M&A Trends: Tech & Government Contracting

Page 1 Copyrighted Material. All rights reserved. The McLean Group, LLC

M&A Trends: Tech & Government

Contracting Deal Dynamics, Valuation, Drivers and Markets in an Era of Uncertainty

Presented by: Greg Boucher

Managing Director

The McLean Group

[email protected]

Direct: 410.799.2053

September 25, 2012

mailto:[email protected]


Speaker Greg Boucher, CMAP, CMEA, SBA

Managing Director

[email protected]

703.752-9022

Greg Boucher is a managing director in The McLean Group’s M&A practice.

He has more than 25 years of both industry and business consulting experience, and writes and speaks regularly on Exit

Planning and M&A, including teaching various M&A courses for The National Association of Certified Valuation Analysts & the

Middle Market Investment Banking Association. Since 2000, he has served private business clientele in strategic consulting

and mergers & acquisition services. Greg has strategic marketing, consulting and M&A experience in the construction, retail,

internet, telecom/broadband, technology, printing/lithographic, direct mail, government contracting, and moving and storage

industries.

Greg holds a Masters Certificate in Business Management from the A. B. Freeman Graduate School of Business at Tulane

University, and holds a BS in Organizational Communications from Missouri State University. He has held professional

credentials as a Certified Business Intermediary (CBI) and a Certified Business Councilor (CBC), and currently holds

professional certification as a Certified Mergers and Acquisitions Professional (CMAP), a Senior Business Analyst (SBA), and a

Certified Machinery and Equipment Appraiser (CMEA).

Mr. Boucher is a member of the Association for Corporate Growth and serves an executive role as Secretary for the Board of

the Maryland Chapter. He is a member of the Middle Market Investment Banking Association, the National Association of

Certified Valuation Analysts, the Society of Business Analysts, and the Mid-Atlantic Business Intermediaries Association, where

he served on the board for three consecutive years. Greg is a National Association of Securities Dealers (NASD) registered

representative (Series 7, 79 and 63).


Selected Recent Advisory Experience


Total US Deal Volume (TTM) lower than 2011

Source: FactSet, July 2012

Number of Deals Closed 2011 / 2012


Trends in Private Equity


PE Investment off to a slow start in 2012

Source: Pitchbook

Number of Deals Closed (orange line) and Total Capital Invested by Year (blue bars)


Add-ons Continue to Represent Half of Total

Source: Pitchbook

Add-on Deals as Percentage of Buyout Deals


Healthcare and IT Large Share of Activity (26%)

Source: Pitchbook

Percentage of Deal Volume (count) by Industry


Trends in IT


IT Deals in Q1 & Q2 2012

Closed deals by Sector


IT slowing down in 2012

Closed deals by Size


Trends in Government

Contracting

Page 13 Confidential and Proprietary

76104

86 96

101

100

96

2009 2010 2011 2012

1st Half 2012 Summary

2012 Transaction Activity by Buyer Type

1st Half Activity in Perspective

For the first half of 2012, we are tracking 96

transactions closed in the defense and

government services sector.

Of these closed deals, financial buyers and

their portfolio companies accounted for

25% of the transaction volume.

Given the level of activity in the first quarter

and the expected increase in capital gains

taxes at the end of the year, we might expect

to see transaction volume similar to that in

2010 – However, it is uncertain exactly how

budget pressures and sequestration risk will

impact transaction activity for the remaining

three quarters.

1H

2H

177

204

182

?

Financial Buyers, 24

Strategic Buyers, 72


-50.00%

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

Defense Primes S&P 500 Index Government Services Middle Market Index

Capital Markets Overview

During the trailing 12 months ending September 14, 2012, the S&P 500 outperformed all of our custom indices. Over this time period the

market was in the negative from September 2011 until just before year-end 2011. Year to date, the S&P has trended upwards. During

this time period our Government Services Index suffered the biggest losses by falling nearly 25%. Our Defense Prime Contractor Index

and the S&P recovered beginning May 2012 to return modest LTM gains; however, our Middle Market index is performing poorly with

negative returns of -10.2%.

