I was recently asked by a client to point them in the direction of some sensible valuation advice for the kind of smaller, founder-run businesses that they are targeting as potential acquisitions.
They felt that there was a gulf between what the would-be vendors of these businesses felt they were worth and what anyone was likely to pay for them, and were looking to point their acquisition targets in the direction of some objective guidance that would (hopefully) help them form a realistic view of value.
Having now searched the internet myself for appropriate SME valuation advice, I am surprised at the lack of useful sources out there. Generic content covers the various valuation methods, but with little of use in terms of identifying which to use and what metrics to apply.
Conventional wisdom is that one should look for a precedent deal in one’s own sector as an indicator of value, but for multiple reasons (which I will explain below), such data is difficult to find and practically impossible to meaningfully interpret.
The reality is, of course, that a business is worth what someone is prepared to pay for it. But establishing what someone might be prepared to pay for it before attempting to find a buyer, is a sensible first step to determining whether you are willing to accept what you are likely to get. It would be frustrating, expensive and time-consuming research to go to market just to establish that what you want/need for your business is not going to be achievable.
So, here is some guidance, practically focussed, and designed to be of relevance to businesses at the smaller end of the market where there is very little reliable precedent and a greater than average risk of input from “friends down the pub” with a strong view, rose coloured lenses and, sometimes, a personal agenda.
The first thing to say is that what follows is aimed at the majority of trading, asset-light, profitable businesses. The valuation method and metrics require these characteristics. For businesses that are pre-profit, loss-making or have a very significant fixed asset base, the approach below will require adaptation, and I don’t propose to cover that here.
I will concentrate my attention on a standard Enterprise/Equity valuation approach which is normal mid-market practice. Valuations are typically based on a standard valuation equation which splits into two parts as follows.
Adjusted EBITDA x multiple = Enterprise Value
Enterprise Value + Free Cash – Debt = Equity Value
It is Equity Value that denotes the sum that the vendor shareholders will ultimately receive (before tax and fees).
Taking those terms in turn;
Adjusted EBITDA
EBITDA (Earnings before interest, tax, depreciation and amortisation). This figure is intended to equate to the operating cash generation of the business, which is why it is usually adjusted for non-cash items like depreciation and amortisation. EBITDA is the right measure for most trading businesses but if there is a need in the business for regular maintenance expenditure to keep a fixed asset base in good condition then the equation would have to be negatively adjusted to reflect an annual capex amount. This would equally apply to software development costs which are being capitalised and amortised rather than fully expensed; the important thing is the net cash generation from trading.
The equation refers to “Adjusted” EBITDA because the figure should equate to the operating cash figure that an acquirer will benefit from post completion. This means that any one-off or exceptional items that impact operating profit should be added back to profit (eg one-off restructuring costs, a new computer system etc) since a buyer will not have to incur that expense again. Likewise, If the exiting shareholders are a) taking a salary from the business and b) will be leaving at the time the deal is done and c) do not need replacing within the business, it is frequently valid to add back their salaries (or part of their salaries) and other employment costs. Equally, if the shareholders normally take their income as dividends and new management will need to be recruited to replace them (with a salary) then the EBITDA would need to be reduced to reflect that additional expense (since dividends do not impact the Profit and Loss account and the costs of their labours is not therefore reflected in the EBITDA number).
To illustrate this for a car repair business generating operating profit of £400,000; Adjusted EBITDA could look something like this:
Operating Profit £ 400,000 Plus Depreciation £ 80,000 Less regular CapEX £ (50,000) Plus Shareholder Salaries £ 200,000 Less cost of replacement MD £ (150,000) Less costs of one-off rebranding £ 45,000
Adjusted EBITDA £ 525,000
Or, it could look something like this:
Operating Profit £400,000 Plus Depreciation £ 80,000 Less regular CapEx £(100,000) Less cost of replacement MD £(150,000) (shareholders draw dividends) Plus costs of one-off rebranding £ 45,000
Adjusted EBITDA £ 275,000
Hopefully this illustrates that understanding how a buyer would/should adjust your profit to reflect the underlying income stream is fundamental to valuation. It also illustrates how reported profit is not necessarily a clear indicator of EBITDA in a deal context.
