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AMC Owners as Buyers and Sellers – Two Perspectives

2013 AMC Institute Loews Don Cesar Beach Resort

Thursday, February 14, 2013St. Petersburg Beach, Florida

Overview of Today’s Topics

• Gregory Cowhey– Pots of Gold – Help for Sellers

• Basic Overview of Valuation Concepts & Principles• Current Observations of the Private Equity Market

• Scott Hermansen– Skeltons in the Closet – Buyer Beware

• Pricing, Due Diligence, Relationships & Deal Structure

• Questions & Answers

Pots of Gold

Help for Sellers

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Business Valuation Issues and Considerations

•Standards of Value

– Fair Market Value

• Willing Buyer

• Willing Seller

• No Compulsion To Act

• Knowledgeable Parties

• Hypothetical Buyer/ Seller

• Transaction Based

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Business Valuation Issues and Considerations

•Standards of Value– Investment Value

Specific Buyer Strategic

Value to A Specific Investor Based on Individual Investment

– Fair Value

Specific Use – Legal Concept

Dissenters’ Shareholders suits

– Intrinsic Value

Analytical Judgment

Perceived Characteristics of the Investment

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Business Valuation Issues and Considerations

• Premise of Value

– Going Concern

– Assemblage of Assets

– Orderly Liquidation

– Forced Liquidation

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Business Valuation Issues and Considerations

SELECTING THE VALUATION METHODOLOGY

Asset Approach Income Approach Market Approach

Capitalization of Cash Flow Method

Discounted Cash Flow Guideline

Comparable Companies

Comparable Transactions

Asset Accumulation

Method

Treasury Method

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Business Valuation Issues and Considerations

• Intangible Assets Seen in Most Businesses

– Identification• Customer related intangible assets• Contract related intangible assets• Human capital related intangible assets• Location related intangible assets• Goodwill related intangible assets• Patents and other intellectual property• Below Market Leases

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Valuing Intangible Assets

• Income ApproachDirect CapitalizationYield Capitalization

• CostReplacement CostReproduction CostResearch and Development

• Market ApproachRelief from Royalty Method

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Adjusting Reported Income Statements

Type 1 – Unusual/Non-Recurring Adjustments

The first type are adjustments that eliminate one-time gains or losses, other unusual items, non-recurring business elements, expenses of non-operating assets and the like.

Type 2 - Discretionary (Control) Expense Adjustments

The second type of normalization adjustment involves adjustments that normalize officer/owner compensation and other discretionary expenses that may be eliminated by an owner motivated to maximize profits and provide the greatest return to its stockholders.

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Type 2 Control Adjustments

Must consider the size of, and level of control associated with, the Subject Interest in determining whether to make Type 2 Control Adjustments.

The use of minority cash flows in the income approach produces a minority interest value.

Minority cash flows are those cash flows without any adjustments for prerogatives of control by the controlling shareholder (e.g. excess compensation and perquisites)

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Examples of Type 2 Normalizing Adjustments

• Remove Non-Operating Income

• Analyze Cost of Goods Sold/Inventory Considerations

• Excessive or Understated Officer’s Compensation

• Family Members/Related Party Transactions

• Travel and Entertainment

• Related Party Rent

• Professional Fees

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Conventional Audit Trail

CASH INVOICESDISBURSEMENTS CHECKS AND LEDGER PURCHASE

ORDERS

CORPORATE FINANCIAL TRIAL GENERAL or PARTNERSHIP TAX RETURN STATEMENTS BALANCE LEDGER

CASH INVOICES RECEIPTS BANK AND LEDGER DEPOSITS RELATED

DOCUMENTS

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Replacement Compensation

• By definition, is a Type 2 Control Adjustment

• Often referred to as “normalized compensation” or “reasonable compensation allowance”

• Pertains to replacement compensation to replace (or retain) the owner/operator for the services performed.

– Separate and distinct from the owner’s return on investment in the form of dividends/distributions

• Trading current income (ordinary tax) for capital gains income (Cap gains tax)

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Measuring Risk in Business Valuations

• Discount and Capitalization Rate Calculation– The Bigger The Risk – The Bigger The Required Return– Rate Reflective of the Risk of The Investment– Rate Must Match Economic Income Stream

Build Up Method - Example– Risk Free Rate 4.92%– Equity Risk Premium 6.14– Small Stock Premium 6.41– Industry Risk Premium 1.43– Other Risk Considerations 2.00

Discount Rate 20.90%

Capitalization Rate = Discount Rate Less Long Term Growth Rate

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Levels of ValueSynergistic (Strategic) Value

Control

PremiumMinority or

Discount

Discount for Lack of

Marketability

Value of Control Shares *

Value of minority shares if freely traded on an active public market (“Publicly traded equivalent value or Stock Market Value

Value of non-marketable minority (lack of control) shares

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Tax Ramifications of Closely-Held Businesses

Corporate income taxes on projected/historical earnings.

