Most buyers would be happy to pay 3x EBITDA for a decent business. I will not go into the details of what a decent business is but sufficed to say this is generally the rule. However I recently took an interest in a small service business and spend some time at the facility. The owner and the broker are looking for 3x EBITDA and are willing to finance 50% of the deal. Pretty good right? Well not so fast.
The owner is the business and quite frankly its short staffed. In other words he has been running the place on the low-down. He can’t go out and chase new business because he answers the phone – along with an assistant and his wife. The issue I have is that the new owner will need to hit the street and sell – however it would entail finding a new inside sales rep to replace the owner. So the business EBITDA is $200,000 and the new addition costs $50,000 – its starts to make the 3x look like 4x EBITDA. And oh yeah his wife is not on the payroll.
A couple of additional thoughts. If the seller had someone on staff that was not conpetent – that person could have been replaced and dollars exchanged – no such luck here. And secondly – if I go out and sell then I should be able to generate additional revenue – fine but I rather be conservative and dult note it takes time to build new revenue. What did I end up doing – see my next post.
Its a common refrain when looking at businesses and its the business brokers favorite selling point. But what is potential and how does one value it? Its one thing to have a company’s top line is growing 10%, 20%, or 30%. I can understand the rationale for paying for this type of expected growth. And of course that’s why internet based companies command high premiums.
My concern is the notion of a business that has not been growing. Here is the problem: if you are buying a business then you are somewhat of an optimist by your very nature. As a result you are susceptible to the idea that almost any business – with an injection of “new blood” and additional capital can be taken to unforeseen heights. And that my friends will be your downfall.
And remember if its true that sales can be boosted – it will cost money so even if the broker is right it should be reflected in the valuation! More specifically if you have a business earning $150,000 per year and you need to spend $50,000 a year to get it really going – guess what? So be leery of boosted valuations for potential – in most cases you should be paying less not more.
So what to do? Here are my suggestions:
- Take what the broker says with a grain of salt – tune it out!
- Assume the seller is not dumb – they understand the competition
- Review the sales and marketing efforts and dollars spent
- Review the competitive landscape – can you really break out
- Review the growth of the industry – its hard to win in a dying industry
- Understand how sales are generated – who are the buyers
- Understand how buyers are engaged
- Assume you need to spend money – sales reps, advertising, etc etc etc etc
So what do you get when someone owns a business for 40 years and is either so enamored with the business or simply wants to retire “in style”? You get expectations that are so ludricris one has to feel sorry for the seller or the buyer that gets involved in this escapade.
As usual the names have been changed to protect the innocent. A construction based company that bids on work through general contractors. The facts: 1) revenue in 2010 was approx $7MM down from $10MM in the previous year 2) gross profit margins are 20% 3) in 2010 earnings were $300,000 4) AR is $2.5MM and AP is $1.5MM and AP is being stretched out due to a downturn in cashflow. The facts part ii —- 1) the seller/owner is the face of the company 2) 40 employees 3) union shop 4) seller owns the building 4) seller admits to a highly competitive industry (and in fact while I was there a contractor asked for a reduction in price from $106,000 to $100,000 and then settled on $104,000.)
The seller is looking for – can I have a drumroll please – $4MM in cash! Basically, the bottom line is that the business was worth 2x/3x earnings (say $600,000) and probbaly requires $500,000 of working capital. If you don’t know the business – forget it – while the seller would provide 1 year – what if something happens to him? Then what? So instead of $4MM in cash – its more like $600,000 with $300,000 down and a note for the balance. And I have to wonder if thats generous.
While the seller was adamant that he would find that one person – “thats all it takes” – I am more doubtful – or better yet sure that it won’t be the case. This is a business that is driven a singular individual – no sales team, is under severe competive pressure, has hurt its relationship with vendors and one in which its hard to predict the future.
Now readers may say that I hate the business – I don’t – I would just hate being the buyer – maybe at any price.
Went to look at a company last week. Decent business with $12MM in revenue in the personnel placement space – health care industry. Problem is that the balance sheet is “upside down” – meaning that liabilities are greater than assets. What happened? The owner was cash rich and invested in Florida real estate and invested and so forth. And we know how that story ended.
So here are the particuliars – about $600,000 in EBITDA, $2.2MM in AR, bank loan of $2.5MM, receivable from the owner of $1.5MM. One could argue the conpany is worth 4X EBITDA or $2.4MM. But revenue has been slightly down, a large piece of the business – almost half resides with one individual and in truth when one looks at EBITDA remember thats before interest. In a company with poor working capital throughput – meaning the AR is slow to collect (ie hospitals) and personnel are paid weekly — then interest is an issue.
