What has a Greater Impact on Valuation, Macro or Micro Factors?

Some owner-entrepreneurs spend quite a bit of time wondering when it will be the right time to sell their business.  This is understandable as it is a critical decision that will probably have the biggest impact on their wealth crystallization.  With the US Fed raising interest rates for the first time in ten years, this conundrum is worth revisiting.

When we say Macro vs. Micro, in this case we will examine the impact of higher interest rates versus a specific company’s growth record and prospects.  High revenue growth typically means a high valuation and, while not an exact science, higher interest rates generally mean lower company valuations.  Higher interest rates result in lower valuations for a number of reasons including: (i) they raise the discount rate used in calculating a company’s value, (ii) they make other more secure investment options more attractive and, (iii) for companies with debt, they lower earnings.

While you would expect a rise in interest rates to affect all companies equally.  In fact, some companies have growth prospects quite independent of macro trends (technically called high alpha companies) while others are affected more by general economic circumstances (technically called high beta companies).  Let’s look at two scenarios.

Let’s say a growing company is generating $5 million in EBITDA this year and expects to achieve $7 million next year (40% growth).  The prevailing multiple for this business is currently 7 times EBITDA.  The owner is wondering should he/she sell now for $35 million or hold off and try for closer to $50 million next year.   At the same time interest rates have just started to go up, and by next year they are expected to be 2% higher than they are today, which will result in a one times lower multiple.  Now he/she is looking at 6 times $7 million in EBITDA which is $42 million. Is it worth the wait? In this case it may be but now let’s at a lower growth, high beta company.  Again, the company is generating $5 million in EBITDA this year, but in this case expects to achieve $5.5 million next year (10% growth).  The prevailing multiple for this business is 5 times EBITDA and, with higher interest rates, the value now changes from $25 million to $22 million after interest rates rise. Many factors go into realizing value but these scenarios illustrate the point.

So how quickly will interest rates rise?  The following chart provided by Capital Economics suggests the Fed funds rate will exceed 3% by the end of 2017.

Globe and Mail Chart

Owner-entrepreneurs are generally optimistic that next year will be better than the current year and that their companies will be worth more in the future.  For high-growth, alpha type companies this is generally true but, if your company is mature and a high beta type company, I would watch rising interest rates carefully because they will erode value.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap M&A International in Toronto.

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Five Recent Examples of Acquirers Paying a Premium

What are buyers looking for in acquisition targets?  The objective of an acquisition is to create value.  This is accomplished by improving profitability and/or reducing risk; both enhance earnings quality and drive value.  More specifically, acquisition objectives can include achieving economies of scale or economies of scope, vertical integration, securing access to talented management, unlocking underutilized assets, gaining access to proprietary technology, increasing market power, shoring up weaknesses in key business areas, geographical or other diversification, to reach critical mass for an IPO or to achieve post IPO full value.

Below we list the rationale for paying a premium behind five recent real-life transactions.

To Maintain or Improve its Competitive Position: This may be the most common motivator for acquisitions by large companies such as Oracle or Cisco.  With the rate of change in the tech sector as fast as it is, it is a lower risk strategy to wait until a new solution is proven and a sector leader has emerged than pursuing this organically.   Acquisitions of this nature achieve a number of risk reducing objectives including strengthening customer relationships.

To Improve the Revenue Mix to Higher Valued Revenues:  Ever since hosted recurring revenue models (SaaS) came into existence, revenue quality has been a hot topic.  In this case the buyer was a public company and a large share of its revenues were of a product reseller nature.  These types of companies typically have a large customer base that they want to sell more products and services to.  The goal is to improve revenue quality.  Potential revenue quality improvements include moving from distribution to higher margin VAR (consulting), or from consulting to support/maintenance (recurring revenues) and, ultimately from support/maintenance recurring revenues to sticky, mission critical recurring (cloud application) revenues.  Acquisitions of this nature create value by improving revenue quality resulting in a higher valuation multiple.

To Fix Underperforming Parts of the Business:  In this case, a large company had a small division that fulfilled a necessary component in the value chain.  The division had HR challenges and was underperforming.  Not only did the seller have a superior technology but it also had a very knowledgeable management team that would become a great asset to the buyer.  The buyer was able to pay far in excess of any other interested party and stood to benefit much more as well.  Finding a buyer that can benefit from multiple aspects of a seller’s business is rare but when it happens, a very good deal is possible.

To Unlock the Potential of Underutilized Assets: In some cases, proprietary resources such as R&D, patents, proprietary processes and technologies and even personnel are underutilized because of limited access to capital or other constraints.  Acquisition by a more, well-resourced company can unlock value in these assets.  Acquisitions of this nature typically achieve revenue and/or margin improvement.

