actually, the company has $10 million in gross profit. If revenues were $100 million, the company would have a 10 percent gross margin.

Gross profit is important because it’s variable — it fluctuates based on revenue levels and pricing. Gross profit needs to be high enough to cover the other costs of the business, called SG&A. SG&A is comprised of salaries, rent, insurance, utilities, supplies, and so on. Although SG&A includes both fixed and variable costs, most companies have a good idea of their SG&A, and therefore know exactly how much it needs to generate in sales to create sufficient gross profit to cover SG&A.

When companies fail to generate enough gross profit to cover SG&A, that’s a bad sign! If a company lowers its prices in order to generate higher sales, those lower prices may result in lower gross profit, and if gross profit dips below SG&A, the company is in trouble.

Other income and other expense

A good offering document should detail the nebulous “other income” and “other expense” categories. Essentially, these categories are revenues or expenses that aren’t related to the underlying nature of the company. If a t-shirt manufacturer sells a piece of equipment for $50,000, it reports that income on the income statement as “other income.” If that company also terminates an employee and pays that employee a $20,000 severance, it should report that expense in the “other expense” section. (Hopefully, firing employees and paying severance isn’t a regular event.)

Although other income and other expenses should appear in the offering document, make sure you adjust the EBITDA for those other income or other expense items. Failure to clearly delineate other income and other expenses may blur the company’s actual EBITDA (EBITDA generated as result of the company’s normal operations and not as the result of one-time expenses or income).

Losses on the books

Companies with losses sometimes keep those losses on the books, applying those net-operating losses (NOLs) against future earnings and thus reducing a future tax liability. Be sure to mention any NOLs in your offering document. In years past, Buyers were able to acquire entities with NOLs and use those losses to reduce their tax burdens. However, Congress has greatly restricted that ability, so Buyers will want to know of any NOLs upfront.

If you’re selling a business or attempting to buy a business with NOLs, speak with your tax advisor immediately.

Accounts receivable terms

An offering document should provide some guidance as to the selling company’s terms with accounts receivable. Specifically, does the company expect payment within 30, 45, or 60 days (or some other amount of time)? Does the company provide a discount for early payments (and if so, what)? What is the reserve policy for uncollectible accounts? How much has been written off due to bad accounts?

Fixed assets (equipment)

Fixed assets are the assets a company uses to make its product. These items run the gamut from desks, phones, and computers to vans, trucks, and delivery vehicles to heavy machinery and production equipment.

The office stuff (desk, phone, computers, and so on) probably doesn’t have much value to Buyer in terms of collateral for financing. Neither do the vehicles; they depreciate very quickly. However, the hard assets (the machinery and production equipment) often form the basis of assets that can serve as collateral to back a loan.

Inventory

Although not all companies have inventory (for example, consultancies and most business service firms), those that produce or distribute a product find that inventory is a key component for Buyer’s financing and thus an important note in the book. Inventory is considered a current asset, which means (in theory) that it should be convertible to cash within a short period of time, usually a month or less.

If you’re a Buyer, pay close attention to inventory. Is it all sellable? If the Seller has been building up inventory with unsellable or slow-moving stock, you may not be able to utilize 100 percent of the inventory to help with financing the acquisition.

Intangible assets

An offering document should have a listing of all intangible assets. Intangible assets include brand names, patents, trademarks, and Internet domain names — items whose value you can’t easily measure. These assets don’t usually help Buyer finance the deal, but they can still be valuable: Household names such as Apple, Exxon, and Walmart (and even smaller-market companies that are less widely known but still prestigious within their market segments) all have intangible value simply because their names are so well known.

If Seller doesn’t want to include some of these intangibles in the deal (perhaps she wants to retain a certain domain name that isn’t used), she needs to specify those carve-outs in the book.

Understanding a Seller’s vulnerability

Going through an M&A sales process in general, and writing an offering document specifically, can leave Seller feeling extremely exposed. If you’re a Seller or potential Seller, you aren’t alone! And if you’re on the buying side, take a moment to read this sidebar so you can sensitize yourself to the worries and fears of Sellers.

Sellers feel vulnerable because every decision they’ve made throughout their careers — good, bad, and everything in between — is fodder for discussion. Every problem, every wart, and every misstep that Sellers would rather forget get rehashed and brought to light. Sellers often have to explain and discuss embarrassing decisions and poor investments. It’s the ultimate mea culpa for many business owners.

But Sellers can comfort themselves with the fact that they aren’t the only ones to go through this process. Buyers are like doctors: They’ve seen it all or will at least pretend like they have.

Sellers afford themselves some level of safety by remembering the following tips:

Hire a capable intermediary: As I discuss in Chapter 5, an intermediary often acts as hand-holder for the business owner and serves as a valuable buffer. An intermediary can make the initial overtures without tipping off the fact that a certain company is for sale until a confidentiality agreement is in place, whereas the mere act of a Seller approaching the Buyer sets off the alarms.

Keep your cards close to your vest. Sellers can protect themselves through the slow, gradual release of information. Each divulgence has its time and a place.

Assume the position: At some point, Sellers have to just get over their shyness and prepare themselves to feel as if they’re being paraded naked through town, poked and prodded, and generally abased and abused. It isn’t pretty, but it’s what happens!

Buyers, be cognizant of these feelings, too. Be gentle! Buyers should only ask for documents and information needed to close the deal.