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Presenting a live 90-minute webinar with interactive Q&A

Structuring Acquisitions of Family-Owned

Businesses: Valuation, Due Diligence, Deal

Structure, Operational Transition and More

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, JUNE 23, 2016

Eva Davis, Co-Chair, Private Equity, Winston & Strawn LLP, Los Angeles

Lawrence M. Kern, Partner, Winston & Strawn LLP, Chicago

Nishen Radia, Managing Partner, FocalPoint Partners LLC, Los Angeles

Margaret Shanley, Principal, Transactional Advisory Services Practice Leader,

CohnReznick LLP, Los Angeles

Rachel Ingwer, Associate, Winston & Strawn LLP, New York

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5 5

S t r u c t u r i n g t h e A c q u i s i t i o n o f

F a m i l y - O w n e d B u s i n e s s e s :

V a l u a t i o n , D u e D i l i g e n c e ,

D e a l S t r u c t u r e , O p e r a t i o n a l

T r a n s i t i o n a n d M o r e

Eva Davis, Winston & Strawn LLP

Rachel Ingwer, Winston & Strawn LLP

Larry Kern, Winston & Strawn LLP

Nishen Radia, FocalPoint Partners LLC

Margaret Shanley, Cohn Reznick LLP

5

6

S t r u c t u r i n g T h e A c q u i s i t i o n O f A F a m i l y O w n e d B u s i n e s s

• Setting the Stage: The M&A Market in 2016

(or, What’s Driving the Buyers?)

• Stage I: Rationale and Strategy for a Sale of Family-Owned

Business (or, What’s Driving the Sellers?)

• Stage II: Getting Ready: Likely Timeline for Buyers and Sellers

• Stage III: Key Legal, Tax and Estate Planning Considerations for

M&A of Family-Owned Business

• Stage IV: Due Diligence Best Practices

• Stage V: Maximizing Closing Cash and

Valuation Challenges and Solutions

7 7

T h e M & A M a r k e t i n 2 0 1 6

( o r , W h a t ’ s D r i v i n g t h e B u y e r s ? )

8

$0

$100

$200

$300

$400

$500

$600

0

1,000

2,000

3,000

4,000

5,000

6,000

13Q1 13Q2 13Q3 13Q4 14Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q4 16Q1

$100M-$250M $250M-$500M $500M-$1B

>$1B Deal Value

U . S . M & A M a r k e t O v e r v i e w

• Despite high stock prices and climbing valuations among private

companies, overall financial conditions for U.S. companies have

rarely been as favorable for those interested in pursuing M&A

• Companies have record cash reserves, which tend to immunize

them against possible interest rate hikes

• This overall trend of stronger corporate balance sheets has already

manifested itself in elevated valuations in the first quarter of 2016,

and will continue to buoy the M&A markets for the remainder of

the year

The first quarter of 2016 has largely continued the positive trends seen in a strong 2015 for M&A, as U.S. companies have

continued to drive their quest for growth through inorganic acquisitions

KEY M&A TRENDS TO WATCH FOR IN THE REMAINDER OF 2016

Optimal Financing Conditions are Likely to Support Deals

(1) Based on a KPMG survey, where respondents were asked to select up to three categories

Source: Pitchbook

TOTAL U.S. M&A ACTIVITY

Takeaways from Q1 2016

• With a continued abundance of capital combined with a shortage

of high quality assets in market, deal volume declined slightly in Q1

2016 as compared to 2015 levels. However, the first quarter of 2016

experienced elevated average valuations, with this metric rising for

the fourth straight quarter

• This rise in valuations represents a continuation of a trend seen in

2015, as an abundance of private equity and debt fueled activity

• Frothy capital markets have also continued to enable independent

sponsors to emerge again, driving increased competition amongst

buyers for deals

7%

13%

16%

20%

25%

34%

36%

37%

37%

Defend against competition

Respond to activist investors

Acquiring additional elements of the supply …

Financial buyer looking for profitable …

Opportunistic - target becomes available

Enhance intellectual property or acquire …

Expand geographic reach

Enter new lines of business

Expand customer base

The Primary Drivers of Acquisition(1)

Total M&A Deal Flow ($ in Billions)

Number of

Deals

Deal

Value

9 9

R a t i o n a l e a n d S t r a t e g y f o r a

S a l e o f F a m i l y - O w n e d B u s i n e s s

( o r , W h a t ’ s D r i v i n g t h e S e l l e r s ? )

10

R a t i o n a l e F o r E x p l o r i n g A S a l e To A F i n a n c i a l S p o n s o r

(1) Illustration assumes a valuation based off of $11 million of Adjusted EBITDA

THOUGHTS AND COMMENTS

Private equity acquirers have been aggressively bidding for assets, competing with strategic buyers

ILLUSTRATIVE ANATOMY OF A LEVERAGED RECAPITALIZATION(1)

• Transaction could provide “second bite of the apple” and additional upside to current shareholders

• Opportunity to re-incentivize key personnel and benefit from the size and scale of a larger organization

• The Company would become a part of the financial sponsor’s portfolio and growth plan, which could provide it with additional resources for future growth and add on acquisitions

• Limited confidentiality issues with financial buyers

• Numerous PEGs with expertise and useful insight into key industry trends and drivers

• Opportunity for non-shareholder management team to gain “sweat equity” or ownership through some sort of Management Incentive Plan (MIP) 5-10% MIP is customary

