Small Businesses are Selling at Record Pace!

According to BizBuySell.com, the Internet’s largest business-for-sale marketplace, all statistical data regarding the Business Transaction Market Place continues an upward trend.

The number of closed transactions reported through the 3rd quarter of 2018 has increased by 8% over the first 3 quarters of 2017!

More importantly for Business Owners, sales prices continue to increase as well.  BizBuySell.com also reported that sale prices of businesses sold in the third quarter of 2018 reached new highs.  Median Sales prices on transactions reported in the 3rd quarter increased 10.7% from the same period last year!  The record sale prices are directly related to stronger business financials which also hit new levels in Q3. With buyers able to offset increasing prices by acquiring healthier businesses, the result is a well-balanced market.

The market place is also seeing good diversity across the various industry segments is indicated by the chart below.

BizBuySell’s 2018 Buyer-Seller Confidence Index supports the idea of an equally beneficial market to both buyers and sellers. In fact, buyers are slightly more confident in today’s business-for-sale market than last year. While seller confidence remains unchanged compared to 2017, 60 percent of owners said they are confident they would receive an acceptable sales price if they exited today.

“The foundation of small business is about taking advantage of opportunity,” said Bob House, president of BizBuySell.com and BizQuest.com. “To be in a place where both buyers and sellers are able to capitalize without the other party losing out is fantastic and a testament to the strong will of entrepreneurs.”

 

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Too Much Customer Concentration at the Top Can Ding Your Value in an Acquisition

Article written by John Wagner, Managing Director at 1StWest Mergers and Acquisitions, and provided courtesy of Axial

Let’s say you were doing business with just one or two very large customers. Your business could, quite rightly, be categorized as overly dependent on too few sources of income. The reason is simple: Any move that those two customers made, good or bad, up or down, would cause an equal reaction in the fortunes of your company, good or bad, up or down. And if one suffered a catastrophic misfortune, so would your company. That may be stating the obvious. After all, you didn’t have to go to Harvard B school to see the importance of spreading risks like these. And that’s what most business do. They engage in transactions with any many businesses as possible, so that the negative performance or outright failure, of any one customer wouldn’t have an outsized negative impact on the provider company.

Yet as businesses scramble to make their numbers, and sales people do what sales people naturally do (book orders, any order, from anyone; all money is green) those sales are often done without respect to what percentage of your gross revenue may be concentrated into your top-volume customers. However, this customer concentration metric is especially important when you take your company to market to seek an acquirer.

IM Disclosures

Any decent Informational Memorandum (a.k.a. “deal book”) that you and your investment banker prepare to bring your company onto the market for acquisition should have a section that declares your Customer Concentration. It’s a very revealing section of the Informational Memorandum indeed, because every potential acquirer will want to review what percent of your business would cease if you lost a few of your biggest customers.

Is heavy concentration at the top of your customer list truly a terrible thing? Not always. If those top performers are predictable and pay on time, there may be no problem at all. In fact, you’d probably be surprised to see how many companies have greater than 40% of their business concentrated in just ten or twelve customers. Plus, as anyone who’s been in business for any length of time knows full well, many large customers take less effort to serve. They often have technology (like mobile scheduling tools or portals for managing digital purchasing) to smooth out delivery and payment schedules.

Rule of thumb: No one customer should represent more than 10% of your business.

Your invoicing might be simplified as well, if you can submit a superbill to a national accounting department, with a strong cash position and a seven-figure credit line. So, high-quality receivables from large buyers can be an asset, not a liability…until there is too much concentration in too few accounts. That might make an acquirer a little nervous, generating a request for more detail about the nature of the customers you are dealing with at that level. Is there a rule of thumb that acquirers look for? Indeed there is. No one customer should represent more than 10% of your business. Anything more than 10% will bring the attention of the acquirer’s due diligence team, wanting to dig into just how consistent that customer will be for years to come.

Are You Holding Your GPMs Too?

When reviewing customer concentration in the list of your biggest customers, a potential acquirer will also review the gross profit margins (GPMs) for each customer on the list. Their interest in GPMs reaches beyond mere curiosity. Here’s why: If you are heavily discounting your highest-volume buyers, expecting, as old joke goes, “to make it up on volume,” that is a source for worry. It usually indicates that you may be shipping large volumes of product at very low margins… a scenario that would potentially ding your company valuation. Maintaining GPM discipline, even among large-volume customers, is certainly a KPI of a well-run company.

