Quarter Two Middle Market M&A Report 2020

Quarter Two Middle Market M&A Report 2020

 

LUTZ BUSINESS INSIGHTS

 

quarter two middle market m&a report 2020

As the COVID-19 pandemic continues to spread, Q2 2020 has registered a massive drop in M&A activity. The total value of lower middle market deals (transaction value less than $1 billion) announced in Q2 was $23.7 billion – 60.3% below the same period the year before. Volume, meanwhile, fell 24.3% year over year and 25.7% quarter over quarter to 2,340 deals. Compared to Q1 2020 when the impact of the pandemic wasn’t quite clear yet around the world, the collapse in dealmaking in Q2 was significant.

Much of the drop in the deal flow is attributed to the current global health crisis and resulting macroeconomic and market turmoil caused by COVID-19. Many buyers chose to either abandon or postpone the deal process until they get more clarity into what the near future holds. Many M&A deals depend on financing availability, and now faced with an uncertain macroenvironment and tightening of credit markets, buyers are forced to restructure terms and levels of debt versus equity. 

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OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

115 Canopy Street, Suite 200

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Salary vs. Distribution: Effect on Valuations

Salary vs. Distribution: Effect on Valuations

 

LUTZ BUSINESS INSIGHTS

 

Salary vs. Distribution: Effect on Valuations

salary vs. distribution: effect on valuations

michael greteman, financial analyst

 

One of the indisputable benefits of owning a private company is the ability to determine your compensation. Whether this comes in the form of salary, bonus, owner’s perquisites or distributions, an owner is able to effectively set their income (within reason, the Internal Revenue Service has stipulated).

In the case of a pass-through entity, such as an S Corporation, after deducting all expenses, including salaries and wages, all of the business income/loss will flow to the owner’s tax returns to be taxed at the individual rather than entity level. This single level of taxation for a pass-through entity is a primary benefit in electing to be taxed as an S Corp rather than a C Corp, which faces both an entity and dividend tax.

If the owner of a pass-through entity elects to make distributions, so long as the distributions received by a shareholder do not exceed his/her basis, they will not be taxable. Therefore, many business owners elect to make distributions from the company on a periodic basis, often becoming reliant on these earnings as a primary income source.

Practically speaking, this indistinguishable reliance upon salary and distributions as equal forms of compensation is not unreasonable. So long as the money flows to the owner and taxes are paid on the earnings, the difference seems more akin to an accounting/tax issue than a misleading indifference.  However, the lack of a distinguisher between the treatment of salary and distributions as compensation can have implications when the need for a valuation arises. To demonstrate this, see the following example:

Example: Valuation of Company XYZ

Company XYZ is an S Corporation engaged in the business of providing landscaping services. The company is owned and managed by three individuals. Recently, a third-party approached Company XYZ with a buy-out offer, which is dependent on the three owners/managers continuing to work for the company. The price included in the buy-out offer is $1,250,000. Management of Company XYZ retained a valuation advisory firm to determine the reasonableness of the third-party offer price.

During the preliminary analysis stage, the valuation firm engaged by Company XYZ made three normalizing adjustments to the company’s pre-tax income to derive an adjusted EBITDA figure, as shown below.

Applying a market-derived EBITDA multiple of 4x to the company’s adjusted EBITDA yields an implied value of company operations of $1,820,000. Based on the current fact set, the offer price of $1,250,000 seems to undervalue Company XYZ significantly.

To better understand the operations of Company XYZ, the valuation firm requested information relating to the management compensation of the company. As stated earlier, the three owners of Company XYZ are also the three managers. When asked about their pay, the individuals stated that their take-home pay was competitive for the market. Owner #1, serving as the President of the company, earned $210,000 in 2018, while owners #2 and #3, both Vice Presidents, earned $160,000 each. Based on the valuation firm’s research, this level of compensation is a fair indication of market compensation and what the owners could expect to receive, assuming they stayed with the company in their current management positions after the transaction.

