Dave Kauppi is the editor of The Exit Strategist Newsletter and Managing Director MidMarket Capital Advisors, providing corporate finance and sell-side advisory services to entrepreneurs in information technology and other high tech businesses. Dave graduated from The Wharton School of Business, University of Pennsylvania with a BS in Economics /Finance. Our ideal client is a business seller who wants more than an EBITDA valuation Multiple.
Thursday, February 28, 2019
When an EBITDA Multiple Doesn’t Work for a Valuation
In the world of mergers and acquisitions, sophisticated buyers, private equity firms, and business valuation firms establish some “rules of thumb” valuation multiples. The International Glossary of Business Valuation Terms defines “rule of thumb” as “a mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay, or a combination of these; usually industry specific.” For one industry it might be a multiple of revenue, for another it is based on assets and capacity like the hotel industry at $25,000 per available room, or Revenue Per Available Seat Mile (RASM) for airlines or for other industries, monthly active users or subscribers, an EBITDA multiple, or a value based on discounted cash flow.
The Pros and Cons of Rules of Thumb Multiples
Rules of thumb multiples are very convenient and a great starting point for a valuation discussion or analysis, but we view them as just that, a starting point. Valuing a business is far more complex than valuing a piece of commercial real estate (discounted cash flow) or a single family home. For a home there are very accurate comparables based on the number of bedrooms, the number of bathrooms, school district, distance to public transportation, square footage, and a few others. The value of a business, however, is subject to the interpretation of the buyers that evaluate it. A strategic buyer will evaluate a potential acquisition based on the value that can be created after the assets of the target are combined with buyer’s assets. This points to two critical elements of your business sale; 1. Capture and articulate your company’s strategic value drivers in your business sale marketing documents and, 2. Get as many opinions from the market as possible.
Capture and Articulate Your Company’s Strategic Value
Below are some of the most powerful drivers of strategic value:
1. Contractually recurring revenue – This is exactly why most major software companies are moving away from a one-time licensing fee to a software as a service (SaaS) offering. Microsoft and Adobe recently changed their business model to this approach and their market values are soaring. Salesforce.com launched their business using the subscription model, and they have been a huge success. The time and materials IT service model is disappearing and being replaced with a managed services offering. Contractually recurring revenue tremendously reduces the risk for a business buyer and they will pay up for it both in purchase price and the percentage of cash at closing versus earnouts and deferred contingent payments.
Time to Market and First Mover Advantage – Most business buyers could develop the sought-after technology themselves, but we suggest they analyze the cost of their time to market delay. Believe me, with first mover advantage from a competitor or, worse, customer defections, there is a very real cost of not having your new strategic product today. We were able to convince one buyer that they would be able to justify our seller’s entire purchase price based on the number of client defections their acquisition would prevent. Think of the difference today between first mover Gatorade and the distant number 2, PowerAde.
Companion Products and Similar Customer Base – There is an old salesman saying, “It is ten times easier to sell an additional product to an installed account than it is to open a new account.” If you product or service is viewed as a logical add-on to the buying company’s product suite it can produce some stunning post acquisition sales growth. Similarly, if the buyer’s and seller’s customer base is similar, great value can be achieved by cross-selling to one another’s customer base. The market may provide you with value expansion because you have an installed base of difficult to penetrate blue-chip accounts.
Removing Barriers to Entry – If your company has already broken the code to federal government business or even more importantly security clearance, this can be quite valuable to a buying company that is anxious to penetrate that client.
A Superior Business Model – For the selling company, of course, their main product, service, and intellectual property are valuable. Often what is overlooked, however, is the value of a better sales system, or social media approach, or the use of outside contractors. The buying company might be thinking that if we implemented the seller’s sales system across our entire sales force, could improve our productivity by 10% across the board. If you have developed a particular strength, make sure your potential buyers know about it and value it.
Improve the Core Product Offering of the Buyer – We represented a seller who had developed a database and algorithm to help hospitals establish the proper level of nurse staffing for the various hospital units. The two final bidders were both major providers of human resources and staffing software for hospitals. Often these software systems would sell for a half million dollars and up. Our client’s product was viewed as an important module that would improve the competitiveness of the buyers’ main system. The selling price ended up being way higher than even an aggressive multiple of EBITDA.
Restate Financials to Reflect the Buyer’s Pricing Power – For small technology companies selling into the enterprise, there is often a substantial required pricing discount when competing with the big legacy provider. In one M&A deal we restated our seller’s historical financials using the pricing power of the brand name acquirer. This client was a small IT company that had developed a fine piece of software that compared favorably with a large, publicly traded company’s solution. Our product had the same functionality, ease of use, and open systems platform, but there was one very important difference. The end-user customer’s perception of risk was far greater with the little IT company that could be “out of business tomorrow.”
By applying the pricing model of the buying company to our client’s income statement, we were able to double the financial performance of our client on paper and present a compelling argument to the big company buyer that those economics would be immediately available to him post acquisition. It certainly was not GAP Accounting, but it was effective as a tool to drive transaction value.
Defensive Response to M&A Activity in the Market – This dynamic can drive company selling price beyond traditional valuation models. We have a number of potential sellers in our pipeline that have contacted us well in advance of taking their company to market. They just wanted to make a connection and to get advice on how to prepare their company for their eventual optimal exit. When we hear about a completed acquisition of one of our prospective client’s competitors, we pick up the phone. This deal announcement will normally elicit a competitive response from the marketplace in the form of several other acquisitions from the buyer’s competitors. You see it all the time. If Merck buys a biotech company with a promising cancer drug pipeline, you can be pretty sure that Novartis, Pfizer and others will soon follow suit. The same goes for the tech industry if Google buys an Artificial Intelligence company. Microsoft and Adobe will be close behind. This produces an arbitrage opportunity and company selling prices shoot up until the competitive demand is satisfied.
Sell to Your Strengths
This list is by no means exhaustive. You are in the best position to recognize your company’s strategic value components. As you engage with the various potential buyers, try to envision how your two companies would combine and how they could leverage your assets to produce performance well beyond 1 + 1 = 2. You can even take this one step further. Try to quantify this synergy and use that in your selling approach. Your value proposition is unique to each individual buying company so it is important that you maximize your exposure to the market and invite as many opinions as possible.