ACQUISITION MONEY
Interest rates are still high, do buyers have money to do deals?
According to S&P Global, Private Equity firms have $2.49 trillion of what they call Dry Powder. This is money they have available to them to buy platform companies and add-ons. A large percentage of P.E. firms are focused on Small Market Businesses, companies with $10 to $50 million in revenues.
Public companies have $2.4 trillion in cash some or all of which can be used for acquisitions. These strategics buy companies focused on customers that fit with their existing product lines and will grow rapidly under their ownership.
Both types of acquirers have to prove to investors that they can make a better return that what a Treasury Bond pays. They need to put the money to work.
We always ask clients to think about the "Make or Buy question." How much money and how long would it take for someone to build your business from scratch? The answer is usually a healthy multiple of your revenue and as long as a decade. That's a good thing for selling companies. It's cheaper and quicker to buy than to build.
VALUATION -- USES, METHODS AND OWNER EMPOWERMENT
One way for owners of private companies to develop bargaining power when dealing with investors and potential buyers is to commission a valuation by an expert.
Different methods can be used for different purposes like a high value for incoming shareholders and a low one for tax purposes.
While there is flexibility on how a company is valued, it is not as freewheeling as it might seem.
The IRS requires Fair Market Valuations.* FMV is what a willing buyer with full knowledge about the company would be likely to pay (the bid) and what a willing seller with full knowledge is likely to accept (the ask).
The valuator’s job is to present a reasoned case based on data and analysis for a price range within which a credible bid will meet a credible ask.
Income makes a company valuable. Sellers give up income from future cash flows. Buyers gain future cash flows. Sound FMVs are based on measures of income. Here are three income measures that are used.
Discounted Cash Flow – This method uses real input from the company which the valuator weaves into a forecast model to present a well-constructed case for a value range. Expected future income is discounted back to today’s dollars using the current cost of capital to render Net Present Value.
Multiple of Revenue – This is a shorthand measure using current year’s revenue times a market multiple. Current market multiples can be hard to find. Using reported public company multiples is one way, also, investment banks run studies and report multiples by industry segment. Specific company information and its future prospects are overlooked in this method, which is often used in Silicon Valley for startups.
Multiple of Earnings – This is another loosey goosey method that gets thrown around in the M&A world. It uses a market multiple times a measure of current profit. The higher the profit and the bigger it is as a percentage of revenue the more the buyer is likely to pay for the company.
An effective valuator will accommodate the three methods and give relative weight to each one in determining the value range in their Valuation Report. How much weight to give one method over another is different for every company and needs to be determined with careful consideration.
Conclusion – A Valuation Empowers Private Owners
A credible Fair Market Valuation is an invaluable tool for the owner of a company. It enables good decision making and can reduce uncertainty. If a sale process is initiated it gives the seller a firm foundation from which to negotiate with buyers.
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* IRS Revenue Ruling 59-60, 1959-1 CB 237 -- IRC Sec. 2031
EVERYBODY LOVES DROP THROUGH
Drop Through is the amount of money that “drops through” the Income Statement from Revenue all the way to Net Income. There are a couple of important measures to look at in regard to Drop Through. Most important, though, is that Drop Through is a company owner’s best friend, especially an owner considering selling their business.
It can be expressed as the formula: Drop Through = (Net Profit / Revenue) × 100. A company with $500,000 of monthly revenue and net profit of $100,000 has a Drop Through of 20%.
A company that closes its books and produces monthly financial statements will facilitate good decision making and be easier to manage profitably.
Potential buyers track Drop Through in those statements to understand how well a company is matched to the market it serves and how successful it is competing in that market. Being able to see trends in Drop Through will increase a buyer’s understanding of the company and encourage them to bid aggressively.
COGS (Cost of Goods Sold) is the first place revenue gets reduced on its way to the bottom line. These are expenses that occur every time a product is sold or a service is delivered. They are generally out of the control of the company and similar for all competitors in a market segment.
COGS deducted from Revenue gets us to Gross Profit which is one of the first things a buyer will look at when they review financials. There are no rules on what is an acceptable Gross Profit, but generally speaking anything above 65% of Revenue is pretty good.
Operating Expenses -- compensation, marketing, sales, overhead, etc. -- are a big factor in determining Drop Through. Since every dollar above Breakeven will Drop Through many owners are tempted to try to minimize Operating Expense and juice up profit. That may work in the short term, but it may lead to lower revenue and/or operating problems in the future. Buyers will look for profit spikes that depend entirely on cost cuts and may not like what they see.
Sellers should remember that Buyers will be focused on what a company’s current Drop Through is and will spend a lot of time thinking about how they can improve it after a sale. A Seller who can talk about what they have done to manage Drop Through – what has worked and what hasn’t – will build trust and credibility with the buyer and improve the chances of a successful sale.
YOU WANT BUYERS TO SAY...
