Approach to M&A Business Valuations
By Aaron Naisbitt
There is no easy way or ‘one size fits all’ approach to estimating the M&A market value of a business. No two businesses are the same and there are several techniques for approximating the value of a company at any given time. At the end of the day, the only way to determine the actual value of a business is to find out the price at which a willing buyer and willing seller will agree to do a transaction. That said, there are numerous factors that directly impact the value of any business, typically including size, growth rate, profit margins, risk, financeability, competitive process and current market conditions.
The most commonly referenced M&A valuation statistics are multiples of revenue and earnings before interest, taxes, depreciation and amortization (“EBITDA"). These multiples are derived by dividing the Enterprise Value of a target company (the total value of its debt and equity) by its annual revenue or EBITDA (often normalized or adjusted to remove extraordinary, non-recurring or unusual items). Although EBITDA (or Adjusted EBITDA) multiples are far more commonly used in most industries, revenue information or estimates for target companies are often more readily available and can be used as a proxy if making certain assumptions about typical profitability margins in a given industry.
There are certain methods that a potential seller and their advisors can utilize to establish likely realistic valuation multiples and ranges, and there are also a series of steps that can be taken that will positively impact the M&A process and best position a business to maximize value. Potential buyers do not focus on the sweat equity and perceived value that an owner may have invested in their business, but on the value that business can and will drive for the benefit of the buyer after the acquisition. Optimizing price and terms is about timing, positioning within the market landscape, and preparedness more than anything else—and a seller should fully understand how the three primary valuation methodologies will be applied to their business: Comparable Publicly Traded Companies; Precedent Transactions and a Discounted Cash Flow Analysis.
Comparable Publicly Traded Companies
Researching publicly traded reference companies in the seller’s industry is a good place to start. It is important to identify and track the financial and stock price performance of comparable public companies to establish a baseline of how the larger businesses in the industry are valued in the current market. This information is all derived from financial data that is readily available. Statistics can be analyzed to compare how your business’s operating statistics stack up to industry participants and indicate whether performance is favorable, unfavorable, or on par with other companies in the sector. And as you might assume, relative performance can indicate whether a business is likely to sell at either a discount or a premium compared to the broader industry.. However, publicly traded companies are typically much larger, more diversified and generally have stronger financial systems and controls than smaller middle market companies. So while their valuation data can serve as a useful reference, the absolute trading multiples typically are not directly relevant to smaller middle market companies.
The most directly relevant statistics used to estimate the M&A value of a business are those of similar companies which have actually been sold. The challenge can be finding enough measurable data that is publicly available, as most middle market transactions do not disclose the price, revenue or cash flow of the target company. That said, any multiples that can be derived from transactions of similar companies can be very useful. The best way to gather this information is to work with advisors who have relevant transaction experience in your industry or access to the databases with target-specific or industry-specific aggregated data. If you are able to collect numerous accurate data points from acquisitions of somewhat similar companies, these are generally the most reliable statistics to consider.
Discounted Cash Flow Analysis
The third methodology that is widely used in valuing a business is a Discounted Cash Flow analysis or “DCF", This is a thorough and detailed analysis that considers the expected growth of a business in the years to come, the risk associated with achieving certain levels of projected financial performance, and the required rate of return for the acquiring party. A DCF calculates the net present value today of the future streams of unlevered free cash flows from the business. This method forecasts the performance of the company, often for the next five years, calculates a terminal value at the end of the period using an range of potential exit multiples, then discounts those cash flows back to today using a range of assumptions relating to the risk of the business and rate of return expected by a buyer. This exercise can be very technical, and while directionally useful a DCF relies very heavily on the assumed terminal value of the business at the end of the period. In our experience the reliability of forecasts declines the further out into the future one looks, so in many cases this analysis can be more of an academic exercise than a practical guide to current value.
The final piece to consider in valuing a business is how current market conditions may be influencing the valuation statistics reflected in the analyses above. At this particular time, the unprecedented levels of private equity funding and high levels of cash on corporate balance sheets are driving very strong volumes and valuations in middle market M&A. Recent data suggests that average transaction multiples have increased by 25 – 30% across all industries, and Q4 2021 is expected to record the highest number of closed middle market transactions seen to date,
A solid valuation analysis will consider all of the factors above, but the value of a business ultimately will depend on how much competition can be generated among potential buyers motivated by potential cost savings, synergies and/or new revenue streams that will help them increase the value of their businesses.
We often find that business owners focus on the wrong question, asking “What’s my multiple?” The real question should be “Which buyers can generate the most cash flow to apply a multiple to?” Most every owner will have a story about someone they know who sold their business for an extraordinary multiple—so, “Why not me, too?” High multiples are typically a function of a buyer paying a reasonable multiple of the cash flow they expect to generate, which can look like a very high multiple of what a seller’s business generates on a standalone basis today. And this is where competition plays a key role in driving a buyer to pay a higher price, as none of them want to pay more than they have to but will likely pay as much as they feel they need to in order to outbid other suitors.
Most business owners go through a sale of their company only once in their lives, and it can be hard for them to clearly understand how important it is to be prepared well in advance of considering a potential transaction. But the old adage, “You have to spend money to make money,” holds true in sale preparation as well. The most exceptional outcomes in M&A usually start with years of proactive preparation ahead of a sale process. One thing all owners should do is work with a financial advisor to know the post-tax proceeds needed from a sale to support their financial goals. The more informed a seller can be well ahead of a transaction of any kind, the better. A second objective is to improve the financial controls and reporting of the business, which will instill confidence in the quality of the company’s financial information as well as its historical earnings performance. These two factors will inform an owner when they will be likely to achieve the outcome they desire and can significantly reduce the risk perceived by a buyer–thereby increasing the value they are willing to pay. Investing in important third-party tools and reports such as a Quality of Earnings report will also help sellers make sure that the offer they choose can ultimately be closed after going through the very meticulous due diligence process.
Every business owner should identify an M&A advisor who can help them understand the process well before they decide to sell their business, most importantly because that advisor can help them prepare the business in a way that will maximize their eventual outcome. At Dunn Rush & Co., our Partners and Managing Directors have all owned, run and eventually sold their own businesses. We can anticipate the questions and concerns an owner needs to address to achieve the desired objective—the sale of your business for the best price and terms, on the timetable and in the manner you desire.
When I decided to sell my third generation, family business, I had many concerns. I wanted to be represented by an Investment Bank who had a strong reputation in the mergers and acquisition market, knew the market we participated in well enough to target likely interested parties, and who would manage the process of the transaction with various family members with various personal interests.
Betsy Alden, Former CEO and Owner, Alden Products
I had never sold a business before and didn’t realize everything that went into it, or the time involved. One of my best decisions was hiring professionals, Dunn Rush & Co., to guide us through the sale process. Their experience, determination and guidance resulted in a very smooth and efficient transaction. They were especially helpful during the negotiations over price. We achieved optimal results for all constituents: our shareholders, employees and customers.
Bill Jemison, Former Owner and CEO, Heyco Products, Inc.
I had never been involved in the sale of a business before, let alone my own. I hired Dunn Rush & Co. to assist me through the process because of their extensive experience helping similar business owners. Kevin and Greg prepared us well for the task, anticipated events and issues, negotiated hard and delivered superb results. They know what they are doing and do it well!
Everett “Vic” Firth (1931 – 2015), Founder and President, Vic Firth Company, Inc.