1 Year Relative Performance 3 Year Relative Performance

Historical LTM Median EV/EBITDA Multiple

Government Services Index: CACI, CSC, CUB, KBR, MANT, SAI, URS

Defense Prime Contractor Index: ATK, FLIR, GD, LLL, LMT,NOC, RTN

Middle Market Index: AVAV, CMTL, DRCO, ICFI, KEYW, NCIT, KTOS

6.3x

5.5x5.7x 5.6x

5.8x

5.9x 4.8x5.4x

5.5x5.4x

6.9x

5.8x 5.8x 5.7x

6.2x6.5x

4.1x

5.3x

5.9x

4.5x

6.5x

5.4x 5.4x5.2x

5.5x 5.9x

4.8x 4.9x 5.0x

5.4x

Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012

Defense Index Gov't Services Index Middle Market Index

-25.00%

-15.00%

-5.00%

5.00%

15.00%

25.00%




1 Year Relative Performance




-25.00%

-15.00%

-5.00%

5.00%

15.00%

25.00%




Historical LTM Median EV/EBITDA Multiple




6.3x

5.5x5.7x 5.6x

5.8x

5.9x 4.8x5.4x

5.5x5.4x

6.9x

5.8x 5.8x 5.7x

6.2x6.5x

4.1x

5.3x

5.9x

4.5x

6.5x

5.4x 5.4x5.2x

5.5x 5.9x

4.8x 4.9x 5.0x

5.4x

Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012

Defense Index Gov't Services Index Middle Market Index


Comparative Stock Price Performance

Defense Government Services Middle Market Index

Data as of Market Close Friday, September 14, 2012

(4%)

(3%)

(3%)

(2%)

(2%)

(1%)

(0%)

0%

0%

2%

2%

2%

3%

3%

3%

4%

6%

6%

8%

8%

15%

17%

(10%) (5%) 0% 5% 10% 15% 20%

Northrop

AeroVironment

NCI

URS

Kratos

Alliant

Comtech

Dynamics Research

Lockheed

FLIR

General Dynamics

Cubic

ICF

Raytheon

S&P 500

ManTech

L-3

CSC

CACI

SAIC

KBR

KEYW

Last 4 Weeks

(69%)

(64%)

(63%)

(46%)

(38%)

(29%)

(26%)

(25%)

(17%)

(16%)

(15%)

(8%)

(7%)

(7%)

(6%)

(6%)

3%

7%

10%

11%

19%

19%

(80%) (60%) (40%) (20%) 0% 20% 40% 60%

NCI

Dynamics Research

Kratos

ManTech

FLIR

CSC

Alliant

SAIC

AeroVironment

URS

KBR

General Dynamics

Cubic

CACI

ICF

L-3

Comtech

Northrop

S&P 500

KEYW

Raytheon

Lockheed

Last 52 Weeks


11 Trends We are Currently Watching

1. Budgets/Sequestration – At the top of everyone’s mind; materially influencing M&A

activity in the sector

2. Use of capital - Buyers continue to have substantial cash reserves and debt capacity;

M&A opportunities weighed against baseline share repurchases/special dividends.

3. Re-considering organic growth v. M&A – Organic growth in current environment

more difficult/expensive – buying market share is looking more attractive to some.

4. Strategic focus - Not seeing the attempted diversification into commercial markets we

saw during previous downturns.

5. Year-end close - Projected capital gains tax increase at the end of 2012 is contributing

to strong sell-side activity; there is an understanding that the buyer will gain leverage

the closer the closing date moves to Dec 31.

6. Small company burden - Budget pressures also contributing to sell-side activity;

tough for privately-held lower middle market companies to diversify risks.


11 Trends We are Currently Watching

7. Not over ‘til its over - Sellers are missing their numbers and buyers are scrutinizing

projections closer; greater risk of re-trade on economics/terms than we have seen

previously.

8. Finding opportunities - Bimodal distribution for valuations; hot areas are cyber,

intelligence, health IT, etc. but opportunities may be on the other hill.

9. ESOPS on the rise - Increasing ESOP activity driven by decreasing delta between

market M&A/ESOP values, increasing small business size standards and continued

scrutiny against set-aside work.

10. Active financial buyers - We are continuing to see very strong PEG activity; OCI

issues, uncertainty in market and fund timing are contributing to this.

11. Financing - Sequestration and budget pressures could lead to significant financing

issues the 2nd half of 2012 – when sellers are rushing to get deals done.


Value Drivers


What Drives IT Company Business Value?

1. Quality of Revenues

2. Financial Performance (Gross & Net Margins)

3. Strong Balance Sheet

4. Management Team’s Depth and Experience

5. Work Force

6. Quality of Assets (tangible and intangible)

7. Proprietary Rights / Intellectual Property (competitive advantage)

8. Growth Potential (business/market)

9. Strength of Products & Services

10. Favorable Economic & Industry Conditions

11. Customer Base

12. Company / Brand – Identity & Reputation

13. Quality and Effectiveness of Sales & Marketing Efforts

14. Place in Market (Leader or Follower) – Barriers to Competitive Entry

15. Quality of Financial, Sales & Operational Records


EBITDA Valuation Multiples

Government contracting value drivers are influenced by industry-specific qualitative factors. Valuation multiples can vary

greatly depending the Company’s attributes.

2x – 3x

8(a) and set-aside contracts

Significant % of subcontracts

Short-term contracts, weak

backlog

Less attractive service offering

(pure staffing, facilities mgmt,

etc.)

Commodity-type services

Less attractive service

offering (IT staffing, facilities

mgmt, etc.)

