Valuing, structuring and financing an acquisition

Once a prospective buyer has carried out the due diligence evaluation of the financial and strategic position of the selected acquisition target (see the June 2000 Deal watch for more information) the parties must agree on a structure and a valuation for their proposed deal. In particular, the buyer must assess the situation of the target firm — as well as his own financial wherewithal — and determine what he is willing to pay for the firm. Valuations are usually determined by conducting a detailed cash-flow analysis model, by looking at the valuations of other similar companies or similar recent transactions and by assessing all of the qualitative and less tangible pros and cons of the proposed deal. If the proposed valuation range is tentatively attractive to the buyer, then the real work begins. The parties sit down and begin to negotiate a deal approach and structure built around the agreed value that will be acceptable to the stakeholders in both companies.

Most acquisitions involve either the outright purchase of the target company's stock — in which case the buyer acquires all of the assets and liabilities of the firm — or simply the purchase of selected assets of the target company. Both "stock" and "asset" deals are common in the environmental services industry, depending on the circumstances. Both typically involve payments from the buyer to the seller in some combination of the following:

  • Payment in cash — both immediate, or in terms of installments over time — which may be tied to the accomplishment of certain milestone objectives, financial or otherwise;
  • Issuance of a debt obligation or a "note," often from the seller, in which the buyer pays off principal and interest over a certain period, similar to a loan from the bank; or
  • Issuance of common stock or a special class of stock, in the acquiring firm to the owners of the selling company.

Elements of comfort

Typically, transactions in the environmental industry include components of all three of these categories, in a wide range of combinations and variations. The financial structure of a merger or acquisition transaction can become exceedingly complex. However, by using creativity and different approaches, these three key elements may present the specific benefits or comfort levels that allow both buyer and seller to be comfortable that their shareholders are getting a fair deal. Below, is a brief look at the characteristics of these different approaches.

Cash payments. As the saying goes, "Cash is king." Although it depends on the individual circumstances, most sellers prefer to receive cash when they sell their company. Once a cash payment is in hand, the deal is done, and the seller has none of the future risks or worries that may come along with accepting a note from the buyer or taking a stock position in the buyer's company. Payment in cash leaves nothing open to question. Likewise, some cash is better than no cash. Partial payment in cash signifies the buyer's seriousness and total commitment to the transaction. In an environment where credit ratings are poor and stock values are declining, it is little wonder that most sellers prefer all-cash deals. Unfortunately, however, cash is not in strong supply today in most environmental companies. As economic conditions in the industry have declined, many transactions have involved very little or no cash.

Cash-constrained buyers will obviously prefer to pay less in cash rather than more and to pay it farther out into the future rather than today. While the typical buyer may offer a certain amount of cash up-front to show good faith or to meet the "drop dead" demands of the seller, he will typically try to structure an arrangement that defers cash payments into the future. This may take the form of a pre-scheduled series of payments that allows the buyer to meet the cash demands of the seller over a period of time.

Another common means of transferring cash between buyer and seller are so-called "earn-out" arrangements, where future payments are tied to performance levels and profitability in the acquired or combined operations going forward. This can often be a mutually acceptable structure in the case where both parties sincerely believe that the transaction makes sense. The seller is willing to take the risk that the combined operation will be profitable and that she will actually receive her payments, and the buyer is given the comfort that his schedule of payments will only have to be made if on-going operations are successful.

Debt from the buyer. In a cash-constrained business such as the environmental industry, payment with borrowed money is more common than payment with cold cash from a bank account. Companies with strong credit may borrow a portion of the purchase amount from their banks and pay off the seller, in effect putting the risk on the bank's shoulders. Buyers with weaker balance sheets may not be able to borrow from lending organizations, and may request that the seller herself hold a "note" — in this type of instance, the seller is effectively "loaning" the buyer part of the purchase price. While this is clearly a less palatable arrangement, many sellers will take a note from the buyer if they are convinced of the fundamental stability of that buyer, and if they believe that the combined organization will be a stronger one going forward.

