“Making a Silk Purse from a Sow’s Ear”
Creating Value with a Negative EBITDA

Having participated in the M&A game for more years than I want to think about, I decided to close my practice in the Chicago area and relocate to South Carolina. I was looking forward to enjoying life without the additional stress associated with deal making. The problem was, with a specialization in the printing industry and over six dozen successful transactions, I began to get calls every few weeks from former owner contacts. These conversations triggered my interest in getting back in the game. As a result, I completed several more transactions. What really made it special was that the deals were made by phone (sometimes on the beach) and Zoom meetings.

I want to share one of these deals, a most interesting and unique transaction. Bob, a printing owner I have known for over twenty years, called me to discuss a problem he was having. He was the sole owner (58 years old) of a company with over 25 years of experience, generating $8.8 million in revenue, $10.9 million twelve months prior (following the departure of several customers), and was incurring a loss. His financials were showing a negative EBITDA. Bob and his son controlled 75% of the customers’ revenues. Two salespeople controlled the balance. His operating equipment and technological capabilities were outdated, and the business was overstaffed. His accountant suggested that an acquisition might solve his problems. He asked me if there were other options to consider.

After reviewing the package of information that Bob forwarded, I concluded that seeking acquisitions would be a low-probability process for a variety of reasons. I suggested another option: Shut the business down, liquidate the operating assets, relocate the customer list’s revenues to a “right-fit” company that could produce the additional revenues, be employed by the acquiring company for a period of time to maximize the revenue retention, and negotiate an attractive compensation package for himself and his son. Additionally, this plan would generate additional proceeds from the imputed goodwill value of the customer list. Bob agreed to pursue this option.

So, what determines the “right-fit” buyer in this situation?

“B” = LT + S + M + F + $ + C + L +T

B = ideal “right-fit buyer”
LT = likability and trust between the principals
S = buyer space available for added employees
M = manufacturing capacity for added customer work
F = strong balance sheet, profitable, and reasonable debt
$ = willing to place capital at risk
C = no conflicts with customers’ lists
L = location friendly to minimize employee relocation issues
T = bonus item, having previous buy-side transaction experience in integrating a company

From a standard valuation point of view, the company’s value was orderly liquidation. Bob estimated $1.9m from the liquidation of operating equipment and miscellaneous items, $375k for good inventory, and $425k for net retained working capital for a total of $2.7m to pay off his various obligations.

So, the challenge was to determine the best way to position this opportunity in the marketplace. 
The teaser focused on an offering of a relocatable customer list generating $8.8 million in revenues, with additional verbiage describing Bob’s company, including 10 large customers who had been with the company for over 10 years. It did not have an asking price. We were basically asking the buyer to pay for “blue-sky.”

My research identified 18 potential buyers that had most of the “right-fit” components. Of this group, 15 signed NDAs. After a series of phone discussions with me and Bob, we narrowed the list to 5. Bob toured their facilities, after which additional Zoom meetings were held. They were all extremely interested in adding my client’s revenues to their operations.

However, they were all unwilling to pay up front for no assets received. Their reluctance stemmed from the risk of losing money for benefits that may or may not be realized in the future. It was a difficult position to argue against. In the meetings, the dialogue never reached the micro level of quantifying the contribution to their bottom line from Bob’s customer revenues. Conceptually, I believe they recognized the value, but were not willing to risk capital upfront. However, they all offered to pay Bob an earnout ranging from 2-4% on retained sales for a period of 2-3 years, in addition to sales commissions.

I asked Bob which of the five companies he would be most comfortable being associated with. He chose John’s company. I knew his company quite well and was very friendly with the owner, having sold him a business many years ago. He had made four other acquisitions in the past decade. His company matched most of the “right-fit” components. His business was very profitable, having state-of-the-art manufacturing/technology and operating from a plant that had excess capacity. In addition, John’s plant was located within a 20-minute drive from Bob’s facility.

