Monday, January 28, 2013

Preparing For The Next Merger Meeting (2)


Before we start this blog, I must point out that, in this story of the merger of Best Blogs Ever, Inc (BBE) and Blog Topics, Inc. (BTI), the numbers used are simply made up in order to arrive at a certain result, the merger of the companies.  This blog points out several ways to value a privately held business; not in order to teach how to do so, but to introduce several financial concepts.  The financial analysis of a publicly traded share of stock is different than the analysis of a share of a privately held company.  As has been pointed out by one commentator, there is "more art than science" in the valuation of a closely held business.  Now we return to the story.

In the last blog, we learned how our financial consultant, Mary Jo, valued the stock of BBE.  She next presented her analysis of the value of the stock held by Bob and Mary Pat in BTI.  She had looked at their company in the same ways she had analyzed BBE in the last blog.

Her valuation of BTI based on an asset analysis showed an equity of $30,000, represented by the 200 shares of common stock, owned equally by Bob and Mary Pat (100 shares each).  Not surprisingly since we are in the same business, the assets of BTI are the same as BBE's assets: servers, computers, office furniture and furnishings.  With the small number of authorized and issued shares, the book value of each share of BTI common stock is $150 per share, which is an interesting number but of little help in determining what BBE should pay for those shares.

Using the income approach, Mary Jo reviewed BTI's income statement and determined that, in the last year of operations, BTI had net income of $40,000 for earnings per share of $200.  She pointed out that these net earnings were after Bob and Mary Pat had each drawn a salary from the corporation of $30,000 for a total of $60,000 in wages paid to the couple.  They could have increased their salaries or declared a year end bonus for themselves if they had wanted to draw a total of $100,000 out of BTI, both of which would be treated as deductible compensation by BTI on its tax return.  However, they always operated the company conservatively and had left the money in the company as retained earnings, opting to pay taxes on that income.  Unlike BBE which declares nondeductible dividends on its common stock in order to provide the non-employee shareholders with a return on their investment, Bob and Mary Pat did not have BTI declare a nondeductible dividend to them.  Mary Jo did not bother calculating a "present value" for the earnings per share of BTI stock and then discounting them since anyone could use the same math and arrive at a different value, depending on the assumptions made.  

Having discussed BTI's income statement prepared according to generally accepted accounting principles (GAAP), she then spoke about a non GAAP way to analyze a company.  This way of looking at BTI's earnings before the usual deductions for interest, depreciation, taxes and amortization results in a number referred to as EBITDA.  If such deductions (some being non cash reductions in earnings such as depreciation of equipment and amortization of non tangible assets) are added back into a company's net income, you arrive at the amount of cash a company has actually produced.  In our case, the EBITDA plus the salaries paid to Bob and Mary Pat reveals how much free cash flow (funds not needed for any other corporate purpose) BTI generates.  That number represents additional money which BBE could anticipate having in order to pay Bob and Mary Pat a fixed dividend on the preferred shares we propose to exchange with them for their common stock in BTI.  Our goal is an increase in cash flow as a result of the merger sufficient to pay the price for BTI's common shares.

Mary Jo then discussed the market comparison method to determine the value of the BTI shares.  Due to the difference in the number of issued shares of the two corporations, she first had to equalize the number of shares to get comparable earnings per share.  If BTI's $40,000 of earnings were spread over the same number of shares as BBE's 13,500 outstanding shares, the earnings per share would be $2.96.  BBE's earnings per share for last year were $4.82.  If she applied the same price/earnings ratio she had used for BBE, 15, to the per share earnings of BTI, she would come up with a value per share of $44.40 as opposed to BBE's per share value of $72.30 with the same P/E ratio.  This indicates that each share of BBE common stock is worth 1.63 shares of BTI stock.  

If we do a rough calculation of the value of BTI as a business by simply multiplying the $200 per share of GAAP earnings by a P/E of 15, the value of each share is $3,000.  That price applied to the 200 shares owned by Bob and Mary Pat gives us a value of $600,000 ($3,000 x 200).  This seems like a high number until Mary Jo points out that, if we look at the EBITDA plus the salaries of Bob and Mary Pat, we would be paying $600,000 for adjusted annual earnings for BTI of $100,000.  In other words, we are paying $6 for every $1 of additional cash flow we hope to achieve with a merger with BTI.  This could be considered a bargain, especially if you factor in anticipated increases in revenue, income and cash flow in future years.