Almost always factored into the business valuation in order to match an after-tax discount or capitalization rate with an after tax cash flow stream. As noted above, a minority of business appraisers believe that S corporations should be treated differently.

Built-In Gains Tax May be considered in underlying business valuation.

Trapped-In Gains May be considered in underlying business valuation.

Income taxes on sale of stock or sale of assets and resultant liquidation of the corporation.

Not considered in business valuation.

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Trapped In Gains (TIG) in Business Valuations

Underlying Theory Applied to Business Valuation

– A hypothetical willing buyer would discount the price which would be paid for a stock in a corporation with trapped in gains (TIG). Similarly, a hypothetical seller will accept a lower price for a stock that is subject to trapped in gains.

– ABC Corporation holds $5 million worth of assets and has no trapped in capital gains. XYZ Corporation holds $5 million of identical classes of assets, but has trapped in capital gains of $3 million due to depreciation recapture and market appreciation of its assets. All other things being equal, a hypothetical buyer would pay less for an interest in XYZ Corporation than in ABC Corporation due to the trapped in capital gains.

Observations From Current Market

Data

Three Aspects of Private EquityFundraising, Investment & Exits Trends

Exits

Investment

Fundraising

PE Fundraising Tentative in 2010Number of Funds Closed and Total Capital Raised by Year

2004 2005 2006 2007 2008 2009 2010*$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

0

50

100

150

200

250

300

$95,590

$154,612

$207,406

$303,517 $311,611

$142,689

$17,330

128

215201

242

189

96

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Capital Raised ($B) # of Funds Raised *Through 1Q 2010

Fundraising Moving in Right DirectionUS Private Equity Fundraising by Quarter

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q2008 2009 2010

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

0

10

20

30

40

50

60

70

$87,320

$101,431

$86,855

$36,005

$61,395

$39,631

$17,000$24,664 $17,330

64

4846

31

39

27

1317

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Capital Raised ($B) # of Funds Raised

Record Levels of Dry Powder; $400BCapital Overhang for US-Focused Funds Raised by US Investors

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*

-$100,000

$0

$100,000

$200,000

$300,000

$400,000

$149,679

$230,187 $231,762

$292,025

$377,878$399,587

Overhang (Cumulative Total) Equity Invested ($B) Capital Raised by Funds ($B) Overhang (By Year)*Through 4/2009

Source: PitchBook

Mid-Sized Funds Make Their Mark Percentage of US PE Funds (Count) by Size

2004 2005 2006 2007 2008 2009 2010*0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Under $100M $100M-$250M $250M-$500M $500M-$1B $1B-$5B $5B+

*Through 1Q 2010

Smaller Funds Dig into Big Fund Market

Percentage of Capital Raised by Size – US Funds

2004 2005 2006 2007 2008 2009 2010*0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Under $100M $100M-$250M $250M-$500M $500M-$1B $1B-$5B $5B+

*Through 1Q 2010

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Recent Performance for $10-$250 MM Deal RangeGF Data Resources Survey

• Private sponsored deals reported by 174 PE firms and 1,431 deals since 2003Q1

• Reporting data for 1,147 transactions that exhibited pricing multiples of 3-10x EBITDA [80% of total universe]

• Size of transaction– Smaller deals $10-$25 M value trade at 5.0-5.4x EBITDA– Larger deals $100-$250M value trade at 7.0-8.5x EBITDA

• Leverage model turned upside down– Pre-2006: typical model was 20% “real money” by PE firm with 80% bank debt– Post-2007: “new model” has averaged 50/50, with Seller taking back debt

• Flight to quality– Inferior performers command lower pricing multiples

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Recent Performance for $10-$250 MM Deal RangeGF Data Resources Survey

• 2010-2012 Statistics– 2010-H1 – 60 deals at pricing multiples in the 5.5x EBITDA range– 2010-H2 – 102 deals at pricing multiples in the 6.1x EBITDA range– 2012-Q1 – 29 deals, still in the 6.1x EBITDA range– Election results – Democrats could not pass tax legislation

• P/E Firms have “Dry Powder”– Need to invest or return– GP paid on %AUM and carried interest– Lack of success from 2007-2009 creates cautionary approach– Above average performance needed to attract attention