If you are heavily discounting your highest-volume buyers, expecting, as old joke goes, “to make it up on volume,” that is a source for worry.

That said, if your GPMs are around the GPMs you are maintaining for your other down-list customers, this indicates you are running a disciplined operation, and that you’ve stuck to your guns when negotiating price, even with your high-volume accounts. That discipline is widely seen as a sign of a well-run business.

Before you go to market, calculate your customer concentration; it’s an instructive exercise to engage in, now or at any time, actually. Run a spreadsheet of your GPMs in the process, and compare those to the GPMs of your smallest customers to plot the spread, and see how they compare. If you are preparing to seek an acquirer, make adjustments now. Then, when you are finally ready to reveal your financials to potential acquirers, you can put them at ease that you’re well within accepted norms for customer concentration and GPMs, even for high-volume accounts.

 

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Which Is Better, a Financial Buyer or a Strategic Buyer?

If you decide to sell your business to an outside acquirer, you’re going to have to decide between a financial and a strategic buyer—understanding the different motivations of these two buyers can be the key to getting a good price for your business.

A financial buyer is acquiring your future profit stream, so they will evaluate your business based on how much profit it is likely to make and how reliable that profit stream is likely to be. The more profit you can convince them your company will produce, the more they will pay for your business.

But there is a limit to how much they will pay, because financial buyers are playing the buy-low, sell-high game. They do not have a strategic rationale for buying your business. They don’t have an army of sales reps to sell your product or a network of retailers where your product could be merchandised. They are simply trying to get a return on their investors’ money, so they tend to buy small and mid-sized businesses using a combination of this investment layered on top of a pile of debt, and they want to buy your business as cheaply as possible with the hope of flipping it five or ten years down the road.

Because financial buyers are usually investors and not operators, they want you and your team to stick around, so they rarely buy all of a business. Instead, they buy a chunk and ask you to hold on to a tranche of equity to keep you committed.

A strategic buyer is a different cat—usually a larger company in your industry, they are evaluating your business based on what it is worth in their hands. They will try and estimate how much of their product or service they can sell if they added you into the mix. Because of their size, this can often lead to buyers who are willing and able to pay much more for your business.

Tom Franceski and his two partners had built DocStar up to 45 employees when they decided to shop the business to some Private Equity (PE) investors. The PE guys offered four to six times Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), which Franceski deemed low for a fast-growing software company.

Franceski was then approached by a strategic acquirer called Epicor, which is a global software business with a lot of customers who could use what DocStar had built. Epicor offered DocStar around two times revenue—a much fatter multiple than the PE firms were offering.

 

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2 Valuation Experts on What Destroys Value in a Deal

Article written by Giff Constable and provided courtesy of Axial

The lower middle market is getting more sophisticated when it comes to mergers and acquisitions, but both investors and owners are still making many of the classic mistakes around assessing and building value. We asked two valuation experts, Scott Hakala of ValueScope and Ken Sanginario of Corporate Value Metrics, what they’re seeing in the market today and their advice for both buyers in the current economic climate.

The biggest mistake Ken sees among business owners is chasing a financial target in an unsustainable way. “Someone tells them that they need to be at a certain EBITDA level, and then they slash costs but not in a strategic manner,” Ken said. “Owners think that they can cut costs for a year or two and have no one notice. But it doesn’t take a buyer long to get wind of what they have been doing.”

The same thing happens when a business takes on revenue that is hard to fulfill or retain. That revenue usually comes with tangible and intangible costs. When it disappears, the company is left in a deeper hole than before. If a seller is taking delayed consideration for their business, in the form of an earnout or a rollover of equity, these short-term measures can cause that future value to evaporate. “I was doing turnarounds for 15 years, and many of those situations came from companies chasing revenue or chasing EBITDA,” Ken said.

Buyers are also guilty of short-term moves that can destroy value and trigger failed expectations on both sides. “A lot of what I see is penny-wise, pound-foolish behavior,” said Scott. “The buyer squeezes R&D or sales compensation. This boosts EBITDA but the cost savings prove to be illusory. What do you do when half your sales force quits within a year?”

