IN THIS ISSUE:
www.masource.org
NO.02
ISSUE
SUMMER 2023
© M&A Source. All Rights Reserved. | The insights and opinions expressed herein are those of the authors and do not represent professional counsel nor an endorsement by M&A Source.
The Bridge
U P D AT E S & I N S I G H T S
F O R T H E L O W E R M I D D L E M A R K E T
Letter From the Chair
8 Mistakes to Avoid
When Determining
Business Value
S-Corporations and a
“Reasonable” Salary
Market Pulse
Anatomy of an Earnout
Letters of Intent
New SBA Rules and Their
Effects on Your Transactions
A QUARTERLY PUBLICATION
OF THE M&A SOURCE
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2 | T h e B r i d g e | S u m m e r 2 0 2 3
Updates + Insights
for the Lower Middle Market
T h e B r i d g e | S u m m e r 2 0 2 3 | 3
Content.
Join us in thanking those that made our
spring conference a success and gear up
for Charlotte this fall!
LETTER FROM THE CHAIR
04
Find out if your office salary meets
the IRS’s expectations.
S-CORPORATIONS AND A
“REASONABLE” SALARY
14
Explore a snapshot of data from the
Q1 2023 quarterly report.
MARKET PULSE
12
Learn how this tool can help maximize the
changes of a successful deal.
LETTERS OF INTENT
20
Find out the most common missteps
owners make when justifying unrealistic
expectations.
8 MISTAKES TO AVOID WHEN
DETERMINING BUSINESS VALUE
06
Discover how an earnout provision can
help mitigate risk during a transaction.
ANATOMY OF AN EARNOUT
16
Gain a better understanding of the
changes coming with the latest SOP.
THE NEW SBA RULES AND THEIR
EFFECTS ON YOUR TRANSACTIONS
22
NO.02
ISSUE
SUMMER 2023
The Bridge
A QUARTERLY PUBLICATION
OF THE M&A SOURCE
4 | T h e B r i d g e | S u m m e r 2 0 2 3
Chair’s Letter
I hope this letter finds
everyone well and enjoying
a fun filled and prosperous
summer!
As you may already know, we are coming out
of one of our most successful conferences in
recent memory. Not only was attendance at or
near an all-time high, but surveyed attendees
also responded with a 95% good or excellent
rating for overall conference experience.
Conference highlights included our performance
award ceremony where we recognized over
50 member firms and individuals for their
achievements in 2022. You can see a list of the
2022 award winners and their accomplishments
on the M&A Source website. In addition, I’d
like to thank the members that served on the
Awards Task Force. Their contribution of time,
talents, and dedication to reviewing all the
submissions and verifying the data made this
program possible.
This year the conference highlighted the
monumental passage of the Sales and
Brokerage Simplification Act which took effect
on March 29th, 2023. This legislation provides
exemption from the SEC registration of M&A
brokers and intermediaries representing
privately held companies for sale with earnings
of less than $25 million or revenues less
than $250 million. This is the culmination of
nearly 20 years of industrywide effort through
donated time, energy, knowledge, and financial
resources in what became known as “The
Campaign for Clarity”. Again, we thank all of
those that have contributed to this effort.
Conference attendees were provided with a
number of great educational opportunities, a
two-day deal market, an outstanding leadership
meeting and several great networking events.
As we begin to pull together the programming
for the upcoming fall conference in Charlotte,
North Carolina on October 15th – 18th we
welcome your thoughts and suggestions on
potential programming, educational content,
and events. Member feedback remains an
integral part of crafting the ultimate conference
experience.
Last, but certainly not least, I’d like to thank
all the volunteer members of the M&A Source
conference planning committee, education
committee, deal market committee, and the
staff of M&A Source for all their hard work and
dedication to the production of a successful
conference. The outstanding leadership of
Lamar Stanley, Conference Planning Chair, Phil
King, Deal Market Chair, and Kylene Golubski,
Executive Director cannot be understated.
Without their vast contributions, none of this
would have been possible. Thank you all for your
outstanding contributions to the association.
Have a great summer! Please take some time to
relax, unplug, and enjoy the company of friends
and family. I look forward to touching base again
with all of you at our next Chair’s Corner on
August 24
th
.
