Susan Brady: Can you give a brief overview of the security industry from a financial perspective and how it got to where it is today?
Dennis Stern, Executive Vice President and General Counsel, HSM Electronic Protection Services Inc.: In the 1990s you had “Bubble Mania”—multiples rose significantly as you had the great market share race—Tyco/ADT, Republic, P-1 [Protection One], SecurityLink from Ameritech, etc. After the bubble burst there were many sellers, few buyers and multiples came down.
In the present market the attraction is cash flow resulting from the recurring revenue stream. It’s a non-cyclical business. In general, there is a great deal of private equity capital looking to invest. There are financial buyers and strategic buyers who approach the market with different perspectives.
In regard to multiples today, there is a gap between the seller’s expectation and buyer’s reality. While margins are high on monitoring services (which systems integrators are not realizing), there is a failure by all parties involved to recognize not all companies are equal.
Brady: What is Due Diligence and why is the process so important?
Raymond Lynn, Director – Financial Analysis, HSM Electronic Protection Services, Inc.: Due Diligence is a necessary but painful information gathering process. It is an opportunity for the buyer to obtain answers to all questions about the seller’s business. Conversely, it is an opportunity for the seller to address and satisfy the buyer’s concerns.
Brady: What is involved in Due Diligence Planning?
Lynn: The process needs to be well planned before information gathering begins to be most successful. The amount of work increases as the amount of risk the buyer is willing to accept decreases.
It starts by developing questions that need to be answered and knowing what information needs to be obtained to answer each question. Buyers should provide a list of the information needed to the seller prior to their visit and be prepared to justify why the answer to each question is required.
Brady: What are the major Due Diligence concerns?
Lynn: The major concerns are recurring monthly revenue (RMR), risk mitigation and transition issues.
The questions that need to be answered in regard to RMR concerns include:
• Does it exist?
• Is it contracted?
• How quickly does it convert to cash?
• How long does it stick around?
• What has been the ability to grow it?
• Is it for valid future alarm service revenue?
• Is any of it subject to special arrangements?
Among the many risk mitigation
questions are:
• Does the seller have the authority to sell?
• Has the seller paid their taxes?
• Is the seller licensed?
• Can anyone else lay claim to the assets?
• Will the buyer be on the hook for past losses?
• What else can the buyer be on the hook for?
• Are fire inspections current?
• Is the seller a good environmental citizen?
Transition issues involve the following:
• How quickly can the monitoring be converted
to the buyer’s central station?
• How effectively will the buyer be able to
service the account base?
• Will the buyer be able to make money
on installations?
• Will the buyer be able to retain the
Seller’s employees?
Brady: Take on the role of the buyer. What are some of the reasons for purchasing a security company?
Stern: There are three major reasons: the ability to use an acquisition to grow the company—fold-in; the ability to enter a new market; and the ability to become a major player. In all cases the basics are still the same. You determine the “quality” of the company from some of the more important business metrics. You look at the company’s contracts and accounts receivables. What is its cancellations/resigns history and how many will cancel once the acquisition takes place? You consider the RMR reconciliation – mix of monitoring, service, response, inspections, etc. The make-up of the account base, commercial vs. residential, is also important.
The way the accounts are monitored is another concern, whether it be internal or 3rd party. If it is 3rd party, you have to look at the method of transmission and how easily movable it is.
Another aspect of the sale is the scope of the employees —techs, sales, administration—and if you’ll need any non-solicitation agreements. You also have to consider the offer itself and whether it’s for assets or stock; for the whole business, not just for the customer contracts.
Brady: Can you go through the acquisition process in order of what happens when?
Stern: Usually it follows this sequence:
• Confidentiality Agreement.
• Initial information.
• Non-binding Letter of Intent.
• Due diligence.
• Contract negotiations – usually runs parallel with due diligence.
• Simultaneous signing and closing.
Brady: What are some other typical issues that need to be resolved?
Stern: Sometimes there are multiples for different types of RMR. The account guarantee period—length, cushion, other factors—might come up. The amount of holdback and what the seller is going to do post-close are other important issues. Most importantly, the deal has to make economic sense.