A lot of heroic assumptions are going into valuation models in order to reach deal-winning multiples in today’s market, but with rising interest rates and employment rates, returns may be harder to come by for both sides. Earnouts are a common tool for bridging a valuation gap and getting a deal done, but both buyers and sellers need to be careful not to make short-term moves that backfire. “We see a lot of examples where earnout issues are taken for granted by buyers assessing transaction risk and sellers taking an earnout as part of the deal,” said Scott. “Then both sides feel defrauded by the other side when it doesn’t work out.”

Both Ken and Scott encourage buyers and sellers to focus on the intangibles. For buyers, “the big buzzword today is quality-of-earnings reviews,” says Scott. “It’s usually easy to catch whether someone was running personal expenses through the business. The real issues are things like management infighting or lack of product diversity.” Once the deal is done, Scott recommends that buyers stay humble and seek to ask the right questions about the business rather than making assumptions. “There’s less room for error in the lower middle market,” he said. “One or two critical mistakes can blow up an entire firm.”

Ken encourages business owners to think about business intangibles years in advance, rather than months. “I think that most private companies can double or triple their value over a three to five year period if they directly work on their weaknesses. It takes getting to the root causes of value,” he said. “Too many owners think that value is driven by what they did last year, as opposed to what the company’s future cash stream looks like. If they plan ahead and build for the future, they will see improved multiples and their deal will close faster.”

 

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CEOs, Do Your Due Diligence, Don’t Just Respond to Theirs

This article written by Danielle Fugazy and provided courtesy of Axial.net

It used to be business owners sold their companies outright to a strategic acquirer or a financial buyer or handed it down to family members. Today, many business owners are opting to take partial liquidity and stay on with the business. This option is a rather good one for business owners who may want to buy out other stakeholders or want a new partner, but aren’t ready to walk away from the business altogether.

However, taking capital and not completing exiting the company is a unique transaction—one that the business owner needs to really understand before they enter in to. Whether the business owner sells 80 percent of the business or 20 percent, it’s important for them to diligence their potential partners. Unfortunately, too frequently, business owners are so elated at the prospect of receiving capital from a financial sponsor that they don’t do the proper due diligence on their potential partner or the deal terms. Then they find themselves at a loss when they can’t get rid of the wrong financial partners without a lot of aggravation, systemic risk to the business, and an expensive outlay. The wrong agreement with the wrong partners will never allow a company to scale as intended.

Non-control and partial-control investments are like a marriage and can last anywhere from three years to upward of 10 years.  Here are some of things owners should be thinking about if they want to take an investment.

Ask the hard questions

Most financial sponsors will say they understand your industry, but the onus is on the owner to figure out if they really do. You need to talk with your potential partner, understand their background, how they obtained their industry knowledge and talk to other business owners in your industry they have invested in. You need know what their qualifications are.

“You need to ask the right questions. Owners cannot be afraid to ask the potential investor why they think they are the right fit.” says Karine Philippon, a partner focused on technology, manufacturing and distribution deals at accounting firm Mazars USA.

If they are experts in your industry they will have already acquired or invested in companies that are similar to your company. They will have successful outcomes to prove it or have partners on their team that have credible track records in the vertical.

“It’s very important that the partner have industry knowledge. The partners have to be vetted and the owners need to figure out how they will be able to leverage that knowledge and how useful it will be to them,” says Philippon.

Charlie Gifford, a senior partner with non-control private equity firm New Heritage Partners, says calling references is key. “Do your homework. Call all the references and then call people who aren’t on the reference list who may know something about your potential partner,” says Gifford.

Look for a true partner

This partner will have a seat on your or board and, in some cases, even more oversight depending on the agreement. It’s important to make sure you respect the financial partners personally. Kenneth Marks, a managing partner at High Rock Partners, an investment bank located in Raleigh, North Carolina, suggests finding out specifically who will be on the company’s board. “You want to know if the person sitting your board has the right temperament and is aligned with you and your business goals. When things go wrong, and they often do, who will be across the table? Will they solve problems or have knee-jerk reactions,” says Marks.

Good questions to ask include: do they have experience, how will they interact with you and your employees, and are they people you would feel comfortable with if you met under different circumstances?

“Like everything in life, it’s a balance between controlling the company, getting the money and having a true partner going forward,” says Philippon.

Every financial sponsor brings capital to the deal, it’s their connections, mentorship and insights that will vary and are often the most important factors. You also want to make sure your ideas align for the company moving forward so there are no surprises. Your partners should be able to help you connect to their network and propel your company forward.

