Authored By: Dr. Carl Craig & John D. Wagner
1st West Mergers and Acquisitions
First Things First
We all know that the cannabis sector represents a unique industry, and accordingly, there are cannabis-specific business factors that must be considered when thinking about selling your business. It is also a relatively new transactional industry with explosive growth opportunities – as well as significant downsides – and these factors should be considered too.
There are plenty of investors already engaged in this industry, everyone from friends and family, to angels, to VCs and institutional money. These investors are hoping to leverage this exciting opportunity into their portfolios. However, the topics covered herein are targeted to individuals and companies seeking a major liquidity event or sale of their business. This is a quick guide on deal aspects to consider and how to prepare for such an opportunity.
It is important to understand that the sale of a prepared business can happen very quickly, just like the sale of a home that has been kept in shape which has all its documentation in place. However, without preparation, the sale of a business can be very lengthy and challenging. This 1stWest M&A white paper will help you prepare today for the opportunity to rapidly transition your business in the right way for you.
Two Common Questions
Many business owners seeking an acquisition ask us the same two questions. 1) “What metrics are used to determine the value of my business when an acquirer is looking to purchase?” 2) “What are the top three or four steps I can take to maximize that value?”
Acquirers all value the same basic performance metrics of a company in any industry and this includes the cannabis industry. These metrics are easy to identify; however, due to the “confidential” and “controlled” nature of this specific industry, these business metrics may never have been collected, nor closely managed or eliminated. Therefore, the first step to preparing for selling your business is to begin (if you have not already) monitoring and understanding these basic business metrics. You must have a verifiable history of performance through these metrics. These aspects of a business cannot be changed overnight, and companies can require a lead time of as much as one year to get their house in order, if they have not been preparing all along. Once you understand and focus on these metrics, you give yourself the highest probability of a successful sale.
What Metrics Need to be Measured?
Current as well as historical metrics will be required by an acquirer. For the historical performance view, it is possible to “backfill” some data that is lost, but an acquirer will want to validate all data, so make certain you can support all your information. You will need to show:
- Top Line (total sales)
- Cost of Goods
- Gross Margin
- Other Operating Costs, especially SGA
- Bottom Line (net profit)
- Taxes Paid
- Capital Expenses
- Day Sales Outstanding (DSO)
- Cash Flow
These are the key metrics; however, the acquirers may also be looking at other characteristics such as employee satisfaction and staff turnover, operating space limitations, facility information, and so forth.
Where to Focus?
During your preparation period for selling your business, focus on continuously improving the productivity and performance of your operation, both top line (total sales) and bottom line (net profit). Keep in mind that potential acquirers will scrutinize your financial statements for the last three years and look for continuous financial performance. You will achieve the highest valuation when you show an improvement year-over-year. For example, a business that books $15 million in business for each of the last three years, with a good net profit margins, may be very attractive to the current owners of that business, but the value of that company will be heightened in a sale if an acquirer sees year-over-year growth, in addition to solid financial performance. In the end, A) a solid P&L and balance sheet, with excellent A/R (showing little or no account dating and low delinquencies), along with B) good cash flow, and C) quality earnings are the primary drivers in the valuation process. It is these metrics that should be the top priorities during the preparation period.
In addition to getting the financial aspects of the business in order, it is also essential that your financial performance be well-documented. Financial statements, well-presented using standardized GAAP methods of accounting, will go a long way to giving an acquirer confidence that you are running a high-performance company. Believe it or not, that alone can heighten values almost as much as solid earnings can. Many privately held businesses often shy away from having their financial statements audited. While the acquirers will still scrutinize your financial data, they can be put at ease knowing you have had your financials reviewed and signed off by a respected accounting company.
Further, as you prepare your business for sale, an internal SWOT analysis (Strengths, Weakness, Opportunities & Threats) can be a useful tool in determining what aspects of the business need improvement. In fact, a potential acquirer of your business will more than likely perform their own SWOT analysis, so you can only imagine how impressive it will be if you get ahead of the curve and perform your own SWOT analysis to show that you are working to improve the business, even as you prepare to sell it.
Within the SWOT analysis, S (Strengths) and W (Weaknesses) refer to internal factors in your company that you can control. O (Opportunities) and T (Threats) are typically outside the control of your business but directly impact your business.