Multiple
This is the black art of M&A. When a deal multiple is apparently available in the public domain, it is usually derived from a published price paid which has then been compared to the published operating profit (in the last audited accounts and sometimes just to the increase in retained profit since that is all that is available in abbreviated accounts).
As you will see from the above examples of adjusted EBITDA, in practice it is impossible to know (unless you were party to the deal) what adjustments to profit had been made and, indeed, what profit had been used to define the price (it could be historic profit, future profit, last twelve months profit, average of last three years profit….). Suffice it to say that a published/inferred multiple is usually higher than the multiple the buyer actually paid.
I always think it helpful to think about what a multiple actually is. Whatever multiple a buyer pays for your business, they have to trade at its current level of profitability for that number of years before they start to generate any payback. So if your business is consistently generating EBITDA of £275,000 (as per the above example), and your buyer pays you a multiple of 4 (ie £1.1m) then for the first four years they hold the business they are simply recovering what they have paid; they generate no value from it until year 5 (and even that doesn’t take into account the effect of inflation/”the time value of money”).
Fortunately, there are factors that influence the logic for a transaction, meaning that this payback equation is less stark. For example 1) your business might be growing rapidly such that the profit in years 2 onwards will be growing and the pay back period is materially reduced, and/or 2) The acquiring business might be able to generate greater profitability off your revenue base, and/or 3) The acquirer might trade at/expect to sell at a much higher multiple themselves which means that your profit is immediately value accretive to them. These factors will normally be in play where a high multiple is paid.
Some practical parameters for SME deals are:
Double digit multiples are very unusual in the lower mid-market other than for very high growth/recurring revenue businesses
Scale drives value, so the smaller a business is, the relatively lower its multiple is likely to be. This is because a) larger businesses are more resilient and b) in value terms a large deal is more likely to “move the value dial” for the buyer than a small one.
Static or low growth (sub 10% per annum) businesses will not command a high multiple since the payback period is inherently longer for the buyer
Overdependence on one or two customers (“customer concentration”) significantly increases the risk to a buyer of making an acquisition and it will affect the multiple they will pay. If that major customer decides to take their business away, the buyer will almost certainly have overpaid.
There are costs involved in doing a deal (legal, accounting and due diligence) which may be factored into the overall price which a buyer is willing to pay. If the business costs £1.1m, but the buyer has to spend £150,000 on irrecoverable acquisition costs, then it has actually cost them £1.25m to do the deal.
There is no “right” multiple to be paid for any business. Judging a fair one is subjective and based on a combination of strategic fit, assessment of risk, evaluation of competition for the business and where the wider market sentiment sits. A mistake that is often made is to reference deals that happened two or three years ago when (for example) interest rates were lower, the economy was growing and a specific market was in a consolidation phase. Multiples don’t happen in a vacuum.
All of that said, the majority of transactions in the lower mid-market are closed on the basis of a multiple of between 3 and 7 of historic adjusted EBITDA. At the lower end of the range are sub £1m EBITDA, static or slow growing businesses with some dependency on their exiting shareholders and potentially some customer concentration risk. At the top end of that range will be £1m+ EBITDA businesses that are growing at a rate of 10% pa plus, offer strong additional growth opportunities, have a good management team and a well spread customer book. As with anything inherently subjective, however, there will be an exception to every rule !
Taking the example above therefore, our £275K of adjusted EBITDA at a multiple of 4x looks about right. If there is a strong strategic fit then it might push to 5X but a business of that scale would be unlikely to get a much higher multiple than that.
Debt Free/Cash Free
Here lies another elephant trap for the unwary vendor. It is conventional that the vendor will settle any debts that the business has as part of the transaction. This doesn’t include trade creditors which are part of the working capital cycle, but it does include bank debt, directors loan accounts and corporation tax liabilities up to the date of completion.
