Tag Archives: valuation

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.

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.

Revenue Quality: What Does it Really Mean?

High quality revenue companies are valued higher than low quality revenue companies.  But what does this really mean and why is this? It is simply a question of risk. High quality revenues reduce risk and therefore result in a higher valuation. What are high quality revenues?  Primarily it is about revenue continuity but also diversity and profitability.

Revenue Continuity
Long term customer contracts provide future revenue predictability.  In many cases capital projects will not get financed without long term customer contracts.  But what if you don’t have long term contracts, what else can give an investor or financier comfort that revenues will stick around? Questions that get at this answer include: How much of an “annuity” does your business model have?  What percentage of revenues can be counted on to recur every year?  Is the product/solution mission critical?  Is it embedded in your customers’ businesses?  Are switching costs high?

As an example, cloud based Software as a Service (“SaaS”) solutions such as Salesforce, Workday or NetSuite are often sold on a per seat, monthly subscription basis.  In some cases upfront customization is required and in all cases customers have to learn how to use the new software.  Once customers have adopted such a solution, they will not switch very quickly.  The solution becomes embedded in another business’ processes which results in high switching costs.  As a result, its recurring revenues are usually quite stable.

There are a number of ways to grow recurring revenues; license or lease your product or technology instead of selling it outright, sell products that need periodic supplies or maintenance, sell service or maintenance agreements, franchise, etc.

Revenue Diversity
The greater the customer concentration the greater the risk.  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 small 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.

Early-stage companies tend to have only a few customers that make up a large portion of revenues but, over time, they must strive to build a diverse revenue base.   Ideally no customer generates more than 10% of revenues.

If you operate in a low barrier to entry, fragmented market then it will be hard to increase prices and produce sustainably strong margins.  Of course different business models generate different margins.  For example, a grocery business will have a lower gross margin than a cloud based SaaS business which can generate gross margins of over 70%.  Over time, competition will put pressure on margins but under certain circumstances, such as first-to-market solutions, proprietary products and processes or patents, companies can sustain high margins for a considerable period of time.

Most entrepreneurs will say they have excellent customer relationships and that certain customers would not leave them no matter what.  But stuff happens.  Maybe this belief is based on personal relationships which cannot be sold with the business.  There are always opportunities to improve revenue quality, whether it is to extend revenue continuity, increase revenue diversity or to improve margin.  Improving revenue quality should be an ongoing priority for business owners as it is a strong contributor to company value.

The Top Five Impediments to Securing Exceptional Value in the Mid-Market

Many owner-entrepreneurs develop expectations for their business’ value based on news items and industry chatter about M&A and financing activity.  However, the small percentage of transactions that make the headlines are not reflective of the average transaction.  The factors we see most often (not in order of frequency or importance) that prevent private mid-market companies from achieving a premium valuation include:

Small Size:  Most transactions in the news concern multi-billion companies.  While we have seen one in a million start-ups fetch billion dollar valuations, most small companies are discounted to larger companies because of their riskier operating profile and because there is less liquidity in the lower end of the M&A market.  Companies valued at less than $10M will not find as much interest as larger companies.

Customer Concentration:  The issue of customer concentration varies by industry and by business model.  In the automotive sector, if you are a supplier to Ford, GM, Chrysler, VW, Honda and Toyota; six clients, then you are in a good position.  Generally, for B2B companies one would like to see at least 20 clients and if your business is a cloud based consumer or SMB focused business than 100 or even a 1000 clients will be seen as small.  Ultimately, it is not the total number of customers that is the measure of risk but the exposure to any particular customer.  Ideally no customer generates more than 10% of revenues.

Modest Growth Rate: Growth needs to be measured over an appropriate period and in the context of the economy and peers.  While a single digit growth is respectable for a mature company, in many sectors it needs to be double digit to warrant a premium valuation.