Shareholders can sell 89% of the business, but effectively own 20% of the recapitalized entity after an equity rollover

Proceeds at Close Transaction Valuation

Enterprise Value $100,000,000

Debt $44,000,000

(4x EBITDA)

Equity $56,000,000

Sell 80% ($44,800,000 at close)

Keep 20% ($11,200,000 rollover)

$44,000,000 Total NewCo Debt: ~4.0x EBITDA

$44,800,000 Buyer Equity: ~80% of New Entity

$11,200,000 Seller Equity: ~20% of NewCo

$88,800,000 Total Cash Proceeds at Close

11

R a t i o n a l e f o r E x p l o r i n g a S a l e t o a S t r a t e g i c B u y e r

Well organized flow of information Strict set of process steps with information gates to control buyer behavior

Tailored marketing process to fit the client’s confidentiality requirements Buyers list will be thoroughly assessed, outside inquirers are fully qualified

Be upfront on all key issues thoroughly prepared marketing documents Fully negotiated LOI and marked up purchase agreement prior to signing Proactively communicated changes in Company operations or financial

performance Keep market interest high – Always have a strong back up buyer

• The Company may be an attractive opportunity given its market leading position and unique business model

• Simplest way for the Company’s shareholders to sell the business free and clear

• Opportunity to re-incentivize key personnel and benefit from the size, scale, and industry expertise and connections of a larger acquirer

• Negotiate employment contracts, performance based incentives, escalating deal bonus, etc.

• Confirmatory style due diligence, as the buyer likely has an understanding of the business and industry challenges

Transaction Valuation

Enterprise Value $100,000,000

100% Sale

Additional Potential Proceeds (Post-close)

$100,000,000 (paid at close)

Escalating Deal Bonus Performance Incentives Company Stock

How can business disruptions be avoided

How is confidentiality managed throughout the process

How can re-trading be prevented

FAIRLY STRAIGHTFORWARD TRANSACTION STRUCTURE ITEMS FOR SHAREHOLDER'S CONSIDERATION

ADDRESSING CONCERNS

Strategic buyer transactions can be more difficult to close, but often result in favorable financial terms relative to private equity buyers

12

C h o o s i n g t h e R i g h t S e l l e r S t r a t e g y – K e y C o n s i d e r a t i o n s

• Transaction objectives – liquidity or lifestyle driven?

• Seller perspectives on growth and the value of rollover equity

• Differing time horizons of shareholders

• Quality of executive management team

• Value of potential strategic synergies

• Sensitivity of key information

13 13

G e t t i n g R e a d y : L i k e l y T i m e l i n e

f o r B u y e r s a n d S e l l e r s

14

S a m p l e T r a n s a c t i o n T i m e l i n e A robust, market-clearing process, such as the one outlined below, is designed to ensure maximum shareholder value

through clearly communicated structure and objectives that promote a competitive dynamic among interested parties

Phase OBJECTIVE PROCESS BUYER

UNIVERSE TIMING

I

Detailed diligence and preparation of offering materials

Prime market with carefully calibrated senior-level calling effort

Communicate the Company’s unique attributes and compelling investment thesis

NDA distribution to strategic and financial acquirers

Investment banker diligence prep

Identification of appropriate target buyer universe

Consider tax and estate planning implications

-- 5 to 8 weeks

III

Review IOIs and determine management meeting invitations

Management meetings

Request definitive LOIs

Potentially provide standardized Sales and Purchase Agreement for buyer review/comment

Grant exclusivity to primary acquirer, and keep secondary acquirer(s) engaged

Narrow the field of acquirers

Conduct site visits and management meetings

5-10 5 to 8 weeks

II

Distribute teaser and CIM to strategic and financial acquirers

Management calls with subset of interested parties

Open initial data room

Request Initial Indications of Interest

Provide detailed Company information to pre-vetted acquirers

10-20

Strategic

acquirers

50-75

Financial

acquirers

4 to 7 weeks

IV

Manage final due diligence

Negotiate transaction documents

Keep backup buyer primed

Finalize and close transaction

Close transaction 1 6 to 9 weeks

Pre

pa

ratio

n

Ma

rke

tin

g

Bu

ye

r Se

lec

tio

n

Clo

sin

g

A typical transaction will take between 5 and 8 months to close

15

P r o c e s s C o n s i d e r a t i o n s The right strategy should provide the greatest likelihood of an optimal outcome and limit investor negotiating leverage

in the event of a road bump in the process

• Successful transactions require a team of advisors that include an investment banker, deal attorney, CPA firm, estate planning and tax advisors

• In advance of landing a transaction, sellers should identify any weaknesses in their internal team (especially CFO and finance) and ensure specialists are retained as third party advisors

Tailoring the Sale Process

Creative Structuring to

Drive Value

Maintaining Negotiation

Leverage

Pre-Emptive Preparation

Assemble the Right Team

• Proper preparation prior to a transaction launch pays large dividends in terms of minimizing the risk of selecting a bidder and hitting a bump in the road at a time when your negotiating leverage is comparatively low

• Development of a comprehensive financial model with defensible projections for FY16 and beyond

• Coordination of efforts between other advisors (e.g. legal, accounting, etc.) to ensure advisory team is harmonized

• Prepare a sell-side quality of earnings report to pre-empt buyer diligence and highlight any concerns to be addressed pre-launch

• Creative transaction structuring can enable the sellers to realize additional value to either create incremental value or to bridge a valuation gap

• The right transaction structure can also include negotiation of deal structure (e.g. minimizing taxes, representations & warranties, employment agreements, etc.)