So for this company the interest should be deduected from EBITDA – so is cash flow really $400,000 whcih would be ($2MM loan @ 10% = $200,000 in interest such that $600,000 – $200,000 = $400,000). And secondly the owner wants to stay on and I have to question his business acumen having blown $1.5MM on multiple FL properties.
So I think we will pass.
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Everyone knows that client concentration is a major issue when acquiring a company. It’s simple. If you have only a couple of large clients and they cease to be clients well then you don’t have much of a business. But what of employee concentration?
Employee concentration exists when a small of number of employees have a relatively high understanding of the business’ inner workings. It is a sure fire recipe for disaster. Why? Because what we have found is that employees tend to be loyal to their previous employ. Because when changes occur, such as the introduction of new ownership, long-time employees become weary of changes and in turn react irrationally.
Specifically employee concentration exists when:
- Client relationships are tied to an employee
- The inner workings of the company are understood by only a limited number of individuals
- Technical and operational capabilities are limited by the know-how of a limited number of individuals
The possible outcomes if not handled appropriately:
Employees will seek to leverage position leading to
- Higher compensation – re: raises and bonus increases
- Internal conflicts amongst employees due to increased perceived or real leverage
- Possible loss of business or technical competence due to employee’s resignation
The bottom line is that no matter what the consideration taken at time of closing, one must buy a company with eyes wide open. Mitigation of personnel issues before they have a chance to fester and cause lasting damage is key to a successful acquisition.
Speaking with a couple of contacts lately and wanted to share some of the buzz I am hearing. Undoubtedly companies are selling however acquisition multiples are bifurcated. The fact is that companies with EBITDA greater than $4 to $5mm with a great growth story and demonstrated earnings throughout the downturn will command higher multiples. And of course weaker entities much less – maybe by a factor of two.
But in keeping with the gist of the blog – what are the multiples? I will give you the usual caveats - it depends on the industry, management, revenue trends, gross profit margins, blah, blah, blah. Companies that have strong growth potential and substance can expect 5x to 9x EBITDA. In fact I was informed that leverage is creeping back into the marketplace. Add that to the fact that private equity is sitting on quite a bit of cash. And it makes sense.
The lower end of the market will still generally command a multiple of EBITDA of 2.5x to 4.5x. In fact I was called by a broker telling me of a new listing: $1.5mm in revenue and $300,000 of EBITDA. The broker was asking for 2.5x EBITDA. No real growth but steady cash flow. Lower multiples clearly reflective of a tougher financing environment combined with uncertainty in the macro-environment.
Finally, buyers will need more cash than the past. Deals used to get done with 20% to 40% down. The current environment is one in which buyers are looking at 50% of the purchase price in cash. So as cash – financing and the economy press on valuation for the lower end of m&a —- the larger deals seem to have buyers with both cash and financing potential. For the right company that is.
If you have had recent experiences in terms of valuation and financings – please feel free to share your experience.
You thought the title should be “What type of Company do you want to Acquire? Maybe, but in truth you are essentially acquiring a revenue stream. The question is the relative stability and growth potential of revenue. And in my mind one type of revenue stream is clearly the more valuable. I refer to recurring revenue versus project driven non-recurring venue streams.
I have been employed or acquired companies with both of these characteristics. Typical recurring revenue stream companies include:
- Logistics companies such as Fedex and UPS
- Phone, utilily and water companies
- Manufacturing companies with targeted niches
- Call centers
- Internet based subscription service companies
- Software companies with annual licenses
Typical project or non-recurring revenue streams include:
- Engineering firms
- Contract manufacturing
- Construction firms
The recurring revenue model offers a high degree of revenue stability however revenues are generally harder to grow. On the other hand, project driven revenue is driven by one’s ability to win projects – with an emphasis on pricing and quality. Project driven revenue by its very nature results in revenue fluctuations from month to month and year to year. Nonethless, it offers more of an opportunity to garner large chucks of business in a shorter time horizon.
But what of the business buyer? Generally speaking its all about price. Hence companies with recurring revenue streams with a degree of growth are more valuable than non-recurring revenue streams that may be more volatile. Remember, as a buyer you must insure that borrowings – both principal and interest – can be paid down with some degree of comfort. That’s typically why private equity investors favor the comfort of recurring revenue streams.
Went to visit what I would call a conglomeration of businesses – all of which have been operating for over 40 years. Well, having gone down the road of buying business for the better and worse, much comes into sharp relief.