Sure, the dollars and cents are critical to getting a deal and a good price and terms. Just as important are all these “other factors” that go into making successful transactions.
Key to this is getting into the buyers’ mind and what you want the buyer to be thinking, and saying. Here is a not so random sampling of “What you want buyers to say.”
- We really like these folks now that we have met them.
- They are really good people.
- We totally trust them.
- Their records are super clean and thorough.
- Their customers love them.
- We like and trust their broker, lawyer and accountant too!
- They have been prompt and thorough in providing info when we request anything.
- We don’t see any significant legal problems or potential liabilities.
- They are very flexible about staying on for a reasonable period of time.
- The key employees are quite competent, seem to be no problem whatsoever, and are looking forward to the acquisition.
- They pay their bills on time and have no supplier problems.
- They have no undesirable contractual commitments.
- This is going to be such a comfortable deal to do.
- As wonderful as these people are I see three terrific opportunities to increase revenue and improve the bottom line.
- Let’s not lose this deal. Let’s bid aggressively!
DON'T LET SUCCESSION PLANNING SCARE YOU
Naming your successor is hard.
CEOs, like everyone else, don’t like to think about leaving their company but after a sale it is likely that they will. There are many reasons why that happens, not the least of which is that having been in the top spot diminishes the allure of being an employee. Especially when you have just put a lot of money in the bank.
A succession plan that identifies the key roles, including CEO, that need to be filled when a vacancy occurs, rates the current incumbents, identifies potential replacements, and authorizes training for their next position can be a huge driver of a buyer’s interest in a company and their willingness to bid aggressively.
That interest will be fueled by the knowledge that a capable team will come on board and continue the successful performance that made the company an acquisition target for the buyer in the first place.
Buyers may also be looking for qualified managers on your team who will be candidates for promotion to positions in other areas of the buying company.
In short, creating a succession plan adds intangible but very real value to a company and doing it should not be put off.
Here are some more reasons -- even if you are not about to sell your company -- that a succession plan can make your company stronger and more valuable:
- Lenders and investors will be more likely to put money into your company if they know there is a written succession plan with buy-in from the key players.
- Team members will appreciate being mentored and trained for greater responsibility.
- Identifying team members’ strengths builds confidence in the other team members and discourages micromanaging.
- The process is a healthy one and encourages loyalty of valued team members.
- It’s not a complex process and much of it is intuitive, which should make it less daunting.
Bear in mind that in the case of a sale of the company the buyer may not follow your plan and may want to put their own people or outsiders they have recruited into leadership going forward. That’s up to them. However, by formulating the plan and having it in place well before you embark on a sale you will have done what you can to advance the interests of the buyer, your team and yourself.
YES VIRGINIA, ACQUISITIONS ARE STILL A THING!
Smart managers building their careers by building their companies through acquisition are always facing the question “Does it REALLY make sense to buy another company?’
The answer is it depends on what you are buying. The goal, of course, is synergy, aka “two plus two equals five.”
Start with revenue. The purchase of another business can bring you new customers whose spending gets added to your business. A buyer with an existing sales force that is bigger than the sellers can ramp up the top line.
In the cost of goods section of the P&L buyers can scale up the volume of purchases they make from vendors and reduce per unit direct costs for the whole company. The buyer can get a two fer. Raising revenue and reducing direct costs can add points to the gross profit percentage which gets the attention of the CFO and the CEO.
The buyer can also get the benefits of adding talented people – big hitters in sales, talented people who develop the products, and innovators who find new ways to delight customers.
Some overhead and back-office costs can often be eliminated to reduce operating costs.
So, yes, there are many good reasons to buy that fast-growing business whose owner is ready to turn over what they have built so that the bigger enterprise can enter a new market sector and take the acquired business to the next level. When they do it right buyers move metrics up and to the right and get a return on the money they used to make the purchase.
IT NEVER HURTS TO LOOK
Growing your business is a move that can pay off big time. For a middle market company there may be more opportunities for buyers than you think. A fast-growing young company with smart tech applications and a steep, upward sales trajectory may be available for a reasonable valuation because the owners are ready to move on to the next challenge. They know that in a few years the value will be much bigger than today, but they don't want to wait around and they would rather start up a new company than operate one.
At the other end of the spectrum is the longtime owner who is ready to retire. They may be willing to forego some monetary value if they believe that the new owner will continue to run the business in a way that is based on similar values to their own.
An acquisition search is time consuming and not easy, but it is worthwhile to know what companies that would complement your business are out there and whether the owner is ready to sell.
We have completed many search assignments for clients. Sometimes after reviewing opportunities that we bring forward (along with strategic and financial information that we have gathered) there is no deal, but the client has learned a lot about companies that are operating in their market. Just as often there is a deal and the buyer expands their business, grows sales and profits, and enjoys the benefits of owning a more valuable company. Cocktail napkin explication below.
