Dan Grossman, Esq., has been Victor Niederhoffer's business partner for four decades.
(Photo: Vic and Dan at the former Jay Gould estate, Lyndhurst, N.Y., Sept. 2005)
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Book Preview: How to Buy Companies, by Daniel V. GrossmanNote from Victor Niederhoffer and Laurel Kenner: Dan Grossman, Esq., who has acquired many companies in partnership with Victor, has been working on a book about his acquisitions and other business deals and some deals of others that he has liked. "My general theme is how an ordinary guy, without sizable capital or the backing of a well-known financial institution, can accomplish deals with large public companies," Dan says. We are pleased to provide the following preview chapter exclusively to readers of Daily Speculations.
Copyright © 2001 Daniel V. Grossman
"The Perfect Deal"
On August 28, 2000, I sold my company, Indiana Precision, Inc., to the NYSE firm Kaydon Corporation for $10,300,000. Based on an original investment of $1,000, this was a gain of more than 1,000,000%.
These numbers would perhaps not be particularly impressive in Silicon Valley and other breeding grounds of the New Economy, where hundred million dollar or even billion dollar gains have become common (at least until recently). But $10,000,000 and a 1,000,000% gain on sale of an Old Economy machine shop in Crawfordsville, Indiana, may be considered, even in this New Economy age, worthy of some note and explanation.
Also, unlike the founders of most software or Internet companies, I had not devoted myself exclusively and fanatically to this single company as the brainchild and focus of all my efforts. I was in the business of acquiring and managing a diverse group of companies operating in different industries in different states. Thus while I worked energetically to make Indiana Precision a success, I was at the same time responsible for overseeing seven other companies.
Building Capital Using a Foreign Sales Corporation
Most of the 1,000,000% gain came in slightly less than two years, from the purchase of Indiana Precision’s business from Alcoa in September 1998 to the company’s sale 23 months later. But there was also an earlier stage in which we used an export tax incentive program to build enough capital in our company to finance the 1998 Alcoa acquisition.
Indiana Precision was not a completely independent venture. It had the benefit of starting life as an affiliate of Tridan Tool & Machine, a company my partner and I had acquired a few years earlier. Tridan had a profitable niche product line, machinery for the production of air conditioners. Since American air conditioning technology was considered the best in the world, this small company in central Illinois had the unusual characteristic of selling a major part of its production overseas. I moved quickly to encourage these export sales, increasing Tridan’s attendance at foreign trade shows and even opening a sales operation in what was then referred to as Communist China. As the country with the largest number of air conditioner factories in planning or under construction, China soon equaled or exceeded the U.S. as Tridan’s largest market.
Those were the days when there was great handwringing over the U.S. foreign trade deficit. To encourage exports Congress enacted the Foreign Sales Corporation (FSC) tax incentive. Basically a U.S. company could set up an FSC subsidiary in a tax haven country such the British Virgin Islands or Barbados. By following procedures which, though highly artificial, were approved by the IRS (for example, offering the company’s products in a $10 Barbados classified ad that no customer would ever see), the company was permitted to exempt 15% of its export income from U.S. tax. This tax-free income could immediately be transferred from the FSC to a domestic subsidiary of the U.S. company and be used in the U.S. company’s business tax-free indefinitely.
Of course the prime beneficiaries of this tax incentive, to the tune of billions of dollars a year, were major exporting companies such as Boeing, GE and Microsoft. Few small, privately-owned companies had sizable export sales and, even if their export sales justified the expense, they and their accountants usually lacked the tax knowledge and sophistication to set up an FSC in a foreign tax haven. In addition, most successful, privately-owned companies in the U.S. had elected S corporation tax treatment. At the time, S corporations were not allowed to have subsidiaries such as FSCs. And even if they could, transfer of tax-free income from an FSC to its S corporation parent would immediately trigger income tax for the S corporation’s shareholders, wiping out the entire FSC benefit. The FSC program was for the big boys only, and it was a rare small business owner who had even heard of this massive tax exemption.
As a former practicing lawyer used to browsing in the Internal Revenue Code for provisions useful to my companies, I had heard of FSCs. And since by 1993 it appeared Tridan’s export sales would increase to $5 million or more, I was not about to accept that a government program exempting 15% of export profits from all income tax should be available only to companies that were members of the Business Roundtable.
My first bit of luck was to find a Ph.D. in Princeton named Ed who was offering to put together 25 small exporters into a “shared FSC”. For $500 Tridan could purchase its own class of stock in an FSC incorporated in Barbados. And for a yearly fee starting at $3,000, Ed would carry out the required offshore procedures, file the FSC tax return, and provide Tridan with the complex FSC calculations needed for its own tax return.
There remained the incompatibility problem between Tridan’s S corporation tax status and use of an FSC. After some thought, I came up with the idea of incorporating a separate C corporation, owned by my partner and myself, to substitute for Tridan as the owner the FSC shares. The C corporation would receive the tax-free income from the FSC in the form of dividends. While as a separate entity the C corporation could not use the tax-free income in Tridan’s business, it could save up the tax-free income to use as the purchase price of another acquisition.
