Podcast M&A

Colonnade Advisors is a middle market investment bank that focuses on mergers and acquisitions (M&A). In this podcast, they discuss the valuation of companies in M&A deals. They explain three main valuation methodologies: comparable company trading valuations, comparable transaction valuations, and discounted cash flow valuations. They also emphasize the importance of market dynamics and competition in determining the final price of a company. The podcast concludes by discussing the use of multiples in valuations, specifically revenue multiples for pre-profitability companies and recurring revenue businesses, and EBITDA multiples for earnings-based valuations. Welcome to the Middle Market Mergers and Acquisitions podcast by Colonnade Advisors. Colonnade is a middle market investment bank, and we've completed over $8 billion in transactions. We are here to dissect the M&A process, discussing the technical aspects and tactics used in Middle Market Mergers and Acquisitions. Today, we'll be discussing how companies are valued. I'm Gina Kochek, and I'm here with my partner, Jeff Skylar. Today, we're going to discuss one of my favorite topics, valuation. Valuation is a big part of what we do, figuring out what a company is worth. There are a couple of different methodologies that are used in valuation, really high level. There's the comparable company trading valuations. There are comparable transaction valuations, and then there are the more complex discounted cash flow valuations. There are also some other types of valuations that aren't really relevant to what we do on a day-to-day basis for specific situations, so we're really going to talk about those three. But first, let me preface it and say that these are all theoretical. As you mentioned, we do a lot of valuation work for our clients. It's often ahead of going to market. Many times, it's ahead of us doing due diligence. It's based on the data we have, and we'll talk about some of that later on in the show and the adjustments we can make that we find in due diligence for the benefit of our clients. Ultimately, it's the market that sets the price. The real value of hiring a financial advisor to help you sell your business is that you want to get the best price in terms. Generally, that's achieved through some sort of auction process, whether it's with one company or many, to get true price discovery. The analytical tools that we deploy at various points throughout our engagement and even in marketing are helpful in getting a ballpark of where valuation may settle out in a transaction. That helps inform our clients' views on, first off, whether they should go to market or not. If they think their company is worth $100 and we think the market is going to give them $50, there's no point in any of us wasting any time. But if we're in the ballpark of what might be a good transaction or a good outcome for the seller, then that's the basis on which we proceed. We can talk about, we may have touched on in other episodes, how we might update these valuation analyses for our clients at various points throughout the process and do a gut check on whether we're ready to go to market or not and whether we're going to get the valuation that we're seeking. The three methodologies, first is comparable company valuations. This is a look at what the market has offered up to companies that are comparable to our client. If our client makes widgets and another widget company down the street that has a very similar profile in terms of size and scale and distribution and management, et cetera, and all the things we talked about that make up a good business to be sold, then you could logically apply the same multiple that that first company transacted for to the second company. If the first company sold it eight times EBTA, it's logical to assume that another company that's very similar or comparable would trade it eight times EBTA. Now, of course, as we'll get into in more detail here later, that multiple has to get applied to the right figure. The multiple, whether it's higher or lower, will depend on all sorts of attributes of the specific target that we're talking about, whether it's growing faster or slower, whether the management team is better or worse, whether there's client concentration, geographic concentration, all sorts of things going to influence the multiple that a buyer is willing to pay, not the least of which is the competition in a transaction. We've seen a lot of deals where the seller says, gosh, I got eight times here, and we look at them and say, well, that's great. You probably could have gotten 10 or 12 if you had run a competitive process because all the other comparables are trading in that range. Competition, as we said, is key. The comparable trading valuation metrics we use are a little more theoretical for the middle market that we operate in, but that's a look at where the public companies that are comparable in nature are trading in the public markets. You can look at any stock price today and say, well, that company is comparable to what I do. They're probably a lot larger than I am, but they traded, let's say, nine times earnings. I would logically think that I could trade at nine times earnings as well. That's a helpful metric, and it's something we certainly use in negotiations with buyers when we're looking at these companies, but there are all sorts of factors, not the least of which is size and liquidity of those shares that drive that multiple relative to what you might expect to achieve in the market. Also, just general macro factors. We're in a time where the stock market is like a roller coaster. Today, the market might be up 500 points, and tomorrow it's down 300 points. Well, that's going to impact valuation of those