Subcontractor

Commodity-type services

3x – 5x 5x – 6x 6x – 8x

> 50% prime contracts

Longer-term contracts

Stronger backlog

Some cleared employees

High % of OCONUS

contracts

High % of prime contracts

Long-term, unrestricted contracts

Strong backlog

Secret & Top Secret clearances

required

Customer within DoD, DHS, etc.

8x – 10x

Large prime awards

Long-term, unrestricted

contracts

Strong backlog and visibility

Highly-Attractive service

offerings

Cleared work

10x + Range of

EBITDA

Multiples

Mission critical capabilities

and entrenched IP

Unrestricted prime contracts

Highly cleared work

Intelligence/Health IT/Cyber

Government Contracting Value Drivers


1. Lack of Customer Diversification

2. Contingent Liabilities

3. Inexperienced Management Team

4. Lack of Management Depth

5. Poorly Maintained Assets

6. High Operating Costs

7. Frequent Contract Renewals (bidding)

8. High employee turnover (Key employees not

locked into a contract – retention by bonus)

9. High Financing Costs

Risk Drives down Value

1. Lack of Customer Diversification

2. Contingent Liabilities

3. Inexperienced Management Team

4. Lack of Management Depth


Consideration Affects Price

----

100 90 80 70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 80 90 100

Consideration

Offered

Non-Cash Cash

Valu

e R

an

ge

High

Low

Example of a

Transaction

SE

LL

ER

’S R

ISK


A. Fair Market Value: An

appraiser’s formal

valuation (normally for

legal or IRS purposes)

B. Investment or

strategic value

(beauty is in the eye of

the beholder)

C. Dynamic

(Transactional)

Value (effective

auctions)

$0

$10

$20

$30

$40

$50

$60

$70

$80

Total Acquisition Valuation (millions)

Dynamic

Strategic

Fair Market

Multiple Realities:


8. Being Represented by an unlicensed broker

9. Communicating your asking price inappropriately

10. Eliminating offshore buyers

11. Assuming the type of buyer

12. Waiting until management is ready to retire

13. Waiting for next year’s growth

14. Ignoring or over-emphasizing timing

1. Selling it without representation

2. Selling to a single bidder

3. The poorly constructed earn-out

4. Disclosing an insufficient amount of information in Offering Memo

5. LOI not thorough

6. Focusing on history and numbers instead of future opportunity

7. Mismanaging team, end runs

The Top 14 Seller Mistakes:


Work toward a solution that is Win – Win

Divesting your company’s assets Without the bitter aftertaste


Negotiating with a single buyer?


MERGERS & ACQUISITIONS | CORPORATE FINANCE | MARKET

INTELLIGENCE | BUSINESS VALUATION | EXIT PLANNING

Greg Boucher

Managing Director

[email protected]

Direct: 410.799.2053

The McLean Group, LLC -

Headquarters

The McLean Group, LLC

7900 Westpark Drive, Suite A320

McLean, VA 22102

Tel: 703-827-0200

Fax: 703-827-0175


http://www.finra.org/

30

Scott Freed

Whiteford, Taylor & Preston, Business and Corporate Law

Scott is a partner in the corporate and M&A practice groups at Whiteford,

Taylor & Preston. Scott represents both private and public clients in a broad

range of transactions and corporate and securities matters, including equity

compensation programs, venture capital, financing transactions and M&A.

WTP is a Mid-Atlantic based business law firm with over 160 attorneys

serving their clients both regionally and nationally. Since 1933, WTP’s

attorneys have provided their clients with trusted representation and

guidance on issues critical to achieving their business goals.

D. Scott Freed | Partner

Seven Saint Paul Street | Baltimore, Maryland | 21202

t: 410.347.8763

[email protected]

Speaker Bio

http://www.wtplaw.com/professionals/d-scott-freed


M&A TRENDS: TECH &

GOVERNMENT CONTRACTING

Equity-Based Compensation Alternatives

Navigating Potentially Disruptive Legal and

Accounting Issues

Earnouts

September 2012

D. Scott Freed

Whiteford, Taylor & Preston

31

Equity-Based Compensation

Alternatives

Alternatives for granting equity awards to key employees:

1. Restricted Stock

2. Restricted Stock Units

3. Stock Options

Incentive Stock Options (ISOs)

Nonqualified Stock Options (NQSOs)

4. Stock Appreciation Rights

5. Phantom Stock

Awards may be used in whole or in part to carry-out a succession plan

32

Restricted Stock

A grant of shares of stock with limitations on transferability; may be subject to vesting requirements or other “substantial risk of forfeiture”

May be awarded for no consideration as a stock bonus or recipient may pay all or a portion of stock’s FMV

May be subject to repurchase restrictions that require the resale of stock to the company at some predetermined or formula price upon certain triggering events

Not treated as “non-qualified deferred compensation” (NQDC) under the American Jobs Creation Act (AJCA)

33

Restricted Stock

Tax Overview

Governed by IRC § 83 – taxation of “property” transferred “in

connection with the “performance of services”

Taxed upon vesting of the award (i.e., when stock is no longer

subject to a substantial risk of for forfeiture)

If no substantial risk of forfeiture, taxed at time of award

Substantial Risk of Forfeiture (IRC § 83)

Exists where rights in property are conditioned upon future

performance of substantial services by any person, or the

occurrence of a condition related to a purpose of the transfer

Section 83(b) election is available.

