Asset Sales vs Stock Sales and What to Consider in Both Scenarios

Mike Harvath  00:04

Hello, and welcome to this week’s Shoot the Moon podcast here, broadcasting live and direct from revenue rocket world headquarters in Bloomington, Minnesota. As a reminder, revenue rocket focuses on helping IT services companies grow through facilitating m&a transactions and helping with optimizing growth strategies. Today, I’ve got my partner, Brian Barnett, on the call with me, Ryan, welcome.

Ryan Barnett  00:31

Hey, Mike, it’s good to be recording a little podcast here. And I have a couple of ideas for you today. One of them to start with just trends that we’re seeing in the market. And then what we’ve seen in the last couple of weeks in have been negotiating deal is that working capital and working capital calculations have been one of the big things that have cropped up as discussion points. So want to do a bit of education and understanding around working capital and where it matters in a deal. But Mike, just want to start out seems like in the second half of the year, things have changed a little bit on people willing to take a call when it comes to selling their business. As our listeners may know, we provide both buy side services to our clients, which means that we’re helping companies acquire other companies and finding the right strategic cultural and financial fit for them, as well as helping companies sell, sell their companies. And we’ve seen a little bit of an uptick in people actually answering their phones, and, you know, typically says, hey, you’re about the third or fourth person I’ve talked to this week. But once this conversation going, there seems to be people willing to consider selling their firm. And, Mike, I’m just kind of curious if you’ve seen the same and why you think that is.

Mike Harvath  01:57

Well, I you know, I do I have seen it, I think people are, you know, hopefully the dust has settled for much. For the most part due to the COVID pandemic. I think a lot of people had their business kind of up ended during the pandemic. And it took them a while to get it re established and reestablished in a way that was consistent and predictable. So I you know, I attributed some of that just the distraction of focusing internally on the business and then ultimately, getting back to, you know, more, little more breathing room, their ability to field calls. Certainly they focused on. It’s not not that businesses have been necessarily seen a material downturn in the pandemic, although some did, and the kind of IT services space. But certainly what we’re seeing and based on conversations lately 2021 has been a banner year, for most, most of our clients and our targets and, and folks that we’ve been talking to, on behalf of our clients. And there’s certainly a lot more conversations going on about, you know, the merits of putting together a deal strategically and culturally. And people are more open to exploring those things right now.

Ryan Barnett  03:29

Yeah, you know, in general, I think we have seen these rising valuations. And in general, if you see that long enough, you finally say, hey, maybe this is the right time.

Mike Harvath  03:41

Yeah, I agree with that. Ryan. I think that’s been fascinating. Certainly, I think the market will continue to consolidate through 21 and 22. and beyond. We certainly don’t see an end in sight to the market. You know, the, the rather frothy market, which has driven valuations. And, you know, I think the more and more people have conversations about combinations, they realize sort of where the real market is for their business. And maybe they’re open to having conversations that are somewhat more realistic for value now. And not just based on kind of what they feel the business is worth. So, you know, I mean, probably multifactorial reason why these calls are happening.

Ryan Barnett  04:29

And last question on this Mike is do you think that we are six months or seven months now into the year of a new political administration and and that may not be as favorable when it comes to taxes when it comes to business combinations?

Mike Harvath  04:49

Well, I I do think that you know, tax considerations are driving many sellers right now. We have we do have sell side mandates with clients that have come to us and Hey, the reason we’re going to market now is because of a potential tax change. We hadn’t planned to go to market yet. But we’re coming to market now, because we’re concerned about a tax change. Now, how real adtech genes is and when it’ll occur, and if it’ll occur, you know, I think is open for debate. I think there’s plenty of room for the current administration to make moves on corporate taxes that don’t involve changes to our material changes to capital gains, I think the fear that a lot of sellers have is that there’s going to be a, you know, elimination of the of the capital gains tax or, you know, 9-10 percent increase in the capital gains tax, which, certainly, if you’re selling a business that have a very material impact on the amount of money you get to keep, but I’m a bit of an outlier on that, I think there’s gonna be other things like the buck tax and, you know, other levers that the current administration can pull to sort of increase, you know, taxes from corporations as well as enforcement activity that will occur in lieu of capital gains increases. And I think if the tax bill is going to get passed, it’s probably going to have to look more like that. Because I do think that there are certainly plenty of people in Congress that are not going to be favor, favorably looking upon a capital gains increase. And certainly that’ll be kind of a last resort type increase, I think, if they’re going to get something passed this year.

Ryan Barnett  06:42

Yeah, exactly. That Well, that’s it, it’s, it’s interesting, I think it’s, overall, we certainly see the worry from our clients and companies coming to market, and that there could be radical changes. But I think no matter what the political environment, it’s smart, to be cautious about how it goes, put it this way you have to put in, you have to incorporate taxes in order in the hole, when you’re looking at your deal, and how to get that done. And that may change a bit, but you have to understand, work with your accountant on careful tax planning, and how that could impact the future.

