How Do I Attract a High Multiple for My Business: The Business Factors

There are two broad answers to this question.  The first concerns the business itself and the second concerns the sale process.  The how, when and why of selling.  I will address the business issues in this post; not to say invent a new mouse trap but from the perspective of what factors you can influence in your existing business to improve value.

In “The Basic Math of Valuations” I presented the risk return curve.  A company will attract a higher multiple if it moves to the left on the risk return curve; i.e. a higher multiple is paid for lower risk, but, the biggest driver in attaining a higher multiple is a company’s profitable growth prospects, and, this should already be evidenced by a historical growth record.

Let’s look at the public markets for an illustration.  The dividend discount model asserts that the fair value of a stock is the present value of all future dividends.  The formula is as follows: fair value of a stock = DPS(1) / Ks-g, where the expected future dividend stream is divided by the required rate of return (Ks) minus the expected growth rate (g).  If a dividend is $5.00 and the required rate of return is 20% then the fair value of the share price is $25.00 ($5.00/0.2) according to this model.  If the expected growth rate is 10% then the fair value jumps to $50.00 ($5.00/0.1).  The growth rate lowers the required rate of return and increases the fair value of a stock.  In this case, 10% per annum growth translates into 100% price improvement.  That is a tremendous amount.  The real world experience is not as exact but the illustration demonstrates the logic and impact of growth prospects on company value.

The same logic applies to EBITDA growth for private companies.  Returning to the example provided in the previous post – a company sustainably generating $5 million in EBITDA is valued at $20 million, four times EBITDA, the equivalent to generating a 25% return on capital per annum – if this company were growing at 20% per annum, the multiple could quite readily improve to 6 or 7 resulting in a valuation of $30 to $35 million.  Again, not quite as exact as the formula but the results are still very substantial.

Now, turning our attention to reducing risk, here are some factors to consider:

Is the owner redundant?
The first thing to address when considering selling a business is to put a strong management team in place that can run the business without the owner.  An owner-operator who is the chief product developer or maintains all of the customer relationships will not be able to exit the business upon its sale.  He/she will have to commit to staying with the business until a suitable replacement solution is implemented.

Is the customer base diversified?
The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a smaller company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration.  While the growth that it drives will increase value the associated risk of these revenues will reduce value.

Are the revenues recurring or project based?
Does every fiscal year start at zero?  What I mean by that is, if your revenues are project based then you are always searching for the next deal.  Consulting companies typically face this challenge.  Along the same lines, a one product company is more risky than a diversified product and services company.

These are three examples of situations where reducing the risk will increase the multiple but the concept applies in general; any combination of improving profitable growth prospects and reducing risk will increase the value of your company.

Share Button

Working Capital is Always a Point of Negotiation in an M&A Transaction

The determination of the closing amount of working capital is always a point of negotiation in an M&A transaction.  Simply put; working capital is current assets minus current liabilities and is the liquid part of the balance sheet, where revenues are collected and suppliers are paid.  Working capital often includes a component of cash (or access to cash in the form of a bank operating line).  Working capital items requiring judgement include:

  • Collectability of accounts receivable; typically accounts receivable aged greater than 90 days are not recognized;
  • Level of inventory; it must be current, sale-able and of an appropriate size;
  • Any stretched account should be examined for its cause and the potential impact on the customer /supplier relationship.

So what is the right level of working capital on closing?  Buyers and sellers should seek to establish a “normal” level of working capital.  This normal amount may not be the “right” amount on the day of closing but is the average level of working capital throughout an agreed period of time.  A reasonable rule of thumb would be to assume the same time period that the valuation of the business is based on.

The following business characteristics will affect the normal working capital amount:

  • Generally speaking, a fast growing company will need more working capital to fund receivable and inventory growth than a no-growth business;
  • if the business is seasonal (for example, heavily dependent on Christmas sales) then, around Christmas working capital will be high, initially with inventory and then after Christmas receivables;
  • if payables are required to be paid quicker than receivables are collected (like staffing companies that typically have to pay contractors every two weeks while  they get paid monthly) then working capital will need to be high;
  • if cash is collected quicker than it is paid (like an online referral business that collects cash, has no inventory and does not have to pay its suppliers for 30-60 days) then working capital can be low.
  • Private companies may not manage their working capital as efficiently as they can.  They may leave cash in the business for tax reasons.  This will inflate working capital, so it is important to determine the level required by the business.

To determine normal working capital, cash flows should be examined for cyclicality and fluctuations for a minimum of the last 12 months.  Sometime before closing, a target closing balance sheet should be prepared reflecting a normal level of working capital.  Excess cash is typically distributed before closing and the actual level of working capital is not finalized until some time after closing.  If it is higher than the normal level of working capital, the seller receives the excess or, if below the agreed upon amount, the buyer is due a credit.  In some cases reserves are held in escrow for the purpose of funding a potential working capital deficiency.