• Key is to hire an investment banker that is well versed in all types of sale processes, ranging from closed negotiations to robust auction processes, and can facilitate a process to meet the unique demands of a given client

• While the traditional sale process has standard milestones inherent within the process, your banker should seek to create a competitive auction with unique milestones specific to a given transaction, in order to unlock incremental value

• Negotiating leverage fluctuates throughout the deal process and it is critical to structure a timeline that delays selecting the final bidder as long as possible to maintain the perception of competition throughout the process

• Strategies to achieve this include requiring short-listed bidders to negotiate key transaction terms in competition rather than under exclusivity, and the creation of diligence milestones that can trigger a termination of exclusivity if not met

16 16

K e y L e g a l , Ta x A n d E s t a t e

P l a n n i n g C o n s i d e r a t i o n s F o r

M & A O f F a m i l y - o w n e d B u s i n e s s

17

Ta x : B a s i s S t e p U p

• Purchaser and Target may be able to achieve substantial future tax savings by structuring transactions to receive a step up in the basis of Target’s assets. They may be willing to pay Sellers more for this benefit or cover the Sellers costs of such transactions.

• LLC

− If Purchaser is buying 100%, it generally should be treated as an asset sale.

− If Purchaser is buying less than 100%, basis step up can be achieved through Section 754 election (if Target is a partnership) or appropriate Section 704(c) election (if Target is a disregarded entity).

• S Corporation

− Section 338(h)(10) or Section 336(e) Election – must satisfy various requirements and does not solve invalid S corporation election issues

− F Reorganization – generally preferable

• C Corporation – The cost to the Sellers of structuring transaction to achieve a basis step up generally will be prohibitive except in very limited instances.

18

“ R o l l o v e r ” E q u i t y b y S e l l e r s

• Frequently, Purchasers require Sellers to “roll over” a portion of their equity, rather than extracting the full value at the time of the sale.

• From a tax perspective, the primary goals are:

− To defer recognition with respect to the equity being rolled over,

− To enable the rollover Sellers to obtain long-term capital gain, and

− To minimize any adverse effects on the ability to step up in basis of Target’s assets (although a step up generally will not be available with respect to the portion of Target being rolled over).

• Sellers generally can rollover tax-free into a new C corporation, but not into an existing C corporation. LLCs provide significantly more flexibility.

• Seller rollover frequently will interfere with the ability to make a Section 338(h)(10) election, and an F reorganization structure will be preferable in such instances.

19

C o m p e n s a t i o n I s s u e s

• Sections 280G and 4999

− If a disqualified individual receives a payment that is contingent on a change in

control and such payment exceeds three times the individual’s base amount,

Section 280G will deny a deduction with respect to such excess.

− Section 4999 will impose an excise tax on the disqualified individual.

− Disqualified individuals include officers, shareholders, and “highly compensated

individuals.”

− These provisions apply only to C corporations. In the case of a closely-held C

corporation, a waiver vote can be obtained. This will permit any excess

payments to be deductible and not be subject to an excise tax.

• Section 83(b) Elections

− If a service provider receives equity subject to vesting, unless a Section 83(b)

election is made, the FMV of the equity generally will be included in income in

the year the vesting restriction lapses.

− If the equity goes up in value during this period, this is disadvantageous to the

service provider. A Section 83(b) election permits the service provider to include

the equity in income in the year received based on the FMV as of the date of

receipt, as if the equity were not subject to vesting.

20

B i p a r t i s a n B u d g e t A c t o f 2 0 1 5

• The Bipartisan Budget Act of 2015 (the “Act”), which was signed into law on November 2, 2015, enhances the IRS’s ability to audit partnerships.

• The Act generally applies for taxable years beginning after 2017.

• The Act provides that tax adjustments resulting from an audit will generally be determined and collected at the partnership level (as opposed to at the partner level).

• If Selling interests in a partnership, Sellers should expect to see provisions relating to the Act including:

− Representations including about not electing to apply the provisions of the Act prior to the Act’s effective date;

− Tax covenants limiting the ability to take various actions under the Act; and

− Indemnification provisions ensuring the Sellers are liable for their allocable share of taxes payable for years prior to the acquisition.

21

E s t a t e P l a n n i n g C o n s i d e r a t i o n s

• A successful family-owned business provides unique estate planning opportunities (and potential pitfalls).

• Valuation Discounts:

− Minority interest or lack of control

− Lack of marketability

• Combination of increased dividend distributions for flow-through entities (e.g., S-corporations, LLCs, and partnerships) and the “grantor trust” rules of the Internal Revenue Code (the “Code”).

• Special Valuation Rules – Sections 2701 through 2704 of the Code.

22

L i f e t i m e P l a n n i n g t o A v o i d E s t a t e Ta x o n D e a t h

• Annual exclusion gifts:

− $14,000 per donee/per year

− $28,000 if spouses elect to “split” gifts

• $5,450,000 gift tax exemption

• $5,450,00 generation-skipping transfer (“GST”) tax exemption

• Leveraged estate planning techniques:

− Grantor Retained Annuity Trust (“GRAT”)

− Sale to an intentionally defective grantor trust (“ IDGT”)

23

G r a n t o r R e t a i n e d A n n u i t y T r u s t ( “ G R AT ” )

• Business owner transfers an interest in the business to an irrevocable trust and retains the right to receive fixed annuity payments from the trust for a set term of years.