Acquirers fall into two broad categories, 1) Those intimately familiar with your industry and maybe even your business, 2) Companies or individuals looking for an acquisition in the cannabis industry who are unfamiliar with it. Either way, the acquirer will want your expert opinion on the growth opportunity for your business. This is your chance to describe the ideas you have for fast-tracking growth, perhaps with the need for outside capital (if you had access to it), or with the industry knowledge and marketing expertise that the prospective acquirer brings to the opportunity. This is not a time to be shy. Show the acquirer there is great opportunity for them to grow this business.
Do not exaggerate the opportunity, but do not hide your expert ideas. At this point in the process, the prospective acquirer is bound by confidentiality, and they cannot steal your ideas, without serious legal consequences. They are more likely to increase the valuation they give if they see that there is an even faster way to grow the business after the acquisition.
Timing the sale of your business is based on many factors, but two factors are critical. You want to sell your business when it is doing well and the industry sector is healthy. Just as an unprofitable business has little value in a good economy, a company with historically strong earnings will not achieve its highest value if it is sold when the economy is on the decline or in the tank. Right now, in early 2018, the economic conditions are ideal for sellers to achieve high values, and they will remain so through the year. But there is already some talk of a constriction in the economy. If you are not prepared to wait out the next downturn, now is an ideal time to engage a mergers and acquisitions (M&A) advisory team to help prepare your business, and put it on the market to see what valuations you could achieve.
There are external factors, such as the overall economy, global events, and industry business cycles as well as the Federal regulations and banking considerations, which are not in your control. These will have an impact on the valuation you receive for your business. That said, while your business may not be exactly at its peak in terms of sales growth and earnings, you may decide to take your exit now, while the cannabis market is in an “up cycle,” and potentially leave a “little bit of money on the table” that you might achieve after another year or two of hard work. It is always good to sell on an upward trend. What are the consequences of waiting? For example: If your business is worth between 5X and 7X multiple of EBITDA today in this strong market (that’s the going rate for a strategic acquirer today), that multiple can easily drop in a down cycle, where you would see a 5X multiple of EBITDA, or lower. You would need to increase your EBITDA by 40% just to get back to a dollar valuation equal to the 7X multiple of EBITDA in an up-market cycle.
Selling today at a 7X, even when you suspect you could achieve a higher value, would likely be a great move in retrospect if the economy were to constrict in a year or two. An advisor who understand the complete perspective in this market will be critical for helping you think about timing and external factors.
Is your business special? Sure it is! Just like a homeowner who puts their house on the market and expects that it will achieve a premium value because it is “special,” almost every business owner thinks their business should achieve a multiple of value in excess of the averages being paid today. That’s not necessarily a bad position to hold, as it shows that the owner of the business takes great pride in what they’ve achieved over many years of hard work building up the business.
That said, in preparation for the sale of your business, it is important to understand the valuation process and have a realistic expectation of the valuation range. The acquirers are investing wisely, and they have a specific appetite for a valuation strategy. While you may push them to the top of their range, you will not change their philosophy. This is clearly one of the most critical elements of negotiating the sale of your business, and you want an excellent team to help you optimize this potential.
You can secure a typical valuation range from your M&A advisory team (investment banker or broker), if they have an understanding of the highly idiosyncratic cannabis marketplace. There are databases available to investment bankers and brokers that show the actual valuations of the sale of businesses similar to yours that have been recently sold. Both strategic acquirers (typically other cannabis companies, or companies wishing to expand their portfolio into this space) and financial acquirers (private equity investors) use these same valuation ranges when determining the value of your business. So, having this valuation information is an essential first step in the sale of your business and determining what is reasonable.
Having the average valuation range for your business is a critical initial step, but it represents an average and not necessarily what you will get in terms of valuation for your business. Whether you receive offers below, at average, or a premium above the average valuation range, will all depend on other factors beyond just the financial performance of your business. Some of these factors include:
- Quality of earnings: Are your earnings sustainable? Or was a great recent year a “sugar high” of earnings that is unlikely to repeat?
- Regulatory aspects of the market: Clearly cannabis businesses are in a challenging place with the disparity between state and federal regulations. In the event the Federal opinion (and laws) are looking to change, the opportunities get much stronger with new potential acquirers at the ready. Clearly this is a big concern.
- Strength of the management team: An acquirer of your business will very likely want to keep the team in place that made the company as strong as it is today. If you have a strong “bench” of management talent, and they’re willing to stay with the company after the sale, that will heighten the value of your business. If you have a team that’s going to vacate as soon as the transaction is complete, that will devalue your business accordingly. Good management invariably leads to high values paid for your company. If you, as the senior business lead, are wanting to step back, then you will need to have a proven team in place to step in; otherwise an acquirer will be burdened with finding that new team.
