CICA/RBC Business Monitor Economic Results Overview

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2 CICA/RBC Business Monitor Economic Results Overview

3 Optimism Is Near 2007 Highs 100% 80% 60% Economic Optimism Company Optimism 40% 20% 0% Q Q Q Q Q Q Q Q Q Q Q Q1 2010

4 Key Metric Projections Continue To Improve 7 % 5 % Profits Revenue Employees 3 % 1 % -1 % Q Q Q Q Q Q Q Q Q Q Q Q % -5 % -7 %

5 Financing Options for Financing Business Options Transition for Business Transition presented by JOHN LIDDY Managing Director, Financial Advisory Services RBC Royal Bank

6 Introduction - Business Succession Planning 54% of Canadian business owners plan to exit their businesses within 10 years (Business Banking Board) 46% 54%

7 Business Succession - Common Exit Strategies Family Succession/Transition Selling to a Partner Selling to a Third Party

8 Business Succession - Common Exit Strategies Family Succession/Transition: Requires as much advance planning as possible. Should start at least five years ahead. All members of the family should be involved in the planning. Prepare the next generation to ensure an effective transition. Gradual transition approach provides continuity in operations and financial stability. Structure is a challenge if there will be a cash payment ultimately from the business. The key concerns are liquidity and leverage (including debt servicing). Evaluate liquidity of the business to support this strategy in the short and longer term.

9 Business Succession - Common Exit Strategies Selling to a Partner or Management: Benefits from inside knowledge of the operation, lowering risk of failure May require the vendor to provide some ongoing support as the buyer may not have sufficient personal equity for an outright purchase With proper planning and time, it is possible to structure an agreement to support the purchase over a longer time frame Option to bring in an investor as a partner/senior role to eventually purchase your interests

10 Business Succession - Common Exit Strategies Selling to a Third Party: Prepare well in advance at least five years Get the business positioned for sale: Improve cash flow Overhead and SG&A expenses Eliminate non-essential costs if it does not add to cash flow then stop doing it. Sell/dispose non-core or non-productive assets Review tax strategies For existing operations: Are there any opportunities to increase after tax income? For the future purchaser: Are there any strategies which could be currently implemented which would make the company more attractive?

11 Business Succession - Common Exit Strategies Selling to a Third Party: Prepare a pitch book about the business. Business & Financial history Current Profile Customers, suppliers Employee relations (union?) Production Product lines R&D Premises Share with current FI no surprises Consider potential buyers: Customers, suppliers, competitors Professional networks Business brokers

12 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers:

13 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Strategic Buyers:

14 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Strategic Buyers:

15 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Strategic Buyers: Interested in businesses that fit their long-range growth plans:

16 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products

17 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability

18 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share

19 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Key decision factors include: Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share

20 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Key decision factors include: Financial performance Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share

21 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Key decision factors include: Financial performance Growth potential Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share

22 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Key decision factors include: Financial performance Growth potential Market opportunities Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share

23 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Key decision factors include: Financial performance Growth potential Market opportunities Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share Key decision factors include:

24 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Key decision factors include: Financial performance Growth potential Market opportunities Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share Key decision factors include: How does this support their business growth plan

25 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Key decision factors include: Financial performance Growth potential Market opportunities Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share Key decision factors include: How does this support their business growth plan Historical earnings

26 Business Succession- Common Exit Strategies Selling to a Third Party: Two Types of Buyers Financial Buyers: Interested in the earnings of the business Key decision factors include: Financial performance Growth potential Market opportunities Strategic Buyers: Interested in businesses that fit their long-range growth plans: New market for products Expanded distribution capability Increases market share Key decision factors include: How does this support their business growth plan Historical earnings Benefits from economies of scale

27 Financing Business Succession

28 Business Succession What is it? Business Succession Planning is the process of preparing to hand over control of the business to others in a way that is the least disruptive to the business s operations and value Business Succession refers to the orderly transfer of ownership of a business entity Such transfer of ownership most commonly occurs in one of two ways: the assets of the company are sold ( asset sale ) the shares in the company are sold ( share sale )

29 Business Succession Either or both parties would dictate the structure (asset vs share) for various reasons but the top three are: 1. Liability: a) Following a sale of shares, the seller loses his connection with the company. The company itself continues to exist and, in particular, liabilities (hidden or otherwise) continue as liabilities of the new owners. b) When only the assets are sold, the seller retains responsibility for settling the liabilities of the company.

30 Business Succession 2. Cost and Complexity: 3. Tax: Ownership of shares is transferred through a share purchase agreement. In an asset sale, each separate asset must be transferred, which can result in complications (e.g. third party consents). Some vendors prefer share sales as there could be a tax advantage. In Canada, if the seller s shares are "qualified small business corporation shares" they can claim a tax exemption up to $750,000 on the gain of the sale which is not available to the corporation if it sells the assets.

