Customer Concentration

Mike Sullivan - Thursday, March 01, 2018

A crucial red flag when evaluating a new acquisition target is a lack of customer diversification. Companies that have customer concentration greater than 20% may pose a significant problem for a buyer.  The nature of the relationship between the company and its large customer(s) need to be fully vetted before finalizing a purchase price and capital structure. The buyer must weigh all the positives and negatives discussed below.

Having one or several large customers can be beneficial with the right circumstances. If a company has a patented product that is integral to the success of its customer, then there is limited risk of losing that customer. A company and customer could also have a special relationship between principals that would be difficult for competitors to usurp. Most importantly, if long-term non-cancellable contracts are in place, there is generally a lower risk in turnover.
Unfortunately, the risks surrounding customer concentration usually far outweigh the benefits. Typically, any loss of business from a major customer will be magnified. A 20% customer probably accounts for 30% or more of profitability due to overhead absorption and production efficiencies (i.e., fewer stoppages and setups).
If the product being purchased is commoditized or has limited differentiation to its competition, then a change in purchasing agent or ownership of the customer could drastically change the levels being purchased. The new purchasing agent may not like the sales person, or they may have a better experience with a competitor. If new ownership steps in they may want to re-bid all vendors and a competitor with a lower price point could prevail.
The strength and position of the customer also will impact the company. If the customer’s business slows down, they will most likely buy less with its vendors. As mentioned above, any loss of business from a large customer is likely to impact margin more than losing business from smaller customers.
Lastly, if the product or service the company offer is re-engineered or becomes obsolete because of changing times/technology, the company will be impacted significantly to the downside.
At Westshore, customer concentration is one of our key filters when processing potential acquisitions. We typically won’t pursue any deal with customer concentration greater than 20% unless it displays one or more of the positive aspects listed above. Even so, any offer made for a company with customer concentration will come with an earn out predicated on the future profitability of the largest customer(s).

Buyer's View of Real Estate

Mike Sullivan - Thursday, August 17, 2017

As we have noted in prior perspectives, there are many things to consider when buying a business. One item that does not always get the attention it deserves is the real estate of the business. First, you must know if the business owns or leases the property and understand the pros, cons, and valuation impacts to each scenario. Second, assuming the business leases its property, you need to understand the type of lease it is contractually tied to and its terms.

Lease vs. Own

Owning property as a business owner is not the same value proposition as owning a home personally. There are pros and cons to owning that need to be fully weighed before deciding how to structure a transaction for a business. The positives are simple: you have more collateral to support the borrowing capacity of the business, and as you pay down the mortgage, you build equity value in hopefully an appreciating asset.  Owning the property also gives you flexibility in customizing the space, and potentially expanding it without having to get approval from the landlord.

The downside to owning is it requires additional equity capital associated with an asset which has a lower IRR than the business, and thereby, lowers the overall IRR of the investment. When selling the business in the future, the next buyer may not want to purchase the real estate, the business could have out-grown the current space, or the location may be inconvenient or unattractive to the labor pool required for the business.  All these factors need to be evaluated when considering owning real estate.

Leasing a facility comes with its own set of positives and negatives. As a lessee, the business is not necessarily tied to its facility long-term and has the option to renew its lease or move to a newer building/area better suited for its needs.  Additionally, the business has limited liability for capital expenditures associated with the normal aging and wear and tear associated with an older property.  The negatives of leasing are the landlord my not want to renew the lease or can escalate the rent, thereby making renewal cost prohibitive and forcing the business to relocate when it does not want to. Moving a business is challenging, costly, and comes with many headaches.

Types of Leases

There are three main types of leases: Non-Triple Net (or Gross), Triple Net, and Absolute Triple Net.

The Non-Triple Net (or Gross) Lease is a lease agreement between the lessee and lessor where all costs and expenses of the lease are included in the monthly base rent. The lessee pays the agreed upon rent and nothing more. Everything is included within the monthly rent, outside of the lessee’s customary obligations to maintain the leased premises. Base monthly rent under a Gross lease is typically higher than base rent under a Triple Net Lease, as all landlord costs and expenses are included.

A Triple Net Lease requires the lessee to not only pay the base rent, but also its proportionate share of the real estate taxes, building insurance, and basic repairs and maintenance to the building. Because the lessee is paying separately for the costs and expenses incurred by the lessor, the lessee generally pays less in monthly base rent than in a Gross lease.