This solution created one further problem. Under the Internal Revenue Code, a C corporation with only passive income, such as dividends from the FSC, would be considered a “personal holding company”, triggering some disastrous tax penalties. Our C corporation had to have active gross income as well, such as income from product sales. Thus was born Tridan Parts & Service Corp., a C corporation organized to own the FSC shares and receive the tax-free FSC dividends, and also to sell replacement parts to Tridan Tool & Machine’s U.S. customers.
The original capital investment in Tridan Parts & Service was $1,000, the amount that would be the tax basis for our eventual $10,000,000+ gain. Over the six-year period 1993-1998, the company received an average of $250,000 per year in FSC dividends plus income from parts sales, building an acquisition war chest of $1,500,000. Ed told me that as far as he was able to determine we were the only group ever to have used the tandem set-up, of S corporation as exporter and C corporation as FSC shareholder, in order to take advantage of both S corporation status and FSC export incentives.
Searching For An Acquisition
Tridan Tool & Machine, which in 1997 we renamed Tridan International, was located in Danville, Illinois, a few miles from the Indiana border. It thus made sense to look for acquisitions in both Illinois and Indiana. A business broker brought me Jones Tool, a family-owned machinery company for sale near Terre Haute. The company had large boring mills which it used to manufacture machine bases and oversize parts for other machinery customers. It had no proprietary products of its own.
While Jones Tool did not appear a very exciting company, I was interested in the profits they were making, profits that were unusual for their type of contract manufacturing business. It turned out their largest customer was an Alcoa machinery division located in Crawfordsville, Indiana. I spoke with the Jones family and made them an initial proposal, including a deal structure designed to accomplish their estate planning objectives. But they were not serious sellers (the company has not sold to this day) and they never bothered to respond to me.
Afterwards the profits from Alcoa stuck in my mind. I asked Tridan’s head of manufacturing to visit the Alcoa division in Crawfordsville, which was only about 35 minutes east of Danville on Interstate 74. While we could not compete with Jones on oversize parts, we had the equipment and expertise to carry out other types of precision machining for Alcoa. No business for Tridan resulted from our visit to Alcoa, although the Alcoa outsourcing people paid a return visit to inspect Tridan’s plant and reportedly liked what they saw. I told our head of manufacturing to keep in touch with Alcoa.
We Hear From Alcoa on a Different Subject
Months later, in February 1998, Alcoa contacted us. They were selling Alcoa’s West Plant in Crawfordsville, including its machining equipment and workforce. Were we interested in being considered as a bidder?
Our head of manufacturing stopped by to pick up the Alcoa offering materials, which were mostly copy-machine-reproduced photographs of the outside of a factory building and of an interior consisting of a “pin cell”, a “tool room”, and a lot of empty office space. I usually travel to Tridan by flying to Indianapolis, picking up a rental car, and driving west for an hour and half on Interstate 74 to Danville. I made arrangements to stop at Alcoa’s West Plant a few days later on my next trip to Tridan.
Alcoa, a contraction of its original, more expansive name, Aluminum Company of America, is the world’s largest producer of aluminum and one of the bluest of blue chip companies. What I soon realized from my visit, however, was that Alcoa’s Crawfordsville operation had nothing to do with aluminum. Rather, this was Alcoa Closure Systems International, manufacturer of plastic bottle caps for Coke and Pepsi. In fact, as I later learned, a mind-blowing 70 billion plastic bottle caps a year.
If you examine one of these plastic bottle caps closely, you will see that it is more complex than first appears. The inside threads are quite intricate, as is the connection of the cap to the matching tamper-proof collar. The Alcoa plant manager explained that the plastic caps were made at high speed on machined metal molds called “forming pins”. The role of the expert workers and specialized machinery in the “pin cell” at the West Plant was to manufacture these forming pins. This involved machining on the pins the reverse of the threads and other features of the cap to a tolerance of one ten-thousandth of an inch – what machinists call “a tenth”.
The role of the “tool room” at the West Plant was to manufacture prototypes of improved forming pins and other new product designs being developed by Alcoa’s engineering department. The pin cell and tool room together occupied only about a quarter of the West Plant. The rest of Alcoa’s machinery operations had been moved out and consolidated into Alcoa’s other, more modern Crawfordsville facilities, as had all of the office occupants. This left most of the West Plant quite empty and desolate.
Our Initial Bid
Whatever awe I felt about dealing with Alcoa was quickly dissipated by the mystifying bidding procedures established by its Corporate Development office in Pittsburgh. Interested parties were to submit their bids for the West Plant by March 15, each bid to set forth purchase price, payment structure or financing, and the salary and fringe benefits to be paid the transferred Alcoa machinists. The top bidders chosen by Alcoa would proceed to a second round in which they would submit further bids of purchase price and terms (including contractual terms). The winner of the second round would then be given the opportunity to negotiate a final deal with Alcoa’s financial and legal people.
