Middle Market Deals and how to buy, sell and raise capital from $5 to $500 million

One of the most frequently asked questions I receive from people buying or selling a business or raising money is: how do I value the business?

Building a thoughtful valuation for a business requires access to data that is not public.  And it isn't cheap or free.  Professionals use data sources, like Venture One and Mergerstat, but don't stop there.   We typically add public data, carefully culled from SEC filings, to gauge values for public companies.

We don't just grab the data, but analyze its relevance for each use, taking into account differences in company size, the age of the data and other variables that can impact significantly the data we're reviewing.

Professionals also like to use a discounted cash flow analysis, which incorporates forecasts of future cash flows, discounted to their present value.  That said, I find the exercise more valuable as a means of confirming other data than of actually valuing a business.  Market data is much more meaningful.

One of the most frequently unasked questions, but one that everyone wants to understand, is what is a fair M&A advisory fee?

To be clear, for a firm that genuinely plays the role of a broker-dealer or investment bank, operating under the requisite legal framework, the answer falls into a fairly narrow band. 

Ignoring the costs of any required fund raising (see my post on fees for raising capital) the fees for advising the buyer or seller in the middle market arena, tend to follow the 5-4-3-2-1 "Lehman Formula."

The Lehman Formula provides that the advisors get 5% of the first million, 4% of the second, 3% of the third, 2% of the fourth and 1% of all the consideration above four million. 

While giving my guest lecture at the University of Utah this afternoon, I invited the students to author a question for my blog with the promise that the best question would go up--with an answer:

Amy Schaber (shown here) asked, "What is the best indicator that a company will succeed?"

Answer:  As the question was phrased in the singular, that is, what is the best single indicator, I will answer that way.  The best indicator, though not a perfect predictor in isolation, is the management team.  What we look for is people who have succeeded before.  The bigger the better.

The investment thesis is that there is a process to creating value in an organization.  The process can be studied, mastered, perfected and most importantly repeated.  That said, the not every deal a serial entrepreneur attempts will yield value.  A great entrepreneur knows when to say enough and move on.

Investment Bank:  As an investment banker, I've learned that most people in the middle market world don't have a clear understanding about what an investment bank does.

Most people do understand that large investment banks help take companies public, but may not appreciate what else they do or how they might help a company that is not seeking to go public.

Ultimately, a public offering (IPO) is means of accomplishing two objectives: 1)  create liquidity for owners and investors, and 2) raise capital to facilitate growth or reduce debt.

Middle market companies often seek to accomplish these objectives without an IPO.  Middle market investment banks can help to accomplish both by using private offerings to raise capital or mergers and acquisitions to help create liquidity.

Today, many private equity firms--who generally rely on intermediaries, including investment banks for deal flow--are willing to allow entrepreneurs to take money off the table at the time of an investment, accomplishing both of the objectives of the IPO without a public offering.

Investment banking firms are typically registered with the NASD.

How an entrepreneur chooses an intermediary to help with a transaction depends on a variety of factors.

There is not a bright line between what makes a middle market financial adviser a business broker or an investment bank.  Those monikers are typically self-selected.

Here are some considerations.

*The lower the transaction value, the more likely that a self-described business broker rather than a self-described investment bank is to tackle your deal.  To be clear, however, there is no line of demarcation and some self-described business brokers effect larger middle market transactions, while some self-described investment banks execute smaller middle market transactions, but this information is a fair guide as a rule of thumb.

I hadn't thought much about it before the last month or so, but suddenly I find myself thinking about why investment bankers are often so young.  Perhaps I wonder because I am not so young.

As I've aged, one of the things I've done most successfully in my life, I've taken a sort of odd sense of pride in my graying hair and the aches and pains I associate with getting older.  I'm certainly not 23 any more! (I'm 41 years OLD.)

That said, I've had a lot of young folks come work for me in the last few years.  Typically, I hire super bright young folks either while they are finishing their last year of school or immediately after they graduate.

Matt Marsh is one of the great ones!  Matt was active in almost everything in school, including serving (and this is top secret) as the regular back up to the school mascot, Swoop, at the University of Utah.

Brad Feld of Mobius Venture Capital articulated something I find to be true and quite interesting even though it is not well understood among entrepreneurs on the topic of Non-Disclosure Agreements or NDAs.

It is not customary to ask investors to sign NDA's when you pitch them your venture deal.  The primary reason that this is so is that a deal better have a better "special sauce" than can be given away in a business plan.  For instance, a software firm may describe in a plan what its technology does, but it won't likely provide a copy of the code, so their truly proprietary information is never jeopardized.

In contrast, it is customary to execute an NDA when conducting a negotiation for the sale of the business.  As Brad points out, it is driven largely by the motivation if the buyer and seller to open up a dialogue that will include some genuinely sensitive information.  While this applies in fact when the buyer and seller are truly competitors, in practice it seems to work even when the acquirer is a private equity firm--with no competing business.

The most common question I think prospective clients have of investment bankers--and rarely ask--is what does it cost? 

It is remarkable that investment banking fees for raising capital, when calculated as a percentage of the equity capital raised, are fairly flat even as scale increases.  For instance, a $5 million private placement of venture capital or private equity is likely to cost about six percent, plus or minus a point or two.  At the same time, a $500 million public offering is likely to be subject to approximately the same fee, that is, about six percent, plus or minus a point or two.

In addition to the banker's fees, expect legal costs to fall in the range of one-half to one percent of the capital raise--no matter how big the transaction gets.  Other diligence costs, including the investor's costs, should also fall in that range.  In addition, the investor may asses a point or two (or three) at closing.

Larry Stay, author of GrowYourFunds, answered a question for me on-line this week.  I've often told the Associates at Thorpe Capital Group that the CFA designation is worth the work, but as I haven't done it myself, I asked Larry (who has) his thoughts. 

Let me summarize his answer: yes.

Check out his complete answer!