31 Business Succession Financing a Business Succession There are a number of ways to effect a transfer of ownership, and various sources of capital available, most common of which are: 1. Cash Equity which may be sourced from existing cash or liquid investments, or through equity in existing assets (e.g. house, company or investment real estate) 2. Senior Secured Debt provided by a bank 3. Vendor Financing provided by the seller of the business in the form of a take back note. These notes are typically contractual settled over a defined period of time and may include: 1. Earn-out: the vendor of the business is paid out over a period of time based on a percentage of annual profits

32 Business Succession Financing a Business Succession con t 2. Fixed payment terms: the purchaser pays a stipulated amount of money over a defined time period regardless of the fortunes of the business. 4. Leveraged / Management Buy-Out (LBO / MBO) or High Leverage Transactions (HLT) result from the acquisition of a majority of a target company s equity through the use of borrowed money. This structure results in a high ratio of debt to equity, beyond industry norms

33 Business Succession Acquisition Using Senior Secured Debt Senior Debt has priority over all other classes of debt and equity It is usually secured with a first rank charge on the assets It also implies the debt leverage is within conventional lending practices Sufficient lending value exists within the pledged asset base to fully secure the proposed debt Loan margins should follow industry practices e.g. 75% AR, 50% Inventory Term/Amortization tends to be five years or less, although there are exceptions on a case-by-case basis

34 Business Succession Vendor Financing Vendor take-back financing (VTB): the seller agrees to finance part or all of the transaction The VTB terms usually include a second charge on the assets, ranking after the Bank Senior Secured Debt When the VTB is formally postponed to the bank, it is usually treated as equity for balance sheet leverage tests, however it is considered debt if it pays cash interest for debt service covenant (DSC) calculations If the DSC is below the covenant due to cash interest payments, consider using PIK (Payment In Kind additional shares, warrants, discounted bonds) For some or all interest payments Until the FI no longer requires the postponement As a mechanism, if a loan default occurs, to continue interest payments without breaching additional covenants The purchaser would be expected to provide the material amount of equity

35 Business Succession Cash Flow Implications All successful entrepreneurs are very good at one or two things, although finance is not usually one of them. It is not uncommon for the small commercial business owner to measure how they are doing by the amount of cash in the current account. Their perception of working capital is generally similar but there are differences from our approach.

36 Client s Perception of Working Capital INFLOWS Collections Trade Credit (extended A/P) Discounted A/R Inventory Sales Investment Income Loan Draws DRAGS Uncollected Receivables Obsolete Inventory Low Investment Rates Tight Credit C A S H OUTFLOWS Disbursements Payroll Payments Taxes Loan Payments Dividends Investments PULLS Early Payments Shortened Credit Limits Limited Credit Lines Low Liquidity

37 Business Succession Cash Flow Implications Many fail to understand how the purchase or sale of a business can effect cash flow. The sale of a business will give rise to one time expenses ( transaction costs ) such as legal, tax, accounting, financing, etc. Normally, transaction costs are estimated, however they are usually underestimated. It is important to be aware of and prepared for the potential for material cash flow disruption. The following will illustrate the impact of transaction costs

38 Free Cash Flow to Shareholders Business Succession Pre LBO Cash Flow Run Rate } Transaction costs: legal, accounting, distracted management etc New Run Rate Cash Flow Transaction Event Integration Fully Completed Time Time

39 Terms & Conditions

40 Business Succession Terms and Conditions: A. Security: Typical security would include one or more of the following: a) GSA; b) Fixed/Floating Debenture or Moveable/Immoveable Hypothec (Quebec), c) Personal or Corporate Guarantees; d) Postponement of Claims, e) Chattel Mortgage, f) Collateral Mortgage g) Relevant to the transaction

41 Business Succession Covenants : Typical key considerations for determining if acquisition financing qualifies for senior debt are the following ratios (calculated after taking into account the impact of the acquisition): Total Liabilities to Tangible Net Worth Debt Service Coverage Current Ratio Fixed Charge Coverage Funded Debt to EBITDA

42 Business Succession Covenants : Typical key considerations for determining if acquisition financing qualifies for senior debt are the following ratios (calculated after taking into account the impact of the acquisition): Total Liabilities to Tangible Net Worth < 2.50 : 1

43 Business Succession Covenants : Typical key considerations for determining if acquisition financing qualifies for senior debt are the following ratios (calculated after taking into account the impact of the acquisition): Total Liabilities to Tangible Net Worth < 2.50 : 1 Debt Service Coverage > 1.35 : 1

44 Business Succession Covenants : Typical key considerations for determining if acquisition financing qualifies for senior debt are the following ratios (calculated after taking into account the impact of the acquisition): Total Liabilities to Tangible Net Worth < 2.50 : 1 Debt Service Coverage > 1.35 : 1 Current Ratio > 1.10 : 1

45 Business Succession Covenants : Typical key considerations for determining if acquisition financing qualifies for senior debt are the following ratios (calculated after taking into account the impact of the acquisition): Total Liabilities to Tangible Net Worth < 2.50 : 1 Debt Service Coverage > 1.35 : 1 Current Ratio > 1.10 : 1 Fixed Charge Coverage > 1.20 : 1