“You need a partner who has the ability to identify areas in which an injection of resources can help solve a problem. You want to align with investors who can say, we have seen this before and this is how we have solved that problem or fixed this bottleneck. An investor’s prior experiences with the challenges that a business owner is facing, can help solve it or improve the situation,” says Gretchen Perkins, a partner with Huron Capital, which recently closed on a $142 million non-control private equity fund.

Think Ahead

Often times business owners wait until the last minute to have meet with potential investors and then they don’t have the time to make truly educated decisions. “Don’t let the pressure of getting liquidity drive the investment decision because you will likely wind up with less control of the company or the wrong partner because you didn’t truly think through your needs and who the right investor would be,” says Philippon.

It’s also important to understand a few things prior to the legal stage of a capital raise. Before getting far down the road, business owners should get clarity around corporate governance issues. “What types of meetings will the investor require, how often, what type of reporting, and what’s their role in the decision making process outside of being a board member,” says Marks.

Business owners also should get clarity on distributions. Many business owners are used to pulling money out of the business when convenient, but arrangements will become formalized with an investor. “Many times distributions are curtailed or managed when an investor comes on. Will these types of changes work for the business owners’ lifestyle?” says Marks.

Think about the future

If they are remaining a partial owner of the business, business owners want to protect themselves when it comes to future capital transactions. Will there be restrictions on taking additional money off the table in a future secondary sale? If the new investor wants to sell or raise more capital, who decides on the new buyer or investor and the terms? “Owners should make sure they have a clear understanding of what the exit strategy is, and they need to think about that in advance. Owners need to pay attention to the terms and conditions set forth,” says Marks.

There can be great upside to bringing on a private equity partner while retaining a stake in the business. Just remember that bringing on an investor is like getting married, but with no option for divorce. Do your due diligence and know what you are getting into.

 

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The Build vs. Buy Equation

If you’re wondering what your business might be worth to an acquirer, there is a simple calculation you can use.  Let’s call it “The Build vs. Buy Equation”.

At some point, every acquirer does the math and calculates how much it would cost to re-create what you’ve built. If an acquirer figures they could buy your business for less than they would spend on both the hard and soft costs of re-deploying their employees to build a competitive product, then they will be inclined to acquire yours. If they think it would be less costly to create it themselves, they are likely to choose to compete instead.

The key to ensuring that what you have is difficult to replicate is focusing on a single product or service and building on your competitive point of differentiation. When you create a product that is unique and pour all of your resources into continuing to differentiate it from the pack, you can dictate terms, because re-creating your business becomes harder the more you focus on one thing.

The worst strategy is to offer a wide range of services and products only loosely differentiated from others on the market. Any acquirer will rightly assume they can set up shop to compete with you by simply undercutting your prices for a period of time and driving you out of business.

C-Labs Focuses On Building An Irresistible Product

Chris Muench started C-Labs in 2008 to go after the burgeoning opportunities presented by the Internet-of-Things (IOT). He began by writing custom software applications that allowed one machine to talk to another. In 2014, he got the industrial giant TRUMPF International to acquire 30% of C-Labs, which gave him the cash to transform his service offering into a single product.

By the end of 2016, Muench’s product was showing early signs of gaining traction but C-Labs was running out of money.

In the end, TRUMPF acquired C-Labs in a seven-figure deal that could stretch to eight figures if Muench is successful in hitting his future targets. Why would a large, sophisticated company like TRUMPF acquire an early-stage business like C-Labs? Because they knew that re-creating Muench’s technology would cost much more than simply writing a seven-figure check to buy it outright.

In other words, TRUMPF used The Build vs. Buy Equation and realized that buying C-Labs was cheaper than trying to reproduce it.

Selling too many undifferentiated products or services is a recipe for building a business that—if it is sellable at all—will trade at a discount to its industry peers. By contrast, the trick to getting a premium for your business is having a product or service that is irresistible to an acquirer, yet difficult for them to replicate.

 

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Learning From Acquisitions That Fall Apart

John McCann sold The Bolt Supply House to Lawson Products (NASDAQ: LAWS) at the end of 2017.

McCann’s strategy involved learning from the acquirers who knocked on his door. He invited would-be buyers into The Bolt Supply House and listened to what they had to say. He was not committed to selling, but instead wanted to know what they liked and what concerned them about his company.

One giant European conglomerate, for example, approached McCann about selling, but after a thorough evaluation, they backed out of a deal, worried about McCann’s central distribution system.