Equally it is also convention that any cash within the business that is not required to trade the business in the normal course is paid to the vendors at completion along with the purchase price. Defining the amount that should be held back in the business to cover a normal working capital cycle is more of an art than a science and usually the subject of debate. Complexities (areas for argument) can include the treatment of deferred income (ie amounts paid in advance by customers), seasonality and exchange rates.
This debt free/cash free position is a very sensible thing for a potential vendor to get their head around before they engage in active discussions with a potential acquirer since the calculations can make a material difference to what is actually received.
Taking our Automotive Repair Business. In one scenario, the ultimate amount paid to the shareholders might look like this:
Enterprise Value £1.1m
Less Corporation Tax due (to completion) £ 50K Less Bank Loan £ 250K Less Directors Loan Account £ 75K
Equity Value after Debt/Cash adjustments £ 725K
But in another scenario, it might look like this:
Enterprise Value £1.1m
Less Corporation Tax Due (to completion) £ 50K Add Free cash in the business £ 250K
Equity Value after Debt/Cash adjustments £1.4m
From these illustrations it is clear that the amount paid over to the vendor can vary considerably depending on the internal funding structure of the business.
Conclusion
While I have laid out some principles and parameters which are sensible in considering the potential valuation considerations for an SME, the reality is that for some small businesses retirement through exit to an acquirer will be challenging to achieve. There is always risk in making an acquisition and some businesses are just too small, messy or lacking in distinct value drivers to secure buyer attention. If approached by a buyer, a vendor should be realistic in evaluating/pricing in synergies, and cautious in the application of published market multiples. Acquisition pricing should be rational and logical and a smart vendor can apply the same rules to gauge their likely value to a particular buyer and establish sensible parameters for negotiation. There is also no reason why a valuation should be higher if the potential acquirer approached you “cold”. The parameters will remain the same, regardless of how the conversation came about. As with anything deal related, the key to a successful outcome is to anticipate and prepare.
I was recently asked by a client to point them in the direction of some sensible valuation advice for the kind of smaller, founder-run businesses that they are targeting as potential acquisitions.
They felt that there was a gulf between what the would-be vendors of these businesses felt they were worth and what anyone was likely to pay for them, and were looking to point their acquisition targets in the direction of some objective guidance that would (hopefully) help them form a realistic view of value.
Having now searched the internet myself for appropriate SME valuation advice, I am surprised at the lack of useful sources out there. Generic content covers the various valuation methods, but with little of use in terms of identifying which to use and what metrics to apply.
Conventional wisdom is that one should look for a precedent deal in one’s own sector as an indicator of value, but for multiple reasons (which I will explain below), such data is difficult to find and practically impossible to meaningfully interpret.
The reality is, of course, that a business is worth what someone is prepared to pay for it. But establishing what someone might be prepared to pay for it before attempting to find a buyer, is a sensible first step to determining whether you are willing to accept what you are likely to get. It would be frustrating, expensive and time-consuming research to go to market just to establish that what you want/need for your business is not going to be achievable.
So, here is some guidance, practically focussed, and designed to be of relevance to businesses at the smaller end of the market where there is very little reliable precedent and a greater than average risk of input from “friends down the pub” with a strong view, rose coloured lenses and, sometimes, a personal agenda.
The first thing to say is that what follows is aimed at the majority of trading, asset-light, profitable businesses. The valuation method and metrics require these characteristics. For businesses that are pre-profit, loss-making or have a very significant fixed asset base, the approach below will require adaptation, and I don’t propose to cover that here.
I will concentrate my attention on a standard Enterprise/Equity valuation approach which is normal mid-market practice. Valuations are typically based on a standard valuation equation which splits into two parts as follows.
Adjusted EBITDA x multiple = Enterprise Value
Enterprise Value + Free Cash – Debt = Equity Value
It is Equity Value that denotes the sum that the vendor shareholders will ultimately receive (before tax and fees).
Taking those terms in turn;
Adjusted EBITDA
EBITDA (Earnings before interest, tax, depreciation and amortisation). This figure is intended to equate to the operating cash generation of the business, which is why it is usually adjusted for non-cash items like depreciation and amortisation. EBITDA is the right measure for most trading businesses but if there is a need in the business for regular maintenance expenditure to keep a fixed asset base in good condition then the equation would have to be negatively adjusted to reflect an annual capex amount. This would equally apply to software development costs which are being capitalised and amortised rather than fully expensed; the important thing is the net cash generation from trading.