However, red flags were raised by the valuation firm upon performing an independent analysis of the detailed compensation paid to the owners. While the owners were technically truthful in describing their level of earnings, both the substance and the form of the compensation must be considered. The following chart details the total compensation paid to the three owners/managers:

There are two main issues in play here.

1) The IRS may take issue with the level of salary and bonus paid to the owners. As demonstrated in various IRS cases (JD & Associates, Ltd. vs. United States of America [Case No. 3:04-cv-59]), a reasonable level of compensation must be paid to owners of pass-through entities. The basic thought process here is that even though the company’s total business income will be taxed as earnings to each of the owner’s personal tax returns, reasonable salaries must be taken to ensure the 15.3% of payroll taxes are collected based on total wages paid.

2) Assuming the owners expect to receive similar compensation after the transaction is completed, the cash flows of Company XYZ are overstated. The $325,000 of distributions paid out to managers in the prior year would now flow directly to the new owners after the transaction. Therefore, an adjustment must be made to appropriately reflect the miscategorized distributions paid to the owners as salaries and wages, as well as the associated payroll taxes, assessed at 15.3%.

Adjusting the company’s compensation levels to classify distributions received as salaries and wages appropriately greatly reduces the EBITDA of Company XYZ, as shown below.

Applying the same 4x multiple to the new adjusted EBITDA results in a diminished value of $321,100.

Conclusion: The above example demonstrates the impact that can occur with a simple adjustment made during the course of a valuation. While there was no ill-will by the owners in how they structured their compensation, the simple reclassification of distributions to salary and wages effectively eliminates the majority of the value of Company XYZ. It is best for both sides in a potential transaction to discover issues related to owner compensation before a large amount of resources are spent pursuing a deal destined to fall apart during the diligence phase.

ABOUT THE AUTHOR

402.514.0015

mgreteman@lutz.us

LINKEDIN

MICHAEL GRETEMAN + FINANCIAL ANALYST

Michael Greteman is a Financial Analyst at Lutz M&A with over two years of business valuation experience. His primary responsibilities include performing business valuation analyses, analyzing and interpreting company historic and projected financial data, building financial models, and developing marketing and transaction materials.

 

AREAS OF FOCUS
  • Business Valuation Analyses
  • Analyzing & Interpreting Financial Data
  • Building Financial Models
AFFILIATIONS AND CREDENTIALS
  • Accredited in Business Valuation
  • American Institute of Certified Public Accountants, Member
  • Certified Public Accountant
EDUCATIONAL BACKGROUND
  • MAC, Creighton University, Omaha, NE
  • BSBA, Creighton University, Omaha, NE
COMMUNITY SERVICE
  • Big Brothers Big Sisters of the Midlands, Volunteer
  • Siena Francis Homeless Shelter, Volunteer

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OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

115 Canopy Street, Suite 200

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

SBA Updates to the Paycheck Protection Program Loan Guidance

SBA Updates to the Paycheck Protection Program Loan Guidance

 

LUTZ BUSINESS INSIGHTS

 

SBA Updates to the Paycheck Protection Program Loan Guidance

SBA Updates to the Paycheck Protection Program Loan Guidance

On June 22nd, 2020, the SBA provided updated guidance to the Loan Forgiveness Interim Final Rule. This new PPP guidance contains the following key updates:

Flexible Covered Period Option

A borrower may submit a loan forgiveness application any time on or before the maturity date of the loan – including before the end of the covered period – if the borrower has used all of the loan proceeds for which the borrower is requesting forgiveness. If the borrower applies for forgiveness before the end of the covered period and has reduced any employee’s salaries or wages in excess of 25%, the borrower must account for the excess salary reduction for the full 8-week or 24-week covered period.

S-Corp Owner Retirement Contributions Allowable

S-corporation owner-employees are capped by the amount of their 2019 employee cash compensation and employer retirement contributions made on their behalf. However, employer health insurance contributions made on their behalf cannot be separately added because those payments are already included in their employee cash compensation.

FTE Reduction Safe Harbor Date

The date on which borrowers need to have eliminated any reduction in salary/hourly wage greater than 25% or reduction in FTEs (Reduction Safe Harbor dates) has been updated to “anytime on or before December 31st, 2020.”