McCann thanked them for their time and set to work turning his distribution system into a masterpiece. Eventually, Lawson cited this as one of the many things that attracted them to The Bolt Supply House.

When it finally came time to sell, McCann commanded a premium, arguing that he had built a world-class company he knew would be a strategic gem for a lot of businesses. He ended up getting five competing offers for The Bolt Supply House and eventually sold to Lawson.

When a big sophisticated acquirer approaches you about selling, the temptation is to decline a meeting if you’re not ready to sell, but hearing what they have to say can be a great way to get some superb consulting, for free. The investment bankers and corporate development executives who lead acquisitions for big acquirers are often some of the smartest, most strategic executives in your industry and—provided you don’t get sucked into a prop deal—hearing how they view your business can be an inexpensive way to improve the value of your company.

 

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Growing Fast? Here’s What’s Likely To Kill Your Company

If your goal is to grow your business fast, you need a positive cash flow cycle or the ability to raise money at a feverish pace. Anything less and you will quickly grow yourself out of business.

A positive cash flow cycle simply means you get paid before you have to pay others. A negative cash flow cycle is the direct opposite: you have pay out before your money comes in.

A lifestyle business with good margins can often get away with a negative cash flow cycle, but a growth-oriented business can’t, and it will quickly grow itself bankrupt.

Growing Yourself Bankrupt

To illustrate, take a look at the fatal decision made by Shelley Rogers, who decided to scale a business with a negative cash flow cycle. Rogers started Admincomm Warehousing to help companies recycle their old technology. Rogers purchased old phone systems and computer monitors for pennies on the dollar and sold them to recyclers who dismantled the technology down to its raw materials and sold off the base metals.

In the beginning, Rogers had a positive cash flow cycle. Admincomm would secure the rights to a lot of old gear and invite a group of Chinese recyclers to fly to Calgary to bid on the equipment. If they liked what they saw, the recyclers would be asked to pay in full before they flew home. Then Rogers would organize a shipping container to send the materials to China and pay her suppliers 30 to 60 days later.

In a world hungry for resources, the business model worked and Rogers built a nice lifestyle company with fat margins. That’s when she became aware of the environmental impact of the companies she was selling to as they poisoned the air in the developing world burning the plastic covers off computer gear to get at the base metals it contained. Rogers decided to scale up her operation and start recycling the equipment in her home country of Canada, where she could take advantage of a government program that would send her a check if she could prove she had recycled the equipment domestically.

Her new model required an investment in an expensive recycling machine and the adoption of a new cash model. She now had to buy the gear, recycle the materials and then wait to get her money from the government.

The faster she grew, the less cash she had. Eventually, the business failed.

Rogers Rises From The Ashes With A Positive Cash Flow Model

Rogers learned from the experience and built a new company in the same industry called TopFlight Assets Services. Instead of acquiring old technology, she sold much of it on consignment, allowing her to save cash. Rogers grew TopFlight into a successful enterprise, which she sold in 2013 for six times Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) to CSI Leasing, one of the largest equipment leasing companies in the world.

Rogers got a great multiple for her business in part because of her focus on cash flow. Many owner think cash flow means their profits on a Profit & Loss Statement. While profit is important, acquirers also care deeply about cash flow—the money your business makes (or needs) to run.

The reason is simple: when an acquirer buys your business, they will likely need to finance it. If your business needs constant infusions of cash, an acquirer will have to commit more money to your business. Since investors are all about getting a return on their money, the more they have to invest in your business, the higher the return they expect, forcing them to reduce the original price they pay you.

So, whether your goal is to scale or sell for a premium (or both), having a positive cash flow cycle is a prerequisite.

 

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Lower Middle Market Too Hot to Touch

Article written by Danielle Fugazy | May 17, 2018 and provided courtesy of Axial.net

The M&A market as a whole remains white hot and the lower middle market is no exception. Sellers are undoubtedly benefiting from today’s strong market conditions. “The market is as robust as it’s ever been. We are seeing high valuations. Average purchase price multiples are at at an all-time high in mid seven times EBITDA,” says Graeme Frazier, president of Private Capital Research LLC and a founder of GF Data, a data provider that tracks companies with enterprise values of  $10 million to $250 million. “Even rising interest rates are not quelling demand.”