• At the end of the term of years (assuming the business owner survives), any assets remaining in the trust will pass to the remainder beneficiary(ies) free of gift tax.

• Essentially, if the GRAT assets increase in value more than the IRS prescribed interest rate (1.8% for June), the GRAT will be successful in avoiding gift tax. If not, all of the GRAT assets will return to the business owner via the annuity payments and nothing will pass to the remainder beneficiaries. However, because the GRAT can be “zeroed-out,” there is no downside risk.

• Disadvantages:

− Mortality feature

− Valuation issues

− Sub-optimal for GST tax purposes

24

S a l e t o I n t e n t i o n a l l y D e f e c t i v e G r a n t o r T r u s t

• Business owner sells an interest in the business to an irrevocable trust for a promissory note.

• Because the irrevocable trust is structured as a “grantor trust” for income tax purposes, the sale is ignored for income tax purposes (as are the interest payments on the promissory note).

• Most importantly, the business owner is personally responsible for paying the income tax on all taxable income generated by the trust. However, the business owner’s payment of the income tax is NOT considered a taxable gift by the business owner.

• Thus, the trust (which is sheltered from estate tax) is allowed to grow income tax free, while the business owner’s personal assets are reduced by the income tax.

• Disadvantages:

• “Seed” gift if trust is new

• 9 to 1 debt-to-equity rule

• Valuation issues/defined value clauses

25

S a l e t o I n t e n t i o n a l l y D e f e c t i v e G r a n t o r T r u s t

Sale of Interest in Family Business

2

Promissory Note

3

BUSINESS

OWNER

GRANTOR

TRUST

Interest/Principal Payments on Promissory Note

5

IRS

Income Tax Payments

on Behalf of Grantor Trust

FAMILY

BUSINESS

Seed Gift

1

6

Note: Circled numbers indicate the order in which the various steps would be taken.

4 Distributions from

Family Business

26

C h a r i t a b l e P l a n n i n g O p p o r t u n i t i e s

• Charitable “bailout”

• Charitable Remainder Trust (“CRT”)

• Charitable Lead Trust (“CLT”)

27 27

D u e D i l i g e n c e B e s t P r a c t i c e s

28

O v e r v i e w & G o a l s o f S e s s i o n

• Most commonly asked question – “What is my business worth?”

• While important, an equally important question and where we

want to focus our attentions today– “How do I increase the

value of my business?”

• In order to maximize value (even years before even

contemplating a transaction), company owners and executives

need to “think like a buyer” so they do not leave value on the

table when the time comes.

• This means that it’s critical to have a fairly robust and objective

self-evaluation and reverse due diligence process in place.

Goal – by the end of today’s session, would like to have

provided you with a few topics that we come across again and

again during due diligence (both buy and sell-side).

29

M o s t c o m m o n l y u s e d a p p r o a c h t o

v a l u i n g a m i d d l e - m a r k e t b u s i n e s s

• Typically most buyers value a business using a multiple of

Earnings before Interest Tax and Depreciation (EBITDA). Often

times, the EBITDA target is specified long before the purchase

agreement and often as early as the Letter of Intent.

• Therefore, when thinking about your business, remember that

every potential adjustment or item found during due diligence

results in a multiple $ effect potentially.

• E.g. A digital marketing business has $20m in revenues, $5m in

EBITDA. During due diligence on behalf of the buyer, we

uncovered that management had reversed an accrual of $500k

in the last twelve months that was initially recorded the year

before, thereby benefiting that period on a one-time basis. At a

multiple of 8 times EBITDA, that resulted in a $4m issue.

Goal – really need to assess and present sustainable and

recurring earnings that take out the impact of one-time events.

30

R e c u r r i n g I s s u e s I m p a c t i n g

E B I T D A - p o s i t i v e a n d n e g a t i v e

• Reversal of accruals and reserves that were built up in prior periods

• Changes in capitalization policies

• High threshold for capitalization – especially with tooling or repairs &

maintenance

• Non-business expenses/income

• Out-of-period expenses/income

• Non-cash balances (stock-option compensation)

• Catch up in inventory write offs especially with the lack of a robust

inventory reserve

• Lack of sufficient reserves – bonus, vacation, warranty, inventory, AR,

customer deduction programs

• Differences between year-end vs. month-end closing

• “One-hit wonders” resulting in profitability anomalies – exceptionally

profitable customer, project or contract, short-term reduction in vendor

pricing or one-time rebate, recurring sale price increases that may not

be sustainable, one-time customer returns/discounts/rebates

• Lack of audited financial statements

31

A - E x a m p l e o f s e l l - s i d e Q o f E Management Adjustments

a) Management Fees– These amounts relate to management fees paid to various parties and summarized in the table below:

(i ) The Company pays management fees ($62.5 per quarter) to a related party pursuant to an advisory agreement. Management provided a copy of the advisory agreement listing a quarterly compensation to related party, a detail of the general ledger listing all quarterly fees paid to a related party, as well as a sample of a transfer from the bank for the Q1 2016 payment totaling $62.5.