34

Stock Options

Represent a right to buy stock during a specified period at a

fixed purchase price

Types:


Non-qualified Stock Options (NQSOs)

Generally not deemed to be “property” for income tax purposes

(IRC § 83)

35

Nonqualified Stock Options (NQSOs)

No statutory limitations on option terms

May be granted to nonemployees (e.g., directors/ consultants)

No tax at date of grant or at vesting date(s)

Taxed at ordinary income rates upon option exercise

Capital gains treatment upon sale of underlying stock

Discounted stock options treated as NQDC under AJCA

36


Plan Requirements: Written Plan

Must specify aggregate number of shares subject to Plan

May limit all awards under omnibus plan or may limit ISO

awards only

“Net” share counting permitted (i.e., forfeited shares and shares

issued to satisfy exercise price can be reissued under Plan)

Must identify eligible Employees or class of Employees

Stockholder approval required within 12 months of adoption of Plan

No additional stockholder approval required for ISOs assumed

in a corporate transaction

ISOs are not subject to AJCA

ISO grant terms are subject to numerous special requirements

under the IRC.

37

Other Types of Equity Awards

Phantom Stock

Employee granted units equivalent to (but not actual) shares of Employer stock

Stock Appreciation Rights

Represent right to be paid spread between grant price and FMV of stock at exercise date

Restricted Stock Units Units representing shares of common stock settled by delivery of

shares at vesting or later payout

38

Equity Compensation –

Employee Tax Summary

NQSO ISO Phantom

Stock

SARs Restricted

Stock

Restricted Stock

Units

Grant Date No tax impact No tax

impact

No tax

impact

No tax

impact

No tax impact1 No tax impact

Vesting Date No tax impact No tax

impact

No tax

impact

No tax

impact

Ordinary

income1

Ordinary income2

Exercise

Date

Ordinary

income on

spread

No tax

impact3

Ordinary

income on

FMV of unit

Ordinary

income on

spread

N/A N/A

Sale Date Capital gain on

appreciation

post exercise

Capital Gain4 N/A N/A Capital gain on

appreciation1

Capital Gain on

appreciation

1 Assumes substantial risk of forfeiture exists and that recipient does not make a §83(b) election. 2 RSU may provide for deferral of payout after vesting – subject to AJCA deferral requirements. 3 AMT may be applicable. 4 Absent “disqualifying disposition.”

39

Equity Compensation –

Employer Tax Summary

NQSO ISO Phantom Stock SARs Restricted Stock Restricted Stock

Units

Grant Date No tax

deduction

No tax deduction No tax deduction No tax

deduction

No tax deduction1 No tax deduction

Vesting Date No tax

deduction

No tax deduction No tax deduction No tax

impact

Deduction equal to

compensation

recognized by

Employee1

Deduction equal

to compensation

recognized by

Employee

Exercise Date Deduction

equal to

spread at

exercise

No tax deduction Deduction equal

to compensation

recognized by

Employee

Deduction

equal to

spread at

exercise

N/A N/A

Sale Date No tax

deduction

No tax

deduction2

N/A N/A

No tax deduction No tax deduction

1 Assumes the recipient does not make a § 83(b) election. 2 Absent Disqualifying Disposition.

40

Basic Types of Exit Strategies:

41

1. Company Stock Redemption

2. Management Led Buyout

3. Third Party Sale

4. Sale to an ESOP

This Presentation is focused on a sale of target to a third-party

Buyer

M&A Risks for Seller

Disruption of business, loss of key employees, etc.