In an unusual twist that distinguished this acquisition offering from all others I had ever seen, Alcoa did not offer financial statements for what it was selling, whether historic or projected. The pin cell and tool room had not been separated financially from the other manufacturing at the West Plant. And as in-house operations, charges had been at cost rather than on an arm’s length basis. However, in response to our questioning, Alcoa did convey the important information that it sometimes purchased forming pins from a third-party manufacturer at a price of $500 each.
Alcoa did give us wage levels for the workforce, which were very high. Most of the machinists had been with Alcoa for many years and were earning in excess of $50,000, plus the cost of Alcoa’s medical, 401(k) and other elaborate fringe benefits. Various other numbers from Alcoa turned out to be inaccurate. The West Plant was listed by them at 62,854 square feet, but when we eventually measured it the building turned out to be about 10,000 feet less. Alcoa told us the electricity, heating and air conditioning costs for the West Plant were $100,000 per year, a shocking amount. Luckily the utility costs turned out to be about half that.
Despite all the negatives, I was interested. The workforce was highly skilled and the forming pins they produced for Alcoa were a marvel of precision work. The machinery was estimated by a Tridan foreman to be worth approximately $1 million (subject to the caveat that used machinery is only worth what you have orders to produce on it). The building, while old, had been well maintained. I figured $900,000 for the machinery and $500,000 for the building, for a total of $1,400,000. On an earnings basis, I was hoping we could make $500,000 per year as a key supplier to Alcoa.
I prepared an initial bid to Alcoa of $1,450,000. This was higher than my Tridan president recommended, but I wanted to put our best foot forward and increase our chance of being selected for the second round. I reasoned that our main competing buyers would be smaller companies (since larger public firms would be put off by the lack of financials and by Alcoa’s elaborate three-step process), and accordingly I emphasized in our bid letter that we could pay all cash upfront and needed no financing. I included in our bid a three-year Alcoa commitment to buy prototypes and forming pins from us, the latter at $500 each. Finally, since it seemed so crucial to Alcoa, I stated that we would pay the transferred employees the same very high wage rates they were earning at Alcoa, as well as equivalent fringe benefits.
Negative Vibes, Including Some From My Partner Victor
In early April we were notified by Alcoa that we were among the bidders selected for the second round. New bids were due on May 15. Alcoa hinted to us that it needed a somewhat higher price than our original bid in order for it to avoid having to report a loss from the values at which it carried the West Plant and machinery on its books, although in keeping with its customary secretiveness Alcoa refused to reveal what its book values were. It also supplied a proposed form of Acquisition Agreement and Supply Agreement (covering Alcoa’s purchase of forming pins and prototypes), and we were asked as part of our bid to indicate any required changes. The agreements were for the most part devoid of legal commitment on Alcoa’s part, and read as if they had been prepared by a secretary copying haphazardly from other agreements in Alcoa’s legal files.
Now things were getting serious and I discussed the transaction with Victor, my 50-50 partner in Tridan. Victor is a speculator in stock futures contracts who sits in front of a trading screen all day (and most of the night). Although we were close friends since college, I rarely bothered Victor with transactions I was undertaking at Tridan. He actually would have preferred that I sell the entire company since he felt he could earn a far higher return on the money in his futures trading. But he did know a lot about acquisitions, having started his career as a leading business broker.
“That’s the stupidest acquisition I ever heard,” Victor commented amiably. “If Alcoa’s selling, they must be planning to phase those things out.”
“No, no, I looked into that. The next technology down the road is EDM, electronic discharge machining. I’m getting Alcoa to commit to buy the EDM pins from us if they switch over from the current forming pins.”
“You won’t make any money selling to them. They must know their costs.”
“I don’t think they do. There’s 50% Alcoa overhead in everything they manufacture. Paul O’Neill, their Chairman, has ordered them to save a billion dollars in costs and this is how Crawfordsville is complying. We’ll have practically no overhead, and we’ll make the 50% as profit.”
“You should get out of machinery and into the Internet,” Victor concluded, returning to his trading screen.
I also worried about having most of a large building sit empty, with a $100,000 yearly utility expense. Surely someone would pay $2.00 a foot to rent the excess 30,000 square feet, justifying the $500,000 I had mentally allocated to the factory building. I called the leading commercial real estate broker in Crawfordsville, a fellow named Maury, and asked if he wanted to participate with us on the building portion of the deal. There were more empty buildings in town than you could shake a stick at, Maury snorted. R. R. Donnelley, the large printer, was about to make some of its buildings available. The lighting fixture company was moving most of its operations to the South. Crawfordsville was the only city in America not sharing in the great economic boom of the Nineties. The factory was probably worth less in Crawfordsville than the annual rent on the building if it were located in New York, New Jersey or California.
We Bid Again
$500 a forming pin. $30,000 for a set of 60. Improved plastic caps and therefore new forming pins constantly being developed. 70 billion caps a year. Coca-Cola expanding in Russia, in China, in Latin America. We could be like Warren Buffett, riding the strength of Coca-Cola’s constantly growing sales.
