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published on 19 May 2022 | reading time approx. 3 minutes
Publications on M&A transactions mostly address topics that usually become relevant in transactions in the so-called mid- and large cap segment. Typical challenges that repeatedly arise and are discussed in this area include dealing with complex, international corporate structures or implementing carve-outs when acquiring individual business units. However, quite a significant number of companies and transactions are to be found in the so-called small cap segment. There are various definitions of a small cap. However, in this case small cap is defined as a company with a turnover of between EUR 1 million and EUR 50 million. In the case of target companies of this size, transaction parties are confronted with challenges that they are often not aware of before the transaction. Some of these specific challenges are discussed below.
It is often the case that small cap companies have been family-owned for generations and are managed by a director who acts as a shareholder at the same time (further: shareholder-director). The management of the company is passed on from generation to generation within the family.
If such a company is to be sold as part of an M&A transaction, its sale is not only a matter of reason, but also a strong emotional component comes into play here. Prospective buyers should have this in mind and approach the seller and conduct negotiations later on accordingly. It is often important for the seller that “his/her” company goes into “good hands” after the transaction, that the employees' jobs are secured and that the company values are nurtured. These factors are particularly important in the process of searching for and selecting a buyer and usually cannot be compensated by a purely monetary incentive.
Experience shows that in a shareholder-director scenario the line between business and private matters often blurs. Relatives of the shareholder-director, such as the spouse, children or parents, are often employed with the target company, even though they do not actually perform any work there. Here, for example, a hidden distribution of profits can become an issue. The subsequent handling of employed relatives after the executed transaction is often a sensitive issue and sometimes results in the termination of negotiations. Time and again, it can be observed that owner-managed companies are also used for financing private expenses, such as private trips or buying works of art, shares or luxurious cars. The identification of such non-operating assets should ideally take place in advance of the transaction and their handling should be regulated before the legal transfer of ownership.
While a financial investor manages and evaluates its portfolio companies with a view to optimising earnings, then in the small cap segment – especially in the case of owner-managed companies – this is often done with a view to optimising liquidity and taxes. This leads to a situation where – assuming that business goes well and is profitable – elections arising from accounting laws are used in such a way that as many costs as possible are also recognised as expenses in the income statement. From the seller's point of view, this can often lead to an undervaluation of a company. From the buyer's point of view, there is certainly the risk of tax arrears arising in subsequent years.
Many companies from the small-cap segment are not subject to audit. As a consequence, the accounts and the annual financial statements are not always prepared in line with HGB or IFRS. A closer look at topics such as changes in inventory, capitalisation of costs or formation of provisions is very important here, so as to ensure that the buyer does not experience any nasty surprises later on regarding the company’s results of operation.
Companies from the small cap segment usually have in place only a rudimentary controlling system. The company is controlled by analysing financial data and through the cash register. The director knows the company’s customers and has a good feeling about the development of the respective business, but this is often not recorded or systematically analysed based on Key Performance Indicators (KPIs). This makes the assessment difficult for an external party and calls for a compromise between a world of exact figures and a pragmatic and goal-oriented process. Too many requests for data can lead to frustration and lack of understanding on the part of the seller; at the same time, lack of transparency can result in the buyer’s mistrust in the figures and ultimately also in the purchase price offered.
The determination of the purchase price itself can provoke many discussions. In small cap transactions, the seller is not always familiar with the pricing mechanisms that are widely used in larger transactions. It cannot be assumed with all certainty that the seller will know terms such as Enterprise Value, Net Debt, Equity Value or Working Capital Mechanism. It is therefore important that the communication between the parties is extremely transparent in the purchase price determination process and that both parties make sure early on that they have the same understanding of it. Otherwise, in the later course of the transaction process – despite both parties agreeing as far as possible that a merger would make sense – this may result in considerable complications and even in breaking down negotiations.
In summary, small cap transactions pose specific challenges and involve peculiarities that can quickly become deal breakers if not identified and addressed by the potential contracting parties at an early stage.
Jochen Reis
Partner
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Felix Markowsky
Associate Partner
Transaction advisory | Mergers & Acquisitions