public companies. You don't see the same day-to-day volatility in a transaction, so those comparable company valuations are good to kind of get an idea of what the valuation is for a company, and as you said, for a middle market company, it's less relevant because there's a larger size differential. And there's certainly market volatility in publicly traded stocks, and that does translate into big picture valuation, as you mentioned, for middle market companies. So if you look at the history of public comparables, and they're trading in the seven to seven and a half times range, and then all of a sudden we get some sort of event like COVID or something else, and that peer group starts trading at six to six and a half times, you might expect your valuation as a middle market company to come down at least a full point, if not more. So publicly traded comparables are helpful as a guide, more as a bench post than anything else, but they're helpful in terms of sizing up valuation. The third bucket is really a little more of the theoretical bucket, so discounted cash flow valuations are the most interesting, most commonly used among valuation firms and others. Discounted analysis are also used, particularly for publicly traded stocks, but also for high cash flow businesses. These really depend on hundreds, sometimes variables that are baked into the forecast. So quite simply, the discounted cash flow analysis is a look at the future cash flows of the company based on historical performance, similar to the financial models that we would help our clients create as part of the package that we present to buyers. But then it's running an analysis of what are the free cash flows of these businesses, and if I discount those back at a certain discount rate, what is the net present value of all those cash flows? The biggest drivers of this analysis include what's the discount rate? Is it five? Is it 10? Is it 15? Is it some really precise number using the CAPM model that my University of Chicago partner would make me use? There we go. Thank you. I would just say 10%. So you have to do this mathematical gyration to figure out what the appropriate discount rate is. You have to figure out what the terminal value is. What are all these cash flows worth in perpetuity? You have to think about what the forecast is going to be. We've talked a lot in our previous forecasts about how do you develop the right forecast? Do you want to be a little aggressive in a sales model? Do you want to have a different viewpoint on a DCF analysis? What's the purpose of the evaluation? Is it to buy out a partner? Is it to sell your company? All these things factor into what are the growth rates? What are the margins over time? How do you expect to be unexpected in a DCF analysis? Anyway, my point here is we often do DCF analyses for our clients, but know that it is the most theoretical of the group. And most buyers will look at it really as an extra data point to make sure that they're not missing anything more than anything else. So most of our attention is focused on these multiples. Gina, tell me about how we think about multiples across industry situations, things like that. People frequently talk about multiples. The question always is a multiple of what? Is it a revenue multiple? Is it an EBITDA multiple? Is it an earnings multiple? What is the right underlying number? So let's kind of work from the top down on an income statement. Revenue. When is a revenue multiple used? Revenue multiples are used when a company is pre-profitability. Because if you take a multiple of a negative number, you're giving somebody money to take your company. So really, revenue is for a pre-profitability company. We often see it used in software companies, high-growth type businesses, biotech. And so you'll see the revenue multiples. The revenue multiples, they can range depending on the industry, anywhere from 2 to 20 times, 30 times, 40 times. And we'll get a little bit more into what are the right multiples. Revenue multiples are also used in recurring revenue companies. So if the value of certain companies, because they have relationships with their clients where it's recurring revenue, and there's a lot of effort up front to get the client, and the client stays for many, many years, and it's an automatically renewing contract, recurring revenue multiples are the right way to go. Also, we will see this, as I mentioned before, with software companies. Software tends to be higher margin type business. But there's a lot of up-front cost in landing that account and in developing the software. So a revenue multiple makes sense. Another income statement item that multiples are done off of are earnings. The one that is most frequently used is EBITDA. Earnings for interest, taxes, depreciation, and amortization. So why the acronym? Depreciation and amortization are not cash. They're a construct, an accounting construct. If you are looking at your company and you have your revenue and you have your expenses, you're not actually going to be able to see depreciation or amortization flow out of your bank account. So EBITDA is a proxy for cash flow. And it is a very common number to use. And it's a number on the income statement to use because it will normalize income between various companies. Let's say you have one company that is a standalone. The family has owned it for forever. And the other company is private equity owned. And when they bought it, they bought it at a premium. So there's amortization of goodwill on the books. And there's amortization of goodwill of $2 million a year. And they both have EBITDA, so earnings for interest, taxes, depreciation, and amortization of $5 million. But if you were to include that amortization, a private equity-backed company