C-Corp Owner Compensation Clarified

C-corporation owner-employees are capped by the amount of their 2019 employee cash compensation and employer retirement and health insurance contributions made on their behalf.

If you have any questions, please contact your Lutz representative or email us at ppploan@lutz.us.

Updated 6/25/2020

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OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

115 Canopy Street, Suite 200

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Paycheck Protection Program + FLEXIBILITY ACT OF 2020 – H.R.7010

Paycheck Protection Program + FLEXIBILITY ACT OF 2020 – H.R.7010

 

LUTZ BUSINESS INSIGHTS

 

Paycheck Protection Program + FLEXIBILITY ACT OF 2020 – H.R.7010

Paycheck Protection Program + FLEXIBILITY ACT OF 2020 – H.R.7010

This bill was passed in the House on Thursday, May 28, 2020, and the Senate on Wednesday, June 3, 2020. Once the President signs the bill, it will become law; it is anticipated the President will sign the bill. The below commentary contains Lutz’s interpretation of the updates. Note, the below may change upon the SBA’s implementation of the bill.

CHANGES TO THE PPP IN H.R.7010 

  • PPP Loan Maturity: Updated to 5-year term from a 2year term (needs to be mutually agreed upon with the lender). 
  • Extension of the covered period. The borrower may select: 
    • Earlier of 24 weeks after PPP loan proceeds received or December 31, 2020, OR
    • Currently defined 8week covered period 
  • FTE Reduction and Salary/Hourly Wage Reduction Safe Harbor Date: Updated to December 31, 2020 from June 30, 2020.
  • FTE Reduction Test – Exemption based on employee availability: 
    • For employee reductions made between 2/15/20 – 12/31/20, these reductions will not be considered so long as the Borrower makes a good faith certification and documents that:
      • Borrower is unable to rehire the employees who were employed as of 2/15/20 AND unable to hire similarly qualified employees for those positions by 12/31/20, OR
      • Borrower is unable to return to same level of business activity that such business was operating at before 2/15/20 due to compliance with requirements established or guidance issued by the Secretary of Health and Human Services, Director of the Centers for Disease Control and Prevention, or Occupational Safety and Health Administration during the period from 3/1/20 – 12/31/20, related to the maintenance of standards for sanitation, social distancing or any other worker or customer safety requirement related to COVID-19
  • Payroll Requirement: reduced to 60% from 75% (amount of forgiveness that must have been spent on payroll). 
  • Deferral of Principal, Interest and Fees: Any payments are now deferred until forgiveness application is remitted to the lender from the SBA. 
  • If the borrower does not apply for forgiveness before ten months from the last day of the Covered Period, payments of principal, interest and fee will start on the date that is ten months after the last day of the Covered Period. 
  • Deferral of Payroll Taxes: PPP borrowers can delay payroll taxes per Section 2302(a) of the CARES Act.

 

FORGIVENESS CALCULATION UNCERTAINTIES AS A RESULT OF H.R.7010 

As can be expected, changes in the bill resulted in confusion as it relates to existing PPP provisions. Below is a list of the questions that will need to be clarified by the SBA. 

  • For the Salary Reduction Test: Is the average salary still determined based on the average over the entire covered period? Issues could arise for borrowers who temporarily laid employees off but now must average those salaries over the entire 24-week period. 
  • Will more clarity be provided on the FTE exception based on the compliance requirements established by the three named government entities? 
  • Does the 60% payroll requirement rule act as a cliff, in that if 60% of total forgiveness is not made up of payroll, the entire portion is non-forgivable? This would go against prior guidance in the forgiveness application. We do not believe it was intended for this 60% rule to act as a cliff. 
  • Does the Alternative Payroll Covered Period now extend 24 weeks? 
  • If a borrower chooses to maintain an 8-week covered period, will they be subject to the same 12/31/2020 Reduction Safe Harbor date? It would likely be more beneficial for these borrowers to measure at 6/30/2020. 

