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The Mind of the Business Buyer – Valuing an Acquisition

A Continuing Series on Exit Strategies for Business Owners

With apologies to my friends in the appraisal business, does a savvy business buyer really care what a business appraiser says about a company’s fair market value, fair value, investment value or other such theoretical “standards of value”?… Not really. Those things are interesting, of course, and a buyer would certainly take a look, but realistically the buyer is going to do his or her own analysis of what an acquisition means to them. The buyer has goals to achieve. The buyer wants to achieve a certain return on investment, and the structure of the deal and the buyer’s actual cost of capital are key considerations. When a business appraiser comes up with a fair market value for a business, there is a lot of inherent averaging going on. If using a market comparison approach, then the appraiser will be looking at some deals with high multiples and some with low multiples, and some sort of a semi-quantitative ranking system that compares your company to the other companies that sold. In all likelihood that comparison will put your company somewhere in the middle of the pack because your company will be better in some regards but worse in others. If your company is being compared to publicly traded companies then a discount is applied to adjust your value down from the public markets (a lack of liquidity discount). The discounts are based on many deal comparisons so averaging is again involved. It’s the same thing when calculating the cost of capital – more inherent averaging. It’s the same with deal structure – cash, buyer stock, seller notes and more inherent averaging across deals. To a business buyer all of these calculations, implicit averaging and so forth start to look like counting Angels on a pinhead, so they get busy and do their own calculations. If any standard of value applies it’s the “transaction value”, but the bounds of a deal may easily go outside the things usually included in a transaction value.

A typical financial buyer is going to do an analysis that is similar to the appraiser’s discounted cash flow (DCF) analysis, but much more specific to the actual deal structure (e.g., asset purchase vs. stock purchase), actual cost of borrowed money for that buyer, actual amount of money that can be borrowed based on the seller’s current balance sheet and the buyer’s balance sheet, actual tax situation for the buyer, the buyer’s own estimate of future cash flow (may differ from the seller’s projections), the buyer’s estimate of what he could sell the company for in 5 years or so, and the buyer’s targeted return on the equity invested to acquire the company. When any factor changes the price of the deal changes as well, because deals really do have value. It’s simple arithmetic for the buyer. Buyers have the flexibility to change pricing if deal structure changes. Typically, introducing a seller note into a deal will create a higher price because this allows the buyer to put less equity into the deal and thus achieve a higher return on each equity dollar invested. Another deal element that can add to the value for sellers is use of an “earn-out” which is a contingent portion of the price that recaptures the value differential between the seller’s view of future growth and the buyer’s view of future growth. An earn-out can have value but it would typically be excluded from transaction value because its value is not certain at closing.

What about those strategic buyers you’ve heard about? They actually do the same kind of analysis but they add another factor – “synergies”. Let’s say you have an accounting organization led by a CFO and they have an accounting organization led by a CFO, and each of them gets paid $100,000 per year. Put the 2 companies together and one CFO is surplus, so after that CFO is laid off, the cash flow for the combined entity is now $100,000 higher. Thus the company is worth more to the strategic buyer who can realize that cost elimination synergy. The trick is to get the strategic buyer to pay full value for that extra cash flow. They won’t pay for this synergy unless they have to, under the theory that the synergy wouldn’t exist but for their willingness to do the deal. But of course, none of that cash flow would exist for the buyer without the seller’s willingness to do the deal, and the cost elimination synergy will surely exist once the deal is done, so the seller has a viable position too. Introduce competition into the mix and buyers tend to account for the value of these synergies in their pricing.

My point in all of the above, is that buyers are much more analytical in valuing what a specific deal to acquire a specific company means to them. An appraiser’s opinion of value on the company means very little to the buyer. The buyer will make his or her own assessment and factor in all the things that matter to that particular buyer. Sellers need to understand this and put themselves in the mind of the buyer when negotiating. It does no good to say “My appraiser said my company is worth $10 million” if the buyer has analyzed your company up, down and sideways, and can’t see any way to offer more than $8 million and still get his required return on investment, although sometimes we can get that buyer to pay more by changing the structure of the deal so the buyer’s projected return on investment is still achieved. Conversely, it will do you no good at all to tell the buyer who is offering $12 million that your appraiser said it was only worth $10 million. That buyer is liable to gain quite an affinity for your appraiser and reduce his offer to correspond with the appraiser’s clearly superior analysis. J

The best way to get more for your business is to find another buyer who will use a different structure, a more rosy view of the future, a lower cost of debt, and a lower expected rate of return on equity. Which buyer would that be? It will be the one who submits the highest bid for your business in the competitive process that you employ when you go to market. The price variations among bidders can be over 100 percent based on all of these factors. These are very significant factors, so there’s almost always at least a 20 percent differential between the high and low bidder. Sellers that don’t use a competitive process are very likely to leave money on the table, and often that’s a lot of money.