- Market position and competitive landscape: If your business is in a crowded market, and you are fiercely competing for new clients, and/or fiercely competing to keep legacy clients, this will cause a downward pressure on your valuation. An acquirer will invariably look at where you are in the competitive landscape and what your relative strengths are against other businesses in your region. A solid market position, or a dominant presence in a competitive landscape, will help you achieve highest value imaginable.
- Product mix and services: A company whose product or services mix is overly concentrated in one area (or with one brand) does not show the diversity that is attractive to a shrewd acquirer. Acquirers like to see a balanced mix of products and services, so that the company is diversified, thereby lowering risks. If you have a good mix, it demonstrates that you have managed your company well, and this should be reflected in a high valuation.
- Customer concentration: If you have one customer who accounts for more than 10% of your business, or one customer whose loss would affect earnings in a meaningful and negative way, an acquirer will devalue your business accordingly. A diverse customer base is essential to a good valuation.
- Asset quality: The quality of the assets being sold will invariably affect the multiple on your earnings. A company that has driven up its earnings by foregoing maintenance (on building, land, equipment), by shorting inventory, or by undermining the strength of their management team with low salaries is not going to be as attractive as a company that takes care of its equipment, its inventory, and its people.
- Compliance: Demonstrated compliance with all applicable regulations will be required. No acquirer wishes to purchase compliance problems, so keep this element of your house in order.
The M&A Process
A controlled auction: Selling your business is a one-time event and one of the most important business decisions that you will make. The sale of your business, if done correctly, can take anywhere from 6 to 12 months. The execution of the sale of your business must be done with the utmost professionalism if you are to optimize the value of your business. The process typically starts with a M&A advisory firm preparing an informational memorandum (IM) that builds a narrative around your business, and explains the various financial declarations that are part of the IM. As that preparation process is completed, and outreach is made to the broadest possible community of acquirers, the M&A advisory firm should extract a premium valuation (with acceptable terms and conditions) through a controlled auction to a group of serious and qualified acquirers. Under this selling scenario, in a process entirely managed by your M&A advisory firm, acquirers privately bid against each other for your business, as you decide what is the best offer based on your sales objective.
The primary steps in this methodology are as follows:
- Your M&A advisory firm should identify all potential qualified acquirers (“targets”) who may have an interest in acquiring your business. In the cannabis market, that target list can easily exceed 1,000 potential targets.
- Your M&A advisory firm should prepare an IM that clearly describes your company, markets, and financial performance. In the cannabis industry, the document is normally a 20- to 30-page document.
- Your mergers and acquisitions advisory firm should prepare a one-page “teaser” that is initially sent to each of the targets. The teaser discusses your business without naming your business.
- Confidentiality Agreements (CAs) are sent along with the “teaser” by your firm. No IMs should be sent until the CAs are signed. Each IM is a controlled document.
- Once everything is in place, the outreach takes place and your business is taken to market.
Getting Help In the M&A Process
Surrounding yourself with a strong advisory team to manage the sales process is a critical component to achieve your sales objective, and it allows you time to run your business during the sales process. Three key components include:
- A M&A advisory firm (investment banker or broker) who really understands the cannabis business and market, and can prepare and execute the methodology and steps described above. There is probably no more unique business than the cannabis industry today. Make sure your advisor understands it thoroughly.
- A transaction attorney who specializes in M&A transactions and can handle the Letters of Intent and Sales Agreements once you decide the winning acquirer.
- An accountant who can assist on the quality of earnings report and provide the necessary financial documentation that will be required.
There is no more exciting time in the life of the business owner than when he/she can sell their business for meaningful profit after many years of building the business value. To maximize the value obtained, and to allow you to run your business successfully during the process, it is a small price to pay to bring in the advisors who can prepare the business for sale so it is as attractive as possible to a potential acquirer. We’re looking at a window of another 12 to 18 months of good selling environment. Be prepared to take advantage of it.
About 1St West Mergers and Acquisitions
1St West Mergers and Acquisitions specialty practice in the cannabis industry, where Managing Directors Dr. Carl Craig and John D. Wagner Managing have decades of combined experience. Focused on the underserved lower middle-market of companies with sales of $10 to $100 million, 1St West Mergers and Acquisitions is an international M&A firm whose principals have transacted more than $1 billion in in deal values. Learn more: www.1stWestMA.com.
Contact John Wagner: [email protected]
Dr. Carl Craig: [email protected]