As every business and every seller is different, working capital will always be a point of negotiation in an M&A transaction.  The working capital issue is more complex than one would think and the amount of capital that is required for working capital can affect the value of a business.  Once you fully understand the cash flows in a business you can settle on a reasonable level of working capital.

Share Button

Four Companies That Know How to Acquire

There have been numerous studies on the difficulties of successfully completing acquisitions.  Some studies note that 50% of all acquisitions fail.  I won’t debate what is a success or failure and over what time frame it should be measured here; what I will do is review four leading Canadian software companies and examine their acquisition records.  The four companies are Constellation Software Inc., The Descartes Systems Group Inc., Enghouse Systems Limited, and Open Text Corporation.  I have reviewed the acquisition transactions where financial metrics were available for the period from May 18, 2006 (the IPO date of Constellation Software) to September 30, 2014 and the following summarizes the results.

Acquisition Summary

The four companies had a combined Enterprise Value (EV) of $1.2 billion in 2006 which grew to $14.9 billion as at September 30, 2014, each generating double digit annual returns.

The challenge in attributing this value creation to an acquisition strategy is that not all acquisitions disclosed payment terms.  Of the 172 acquisitions completed in total, 82 had disclosed financial terms.  What we can assume about the acquisitions without financial disclosure is that they would have been relatively small.  The Ontario Securities Commission requires the filing of a Business Acquisition Report (BAR) when the target size is greater than 20% of the pro-forma combined company.

In looking at each company specifically, we discover a number of interesting metrics.

Of the 22 acquisitions with disclosed financial metrics completed by Constellation, only one was of a size (as measured by enterprise value) greater than 10% of the size of Constellation.  The average size of the acquisitions, taking out the one bigger one, was 1.7% of the size of Constellation.  The median target acquisition price paid was 1.2 times revenues and 5.1 times EBITDA.

Of the 23 acquisitions with disclosed financial metrics completed by Descartes, three were larger than 10% of the size of Descartes and the average size of the acquisitions, taking out the three bigger ones, was 3.0% of the size of Descartes.  The median target acquisition price paid was 2.8 times revenues and 8.8 times EBITDA.

Enghouse was quite a bit more aggressive than Constellation and Descartes, of the 16 acquisitions with disclosed financial metrics completed by Enghouse, five were of a size greater than 10% of the size of Enghouse.  The average size of the acquisitions was 12.7% of the size of Enghouse.  The median target acquisition price paid was 0.9 times revenues and we were not able to deduce a meaningful EBITDA multiple.

Finally, of the 21 acquisitions with disclosed financial metrics completed by OpenText, again, only two were of a size greater than 10% of the size of OpenText.  The average size of the acquisitions, taking out the two bigger ones, was 2.5% of the size of OpenText.  The median target acquisition price paid was 1.2 times revenues and the EBITDA multiple was not meaningful as a number of the targets were incurring losses at the time of the acquisition.

From the acquisitions with financial disclosure, we know that 82 acquisitions cost approximately $2.7 billion.  If we assume the acquisitions without financial disclosure were completed at each company’s average acquisition metrics, then this would add another $2.5 billion to the cost.   Based on these assumptions, a total of $5.2 billion was spent on acquisitions and $8.6 billion in value was created, suggesting the acquisition strategies created tremendous value.  While this is not perfect math, the simple truth is that when you look at the share price, each company has outperformed the TSX by a wide margin over the last 8 years.

There are many ways to study acquisition performance, from large worldwide/all industries studies to sector and geography specific studies.  While this data set is small, what we have observed is that the profiled companies have completed many small acquisitions.  There are a few bigger ones, but we would not call them transformational – those are the hard ones.  What we see here are a series of small, formulaic/cookie cutter acquisitions, rigorously held to reasonable valuation and payment terms.  Integrating acquisitions is hard but what this overview tells us is that if you establish strict parameters around size and value and you do enough of them, you get pretty good at it.

Share Button

How Do I Attract a High Multiple for My Business: The Sale Process

I noted in the previous post that there are two broad answers to the question of: how do I attract a high multiple for my business.  The first concerns the business itself and the second concerns the sale process.  The when, to who, why and how much of selling.  I will address the sale process in this post.  The sale process cannot transform an average business into a high multiple business but, by following a few guidelines, it can result in a higher transaction value.

When to sell is the most important item to discuss here.  Not only in the context of the economy in general but also with respect to the business’s performance and the owner’s objectives.  The ideal time to sell is when there are positive trends in revenue and earnings with the expectation of more to come.  Growth is very influential in attaining a strong multiple and, while valuation is determined by future prospects, historical performance is the most common way to get comfort with those prospects. By historical performance I mean at least two years of consistent growth. Many businesses grow in steps.  A pattern of revenues at $20 million for several years and then jumping to $25 million does not present a convincing growth trend. Another jump to $30 million the next year will go a long way to realizing a growth multiple.  Ultimately, whether a buyer is convinced depends on how the growth was achieved and what the current prospects are.