(i i ) The Company also accrues $20.8 monthly ($62.5 per quarter) for management fees due to another advisor, in accordance with the same advisory agreement. This advisor has elected to defer payment of their fees. We noted a $312 accrual balance ($20.8 for 15 months) on the balance sheet as of March 31, 2016. Management provided a copy of the advisory agreement and a detail of the general ledger listing all quarterly fees accrued to this advisor.

(i i i ) A board advisor receives a $12.5 quarterly fees from the Company pursuant to a management consulting agreement. Management provided a detail of the general ledger listing fees paid to the board advisor, as well as a sample of an invoice for Q1 2016 and a subsequent confirmation of the payment from the bank.

(iv) The Company pays on-going amounts (management fees plus expenses) to an outside advisor to the Company’s Board of Directors.

($ in Thousands) FY13 TTM Mar 14

Christals Management LLC (i) 250$ 250$

CP IV SPV, LLC (ii) 250 312

Phyllis Heppenstall (iii) 50 50

Lisa Berman (iv) 112 142

Total 662$ 754$

REDACTED

($ in thousands) Amt % of Rev Amt % of Rev Amt % of Rev

Net Sales 39,485 100.0% 39,973 100.0% 42,461 100.0%

Cost of Goods Sold 13,640 34.5% 13,730 34.3% 14,238 33.5%

Gross Profit 25,845 65.5% 26,243 65.7% 28,223 66.5%

Store Operating, G&A Expenses 21,472 54.4% 22,035 55.1% 21,889 51.6%

Other Expenses/(Income) 6,951 17.6% 6,750 16.9% 8,535 N/A

Net Income (2,578) -6.5% (2,541) -6.4% (2,201) -5.2%

Depreciation 1,902 4.8% 1,880 4.7% 2,001 4.7%

Interest 7,004 17.7% 7,000 17.5% 6,910 16.3%

Other - 0.0% - 0.0% 1,625 3.8%

Taxes 233 0.6% 185 0.5% - 0.0%

Reported EBITDA 6,563 16.6% 6,524 16.3% 8,335 19.6%

Management Fees [a] 662 1.7% 754 1.9% - 0.0%

Transition Cost [b] 433 1.1% 300 0.8% - 0.0%

Executive Bonus [c] 320 0.8% 320 0.8% - 0.0%

Opening Expenses [d] 151 0.4% 200 0.5% - 0.0%

Permitted Acquisitions [e] 141 0.4% 155 0.4% - 0.0%

Gift Cards [f] (45) -0.1% (45) -0.1% - 0.0%

Donations [g] 18 0.0% 20 0.0% 3 0.0%

Gain/Loss on Disposal [h] - - 14 0.0% - 0.0%

Store Closing [i] - - 8 0.0% - 0.0%

Total Mngt Adjustments 1,679 4.3% 1,725 4.3% 3 0.0%

Mgmt Adj EBITDA 8,242 20.9% 8,249 20.6% 8,337 19.6%

Opened/Closed Stores [j] 428 1.1% 394 1.0% - 0.0%

Burien Store [k] (99) -0.3% (97) -0.2% - 0.0%

Audit Fee [l] (50) -0.1% (50) -0.1% - 0.0%

Total Run-Rate Adjustments 278 0.7% 247 0.6% - 0.0%

Run-Rate EBITDA 8,520 21.6% 8,497 21.3% 8,337 19.6%

Non-Cash Items

Vacation Adjustment 148 0.4% 125 0.3%

Points Program Liability 104 0.3% 104 0.3%

Rental Expense 184 0.5% 165 0.4%

Total Non-Cash Items 436 1.1% 394 1.0%

Quality of Earnings

FY15 TTM Mar 16 FY16 F

REDACTED

REDACTED

32

Management Adjustments

a) Management fees (cont.) -

(iv) Management provided a detail of the general ledger (acct no. 15-000-8314) listing all fees and expenses paid to a board advisor, as well as a sample of an invoice Berman and a subsequent confirmation of the payment from the bank.

Based on supports provided and our understanding that these amounts wil l not continue under new ownership, we agreed to the management add-back.

b) Transition Cost – These amounts relate to the cost to integrate the two companies as a result of the 2014 acquisition. Management added back transition expenses including professional fees for due diligence, audit, and legal as well as amounts for travel and labor. We agreed this add-back to the general ledger (acct no. 8600), noting that the general ledger contained an additional $5 in the TTM period, which was related to a legal expense Management excluded from the add-back as it related to on-going operations. We also obtained a detail of the general ledger, reviewed 100% of the expense amounts recorded, and vouched a selection of the largest invoices to validate the amounts recorded. Management represented that they were unable to provide supporting documentation for three invoices, totaling $51 within the Transition Expense category.

c) Executive Bonus - These amounts are Management’s bonuses paid to the executive team. As Management’s compensation would be negotiated as a part of a transaction, Management has added this amount back to EBITDA.