To Achieve Full Value as a Public Company: Reverse Takeovers (“RTOs”) are an active part of going public in Canada.  However, in some cases, once public, the company’s share price languishes as there isn’t sufficient value or liquidity to attract analyst coverage.  With publicly traded shares as available currency, an acquisition strategy will increase the share float and diversify the investor base.  In time, costs will have to be rationalized or synergies achieved in order to evidence margin improvement.  The stronger business attributes combined with improved trading liquidity will realize full value over time.

While the situations outlined above sound like textbook cases, in the real world, the stars don’t line up to create a premium sale as often as one might think.  The timing has to be just right, where the buyer-target fit is considered a high priority and the target business is of sufficient size (and that typically means having grown beyond start-up) to be worth the effort.  A managed sale process can bring a number of interested parties to the table and help identify the rationale to drive exceptional sale value.

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Raising Capital? Prepare for Your Needs Well in Advance

Raising capital can be time consuming and expensive.  Capital may be in the form of a loan or an investment.  The lender/investor will seek a return on the capital in the form of interest, royalties, dividends, and/or capital gain.  Different forms of capital require different degrees of investment in time, due diligence, and closing costs.  The spectrum, as measured by ease and timeliness of closing, ranges from a bank secured term loan, being relatively quick and easy, to a minority or majority equity investment which can be complex and arduous to complete. Simply put, low risk capital is cheap and fast, and high risk capital is expensive and time consuming.

A secured loan can close about as quickly as the proper documentation and legal searches can be completed.  This usually takes several weeks.  An unsecured financing requires an assessment of equity risk which, if the issuer is not properly prepared, can take many months and, in a worst case scenario, unforeseen issues can derail the process entirely.

An unsecured, or equity based financing is best approached in a prepared manner.  Even if only 10% of the equity is being sold, the steps in the process are similar to those of selling the entire business.  This includes writing a comprehensive business plan with a detailed use funds. Amount sought and use of funds are critical and, if the capital is for an acquisition then the investor may want to do due diligence on both companies and time the transactions to close at the same time.  The amount should be enough to fund the plan plus a cushion to reduce risk.

Owner-entrepreneurs tend to under-estimate the difficulty of raising capital.  Not being properly prepared can result in anticipated interest fading, a more expensive deal or, worst case, no deal at all.

If the required information is readily available, the preparation phase can be completed in about one month.  Securing investor interest will take another month, investor presentations another month, negotiating an LOI and closing another 60-90 days.  So six months, best case scenario.  While technically the process can move faster, practically speaking, taking busy schedules into account, this is realistic.  If the financial statements are not audited,  then a quality of earnings review can add another 6 weeks to the process.

For a secured loan, pricing factors include: credit quality of the borrower, the bank’s cost of funds and the level of competition in the marketplace.  As an example, if the bank’s cost of funds is 3% and the credit quality of the borrower warrants a 300 basis point premium, the bank would charge an interest rate of 6%.  On the equity side, the cost of funds is much higher and to meet target returns, investors have to compensate for the fact that not all investments will turn out as planned.  Equity investors target returns of 2-3 times their original investment at the end of a 5 to 7 year holding period.  A “triple” in six years is the equivalent of 20% return per annum.

Hiring an Advisor
Raising capital is generally not normal course business.  Therefore, hiring external resources to manage the process can be an ideal solution to these ad-hoc circumstances.  While the cost of an advisor typically represents a few points of the equity raised, it may well be that this would otherwise have been given up by going it alone anyway.  The intangible benefits of finding the right partner that is a cultural fit and has sector relationships to help grow the business are immeasurable.  The benefits of outsourcing management of the capital raising process to an advisor include:

I           Experienced strategic positioning and the preparation of a comprehensive CIM
II          Identification and engagement of the most suitable potential investors
III         Professional assistance in the preparation for presentations and due diligence
IV         Timely management of the process and securing the best price
V          The strongest chance of closing

If raising capital is critical to your business’s success, then don’t take any chances.  Start six to nine months in advance, assemble the best team and follow a process for success.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap M&A International in Toronto.

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What Makes a Good Buyer?

Now that we have constructed the buyer list, what really went into the thinking of who to include?  What are the buyer list criteria?  I have outlined several considerations in my previous post but another way to look at it is as follows: identify companies with an ability to pay and an interest in paying a premium.

Assessing the ability to pay in the private market space is difficult.  While for public companies you can peruse their financial fillings, private company information is usually based on voluntary disclosure and may be out of date.  The other area where ability to pay is difficult to assess is if the company has a relationship with a private equity group.  The company may appear small and unable to acquire but the private equity group may have access to hundreds of millions of dollars.