The last and most onerous type of lease is the Absolute Triple Net Lease. This type of lease has the same stipulations as the Triple Net, except the lessee is responsible for virtually ALL structural repairs to the building and surrounding property. For example, if the building foundations, driveways, sewer lines, or roof deteriorate and needs to be replaced, these costs become the responsibility of the lessee. The lessee has the responsibility of an owner, but without the benefits of ownership.  This type of lease is very common with property that has related party ownership with the business or has gone through a sale-leaseback transaction, both situations where the terms of the lease are generally more favorable to the lessor.

Terms of Leases

Whether a buyer is assuming a lease as part of a transaction or renegotiating the lease terms at the expiration, there are six key items to consider.

Annual Increases. Understand the magnitude and timing of any increases to rent. Look for comparable market terms in the area.

Taxes. Understand the assessment of the property and verify the business is not paying an overburdened tax bill.

Common Area Maintenance (“CAM”). These charges typically include costs to maintain the building like landscaping, snow removal, janitorial services, common area utility costs and general repairs to the building shared by all the tenants. However, a lessor may include additional items into this category such as cost sharing on roof repair and replacement, HVAC systems, capital improvements, lighting, plumbing, or electrical wiring.

Expiration and Renewal. Understand when the lease ends and how it will affect the business. If the business needs flexibility, it should look for a short-term lease. If the business needs a guarantee of longevity in the building, then look for renewals that have longer-term provisions.

Tenant Improvement Funds. These are funds given to the lessee to improve or potentially fully build out the space in a desired fashion. Typically, this will increase the value of the space for the lessor so they should be amenable to most changes. These funds are usually given at the renewal or start of a lease and will include new carpet, paint, and office buildouts.

Indemnification. This is required before acquiring a company that leases the building from a related party. The seller of the business (or related party) needs to indemnify the buyer from any material problems with the building or property.

There are many factors to consider in the lease versus own debate. In general, many buyers prefer to rent versus own, and it creates a cleaner transaction. 

Debt Impacts Valuations

Mike Sullivan - Thursday, May 11, 2017

Valuing and financing a company is more complex than using a discounted cash flow model or market comparable EBITDA multiples. Unlike certain outliers (looking at you Tesla), debt compliance plays a major role in valuing a company. Fixed charge coverage ratios, leverage ratios, weekly or monthly borrowing base calculations, and capital expenditure caps all play a major role in determining how much debt can be borrowed versus the equity needed to close a transaction.

As a buyer, modeling the capital structure of a transaction goes beyond calculating the projected IRR of an investment. Rather, a buyer needs to understand the monthly working capital requirements of a business, its after-tax cash generation capabilities, and its liquidity. Businesses that are seasonal, cyclical, and have high working capital requirements, tend to be valued less because excess free cash flow is less, if not zero. A buyer needs to know (i) how much a business can draw on its revolving line of credit to fund growth, seasonality, or illiquidity, and (ii) can a business make its interest, principal and capital expenditure payments in an expanding or contracting market.

Buyers typically use a combination of revolving/asset-based debt, senior debt, and subordinated debt to fund transactions. Each type of debt has certain terms, costs, and covenants that must be met to avoid a credit default or a liquidity crisis.

Revolving or asset-based credit financing uses a company’s accounts receivable and inventory as collateral for the loan amount, and establishes a borrowing limit based on the assets quality, age, location, salability, and liquidation value. These items affect the borrowing capacity of a company because “advance rates” on “eligible” accounts receivable and inventory determines how much a company can borrow. For example, the Company may have a revolving/asset-based credit facility of $10 million, but based on the characteristics of the accounts receivable and inventory, the Company may only be allowed to borrow half of that amount or less. Revolving/asset-based credit is not permanent capital and is subject to limitations and quality restrictions. Having a line of credit does not mean you have access to it, nor use it to finance an acquisition.

