In the past nine years, DepoTexas has grown dramatically by acquiring other court reporting firms. We are frequently asked how we approach new acquisitions, how we find candidates, what our valuation model is, and how it has worked for us. This article will address all of these issues and will provide some strategies that may be useful to other firm owners.
WHAT CONSTITUTES A GOOD ACQUISITION TARGET?
The ideal candidate is located near one of the acquiring company’s existing physical offices and will not require the inheritance of current leased space. Even better is a candidate that has no additional lease obligations remaining for common court reporting firm equipment such as copiers, scanners, or mailing machines. Unfortunately, it is difficult to find a firm that is completely devoid of such remaining liabilities. However, the fewer remaining obligations, the better the acquisition situation. Rent is obviously the biggest financial issue. Some companies might be looking to add a strategic location and are prepared to inherit leased space for their new geographic footprint.
Staffing is a more sensitive area. Typically, the first consolidation in the consolidation process involves billing, accounting, and financial controls. Beyond that, every acquisition is different. It is critical to ascertain who controls the business in the firm. How important is the office manager? In our experience, we have always retained the staff member who communicates with clients, confirms jobs, and assigns reporters. Production is often an area that can be partially consolidated. The synergy that comes from reducing rent, leases, and staffing costs is the financial engine that can drive an acquisition and make it more attractive for the buyer and the seller. We have also been fortunate to inherit some talented team members in the production area. A buyer should take all necessary steps to train the reporters and staff members on the acquiring company’s policies and procedures.
Though a company may have good reason to expand its geographic boundaries, it will be best served to first explore candidates that are near its main office and whose rent and lease obligations are nearing the ends of their terms. These strategic fits are more financially viable than acquisitions that move a firm into new territories.
Another characteristic of an ideal firm to acquire is one where the owner is still an active reporter or videographer but has grown weary of the administrative and back office part of the business. This creates an opportunity for leveraging the existing infrastructure to support the daily needs of the acquired business while enabling the owner to do what he or she does best.
WHAT IS THE BEST WAY TO FIND CANDIDATES AND START THE PROCESS?
For a business located in one of the 36 states that require certification, the best way to start is by looking at the state’s web-updated list of registered firms. We have tried several methods of approaching firms, including sending out letters with our firm’s background and track record in acquisitions. However, nothing beats the old-fashioned personal phone call. After introducing myself, I start with, “You probably have no interest in this, but my firm actively seeks to acquire other firms, and I was calling to see if you have ever considered a sale of your firm.” A direct phone call lets me find out quickly whether there is any interest. If there is, I then ask that owner to sign a non-disclosure agreement, which I also sign, ensuring that any discussions will be conducted in the strictest of confidence.
We do not use business brokers to find target firms. We prefer to rely on our own professional network, which we have developed over the years. A broker’s typical fee may be in the 10 percent range, and that fee alone can make the economics of a deal difficult We typically ask for the past two years’ financials as well as the year-to-date numbers, the past two years’ tax returns, and detailed information on what the owner is pulling out of the business, including health insurance, automobile leases and insurance, and any other compensation that may not be easily found in the financials. We always offer the same information from our firm to put the owner at ease and also so that the owner can see we are financially capable of handling such a transaction. Additional due diligence will include a review of the company’s billing rates, what percentage it pays reporters, if it pays on bill-out or collections, if it has any work that requires discounts, such as networking or special contracts, and who the clients are. This last question is the one at which most firm owners become very cautious, and understandably so. Again, we always offer to provide the same information. Analyzing the firm’s client list, how diverse it is, and the types of business they have are some of the most important factors to consider.
WHAT’S THE BEST WAY TO DETERMINE THE VALUE OF THE FIRM?
There is nothing trickier in the entire process than figuring out what a firm is worth. For the purpose of this brief article, we will address some simple metrics with the caveat that there are many additional factors that influence value.
Analyzing the type of business that the candidate has is critical. The most valuable business is the repeat business of law firms who are billed at regular rates. Any work that is billed at discounted rates, such as networking or contracted business, is worth less. A business that is dependent on a relative few clients is also riskier. Any business that has more than 10 percent residing with one client should be viewed as a much higher risk because of the impact that losing one client could have on the buyer.
Our firm is a good example of the kind of diversity an acquiring company should seek. Our largest single client represents a little less than 3 percent of our overall business, and our top 10 clients represent less than 10 percent of our overall volume. While we hate to lose a single client, we also know that we can withstand the loss of that client and still perform well.
If a firm has less than $2,000,000 in annual revenues, most bankers would say that the firm is worth three to four times EBITDA (income before interest, taxes, depreciation, and amortization have been subtracted). As the revenue heads north of $2,000,000, the valuation multiple begins to rise gradually as well. Generally speaking, a professional services business will not command a multiple of higher than four times until it has reached $1,000,000 in EBITDA. Don’t faint at the numbers; remember that the compensation the owner is pulling out also needs to be factored into the earnings equation.
Most owners will realize quickly that selling their business does not enable them to retire with the same income they have been deriving from their business. In today’s low interest marketplace, an owner may be lucky to get a 3 percent return on his or her money.
However, there are ways to sweeten a deal that may make the offer much more lucrative to an owner. We are able to offer more than the standard EBITDA multiple if the owner is willing to take a significant amount of the payment as an earn-out, meaning the owner will be paid based upon the amount of business that is retained over a longer period of time. This method is particularly attractive as it encourages the owner to stay involved to such an extent that together you will both have the best opportunity to retain most of the business. Owners who stand firm about a large upfront payment or fixed, guaranteed payments must be prepared to take a lower multiple as they are placing all of the risk on the buyer.
