Fall 2008 InfoLetter - Bober, Markey, Fedorovich & Company

Making the Deal: Valuation Key to M&A Process
By Mark B. Bober, CPA/ABV, CVA, Partner

With baby boomers approaching retirement, business owners need to consider exit planning. Valuation services are essential for both buyers and sellers in the M&A process, and valuation experts are critical to the success of a buyer's or seller's advisory team.

Business owners — particularly those who founded the business — often have an unrealistic idea of the company's value to a buyer. Sometimes it's just false hope or an inflated ego that clouds the owner's vision. More often, however, owners have a number in their heads that they believe their companies are worth, but can't support that number with data.

For this reason, it's a good idea to have a business valuation performed early in the sale process. This will give the owner a range of realistic values to pursue, based on comparable companies and multiples of EBITDA, sales, book value or other relevant data. If the range is unacceptably low to the owner, it will also give him or her time to make adjustments in the company, increase earnings or address other problems before sale.

Valuation experts also assist business owners in several other areas before and during the sale process:

Confidential Offering Memorandum: The confidential offering memorandum is a formal offer to sell the business. It presents an overview of the company and its management, historical data from audited or reviewed financial statements, and other information of interest, customized for potential buyers.

A business valuation professional plays an important role in the preparation of this document. The valuation expert is tuned in to the synergies the business has with each potential buyer and can tweak the overall presentation of the company's strengths to align them with the needs of targeted buyers.

Data Room Set-Up and Due Diligence Response: As potential buyers respond to the confidential offering memorandum, the valuation expert should be considered as the gatekeeper for the due diligence team. He or she often sets up and monitors the "data room," or online repository of information, as it is made available to buyers.

The valuation expert also plays a role in crafting due diligence responses. His or her input can help sellers avoid problems by revealing too much, saying too little or using language in a way that may have unexpected consequences.

Purchase and Sale Agreement: The design of this legal agreement requires the input of the business valuation expert as a reviewer. He or she can help draft wording that defines the purchase price, provide detail for calculations, give examples to illuminate the interpretation of legal terms, and ensure that the agreement is in conformance with the client's accounting procedures and policies.

A valuation professional is also an integral part of the buyer's advisory team. For example, a valuation expert has knowledge of the necessary financial information to draft the letter of intent to buy a business. He or she is also involved in determining fair market value, the synergies expected and the purchase price for the target business.

In the due diligence phase, a valuation expert can help the buyer by reviewing the initial valuation and the details of the confidential offering memorandum. Valuation professionals are also involved in drafting the purchase agreement and translating legal terms into workable examples.

When putting together an advisory team for mergers and acquisitions, choose a valuation expert who knows your business and industry. Given his or her knowledge, the business valuation expert can help ensure that you make the most of the purchase or sale.

For more information about business valuation services in the mergers and acquisitions arena, please call or email me at mbober@bobermarkey.com. BMF&C

Hedging Against Volatility: Can You Swap Your Interest Rate?
By Lori A. Sheets, CPA, Senior Manager

From time to time companies need to borrow — sometimes for working capital, more often to finance equipment, real estate or other expansion.

But when a company, even one with stable and sizeable inventory and receivables, needs to borrow several million dollars or more, it might find itself able to obtain credit only at a variable interest rate.

Bankers are reluctant to extend too much fixed-rate credit over a long period of time. The lender might offer fixed-rate financing over a shorter term, but at higher rates.

Variable Rates: Sometimes Good, Sometimes Not

Under these circumstances, a variable-rate loan can look attractive. Over the past two decades, variable-rate financing has often proved less expensive than fixed-rate loans.

But as some recent homebuyers are finding out, a variable-rate loan can turn dangerous in a volatile financial environment. For a business, a variable rate makes for less predictable earnings.

What can a company do to obtain the stability and certainty of fixed-rate pricing on the credit it needs?

Hedge Against Volatility

An interest rate swap is a method of fixing the rate on a portion of a loan in order to mitigate the risk of interest-rate movements. It constitutes a hedge in which the borrower gives up a little (points on a fixed rate) to protect against something potentially worse (high resets on a variable rate).

Rate swaps can be complex, involving lenders, underwriters and other parties. But for most conventional businesses the transaction is simpler, and most swap agreements for manufacturers and distributors are issued by their primary banks.
The amount of the loan that can be brought under a fixed rate through a swap is negotiable. It's called the notional amount, and the swap contract is independent from the loan agreement.

Not All or Nothing

Some owners automatically think that the most conservative play is to hedge 100 percent of the loan, essentially swapping to a higher fixed rate in return for the stability of knowing what that rate will be. But if interest rates fall, they can end up paying substantially more than they would have paid under a variable rate.

Other owners, put off by elaborate financial transactions, accept a variable rate from the beginning simply because it's easier to understand. They figure they'll deal with volatility as it comes and refinance as needed.

