Potential. I call it the dreaded P-word. Why is that? So many times over the years I’ve had a business owner tell me, “My business has a lot of potential.” Then they go on to explain how, for the right buyer who is willing to invest in the business – contributing, time, energy and capital – the business could become a gold mine, a regular money-making machine. Of course that very fact, the potential, is why they expect to get a premium price for the business, not some run of the mill multiple like all those other businesses get. What the owner is saying, in effect is “I don’t want to invest any more of my money in this business, but if someone else would just step up and spend more on marketing or new equipment or something else, then I know this business would take off like a rocket”.
What do buyers think about that concept? Honestly, they may be interested in the potential, since who wants to invest in a business that has no upside, but if they have to invest more of their money to realize that potential it’s like 2 transactions: one to buy the business as it sits today and another growth capital investment to make the business worth more money in the future. Buyers want to buy based on the company’s proven performance. If they have to invest more of their money to increase the value, then they tend to think that all of that increase in value due to the money they invested should belong to them. They have a good point.
But there is a middle ground. The middle ground is often seen in the typical private equity deal structure where the seller and the buyer partner to create that future value…turning potential into reality. These are schizophrenic deals for the owner since the owner becomes both a seller of some of his equity interest in the business and an investor in the company going forward. That investment by the owner can be in the form of what’s called “rollover” equity or “retained” equity, even if the investment is made at the level of the special purpose acquisition entity. Another form of the investment by the owner can be “earn-outs” which are contractual ways that an owner can participate in future growth of revenue or earnings. Earn-outs are typically more short term payoffs for future growth in the next 1-5 years, and not viewed as true partnering, since only the seller gets the reward specified in the earn-out terms. Still, private equity deals may include both earn-outs to reward the seller for future earnings growth already baked in the pie at the closing date, plus rollover equity to allow the seller to participate in growth that the owner and the private equity partners create together.
One of my private equity friends says “If the owners don’t think this is a good enough company to invest in themselves, then we don’t see any reason why we should invest in it either.” In other words, no partnering = no deal.
The bottom line is that if you want to get paid for potential, you need to be willing to go along for the ride and accept a partnering role alongside the buyers of your business. Why wouldn’t you want to do that? After all, the business has so much potential.
Real Multiples From Real Deals
We recently completed the Alliance of Merger & Acquisition Advisors’ Deal Stats report for the second half of 2012. Jason Boldt of Columbia Financial Advisors has been doing the heavy lifting on the last few reports and I’ve taken an editorial role. The deals reported came from M&A Brokers, Investment Bankers, M&A Advisors of various kinds, as well as business buyers who are members of AM&AA. The key results seem to indicate that we are still in a good market for business sales with reasonable multiples. The results are summarized below.
Median multiple for all deals of all sizes in all industries was flat at 5.25, but the average was down slightly in the second half dropping from 5.35 in the first half to 5.06. Because the data are not normally distributed we think the median is a better measure of what’s happening in the marketplace. If you look at the graph and squint a little it may be that some of the volatility we had seen during and immediately after the Great Recession has now quieted down so that we have more stable pricing for businesses.
One of the ways I like to look at things is to look at the frequency of occurrence of different multiples. If you look at the graph below you can in essence judge the probability that a deal will fall within a certain multiple range.
The chances that any random company will sell for less than 5.5 x or 6.5 x EBITDA are pretty high, but the chances that that company will sell for greater than 7.5 x EBITDA are pretty low (less than 10%). We’ve done this analysis quite a few times and it’s never exactly the same, although the big picture conclusions tend to be pretty stable. The chance of getting a deal with over 10x EBITDA is almost always less than 10%, and the chance of a deal ending up in the range of 3 to 6.5 x is pretty high. We tend to think about a 4 to 6 x EBITDA “box” where about half of all deals end up. In the latter half of 2012, 45% of all deals were in the 4 to 6x box. Seventy percent of all deals were in the larger 3 to 7x box.
These results tend to apply to companies that are mostly valued at less than $50 million, with the great majority in the $1 million to $25 million range, as illustrated in the graph below.
Once again we demonstrated that larger deals (generally for larger companies) carry higher multiples. The relationship from the last 4 surveys seems pretty clear. “Consideration” as used here is essentially the debt free enterprise value of the companies involved.
What does all this mean to a business owner? It means that deals are being done, and that there are reasonable prices being paid (or else those deals wouldn’t get done). The market for small and mid-sized business sales may be a little less frothy than it has been, as multiples seem to be stabilizing. There is always better pricing for larger enterprises, and for those with special situations, but the special situations tend to be rare in the marketplace. A seller going to market today with a quality company for sale can expect to receive a fair price, but the variability in pricing between deals confirms the same kind of variability we see among buyers when we take a company to market. It’s not uncommon for one buyer to pay 20% or 50% more than another will pay for the same company, and I’ve seen over 100% difference between 2 buyers bidding to acquire the same company. Hence, the way to maximize value is to market the company broadly using a proven confidential ”auction” or “limited auction” process in which buyers must submit competing bids. You can use the average and median multiples as guidance on what you might expect, but the true value is only delivered by a competitive process with multiple buyers involved. That’s the way I see it anyway.
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