Such arrangements are fairly typical in strong and healthy industries or where they involve companies with unassailable credit ratings. Unfortunately, debt deals are more risky in the highly competitive and financially constrained environmental industry. Both parties must fundamentally realize that the ultimate pay-out and retirement of the debt is dependent upon the on-going viability and performance of the buyer. In other words, if the company doesn't do well, the seller may not get paid. Unfortunately, several companies in the industry have proven to not be viable over the past several years, and some note-holders have been left holding the bag. However, many sellers may see a debt obligation from a relatively strong company as their best alternative for recognizing value from their own investment. There are a number of ways of securing the note, varying the duration and interest rate, and the seniority of the note versus other debt obligations of the buyer — all of these issues are important aspe cts of the negotiation.

Securities in the buying firm. Strong buyers in vibrant industries typically use their stock to make acquisitions, wherein the selling company shareholders become partial owners of the acquiring firm. When equity values are strong and growing, a little bit of stock is worth a lot to a seller and doesn't do much to dilute the buyer. In the environmental industry today, the relative desirability of payment in stock — to both sides — depends on a number of things. If the seller is going to take stock from the buyer, she obviously will want confidence that the value of this stock is likely to move up rather than down in the future. More importantly, she will want a stock that offers some liquidity — i.e., that she has some way to sell the stock and turn it into cash. When the buyer is a large public company, the "sell-ability" of the stock is not an issue. In the environmental industry however, only a few buyers can claim to offer a liquid public stock. Furthermore, many buyers in this indu stry are private companies whose stock doesn't trade and hence the attractiveness of a stock deal is much more complex. Taking stock in a relatively smaller or private company involves many of the same risks and questions that were mentioned in the debt section above: Will the company succeed and allow its stock grow in value, how will the firm actually measure the value of its stock and at what point will it undertake a public offering to make the stock truly tradable?

The use of stock also provides the buyer with some difficult choices. While it protects valuable cash and avoids the assumption of new debt, it also dilutes the current ownership of the company and may ultimately change the balance of power amongst shareholders. While the true value of a private stock is often difficult to pinpoint, the buyer will clearly prefer to use stock if its value is perceived to be relatively high. If the stock value is high, the buyer needs to issue less to the seller in order to reach a certain transaction value. If the stock value is low, he will have to offer more shares of stock to reach the same value and hence will create more dilution of the existing shareholders.

Stock options

Common ground between buyer and seller can sometimes be found by creating a special type of security, carrying special privileges or characteristics which may be critically important to one side or the other.

Preferred stock. The buyer may issue the seller a "preferred" stock — a separate class of stock that may have special privileges and voting rights attached to it. A preferred stock provides the seller with a preferred right to the buyer's assets in the event of a liquidation or bankruptcy of the company. Sellers may want this type of security in order to minimize downside risk and loss in the event that the company fails. This type of stock may grant certain other authorities to the holder, including such things as the right to approve top management and acquisition decisions.

Convertible preferred. Convertible preferred stock grants the holder similar rights for a certain period of time but converts into ordinary common stock, at a predetermined ratio, at some point in the future or at the holder's option. This type of security is used to give the shareholder some comfort during a perceived higher-risk early period following the transaction.

Convertible debt. Such instruments can offer a combination between payment in debt and equity and involve a loan to the seller that can later be converted into stock. This allows the seller to take a note but to have the upside of converting that note into equity in the event the stock of the company does well. These types of arrangements are sometimes utilized in deals where the buyer has a strong preference to avoid equity dilution and where internal cash generation can cover interest payments without threatening the viability of the company.

This brief overview illustrates the dizzying array of structures and combinations of financing alternatives that may allow the buyer and seller to make a strategically desirable deal work. There are an infinite number of ways to structure and finance a transaction. Creative and determined parties can usually hit upon a scheme that is acceptable to both sides.

This article appeared in Environmental Protection, Volume 11, Number 9, Septemeber 2000, Page 64.

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This article originally appeared in the 09/01/2000 issue of Environmental Protection.

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