Best Regards,
Scott Mashuda
M&A Source 2023 Chair of the Board
Thank You for a Great
2023 Spring Conference
T h e B r i d g e | S u m m e r 2 0 2 3 | 5
2023 M&A SOURCE
®
THE PREMIER LOWER MIDDLE
MARKET EVENT
CHARLOTTE, NORTH CAROLINA
6 | T h e B r i d g e | S u m m e r 2 0 2 3
8 Mistakes to Avoid When
Determining Business Value
THIS IS THE SECOND PART OF BLUE RIVER’S EDUCATIONAL SERIES ENTITLED “STRAIGHT
TALK TO OWNERS ABOUT BUSINESS VALUATIONS” WRITTEN BY BLUE RIVER’S MANAGING
PARTNER, WILLIAM LOFTIS. THE SERIES IS DESIGNED TO HELP MIDDLE MARKET BUSINESS
OWNERS AND THEIR TRANSACTION ADVISORS (I.E., ATTORNEYS, CPAS, INVESTMENT
BANKERS, M&A BROKERS, AND OTHERS) APPRECIATE THE IMPORTANCE OF ACCURATELY
UNDERSTANDING BUSINESS VALUE BEFORE GOING TO MARKET. WRONG EXPECTATIONS
LEAD TO UNDESIRABLE OUTCOMES, WHILE RIGHT EXPECTATIONS ALWAYS IMPROVE
TRANSACTIONAL RESULTS FOR OWNERS.
If you missed the first article, click here:
Part 1: What Is My Company Really Worth?
The first article cautioned owners to avoid embracing
valuation expectations that deviate from financial
reality, because wrong beliefs can produce at least three
unfixable consequences:
1. Understimated Value.
When owners sell their businesses at prices lower than
fair value, the buyer achieves a windfall gain at the
seller’s expense. The seller’s lost value is gone forever.
2. Course Correction Opportunities.
Lost – When owners depend on transaction proceeds
to fund next chapters of life, they need to know
what the real business value is long before it is
time to sell. If insufficient, they can take corrective
actions to enhance value. However, if a business sale
fails to deliver against expectations, reconciling to
unforeseen economic realities can be painful.
3. Overestimating Value.
When owners take their businesses to the market
insisting on financially unachievable prices, it chills
market demand and actually drives business value
down. To rekindle interest from buyers, sellers must
demonstrate they have abandoned unrealistic notions,
which often requires meaningful price discounts.
This article addresses the mistaken approaches and
methods owners use to arrive at and justify unrealistic
valuation expectations.
Valuation approaches that lead to unrealistic
expectations
Every business transaction has at least 4 components:
1) the buyer; 2) the seller; 3) the buyer’s transaction
consideration paid to the seller (a.k.a., the purchase price);
and 4) the seller’s assets or securities conveyed to the
buyer in exchange for the transaction consideration.
Buyers of privately held middle market companies (e.g.,
private equity firms, corporations, and family offices)
and their lenders ultimately set prices using the acquired
company’s expected free cash flows. Free cash flow, as
used here, is defined as:
EBIT X (1 – t) + Depreciation and amortization – Changes in
working capital – Capital expenditures = Free Cash Flow
Where:
EBIT – Earnings before interest and taxes (a.k.a., operating
earnings);
t – the marginal tax rate of the c-corporation or the pass-
through entity’s owners;
Depreciation and amortization – non-cash expenses;
Changes in working capital – increases or decreases in net
working capital (typically , accounts receivable + inventory
– accounts payable); and
Capital expenditures – the cash investments necessary
to maintain property, plant, and equipment or other fixed
assets arising from the ordinary course of business.
Free cash flow – the remaining cash available to equity
stakeholders and lenders produced by the operations of
the business.
While examined in more detail in a subsequent article,
a buyer’s transaction consideration will always be
constrained by its assessment of free cash flows. Free
cash flows must cover operating expenses, working capital
requirements, capital expenditures, taxes, transaction
By William “Bill” Loftis
Blue River Managing Partner
T h e B r i d g e | S u m m e r 2 0 2 3 | 7
debt service, and deliver appropriate returns to investors.
If investors and lenders don’t believe free cash flows are
adequate to satisfy debt service and deliver risk adjusted
returns to investors, there won’t be money to fund the
deal. If a deal won’t bank, it won’t close.
Owners, on the other hand, frequently use unconventional
methods that lead to mistaken valuation expectations like:
1. Market Rumors
2. Wrong Comparisons
3. Reverse engineered value from perceived personal
post-closing needs
4. Excessive zeal for potential
5. Replacement costs
6. Career benchmarking
7. Dependence on valuations created for non-
transactional purposes
8. Dependence on the wrong advisors
It is natural for owners to think the best of their
businesses, but when expectations are built on faulty
methods and assumptions, the resulting valuation opinions
are usually wrong. Unfortunately, the longer incorrect
expectations go unchallenged, the more entrenched
wrong beliefs become.
Mistake #1:
Market Rumors
Owners carefully guard the confidential information
of their businesses, but they do talk to other owners
with some transparency – at the country club, at CEO
roundtables, on the sidelines while their kids play soccer…
When the topic centers on mergers and acquisitions
(“M&A”), some owners like to share their inside anecdotal
insights to others who are eager to apply the information
to their own situations.