The equation refers to “Adjusted” EBITDA because the figure should equate to the operating cash figure that an acquirer will benefit from post completion. This means that any one-off or exceptional items that impact operating profit should be added back to profit (eg one-off restructuring costs, a new computer system etc) since a buyer will not have to incur that expense again. Likewise, If the exiting shareholders are a) taking a salary from the business and b) will be leaving at the time the deal is done and c) do not need replacing within the business, it is frequently valid to add back their salaries (or part of their salaries) and other employment costs. Equally, if the shareholders normally take their income as dividends and new management will need to be recruited to replace them (with a salary) then the EBITDA would need to be reduced to reflect that additional expense (since dividends do not impact the Profit and Loss account and the costs of their labours is not therefore reflected in the EBITDA number).
To illustrate this for a car repair business generating operating profit of £400,000; Adjusted EBITDA could look something like this:
Operating Profit £ 400,000 Plus Depreciation £ 80,000 Less regular CapEX £ (50,000) Plus Shareholder Salaries £ 200,000 Less cost of replacement MD £ (150,000) Less costs of one-off rebranding £ 45,000
Adjusted EBITDA £ 525,000
Or, it could look something like this:
Operating Profit £400,000 Plus Depreciation £ 80,000 Less regular CapEx £(100,000) Less cost of replacement MD £(150,000) (shareholders draw dividends) Plus costs of one-off rebranding £ 45,000
Adjusted EBITDA £ 275,000
Hopefully this illustrates that understanding how a buyer would/should adjust your profit to reflect the underlying income stream is fundamental to valuation. It also illustrates how reported profit is not necessarily a clear indicator of EBITDA in a deal context.
Multiple
This is the black art of M&A. When a deal multiple is apparently available in the public domain, it is usually derived from a published price paid which has then been compared to the published operating profit (in the last audited accounts and sometimes just to the increase in retained profit since that is all that is available in abbreviated accounts).
As you will see from the above examples of adjusted EBITDA, in practice it is impossible to know (unless you were party to the deal) what adjustments to profit had been made and, indeed, what profit had been used to define the price (it could be historic profit, future profit, last twelve months profit, average of last three years profit….). Suffice it to say that a published/inferred multiple is usually higher than the multiple the buyer actually paid.
I always think it helpful to think about what a multiple actually is. Whatever multiple a buyer pays for your business, they have to trade at its current level of profitability for that number of years before they start to generate any payback. So if your business is consistently generating EBITDA of £275,000 (as per the above example), and your buyer pays you a multiple of 4 (ie £1.1m) then for the first four years they hold the business they are simply recovering what they have paid; they generate no value from it until year 5 (and even that doesn’t take into account the effect of inflation/”the time value of money”).
Fortunately, there are factors that influence the logic for a transaction, meaning that this payback equation is less stark. For example 1) your business might be growing rapidly such that the profit in years 2 onwards will be growing and the pay back period is materially reduced, and/or 2) The acquiring business might be able to generate greater profitability off your revenue base, and/or 3) The acquirer might trade at/expect to sell at a much higher multiple themselves which means that your profit is immediately value accretive to them. These factors will normally be in play where a high multiple is paid.
Some practical parameters for SME deals are:
Double digit multiples are very unusual in the lower mid-market other than for very high growth/recurring revenue businesses
Scale drives value, so the smaller a business is, the relatively lower its multiple is likely to be. This is because a) larger businesses are more resilient and b) in value terms a large deal is more likely to “move the value dial” for the buyer than a small one.
Static or low growth (sub 10% per annum) businesses will not command a high multiple since the payback period is inherently longer for the buyer
Overdependence on one or two customers (“customer concentration”) significantly increases the risk to a buyer of making an acquisition and it will affect the multiple they will pay. If that major customer decides to take their business away, the buyer will almost certainly have overpaid.
