How do you Realize Full Value for your Business?
The first answer concerns the business itself, while the second answer concerns the sale process.
A higher EBITDA multiple is paid for lower risk, but, the biggest driver in attaining a higher EBITDA 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). However, 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.
Strong Growth Drives a Strong EBITDA Multiple
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, a 4x EBITDA multiple, 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.
What About Managing Risk?
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.
Is the EBITDA Multiple the right metric for most private companies?
For most companies yes, but in certain cases, where there is no EBITDA to speak of, valuators will use a multiple of revenues (for companies that are investing all free cashflow in growing the business) and in some cases, such as for pre-revenue companies, user metrics are used such as average monthly users or video or page views.
The Sale Process
The sale process focuses on the when, who and why parts of selling a business, which I will address in this article. The sale process cannot transform an average business into a high multiple business. However, by following a few guidelines outlined below, it can result in a higher enterprise value at the closing date.
They Say Timing is Everything
The timing of the sales process is perhaps the most important factor in the entire process. Not only is timing important in the context of the economy in general, but also with respect to the company’s performance and the owner’s objectives.
The prospect of growth is is very influential in attaining a strong multiple. However, while a valuation is determined by a company’s future prospects, buyers often use historical performance to assess future prospects. When I say “historical performance,” I mean at least two years of consistent growth. Many businesses grow in steps. A pattern of revenues at $10 million for several years, which then jumps to $25 million for one year, 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 (now we’re talking). Ultimately, convincing a buyer to pay a premium depends on on how the growth was achieved, and what the current prospects are.
The selling process is one that can take seven to ten months to complete if things go well. Therefore, inevitably you will run in the single most important question that a buyer wants answered while the sales process is ongoing, “Are you on track?” Or its very close cousin, “Can we have a look at the latest financial month or quarter end?”
Under performing at this stage to what you originally told the buyer is definitely the worst case scenario. If you are four to six months into the process, you will have already received a number of expressions of interest and are likely working with a small group of seriously interested parties. An earnings number below expectations may open up the possibility for a value revision or structure change in an LOI. This may cause serious delays in the process, since an alternate buyer may need to be found. The moral of this story is… don’t miss.
Any Buyer Is Good, Right?
The second most important consideration in the sales process is: Who to sell to? I’ve also written a detailed article on how to identify the best buyer. I won’t go into the details here, but I will say state one key point. The most important step when identifying the right buyer is to ensure your M&A adviser runs through a complete, thorough and diligent buyer selection process.
The four phases of a divestiture are: Plan, prepare, market and complete. A critical factor in achieving a successful sale is to keep as many options open as long as possible. The seller has power when there are many choices. If there is only one interested party, then guess what? You have no leverage and chances are you either a) don’t sell your business or b) end up selling it a multiple far below your expectations.
Why Am I selling Again?
The “why” of selling may not be a key driver in realizing the most value in a transaction, but it is a factor in the form of consideration received 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 and has made him/herself redundant, then he/she is in a position to structure the transaction to include as much cash as possible and a short transition period. However, if the reason to sell the business is to take advantage of an opportunity to accelerate growth, then partnering with a well capitalized financial buyer may be a better solution. This buyer may bring the investment and/or sales or distribution resources to the table that you need, but you should expect to spend more years with the business.
Ultimately, the best time to sell is when the owner is still interested in the business. This is when this interest will translate into a solid sales process, which will resonate with the buyer and is likely to drive the multiple higher. The best time to sell has passed when the owner is no longer interested in the business (i.e., if he/she is spending more time on other interest), or if the owner is compelled to sell for health reasons, or as a result of changing competitive/technology dynamics that are substantially reducing the economic prospects for the business. The sales process, from consideration to closing, can take many years. With economic uncertainty as it is, it is best to start the planning from a position of strength.
Recommended Further Reading
For more on valuation and EBITDA, see: EBITDA: How to define and measure
For more on how to optimize net proceeds, see: Share Sale or Asset Sale: It is Mostly About Minimizing Taxes