A common metric used in valuing a business is a multiple of Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"). A differential of one point in the multiple of EBITDA adds up to a substantial difference in value. So how does one attract a high EBITDA multiple in the sale of a business? 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.
The Business Issues
Generally speaking, the lower a business's risk profile the higher its value 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) according to this model. If the expected growth rate is 10% then the 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. Let's say a company 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:
Are the revenues recurring or project based?
Does every fiscal year start at zero? If 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.
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.
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.
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 a company.
The Sale Process
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 note 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. As noted above, 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 we 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 one 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 a seller is four to six months into the process, then he/she will have already received a number of expressions of interest and is 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 substantial 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? For an owner entrepreneur to not want to approach a key competitor is fine but to restrict the potential buyers to two or three possible buyers can be a critical mistake. As an overriding comment, I would say that an M&A advisor needs to run a thorough and diligent 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 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. On the other hand, if the owner-operator has spent 20 years in the business 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 make the transition period as short as possible.
The sale process, from consideration to 100% out, can take many years and, in order to achieve a high sale multiple, it is best to start the planning from a position of strength.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.