When doing deals, size matters. Revenue matters, but from the prospective of business buyers, the size of a company’s EBITDA is particularly important. Both strategic and financial buyers alike view EBITDA (earnings before interest, taxes, depreciation and amortization) as a key yardstick for where the business sits relative to others within a particular industry. Buyers are also likely to compare other metrics surrounding EBITDA like what is the EBITDA margin percentage when compared to overall sales revenues? How much “DA” (depreciation & amortization) is included in the overall EBITDA calculation? While these other metrics are certainly important, the overall earnings number will be the very first barrier in attracting various buyers to the business. Knowing the level of earnings required to snag different types of fish is helpful when you want to reverse engineer your business sale to maximize your company’s sellout price.
Just like businesses in general, there are a large number of private equity buyers that will play below the $1M EBITDA threshold. Many of them do so in hopes that they can play the arbitrage game and acquire companies on the cheap. It is getting more difficult to buy below market, especially as companies increase in size. It is easier for buyers to acquire below market when they move lower down the value chain as many of these companies have customer/regional concentration issues, unsophisticated systems and other not-so-desirable characteristics that create wiggle-room for buyer negotiation.
While cresting the $1M mark is somewhat of a signal, the most legitimate and healthy private equity firms and strategic buyers will be playing well above this level, holding out for the companies with greater sophistication and better company preparation for scale. Many will be looking for that platform company that could be used for bolt-on acquisitions. In fact, it is the $1M to $2M EBITDA size threshold that many a strategic buyer will target as a bolt-on acquisition in an industry roll-up.
Something tends to happen between the $1M and $3M levels of EBITDA. First, companies get more complex. They become more sophisticated in their accounting, resource planning, operations and sales. They tend to hire up-market talent and thus the business becomes more of a well-oiled machine. In most cases, the family bookkeeper (or someone simply trained internally) no longer is the chancellor of the financial statements. In short, the EBITDA is a signal of a more mature target. The increase in sophistication may not always the case, but the EBITDA helps signal that it is certainly a potentiality. This level of EBITDA is at least a prerequisite for many a buyer. There is also a slight bump in the EBITDA multiple paid for businesses in this range.
Additionally, once a company crests the $2M EBITDA number they become less of a potential target for individual buyers with SBA loans in tow. This is a distinction in its own right. When companies are small, they are more easily purchased by individual buyers looking to acquire a business using the SBA as a lending tool. The SBA’s threshold is typically in the $5M range. As valuations creep above that level, buyers tend to get a bit more sophisticated, utilizing SBICs (small business investment companies) and other SBA-sponsored entities to make the acquisition financing work. In many cases, private equity buyers bring their own equity and debt and structure the deals as they see fit. SBICs and other mezzanine-like lenders are often very selective in the buyers to whom they will work. In other words, the larger pool of more unsophisticated buyers begins to shrink.
This is also the level at which many buyers will begin to “take a look.” Many a private equity group has made their reputation on buyer in this lower middle-market range, growing the business both organically and inorganically and then selling the company later to another PEG higher up the food chain.
The most well-known buyers and private equity groups typically will not get out of bed in the morning until you reach a minimum of $5M EBITDA, but many have a preference for $10M. In fact, some have arbitrary, but set and disciplined thresholds above $10M. For instance, GE Capital will not look at a deal until it reaches the magic number of $12M. By definition, this level of EBITDA could be truly deemed “the middle market.” Most would consider anything below the $10M EBITDA size range as “lower” middle-market.
Once a company reaches this range of EBITDA, the multiples paid increase yet again. Due to the large amount of investor capital available in the market, it is nigh to impossible to find a “good deal” or an “arbitrage play” when companies reach this size. Multiples are higher, companies get more expensive, but the opportunity for scaled returns also increases.
When it comes to doing deals, both buyers and intermediaries have their own internal gauge on how low they will dip before they will agree to start the process. For both buyers and intermediaries, the argument is most often a time-value trade-off. It takes just as much time and effort to source, close and manage a deal that is $2M in EBITDA as it does to do a deal that is $10M. There is a vast difference in the payout for the same amount of time/effort input, however. For the buyers, the conundrum is compounded by the amount of capital a fund may have available to deploy under a given mandate. If the fund is large enough, doing deals under $100M would simply be a waste of time and not a general good use of financial and human resources.
Entrepreneurs and shareholders looking to sell their businesses should consider the ramifications of the magical EBITDA size thresholds both intermediaries and buyers will want to see before they will get out of bed in the morning. It may be helpful to make adjustments toward growth, but also to prepare the business internally. EBITDA may be the first barrier, but other operations, sales, accounting and finance hurdles may await a company that is simply just not prepared to sell.