had EBIT of $3 million. It doesn't mean it's a worse company. It's just normalizing. There's so many different metrics that buyers and sellers can focus on. And it really is industry-specific. So some companies in a certain industry always trade on revenue. Some always trade on EBITDA. Some trade on EBIT. Some trade on adjustment of earnings, which we'll talk about in a second. But it's really important for you and your advisor to focus on what are the right metrics for my business for when I'm going to sell the company. And so that can be part of the preplanning process is to make sure that you're optimizing to the market what this metric is going to look like. The valuation is a metric times a multiple. People tend to get hung up on multiples. And they're like, well, that company sold for eight times, so I must be worth eight times. The question is, eight times what? You say, well, eight times EBITDA, so I must be worth $40 million. But the real question is multiple of eight times trailing EBITDA, meaning the last 12 months you've already earned. Eight times next year's EBITDA, forward EBITDA. Eight times pro forma, adjusted, annualized EBITDA. There are a lot of different ways to look at what the metric is. So there are different methods that are used in different industries. Some industries always use GAAP accounting on their metrics. Other industries use some sort of special accounting. For example, we do a lot of work in the automotive F&I industry. And there is an accounting methodology called modified cash. And that is what is standard in the industry. So when we say that company traded for eight times, it was eight times modified cash. In reality, it might be like 16 times GAAP, but it's a modified cash number. Then there are all of the add-backs and adjustments to EBITDA. You see some of it on revenue, but really on EBITDA. And add-backs can include personal expenses, severance, special legal expenses, projects that you've done, investment banking fees. Anything that's unusual and extraordinary, you can add back to your EBITDA to increase your EBITDA as if it never happened. Because a buyer wouldn't see that on a go-forward basis. That's the important point there. We're trying to get a sense and demonstrate what the earning stream of the company looks like going forward. So we have to look backwards and say, what has the earning stream been historically? What are the pure earnings of the business as if a new owner bought it? They can do whatever they want with it, of course. But what are the core earnings of the business? And from there, on that basis, we can make a projection about what the future looks like. And that's where the multiple comes in. We say, okay, well, if you've earned $5 million historically last year, I bet I can earn more than that. So I'm going to apply a multiple to your $5 million of core earnings. In addition to that, we see other, beyond the add-backs, there are adjustments and pro forma adjustments to the metrics. For example, if the company were to enter into a new arrangement with a vendor that dropped the expense with that vendor 5%, you can go out to market and say, I'm adjusting my historical EBITDA as if that 5% savings happened every year in the past. That's a pro forma adjustment. Or let's say you are operating at a higher efficiency level. You can adjust the numbers and go out to market with an adjusted EBITDA as if you always had that higher level of efficiency. Basically, we're saying the buyer, once again, is buying for this new state of the business. This is how it's going to operate going forward. So they should pay based on as if they operated that way in the past. Now, we're saying that you state the numbers like that. There's no guarantee here that you will get that number in your valuation. But by presenting it as such, you put yourself in a better position to get that higher valuation. And that's where some of the negotiation come in. Buyer may say, well, that's interesting. Looks like you're projecting 5% benefit from this contract. But the way I read it, I only see 2.5%, for instance. And it will depend. And if it's the first quarter of a newly revised contract and you want to get the transaction done today, then you're going to have to agree on what's a fair price based on this component. The alternative, of course, is to wait a full year and see what the full year of earnings pans out to be. And then you can pound your fist on the table and say, well, this is what happened. But then you're a year later. So the adjustments here can be significant and meaningful, and they can run up and down the P&L, and sometimes in the balance sheet, too. Sometimes we make adjustments all over the place that are important and are intended to reflect the true operating condition of the business going forward so that buyers and sellers can make informed decisions. If we figured out what are the ad backs, what are the adjustments, another big question we get is regarding synergies. The definition of a synergy is when a buyer buys a company, the two companies combined, instead of being 1 plus 1 equaling 2, 1 plus 1 equals 3. And that could be because of expense reduction. This is the most common. Does the buyer get paid on synergies? We get that question all the time. Every buyer says, I want to get paid on the synergies. Well, we strive to do that. And a competitive process will increase the likelihood that a seller will get paid for synergies. A buyer never wants to pay for synergies because a buyer will say, well, synergies wouldn't exist if I didn't buy you. So it's a balance that comes out through negotiation, and a competitive process always yields the best results. The next question, Gina, is, well, what's the right multiple? I've got all this analysis. I've