The deal was highly uncertain, good information was not available, but my instinct told me the upside could be very exciting. And if the gamble went against me, the building and machinery had to be worth something. I was paying about book value. The downside was not that terrible.
I had always been good at creative legal and financial concepts. I would present our second bid in a favorable light. We had to increase our purchase price, but I would figure out a way to get the value back. And I thought I had an idea how to partially shelter the earnings from tax.
I raised our bid to $1,515,000. Alcoa’s form of Supply Agreement provided very delayed Alcoa payment terms, 45 days from our delivery of the entire order of forming pins or prototypes. I used this as an excuse to add to the Supply Agreement a $75,000 Alcoa downpayment, creditable against Alcoa’s final orders under the Supply Agreement. We were paying $65,000 more in purchase price, but getting back interest-free cash of $75,000.
In our bid I responded mildly to Alcoa’s form of Acquisition Agreement and Supply Agreement. As a small company, I wrote, we could not at the bid stage afford the legal expense of a law firm to review and revise these complex agreements. If we won the bid, we were confident our and their lawyers would be able to work out a fair Alcoa environmental representation, forming pin purchase commitment, etc, etc.
A few days after the May 15 due date for second bids, Alcoa gave us the news we were selected as the purchaser. We now had only to negotiate final Acquisition and Supply Agreements. Why this negotiation should then consume an entire agonizing summer until our signing and closing on September 30 is difficult to explain to someone who has never been in the position of a tiny company trying to complete a transaction with a Fortune 100 company such as Alcoa. It takes patience, and a willingness to accept some totally unreasonable terms – you have to step back and decide that those particular terms are not crucial to the economics of the transaction.
You would think an occasional attempt at levity would help, but this was not necessarily the case. During one frustrating negotiating session I finally said, “Okay, okay, Alcoa’s the 800-pound gorilla. Just tell me what you want here and I will do my best to accept.”
Having thought it over for a few minutes, one of the Alcoa participants then complained in a very hurt tone, “You called us a gorilla!”
“I meant a friendly gorilla. A lovable, friendly gorilla,” I said, realizing that even $100 billion companies have their sensitivities.
While Alcoa had accepted the $500 price included in our bid for forming pins, which constituted about half the expected output of the West Plant, we were miles apart on the other half, the building of prototypes and other tool room work. The price for this work we had included in our bid was an admittedly optimistic $119 per hour. Although Alcoa had accepted our bid, it now insisted it would pay only $70.
In general $70 per hour for run-of-the-mill machining is not a bad rate. But the West Plant performed extremely high level design and manufacture of complex parts. And as new owner we were taking over the expensive compensation level of the Alcoa machinists – base pay averaging $25 per hour, plus 40% for social security, health insurance and elaborate fringe benefits, plus the large amount of overtime, at time-and-a-half, needed for Alcoa prototypes and other hurry-up projects. Total labor cost was thus in the $50 per hour range, to which it was necessary to add supplies, machinery repairs, depreciation and other factory overhead, administrative overhead, and profit. (This overhead argument was more for Alcoa’s benefit than for our own internal calculation, since I had already decided we had to run the West Plant at a small fraction of Alcoa’s factory and administrative overheads.)
“Bob, let’s just cut through this,” I said to Alcoa Closure System’s CFO during a long and frustrating negotiating session. “We’ll meet you more than halfway: $85 per hour for Alcoa’s guaranteed minimum hours, and $70 per hour for the excess. That’s the absolute furthest we can go. We have to cover the high compensation and fringe benefits of your employees, as you have asked us to do. But the two go together. To pay your people we have to have a matching hourly rate. If Alcoa can’t accept this compromise, then perhaps a deal isn’t workable and we should just shake hands and part as friends.” I was serious about our willingness to walk away if we could not get a favorable rate. Alcoa did not answer immediately, but at the close of our meeting their CFO said he would take up the $85-70 proposal internally and they eventually accepted it without further debate.
Our commitment to pay the same high wage rates and benefits to the West Plant employees turned out to be a key aspect in our favor in Alcoa’s evaluation. (When told we had no feature available in our health insurance equivalent to Alcoa’s Vision Plan, I luckily was able to find out that this aspect of Alcoa’s insurance boiled down to a new pair of glasses for each employee every two years. Calculating that the cost would amount to only about $200 per employee, we took the innovative step of committing to pay that out of our own pocket without the benefit of a “Vision Plan”.) Alcoa’s termination pay policy was three weeks for each year of service and, by having us continue their employment at exactly the same wage rates and benefits, Alcoa was saving some $400,000 in termination pay that it would otherwise have owed these high wage employees with ten or fifteen years of service.