Loss of ownership/control

Confidentiality issues and risks

Unless an “all cash” deal, Buyer’s stock

Substantial costs and negotiation time

Earn-outs and contingent consideration

Escrow, holdbacks and indemnities

Failure to integrate and execute successfully

Affect on customers/suppliers if deal doesn’t go through

42

Preparing a Company for Sale

Buyer’s evaluation of target falls into four major categories:

1. Financial (e.g., accounting, financial systems and controls)

2. Business (e.g., products, customers, facilities, operations)

3. Legal (e.g., contracts, records, intellectual property,

compliance)

4. Other (e.g., environmental, HR, insurance)

43

Address Problems Early

Seller should conduct pre-go to market self-diligence

Consider/address poor earnings history

Incomplete/inadequate management team

Analyze/confirm business model or revenue stream

Market size/limited up-side

IP, Employment, Tax and other legal complications

Lack of competitive advantage/barriers to entry

Capitalization defects

Self-dealing/related party transactions

Deficient financial statements

Inadequate corporate infrastructure/accounting controls

44

Don’t Forget to Address

Opportunities

Reinforcing management depth and strength

Improving financial and IT systems

Confirming financial performance (audited financials are

recommended)

Strengthening sales and marketing infrastructure

Deepening customer and supplier relationships

Identifying potential growth initiatives

Strengthening any operations

Resolving contingent liabilities

45

Business steps to be taken

Standardize and document all company procedures

Eliminate liabilities or liens and resolve any outstanding litigation

Investigate transferability of leases and sales & supplier contracts

Perform maintenance on company equipment to ensure good operating condition

Secure key employees with employment contracts

Consider equity-based grants for truly key employees

Eliminate non-performing or non-contributing employees from the payroll

Establish a management team that can operate without the current owner

Reduce reliance on one or two large customers for the majority of sales

Spruce up the physical aspects of the business facility

Have clean, verifiable financial statements for the past three years

Financial statements should be audited if business has greater than $10 million in revenues

Reduce unnecessary inventory

Collect any outstanding receivables

Re-negotiate favorable key supply contracts

Reduce or eliminate owner adjustments on Income Statements

Ensure financial controls and procedures are established and followed

46

What is an Earnout?

Basic Definition: An earnout is a risk-allocation mechanism

used in an M&A transaction whereby a portion of the purchase

price is deferred and is paid out based on the performance of

the acquired business over a specified time period following the

closing.

47

Reasons for Use of Earnouts

Valuation Bridge: Earnouts can bridge the business valuation

gap between Seller and Buyer.

Financing Tool: An earnout can serve as a financing device for

a Buyer by permitting Buyer to pay for a part of the acquisition

with future profits of the target business.

Incentive-Based Compensation: Earnouts can also can be a

form of incentive-based compensation for Sellers who are

continuing as employees.

Early-State Companies: Earnouts are often used for

companies with little operating history but significant growth

potential (which are not easily valued).

48

Key Structural Considerations

Principal considerations when negotiating and drafting an earnout:

1. The definition and scope of the target’s business subject to the earnout.

2. The selection of the performance benchmark.

3. Measurement of the target’s performance relative to the benchmark.

4. The determination of the payout structure and form (cash, equity, debt or

a combination) and establishment of the earnout period.

5. Post-closing operation (i.e., the allocation of operational control between

buyer and seller and the level of support, if any, that buyer will commit to

assist the target business in achieving its earnout objectives)*.

6. Dispute resolution.

*Courts have held that the covenant of good faith and fair dealing will require buyer to operate the

business to maximize the likelihood of an earnout payment absent specific agreement on this point

(DE law)

49

Defining the Target Business

Clearly define the scope of the target business subject to the

earnout.

Where Target will be integrated into Buyer’s existing

business, the performance of the business may be more

difficult to track and special accounting allocations may be

required.

Matters to be addressed include: (a) the defined line of

business, (b) whether geographic or product expansion will

count toward the earnout and (c) sales to common

customers.

50

Performance Metrics

Financial Metrics: The most common financial metrics are (i)

revenue, (ii) net income, (iii) EBITDA and (iv) earnings per

share.

Non-Financial Targets: In some situations, non-financial

metrics are more appropriate because there is historical

information to use as a basis for financial projections.

51

Accounting Principles

Accounting Principles

Establish appropriate accounting principles for measuring

the performance metric.

Reference to GAAP in and of itself is usually not sufficient.

Parties should, at a minimum, stipulate that GAAP will be

applied consistent with either Buyer’s or Seller’s historic

practices.

Some specific accounting matters to be considered include

(i) use of cash or accrual revenue basis, (ii) revenue and

expense allocation, (iii) timing of revenue recognition, and

(iv) treatment of acquisition expenses, non-recurring items,

intercompany transactions and uncollected receivables.

52

Payout Structure and Earnout Period

Structure Alternatives

Installments vs. lump sum

Percentage of earnout payment upon partial satisfaction

of benchmarks vs. all-or-nothing approach

Earnout conditioned on participation by Seller in acquired

business

Cap on earnout payments

Setoff of indemnification claims

Adjustments based on subsequent performance (e.g.,

carry back/carry forward of EBITDA from one

measurement period to other measurement periods)

53

Payout Structure and Earnout Period (cont’d)

Earnout period: Period over which performance metrics are

measured.

An earnout period that is too short risks performance

distortion by short-term factors Sellers generally seek a

shorter period in order to receive full payment sooner and

mitigate risk.

A longer earnout period allows Buyer time to better evaluate

the target business.