figured out what the right metrics are. I've adjusted my earnings or my revenue or something in the P&L accordingly. I think I've got a handle on that. What's the right number? Well, a person may even go to Colonnade's website and to one of our blog entries. Every quarter, we do a blog about what the industry multiples are just across M&A in the United States. What are the average M&A EBITDA multiples that we're seeing? For example, Q3 is 10.5 times EBITDA. So a seller says, I want 10.5 times. You said 10.5 times. Well, the right multiple is situational. It depends on the company, the industry, the economy. If deals in the industry are currently going for 12 times, the last two deals you saw of your competitors were 12 times were paid. Should you get 12 times? Well, we're going to strive to get that. The competitive process will yield the highest price. But there are many factors that dictate what the right multiple is. How does your company compare to the competitors? Are you smaller? Are you larger? Do you have customer concentration? And I can't rally on this one enough. Customer concentration or any kind of distribution channel concentration will bring down valuation. And I call concentration anything greater than 15%. So do you have concentration where your competitors didn't? What is the depth of your management team? What is your client profile like? How have your numbers been trending? Meaning, are you having an incredible year this year, but you had two bad years prior to it? That could impact the multiple. What happened to you during the Great Recession? What happened to you during COVID compared to everybody else in your industry? What makes your company different? And then I have to revert to the process. All these things are critically important. Size, performance, future outlook, depth of management team. But another element of, again, as we beat this dead horse over and over is, what does the process look like? Are you doing a one-off negotiation with someone? Are you running a broad process amongst dozens of interested parties? The timing of the sale of the company, as you mentioned, Gina, depending on macro factors is important. We always like to go to a broader universe rather than a smaller one, just because priorities in the boardroom change frequently. We're not sitting in every boardroom every quarter, and so we don't have a crystal ball about what the priorities of all the buyers are at any given point in time. And the likelihood of us making the phone call to the best buyer, as defined by us or by our client, really may just miss through no fault of anyone's other than the timing wasn't right. They were looking at another acquisition. Lawsuit came up at the buyer level. The CEO was on vacation. All sorts of factors can lead to a whiff. And so finding the greatest number of highly qualified buyers to get involved in your process and work diligently through the process that we outlined is really key towards delivering the best results for our clients. And that will ultimately translate into the best multiple. But again, this is about getting the best price in terms. And so the process area is really key. We'd be remiss in not hitting on the difference between enterprise value versus equity value. Kind of doing a little math tutorial here. So if a investor comes to a company and says, I'm going to invest $10 million in your company, and I will own 60%, you will own 40% after the transaction. That doesn't mean your company is worth $10 million. Actually, it has a valuation of $16 million. $10 million divided by 60%. Now what happens if you have debt on the company? Private equity firm says we're buying the company for $100 million. Now the company had $20 million of debt on the books. Then that debt is subtracted from the enterprise value to get to the equity value. It's retired or refinanced as part of the transaction. So the seller, if it had $20 million of debt on the books, the seller is actually getting $80 million of cash proceeds at close. So enterprise value versus equity value is always a discussion we have. Again, it depends on the industry. It depends on what sort of debt is on the balance sheet. Financial services companies are different than services companies. A lot of financial sponsor companies in particular have acquisition leverage that's on the balance sheet that needs to be adjusted out that is not used to operate the company. Whereas a balance sheet company like a specialty lender might have a huge chunk of leverage on the balance sheet, but that's not generally included in valuation. So again, it depends. The point about hiring the right advisor that knows the industry, that knows the metrics, that knows the right buyers is really key here. We've talked for the last, I don't know, 30 minutes here about valuation. So once again, the question is, what is your company worth? The answer is whatever someone is willing to pay for it. So a process where you bring in multiple bidders will yield the highest price. Valuation is a big topic, and I have three highlights. One, the right valuation with the balance sheet depends on the industry and the company. Two, the valuation, don't be overly focused on the multiple. Consider the metric with ADPAT, the jump in the pro forma presentation. And finally, most importantly, full market price discoveries through a competitive process will drop the highest valuation. Thank you for joining us as we discuss valuation. As I mentioned earlier, on Colonnade's website, you'll find a quarterly blog post on the average M&A multiples in the U.S. To learn more about Colonnade, the deals we've done, and our thoughts on other M&A-related topics, please go to our website at colabv.com or join us on LinkedIn. colabv.com or join us on LinkedIn.