A - E x a m p l e o f s e l l - s i d e Q o f E Management Adjustments

c) Executive Bonus (cont.) - The amount of the bonus is discretionary, based on performance and paid at the time awarded – with the exception of key employee’s bonus, which is paid in equal installments over 12 months. We agreed the full $320 to the GL (noting Management continues to accrue same bonus amounts through March 2016 as it did during FY15), one monthly amount to payroll records, and obtained a copy of the bonus authorization. We noted that the monthly amount was payable to the key employee beginning March 2014 and that the balance sheet accrual was not adjusted accordingly. We have proposed an adjustment for this amount to working capital. The $60 accrued for various management level employees was not paid as of Apri l 2014.

d) Opening Expenses - These amounts relate to Management’s cost to open new stores in FY15 and TTM Mar ‘16. I t Includes costs for construction, travel, fixtures, cleaning, grand opening advertising, and other opening expenses. We agreed this amount to the TB, noting an additional $68 in expense recorded in the GL. Per Management this $68 was related to on-going operations and was not added-back. We also obtained a detail of the general ledger, reviewed 100% of the expense recorded, and vouched a selection of invoices to the detail without exception to validate the amounts recorded.

33

Management Adjustments

e) Permitted Acquisitions – These amounts relate to Management's cost due to the integration and transition of operations after the 2014 combination. Amounts include travel and professional fees, including (1) legal – related to a lease assessment in preparation for a potential new store, (2) consumer survey, (3) legal – trademark research as part of the Company’s effort to have all stores under one brand, and (4) legal – employee mediation. We agreed this add-back to the general ledger without exception, obtained a detail of the general ledger, reviewed 100% of the expenses recorded, and vouched a selection of the largest invoices without exception to the detail to validate the amounts recorded.

f) Gift Cards – Management has a policy of reversing gift cards that have not been redeemed after two years or with a balance under $1 (actual) into income. This is performed annually at year-end and creates an incorrect period benefit to income for the amount of the reversal. Per Management, $45 of gift card balances were written into income in FY15. Per Management this was a historically high amount as the process was not performed in FY14.

g) Donations – Management adjusted historical EBITDA for donations, which a potential buyer may wish to discontinue. We agreed amounts to the Company’s trial balance. In November 2015, the Company made a $15 donation to a fundraiser as well as made smaller donations to another organization in FY15.

h) Gain/Loss on Disposal – Per Management this is a write-off mainly related to unamortized portion of leasehold improvements (with no salvage value) at a store, which was closed during the historical period. We agreed amount to the GL and reviewed GL detail noting the write-off amounts. We have proposed an add-back for the full amount recorded in the GL during the historical period.

A - E x a m p l e o f s e l l - s i d e Q o f E Management Adjustments

f) Store Closing – Per Management, these are moving and travel expenses related to the closing of a store location. We agreed amount to the GL and reviewed GL detail. We have proposed an add-back for the full amount recorded in the GL during the period under consideration (FY15 and TTM Mar ‘16).

Run-Rate Adjustments

j) Opened/Closed Stores - We noted that the Company opened two stores in FY15, three stores through March of FY16, and per discussion with Management there are plans to open four additional stores during the remainder of FY16. Refer to table below for historical and projected results of new stores, which includes projections up through FY17 to show ramping up of sales over the next several years. For comparison, the average store contribution margin was 31.3% in FY15 and 31.5% in TTM Mar ‘16

We have proposed a run-rate adjustment to FY15 and TTM Mar ‘16 EBITDA for the incremental amounts of EBTIDA projected for the new stores in FY16 F. Refer to table for calculation of adjustment amount.

Contribution to EBITDA

($ in thousands) Open FY15 TTM16 FY 16 F FY16 F

Closed during period

REDACTED (17)$ (27)$ -$ 0.0%

Other stores

REDACTED 35 78 201 27.0%

REDACTED (7) (22) 32 8.2%

REDACTED - (2) 68 18.2%

REDACTED - (8) 43 14.8%

Add'l FY16 stores (4) - - 94 NQ

Total new stores 12$ 45$ 439$ 14.3%

FY16 EBITDA 439 439

Incremental EBITDA 428$ 394$

34

Run-Rate Adjustments

k) Store – Per Management, the store will be closed in FY16. As this store wi ll not be part of operations going forward, we have proposed an adjustment to remove its effects from EBITDA. Refer to summary table of the Burien store’s results for FY15 and TTM Mar ‘16.

l) Audit Fee – Management’s policy prior to FY15 was to accrue for audit fees in the year under audit (i .e., accrue expense in 2015 for audit of 2015 financial statements). Management’s external auditor, however, correctly proposed an adjustment to properly record the expense in the period incurred. As a result, FY15 did not have an audit expense charged against i t. We proposed an adjustment in the amount of $50 for Management’s estimate of the cost of an annual audit.

A - E x a m p l e o f s e l l - s i d e Q o f E Non-Cash Items

Under the existing loan covenant calculation, all non-cash items are excluded in the definition of EBITDA. These items are summarized below:

Vacation Adjustment – The Company maintains a vacation accrual for eligible employees that is trued up based on time taken on a monthly basis. An increase in accrued vacation has a non-cash impact on historical EBITDA (i .e., accruing for vacation starting year one and before accrued vacation is avai lable to be used). The increase totaled $148 in FY15 and $125 in TTM Mar 16.

Points Program Liability – The Company maintains a loyalty program for customers, in which they can earn points that are convertible to dollars available for purchases with the Company. The Company’s l iability is based on a monthly detai l received from the Company’s third party administrator. This is an operational amount that is owed to customers and properly accrued in accordance with GAAP; however, an increase in this liability has a non-cash impact of $104 decrease to FY15 and TTM Mar 16 EBITDA.