46 Business Succession Covenants : Typical key considerations for determining if acquisition financing qualifies for senior debt are the following ratios (calculated after taking into account the impact of the acquisition): Total Liabilities to Tangible Net Worth < 2.50 : 1 Debt Service Coverage > 1.35 : 1 Current Ratio > 1.10 : 1 Fixed Charge Coverage > 1.20 : 1 Funded Debt to EBITDA < 2.75 : 1

47 Business Succession Covenants : Covenants are intended to set boundaries within which both parties are comfortable They are not intended to interfere with the normal course of business The likelihood of reality following projections is around zero Covenant levels should be tested against forecasts, using several scenarios (good, bad and worse) which could identify future problems Any problems should be addressed with the FI in advance no surprises and could result in temporary relief

48 Business Succession: Debt Covenants Integration Period D/E Forecasted / Planed / Expected Max D/E Actual Normal D/E Transaction Event Integration Fully Completed

49 Business Succession Due Diligence

50 Business Succession Purchase Price The amount paid to acquire the business has a direct bearing on the ability to successfully operate the business post acquisition. In all cases, the valuation should be known and a Sources & Uses should be provided to the FI. Sources Uses Senior Bank Debt $10,000,000 Working Capital Assets $12,000,000 VTB $2,000,000 BV LT Assets $1,000,000 Equity $5,000,000 Goodwill $4,000,000 Total $17,000,000 Total $17,000,000

51 Purchase Price Business Succession Security Value vs. Enterprise Value Enterprise Value ( EV ) represents the entire economic value of a business. EV may be established through a business valuation, or may be equal to the sale price negotiated in an arms length succession based acquisition. Most often, the EV will exceed the net asset value of the business, with the difference comprising goodwill. For Senior Secured Debt transactions, loan amounts should be based on the actual confirmed values of the tangible assets of the business (not the enterprise value). Where shortfalls exist, refer to alternative Bank, such as Cash Flow or Mezzanine Term Loans or non-bank (e.g. EDC subdebt) solutions.

52 Business Succession Purchase Terms Purchase terms (i.e. all cash, combination of cash and shares, earn out provisions, amount of vendor financing) should be known as this influences the amount and type of financing to be provided. A purchase which calls for fixed vendor payments to be made regardless of company earnings carries a higher degree of default risk for a lender. A review of the major terms and conditions of the transaction (including the contents of the Purchase Agreement), representations and warranties by the vendor, and any due diligence reports completed by the professional advisors to the acquirer should be reviewed by the FI to ensure the transaction is understood and that the financing structure will not unintentionally create a default.

53 Business Succession Cash Flows: The cash flow of the acquired company must be adequate to cover operations (including regular capital expenditure requirements) as well as service all debt obligations with a sufficient buffer to account for unexpected events. A lender will not be overly reliant on forecasts and anticipated synergies in making its lending decision. Established supporting historical cash flows should be evident along with an expectation of continued performance. The cash flow forecast assumptions should provide a clear link between prior & post.

54 Business Succession Debt: When determining appropriate debt levels and lending products, consideration for how levels and repayment structures of debt could negatively affect the company s ability to: operate grow compete resulting in reduced financial flexibility. These issues should be addressed in the Company s business plan, failing which, clarification should be sought.

55 Business Succession Historical Financial Performance Three years worth of historic financial information for both the acquirer (if applicable) and target company should be reviewed. The historic financial information should be examined to ascertain : trends in sales growth and margins and the reasons; the extent to which the business is cyclical; requirements for capital expenditures or research and development expenditures; the extent to which costs are fixed or variable with sales. This analysis is geared to substantiating a case for the amount of total debt being contemplated.

56 Business Succession Financial Projections The projections (balance sheet, income statement, and cash flows) provided should be critically evaluated, with an overall emphasis to determine whether the forecasts appear credible. A sensitivity analysis should always be undertaken to gauge the impact of the key variables and if the assumptions are not met. Key sensitivities would include: reduction in sales growth exclusion of margin improvements or synergies increase in interest rates seasonality should be considered to accurately forecast the peak borrowing requirement and interest charges.

57 Business Succession Management: The potential impact on the business of a change of management should be considered. The new ownership and management should be able to demonstrate their managerial and operational qualifications both relative to the previous management and the business needs. Lending appetite should take into consideration: The relative experience of the new management team. In circumstances where new management has been deemed satisfactory, but lacks certain existing management traits, less leverage would be preferred.

58 Business Succession Management con t Management should be asked how they would respond to any downturn in demand, recession, or other factor that might produce a divergence between actual and planned performance. The current owner s ongoing role in the company may impact lending appetite. New management would not know everything Contract length Non-compete Licences, patents, trademarks, etc. The impact on cash flow of the management contract should be taken into consideration when establishing lending terms.

59 Questions?