I met with the owners of an automotive supplier who
believed their company was worth $24 million. The
company’s most recent historical year produced $2
million earnings before interest, taxes, depreciation,
and amortization (“EBITDA”), which meant they used an
EBITDA multiplier of 12 ($24 million/$2 million). When
asked how they identified 12 as the right multiplier, one
of the owners reported a friend at the country club
knew a guy who just sold his aerospace company for 12
times EBITDA. In many ways, the parts manufactured by
both companies were similar. Only their customers were
different. Therefore, it seemed reasonable to the owners
that both companies should have the same multiple.
Transaction accounts are often like fish stories, they are
frequently embellished and each retelling improves on
earlier versions. In reality, sellers usually contractually
prevented from sharing transaction terms with the public.
That is why press releases typically state: “The terms of
the transaction were not disclosed.” Consequently, it is
difficult to verify or depend on rumored transaction terms.
Illustration: Owner With High Valuation Expectations Never
Sells Business
“Wrong expectations lead to
undesirable outcomes, while right
expectations always improve
transactional results for owners.”
8 | T h e B r i d g e | S u m m e r 2 0 2 3
Mistake #2:
Wrong Comparisons
Previous private company transactions are difficult to rely
upon when determining value, because, unlike real estate,
businesses are not commodities and are rarely perfectly
comparable to one another. Is a hair salon products
supplier comparable to a janitorial supply company?
No, yet they are classified in the same industry and
databases report transactions by industry. Is a landscape
company from Florida or California comparable to a
landscape company in Wisconsin or Michigan? Of course
not, but the preponderance of transactions in databases
overwhelmingly come from Florida, Texas, and California.
For these and many other reasons, few valuation analysts
rely on previous transactions as a primary approach to
determining value.
In the illustration above, the owners of an automotive
supplier compared their business to an unsubstantiated
rumored transaction in the aerospace industry. Even if the
referenced aerospace supplier did achieve a 12X multiple,
the prevailing multiples in the automotive supplier sector
ranged from 3.75 to 4.25 for companies of that size. In
other words, the valuation range for the auto supplier was
likely between $7.5 million and $8.25 million using like-
kind comparisons – nowhere near the $24 million they
expected.
Illustration: Owner Compares Business To Microsoft &
Amazon, Unable To Find Buyer
Mistake #3:
Reversed Engineered Value from Perceived
Post-Closing Needs
Successful businesses permit owners to enjoy the fruits
of their labor through income, perks, and other benefits.
Owners grow accustomed to company-paid conferences
to exotic places, luxury cars, car insurance, gas, country
clubs, tickets to entertainment venues, health insurance,
and many more. Some owners set the sale price of their
business by estimating the cash a sale must deliver to
produce an equivalent lifestyle after the closing.
The problem with using the seller’s post-closing needs
as a valuation method is that it fails to account for an
essential ingredient to the transaction – the buyer.
Professional acquirers base their purchasing decisions on
a number of factors, but the seller’s post-closing financial
needs is not among them.
Illustration: Reverse Engineering Method Produces
Valuation Twice As High
T h e B r i d g e | S u m m e r 2 0 2 3 | 9
Mistake #4:
Excessive Zeal for Potential
Some owners base their valuation expectations on the
business’ potential. Owners frequently say in one form or
another:
“Sales and earnings are bound to go through the roof if only…
•
the Defense Department comes through on that
contract
•
Amazon embraces our product
•
GM begins buying parts from us…”
Optimism is necessary in business, but potential, as my
grandpa used to say, means you haven’t done it yet.
To be clear, buyers purchase future financial performance
and not the past, which means potential must be taken
into account. Even so, the past is often a better proxy to
predict the future than hope, and most buyers will not
write checks for unrealized potential.
With the above said, there are ways for sellers to capture
the value if previous initiatives are likely to produce
future cash flows. For example, if the business planted
apple seeds several years ago and the orchard will begin
producing apples next year, the seller deserves some
value for future cash flows. Buyers will sometimes pay for
expected future financial performance through earnout
agreements where the seller shares risk with the buyer.
Earnout agreements make transaction consideration
contingent upon future events.
Mistake #5:
Replacement Costs
A frequent argument owners use to justify higher business
values is that the sale price should be the cost it would
take in today’s dollars to replace all the assets put in
service through the years. While I was touring a 75-year-
old business, the owners pointed out original machines still
in use on the factory floor. The vast majority of equipment
was more than 30-years-old. The owners proudly stated
that it would cost over $50 million to replicate the factory,
which was the price they wanted for the business.