Earnout period may accelerate upon specified events that

negatively impact ability to achieve earnout targets (e.g.,

Buyer’s subsequent sale of acquired business, bankruptcy or

change of control).

54

Post-Closing Operation of Acquired

Business

Allocation of Control over Operations

Seller may request a level of control over the operations of

the acquired business (e.g., approval rights over major

decisions).

Seller may request restrictive covenants that limit how the

target business may be operated.

Buyer may be required to operate the target business

consistently with how it was operated prior to closing.

The parties should address the treatment of Buyer's existing

competing businesses and after-acquired businesses.

55

Post-Closing Operation of Acquired Business (cont’d)

Level of Support

Requirement that Buyer use specified efforts to maximize the

earnout.

Buyer's objective is to operate the acquired business in its sole

discretion without regard to the earnout.

Buyers will seek language in the acquisition agreement that (i)

gives Buyer absolute discretion over operations and (ii)

disclaims any obligation (express or implied) to support the

target business or achieve the earnout.

56

Disputes and Resolution

Financial statements and earnout calculations are typically

prepared by Buyer and its accountants.

Seller is afforded opportunity to review and challenge the

financial statements and earnout calculation.

Arbitration procedures should be established in advance to

resolve future disagreements concerning the earnout

calculation in a fair and expeditious manner.

Often an independent accountant serves as the arbitrator.

2019070V2

57

From P&L to Portfolio Bernstein.com

Speaker Bio

58

Rick Monfred

Bernstein Global Wealth Management

Rick is a Financial Advisor with Bernstein Global Wealth Management.

He advises individuals, families, corporations and nonprofit entities in

the Baltimore/Washington area regarding investment strategies. Using

Bernstein’s proprietary wealth forecasting analysis, Rick provides a

roadmap for owners experiencing a liquidity event in connection with

the sale or recapitalization of their business.

Rick Monfred Bernstein Global Wealth Management (O) 202-261-6753 [email protected]

https://www.alliancebernstein.com/



A Holistic Approach to Pre-Transaction Planning

59

Determine when (and how) to sell the business

Analyze the impact of the deal structure on the owner’s ability to meet lifetime financial

goals and objectives

Explore advantages of wealth transfer planning pre-transaction

From P&L to Portfolio Bernstein.com 60

Quantifying the Opportunity: The Wealth Forecasting System SM

Based upon the current state of the capital markets

Prospective returns

Forecasts returns for 30+ asset classes and 16 different planning vehicles

Tracks wealth of G1, G2, G3 and charity after income and transfer taxes

Family Profile Data

Wealth

Forecasting Model

Probability

Distribution

Financial Goals

Assets

Income Requirements

Risk Tolerance

Tax Rates

Time Horizon

Dis

trib

ution o

f 10,0

00 O

utc

om

es

Simulated

observations

based on

Bernstein’s

proprietary

capital markets

research

5%

50

90

10

95

Scenarios

Allocation

Deal

Terms

Source: AllianceBernstein

See Notes on Wealth Forecasting System at the end of this presentation for further details.


Evaluating What You Need and What You Want

61

How much?

To whom?

How quickly?

What techniques?

Excess Capital

Amount that can be

transferred

How much do you spend?

What is your age?

What is your risk tolerance?

Core Capital

Amount to ensure spending

needs are met

Calculated at 90% level of

confidence

Charity

Capital for Next

Venture

Extra Spending

Children and

Grandchildren

Personal Reserve

Lifestyle

Spending


How does their risk tolerance affect their decision?

Which offer should the couple take so that they can retire confidently today?

Case Study: Retiring Securely

Married couple, age 60, wants to sell their technology company and retire

Investment assets of $1.25 million of which $250,000 is in a qualified retirement plan

Currently spending $240,000 per year

Evaluating two term sheets:

(More Upfront) The first provides $10 million total—$8 million upfront and an annual earnout of

$400,000 for five years

(Less Upfront) The other provides $12 million total—$4 million upfront and an annual earnout of

$1.6 million for five years

62


$12.6

$9.5

$8.2 $7.7

0/100 20/80 40/60 60/40

$4.5 Mil. (Less Upfront)

$7.7 Mil. (More Upfront)

Current Assets**

What Is the Couple’s Core Portfolio?

63

Amount Needed to Fund Core Portfolio Today Spend $240,000 (Real)

($ Millions)*

*Based on Bernstein’s estimate of returns for the applicable capital markets over the applicable time horizon. Data do not represent past performance and are not a promise of

actual or a range of future results. Core capital calculated at 90% level of confidence assuming adjusted joint life expectancy. Variations in actual income, spending, applicable

tax rates, life span and market returns may substantially impact the likelihood that a core-capital estimate will be sufficient to provide for future expenses.

