How much are you expecting when you sell your business? I
always ask this question of our clients. The answers are as different as the
businesses. "We need $5 million to give us the type of retirement we want.
We have invested $2 million in the product. Our investors have put in $3
million so far. It should sell for $5 million. I heard that xyz Company got $30
million for their company." Well, my response to my clients doesn't
necessarily endear me to them, but it is the truth. The market doesn't care.
The market doesn't care how much it cost you to develop the product or how much
your investors have in or how much you need to retire or how much you think it
is worth.
The market looks at what the ROI is for its investment in a
company. If you are fortunate enough to have a technology that can be
leveraged, the market may look at the future returns of that technology in
stronger hands.
For most businesses, there are benchmarks that are often
used as a starting point. The most common in a merger and acquisition situation
is an EBITDA multiple. That is the gold standard for privately held companies,
similar to what a PE multiple is as a business valuation metric for publicly
traded stocks. One of the measures that has come into vogue on Wall Street is a
PEG multiple or Price Earnings Growth. It is essentially a way to attempt to
quantify the difference in PE multiples between two firms in the same industry
that have a much different future growth scenario.
Buyers of businesses that are privately held attempt to
ignore this factor when making their purchase offers.
One small company was in an industry characterized by slow
growth of about 4%, had commodity type products and consequently very thin
gross margins, and had little pricing power. This company introduced a new
product that was unique, had very healthy margins, retained some pricing power,
and was experiencing 50% year over year growth.
The industry benchmark valuations were at 4.5 X EBITDA. The
three largest players in the industry were all interested in the acquisition
and each one put out an initial bid that was, surprise, about 4.5 X EBITDA.
Another factor was that our client was in rapid growth mode so a good deal of
their costs were front end loaded as they launched a few big box retailers
during this period. The effect of this was to depress their EBITDA performance.
This made these offers even more inadequate.
The result is that we have a classic valuation gap between
business buyer and business seller. This is the biggest reason that many merger
and acquisition transactions do not happen. The clients are terribly
disappointed and suggest that these buyers "just don't get it." The
buyers have experience in making several acquisitions in their space and have
their business valuation metrics pretty much in stone and think our sellers are
being unreasonable in their expectations. Game over, right?
Not so fast. One of the most important roles of a business
broker, merger and acquisition advisor or investment banker is devise a
transaction value and structure that works for both parties. We pointed out to
the buyers that their traditional way of looking at these transactions is
appropriate for their prior acquisitions with standard growth metrics, lack of
pricing power, and commodity type products.
We suggest to business sellers that
as a small company with a few big box retailers comprising 80% of company sales
with essentially one main product, that they have a great deal of small company
risk. For example, if the retail buyer from xyz Big Box Retailer changes and is
replaced by a buyer that has a consolidation of vendors bias, then they could
lose 30% of their business with one decision. A bigger company, however, with
30 SKU's would be much harder to replace with a change in buyers.
We have established a platform with both buyer and seller to
consider alternatives to their hard and fast valuation positions. Here is an
example of a business sale transaction structure that could be a win for both
buyer and seller:
1. $1,000,000 Cash at Close which is approximately a 4 X
EBITDA multiple for the year 2007.
2. An Earn out (Additional Transaction Value) based on
Seller Company's Sales Revenue beginning in year 1 and ending at the end of
year 5. The earnout is at risk, but is set to net the shareholders a 6 X EBITDA
multiple on 2008 projected sales (sales $6 million and EBITDA margin of 16.67%
or EBITDA of $1,000,000).
This is the transaction structure we are recommending to
balance a low EBITDA valuation on a company that will grow revenues by 50% next
year. If they don't, then the earn out will be less. Most of the transaction
value is in future performance based earn out. Our projection is that with
Buyer Company cost efficiencies, Buyer Company can improve operating
performance by an amount that covers the entire earn out amount and maintains
or even improves Seller Company's historical margins.
Most business buyers that approach a company with an
unsolicited interest in acquiring them are bottom feeders and will attempt to
buy way below the market. They will attempt to draw out the process and pursue
several acquisitions simultaneously hoping that one or two sellers just cave
and sell out at a discount. They may start out at a decent valuation, but as
they go through their due diligence process will find one issue after another
that makes them reduce their offer. They often throw out the term
"material adverse change" in an attempt to justify their value reducing
behaviors. Some business development directors get judged or paid bonuses on
how much below the original offer they can ultimately close the deal.
Think about how effective you will be in this single buyer scenario. We tell our prospective clients that contact us after an unsolicited offer, "When it comes to business valuation, if you have only one buyer, he is right.
Dave Kauppi is
the editor of The Exit Strategist Newsletter, a Merger and Acquisition Advisor
and Managing Partner of MidMarket
Capital, providing business broker and investment banking services to
entrepreneurs and middle market corporate clients in information technology,
software, high tech, and a variety of industries. Dave graduated from The
Wharton School of Business, holds a Series 63 and is a registered business
broker. Dave began his Merger and Acquisition practice after a twenty-year
career within the information technology industry. Visit MidMarket
Capital to learn about maximizing your selling price, valuation of
intellectual property, minimizing taxes, negotiating tactics, Letters of
Intent, how to select an advisor, and much more.