The deal that final closed was a mixture of hard-fought points won by each side. We had to accept the West Plant “AS IS, WHERE IS, WITH ALL FAULTS”, as Alcoa’s lawyers quaintly wrote in all capital letters in the Acquisition Agreement. Alcoa insisted on inclusion of its elaborate standard supplier terms in the Supply Agreement, which risked undercutting what we felt should be their clear obligation to buy from us. But the numbers remained favorable. $500 per forming pin and $85 per hour. Alcoa kept its word on the $75,000 three-year downpayment. We also won a $32,698 adjustment from Alcoa for accrued employee vacation time and a $50,000 price reduction for the missing 10,000 square feet. Although the $75,000 downpayment and $32,698 vacation accrual were obligations we would eventually have to make good on, our $1,515,000 bid price minus $75,000 minus $32,698 minus $50,000 meant that $1,357,302 was all we had to pay Alcoa at the closing. A few more adjustments and Alcoa would have to pay us.
Some Stock Purchased, Some Sold
We closed with Alcoa on September 30, 1998. Our new company, which we named Indiana Precision, Inc., was formed as a subsidiary of Tridan Parts & Service, whose tax-sheltered $1,500,000 was then used to pay the purchase price to Alcoa and for initial working capital.
In July and August, while we were still in negotiations with Alcoa, Victor ran into severe margin calls from his trading and asked if I could purchase for immediate cash any part of his stock in our companies. Although sympathetic to his situation, I told him selling his interest in Tridan International, a stable and growing money-earner, would be a very bad idea. But since he continued to be very negative on my efforts to acquire the Alcoa West Plant, I did agree to purchase his interest in our acquisition vehicle, Tridan Parts & Service. This I completed in three tranches for a total purchase price of $925,000, a higher price than Victor had asked and a gain over his $500 cost (half our original $1,000 investment). I then had Tridan Parts & Service give up the FSC, and the parts business it was conducting for Tridan International, and merge into its newly-formed subsidiary, Indiana Precision, Inc. This left Indiana Precision as the surviving company, fully independent of Tridan.
Having purchased Victor’s stock, I next sold 10% of my stock to the two executives I wanted to run Indiana Precision with me. The price to them was the lowest that could be justified for tax purposes and involved no cash, only installment payments that they would pay when they were able, out of the dividends they would eventually receive. Creating a company from the bare-bones manufacturing operation we were buying from Alcoa would require a lot of hard work and I wanted to make sure our key people had the maximum incentive to make Indiana Precision a success.
Up and Running
Our closing with Alcoa was on a Thursday, and we were up and running for our own account on Friday. After seven months of abstract negotiation and planning, it was good to be in actual production, making forming pins for Coca-Cola bottle caps. It was also good to be able to deal directly with our inherited employees, who had been kept at arm’s length from us by a cautious Alcoa management.
Our employees were, with minor exceptions, a friendly, highly intelligent and independent group. They came to us with a healthy dose of hostility towards Alcoa for having kept them in limbo for seven months, and for having in effect terminated them without the major severance packages they felt entitled to under Alcoa guidelines. This attitude towards Alcoa served its purposes in helping the employees more enthusiastically appreciate that our profitability depended on maximizing the revenue flow from Alcoa to Indiana Precision. In a major step to share this profitability with our employees, we announced that, in addition to their significant hourly compensation, we would pay them 10% of company profits above certain capital costs.
Besides keeping administrative expenses low, we knew the key to profitability was increased efficiency in forming pin production. Here the impressive expertise and intelligence of our employees proved to be a key asset. It turned out they already knew or at least had very good initial thoughts as to the improvements to be made. But Alcoa’s elaborate rules, and its extreme reluctance to permit changes in production methods, had totally inhibited the employees from implementing any such improvements.
Alcoa had not permitted at the West Plant those little black paper clips with folding wings, apparently on the theory that they might snap and hit someone. As I write this account, early in the George W. Bush administration, I see reported in the Wall Street Journal that former Alcoa Chairman, now Treasury Secretary, Paul O’Neill, while less than fully enthusiastic about the President’s tax reduction package, is devoting himself to “improving industrial safety in the Treasury Department.” It is striking how a seemingly minor news report can confirm a key characteristic about a person, whether at Alcoa or the U.S. Treasury: “Tax policy and the economy may be important to some, but I’ll be damned if I’m going to let anyone get seriously injured because the Budget is fastened with the wrong type of paper clip!”
Taking my chances at Indiana Precision, I told our people they could use any kind of paper clip they wanted. More importantly, they should please undertake a careful program of testing all ideas for reduction of forming pin cycle time. Giving them encouragement to implement their ideas combined with the promise of a share of the profits produced some amazing results. New types of grinding wheels were ordered and within weeks average cycle time dropped from about 90 minutes per pin to less than an hour. (It would eventually drop by a total 66% to a little over 30 minutes per pin.) With our locked-in price of $500 per pin, our gross profit soared. During our first three months of operation, from the September 30 closing through December 31, 1998, we earned a quarter of a million dollars.
A few weeks before the close of the year I called Craig, our office manager, and asked him to schedule a Saturday night dinner for all of us, our employees and their wives, celebrating our first Christmas season together.
“There’s the restaurant at the Holiday Inn,” Craig offered. “What do you want to spend, about $8.00 a person?”
“I think we can do a little better than that,” I said. “There must be good steaks in Indiana. Get us the best steak restaurant you can find.”