The selling process is one that takes seven to ten months to complete and therefore you will always run into the question of: “are you on track”.. “can we have a look at the latest quarterly numbers?”  To underperform at this point is a worst case scenario. If you are four to six months into the process, then you will have already received a number of expressions of interest and are likely working with a small group of seriously interested parties.  A quarterly profit number below expectations will open up the possibility of a revision to the value/structure in an LOI and may cause serious delay in the process as an alternate buyer may need to be found.

The second most important consideration in the selling process is who to sell to?  I have written several posts about how to identify the best buyer (and I will address management as an option shortly) but, as an overriding comment, I would say your M&A advisor needs to run a thorough and diligent process.  The four phases of a divestiture are: plan, prepare, market and complete (I will expand on how an advisor can add value in each phase in a later post).  A critical factor in achieving a successful sale is to keep as many options open as long as possible.  The seller has power when he/she has choice.

Finally, the why of selling is not a key driver from the perspective of realizing the most value in a transaction but it is a factor in the form of consideration and how long the process will take.  Remember, if the business is dependent on the owner-operator, he/she will not be able to leave the business upon its sale.  If the owner-operator has spent 20 years in the business, is nearing retirement, has made him/herself redundant, then he/she is in a position to structure the transaction to include as much cash as possible and make the transition period as short as possible.  However, if the reason to sell part or all of the business is to take advantage of an opportunity to accelerate growth then, by partnering with a well capitalized entity that can bring investment, sales or distribution resources to the table, you may expect to spend many more years with the business.  Finally, the best time to sell may have passed if the owner is no longer interested in the business (he/she is spending more time on other interests) or, he/she is compelled to sell for health reasons or changing competitive/technology dynamics that are substantially reducing the economic prospects for the business.

The sale process, from consideration to 100% out, can take many years and with economic uncertainty as it is, it is best to start the planning from a position of strength.

Share Button

What Will a Strategic Buyer Pay?

Now that we have identified reasons for paying a premium; what is a premium? By definition, it is higher than the average price.  But if the market will ultimately determine the price, where do you start?

You start with the notional value.  A notional value determination is one in absence of an open market transaction, in other words, intrinsic or stand-alone value.  The notional value of an enterprise does not include what a strategic acquirer can bring to the operations (i.e. with a distribution network or sales force, etc.)  The notional value is determined through an extensive analysis of the company’s financial performance and market opportunities typically by applying a Discounted Cashflow Analysis (DCF) and/or a public company market trading and acquisition comparable analysis (I will provide more details regarding valuation analysis in a later post).

The notional enterprise value is driven by earnings and earnings potential and the risk associated with generating those earnings.  Earnings may be generated by levered or unlevered assets.  Enterprise value consists of term debt and equity (assuming a normal level of working capital), so if there is debt in the company, it must be subtracted from enterprise value to get to equity value, which is the net amount a seller can expect to receive.

A premium is the amount a buyer will pay, over and above the notional value, however, how the purchaser is being valued is a factor in this equation.  Only in rare cases will a buyer pay a price that is dilutive to the acquiring company’s forecast earnings.  An example is acquiring technology; whether it is a patent that doesn’t generate any direct revenues or whether it is a company that is losing money presently but is expected to be very profitable in the future.  In cases like this it may make sense to accept short-term dilution to earnings (i.e. an investment in future earnings) from an acquisition.

The norm is that an acquisition is accretive to the purchaser’s earnings.  An example of an accretive acquisition is best illustrated with an example of a publicly traded company (Company A).  Say Company A trades at 12 times EBITDA of $10M (i.e. an enterprise value of $120M) and the target is purchased at 7 times EBITDA of $1M (a price of $7M).  The go forward enterprise now generates $11 million (excluding synergies) and with a multiple of 12 (assuming the market likes the acquisition and views the pro-forma combined company as having similar prospects), the enterprise value is now $132M.

While the example is simplistic, the concept that I want to highlight is, what if the notional value is $5M?

Perhaps during a divestiture process there would have been several expressions of interest at $5M but the winning bidder had to pay more.  Company A could have paid $10M (10 times EBITDA – as it trades at 12 times EBITDA) and it would still have been accretive.  How much of a premium should Company A pay? This is the technical dance; the grey area between the intrinsic value and the value to a buyer.

So what will a strategic buyer pay?  They will pay somewhere between the notional value and the value to the buyer.  Creating a competitive bidding environment can persuade the winning buyer to pay more than the notional value and share some of the value to the buyer with the seller.

Share Button