There are multiple factors leading to the frenzied deal pace in the lower middle market. First, there’s a tremendous amount of capital in the market. The abundance of dry powder has been well documented over the years. Second, the lending markets are feeding the frenzy. According to GF Data, debt multiples have reached a total of 4.2 times EBITDA and on the senior side they have inched up to 3.4 times EBITDA in the lower middle market. “It’s not a record, but there is sustained strength in the lending market for sure,” says Frazier.

Robin Engleson, a managing partner with Sapphire Financial, which provides debt and equity to middle and lower middle market companies, says it’s the combination of both the dry powder and equity available fueling activity. “You have an abundance of debt, and buyers are willing to over equitize these transactions today. Today, lower middle market companies that have a reasonable story have a good shot of getting the highest valuations they could ever get,” she says.

Additionally, some of the frothiness in the lower middle market can be attributed to larger buyout firms and strategic acquirers—perhaps priced out of their own markets—coming down market to find good deals. One of the main reasons private equity firms look down market is to average out their cost of capital. After buying a platform company at a high valuation they more frequently move down market to find add-on opportunities at a better price to average down their costs. According to Pitchbook, as of Q2 2018 roughly half of all buyouts globally and more than two-thirds of all buyouts in the U.S. are add-ons. In the first quarter alone add-ons accounted for 70 percent of all buyout activity.

“You are seeing a lot of traditional middle market sponsors compete in the lower middle market.  Valuations are high for good middle market platform companies and so they’ve entered the lower middle market to find a company that can serve as a buy-and-build platform,” says Dan Lipson, a partner with Rotunda Capital, a Washington, DC-based private equity firm. “With more resources dedicated towards business development, either through internal staff or external buyside firms, traditional middle market sponsors feel comfortable they can deploy an adequate amount of equity capital through an add-on acquisition strategy even when starting with a lower middle market platform. It’s given growth to companies like Axial and the role of the business development professional.”

Moving  away from financial engineering and organic growth, it’s clear that the buy and build strategy have become one of the most common value creation tactics today. According to Pitchbook, it’s most frequently used in sectors that are highly fragmented like healthcare and education.

As a result of the strong market dynamics at play even less attractive deals are starting to get more attention. “The higher quality deals get done at a premium. Even deals that aren’t above average are starting to get bid up. The quality premium is narrowing. This is when things can start to get ugly. During a downturn your higher quality assets will weather the storm. Assets that are of lesser quality will have difficulty,” warns Frazier. “We see the IRRs they are modeling and unless they are able to grow these assets fast, it’s going to be challenge to make the return on capital with the high valuations that were paid or make it through lean times.”

Waiting for things to turn

Many typical lower middle market investors continue to wait on the sidelines for valuations to come down. “It’s a competitive market. Everyone’s look-to-bid and bid-to-close ratio is lower. We look at a lot of attractive companies, but we constantly push ourselves to remain disciplined. Unfortunately that means we are sometimes passing on companies in auction simply because we know the market clearing price is beyond what we’re willing pay,” says Lipson. “It’s not an easy market to be a buyer. When you’re paying full value, you have to have to be very focused and confident that you can execute your value creation strategy.”

Jeff Kadlic, a founder of Evolution Capital Partners, a lower middle market private equity firm, agrees that it is hard to compete in today’s market. “The larger funds are just so well capitalized that they don’t even need financing contingencies to close acquisitions in the lower end of the market, so it’s an attractive offer as a seller. The valuations for growth have become eye popping,” he says.

Hunter Street Partners, a firm that provides opportunistic debt and equity to the lower middle market, is looking to target areas where they feel there are pockets of dislocation. “We are looking for good companies with stressed balance sheets. There is not a lot of distress yet, but frothiness leads to dislocation. Although tough to predict when dislocations will increase, we are positioned to further take advantage of them as they occur,” says Neal Johnson, CEO and founder of the firm.

Despite feeling like the market is at the top or close to it, market professionals don’t see anything on the horizon that will change market conditions anytime soon. “There’s no sign of a slow down. We are seeing a lack of good target companies, but there’s nothing to make us believe that demand for lower middle market companies will slow. It’s certainly a compelling market to be a seller,” says Frazier.

Frazier also suggests that the growth of the private lending industry in the lower middle market could be a red flag, but says even that is only fueling demand. “After traditional banks had their wings clipped finance companies came in to fill the void. The underwriting standards can become relaxed, just like they did in the last cycle, but still we have no reason to believe things won’t continue as they are. There’s no fundamental reason for them to stop.”