Another Tax Idea
For some twenty years, ever since I started in acquisitions, I had been interested in a minor Internal Revenue Code provision permitting farmers, tree growers and certain other business corporations to exempt themselves from the rule requiring use of “accrual basis” accounting in computing taxable income. These few qualifying corporations are allowed to use “cash basis” accounting instead.
Take the case of a corporation that as of the end of year 1 has shipped and billed its customers for $500,000 of product which, because of the normal payment cycle, will not be paid until January of the following year. Under accrual accounting, the corporation must include this $500,000 in computing its year 1 taxable income. However under cash basis accounting, the corporation does not include this $500,000 until received by it in cash the following year, even though it can deduct in year 1 all expenses it has paid of manufacturing the product. There is thus a deferral from year to year of $500,000 of taxable income, potentially increasing each year to the extent the corporation’s business continues to grow.
For a manufacturing corporation to qualify for cash basis accounting, its gross receipts must not exceed $5,000,000 per year and, most unusually, its business must not use an inventory. It is also important for it to have elected cash basis accounting from its first tax year since a switch to cash basis accounting requires IRS permission, which would virtually never be granted.
“We’re going to elect cash basis and shelter our entire first year’s income. I’ve been waiting for years for a company to do this with,” I told Jeff, my group CFO.
Jeff’s initial reaction was not favorable. The IRS hated cash basis and would never allow it.
“That’s the beauty – it’s not up to them. I’m going by specific law and regulations. There’s no interpretation or IRS permission required.”
Indiana Precision could meet all the cash basis requirements. As a newly-formed corporation, we would elect cash basis from the outset. Our gross receipts, at least in the first couple of years, would not exceed $5,000,000. And on the unusual point of operating without inventory, all our work consisted of transforming metal for Alcoa. To make forming pins, we processed pin blanks supplied by third parties. Alcoa actually had in its possession a year’s supply of blanks, so that for the entire first year Alcoa would be providing blanks free of charge and we would be processing them into forming pins for a processing charge net of the cost of the blanks. Thus everything we worked on was Alcoa’s, and we held no raw material, work-in-process or finished inventory for sale to others.
Once he understood the statutory authorization for Indiana Precision’s cash basis accounting, Jeff became an enthusiast. Like farmers and tree growers, we had Congress’ special blessing.
The Money Comes Rolling In
In many ways Indiana Precision was the best small business I had ever seen. Thanks to the incredible improvement in cycle time, our gross margin on forming pins was now up to 70%. And since we decided to keep administration and accompanying overhead expense to a minimum, an unusually large part of the gross margin passed through to the bottom line. [To come]
Testing The Acquisition Market
When things are going well, that is the time I start to worry that perhaps they cannot get much better. By late summer 1999, almost a year after the acquisition, things were going so well at Indiana Precision and the other companies that I felt I had to offer at least one of them for sale. This was not an easy decision for me since I wanted to continue, almost as if they were my children, helping each of the companies grow and prosper.
Tridan International was the logical sale candidate. It was owned 50-50 with Victor and I had promised him I would at some favorable point offer it for sale. It had its own branded product line marketed throughout the world and a multi-year financial record, while Indiana Precision, no matter how profitable, had only a single customer and barely a year of financial history.
The customary way to offer a company for sale is to hire a financial intermediary. Large companies, and companies with highly-desired technology, hire prestigious intermediaries like Morgan Stanley and Goldman Sachs, who refer to themselves as investment bankers. More modest companies like mine hire smaller intermediaries, who call themselves business brokers or finders. But in offering a company for sale, all intermediaries do pretty much the same thing: They contact the CEO or Vice President of Business Development at an array of potential acquirers, and then provide information about the attractions of their client.
When I practiced law on Wall Street, I was always surprised at the extent to which companies were willing to pay my investment banking clients exorbitant fees basically to put them in touch with other companies to discuss acquisition or another inter-company transaction. Why not simply pick up the telephone, call the other company’s CEO and save the $1,000,000 fee?
That is what I decided to do on behalf of Tridan. But instead of telephoning, I drafted a letter describing Tridan’s business, its favorable return on sales and invested capital, and its expected growth rate for the current and following year. I then prepared an initial list of a dozen logical acquirers, called each company to find out the CEO’s direct fax number, and faxed the CEO my letter. While I varied the letter’s concluding section depending on the company I was writing to, it was usually along the following lines:
We are frequently approached about acquisition and always answer that we are not interested. However we feel there are now some specific opportunities available to us (which I would be pleased to describe to you by telephone) which could allow us to double or triple our profits over the next few years, opportunities which could be accomplished with the help of the right partner.
I am writing this private and candid letter to you because I have long admired your engineered framajig product line, and I believe Tridan could be an excellent manufacturing and marketing fit with your Widget Division. While small, Tridan is a leader in a profitable niche market, produces high quality products complementary to your own, and offers outstanding financial performance. If our situation is of interest, I look forward to speaking with you.”