Mike Harvath  07:21

Yeah, just to add that, I mean, it’s a material thing, not only in the States, but certainly in Canada, we have a lot of listeners in Canada, and a lot of our clients are, frankly, in Canada. And this is similar around the world for global tax policy, there’s structuring that you can do to be tax efficient in preparation for selling a business. And we certainly recommend that all business owners understand those options, and they understand those well in advance of selling maybe even years or, you know, many years in advance of selling, that’s certainly the case. In Canada, there’s some structuring that has to be put in place. So certainly structuring here in the US as it relates to your classification of a corporation to make it more efficient for selling a business tax wise, a small business, and particularly a services business. And so you know, you should be having those conversations with your accountant to make sure that you’ve done the early groundwork so that even if you’re not ready to sell now, that you’re you’re in a position to do so when the time comes.

Ryan Barnett  08:25

Yeah, absolutely. And that’s how I transitioned a little bit. The other topic that we had seen as of late is, companies, when you sell your company, there is typically a number of different transactions you can have. So, Mike, can you just explain to the audience something, you hear that cash free debt free? What’s that mean?

Mike Harvath  08:49

Yeah, I mean, there’s a couple things on structuring, we get a lot of questions about, you know, I want an asset deal or a stock deal, or I want, you know, all working capital to be a certain way. You know, we’ve talked about, you know, assets and stock deal before I can quickly address that, again here, which is for a tech services company, it really doesn’t matter all that much. You know, I think in some cases, there’s advisors in the market that give bad advice. Typically, these are accountants, they may be lawyers that are used to more you know, what I’ll call asset intensive businesses, like manufacturing companies, or quick serve restaurants or, or even, you know, convenience stores and things like that, where they have a lot of assets and it does make a huge difference tax wise to a seller if it’s a stock deal or an asset deal. In a technology consultancy, it really doesn’t matter all that much. It has much more to do with the allocation of that purchase price and how its allocated to Goodwill or other asset classes. These kind of go hand in hand with working capital working capital. In order to sell a business you need to sell it as a going concern and the definition going concern would mean that it has enough working capital in the business to sell. A lot of sellers get advice from their advisors that they want to keep all of the assets in the business and try to, you know, sell the business with the liabilities. And that just doesn’t really work. You have to have enough assets in the business and the appropriate allocations in the liability side of the business, in order for there to be enough working capital to operate the business by the buyer after the deal is done. And they don’t have to be able to operate it assuming no revenue or you know, no profit, you know, blah, blah, blah for a long time, that you need to cover about a month’s worth of expenses typically. And so understanding that clearly, is important. Now, most small businesses, most particularly IT services, businesses, if they’re Runwell, are over capitalized, have more working capital than they need. And thus, the sellers can harvest some of that capital, or all of that excess working capital we call or the value in excess. Sometimes people use that term. Understanding what that working capital ratio is what’s involved, what a buyer needs to run a going concern is important. Cash free debt free is not a very good strategy for the seller in a growing business. And the reason why that is, is because you have a lot of your asset, tied up in receivables. And this is particularly important if you’re in a fast growth services firm. And it leaves too much capital in the business, or an excess amount of working capital, in our opinion in the business for the buyer. It also isn’t very buyer friendly, because oftentimes, if someone does negotiate what we call a cash free debt free deal, it requires the buyer put cash into the deal in the first month to cover operating expenses. The theory is a good one. But it’s one that doesn’t always work perfectly in practice, because it assumes that that buyer is going to be collecting AR throughout the month. And that AR is going to fund operating expenses for payroll, which is a significant cost in an IT services, business and other expenses. And as much as that’s true, and will be the case over time. They can’t assume that they’re going to be able to in a transaction, when things are changing with a customer base, that they are going to pay as consistently as they have up to that point, it will take a little bit of time for them to get used to the new buyer make sure that you know if there was changes and who they should pay that they’ve made those adjustments in their system, and it can create a little bit of a delay in collections doesn’t mean they’re bad, but just it’s a delay. So we think it’s a better idea to we have a combination of cash and receivables to cover off the liabilities and their curls in the business. And make it a little easier for the buyer to operate the business without putting cash in and be more faith and be more fair to the seller to take excess working capital out.

Ryan Barnett  13:27

It’s really insightful and helpful. It’s one of those areas that you don’t necessarily think of until later in the transaction typically. That being said, as of late, we’ve seen a number of deals that have tried to look at cash early on in a negotiation. The factory we’ve even seen a bit of an attempt to calculate working capital before an ally. So we that’s typically we don’t see it that really when you start bringing cash in to the into the equation like when you are working through a deal.

Mike Harvath  14:04

Well, it’s typically after the letter of intent, and it comes in through due diligence. oftentimes there’s a comment in the letter of intent about adequate working capital, which is fine in more detail than that, or can specify a working capital ratio. But seldom does it get to a working capital peg as we call it, or the exact number until we’re through due diligence, and it’s part of the definitive agreement to begin to look at cash and working capital ahead of the letter of intent is premature. It’s premature predominantly because working capital is a moving target, how much of it is in AR and cash and depending on invoicing cycles. How much money is left in the bank versus that has been paid out or is dividend out is a number that changes every month and it points in time throughout a month in a Typical cycle. So, you know, we think it’s best practice to probably outline at a minimum that there’ll be adequate working capital left in the business and excess working capital will be determined and able to be kept by the seller in the letter of intent. Or you can specify a working capital ratio or what some call coverage ratio into the letter of intent. And then the exact numbers calculated later and documented in the definitive agreement.