Mary Jo and Kate from VFI shared their thoughts on offering Bob, Mary Pat and their blog writers a second class of common shares with different voting rights in order to maintain the current voting control balance in BBE common shares.  We intend to bring this up at our next meeting.  We know that they have been going through the same financial exercises with BBE's financial information.  We look forward to, hopefully, reaching an agreement with them next Monday.

Comments are always welcome.

Monday, January 21, 2013

Preparing For The Next Merger Meeting (1)

Before we start this blog, I must point out that, in this story of the merger of Best Blogs Ever, Inc (BBE) and Blog Topics, Inc. (BTI), I assume that both companies pay income taxes.  Given that BBE and BTI are small, privately owned businesses, in the real world, they would be organized in such a manner as to avoid double taxation on their earnings (tax on the company's earnings and then tax on the shareholders' dividends).  Under US tax rules, they could elect to avoid income taxes at the corporate level, and their owners/shareholders would be directly taxed on the company's earnings.  The tax rules give a benefit to small, closely held businesses since one layer of taxes is avoided, i.e., the tax on the entity's income.  In order to explain some financial concepts, we will suspend reality on this issue.  With this caveat, we return to the story. 

When we first met with Bob and Mary Pat, we had exchanged financial information with them.  Each side had provided the other with three years of financial statements and tax returns.  We have agreed that the merger will be a swap of shares.  Therefore, the most important issue is the value of each company's common shares.  Since Bob and Mary Pat have agreed to trade their common shares in BTI for a combination of BBE preferred shares and common shares, we need to reach agreement on the values of our respective businesses.  Preferred shares have a par value so it is easy to determine how many preferred shares Bob and Mary Pat will receive once agreement on the price for their shares is reached.  Since preferred shares have no voting rights, their par value has no impact of the voting structure of BBE.  If those shares were to be redeemed, Bob and Mary Pat would receive the stated par value for each share, which also plays a role in establishing the dividend rate.

Since BBE stock is the currency we will spend on the merger, it is important that we decide what each share of our stock is worth.  We will propose that the par value of each share of the preferred shares will be $500.  The value of the common shares, with no par value, is a different story.  Our financial consultant, Mary Jo, has spent quite a bit of time on BBE's financial statements.  She tells us that there are three different ways to value a small business: the asset analysis, the income approach and the market comparison method.  She reviews each of them as they might apply to our company.

The asset approach involves a review of our balance sheet.  In the latest year, BBE's assets, which consist of our servers, computers, office furniture and accounts receivable, total $150,000.  BBE owes its bank a total of $35,000 divided between an equipment loan with a balance of $30,000 and a revolving loan with a balance of $5,000.  Here is a link to the blog about those loans.  The equity in BBE is the difference, $115,000.  The equity in BBE includes the $5,000 invested by the original shareholders when the company was formed,  the later VFI investment of $70,000 in preferred and common stock plus retained earnings of $40,000.  Retained earnings represent the net income earned in the past which was not distributed to the shareholders as dividends.  Since the 600 preferred shares issued to VFI with a par value of $100 per share totals $60,000, the remaining equity of $55,000 is shared by the 13,500 issued common shares.  This gives each share a book value of $4.07.  Mary Jo points out that the book value for the shares does not reflect the true value of the stock.  The real assets of BBE are its people, the blog writers whose efforts produce the company's income.  In a very real sense, our assets leave the office every night.  Although mathematically correct, the asset approach does not present the true value of BBE's common stock.