Both senior debt and subordinated debt are considered long-term debt (greater than three years) supported by all the assets of the company, whether tangible or intangible, as well as a pledge of the company’s stock. Typically, senior debt lenders provide the revolving/asset-based credit and have first lien on all the assets of the company, while subordinated lenders are typically uncollateralized and considered having a second lien on all the assets and stock. Commonly, the amounts loaned are more than what the lenders could recover in an orderly liquidation. The lenders monitor the liquidity of the business and the cash flow generation capabilities with various financial ratios and restrictions, such as fixed charge coverage ratio being greater than 1.15, senior debt ratio not exceeding 2.50, total leverage ratio not exceeding 4.00, and many others. These ratios are based on the company’s negotiated adjusted and projected EBITDA for the business (please see April’s perspective Adjusting and Normalizing EBITDA for more details). For future years, the financial ratios become more stringent (increases or decreases based on the ratio), thereby holding a buyer accountable for the representations and projections that the business can generate the cash needed to meet all operational, tax, and debt obligations.

In summary, a buyer’s diligence of a company’s historical profits, quality of assets, and projected earnings provided by a seller affects the amount of debt a buyer can borrow, the amount of equity to be invested, and the potential equity return (IRR) on invested capital.

Adjusting and Normalizing EBITDA

Mike Sullivan - Tuesday, April 25, 2017

Adjusted or normalized EBITDA is one of the components in determining a company’s valuation, as well as establishing debt financing and its various loan covenants. Once Adjusted EBITDA is established through a quality of earnings analysis, it becomes the baseline for future performance measurement, incentives, and compliance calculations of the business. Arriving at this calculated number is more of an art than a science and involves giving a seller credit for any non-recurring, personal, and extraordinary expenses run through the income statement that are not related to the future ongoing operations of a company. It is also important to adjust EBITDA for other expenses the business either desperately needs or has not been capturing properly.

Non-recurring expenses are one-time, non-repeatable expenses incurred by a company that a potential buyer would likely not incur in the future. These expenses could include start-up costs for new product lines, facility relocation expenses, costs related to discontinued operations, severance or termination expenses, recruiting fees, or consulting fees, to name a few.  Expenses that repeat on a consistent basis are not considered non-recurring, for example, consistent use of consultants or cost related to R&D or business realignment/restructuring.  Also, employee compensation, benefits and bonuses are not considered an adjustment.  These employment costs are expected by employees, and any changes do nothing more than harm morale, which effects productivity and eventually profitability.

Personal expenses are shareholder specific expenses that are unrelated to the operations of a company and expensed through the income statement.  These expenses could include cars, computers, travel, hobbies (e.g., country club dues or airplane costs), healthcare for non-employee family members, or other similar expenses. These expenses need to be well documented and traceable through the general ledger with enough detail to allow a reasonable person to substantiate the expenses. A rough estimate or an approximation is not good enough and generally not allowable. Other non-allowable personal expenses are meals and entertainment. This is almost impossible to reconcile and usually not a meaningful addback.

Extraordinary expenses are one-time expenses or losses that arise from significant events that were not driven by the ordinary course of business. Examples include lawsuits, settlements cost, losses related to a customer bankruptcy, product recalls, warranty related expenses, or other act of God related events. Extraordinary expenses do not include inventory write downs or bad debt write offs. These are normal course of business items and should be properly accrued for monthly. Inventory goes stale and becomes obsolete regularly in every business, as well as collectability of account receivables.

Pro forma expenses need to also be reflected in the calculation of Adjusted EBITDA to properly determine a company’s profitability. Owners’ compensation or rent expense to a related party needs to be adjusted to properly reflect the fair market value of a person’s wages or a market rent.  Other necessary expenses that need to be included are accruals for vacation pay, bonuses, audit and tax fees, and salaries for employees who are necessary but have not been hired yet.

As mentioned above, calculating Adjusted EBITDA is more of an art than a science. There are rules and exceptions to every rule. However, all potential add backs must be well defined and traceable to be allowed in the calculation. It also needs to include the proper overhead to continue running the business the same way it did the day prior to closing and into the future. 