But a more nuanced approach — one that proceeds from a careful analysis and involves some strategic hedging — is generally better than either of these all-or-nothing strategies.

Optimal Hedge?

Generally speaking, a 50 percent hedge on a company's debt — putting half at a fixed rate, half at a variable rate — takes interest rate volatility off the table.

When rates rise, one portion is protected under a fixed rate. When rates fall, the other portion benefits from the falling variable rate. A company so hedged knows it will neither win nor lose significantly by rate fluctuations. Consequently, it can budget more surely and focus its efforts on managing and improving its business.

But the right hedge for a given company depends on its circumstances. A manufacturer with heavy debt and thin margins can't tolerate much uncertainty, and may benefit by fixing a larger part of its interest payments with a swap.

On the other hand, a company with strong equity and predictable margins, even with a fair amount of debt, might not be inclined to hedge at all. It could accept some uncertainty, and choose the simpler course of allowing its interest rates to float over the long term.

Due Diligence on Swap Offers

Not every rate swap is right for a company, nor should every interest rate be locked in. The company that hedges too much or too soon can end up paying interest well above the going rate, or facing a high price to buy its way out of the agreement.

The timing of an interest rate swap is critical, but its impact is fully known only after the fact. Predicting the events that move interest rates up or down, such as the actions of the Federal Reserve, is a less-than-perfect science.
For that reason, and because every company is different, determining the benefits of this kind of hedge, as well as an optimal position to take, requires close analysis.

An interest-rate swap can be complex, and every company faces unique circumstances. A business should not enter a swap agreement lightly, but only after strong collaboration with its advisory team.

Could your company save with an interest rate swap? We can help you find the answer. Please call or email me at loris@bobermarkey.com to discuss how we can help you with this complex decision. BMF&C

FINANCING STRATEGIES
How to Fund Your Business's Growth
By Michelle L. DeGordon, CPA, Senior Manager

Most business owners aspire to grow their companies. After all, if a business isn't growing, then it is probably stagnant — or worse yet, in decline.

But growth brings many new challenges, especially when it comes to financing. Growing a business requires money — for new equipment, additional inventory, more staff, new marketing initiatives, etc. — that can place a severe financial strain on the company. Owners who don't plan carefully for the financial impact of growth can end up growing themselves right out of business.

For starters, growth usually requires a significant increase in receivables and inventory to support the higher level of sales that will result. This cash must come from either owner's equity (i.e., retained earnings, capital or personal funds) or outside financing.

Since few companies can finance growth completely on their own, one of the first tasks for most owners who want to grow is to secure financing to support growth. This kind of financing generally takes one of two main forms: debt or equity.

Traditional debt financing is usually provided by banks, which loan money to businesses with the expectation that it will be repaid with interest within a certain time frame. Equity financing, on the other hand, is provided by investors — usually venture capitalists, private equity firms or so-called "angel" investors — in exchange for a share of ownership in the company.

Generally speaking, debt is preferable to equity financing because it doesn't require giving up any ownership in your business. Each share of ownership you divest to an equity investor is an ownership share out of your pocket, with unknown value in the future. For example, imagine an early-stage investor in Microsoft who secured just 10 percent of ownership in the company in exchange for financing, and what that 10 percent share is worth today!

In addition, most equity investors expect a high rate of return on the companies they invest in — typically 25 percent per annum or higher — because they know that for each home run they hit, there will also be a number of strikeouts.

But with debt financing, you retain 100 percent ownership in your company. That's because banks aren't "investors" — they are lenders. Your cost of funds with a bank loan is simply the interest rate that you pay on the loan.

While debt financing is generally less costly in the long run than giving up equity, obtaining a business loan may be easier said than done. Banks have very specific criteria and expectations for repayment and return of their capital and take steps to minimize their risk of loss as much as possible.

These steps include collateralizing loans (i.e., requiring that assets, such as equipment or accounts receivable, be pledged as collateral in case the loan is not repaid) and requesting detailed financial information from potential borrowers to help them analyze their true ability to repay the loan. The challenge for many companies in a growth phase is that they may not have the kind of collateral or balance sheet a bank wants to see before making a loan.

Bankers also want to see that owners are prepared to invest some of their own money into their businesses — that they have some "skin in the game," so to speak. One rule of thumb is to be able to show one dollar of equity for every three dollars of debt you want to assume.

The two most important factors to consider before approaching a bank for a loan to support business growth are:

Also keep in mind that different banks tend to specialize in lending to certain types of businesses, such as companies in certain industries, at different stages of development or of a particular size. Do some research to determine which banks in your area specialize in lending to businesses like yours, and don't give up if you're turned down by the first bank you approach.

If you're unsuccessful in obtaining a loan to support growth, you may want to consider taking on investors in your business.