**Current assets are the sum of the beginning portfolio assets plus the after-tax sale proceeds in the first year of the analysis. A combined 19.25% state and federal capital gains tax

rate was assumed.

***“Asset Allocation” refers to the proportion of assets invested in stocks and the proportion invested in bonds over the next 35 years. Assumes globally diversified stocks (21% US

value, 21% US growth, 21% US diversified, 7% US small and mid cap, 22.5% developed international and 7.5% emerging markets); bonds are assumed to be intermediate term

with municipal bonds in the taxable portfolio and taxable bonds in the tax-deferred portfolio. See Notes on Wealth Forecasting System at the end of this presentation for further

details.


Asset Allocation (Stocks/Bonds)***


What Is the Couple’s Investment Risk?

42%

32%

69%

93%

2% 2%11%

46%

2% 2% 2%

12%

0/100 20/80 40/60 60/40

10% Loss 20% Loss 30% Loss

64

Probability of Peak-to-Trough Losses over 40

years*

Data do not represent past performance and are not a promise of actual or a range of future results.

*Data indicate the probability of a peak-to-trough decline in pretax, pre-cash-flow cumulative returns of 10%, 20% or 30% over the next 40 years. Because the Wealth Forecasting

System uses annual capital markets returns, the probability of peak-to-trough losses measured on a more frequent basis (such as daily or monthly), may be understated. The

probabilities depicted above include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years.

**“Asset Allocation” refers to the proportion of assets invested in stocks and the proportion invested in bonds over the next 40 years. Assumes globally diversified stocks (21% US



details.


Asset Allocation (Stocks/Bonds)**


94% 96% 96% 98%

40/60 60/40 40/60 60/40

Both Deals Meet Spending Plan—If They Get 100% of Earnouts

65

35th Year—Probability of Maintaining Spending* Spending $240,000 (Real)

100% Earnout**


*“Probability of Maintaining Spending” represents the probability of having assets greater than $0 at the end of the 35th year. Based on Bernstein’s estimate of returns for the

applicable capital markets over the next 35 years. Data do not represent past performance and are not a promise of actual or a range of future results.

**Assumes the couple receives each annual payout in its entirety as described previously.




details.


More Upfront

Less Upfront


If Earnouts Are Less Certain, Asset Allocation Can Help

66

35th Year—Probability of Maintaining Spending* Spending $240,000 (Real)

60% Earnout**

*“Probability of Maintaining Spending” represents the probability of having assets greater than $0 at the end of the 35th year. Based on Bernstein’s estimate of returns for the

applicable capital markets over the next 35 years. Data do not represent past performance and are not a promise of actual or a range of future results.

**Assumes the couple receives an earnout of only $240,000 per year in the “More Upfront” scenarios and $960,000 per year in the “Less Upfront” scenarios.




details.


91% 94%

84% 89%

40/60 60/40 40/60 60/40


More Upfront

Less Upfront


0

23

45

68

90

$3.3$1.1

What Is the Impact on the Couple’s Future Wealth?

67

$45.9

$14.1

$26.7

$8.7

$62.5

$20.5

$36.9

$13.5

Range of Wealth Values, Year 35* After Taxes and Cash Flows, Nominal

60% Earnout**

$ M

illio

ns

*Based on Bernstein’s estimate of returns for the applicable capital markets over the next 35 years. Data do not represent past performance and are not a promise of actual or

a range of future results.

Asset values represent the estimated market value; if the assets were liquidated, additional capital gains or losses would be realized that are not reflected here.

**Assumes the couple receives an earnout of only $240,000 per year in the “More Upfront” scenarios and $960,000 per year in the “Less Upfront” scenarios.



with municipal bonds in the taxable portfolio and table bonds in the tax-deferred portfolio. See Notes on Wealth Forecasting System at the end of this presentation for further details.


40/60 60/40 40/60 60/40


More Upfront Less Upfront

5%

10

50

90

95

Level of

Confidence


Case Study: Excess Planning—Client Situation

68

Married couple, age 57, with two children ages 21 and 18; The couple is a 50% owner

of a private, family S-corporation, valued at $40 million

In addition to the business, the couple has investment assets of $920,000; with

$260,000 in qualified retirement plans and $100,000 in section 529 college savings

plans

The couple receives the following pretax income:

$1.4 million in business distributions

$150,000 in total salary, adjusted each year with inflation

The couple spends $225,000 per year, indexed for inflation. Additionally, their daughter

begins college this year ($40,000 per year, indexed by inflation, plus 2% for six years).

