Growth Through Acquisition: How Should You Value an Acquisition?*
February 24, 2021 •Oak Street Funding
If you are interested in growth through acquisition, there are many steps you must take when performing due diligence before making an acquisition. These steps include making sure the timing and the opportunity are right, seeking advice, and understanding the dynamics of the business you want to buy. Client and staff satisfaction, marketing, and technology must also fit into the equation. However, when it is time to sign on the dotted line, be sure to conduct a thorough valuation of the business you are acquiring.
Finding the value
When acquiring a new business, accurate business valuation is critical. Of course, finding an accurate valuation involves both some art and some science. This blog looks at the science, as the art can be found in our Acquisition growth: The benefits and the challenges of growth by acquiring another company blog. Several formal models are in wide use, so it becomes a matter of choosing the one that’s right for you.
An inherent challenge in comparing private companies’ valuations is there may be variations in their accounting statements. Additionally, it’s not unusual for smaller businesses to include personal expenses and owner salaries within business expenses. It’s important to remember that any value calculation is based on multiple assumptions and estimates.
Professional appraisers generally use some combination of approaches that focus on market multiples of revenue, assets under management, and cash flow. Of the three methods, discounted cash flow (DCF) may be the most common. DCF is based on projections of future cash flows that are discounted to reflect the impacts of inflation using the company's weighted average cost of capital. Discounted cash flow is a more detailed approach that requires more preparation, but any extra work typically results in more accurate valuations. Other valuation models include:
- Times Revenue, where current revenues are multiplied by a factor reflecting the industry's current norms.
- Earnings Multiplier, which views profits as a more reliable indicator than earnings, adjusting future profits against the likely return if cash flow were instead invested over the same period.
- Book Value, using the owner’s equity as reflected by the current balance sheet.
- Liquidation Value, estimating the cash the business would receive if it were liquidated.
- Comparable Company Analysis, which compares the business value with those of similar businesses using common ratios.
- Precedent Transactions Analysis, which looks at the business through the lens of recent transactions involving similar companies.
Why EBITDA multipliers are a preferred valuation method
The most common factor in determining valuations involves what’s known as EBITDA, or earnings before interest, taxes, depreciation, and amortization. To calculate your prospective acquisition’s adjusted EBITDA, add together net profit, interest on debt, income tax paid, depreciation and amortization, nonrecurring expenses, and owners’ salaries and benefits. Then, adjust for projected expenses such as rent, employee compensation, and the cost of replacing the owner(s) as the managers of the business. Business advisors and potential buyers will often use a multiple of EBITDA valuation to arrive at the price they’re willing to pay.
One common use of EBITDA is determining what’s known as a company’s enterprise value (EV) multiple, which is an effective way to bring debt into the calculation. The EV of a business represents the total of its market capitalization, the value of debt, minority interest, and preferred shares subtracted from cash and cash equivalents.
Dividing the EV by EBITDA delivers what many feel is a more accurate valuation. That's because EBITDA accounts for differences in how businesses structure capital, account for fixed assets, and handle taxes. EV also addresses differences in how capital is structured, so it can provide a normalized ratio that makes it easier to compare different companies.
There are many risks to consider when determining how to value an acquisition. Some common risk factors you might want to consider include:
- Declining revenue or earnings
- Revenue concentrated in a few sectors, producers, or clients
- Revenue concentrated with low-fee assets or substandard markets
- Low client retention or renewal fee base
- Employee issues
- High loss ratios
- Poor recordkeeping
Profitability and performance
Another critical factor in assessing a business’s value to a buyer is its profitability and performance compared to that of its peers.
Some business owners fail to differentiate between their company’s profits and the salaries they receive, making it challenging to estimate profits accurately. In such cases, valuation experts may prefer to use Earnings Before Owner’s Compensation to focus on what the business actually earns. Then, by subtracting what it would cost in salary to replace the present owner’s role, it’s easier to determine the actual profit margin and free cash flow.
Debt service coverage ratio
A key measure of a business’s health is what’s known as the debt service coverage ratio (DSCR). A company’s DSCR measures how well it can meet its current debt obligations given its available cash flow. Those debt obligations include any short-term debt and the current portion of long-term debt, including interest and principal payments, sinking fund, and lease payments due in the coming year.
Typically, DSCR is calculated by dividing net operating income by total debt service. If a business has $500,000 in net operating income and current debt service of $375,000, the DSCR is approximately 1.33. What’s seen as high-quality DSCR depends on many factors, including the industry and the company’s stage of growth. Higher DSCRs indicate substantial financial resources. Generally speaking, lenders see DSCRs over 1.25 as strong and assume that companies whose DSCR is below 1.00 are experiencing negative cash flow and may be unable to meet their current obligations. When comparing DSCRs from multiple companies, it’s essential to use consistent criteria.
The critical transition
The work doesn’t end once the papers have been signed. The transition between owners is full of make-or-break moments involving clients and employees. Even though your business and the company you’ve purchased are both established, in effect, you’re creating a whole new set of first impressions.
Employees want to know their jobs are secure and do not face significant changes in the work environment. The more time you devote to getting to know them and sharing your plans, the less uncertainty they’ll face. That’s important because their moods and statements will significantly affect what the clients think of you, the new owner.
Overall, clients want to be assured that their service will not suffer any disruptions and that the acquisition won’t create any stress for them. If the employees are well-liked, clients will also want to be reassured that they’ll deal with the same friendly faces. Focus on getting to know existing clients and reassuring them that they won’t notice any bumps during the transition. And, again, happy employees will have a tremendous influence on client satisfaction.
If you’re combining office staffs, give everyone a chance to get to know each other outside of the work environment. Simple, informal events such as cookouts and potluck dinners can provide the opportunity for comfortable conversations. If you have multiple locations, give employees the time to visit the other offices and get to know each other. That way, the best elements of both businesses’ cultures will combine. And, depending on the state of the pandemic, you can always use Zoom for fun and unique social gatherings.
The Importance of Valuation in Growth through Acquisition
Growing your business through an acquisition can be exciting. It is also a critical time to focus on valuation and not get caught up in the emotions that might drive the process. If you are considering growth as an acquisition strategy and don’t know exactly where to begin, please feel free to contact us. At Oak Street Funding, we have experts in lending who have helped hundreds of clients make their acquisition goals a reality.
Disclaimer: Please note, Oak Street Funding does not provide legal or tax advice. This blog is for informational purposes only. It is not a statement of fact or recommendation, does not constitute an offer for a loan, professional or legal or tax advice or legal opinion and should not be used as a substitute for obtaining valuation services or professional, legal or tax advice.