After 20-plus years of transacting middle market acquisitions, I know the factors that affect the attainment of premium prices. Middle market acquisitions are transactions ranging in price from $1 million to $200 million. Many middle market executives mistakenly believe that external economic conditions significantly impact the timing and pricing of these deals. This is a gross misconception. Economic conditions should have little, if any, impact on middle market transaction prices as long as a strategic buyer is located.

A selling owner should not allow a large corporate acquirer to cite bad economic conditions as justification for a substandard transaction offer. Instead, they should demand a deal similarly priced to one under optimal economic conditions. This is the position that a sophisticated, strong-willed seller will enforce as a prerequisite to selling their company.

Acquirers are always trying to "steal" a seller's company. This psychology is a logical outgrowth of the capitalistic system. This condition exists if you are in an economic downturn, a recession, or even in optimal economic times. In addition, large acquirers by their very size and acquisitive nature are usually more familiar with the acquisition process than a selling owner. This, combined with the vast financial clout of multinational companies, enables them to approach the prospective seller in an arrogant manner demanding unreasonably low transaction prices. This is the norm. Unfortunately, most sellers fall prey to this approach and accept the norm.

The pricing of large corporate acquisitions, which have transaction prices in excess of $200 million, tends to be quite volatile. The pricing of these deals tends to mirror changes in the stock market. Contrary to these deals, the volatility of pricing of middle market acquisitions is minimal. As the upside on pricing of middle market deals during good economic times is not significant, the downside volatility of middle market transaction pricing during bad economic conditions also should be insignificant. However, large acquirers try to use poor economic conditions as the rationale for substandard offers. Don't let them!

Cut-rate pricing

During the recessions of the early '80s and 1990-91, many acquisition advisory firms accepted less than adequate pricing for their client's deals. During the latter period, George Spilka and Associates was able to close 31/2 deals per associate per year. All deals were fully-priced, as if economic conditions were optimal. Over 90% were all-cash offers. This is how middle market acquisition pricing should work during difficult economic times, if the buyer is a strategic acquirer. The reason is that middle market transaction prices should be determined by the expected future earnings (cash flow) and the risk in achieving those earnings from the business foundation given an acquirer. The expected future earnings used in developing an acquisition price will more than likely be based on the projected earnings flow through the next business cycle. Therefore, the pricing of a deal should not be significantly affected based on what point in the business cycle a company is sold.

A strategic acquirer will determine an affordable transaction price based on the expected incremental future earnings produced by the combination of the two companies. To the extent strong synergistic benefits are produced by the deal, the combined future earnings of the companies will exceed the total of both operating separately. This enables the payment of a higher premium price by a strategic acquirer, while still generating an attractive return on investment.

This is why an owner of a middle market company should avoid selling to a private equity firm (financial buyer) that brings no synergy to the deal. Without synergistic benefits, the optimum acquisition price can't be paid. In addition, financial buyers are known to avoid risk. They must generate extremely high returns on their transactions to keep the flow of institutional money into their funds. These funds guarantee their future existence. As financial buyers usually bring no synergistic benefits to the deal, and typically very little in the way of additional management skills, the sole way they can produce high returns for their institutional investors is by buying at vastly discounted prices. Their prevalence reflects that few middle market advisors are willing to commit the considerable time or develop the necessary expertise to locate domestic and foreign strategic players that are willing to complete a fully-priced deal.

When a seller proceeds to the market, its business foundation should be in solid shape. This has a substantial impact on attaining a premium price. A selling owner should have an acquisition advisory firm review its business foundation before proceeding with the sale. If there are any deficiencies in the foundation that would impact the transaction price, a skilled advisor can recommend the necessary changes. Implementing these changes will secure payment of a premium price.

For a manufacturer, certain considerations in evaluating a seller's business foundation includes: the strength of their market niche; the ability to control their customer base over a long period of time; the capability of being a cost-efficient producer; a modern plant and equipment; and the strength of the management group, among others.

For a distribution firm, the following might be considerations: the quality of the product lines; the capability of management; the sales force's control of the customer base; the capability to maintain strong pricing; the operation of a cost-efficient warehouse; and the ability to procure goods at a competitive price with their large national competitors.

Other characteristics might affect the business foundation and deal pricing, depending on the specific industry. An acquisition advisory firm can counsel a seller on the most important factors that define the strength of the business foundation in their industry.

There are five key points to remember, if a selling owner is to consummate a fully-priced deal during an economic downturn or a recession. These will be discussed in next month's issue.