First off the total of three company’s combined revenue was approximately $1MM in 2008. As for profitability – it’s hard to say because the financial statements I received included the revenue from real estate holdings. However the manufacturing companies had a gross profit of 30% and the total entity including the real estate was not profitable – even with the real estate contributing $600,000 of income (for a total of $1.6MM).
The fact is that every aspect of the business seemed run down and outmoded. The two facilities including equipment seemed as though no improvements had been made in 20 years. The marketing brochures were black and white photocopies that were stapled together. The inventory was haphazard. The website was sparse and uninformative. There was no sales force or distribution capability. There was no engineering group to upgrade the products. Financial sophistication was not apparent. I wondered how a losing operation supported a General Manager’s Mercedes.
What’s my take? No matter what the valuation it almost felt as though it would require too much time and money to bring these companies into the 21st century. One would need to invest in equipment, people, and the various disciplines such as marketing, sales, engineering and so on. Furthermore, it was not clear to me whether the companies needed to be moved from existing facilities. The move along could cost $400,000 (the equipment was heavy and large). I did not even broach the subject of the competitive landscape and the overall viability of the businesses.
It almost felt as though the seller should pay the buyer to take the business off his hands. It felt as though the basic foundation was not sufficient to support a renewed effort at expanding the businesses. The seller, while nice enough, would seem to have a valuation expectation that would make this deal impossible to conclude.
The last post explored the EBITDA Trap. The EBITDA Trap is notion that when one purchases a company the price is based, typically, on a multiple of EBITDA – which is shorthand for Gross Cash Flow. However, as buyer you are ONLY concerned with Free Cash Flow. To reiterate one acquires a company based EBITDA (Gross Cash Flow) and in return is entitled to Free Cash Flow. Read previous posts regarding the definition of EBITDA and Free Cash Flow.
The key to avoiding the EBITDA Trap is insuring that Free Cash Flow is adequately provided for. Please see “Financial Analysis” page. The first step is analyzing Free Cash Flow under differing circumstances. In addition to the financial analysis one must adequately address: 1) purchase price 2) company’s future prospects 3) macro-economic concerns 4) management’s ability to operate the business and 5) capital structure.
For now however we are exploring an analysis of Free Cash Flow and will address other issues in later postings. The following example is a company with an EBITDA of $100 and the following characteristics: 1) selling price of 4x EBITDA or $400 2) acquired with $200 of debt – payable over five years at an interest rate of 8% and 3) a 40% tax regime. Note that the any one of the five items that can affect the Free Cash Flow of the business.
The example simply indicates that Free Cash Flow can limit or expanded by 1) revenue (or expense) changes and 2) capital structure – re: payback of loan and interest. Implied are the other factors noted in paragraph 2. Hence, one can avoid the EBITDA Trap by attending to 1) purchase price 2) capital structure 3) future prospects of the business (as well as macro and management issues) and having a CLEAR UNDERSTANDING OF THE EXPECTED CASH FLOWS.
Purchase price is correlated to the ability of the company to generate cash. So while the seller is asking for a multiple of EBITDA – the buyer must get a firm handle on the company’s prospects in order to assign a multiple that makes economic sense. A deeper dive next time.
I could not let the subject of EBITDA off the hook until I took a couple of more minutes to explain the “EBITDA Trap”. What is the EBITDA Trap? It’s when you value and pay for a company based on EBIDTA (or Gross Cash Flow) but only earn Free Cash Flow. For instance, a company has an EBITDA of $1MM and you decide to pay 4X EBITDA or $4MM. Congratulations, you have made a deal and best of luck it’s all good from here on in.
However, you find that the cash generated from the business is not $1MM – that was the EBITDA and so you start to have some doubts. So what happened? Remember from the last post that EBITDA was shorthand for Gross Cash Flow. You need capital equipment of $100,000. Oh yeah, you have interest payments of $210,000 (say you borrowed $3MM @ 7%). By the way what about taxes? (Say 40% of $1MM less interest deduction of $210,000) which is $320,000. So your Free Cash Flow is equal to $1MM – $100,000 – $210,000 – $320,000 or $370,000!!!!!!!!!!!!!!
This is a close approximation of what really occurs aside from the nuances of some tax issues. The TRAP is that acquirer’s value and acquire Gross Cash Flow but in return generate Free Cash Flow. This example does not even that into account the notion of principal payments on the borrowings. Consider the implications – on a Free Cash Flow basis you may have paid 10.8X Free Cash Flow – or 11 years worth of cash flow. And you thought you were paying 4X.
Chew on that for a bit and next posting we’ll work through how not to get trapped.