There are costs involved in doing a deal (legal, accounting and due diligence) which may be factored into the overall price which a buyer is willing to pay. If the business costs £1.1m, but the buyer has to spend £150,000 on irrecoverable acquisition costs, then it has actually cost them £1.25m to do the deal.
There is no “right” multiple to be paid for any business. Judging a fair one is subjective and based on a combination of strategic fit, assessment of risk, evaluation of competition for the business and where the wider market sentiment sits. A mistake that is often made is to reference deals that happened two or three years ago when (for example) interest rates were lower, the economy was growing and a specific market was in a consolidation phase. Multiples don’t happen in a vacuum.
All of that said, the majority of transactions in the lower mid-market are closed on the basis of a multiple of between 3 and 7 of historic adjusted EBITDA. At the lower end of the range are sub £1m EBITDA, static or slow growing businesses with some dependency on their exiting shareholders and potentially some customer concentration risk. At the top end of that range will be £1m+ EBITDA businesses that are growing at a rate of 10% pa plus, offer strong additional growth opportunities, have a good management team and a well spread customer book. As with anything inherently subjective, however, there will be an exception to every rule !
Taking the example above therefore, our £275K of adjusted EBITDA at a multiple of 4x looks about right. If there is a strong strategic fit then it might push to 5X but a business of that scale would be unlikely to get a much higher multiple than that.
Debt Free/Cash Free
Here lies another elephant trap for the unwary vendor. It is conventional that the vendor will settle any debts that the business has as part of the transaction. This doesn’t include trade creditors which are part of the working capital cycle, but it does include bank debt, directors loan accounts and corporation tax liabilities up to the date of completion.
Equally it is also convention that any cash within the business that is not required to trade the business in the normal course is paid to the vendors at completion along with the purchase price. Defining the amount that should be held back in the business to cover a normal working capital cycle is more of an art than a science and usually the subject of debate. Complexities (areas for argument) can include the treatment of deferred income (ie amounts paid in advance by customers), seasonality and exchange rates.
This debt free/cash free position is a very sensible thing for a potential vendor to get their head around before they engage in active discussions with a potential acquirer since the calculations can make a material difference to what is actually received.
Taking our Automotive Repair Business. In one scenario, the ultimate amount paid to the shareholders might look like this:
Enterprise Value £1.1m
Less Corporation Tax due (to completion) £ 50K Less Bank Loan £ 250K Less Directors Loan Account £ 75K
Equity Value after Debt/Cash adjustments £ 725K
But in another scenario, it might look like this:
Enterprise Value £1.1m
Less Corporation Tax Due (to completion) £ 50K Add Free cash in the business £ 250K
Equity Value after Debt/Cash adjustments £1.4m
From these illustrations it is clear that the amount paid over to the vendor can vary considerably depending on the internal funding structure of the business.
Conclusion
While I have laid out some principles and parameters which are sensible in considering the potential valuation considerations for an SME, the reality is that for some small businesses retirement through exit to an acquirer will be challenging to achieve. There is always risk in making an acquisition and some businesses are just too small, messy or lacking in distinct value drivers to secure buyer attention. If approached by a buyer, a vendor should be realistic in evaluating/pricing in synergies, and cautious in the application of published market multiples. Acquisition pricing should be rational and logical and a smart vendor can apply the same rules to gauge their likely value to a particular buyer and establish sensible parameters for negotiation. There is also no reason why a valuation should be higher if the potential acquirer approached you “cold”. The parameters will remain the same, regardless of how the conversation came about. As with anything deal related, the key to a successful outcome is to anticipate and prepare.
As a business owner about to begin the process of selling your business, it is important to consider how the process itself is likely to impact the business and the people working in it.
As a rule, it is unwise to share with the wider business that you are planning to sell it. Knowledge that something is likely to happen, without knowing what that something is, will inevitably create uncertainty and will distract people from getting on with their work at a time when you really want them to be focused on “business as usual”.
