The crux of multiples continued — One company, many multiples
March 14, 2018
By Martha Sullivan, CPA, CVA/ABV, CM&AA, CEPA
Partner, Succession Planning Practice Leader
Martha leads HK’s succession and exit planning services division and is a regular contributor to Wisconsin’s InBusiness digital magazine.
In our last blog post, “The crux of multiples in business valuation,” we discussed how the multiples used to value a company fundamentally represent the buyer’s view of the business’ risk profile. It’s easy to get caught up in what the multiple is. Was it a “3” or a “5”? If that company got that, then my company should get this. This approach fails to ask the most important question — “Why that multiple?”
Multiples tell a lot about the state of the company. They represent the potential opportunities and threats a given investor believes they face in getting their desired return on investment.
The previous blog post illustrated how the multiples for two seemingly identical businesses could be drastically different. In today’s discussion, I want to talk through how a single company may be offered wildly different multiples. Now, if the multiple is a proxy for a company’s risk and opportunity profile, and you’re only looking at one company, why would they be different? After all, it’s the same company!
It boils down to what type of buyer is involved and their unique circumstances.
Types of buyers
There are three primary categories of buyers: strategic, financial, and inside parties.
Strategic buyers see a market or operational advantage to adding the company to their existing business. They seek synergies across markets, product lines, customers, and cost structures. They are industry players or companies that want to move into an industry. Strategic buyers tend to pay more because they perceive greater upside through these synergies.
Financial buyers are those that are first and foremost investors. They generally do not want to operate the business, although they may strongly influence its management and operational decisions. Private equity groups, family, offices, angel investors, and venture capital funds are common examples. Financial buyers, particularly private equity groups, will offer competitive multiples. Nonetheless, financial-buyer multiples are generally lower than a strategic buyer since they will not achieve the synergies.
Inside parties are those buyers that are known to the seller — family, management, or employee groups. There is a personal connection compelling the seller to transition their company to this buyer. Prices are frequently lower or discounted for inside parties so it’s affordable while still achieving the owner’s personal priorities.
There are many factors within any given type of buyer group that influence their proposed multiple, including:
- Deal structure and financing;
- Return on investment targets;
- Risk tolerance; or
- Potential synergies.
Consider three different buyers looking at a technology company. The private equity firms both have the same size fund and hold investments in the industry. The strategic buyer is also in the industry. The technology offered is cutting edge. The target’s existing management team is in place and runs the company operationally, but is still developing its long-term strategic skills. The VP of Sales and VP of R&D are on the fence about whether they want to sell and be owned by someone else.
These buyers would offer very different multiples:
Deployment of invested dollars (Private-equity only)
- Group A has dollars it must deploy on behalf of its investors. It wants a platform company that it can later add complementary investments around.
- Group B is already almost fully deployed and this would be a “bolt on.” They do not “need” the investment as much as Fund A.
- The proportion of debt to equity in a deal determines the buyer’s ultimate cost of capital.
- Group A has access to 75% of its total fund value. Group B only has 20% remaining. Depending on the size and structure of the deal, Group B may need to finance a bigger proportion of the purchase than Fund A, adding to their cost of the deal.
- Every buyer has a different required rate of return. This drives what is an acceptable deal structure and the purchase price/multiple paid.
- Group A eats risk for breakfast. They’re serial entrepreneurs and industry players. They’ll accept more risk than the other group.
- Group B’s principals have limited operational experience. They’re finance guys. While the existing platform company could provide guidance and management bandwidth, there are interpersonal dynamics that are waving red flags.
- The strategic buyer is large enough to roll the dice. If the deal goes sideways, it won’t cause significant harm. However, if it goes well, it will provide a substantial competitive advantage. They need to “get this one.”
- Synergies are a critical consideration in an acquisition. The more synergies a buyer believes they can achieve, the higher the multiple that may be offered.
- Group B and the strategic buyer anticipate immediate synergies from the acquisition. Group A does not, at least not at this stage in their fund. Accordingly, Group B and the strategic buyer may be willing to pay more than Group A.
There is a lot to digest here and this is just scratching the surface. Any given buyer brings his or her own unique view to the deal. How much risk are they willing to take on? How does it fit strategically? What pressures are placed on the required rate of return? To fully understand a proposed multiple, you would have to understand the buyer’s point of view and the underlying motivations. This alone is a reason for sellers to do due diligence on the buyer!
If you’re a business owner, there are many ways to create value in your company. It’s critical to do so. You will benefit now and ultimately when you (or your family) harvest the business. (The next blog will do a deeper dive into value drivers.) You also need to keep in mind that each potential buyer is looking at your company through their own set of lenses and view of how it fits into their world. These two elements — what you’ve done to create value and what they hope to achieve — combine to form the crux of multiples.