The next step in this process will be implementation guidance provided by the SBA. The application for forgiveness will likely change considering this new bill, and other key provisions could materially change. 

 

ADDITIONAL LUTZ GUIDANCE AS IT RELATES TO FTE REDUCTION TESTS 

The FTE reduction test was intended to reduce the amount of loan forgiveness afforded to recipients of PPP funds who still furloughed or laid off employees due to COVID-19. The FTE Reduction Safe Harbor test was implemented to relieve borrowers of this reduction in forgiveness if they increase headcount as of 6/30/20 (now 12/31/20) to 2/15/20 levels. 

The FTE Reduction and safe harbor test were well-intended and reasonable on paper. However, issues arose given reductions in employees (FTEs) for nonCOVID-19 reasons. To account for these nonCOVID-19 reductions in FTEs, the SBA added two exceptions when the application for forgiveness was released: 

FTE Reduction Exception #1: 

Any positions for which the borrower made a good-faith, written offer to rehire an employee during the covered period (or APCP), which was rejected by the employee. 

FTE Reduction Exception #2: 

Any employees who during the covered period (or APCP): 

  • Were fired for cause, 
  • Voluntarily resigned, or 
  • Voluntarily requested and received a reduction of their hours. 

Exceptions #1 and #2 apply only if the position in question was not filled by a new employee 

Similarly, bill H.R.7010 passed in both the House and the Senate provided two further “exceptions” for a reduction in FTEs. During the period beginning on 2/15/20 and ending on 12/31/20, the amount of loan forgiveness shall be determined without regard to a proportional reduction in the number of FTEs if a Borrower in good faith is able to document:  

FTE Reduction Exception #3: 

An inability to rehire individuals who were employees of the borrower on 2/15/20; and an inability to hire similarly qualified employees for unfilled positions on or before 12/31/20. 

FTE Reduction Exception #4: 

An inability to return to the same level of business activity as such business was operating at before 2/15/20, due to compliance with requirements established or guidance issued by the Secretary of Health and Human Services, the Director of the Centers for Disease Control and Prevention, or the Occupational Safety and Health Administration during the period beginning on 3/1/20, and ending 12/31/20, related to the maintenance of standards for sanitation, social distancing, or any other worker or customer safety requirement related to COVID–19. 

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Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

115 Canopy Street, Suite 200

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Quarter One Middle Market M&A Report 2020

Quarter One Middle Market M&A Report 2020

 

LUTZ BUSINESS INSIGHTS

 

Quarter One Middle Market M&A Update 2020

QUARTER ONE MIDDLE MARKET M&A REPORT 2020

After a record level of M&A activity in the last decade, the deal pipeline is slowing down as transaction participants are trying to assess the disruptions caused by the economic lockdown. Market analysts around the world were forced to throw away all their March 2020 forecasts, as the economic shockwave that came as a result of the COVID-19 pandemic began to ripple through domestic and international markets.

 Acquisitions are still being completed, albeit at a slower pace and at lower valuations than before. Many ongoing deals have been put on hold or pushed back to the last two quarters of the year due to increased market uncertainty as well as valuation and financing concerns. The 23% drop in monthly transaction volume from January to March is a sobering depiction of the current state of affairs in the lower middle market.

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Financial Statements 101

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We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

115 Canopy Street, Suite 200

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Am I Ready to Sell My Business?

Am I Ready to Sell My Business?

 

LUTZ BUSINESS INSIGHTS

 

Am I Ready to Sell My Business?

Am i ready to sell my business?

bill kenedy, LUTZ consulting and M&A shareholder

 

When is the right time to exit your business? There is never a clear answer to this question. However, whether you are considering a business sale or not, it’s important to understand your options, so you are prepared when the time comes. After all, an important key to a successful transaction is finding the right buyer. Here are a few tips to keep in mind when working on a potential deal:

 

Non-Disclosure Agreements

Before you start any discussions, you must begin by executing an NDA or non-disclosure agreement (confidentiality agreement) with potential buyers. We recommend you have your attorney draft the contract as opposed to just signing an agreement provided by the buyer (or from a Google search!). 