Exit Strategy Tips: 1. Think like a buyer so you can negotiate with one.
2. Theoretical value is one thing, a deal is something else.
3. Don’t rely on one buyer, but make them compete to get your best price.

Private Equity Deal Trends

Pitchbook just issued their “2Q 2013 Private Equity Deal Multiples & Trends Report”. The results were pretty interesting. Deal multiples appeared to be much more volatile for the large deals (over $250 million) than for those less than $250 million, and median multiples in the first quarter of 2013 were well below where they were in the first quarter of 2012. By contrast the multiples for companies in the transaction size category of $25 million and below were much more stable, with little difference between the first quarter of 2012 and the first quarter of 2013. In fact median multiples for these smaller deals were up compared to the fourth quarter of 2012. Deals in the $25 to $250 million range were intermediate in stability. These middle-sized deal multiples had maintained a pretty good spread of up to 2 x EBITDA (earnings before interest, taxes, depreciation and amortization) higher than the $0-$25 million deals throughout 2012, but by the first quarter those median multiples were only fractionally ahead of the smaller deals.

· The median cash flow multiple for all deals was 5.5 x EBITDA.
· The median revenue multiple for all deals was 1.1 x revenue
· The median percent of debt in all deals was 55% (buyers put up 45% equity and borrowed the rest)
· The average time to close was 15 weeks (105 days).

With the big tax changes at the end of 2012, it seemed that the larger more complex deals were done in 2012, while simpler deals and add-ons made up much of the deal mix in 2013.

The data also indicated a strong tendency for private equity groups to close deals when the prior 12 months showed revenue growth and also when the outlook for the following 12 months was for more growth. 93% of deals closed in the first quarter of 2013 were with companies that grew in the preceding 12 months, and 100% of those companies anticipated growth in the following 12 months. In the eyes of a private equity buyer, growth is good and the alternative…not so much.

Another interesting piece of information came in an email from This compiler of private equity industry information sent a chart showing how private equity groups are now holding their investments nearly twice as long as they did in 2000. The trend has been straight up since 2008, no doubt due to the recession and perhaps due to the fact that it’s taking longer to grow those businesses and realize a satisfying return on investment. I expect that trend will reverse itself as the equity groups necessarily exit their investments, many of which are growing long in the tooth.

GF Data reported that private equity deal activity dropped sharply in the first quarter of 2013. GF Data has 183 active contributors in their data base of private equity firms. They completed 92 transactions in the fourth quarter of 2012 but only 14 transactions in the first quarter of 2013. Another indicator of a reduction of deal activity in the first quarter came from the Private Equity Growth Capital Council’s Private Equity Index. This measure of U.S. private equity activity dropped 42 percent in the first quarter of 2013. In dollar terms deal volume dropped from $126 billion in the fourth quarter of 2012 to $52 billion in the first quarter of 2013. Finally, S&P Capital IQ reported similar declines in transaction activity in both North America and Europe, and for both financial and strategic buyers. There is no doubt, the first quarter of 2013 was slow.

The reported pricing for GF Data firms was a little better in the first quarter of 2013 at 5.9 x EBITDA than for Pitchbook private equity firms at 5.5 x EBITDA. Pricing for the transactions reported to GF Data was slightly lower than what they had recorded in the fourth quarter of 2012 (6.0x), but much lower than reported in the third quarter (6.8x).

The deal volume changes are real enough, but one must always take the multiple data with a large grain of salt since there are so many factors that affect average or median transaction multiples – industry, company size, profitability, growth rate, etc.

Main Street and Lower Middle Market Trends

A new report for Q1 of 2013 from the Pepperdine Capital Markets Project in association with the International Business Brokers Association and M&A Source called “Market Pulse” provides some information on Main Street ($0 to $2 million) transactions and Lower Middle Market ($2 million to $50 million) transactions. Interestingly this survey of brokers and intermediaries saw the market differently depending on deal size. The most common buyers for Main Street deals were individual, first time business buyers. This was also just barely true for companies in the $2-5 million size, although private equity buyers seeking add-ons were almost as common. In the $5-50 million deal size range strategic industry buyers were most common, followed by private equity buyers of “platform” companies. Most Main Street brokers saw a buyer’s market in the first quarter of 2013, but in the $2-5 million size range brokers and intermediaries were evenly split on which side, buyers or sellers, had the upper hand. In the $5-50 million size range, 65% of intermediaries considered the market to be a seller’s market.

Transaction multiples were reported as modes with some indication of trending up or down. For deals in the $1-2 million range, 66% of deals ranged from 4.25 to 5.0 x EBITDA and rising, and 54% ranged from 2.5 to 3.5 x “Seller’s Discretionary Earnings” (SDE). SDE includes owner compensation and perks for a total benefit to the owner. In the $2-5 million category 66% of the deals were in the range of 4.5 to 5.75 x EBITDA and rising. In the $5-50 million size category, 70% of the deals were in the range of 4.5 to 6.5 x EBITDA.

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