Analyzing the company's income statements is the second way to look at the company.  The value of a company is based, in large part, on the income the shareholders can expect the business to earn over their period of ownership.  In the last fiscal year, BBE had gross revenues of $185,000 and expenses of $100,000 for a gross profit of $85,000.  After debt service, preferred and common share dividends, depreciation, taxes and other accounting deductions, the net income for the year under GAAP accounting rules was $65,000.  If you divide that net income by the 13,500 shares of issued BBE common stock, you arrive at $4.82 earnings per share.  A person interested in buying shares in BBE would then have to estimate its future earnings for several years and then calculate the discounted value of that income stream in order to arrive at a "present value" for the shares.  Because the result of this mathematical exercise depends heavily on what earnings are projected and the discount rate used in this analysis, the results can vary over a wide range of value.  In effect, similar numbers looked at in different ways will produce different values.  Although the mathematical formula may be correct, the financial assumptions made will determine either a high or a low value for the stock being studied.  Like beauty, value is in the eye of the beholder.

The final method of valuing shares in a private company is market comparison.  You can look at publicly traded companies in the same business and see how the stock market values them.  One of the easiest metrics to apply is the price/earnings ratio (P/E), which we have discussed in other blogs.  Let's assume that there is a publicly owned company which posts blogs just like BBE and BTI, and its shares trade in the market with a P/E of 21.  The higher the P/E, the higher the stock value.  Since this is a public company, its P/E is higher than one that could be commanded by our small business.  Mary Jo tells us that if you apply a lower ratio, such as 15 to BBE's earnings per share of $4.82, the value of a share would be $72.30 ($4.82 x 15).  Obviously, Bob and Mary Pat would argue for a higher P/E ratio.

We will return to Mary Jo's analysis and advice in the next blog.

Comments are always welcome.

Monday, January 14, 2013

Meeting To Merge (2)


During the week leading up to our next meeting with Bob and Mary Pat, we met with our original shareholders and the representatives of venture Funds, Inc. (VFI), Kate, Daniel and Susan, to discuss how to accomplish the merger with Blog Topics, Inc. (BTI).  Although supportive of the idea, none of the shareholders want to have BBE issue enough common stock to upset the existing share structure of BBE.  VFI, in addition to its common shares, also owns 600 shares of cumulative, convertible preferred shares with a par value of $100 per share and a dividend of 2% per annum.  After further discussion, we formulate a plan for negotiating the merger as a stock swap for the common shares of BTI.

Bob and Mary Pat arrived for the second meeting with their legal counsel, Dennis, and two of their blog writers, Will and Catherine.  BBE was represented by Alice, our president.  She was joined by Daniel, on behalf of VFI, Carl, our attorney, and me.  After some preliminary pleasantries, we got down to business.  Carl had advised us that one of the basic rules of negotiation was to have the other side name their price first.  If the amount expected by Bob and Mary Pat was too high, we could start to whittle them down.  If they offered less than we were willing to pay, then we immediately started out ahead of the game.  Dennis, an experienced mergers and acquisitions lawyer, deflected Carl's question of price by suggesting that we start with the structure of the merger.  He confirmed that Bob and Mary Pat want to avoid taxes to the extent possible so they did not want cash for their BTI shares.  Everyone readily agreed that a stock exchange, a swap of BTI shares for BBE shares, was the preferred form of merger.

Bob and Mary Pat were interested in receiving a fixed amount of income to fund their retirement.  They looked forward to spending their summers on Lake Michigan and wintering in Cabo San Lucas.  Daniel proposes an issuance of BBE preferred stock with a fixed dividend.  Since VFI owns the previously issued series of BBE preferred shares, the ones to be held by Bob and Mary Pat would be second series preferred shares.  Their preferred shares would be subordinate to VFI's preferred shares.  This means that, in the event of a liquidation of BBE, VFI would have its preferred shares redeemed prior to those owned by Bob and Mary Pat.  VFI's preferred shares would have a prior claim to the assets of the company.  Since their shares would also be preferred, Bob and Mary Pat would have their shares redeemed before any common shares.  After some discussion, we agree that the BTI shares would be exchanged for a combination of preferred and common shares.

When VFI invested in BBE, it wanted to share in the growth prospects of the company in addition to the fixed dividend paid on its preferred shares.  As a result, it also bought a minority percentage of the common shares.  Both VFI and the original shareholders want to keep the present balance of control in the common shares of BBE.  Bob and Mary Pat seem to accept this structure, assuming we reach a mutually acceptable price for their shares of BTI.  Their lawyer, Dennis, indicated that there might be certain other terms on which agreement had to be reached, but he would save those for another meeting.  Bob and Mary Pat then reiterate their desire that their five blog writers are protected in the negotiations.  We had already assured them that no blogger would lose his or her position with the company.  