Principal Goodwill: Principal goodwill is the value of the knowledge and relationships that the Principal holds.  Large companies have documented relationships, usually multiple points of contact and formal processes for dealing with change.  This reduces risk and improves value.

Lack of Business Model Focus: The challenge with a business pursuing various services and segments at the same time is that it reduces the buyer universe.  As an example, take a business that starts out as a IT services/consulting business and then develops a SaaS based service.  It gets some traction and now the revenue mix is 60% consulting and 40% recurring SaaS revenues.

We would market this business as having recurring revenues but to pure SaaS companies this would dilute them.  Certain consulting businesses won’t have the appetite or capital on hand to invest in the marketing that the SaaS business needs.  Lack of focus in the business model will reduce buyer interest and hence value.

So, what does produce a headline grabbing valuation?  Simply put, you have to be viewed as being on a path to achieve a leading position in a new segment that is expected to be enormous.  Rare, but we do have a number of Canadian technology sector examples including Hootsuite in social media monitoring, D2L in personalized learning solutions, Shopify in online stores and Wattpad, creating a brand new segment, in a community of readers and writers.

Managing Operating Risk To Drive Value

In my previous post I said that if revenues are diversified and sticky then they are characterized as high quality.  A business with high revenue quality is one that will likely be around for some time to come, and is therefore highly valued.  However no business is risk free.  If your revenues are project oriented with little opportunity for repeat business, or you operate in an industry with low barriers to entry, or a people dependent business such as consulting, advertising or staffing, then what can you do to realize as much value as possible?

Mitigate the risks inherent in the business model by focusing on the following:

Differentiate your Product or Service
While at first glance, it may seem hard to differentiate a business in a well established and competitive sector, keeping an eye on consumer trends combined with creative marketing can often carve out a new profitable niche and present a tremendous growth opportunity.  Lululemon Athletica in the apparel sector and Chipotle Mexican Grill in fast food are examples of effective differentiation strategies.

Grow and Strengthen Customer Relationships
Reduce the unpredictability of project revenues by nurturing customer relationships.  If you can show that the same customers use your services several years in a row then you have an argument for revenue predictability.  If that list of customers is more than twenty then you have an argument for revenue diversity. Length of customer relationships is also a good indicator of a high quality product/service.

Focus on Execution Excellence
In a service business, it comes down to attracting and keeping the best personnel in order to deliver service excellence.  Human resources is a complex, multi-dimensional field and should include processes for recruiting, role definition and responsibility, position incentives and benefits, periodic feedback, and documentation and procedures to fill gaps in the case of unexpected departures.

Add Products and Markets
A one product company is riskier than a product line company.  A local company is riskier than one with a multi-national presence.  While it is easy to over-extend yourself, consider managed product and geographical growth to mitigate risk.

Cultivate Multiple Supplier Relationships
Don’t let your business become “captive” to a sole supplier of component parts.  Cultivate multiple supplier relationships to reduce supplier power and dependence.

Improve Profitability
Analyze your profit margin to see where you want to drive your sales — to higher-margin areas.  A trend of improving margins as a result of operational efficiencies and returns to scale will result in a higher valuation.

Protect Intellectual Property
IP can be patented, copyrighted or treated as a trade secret.  Identify the IP in your business and make sure it is protected and properly owned.

Build Your Brand
Spend time on all of the above will build your reputation and your brand.

The following chart summarizes various characteristics that drive company value.

op risks

Operating risk should be addressed by implementing formal processes.  A business with formal processes, systems and documentation reduces the dependence on individual talent and can quickly respond to exogenous shocks.  Items such as Service Level Agreements (“SLAs”), marketing plans, job descriptions, employment contracts, confidentiality agreements, professional codes of conduct, organization charts, etc. institutionalize a business.  Documented processes are transferable value.  Capturing and transferring knowledge will make the business more sustainable and more valuable.

If potential buyers feel that a business has a high risk profile, they will either not buy it, reduce the price they are willing to pay, or make a portion of the price contingent upon the business’s future performance.