It’s also beneficial to utilize the help of a professional M&A advisor. These individuals spend most of their time on M&A transactions, meaning they have the knowledge and experience needed to be an extremely valuable asset to have on your team. 

 

Financial Documents

Initially, it’s only necessary to provide high-level financial information, such as revenue and normalized EBITDA.  There is no need to provide full financials or tax returns early in the process. You should request that the buyer provides you with a valuation range based on these metrics with the understanding they will have to verify those numbers if you agree to continue negotiations. If the buyer is not willing to provide a range based on these metrics, they may not be a serious buyer.

 

Formal Offer

If the potential buyer provides an acceptable range, ask them for a list of what they would need to review to submit a formal offer. At this point, you should involve your attorney and M&A advisor to review the list and determine what is necessary to provide. This is especially important if the potential buyer you are in discussions with is a competitor. It is imperative not to disclose too much information too soon. They could potentially misuse the information if a deal is not consummated (even though they signed and NDA)!

 

Use An M&A Advisor

Most importantly, don’t try to get through this alone! Based on a number of our experiences, we generally advise both buyers and sellers to work with a professional to get the most out of a business transaction. Here are two primary examples of both negative and positive sale outcomes our team has experienced over the years:

Example #1

Company A determines that the Private Equity Group they had been having discussions with for years was the group they wanted to sell to. They understood that a competitive process was an option, but chose not to take that path, as they were comfortable with the offer from this group. The transaction closed successfully, but within 15 months of the closing, the PE Group sold the company for a significantly higher price (with no significant change in the business over the 15 months). This example teaches us not to depend on factors like industry and location. Going through a competitive process is the only way to understand the full value of your business. Although, in this case, the initial sale price was slightly above the average of similar companies in their industry, it was not representative of the actual value of this particular business.

Example #2

Company A signs a non-disclosure agreement with a potential buyer; they provide them with the appropriate financial information and then receive an offer. Shortly after, Company A hires Lutz M&A to run a competitive M&A process, which includes this particular potential buyer. Based on the competitive process and properly presenting the company and its financials, the buyer ended up raising their offer to over 70% higher than their original offer (and was not the highest offer!).

 

Benefits of Hiring an M&A Advisor

We have many examples, similar to the two above, which is why we strongly advise business owners to engage in a competitive M&A process. Here is a list of some of the key reasons we believe this is the best course of action:

  • The competition of having many potential buyers drives up the price.
  • There’s a better chance of meeting the right buyer for the business (note that many of our deals have gone to buyers that were not the highest bidder!).
  • This process typically ensures ‘backup’ buyers if the deal with the original buyer falls through.
  • The systematic process helps reduce the amount of time it takes to close the deal. The selected buyer will know other suitors are waiting for their shot at the business, which keeps them focused.
  • At the end of the process, the owner will feel as though they found the best buyer at the best price for their company.

Selling your business will be one of the biggest decisions you ever make. It’s never too early to begin exploring your options. Contact Lutz M&A today to start the conversation!

ABOUT THE AUTHOR

bill kenedy

402.492.2132

bkenedy@lutz.us

BILL KENEDY + LUTZ CONSULTING AND M&A SHAREHOLDER

Bill Kenedy is a Lutz Consulting and M&A Shareholder at Lutz. He specializes in business valuation, litigation support, and merger and acquisition advisory services.

AREAS OF FOCUS
AFFILIATIONS AND CREDENTIALS
  • American Institute of Certified Public Accountants, Member
  • Nebraska Society of Certified Public Accountants, Member
  • Certified Public Accountant
  • Accredited in Business Valuation
  • Certified in Financial Forensic
  • Certified Exit Planning Advisor
EDUCATIONAL BACKGROUND
  • BSBA in Accounting, St. John’s University, Collegeville, MN
COMMUNITY SERVICE
  • Construction Financial Management Association, Past Treasurer, Board Member
  • A Time to Heal (non-profit focused on cancer patients), Past Board Member

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We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.

Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

115 Canopy Street, Suite 200

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850