Will and Catherine, the two senior BTI bloggers, attended the meeting to represent the other bloggers.  Will, a famous Irish playwright with an English knighthood for his efforts, had been the first writer to join Bob and Mary Pat when they started the company.  He had quickly developed a devoted following to his blogs on live theater and the entertainment industry in general.  Revealing his Irish humor, he had jokingly asked, when we were introduced, to be addressed as "Sir."   Catherine had been with BTI almost as long as Will.  Before joining the company, she had authored several highly acclaimed historical  novels.  Like Will, she had become a very successful blogger, posting weekly on American historical events and their relevance to the country today.  They confirmed that none of the bloggers had any interest in owning or managing BTI; however, they felt that the blogging staff should receive some financial consideration if they agreed to continue their blogs under the BBE banner.

Carl, our attorney, indicated that the blog writers might receive some common shares of stock in BBE so they would have an equity interest in the company and its success; however, the present balance of voting control had to be maintained.  He suggested that BBE might issue a second class of common shares to Bob, Mary Pat and the writers.  These shares could have different voting rights.  Having reached the broad outlines of an agreement, we agreed to meet again next Monday.

Comments are always welcome.

Monday, January 7, 2013

Meeting To Merge (1)


We meet with Bob and Mary to discuss the possibility of Best Blogs Ever, Inc. (BBE) merging with Blogging Topics, Inc. (BTI).  When Venture Funds, Inc. (VFI) made its investment in BBE several years ago, the final agreement resulted in VFI using some of its money to purchase a minority interest in BBE common stock and investing the rest in BBE's newly authorized issue of cumulative, convertible preferred stock (par value of $100 per share) with a 2% dividend.  Here is a link to the March 14, 2011 blog on VFI's investment.

Our financial consultant, Mary Jo, lays out three possibilities for a merger.  BBE could pay Bob and Mary Pat cash for their stock in BTI.  The downside of such a sale for Bob and Mary Pat is that if they receive cash, they will have to pay taxes on their gain, i.e., the difference between their tax basis (the cash they paid for their stock) and the sale price for those shares.  Since this results in less money for their retirement, Bob and Mary Pat are not very interested in this sort of merger.  The second type of merger would involve a swap of BTI shares for BBE shares (common or preferred).  If structured correctly, they would receive shares in BBE and yet have no taxes to pay.  A third option would be for them to receive a combination of stock and cash for their BTI shares.  Here is a link to some of the US tax rules affecting mergers.

When we negotiated with VFI, the original shareholders were adamant that they maintain voting control of the company.  Consequently, in addition to its preferred shares, VFI bought 400 shares of common stock.  At that time, the original shareholders owned a majority of the common stock, 500 shares.  These holdings had become, after the 10 for 1 stock split, 4,000 shares and 5,000 shares respectively.  Faced with passing the dividend on the common shares due to low cash reserves the year after the VFI investment, the Board had declared a 3 for 2 stock dividend in lieu of a cash dividend.  This had increased the stock holdings of VFI to 6,000 shares.  The original owners now own 7,500 shares.  BBE still has 27,500 shares of authorized but unissued shares of common stock.  Our president, Alice, suggested that some of these shares could be swapped for the BTI shares owned by Bob and Mary Pat.

They agreed with this idea in principle, but said they needed to consult with their legal and financial advisers about the details.  We need to discuss this with our shareholders and advisers as well.  Mary Pat brought up their concern about how a merger might affect their employees.  Alice said that we had no intention of taking over the posting of their existing blogs.  We would hire all of their bloggers.  Our staff would take over all of the adminstrative,  "back office" issues for BTI, which had been handled entirely by Mary Pat.  The purpose of this merger is to grow BBE by adding blogs to its internet offerings, not to reduce administrative costs.  We assured her that all BTI bloggers would continue posting as usual.

Both sides agree to another meeting next week, which will give everyone time to consider the ramifications of a merger of BBE and BTI.

Comments are always welcome.