I thought John showed more interest in the opportunity compared to the other parties. John and Bob hit it off personality-wise, and they liked each other. I decided to focus on John and make the case for him to pursue this opportunity. My approach was twofold: one, to have him agree to what the contribution to his bottom line would be if $8.8m revenues were all retained, and two, to convince John that it would be prudent investment sense to place cash at closing with minimum risk.

I began my analysis of what John’s bottom line would be by adding the customer revenues. Bob assisted in identifying what expenses would be eliminated. Since he visited John’s facility a couple of times, he had a good understanding of his operations. Bob determined that if his revenues were retained, and all of Bob’s 36 employees relocated, the contribution would be $1.475m.

John conceded that if the revenues were retained, there would be considerable value. His opinion was $1.15m – $1.3m. However, he felt that it was a big “if” in retaining the revenues, given the fact that Bob lost $2m in revenues the previous year. I reminded him that 10 large customers had been doing business with Bob’s company for over 10 years, that he and his son controlled 75% of the customers, and they were willing to join his company with the two salespeople.

John emailed a term sheet detailing what he was willing to consider. He offered $250k at closing and an earnout of 4% on revenues for a 3-year period. Before responding to his offer, I wanted to develop several “what if” scenarios using different revenue and employee levels. We chose the projection with $5.3m revenues, a 40% decrease, and eliminating 13 employees from Bob’s 38. That situation indicated a $725k contribution. We countered with $400k and 7% earnout for 4 years. John’s reaction was not favorable. The only thing he would consider is increasing the earnout to 5%.

The next day, I met with John to discuss our counter and his reluctance to accept it. I made sure he understood that at the projected $5.3m revenues, paying an earnout of $370k, the numbers showed he would recoup most of the asking $400k cash in the first year. After additional conversations, he shared his business model for integrating another company with me. His process was to hire all the targets’ employees, and over the first quarter, decide which employees to let go. He agreed that the additional work could be completed with 20-22 of Bob’s employees. However, he was not willing to increase the cash offer.

In these conversations, John revealed that his major concern was the additional financial risk with the integration process and his concern regarding the retention of Bob’s customers. I surmised that John’s comment on the customer risk, at the $5.3m mentioned level, was negotiation-related. As for the additional capital expenditures for the integration, he clearly had a valid point.

I met with Bob to consider the next steps. I asked him how strongly he felt that he would be able to keep his customers after closing. He stated on a “worst case” basis $7.5-$8m would be retained. Given that, I proposed that we contribute $350k of value at closing, made of portions of WIP, inventory, and A/R, with the caveat that the contributing amounts be reimbursed to Bob, provided that a $5.3k revenue level was attained during the first 12 months. Bob felt that there was very limited risk in making these contributions, and he agreed with my suggestion. For negotiating purposes, in our second counter, I reduced the contribution value to $200k, $300k at closing, 5% earnout, and 4-year term.

I met John to discuss the counter. His response was very favorable. The $200k contribution alleviated some of his integration risk. He increased the cash to $300k and agreed to the 6% earnout. Judging from his increased interest, I sensed that there was more value to be realized.
 I played our last card. I increased the contribution by $150k, in exchange for an additional $50k at closing, a 7% earnout, and an additional $100k at the end of each of years 4 and 5, provided the revenues were above $5.3 million.

Not surprisingly, he accepted the request. Afterwards, John shared with me that the additional contribution made the integration virtually risk-free. He estimated that he could recoup the cash at closing within two months, and if the revenues in years 4 and 5 reached the $5.3m level, his ROI would be more than could be expected. John was really playing with “house money” after the second month.

Obviously, Bob was very pleased with the outcome. In addition to the earnout, he and his son were paid commissions. Bob and I both recognized that the $8.8m revenue level was most likely not achievable 4 or 5 years out. Even at the $5.3m number that Bob thought was easily attainable, his deal value would amount to $1.83m, considerably more than the estimated liquidation value of $2.7m. On a side note, my engagement fee also included retained assets and 50% of the equipment liquidation value.

by George A. Petrulis M&AMI, CBI