Venture Capitalists (VCs) seek to identify and fund companies they believe offer opportunities for a high return on their investment, in exchange for a piece of the pie. How much equity this type of funding will cost you depends on many different factors, but primarily on how risky your business venture is perceived to be in relation to the potential reward should the business become successful.

Your business growth plan is especially important when approaching venture capitalists, who will scrutinize it carefully to determine your prospects for success and the degree of risk involved. It is important to note that VCs have an obligation to invest the money they've raised in transactions that match very specific criteria. With this in mind, make sure that any VC you approach has a true mandate to invest in your particular variety of company.

Angel investors are typically wealthy individuals investing primarily in early-stage companies in exchange for ownership shares. Generally speaking, angels invest in start-up companies or entrepreneurs with whom they have a personal connection.

As a result, angels tend to make much smaller investments than VCs — on average, between $25,000 and $35,000 per investor, per company — while VCs may invest millions of dollars at a time. Like banks, VCs and angels tend to specialize in lending to certain types of businesses, so do some research before seeking this type of financing.

Finally, if you are unsuccessful in obtaining a bank loan or VC or angel funding, you might consider approaching your family and friends for financing to support business growth. This can take the form of debt or equity, depending on the needs and expectations of both sides.

If you go this route, be sure to formalize the terms of the agreement. Document everything in writing, with repayment terms and interest rate or equity specifics, so that it's not treated casually by either party.

We can help you prepare financial statements, projections and even assist in your request for proposal process in order to secure funds to grow your business. Please call or email me at michelle@bobermarkey.com in order to discuss how we might be best able to assist you. BMF&C

Fraud is big business, as U.S. companies lose some $660 billion annually to it. Since forewarned is forearmed, the roots of fraud are worth examining.

In the 1950s Prof. Donald Cressey reported on actual fraud schemes he had studied, in which he always found three elements: pressure, rationalization and opportunity. Cressey believed that all three "sides of the triangle" must be in play for a fraud scheme to develop.

Pressure is a function of the human condition. A spouse is laid off, credit card debt mounts, a trip to Vegas goes sour — these and other events can have grave financial consequences. There are many such events, but generally only one sure cure: money.

Rationalization is the invention of the schemer. Everyone is under stress, but not everyone diverts company funds or pays no-show employees. Most frauds, in fact, are committed by employees who view themselves as fundamentally honest. For them, crime requires a personal twist of morality and reason. (I was only borrowing. Everybody does it. I'm owed. My family needed it.)

Opportunity is the third side of the fraud triangle. A fraudster must see a way to steal without being caught.

So if life generates the pressure, and the fraudster provides the rationale, who provides the opportunity? That would be the employer — who can also withdraw opportunity.

Cressey noted that fraud schemes can't develop if one leg of the triangle is missing. People not under pressure are not desperate for cash. Even under pressure, people who can't rationalize criminality will find other solutions. And without opportunity, even the most committed fraudster — frantic for funds and lost in a dream-world of rationalization — can't steal from you.

Our firm can help your company remove opportunity from the fraud triangle. If you would like some assistance in mitigating your organization's risks of fraud, please call or email me at steves@bobermarkey.com. BMF&C

Dave is a senior manager in the Assurance & Advisory Services Department where he focuses on serving the needs of publicly traded companies, large privately held companies and emerging private equity-backed companies in a variety of industries, including manufacturing, distribution, banking and technology.

Dave has extensive SEC and transaction accounting experience and expertise from his previous positions as senior manager at a "Big Four" firm and as a corporate controller. Dave's "Big Four" experience includes considerable transaction and acquisition experience from assignments in the Silicon Valley and Washington D.C. technology corridors. He has also been a corporate controller for a publicly held, regional financial institution overseeing the financial close process, accounting policy, management, board and SEC reporting, acquisition due diligence and integration and income taxes. In addition, earlier in his career he was an internal auditor for a publicly held, multi-national manufacturing company responsible for auditing its consolidated and U.S. operations as well as several of the company's European subsidiaries.

Dave earned his bachelor's degrees in Accounting and Finance in 1991 from Miami University. He is a member of the American Institute of Certified Public Accountants and serves on the boards of Big Brothers & Big Sisters of Mahoning Valley (past board president) and Junior Achievement of Mahoning Valley.

"I am proud of Bober, Markey, Fedorovich's ability to offer a broad range of services often performed by "Big Four" firms, providing technical accounting and reporting consultation, tax compliance and planning as well as mergers and acquisitions transaction advisory assistance. As a supplement to our excellent internal resources, the Firm's affiliation with PKF, an association of independently owned, public accounting firms in the United States and worldwide, provides resources comparable to those of a "Big Four" firm, including training, knowledge and experience that enables us to meet the needs of our clients and their operations in the U.S. and throughout the world." BMF&C