Purchase Price Includes Working Capital

Mike Sullivan - Thursday, March 23, 2017

The sale (or purchase) price of a company, in most instances, implies that a business is being sold as a “going-concern” to a buyer.  Therefore, as part of any sale, a seller needs to deliver to a buyer all the assets (tangible and intangible) necessary to operate the business as a going-concern.  Working capital is a large part of any company’s assets and is the life blood that allows a business to operate.  Whether a transaction is an asset or stock sale, working capital is always included in any valuation and sale, and must be delivered at the time of closing.  A seller cannot operate a business without working capital, so why would a seller try to sell a business as a going-concern and not provide the working capital?
Many sellers believe accounts receivable, inventory, customer deposits, security deposits, and other assets belong to them because it is “their money” they made, invested or reinvested into the business, and hence, the buyer should pay them for these assets.  However, these assets are part of the capitalization of a business and are the reasons why a company can generate the products, services, quality and delivery that customers value.  This value is reflected in the earnings of a business which determines its valuation and sale price.  Thus, working capital is symbiotic with the sale price.  Any seller asking to be paid for these assets is attempting to double dip on valuation.
Some sellers also claim that buyers should pay them for some of their working capital because it is bloated (higher than necessary) due to their management style, comfort level, lack of need for excess cash, unique market conditions, or lack of sophistication.  These claims are difficult to verify or substantiate.  If a buyer is able to operate a business differently post-closing that requires less working capital and frees up cash, then that is the risk and return for the buyer to realize, not the seller to gain.  Remember, the seller had years to manage the working capital differently.  Once again, the seller is attempting to double dip on valuation.
In summary, buyers want an average amount of working capital necessary to operate a business on a daily basis, based on a company’s historical operating procedures and practices.  A business needs to operate the same way the day after closing as it did the day prior to closing.  A simple calculation of the average monthly working capital for each of the last twelve months is all that is needed.  Occasionally, there are anomalies that can skew the average, but these are extremely obvious and can be considered. 

EBITDA is Not Cash Flow

Mike Sullivan - Tuesday, February 21, 2017

The world has become obsessed with EBITDA.  Public companies, private companies, business owners, investment bankers, lenders, valuation firms, and the mainstream business media constantly reference EBITDA and use it as a business term to negotiate value, define agreements, and reference cash flow.  However, EBITDA is not cash flow, and frankly, it is far from it.  In fact, it is not an accounting term, nor is it recognized under Generally Accepted Accounting Principles (GAAP).
Earnings before interest, taxes, depreciation and amortization (“EBITDA”) was created in the 1970’s to demonstrate the cash flow generation potential of the cable television industry, and was also used by leverage buyout firms. Over time, this non-GAAP metric has taken center stage and is widely used to demonstrate a company’s financial health. Unfortunately, this metric ignores real cash expenses that must be paid, such as capital expenditures, taxes, and funding working capital.  These cash outlays need to be understood and properly reflected in any cash flow calculation and company valuation.
As a buyer, we do not care about EBITDA.  We care about whether a business under our ownership can: (i) reinvest in and expand its capital assets (capital expenditures), (ii) service its debt, (iii) give raises and bonuses to its employees, and (iv) deliver equity returns to its shareholders.  The quote below properly summarizes this.
“It amazes me how widespread the use of EBITDA has become.  People try to dress up financial statements with it. People who use EBITDA are either trying to con you or they are conning themselves … People want to send me books with EBITDA, and I say fine, as long as you pay the CapEx [and other cash expenditures].”  -- Warren Buffett

Inventory Games

Mike Sullivan - Thursday, January 19, 2017

Over the past 25 years, Westshore’s principals have purchased many companies, but the transactions that are the most challenging tend to involve companies where the inventory was either under managed or reflected aggressive inventory tax strategies.  Many variables affect the valuation of a business and the terms of a transaction, however, for product oriented companies (such as manufacturing and distribution businesses), inventory valuation is probably the most overlooked economic consideration prior to executing a letter of intent. During diligence, the quality and accuracy of inventory can have significant ramifications affecting the EBITDA, purchase price, working capital settlement, and even the buyer’s debt structure and capacity at closing. 

In simplistic terms, inventory is not just a balance sheet account, but rather a component of a company’s cost of goods sold, which runs through the income statement and, hence, the earnings of a business.  How a company has costed, managed, and represented its inventory can both understate and overstate the EBITDA of a business, as well as its balance sheet and its borrowing capacity.  It is a good practice for business owners and their advisors to undertake the following prior to marketing a company for sale:  1) a full physical inventory two months in a row, 2) a complete inventory aging analysis, 3) an updating of inventory reserves, 4) an updating of the company’s cost roll and capitalized labor allocation to finished goods, and 5) an updating of the company’s inventory valuation and earnings based on market cost of raw materials and purchased items.

Transactions are time consuming, stressful and costly.  Not addressing inventory and its components prior to a sale is a "game" that the buyer and seller will not enjoy.