Vendors often find this secrecy uncomfortable. Frequently they will have employees who are not only longstanding colleagues but also friends and it feels as if they are being advised to lie to those friends. The reality is that those colleagues and friends will only worry about the process outcome if they are aware of what is going on and until it is clear what deal will happen and what the plans for the future of the business are going be, there is nothing constructive that you can say to them.
Despite this general advice to keep quiet about the process, you will almost certainly need to bring certain individuals into your confidence to help you meet its requirements. Usually, your most senior finance person will need to be heavily involved even in the preparation stage, providing information to your advisers, helping to populate a virtual data room and supporting the preparation of a financial model that will underpin financial due diligence and help define the bidding EBITDA figure.
If you are planning to offer the business to private equity as well as trade bidders then if you are to achieve an exit and not be locked in, you will need to field a management team who can run the business in your absence and with the ambition to want to grow it and to lock into an equity position. For many founders, this is a key challenge which needs to be planned for well in advance. Though it is perfectly possible to run a “trade only” exit process, private equity buyers widen the field and frequently offer more than trade.
If management are to be actively involved in the process, then they will need to spend time understanding the implications of private equity ownership, to ensure that they can respond effectively to questions about all aspects of the business. As above, this can take their eyes off the “business as usual” ball with unhelpful consequences.
While it is entirely possible to run a process so that most people in the business are unaware of any potential change, there are key people who will need to invest time in preparing for an engaging with the process. Since this needs to happen without any negative impact on the business itself, it requires thought and pre-planning to get right. One thing potential vendors often consider, is rewarding their management teams and key member of their finance and admin support with some kind of exit bonus. It can significantly soften the blow of the additional burden of work that the process itself entails. Equally, with long term planning, many vendors will put shares in the hands of key members of the team through share option schemes, giving them some value to “roll” into a private equity deal or the opportunity to cash something out in a trade deal. Again, this better aligns their interests with yours and makes the extra work they will have to do worthwhile.
As a business owner about to begin the process of selling your business, it is important to consider how the process itself is likely to impact the business and the people working in it.
As a rule, it is unwise to share with the wider business that you are planning to sell it. Knowledge that something is likely to happen, without knowing what that something is, will inevitably create uncertainty and will distract people from getting on with their work at a time when you really want them to be focused on “business as usual”.
Vendors often find this secrecy uncomfortable. Frequently they will have employees who are not only longstanding colleagues but also friends and it feels as if they are being advised to lie to those friends. The reality is that those colleagues and friends will only worry about the process outcome if they are aware of what is going on and until it is clear what deal will happen and what the plans for the future of the business are going be, there is nothing constructive that you can say to them.
Despite this general advice to keep quiet about the process, you will almost certainly need to bring certain individuals into your confidence to help you meet its requirements. Usually, your most senior finance person will need to be heavily involved even in the preparation stage, providing information to your advisers, helping to populate a virtual data room and supporting the preparation of a financial model that will underpin financial due diligence and help define the bidding EBITDA figure.
If you are planning to offer the business to private equity as well as trade bidders then if you are to achieve an exit and not be locked in, you will need to field a management team who can run the business in your absence and with the ambition to want to grow it and to lock into an equity position. For many founders, this is a key challenge which needs to be planned for well in advance. Though it is perfectly possible to run a “trade only” exit process, private equity buyers widen the field and frequently offer more than trade.
If management are to be actively involved in the process, then they will need to spend time understanding the implications of private equity ownership, to ensure that they can respond effectively to questions about all aspects of the business. As above, this can take their eyes off the “business as usual” ball with unhelpful consequences.
While it is entirely possible to run a process so that most people in the business are unaware of any potential change, there are key people who will need to invest time in preparing for an engaging with the process. Since this needs to happen without any negative impact on the business itself, it requires thought and pre-planning to get right. One thing potential vendors often consider, is rewarding their management teams and key member of their finance and admin support with some kind of exit bonus. It can significantly soften the blow of the additional burden of work that the process itself entails. Equally, with long term planning, many vendors will put shares in the hands of key members of the team through share option schemes, giving them some value to “roll” into a private equity deal or the opportunity to cash something out in a trade deal. Again, this better aligns their interests with yours and makes the extra work they will have to do worthwhile.
