Top Value Drivers In Exit Valuations for M&A
The middle and lower middle markets are competitive fields where business owners looking to exit will often find several nearly identical firms looking to sell at the same time. They need an edge, therefore, which will allow them to achieve an attractive exit valuation. Experience shows that when it comes to acquisitions in these markets, there are three value drivers which trump all others. Below, we look at each in turn.
Growth Rate
Growth is the holy grail of business. The realm of M&A is no different. When looking at businesses to acquire, there can be several motives for the buyer. Ultimately, they of the reasons come back to ensuring growth for the acquirer. So, unless there are extenuating circumstances, if the target company hasn’t been growing over the previous three to five years, it’s going to raise a red flag with the buyer.
Aswath Damodaran, Professor of Finance at the Stern School of Business, says of this phenomenon: “An overriding problem that most analysts face with valuing companies in decline is a psychological one. As human beings, we are hard wired for optimism and reflect that with positive growth rates and higher cash flows in the future for the companies that we value.”[1]
Everyone wants growth. A question often asked by business owners is:
‘Why should I sell when the business is still growing?’
It’s a reasonable question from the perspective of an owner. However, on the other side of the equation, there’s a buyer who’ll ask:
‘Why should I buy when the business has stopped growing?’
Growth is the fundamental reason, among others, why startups – sometimes laden down with debt – receive valuation multiples in excess of 10x earnings and the same reason that debt-free mature companies are thankful to receive if they achieve a valuation of anything over 3x earnings. Growth is– without question– the number one driver of exit valuations in M&A.
Sustainability of Earnings
Closely related to the previous point is the sustainability of earnings; the sustainability of earnings gives a much clearer picture of the dynamics of the growth that a firm has been experiencing. Establishing the degree to which earnings are sustainable can usually be done at a reasonably high level before due diligence begins, but will mostly involve a deep-dive into the target company’s financials.
When arriving at a valuation for smaller businesses, the acquiring firm will often look to strip away discretionary and non-recurring expenses to arrive at what they deem this figure to be. Typically, this will also include looking at the percentage of return clients relative to the entire client base, as well as an in-depth analysis of the composition of the firm’s top 10%, 25% and 50% sales.
Sustainable earnings essentially looks at the long-term prospects of the firm. As Tim Koller, partner at McKinsey says: “there’s a myth that companies should have smooth earnings growth and meet quarterly earnings consensus. Long-term companies are not concerned with managing short-term earnings and are less likely to consistently hit earnings consensus or to have smooth earnings growth.”[2]
For owners of companies which are looking to sell, the message is clear: The more sustainable the earnings, the better prospects of a higher valuation.
Size Matters
Buyers pay a premium for the size of a company in the middle and lower middle market. We have discussed how size bolsters M&A sales multiples previously: “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.”
Therein lies the crux of the issue: at higher levels of EBITDA, firms are more likely to fit the profile of what acquirers are looking for in terms of senior personnel, client profile and operations, thus allowing them to achieve a higher premium when it comes to selling their business. Those firms with higher EBITDA are more ‘ready to go’ than those further down the market.
Furthermore, by virtue of the fact that these firms have already reached a higher level of EBITDA, there’s an increased probability that they’ve already addressed the issue of sustainability of earnings to a certain degree. Sophisticated buyers aren’t just looking at EBITDA as a financial indicator – they’re also using it as an indicator for the company’s overall quality. And quality always drives value.
Conclusion
It may come as little surprise that the variables which make a company attractive to potential buyers are those which business owners should be looking to improve whether they’re selling or not. The value drivers which this article mentions not only maximize the chances of business owners to sell at attractive exit multiples in the mid- to long-term, but also to benefit in the short-term from running a successful company.
[1] http://people.stern.nyu.edu/adamodar/pdfiles/papers/NewDistress.pdf
[2] https://www.mckinsey.com/about-us/new-at-mckinsey-blog/long-term-value-from-intuition-to-index
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