The couple will pay expenses that exceed the college savings plan

The couple anticipates wedding expenses of $50,000 upon their daughter’s graduation


Case Study: Excess Planning—Business Facts

69

The couple will sell 30% of their ownership in the business in five years, which is taxed

as a long-term capital gain with a cost basis of zero (30% of the business distributions

stop). The remaining 70% of the business interests are sold in Year 10 (business

distributions stop entirely along with the couple’s salary)

We examined the following growth scenarios for the business:

5% Annual Growth: The $1.4 million business distributions remain flat and the value of the

business interest grows 5% annually

10% Annual Growth: The $1.4 million business distributions increase by 5% annually and the

value of the business interest grows 5% annually

18% Annual Growth: The $1.4 million business distributions increase by 10% annually and the

value of the business interest grows 8% annually


No Wealth Transfer: Distribution of 40-Year Family Wealth*

40/60 Portfolio for G1 After Spending and Taxes in Typical Markets (Nominal)

Bernstein is not a legal, tax or estate advisor. Investors should consult with professionals in those areas as appropriate before making any decisions.

*Median results. Assumes the grantor’s assets are invested 40% globally diversified stocks and 60% intermediate term bonds. Assumes that the spouses die in the same year, and

that $5 million, indexed for inflation, per person, is exempt from estate taxes less any gifts made during life. The remaining estate is taxed using a 35% estate tax rate. See Notes on

Estate Transfer and Taxation at the end of this presentation for further details. Based on Bernstein estimates of the range of returns for the applicable capital markets over the

duration of the analysis. Data do not represent past performance and are not a promise of actual or a range of future results. See Notes on Wealth Forecasting System at the

end of this presentation for further details.


Family $93.1 Mil.

Family $99.2 Mil.

Family $129.1 Mil.

Government $37.9 Mil.



$131.0 Million $140.4 Million $186.9 Million

Probability of Meeting Spending over 40 Years

>98% >98% >98%

5% Annual Growth 18% Annual Growth 10% Annual Growth

70


You’re Kidding, Right? There Has to Be a Better Way

71

Couple makes an $8 million gift of interests in their business to an irrevocable grantor

trust for the benefit of their children

Pro: Couple has a combined $10.24 million applicable lifetime exclusion in 2012 and can

comfortably make gifts without jeopardizing their core portfolio; immediately removes the present

value of the growth of the business from their estate

Con: Uncertainty about future gift and estate tax policies

Other Strategies to Consider:

Discounted sale to children or a trust for their benefit in exchange for a promissory note

Pro: Uses little or no gift tax exclusion and requires little to no gift taxes to be paid; the applicable

federal rates are near historic lows

Con: The principal value of the note remains in the grantor’s estate

Discounted transfer to a grantor retained annuity trust (GRAT)

Pro: Requires no gift tax exclusion to be used when GRAT is zeroed out; Section 7520 rates are

near historic lows

Con: Mortality risk; frequent valuations required


Gift/Estate Strategies Benefit from a Discount

72

Capitalize on the valuation discount, due to illiquidity and lack of control

Assuming transfer of a minority interest. Bernstein does not advise on the value of any discounts; information on discounts was provided by clients’ tax and legal teams.


Grantor

Value of Gift for

Transfer Tax Purposes Discount

$8.0 Million

$6.0 Million

$8 Million

Pre-

Transaction

Gift

$5.2 Million 35%

25%

0%

The couple’s deal team advises them to use a 25% valuation discount, due to illiquidity and lack of marketability


Planning: Distribution of 40-Year Family Wealth*

73

40/60 Portfolio for G1; 80/20 Portfolio for G2** After Spending and Taxes in Typical Markets (Nominal)

Bernstein is not a legal, tax or estate advisor. Investors should consult with professionals in those areas as appropriate before making any decisions.

*Median results. Assumes G1 assets are invested 40% globally diversified stocks and 60% intermediate-term bonds, and G2 assets are invested 80% global stocks and 20% bonds.

Assumes that the spouses die in the same year, and that $5 Million, indexed for inflation, per person, is exempt from estate taxes less any gifts made during life. The remaining

estate is taxed using a 35% estate tax rate. See Notes on Estate Transfer and Taxation at the end of this presentation for further details.

**G2 portfolio is assumed to be an irrevocable grantor trust for the first 10 years, at which time the trust pays its own taxes. Based on Bernstein estimates of the range of returns for

the applicable capital markets over the duration of the analysis. Data do not represent past performance and are not a promise of actual or a range of future results. See

Notes on Wealth Forecasting System at the end of this presentation for further details.


Family $236.5 Mil.


$171.7 Million $183.7 Million $240.6 Million

Probability of Meeting Spending over 40 Years

93% 94% >98%

5% Annual Growth 18% Annual Growth 10% Annual Growth

Family $183.7 Mil.


Family $171.7 Mil.



How Bernstein Can Help

74

Give clients comfort and confidence to proceed with the transaction

Simplify and ease implementation

Help clients choose between competing offers with different deal terms

Provide our unique ability to model deal terms, personal wealth planning and wealth

transfer strategies in an integrated and customized analysis

AllianceBernstein.com/go/SellingABusiness

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