This blog was guest written by Cody Boyte, Marketing Manager of Axial Market
In most small business sales, there are generally three main types of acquirer: individual buyers, private equity groups and other businesses in the same industry. For the sake of this article, the focus will be on how private equity groups differ from individual buyers in the way they analyze and make offers for businesses. In another article we’ll examine how different sized businesses think about acquiring your company in a business to business sale.
Private equity groups and individual buyers tend to think about the purchase of a company and valuation of a company very differently, and thus will negotiate with you differently. Why do they think about your business so differently if they’re both hoping to buy it?
For the most part, individual buyers are looking at your company as something they’ll purchase and run themselves indefinitely. Private equity groups, on the other hand, are professional investors considering your company more like a stock. They’re hoping to purchase the company, grow it, and resell it a few years later for a profit. The differences are why you get offers that are positioned dramatically differently.
How Individual Investors Value Your Business
An individual investor is typically going to look at the annual income produced by your business and compare it to the price you’ve set for the business. In many ways an individual investor is actually thinking about your company the same way you’d think about a mortgage. How much money, per year or month, is the loan on the business going to cost me? How long will it take me to pay of the loan or get back my invested capital? Then, once I’m making money, how much money am I making per month or year?
These mental calculations tend to lead towards individuals negotiating based on the price you’ve set for the company, trying to lower the price so they can break even faster. In the event that you have multiple parties bidding on your company at once, individual investors typically bid in relation to their previously approved funding sources (bank loans, friends and family, cash in the bank, etc). They’re thinking about their own personal balance sheet, risks against their other holdings and negotiating with you based on the price you’ve set in most cases.
How Private Equity Groups Value Your Business
Private equity groups think about purchasing companies in a very different way. As professional investors, most of the funds a private equity group (PEG) invests come from ultra high net worth individuals, pensions, endowments, and other limited partners who expect a good return on their investment. Private equity groups are typically judged by their “Internal Rate of Return,” which calculates how much a dollar given to the firm appreciates each year. That causes PEGs to generally focus on investments that will help them hit their “target IRR”, or the return on investment that is high enough to satisfy the investors.
In order to judge how much the firm should pay for your company, the private equity group will usually use a combination of three methods: discounted cash flow, comparables, and EBITDA multiples. All three methods will be compared against the target IRR to decide at what price it’s worth buying your business and thus the offer you receive. Notice, your asking price isn’t anywhere in their calculation. So how do they calculate each part of their valuation?
Discounted Cash Flows
Private equity groups calculate discounted cash flows by looking at the Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), which is very similar to owner’s cash flow, and projecting how they will change over the next 5-10 years. The EBITDA number is basically the cash available to pay down any debt associated with the company, since most private equity groups use debt as a large part of the acquisition financing. To calculate the value of your company, they’ll add up the expected profits in the next 5-10 years, apply a discount for the time-value of money, and then add a discount for the projected riskiness of your business. The more stable your business, the more confident they’ll be in your numbers and thus the easier it is for them to offer you more money.
The second, and most common, method by which a company is valued is to use comparable businesses that have sold recently. There are typically two different ways of thinking about using comparable: using public market data and calculating back or using database of historical reported sales. The method is fairly similar to looking at houses that sold in your neighborhood in order to figure out the value of your own home.
For large businesses where there are public companies with comparable revenues and earnings in a similar industry, the best way to value the company is to look at how the stock market is valuing the public company. Then adjustments are made based on differences between the nature of the private business and what is known about the public business. One caveat is that PEGs will often adjust their offer for your company based on changes in the fiscal environment, lending rates, and perceived differences between your business and the business reported on.
For smaller companies where there aren’t any comparable public companies, comparables data is pulled from databases of past business sales that were reported to the database companies or where a public announcement was issued. The most common database services are Bizcomps, Peercomps, or the IBA database. This method is generally referred to as the Direct Market Data Method.
Private equity groups will occasionally purchase similar firms as part of a roll-up strategy, making many acquisitions in a single vertical. . If a PEG can find comparable sales in the recent past, they’ll often use that company as a precedent for the sale of your company. If the company that sold was 10% bigger, they’ll offer 10-15% less for your company. If you’re the third or fourth plastic extrusion manufacturer a PEG has acquired in the last year or two, they’re not going to pay significantly more for your business than they paid for the previous ones.
The last way of valuing a business, or at least getting a quick idea about the rough selling price, is to consider multiples of either revenue or EBITDA. Typically, most PEGs are going to focus on EBITDA unless your business is extremely rapidly growing – as long as it seems like a reasonable expectation that you’ll convert market share into earnings in the future. The reason that multiples are often used is because they can be scaled nicely for different sized businesses. Generally, a business with less than $1M in EBITDA will be valued in the 2-3x earnings while a company in the $10M EBITDA range will be valued closer to 5-7x EBITDA or more.
The reason for the different valuations based on EBITDA size is actually based on three things. First is the concept of ‘multiple arbitrage’, where a publicly traded company can get immediate value by acquiring a company at a price to earnings (P/E) ratio lower than it’s trading at in the public markets. The larger the acquired company, the greater the impact on the earnings per share of the public company and thus the bigger the relative value for their shareholders. Second is based on acquisition financing, since many of the lenders for a PEGs acquisition of your business will be loaning based on multiples of EBITDA. They’ll only lend 3x EBITDA or 4x EBITDA, so the private equity group can only offer you that much. Third is based on risk. The larger your company, the more room there is for recovery if something goes wrong in the general market or in running the business. Less risk = higher prices.
Who should you work with?
Private equity groups and individual investors typically also structure the acquisition differently. Most often an individual investor wants to acquire your entire company and run it himself. If the company grows after you sell, the new owner reaps all of the benefit. Many private equity groups, on the other hand, would like to retain you at the company with some ownership so you can continue to help growing it. This can lead to an experience where you are able to focus on what you do best while the PEG takes care of some of the financial aspects of the company and you both share in the growth after their acquisition.
However, making the decision isn’t always cut and dried. Private equity groups, as professional investors, will also have significantly more experience acquiring companies than you have selling them. Watch out for terms in your sale like impossible to hit earn-out targets or clauses making you liable for any future actions of the company. Working with a good broker can help protect you from thinking you’re selling for $20M and only ending up with $2M in your pocket later on. To see which PEGs are most active in the middle market right now, visit the AxialMarket list of private equity groups.