Rental Expense – This represents the excess of straight-line rent expense over cash rent payments for FY15 and TTM Mar ‘16. We obtained a detailed lease schedule, re-calculated the straight-line expense based on payment amounts and vouched selected lease terms to lease agreements to validate amounts. We also compared the March 2016 lease amounts to the general ledger, noting insignificant differences related to change in rent terms and between cash rent and straight-line expense during the historical period.

Contribution to EBITDA

($ in thousands) FY15 TTM16

Sales 361$ 358$

COGS 117 114

Gross profit 244 244

Store expense 145 148

Contribution profit 99$ 96$

($ in thousands) FY15 TTM16

Rental payments 3,880$ 3,961$

Rent expense 4,064 4,126

Excess of rent expense over cash rent 184$ 165$

35

A - E x a m p l e o f s e l l - s i d e Q o f E

Other EBITDA Considerations

New/Open Positions – In the course of our discussions with Management and a review of the organization chart, we noted two open positions under the CFO (accountant and buyer), two new positions for FY16 under the VP of Sales (retai l recruiter and retai l trainer), as well as four other new full-time-equivalent positions in Management’s FY16 budget for technology, marketing, purchasing, and loss prevention. Management estimated an additional $571 for these new administrative positions in FY16 F. These amounts were included in the FY16 forecast.

Margin Improvement – Late in FY15 the Company hired a new VP of Merchandising and began investments in a new inventory management add-on to accounting software. From this investment and the new practices being instituted by the new VP of Merchandising (movement towards new branding approach and discontinuation of the certain categories of products), the Company expects to be able to realize an improvement in gross margin of 1-2% in the next 12 months and up to 4-5% over the long term. This improvement is starting to be realized in the first quarter of FY16, with gross margin improving from 64.6% during Q1 FY15 to 65.4% in Q1 FY16.

Based on FY15 sales of approximately $40,000, each percent increase in gross margin would add roughly $400 to EBITDA. Making Management’s estimate of potential EBITDA somewhere between $400 and $2,000 going forward.

($ in thousands)

Net sales 10,615$ 100.0% 3,961$ 100.0%

Cost of goods sold 3,753 35.4% 4,126 34.6%

Gross profit 6,862$ 64.6% (165)$ 65.4%

YTD Mar 15 YTD Mar 16

36

• A potential buyer wants to see a trend of increasing profitable sales and consistent or

improving performance. Are there low-lying opportunities that could be taken advantage of

short term e.g. online sales, strategic relationships to drive sales, national sales groups

• All underlying assumptions used in a company’s forecast should be supportable.

• Do you have a budgeting process and mechanism to track budget to actual performance?

• Start to put together a monthly reporting package - in addition to the financials, this should

include your KPI’s. In particular, gross margin generally (and contribution by customer,

product category), customer retention, revenue trends (price versus volume) and working

capital (particularly excess inventory) are key metrics

• Important contracts – customer, vendor, employee – are all important arrangements

documented in a written contract and signed by both parties? Have you a written summary of

these agreements? Are there change in control or other restrictive provisions

• Manage your supply chain – Prepare a summary of purchases by top vendor; are you getting

sufficient discounts and rebates from your top vendors? When was the last time you sent work

out to competitive bid?

• Analysis of fixed versus variable costs – cost reduction initiatives, potential synergies

O t h e r C o n s i d e r a t i o n s – A l l n o r m a l

i s s u e s i n a g r o w i n g m i d d l e - m a r k e t

b u s i n e s s ( c o n t i n u e d )

37

• Finance Team – are there any gaps in skil ls or positions? Question we’re often asked at the end

of dil igence is our thoughts and opinions on the Finance team and management in general

• General management – same question – are the right people on the right seats on the bus and

what is done to retain right people? Is your team ready for buyer due dil igence?

• Controls – are there weaknesses in controls, gaps in processes, segregation of duties issues?

• Systems – identify gaps in systems, how processes could be more efficient and automated

• Legal issues – outstanding l itigation or other contingencies that may be lurking?

• Tax issues – talk to your tax advisor – clean up complicated tax structures and pending audit

issues

O t h e r C o n s i d e r a t i o n s – A l l n o r m a l

i s s u e s i n a g r o w i n g m i d d l e - m a r k e t

b u s i n e s s ( c o n t i n u e d )

38 38

M a x i m i z i n g C l o s i n g P a y m e n t s ;

V a l u a t i o n C h a l l e n g e s

a n d S o l u t i o n s

39

R e p a n d W a r r a n t y I n s u r a n c e ( R W I ) – C u r r e n t T r e n d s

• Product has matured since its introduction in 1998

• More competitive pricing

• More efficient process

• Significant acceptance by legal and investment banking community

• Statistics from Key US insurer Lockton (2103 vs. 2015)

− Submissions up 235% (500+ in 2013 vs. 1700+ in 2015)

− Policies issued up 250%

− Premiums written up 300%

• Insurers are paying claims

• Available in almost all industries (except healthcare)

40

R W I A d v a n t a g e s f o r B u y e r s a n d S e l l e r s

• Sellers:

− Clean exit

− Maximizes cash at closing

− No concerns about significant indemnity claims

• Buyers:

− Customize own indemnity package

Survival: “shorter” in documents with seller; “longer” in documents with insurer

Caps: “lower” in documents with seller; “higher” in documents with insurer

− Protects key relationships, especially when sellers stay on as management

− Ease collection concerns, especially when sellers are numerous

− Improved credit quality (AAA-rated insurer vs. individual seller)

− Can distinguish bid in auction

41

K e y Te r m s f o r R W I

• Premiums: 3% to 4% of coverage amount.

