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.
MacGladrey Capital Markets LLC just completed an excellent report on the state of M&A. I was just about to summarize their findings when I realized that I should take a step back. In almost every discussion of valuation EBITDA is mentioned. Buy why EBITDA? Why not the Net Income of a company as a means to value a company? Because EBITDA is shorthand for gross cash flow. And when you are acquiring a company you are buying cash flow – the amount of cash that the entity will generate. Actually, you are buying FREE cash flow, but companies are typically valued on GROSS cash flow or EBITDA. We’ll explore FREE cash flow on our next turn at understanding financial metrics.
EBITDA defined is Earnings before Interest Taxes Depreciation and Amortization. But why use this measure of earnings? Because it normalizes cash flow, for instance;
- Interest is excluded because companies are capitalized differently. For example if you acquired a company for $5MM and borrowed $4MM the interest carrying costs would be much greater than if you paid all cash or stock for that matter. Additionally, companies have different costs of capital – or pay differing interest rates. Some companies borrow money to operate while the same company may choose not to borrow. Nonetheless they may produce the same amount of cash flow prior to an interest deduction.
- Taxes are excluded because companies have different legal structures. For example, a partnership or LLC pays taxes at the partnership level. As such no taxes appear on the financial statements of the COMPANY. On the other hand a company formed as a corporation pays taxes at the corporate level. Hence, taxes appear as an expense line item in the financial statements.
- Depreciation and Amortization are non cash items that appear on the financial statements. For accounting purposes depreciation is calculated as follows; 1) company buys equipment for $1MM 2) the equipment has a useful life of five years 3) the equipment is expensed over a period of five years 4) the expense on the books of the company is $200,000 per year EVEN THOUGH the company paid $1MM in year one. So in reality the $200,000 of expense in years 2 thru 5 is only an accounting adjustment – hence it’s added back (no cash expended).
Next post we will discuss the pitfalls of valuing a company on EBITDA alone. And provide some concrete examples of EBITDA calculations.
It’s hard to say if the seller was aware of the changing landscape that was affecting the business. Was it strictly good timing upon the sale? One can never say for certain and my partner and I had a degree of suspicion. Nonetheless, in reality it felt like this;
- The client base that was typically served was now giving us less work
- The average price per project dropped
- Clients were not allowing us to bid due to corporate dictates
- We quoted more jobs to maintain the same amount of sales
What I Would Do Different
It’s almost impossible to get a sense of shifts within an industry. The nuances of a business maybe so slight that detecting changes is almost impossible. But here is what I would do better:
- Speak to as many people in the company as possible – don’t be shy
- Focus on the sales staff and ask insightful open-ended questions ask the following
- How have the clients demands changed over time?
- Why do clients continue to buy from us?
- Which competitors are the most forceful?
- Which competitors do you find more often?
- Spend as much time as possible at the company before closing – listen and observe
- Consider macro changes to the industry served – consolidation? Offshoring?
- Read industry periodicals
- Speak with the company’s clients
- Look at the client list over a long period of time 5 / 10 / 15 years
- Consider the average price per product or service over a long period of time
Just some general suggestions but essentially ask, listen and question everything.
…so you better get used to it.
We all know the world has changed in the past 18 months, and in keeping with those changes potential purchasers of companies need to change their due diligence focus as well. In that regard I’d offer the following:
Focus on the future: In the past financial due diligence was historically focused; however, in today’s economic environment historical performance may not be an accurate indicator of current or future value. Evaluating the sustainability of earnings remains a critical and increasingly complex part of the due diligence process and buyers should be cautious of short term unsustainable measures taken by potential acquisition targets to temporarily improve their performance metrics.
Cash is still king: Now more than ever, buyers must understand not only the cash-generating abilities of a business, but also the cash required to sustain and fund its growth. Working capital that is artificially lean and deferred-capital spending are areas requiring heavy scrutiny.
What the numbers don’t tell you: Financial metrics are only half of the picture. Operating efficiency, customer and supplier relationship quality and longevity, key management effectiveness and retention, strategic focus and responsiveness, and their collective contribution to value merit careful and ongoing evaluation throughout the deal process.
Hopefully if you keep the above in mind when you look at potential acquisitions you’ll successfully be able to navigate the brave new world we are all living in.
…but the real challenge is to be able to pay 80 cents (or less) for that same $1 of value. Buying a company is no different. The seller wants to receive $1.00 of value (or more) for the $1.00 of value (or less) that he is selling you, and any fool can (and many do) rush to the closing having over-paid for an acquisition.
Years ago I had a partner whose words of wisdom still resonate with me. He used to say, and believe me he was correct, that you “make your money going in; and if you don’t you’ll be chasing your money throughout the deal.” That’s a lesson I’ve learned the hard way over the years, and as an investment banker am cautious when advising clients on buy-side M&A deals (some would say too cautious) not to overpay for the acquisition of a company.
When you go into a potential acquisition you’ve got to have discipline and not allow the heat of the moment, or the euphoria of the deal, to get the better of you and do something stupid (i.e. overpay). While at the end of the chase you may not end up with the prize, and sadly as advisor that has happened to us more times than I care to remember, it will allow you to avoid a costly mistake that you’ll live to regret down the road.