It turned out to be the right strategy to go directly to the CEO (usually the company’s Chairman, but sometimes its President), rather than to the head of business development or finance. First of course, if the CEO became interested, no other approval level would be required. Second, it was my impression that CEOs were usually less busy than executives with daily departmental responsibilities. Aside from appearing before stock analysts and shareholders and sitting in on long-term planning meetings, CEOs of public companies were probably looking around for substantive things to do. As I imagined it, my letter would drop into the CEO’s lap an opportunity to show his young whippersnapper staff that he still had his own sources and ways of getting things done: “Geez, the Old Man has come up with an acquisition on his own.”
A Database to Expand My Efforts
The letter worked well. A couple of the CEOs telephoned me the day after receiving it, which was pretty amazing. Others wrote back, or had their acquisition people call me. Of course most of the companies had reasons they were not interested in Tridan. But two were interested and asked for more information, as I reported to my partner Victor.
Victor’s approach was a little different from mine. I only wanted to sell Tridan if we could find a “strategic acquirer”, a company eager to be in the business Tridan was in, who would pay us a premium price. Victor’s view was more along the lines that if you want to sell Tridan, you sell Tridan.
“Two is a start, but it would be better to contact maybe 100 companies,” he suggested.
“I’ll get there. I can only handle a few at a time. And I usually learn something from each as I go along.”
“You know there’s a reason there are business brokers.”
“I’ve talked to a few brokers but I don’t see what they would add. They can also mess things up pricewise. If you want something done right, do it yourself.”
“You would probably also be better at sweeping the floor than the janitor at Tridan, but that doesn’t mean it’s the best allocation of your time.”
To optimize my chances, I did agree that I needed to write to more acquirers. Thus far I had been selecting potential acquirers based on my existing knowledge of public companies in related industries. I needed what the investment bankers and brokers had, a “database” of virtually every potential strategic acquirer.
I ordered a subscription to the Value Line Investment Survey for the introductory price of $55. To begin the subscription, Value Line sends a 5-inch-thick looseleaf book describing in intense, efficient detail the 1500 leading companies of interest to U.S. stock market investors. I started to read through Value Line each evening, marking those companies of potential interest that I would research further on my computer in the morning. My daughter Kate wanted to know why I was always immersed in such a ridiculous fat book, like Bob Cratchit. It’s my database, I said.
More than a year after I found in Value Line the company that would be our eventual acquirer, I attended a dinner party where one of the guests was Sam Eisenstadt, Value Line’s legendary Director of Research for more than 40 years. I told him the story, and that I felt I owed him something more than $55 for using Value Line to find an acquirer to pay us many millions of dollars. He said he had never heard of Value Line being used in that particular way.
Do You Have Something Larger?
I was sending out more letters and chatting with more CEOs, but most of them were turning me down. Tridan was too small for them. With their billions of dollars of revenues and market value, they could not afford to spend the management time to acquire and run a company with sales of less than $10 million and profits of less than $2 million. If I wanted to be seriously considered by public companies, I would have to offer something larger.
I decided to change my approach and offer three of my companies together as a combined group. Early on, when I was interviewing business brokers, I had asked about this possibility but the brokers had been negative on it. Brokers were interested in a company easy to explain, sold to anyone – a public company, a private company or a financial buyer. I on the other hand was interested only in public acquirers who would pay a strategic price.
Tridan and Indiana Precision were related geographically and were both in the precision machinery field. I also owned a New Jersey company, Canfield Technologies, Inc., a manufacturer of solders and other metal alloy products. Deciding that Tridan, Indiana Precision and Canfield could all be considered manufacturers of engineered industrial products, I combined the three companies for offering purposes into the newly-conceived “Tridan Group”. While selling all three companies was not my first choice, it seemed the only way to have a shot at attaining my goal of a premium price.
Jeff prepared financial statements for the Tridan Group by combining the financials of the three companies. The financials were complementary to each other and made for attractive totals. Canfield’s sizable $18 million of sales resulted in total sales for the Group of $30 million. And since Indiana Precision and Tridan earnings were unusually high in relation to sales, the Group’s combined earnings were impressive. The combined amounts would be enough to overcome the size barrier and tempt potential acquirers to move to the next step of scheduling a visit.
I faxed out a new batch of letters to companies that made various types of industrial products. One of these companies was Kaydon Corporation, a bearings manufacturer based in Michigan with a market value of slightly less than $1 billion. Value Line deserved full credit for this one since I was unfamiliar with Kaydon until coming across it in Value Line and then ordering its annual report.
Brian, Kaydon’s CEO, called me in response to my fax. He was flattered my letter had referred to his somewhat arcane explanation of Kaydon’s criteria for acquisitions, spelled out over several dense pages of the company’s annual report. We set up a visit by Brian and three other Kaydon executives to the Tridan, Indiana Precision and Canfield factories. I accompanied them, musing to myself that only five people in entire world, in or outside of my companies, had visited all three of the Tridan Group’s locations – me many times, and now the four of them.