Unfortunately, the company’s EBITDA was under $1.5
million in an industry where EBITDA multiples hovered
around 4X, which implied a value of approximately $6
million. The company’s balance sheet did not reflect $50
million worth of assets either. Instead, most assets had
been fully depreciated, and net book value was under
$3 million.
When establishing valuation expectations, owners should
think like professional acquirers. Buyers set prices using
benefit streams like free cash flow or EBITDA. Benefit
streams deliver the returns buyers seek, and assets are
only the means to produce the benefit streams. Unless the
purchase price delivers satisfactory risk adjusted returns
from benefit streams, buyers will not commit capital.
Based on the above company’s EBITDA, no investor would
want to replicate the factory at the seller’s asking price.
They buyer would be better putting its money in a low risk
bank certificate of deposit.
Illustration: Manufacturing Business Believes Replacement
Cost To Be Appropriate Valuation Metric
Mistake #6:
Career Benchmarking
Some owners believe business value is the monetary
summation of their life’s work. One owner looked at a
$2.5 million appraisal on his business and said with tears:
“For the past 40 years, I have dedicated myself to this
business. I sacrificed my time, my energy, my treasure for
this business. I gave everything I had to this business, and
you say it’s only worth $2.5 million? That cannot be!”
Perhaps doctors accustomed to entering difficult
mortality/morbidity discussions with patients can
understand the emotions owners experience when the
summation of their life’s achievements is reduced to a
number. Owners often don’t know the value they would
apply to represent their life’s work, but it is usually much
higher than actual value. When emotions contend with
rationality, feelings often win. However, it is always
better to reconcile with reality than to base decisions on
emotions, because emotions are notorious deceivers.
Mistake #7:
Dependence on Appraisals Performed for
Non-Transactional Purposes
Business appraisals can be performed for a host of reasons
such as estate and gift taxes, shareholder buyouts,
litigation, damage calculations, buy/sell purposes, and
more. Each specific purpose can produce a different value.
No appraisal should ever be relied upon except for the
specific purpose it was created. When setting transaction
expectations, owners should only trust valuation reports
produced specifically for buy/sell purposes.
To illustrate, valuations used for litigation purposes are
likely to vary widely depending on whether the valuator
represents the plaintiff or defendant. If a report produced
for litigation purposes is used by a seller in a transaction,
the recommended value will likely be far too high for most
buyers or significantly lower than the seller should realize.
Illustration: Husband And Wife Engage CPA Firm Valuations
In Midst Of Divorce, Providing Unrealistic Values
1 0 | T h e B r i d g e | S u m m e r 2 0 2 3
Mistake #8:
Dependence on the Wrong Professional Advisors
A reliable valuation is foundational to good decision-
making in business transactions. Therefore, professional
advisors who offer valuation opinions need to get it
right. Regrettably, many advisors offer indefensible
quasi-professional opinions that cause more harm
than good. Professional advisors tend to trust that
their general education equips them to render reliable
valuation advice. However, without specialized training,
access to valuation resources, and other tools of the
trade, advisors often step into the same traps as owners
by relying on rumors, inappropriate comparisons, etc.
When professional advisors render erroneous opinions,
their clients’ expectations harden like cement. Quasi-
professional opinions are an extreme disservice to
business owners, because it sentences them to the
consequences of indefensible valuation expectations.
Illustration: Owner Storms Out In Disbelief
View original content on the
Blue River Financial Group website here.
William “Bill” Loftis
Is Managing Partner and co-founder of
Blue River. Mr. Loftis developed a passion
for M&A as a transaction principal, and has
assisted buy and sell-side clients through
the M&A process in multiple industries. He
earned a B.A. in Business Administration
from Alma College and a Master of Science
in Finance from Colorado State University.
Bill’s full bio is available here.
“When emotions contend with rationality, feelings
often win. However, it is always better to reconcile
with reality than to base decisions on emotions,
because emotions are notorious deceivers.”
Blue River has been representing
middle market business owners and
professional acquirers through the
merger and acquisition process for
nearly two decades.
We understand transaction values from
the theoretical and practical levels like
few others. Since transactions depend
on funding, we blend traditional appraisal
methods with advanced modeling used
by banks and professional investors
to support our opinions. Our findings
are supported by internal and external
industry transaction databases, original
research, and experience.
If you plan to sell all or a portion of your
company in the near term or over the
next 5 to 10 years, transaction value
will likely be among the most important
decision variables. The sooner you
understand how key internal and external
drivers affect value, the more time
you will have to strategically influence
outcomes. Contact us to schedule an
appointment with one of our Certified
Valuation Analysts.
About
Blue River