• Coverage Amount: Commonly 10% of deal size (can be higher)

• Retention:

− Underwriters want sellers to bear some risk to create incentive for sellers to negotiate reps (a.k.a., “skin in the game”)

− Underwriters usually ask for 1.5%-2%

− Possible to obtain policies with no seller retention but pricing and other terms may be worse

• Policy Period:

− Seller side: Typically mirrors the survival terms in the acquisition agreement (up to 6 year maximum)

− Buyer side: Up to 6 year term is available

42

R W I C o m m o n E x c l u s i o n s

• Common Exclusions

− “Actual knowledge” of breach

− Fraud of insured

− Fines and penalties (uninsurable by law)

− Asbestos/Environmental (varies)

− Underfunded pension liabilities

− Medicare/medicaid exclusions

− Purchase price/working capital adjustments

− Specific reserves on financial statements

− Forward-looking statements

− Consequential and “valuation” damages (e.g., multiples of EBITDA) previously excluded but now can be covered (typically, only if seller also provides for such damages in its agreement)

43

E a r n o u t s : W h a t a n d W h y ?

• Consideration in an M&A transaction payable to seller which is contingent upon the future performance of the target business and/or based on the achievement of certain milestones.

• Generally structured as payment(s) contingent on satisfying future milestones, such as:

− Financial: EBITDA, Revenue, Net Income

− Non-Financial: Regulatory Approval, Increase in New Customers

44

W h a t i s M a r k e t ?

• ABA Private Target Deal Study (published 2015)

− In 26% of deals in 2014

− In 25% of deals in 2012

− In 38% Of deals in 2010

− Duration: Range from about one to four years;

Majority end after 3 years

• Houlihan Lokey (for firm’s mid-market change of control deals, published 2015):

− Over 20% of deals in 2010; Only 10% of deals in 2014

− Median earnout was just under 10% of purchase price in 2010;

just under 15% of purchase price in 2014

45

N u t s a n d B o l t s o f E a r n o u t s

• Targets: Must be objective, measurable, plainly defined, consistent with the character of the target company

• Performance metrics should be tailored to specific business in question (creative approaches: customer retention, growth in customer backlog)

• Heavily litigated:

− Post-closing accounting methodologies

− No clear definition of how thresholds to be calculated

− Not account for treatment of certain expenses, overhead allocations or revenues

− Dispute resolution process (accounting firm vs. arbitration vs. litigation)

− Post closing business operation disputes (acted to minimize earnout, not invest in business, failure to pursue opportunities)

− Courts highly unlikely to entertain an implied covenant of good faith and fair dealing

46

S e l l e r P r o t e c t i o n s i n E a r n o u t

• Sellers seek protective covenants, i.e.

− Require target business to operate in the ordinary course

− Restrictions on disposing a portion of the target business

− Run business to maximize earnout

− Good faith and fair dealing

− Information rights

− Additional protection if change in management (e.g., liquidated damages or acceleration of payments)

47

E a r n o u t s : Ta x M a t t e r s

• Earnouts generally are subject to special rules applicable to installment sales.

• Different calculation methodologies are prescribed if

− A Seller can compute the maximum possible amount that could be received in an installment sale (e.g., earnout has a fixed cap);

− A Seller cannot compute the maximum possible amount that could be received in an installment sale, but the time period for receiving payments is fixed (e.g., earnout to be paid within 3 years); or

− A Seller cannot compute either the maximum or the time period (e.g., an uncapped earnout to be paid at unspecified dates).

• The open transaction doctrine may be applied when the market value of a payment is not ascertainable, though Treasury Regulations limit the use to “rare and extraordinary case[s].”

• Escrows established to secure indemnification obligations also may qualify for installment sale treatment.

48

T h a n k y o u ! C o n t a c t u s !

Eva Davis Co-Chair, Private Equity Winston & Strawn LLP 333 S. Grand Avenue Los Angeles, CA 90071-1543 D: +1 (213) 615-1719 F: +1 (213) 615-1750

evadavis@winston.com

Lawrence M. Kern Partner Winston & Strawn LLP 35 W. Wacker Drive Chicago, IL 60601-9703 D: +1 (312) 558-3202 F: +1 (312) 558-5700

lkern@winston.com

Rachel Ingwer Associate Winston & Strawn LLP 200 Park Avenue New York, NY 10166-4193 D: +1 (212) 294-4760 F: +1 (212) 294-4700

ringwer@winston.com

Nishen Radia Managing Partner FocalPoint Partners, LLC 11150 Santa Monica Blvd., Suite 1550 Los Angeles CA 90025

D: +1 310 405 7040 M: +1 310 562 1240 nishen.radia@focalpointllc.com

Margaret Shanley Principal Transactional Advisory Services Practice Leader Cohn Reznick 1900 Avenue of the Stars, 29th Floor

Los Angeles CA 90067 D: +1 310-598-1669 F: +1 310-622-4320 M: + 1 310-849-2537 Margaret.Shanley@CohnReznick.com