If the owner is a reporter or videographer, we will always offer him or her the first right of refusal to take as much of the work as he or she would like. Because we want acquired owners to stay in front of their clients, it can also help to offer a slightly higher percentage than what is being paid to the other reporters or videographers.
WHAT ARE THE BEST WAYS TO FINANCE AN ACQUISITION?
There are a variety of ways to raise capital. All of them become much easier if the acquiring business is profitable. If a business does not have strong positive cash flow, it is probably not ready to begin making acquisitions. An acquisition would only add to immediate cash flow problems. Buyers should always remember that it takes a newly acquired court reporting business about 60 days before it begins generating cash.
If the company is profitable, one common source for funding is the Small Business Administration. Most banks offer this government-assisted funding. The SBA process requires that borrowers buy 100 percent of the target firm and that they utilize a business valuation firm to provide a third-party evaluation. For more information, see: http://www.sba.gov/loanprograms.
A bank may also provide an operating line of credit secured by the acquiring company’s receivables, creating a credit line that may allow the buyer to leverage additional capital for an acquisition.
Raising private capital is still probably the most common method used in acquisitions. Companies choosing this route can offer either debt or equity or both to investors. Investors need to be provided with an attractive rate of return and a clear exit strategy, and, for many investors, three years is a long time. If a longer period of time is needed to recoup the investment, be clear and realistic from the beginning with a conservative business plan.
WHAT ARE THE NECESSARY LEGAL STEPS AND HOW DO YOU NEGOTIATE THE DEAL?
After the acquiring company has completed its due diligence, the first step is to offer a letter of intent, outlining the proposed terms of the acquisition. The seller will respond, and it will take multiple discussions to hone in on a mutually agreeable deal. Try to stay with a steady schedule of meetings. If a seller begins to be less timely in responding, it is in the buyer’s best interest to keep up the momentum. We have completed 15 deals, and every single one was an emotional experience for the seller. This is a big step for the owner, so it can be useful to reassure him or her of the mutual value that is being created.
Once both parties have agreed to the letter of intent, the buyer needs to consult with a good transactions attorney to help with the contract. There is much to include in the contract that this article cannot sufficiently address. We do suggest several very important elements of a good contract, however.
First, the buyer should be very clear about the consideration he or she is agreeing to pay, and what part of the consideration is being applied to furniture, fixtures, and equipment, what part to non-compete, and what part to goodwill. This segment of the contract has tax consequences that affect both the buyer and the seller, and a CPA should be consulted to ensure that this part of the agreement has been properly structured.
Second, the buyer should ask the owner for as lengthy of a non-compete agreement as the buyer’s attorney says is legally valid. This non-compete clause will prevent the seller from trying to take back clients or attempting to recruit existing employees or reporters once ownership changes. A seller who is moving more than 200 miles away from the buyer’s geographical territory does not need to be restricted from starting a new business in a different area if that person is not raiding the buyer’s clients. Finally, the buyer must always include a clause in the contract that protects him or her from fraudulent information that might have been provided by the owner.
WHICH IS BETTER: AN ACQUISITION OR A MERGER?
It is important to retain the identity of the firm being acquired, and this is why it can be effective to announce the acquisition as a “merger” of the two firms. A buyer can add credibility to this by offering the seller a small amount of its company stock as part of the deal. This will enable the previous owner to say he or she is a new shareholder in the purchasing company. It also reinforces the idea that the buyer is combining forces with the seller’s reporters and staff, and that clients will continue to receive the same supportive service they enjoyed with the prior owner.
We typically keep the previous firm’s name intact for at least one year so that it is seen on email, invoices, and other communications. Change is threatening to most people, and clients will be less anxious, knowing that the acquired company will stay intact.
CAN SUCCESS BE ASSURED?
The key is to do everything possible to retain and grow the business being acquired. It always works better if the seller stays involved at some level. The buyer should bring his or her full focus to bear on the transition. Seemingly simple issues, such as provisioning the previous owner’s phone lines over to the purchasing company, can go awry without attention and follow-up. The extra work applied to ensure a smooth transition in the first few months will be well worth the effort.
The buyer needs to be especially careful with rates. If the acquired company has lower rates than the purchasing company, the lower rates should be honored for at least six months prior to making any changes. Any client who has been offered special rates continues to receive those discounts for an agreed-upon time. Work closely with the seller to determine how and when to apply rate changes.
The buyer should stay connected with the owner/seller and learn everything possible about their clients’ special needs. That owner should be treated as a valuable client. The buyer is only as good as his or her track record with previous owners. We always ask for a letter of recommendation from the previous owner a year after we have completed the transaction. We want new candidates to understand that we are always timely with our payments, that we know how to run a court reporting business, and that we honor our agreements.
The acquisition process can be demanding and tricky, but it is one of the best ways to expand. We have been especially gratified that the more firms we have folded in to our company, the more our overall business seems to build and grow. An acquisition is often called “inorganic” growth as compared to “organic” growth coming from an existing business base. But the organic and inorganic lines blur quickly as exciting opportunities can grow from the wedding of new with old business.
Zack Miller is co-owner and chief acquisitions officer of DepoTexas, Inc., a deposition services company based in Houston, Texas, with offices in Austin, Corpus Christi, Dallas, Henderson, and San Antonio. Mike Clepper is the co-owner, founder, and CEO of DepoTexas.