Ryan Barnett  15:33

Interesting, and then when you’re talking about enterprise value, do you typically include cash?

Mike Harvath  15:40

No, enterprise value certainly will include adequate working capital. So back to this point, you know, it’s a going concern, and it has enough capital to operate. That’s what everyone wants. Now, that discussion about what’s adequate is a negotiation. And, you know, some buyers want all the working capital that someone’s had in the business over the last year, average or two years, and generally in small businesses, that is, that advantages the buyer, it’s unfair to the seller. For all the reasons I’ve talked about before, we just had a conversation, the day we’re recording this podcast, with a client that has, you know, $3 million in excess working capital and their balance sheet and cash. That’s beyond what’s needed to operate and run the business. From a working capital perspective. That should be the sellers money. It’s not something that would be included in the transaction, typically. And so, you know, enterprise value, the way we see it is to define it as a going concern and then to be able to strip excess working capital. There’s another reason for that it’s not the way it is always in business valuations is that most businesses in IT services are valued based on free cash flow, and a multiple of free cash flow, not book value. There’s certainly book value considerations and, you know, add the assets on the balance sheet in excess liabilities impacts book value. But in models that we run, we de emphasize the book value some, some people do evaluations and IT services completely disregard book value. We think at a minimum there should be a consideration. Because certainly if the business is under capitalized, that needs to impact valuation or impact a true up. Just like if it’s over capitalized, the seller can harvest that money. More often than not, we see in the small businesses, if they’re successful in growing, they tend to be over capitalized or have too much working capital, or excess working capital on the balance sheet. Pack close.

Ryan Barnett  18:12

And they’re very interesting. It’s a it’s a topic that moves so much. It seems like it’s something that doesn’t necessarily get resolved until nearly the day of close. So I know when there’s pushing and shoving on deals, we see this most often around working capital. Like is there just to wrap this kind of conversation up? Why is it such a tested item throughout?

Mike Harvath  18:42

Well, I think private equity firms have had a history of trying to take excess working capital to kind of cut to the chase on it on the guys that tried to do cash free debt free deals. That advantages the buyer and advantages a buyer that has capital to put into the business because almost all of these businesses, if it’s done as cash free debt free, the buyer will have to float one month to expenses to be able to get through a collection cycle. They’ve for a long time private equity buyers required that they wanted to do that they would say we’re gonna approach this deal as cash free debt free. Now I should say that all deals are generally debt free from a long term debt perspective, and if not, that, that needs to be reconciled with purchase price at the time of close or ahead of close and, and the only liabilities that really come by are come by past or what we call trade payables or or you know, putting some things on the balance sheet that would be appropriate for you to put there into liabilities like accruing for a payroll. So having an accrual for a payroll or a month of payroll is an appropriate best practice. When you’re looking at working capital and working capital ratios, for example, I mean in IT services, it’s the biggest expense. So the whole cash free debt free concept came out of capital market operatives that wanted to advantage or get their hands on more working capital and probably needed. And in a perfect world, if you had perfect receivables collection at 30 days or less, and you were not growing the business at all, then Caspi definitely could work and be fair. I think if you’re if there’s variables around the growth of the business, let’s say the business is scaling and growing materially, which means you’re continuing to grow month after month, and are your maybe your VSL your sales outstanding, or your AR Aging’s are showing more than 30 days. In that scenario, it’s always gonna advantage the buyer as it relates to kind of fair working capital. And we just don’t know that that works out. We’ve even seen some buyers want the seller to clear the trade payables, which is completely we think a big land grab on on capital. And because, you know, working capital is sort of a not well understood principle. For most business owners. It’s an area where people can take advantage of a seller, frankly, and you know, begin to subsidize their purchase price. And so it’s probably a good business case to have a m&a advisor in the middle who negotiates working capital all the time, and can help you get your fair share of that excess working capital, or what I’d say all of that excess working capital that’s not needed to run the business moving forward.

Ryan Barnett  22:02

Yeah, I totally agree. We’re happy to help. And it’s something that is core to every deal that we get done. Like this. That’s all the questions I’ve got for you today. Appreciate you getting through this and I’ll let you wrap it up.

Mike Harvath  22:17

Sounds great, right. So with that, tie a ribbon on it, hopefully enjoyed our conversation about working capital. Certainly if you have any questions about your own working capital, or how you would cap calculate a reasonable amount of working capital in your business pursuant to Sally be happy to advise you on that. Likewise happy to help you in any way we can on the m&a front or optimizing your strategy to grow. Hopefully you’ll tune in next week we have a new podcast, coming to you from Minnesota. Talking about m&a and strategy for IT services reps, take care and have a good week.