• Financing Deals– Deal multiples – 6.1x EBITDA– Senior Debt – 2.2x EBITDA– Total Debt – 3.0x EBITDA --- Sellers need to keep “skin in the game”– P/E Firm Equity – 3.1x EBITDA

Small Deals Dominate VolumePercentage of Deal Volume (count) by Deal Size Range

2003 2004 2005 2006 2007 2008 2009 2010*0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Under $50M $50M-$250M $250M-$500M $500M-$1B $1B-$2.5B $2.5B+*Through 1Q 2010

Median Valuation Continues 2009 TrendPE Deal Activity (count) and Median Valuations by Year

2004 2005 2006 2007 2008 2009 2010*$0

$20

$40

$60

$80

$100

$120

0

500

1000

1500

2000

2500

3000

$56

$70

$92

$116.33

$80

$61.3$64.251582

1955

2451

2859

2023

1072

305

Median Deal Value ($M) # of Deals *Through 1Q 2010

Median Amount Rebounding in 2010PE Deal Activity (count) and Median Deal Amounts by Year

2004 2005 2006 2007 2008 2009 2010*$0

$10

$20

$30

$40

$50

$60

$70

0

500

1000

1500

2000

2500

3000

$47.25$45

$56.7

$70

$52.15

$33.05

$46.8

1582

1955

2451

2859

2023

1072

305

Median Deal Amount ($M) # of Deals *Through 1Q 2010

Secondary Deals Return, Strategics DominantUS PE Exit Activity (Exit Type Percentage)

25%

41%

59%

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q2006 2007 2008 2009 2010

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Corporate Acquisition IPO Secondary Transaction

Exits Up, IPOs Reemerge in 4Q Quarterly PE Exits by Corporate Acquisition, IPO and Secondary Sale

Percentage of capital invested by industry

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q2006 2007 2008 2009 2010

0

20

40

60

80

100

120

140

Corporate Acquisition IPO Secondary Transaction

Skeletons in the Closet

Help for Buyers

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Overview

• Buyer beware – there are skeletons everywhere.• Seller will give a great song and dance.• Independent appraisal is good, but need to determine what you

think it’s worth.• Remember, most appraisals are MAI (made as instructed).• If deal sounds too good to be true---watch out.• Everyone uses data rooms these days --- they don’t tell the whole

story – What is presented can be very filtered.– There’s nothing like hearing someone explain something.

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Pricing

• Determine if asking price is FV.• Look at 5 year history of earnings.• Do 1 or 2 clients make up the total book of business?• Prepare pro-forma statements:

– Staffing costs/savings– Overhead savings vs. overhead increases– Cost to relocate– Determine worst case/best case– Reasonable return on investment

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Liability

• Depends on the deal structure – will be discussed later.

• Can end up with less business than projected.

• Value of business can go down.

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Due Diligence

• You need a NDA, LOI and/or contract in place first.• Not always objective, can be very subjective.• Review client contracts:

– Assignability of contracts– Out clauses of contracts– Have most clients been around awhile or do they turn

• What is likelihood clients will stay.• What synergies can be realized.

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Relationships

• What is the current ownership structure?– Are the current owners active in organization?

• Logistics:– Does office need to be in a certain city– How hard is it to relocate/consolidate

• Relationship between staff and clients– Relocation of current key players

• Why does current ownership want out?

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Deal Structure

• Stock – sellers love them, buyer beware– Sellers get easy capital gain treatment for taxes– Buyer gets very limited ability to deduct anything for taxes– Since no deductions to help fund deal, want lower asking price– Assume any and all Corporate liabilities, including staff issues

• Pure merger– New ownership– Consolidate locations– Consolidate staffing

• Book of business – contracts– Contingency payments

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Conclusions

• You may need to kiss a bunch of frogs before you find a prince.• Determine what you are really buying

– Do you really want all the clients?– Are you just getting the inside track when the RFP goes

out?• This could be an easy way to increase client base.• Factor in tax consequences, but don’t let them drive the deal.• Not every deal is priced right or a good fit

– Don’t fall in love– Be willing to work– Don’t settle

Questions&

Answers

Contact Data

Gregory CowheyManaging Director – Forensic & Financial Services

CBIZ MHM, LLC

401 Plymouth Road, Suite 200

Plymouth Meeting, PA 19462

Direct: 610-862-2227

gcowhey@cbiz.com

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Contact Data

Scott M. Hermansen, CPAChief Financial Officer

Applied Measurement Professionals, Inc.

Phone: 913-895-4600

shermansen@goamp.com

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