Negotiating With Kaydon
My original letter to Brian was faxed on October 5, 1999 and the acquisition closed on August 28, 2000, so I negotiated with him for nearly a year. I never did figure him out. [To come]
The Perfect Deal
From the perspective of my original worry that things were going so well they could not get much better and that it was time to think about selling, August 28, 2000 turned out to be an excellent time to sell. From a macro standpoint, the economy and the stock market started to weaken in September and went straight down from there, pulling down the values acquirers were paying for companies in the acquisition market.
From a micro standpoint, Indiana Precision had only thirteen months to go on its three-year supply contract with Alcoa. While there was reason to believe it would be in Alcoa’s interest to continue to purchase forming pins and prototypes from Indiana Precision after the contract ended, there was no way of knowing whether business from Alcoa would continue at the same level. And our cash basis tax shelter had largely run its course, sheltering most of the company’s earnings in its first year but thereafter only the increase in receivables over payables.
On the terms of the acquisition itself, we were able to achieve some perfectionist touches that warmed my dealmaker’s heart. Unlike the Tridan and Canfield acquisitions, which Kaydon structured as purchases of company assets, I insisted that the Indiana Precision acquisition be structured as a purchase of our stock. Because the company had $1,500,000 of Tridan Parts & Service retained earnings (used to fund the Alcoa acquisition), a purchase of the assets of Indiana Precision and distribution of the purchase price to us would have been considered a dividend of the retained earnings, triggering ordinary income tax. A stock sale, however, was subject to capital gain tax treatment only.
The acquisition price was also free of investment banking or broker fees, and free of legal fees from a major law firm. A typical business broker’s fee for the Indiana Precision acquisition would have run $500-700,000, and three or four times that amount for acquisition of the entire Tridan Group. A major law firm’s fees would have added additional expense equal to perhaps half of the broker’s fee.
In a gracious email to me after the acquisition’s closing, Victor freely admitted his prior advice about using a business broker had been mistaken in that my headstrong strategy of going directly to acquirers had probably increased the acquisition price by 25%. As someone who himself had been a leading business broker, Victor felt that a broker, to increase the likelihood of a deal, would have pushed the parties to an acquisition price comparable to other deals. With a broker gossiping to each party about what acquisition price was likely or could be justified by the “comps”, the price would have tended to regress to the mean and it would have been very difficult for me to fully maintain my demand for a premium price.
Victor was also one of the few persons in this world who, having sold his shares at a company valuation of less than a $2,000,000, would feel genuinely happy for me in my sale of Indiana Precision to Kaydon at a valuation of $10,300,000. Though his sale to me two years earlier had been at his request, and though he had been very much against the Alcoa deal, I told Victor he deserved something more and I was planning to pay him a large consulting fee from my sale proceeds. Victor refused, saying I had done more than enough for him by selling his 50% of Tridan International to Kaydon at a favorable price and without a broker. But I kept bringing the matter up until he relented to the extent of agreeing to accept a fee to be given to his wife Susan to save for a rainy (i.e., bad trading) day.
The $10,300,000 we received for Indiana Precision had to be considered pretty close to an optimal price. We had found the right buyer, who needed to do an acquisition. And our infant, single-customer company had benefited tremendously from inclusion in the three-company deal, since it was unlikely to have been valued similarly on a standalone basis.
Every key step in our story had worked out favorably. The Indiana Precision business was purchased favorably from Alcoa, with funds accumulated favorably in a tax shelter not usually available to small business. The company was run favorably, returning a profit of 100% per year on its purchase price. And it was sold favorably to Kaydon.
These key steps were just the bare bones. Relatively minor aspects also had to work. A little thing, but I always thought the recognition that Jones Tool was making a lot of money from Alcoa, and that we should see what was going on with Alcoa, was important. I believe most people would not have bothered. Also minor in the usual scheme of things, but totally necessary in retrospect, was our patience in complying with Alcoa’s over-elaborate, three-step bidding process, and our forbearance (in all except a couple of instances) in the face of Kaydon’s year of torturous inefficiency and discourtesy.
Laid out in a narrative, each step seems logical, even probable. But from my years pursuing acquisitions I knew the long odds involved at every stage. To acquire one company, you must study 100, and negotiate with 10. Even with such winnowing, it is very easy to make a mistake and lose a great deal of money. Among other risks, every company someone acquires is a company someone else wants to get rid of.
Operating a company has its own risks, people risks, production risks, sales and marketing risks, technological obsolescence risks. The “creative destruction” nature of capitalism means that no product or profit margin is safe. All are being competed away, reduced to a nominal return either slowly or quickly. Making an acquisition, even a good acquisition, is basically putting yourself in a position to be lucky. There is no assurance.
In selling a company, it is again a matter of probabilities. You try to interest dozens and dozens, even hundreds, of potential buyers. The accurate statistics are that, on the average, if you can get seven potential acquirers to visit you, you will arrive at a deal. But you have to have quite a good company to get seven acquirers to visit. And then there is the matter of negotiating the acquisition price and all the other terms.
So while exuberant about Indiana Precision’s journey from an original investment of $1,000 to an acquisition price of $10,300,000, I knew the long odds involved at every stage and I knew that I would never see such a perfect deal again.