With respect to paying a premium, the rationale for doing so may be:

  • Economies of scale
    The combined company can often reduce its fixed costs by removing duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit margins.
  • Economy of scope and cross-selling opportunities
    Economies of scope are attained when, for example, efficiencies are gained by increasing the scope of marketing and distribution to additional products (sometimes creating product bundles as seen in the Telecom sector).
  • Unlocking underutilized assets
    In some cases proprietary resources such as R&D, patents, proprietary processes and technologies and even personnel are underutilized because of limited access to capital or other constraints.  Acquisition by a more well resourced company can unlock these assets.
  • Access to proprietary technology
    In some cases start-up or R&D focused companies have developed technologies that can have an immediate and broad impact on the operations of leading incumbents and substantially improve their competitiveness.
  • Increased market power
    Acquiring a close competitor can increase market power (by capturing increased market share) to set prices.
  • Shoring up weaknesses in key business areas
    When talent is hard to attract, acquiring businesses that perform functions that are under performing can be an efficient way to fill gaps.
  • Synergy
    An example of synergy includes increased purchasing power as a result of bulk-buying discounts.
  • Geographical or other diversification
    Acquisitions can achieve immediate access to new geographic or product markets.  In some cases this can also serve to reduce earnings volatility.
  • Providing an opportunistic work environment for key talent
    Growth through acquisitions provides managers for new opportunities for career growth and advancement.
  • To reach critical mass for an IPO or achieve post IPO full value
    Larger companies typically have more financing options thereby reducing capital risk.  Once public, companies need sufficient trading in their shares to realize full value.
  • Vertical integration
    Vertical integration occurs when a company acquires its supplier and can result in significant savings if the supplier has substantial market power.

Determining beforehand whether a private company has these goals or can potentially achieve these results is nearly impossible.  The best way to find the company that will pay the most is to approach all possible buyers, talk to them and discuss the possible fit.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap M&A International in Toronto.


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The Basic Math of Valuations – Why Mid-Market Companies Are Valued Lower Than Their Public Company Peers?

For public companies, analysts express the value of a company as a multiple of earnings.  It is called the price-earnings ratio or P/E ratio.  If the price of a stock is trading at a low multiple (say eight times earnings) and its prospects are strong, it would be good value; at 50 times earnings that same company would probably be expensive.  For private companies we typically look at a multiple of EBITDA. Let’s say a company has been valued at $20 million; it can sustainably generate $5 million in EBITDA, then it is valued at four times EBITDA.  As I noted earlier, four times EBITDA is equivalent to generating a 25% pre-tax return on capital per annum; more if cheaper debt is used to lever the equity (for an explanation of this see my “What Will a Financial Buyer Pay?” post).

How do you decide if that is a proper risk adjusted rate of return for your capital?  Risk adjusted is the key word here.  To figure this out we have to start at the risk-free rate and build on layers of risk to see where comparable assets should be priced.  We start with the risk-free rate.  The risk free rate is the rate generated by the most secure assets possible.  The proxy for this is typically federal governments.  They can print money at will so you can be assured you will get your money back (what it will be worth is another matter).  Countries such as Canada, Germany, Austria, and the Netherlands are rated AAA by S&P and are as close to risk free as you can get and therefore set the proxy.

Let’s say the 10 year risk free rate is 3%.  What is the next bucket of riskier assets?  State bonds, Municipal bonds, AAA corporate debt, AAA preferred shares?  All riskier, but lets jump straight to S&P 500 equity.  What is the risk premium of a top tier, multi-billion dollar S&P 500 company?  About 5% to 7% (note: even within the S&P 500, there are riskier subgroups.  i.e. cyclicals vs. consumer staples).  Adding this risk premium to the risk free rate, you get approximately 10%.  So getting back to my introduction, buying a S&P stock at 10 times earnings may very well achieve a proper risk adjusted return.

The concept of the risk-return curve is that it measures the risk premium required for riskier assets.  The idea is that you should be indifferent between different asset classes on the curve because you are being properly compensated for the additional risk.

risk return curve

Intuitively, it makes sense that a small private company is riskier than a S&P 500 company but what are the specific drivers of this?  A small private company typically has fewer customers, more customer concentration, comparatively a less established brand, a limited R&D budget, less access to funding sources (be it banks or equity investors) and much less liquidity for the holders of its equity to name a few key drivers and, as such it is riskier than an S&P 500 company.

So is four times EBITDA a fair value for a small private company?  It could be, but it depends on many company specific risk-return factors such as its growth prospects, the nature of its revenues (highly recurring or project based) and the size and diversity of its customer base.  I will expand on these factors and their impact on valuations in future posts.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap M&A International in Toronto.

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