Sapphire’s Engleson says she is seeing creative lending structures put in place to help boost returns from lower middle market companies. “As soon as lower middle market companies reach a certain threshold, their valuation multiples go up. This has always been true, but the increase is more significant now. Buyers are entertaining the purchase of smaller and smaller companies as combining them and bringing them to that next level today can mean increasing their value from five to six times EBITDA to 10 times EBITDA. This scenario is happening a lot more frequently. It’s a great time to be a seller.”

 

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How To Use EBITDA For The Valuation Of Your Small Business

Article written by Jeffrey Kadlic Evolution Capital Partners and provided courtesy of Axial

Selling a business can be a difficult decision for entrepreneurs to make, both on an emotional and financial level. There are a number of factors that come into play when determining an appropriate asking price, including competitive advantages, growth opportunities, and historic financial performance.

However, one valuation metric in particular — EBITDA — can be a great starting point in measuring a company’s potential value in a sale. Before sitting down with prospective buyers or investors, small business owners should understand how this valuation metric will be used to calculate the worth of their company.

What is EBITDA?
EBITDA — or earnings before interest, tax, depreciation, and amortization — is an indicator commonly used by prospective buyers or investors to measure a company’s financial performance.

In its simplest form, EBITDA is calculated by adding the non-cash expenses of depreciation and amortization back to a company’s operating income. Below is the basic formula:

EBITDA = Operating Profit (EBIT) + Depreciation (D) + Amortization (A)

By eliminating the non-operating effects that are unique to each business, EBITDA can help balance the scales by focusing on operating profitability as a singular measure of performance. This is particularly important when comparing similar companies across a variety of industries or different tax brackets.

EBITDA as a Valuation Metric
As a key factor of a successful sale, small-business owners should have a clear understanding of how prospective buyers or investors will determine the value of their business. More often than not, that valuation comes down to a multiple of the company’s earnings.

On its own, EBITDA makes for a relatively futile statistic. After all, there is good reason behind the depreciation and amortization of assets. Simply adding those non-cash expenses back to a company’s net income can paint a misleading picture of its financial performance.

That’s where the need for adjustments comes in. Because EBITDA is a non-GAAP figure, prospective buyers or investors are at the discretion of a business to decide what is, and is not, included in the calculation. For instance, one might devalue tangible assets such as old equipment and add intangible assets like management and employees. As such, companies tend to adjust the included items from one reporting period to the next.

However, it’s important to understand the limitations of EBITDA. Although it’s often used as a proxy for evaluating the earning potential of a business, EBITDA cannot measure cash flow — it strips out the cash required to fund working capital and equipment upgrades.

Because EBITDA is almost always higher than reported net income, it is often used by businesses as an accounting gimmick to “window dress” their profitability. It also doesn’t take into account a company’s growth potential and customer base.

Therefore, small-business owners should be sure to analyze EBITDA in conjunction with other important factors, such as capital expenditures, changes in working capital requirements, debt payments, and net income.

Using EBITDA to Strike a Deal
If a company is in a high-growth market, it can expect a significant acquisition premium — a buyout offer that is several times more than its most recent EBITDA. Generally, the multiple used is about four to six times EBITDA.

However, prospective buyers and investors will push for a lower valuation — for instance, by using an average of the company’s EBITDA over the past few years as a base number.

In order to ensure the highest valuation, small-business owners will need to boost their company’s overall financial performance. As a starting point, the focus should be on preparing high-quality financial statements.

If a company’s financials are poorly done, it sends the signal that there is a lack of competency and/or knowledge of the business. From a value perspective, thorough numbers also greatly reduce the risk of missing an item that might work in favor of the buyer and, thus, lower the company’s valuation.

In addition, making the right changes — such as cutting unprofitable costs, increasing sales, or reaching new markets — can also have a significant impact on a company’s EBITDA.

That said, it can still be difficult for a company and the prospective buyer to reach an agreement on a purchase price — otherwise known as a “valuation gap.” In this case, a small-business owner will need to prove that its ROI and growth potential justifies a higher EBITDA multiple.

This can be achieved by developing a solid strategic plan that will help showcase the background and performance of a company. In turn, small-business owners will need to find facts or data that support the story they are trying to communicate to prospective buyers or investors.

 

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