The seller of a company is entitled (perhaps too strong a word) to fair value for the business he is selling. He is NOT entitled to value for the synergies you as buyer can bring to the acquisition or any increment of value you may create through your hard work and effort post closing. Those belong to you as buyer, and are the compensation for you putting your capital and time at risk.
Being disciplined may not be a lot of fun, but in the end it’s a hell of a lot better than, as my former partner used to say, “chasing your money through the deal.”
There is a real truth about buying a business in an industry in which you have not had previous experience. The fact is that no matter how much due diligence, research and fact finding you will attempt – the fact of the matter is the only person that really understands the business in the context of the industry is the seller. It is knowledge built upon years of experience – it’s a keen sense of the competition, the company’s relative strength and weaknesses and changes in the industry at large. The seller has a unique vantage point as the 5 / 10 / 20 or 30 years of experience have in some respects happened in slow motion – a view from a high vantage point. He or she knows where all the skeletons are buried.
You don’t have that luxury. You are in the throes of spending quite a sum of money and a bit of borrowed money. You better be right because changes affecting your acquired business will Not happen in slow motion. I know —- we acquired a company in which revenue was severely diminished due to contraction of the overall number of industry players. In our case we found that the largest acquirer in the market was much closer to our nearest competitor — generating revenue for our competitor and leaving us gasping for air. Was the seller aware of the effect that this was having on our industry?
More on this next time and why we missed it.
Well as hard as it is I figure the only practical way to educate readers is through an examine my screw-ups. In keeping with the theme of the blog I want to make sure it means something to you and I guess that means its information that you can use to act upon. So to start lets start off with the notion of understanding the market in which your business exists. If you are looking to buy a dry cleaner, workout gym, manufacturer of bearings, logistics company or whatever — never underestimate the possible effect on the future potential of the business of a changing business landscape. You must ask the following questions – 1) What is the competitive landscape 2) How is technology changing the business model 3) How is the macro-economy likely to effect the business 4) What is REALLY going on for all companies in this market space 5) Is there growth for companies in this space (is the market growing) 6) How proprietary is the process or products and 7) How can the company be affected by imports. This is only a start – really a means of getting you to think about the reality of invisible cross currents. Next up I will spell out some of my mistakes in the context of the items listed 1 thru 7 an ugly primer on what not to do.
Last wrote about the five aspects of revenue analysis that one must be cognizant of. A little bit more in depth now we shall go. For number (1) revenue that’s concentrated in only a few clients – this should seem obvious – if a couple of clients make up a large majority of the revenue – it’s a very bad sign. Not only because any loss of client would devastate the business but because its indicative of how tough it is to grow revenue. Regarding (2) revenue that has increased as a result of price increases not volume increases – I happen to have first hand experience with this (unfortunately) – and it occurs typically in commodity based businesses. In may case the price of plastic resin was increasing which led to higher year over year revenue – however the volume of plastic resin sold was NOT. Clearly, a danger sign because once again its indicative of a company that finds it tough to attract customers beyond its base and secondly – what happens when the plastic price drops and one has purchased the business with different expectations of revenue and profits? Regarding (3) revenue that is a result of one time revenue generating opportunities – thats simply seeing where revenue may have occurred due to one time generating opportunities that won’t recur. Regarding (4) revenue that may have been booked but at lower margins – revenue at any price to inflate revenue growth reduces the overall quality of the business. And finally (5) revenue that has been reoccurring but may not in the future – in which the seller knows something that you don’t. In this case is the business changing – has a client indicated that they may not require their services. Next Post – Tales from the Crypt – deathly tales of failed revenue streams.
Revenue quality is a key component of your financial review. If you miss this – you have probably missed the boat and will find yourself with expectations of a company that cannot be met. In other words you may have overpaid and worse yet – been bamboozled. Revenue is tricky in the sense that it may be going up – that’s good – but the question is why? You always want to see increased revenue over time – it’s considered the basic strength of the business. However you don’t the following; 1) revenue thats concentrated in only a few clients 2) revenue that has increased as a result of price increases not volume increases 3) revenue that is a result of one time revenue generating opportunities 4) revenue that may have been booked but at lower margins and 5) revenue that has been reoccurring but may not in the future. In Part II we are going to take a closer look at revenue quality and the five preceding points.
Received detailed information on a company that manufactures food processing equipment. I can’t give away too much – re: NDA. But for the last four years revenue has fluctuated between $4.6mm and $5.5MM but for 2009 ended at $4.9mm. Operating earnings between $500,000 and $600,000. The revenue are split 50% new machines and 50% parts. The client base seems well diversified – apparently over 300 clients last year. Its a long standing – well established business – founded in 1956. So operating income is 10% or revenue – not bad. The question that looms large in my mind is – how is it that revenue is only $5mm? Is it management? Is it the competitive landscape? Or is it the size of the marketplace? Guess we’ll have to try and figure this out. I have learned that as much as I think I am smarter than the seller – guess what – probably not. And so is this a 10 / 20 mm business?