M&A: What is the valuation?
According to the Institute for Mergers, Acquisitions and Alliances (IMAA), there were 13,424 transactions in North America in 2015 compared with 14,215 in 2014 for a decrease of 5.6%. However, the value of the average transaction went up by 15.7% from $160.4M USD to $185.6M USD. Similar numbers were experienced globally with a 16% overall increase in average value to $91.5M USD and a volume of 42,930 total transactions. Several notable increases in average acquisition value from 2014 to 2015 was the Middle East and Africa at 232.6% and Asia-Pacific with a 42.6% increase. Every transaction has a risk and potential reward. With transaction values rising for fewer opportunities, the inherent risks continue to rise.
All too often, due diligence can be relegated to a financial investigation to ensure margins, assets and liabilities are accounted for. In some cases, Lean or Six Sigma experts are enlisted to assess opportunities for improved operational performance. In yet fewer instances is adequate verification performed on the processes directly associated with growth. These include competitive landscape, market value of Intellectual Property (IP), viability of technology road map, robustness of product development processes, retention of key technical personnel and strength of customer relationships. For projects where this research is performed, relying on secondary information or macro-market reports is inadequate. This is especially true for high-technology companies that represented 19.5% of all transactions globally in 2015, the largest of any single industry. As due diligence is a risk management process, perhaps more…well…diligence is warranted.
There are infinite reasons businesses come up for sale; however, in few instances is it because the business is healthy, vibrant or competitive. In response to this statement, the example of the aging owner of a very profitable privately held company seeking a liquidity event is often quoted as a counter-argument. These opportunities do exist and represent low hanging fruit for private equity and corporations alike. But for the vast majority of cases where an organization is on the market, the lack of performance is driving divestiture of the company or business unit. Think about it, even non-core businesses that generate double-digit Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) growth year-over-year are hard for most owners to part with! Reading annual reports or listening to earnings calls, it would appear that the best leaders want to “shape the portfolio” or “refocus on the core business”. It sounds like they simply don’t prefer a business unit that plays in a different market – like a preference for mayonnaise instead of Miracle Whip. The unspoken truth is that to fix a struggling business that is non-core isn’t worth the time and energy. For those that have been through this culling process, reality is a bit different than official public statements.
In another counterpoint to the statement that most business for sale are poorly performing, some cite the start-up that will be the “next Google”. After all, the chance of a lifetime, by definition, can only come along once…and that time is now before the company goes big! If it were really going to be the “next ‘paste wildly successful company name here’ “, why are they trying to sell before it goes big? Wouldn’t it make a bit more sense to sell after it went big? Shouldn’t the founders be asking for funding instead of a purchase agreement? Maybe the founders are altruistic and simply want to make the prospective company rich…because that is just the kind of people they are. Learn more about them at #ReallySmartButExtremelyNaïveFoundersThatDon’tExist.
It is time to ask the critical question: why is the business for sale, really? Due diligence is the process of discerning if the seller’s answer to that question can be taken at face value. It is a general term for all activities requisite to establish a current value for the company based on the objectives of the acquiring party. The formula for valuation is not a one-size-fits-all recipe. Depending on the type of business, it can be very difficult to determine the starting point for purchase price negotiations, especially for technologies that are still in development. Agreeing on EBITDA is not the hard part, it is deciding the appropriate multiplier. Historical financial results are used to derive the former, but are less relevant to calculate the latter. The multiplier is based on estimated potential value post-acquisition, integration, operation under new management and launch of new products. It is the numerator in the Return on Investment (ROI) equation that must be well understood.
For private equity in the US, a 30% annual ROI in 3 to 5 years is the threshold for a feasible opportunity. This means EBITDA has to grow 200% to 300% from acquisition to liquidity. There are two variables required to calculate any type of margin in any country: Income and expenses. Due diligence always includes both elements. The most basic questions potential investors have to answer are:
1. Can costs be cut from the business making it more profitable while maintaining or improving quality?
2. Can more products or services be sold to increase revenue with equal or less fixed cost?
Businesses cannot depend on cost reduction alone to achieve private equity ROI expectations: Revenue has to increase dramatically. Therefore, the purpose of this article is to discuss best practices in forecasting future income. It is also a good reminder that most businesses are for sale because they aren’t currently performing or future viability is in question.
Three generalized functions of a business are critical to revenue generation. They are development, sales and delivery. The first role, development, understands the unmet market need and how the company can provide a unique, compelling solution to this problem. Then it develops a functional product that meets or exceeds market requirements. Typical departments and skills encompass market research, strategic planning, product management, R&D, engineering, and product development. These roles work together to ensure new technologies actually solve a problem instead of being a nifty idea looking for a problem.
The function of sales is to make consumers aware that the developed product is available and where it can be purchased. Departments of marketing communications, channel/distributor management, and direct sales are often lumped together in the same, “sales and marketing” group because they are so tightly coupled to complete this essential task.
Delivery is a broad term to describe the process of getting developed product to customers. This involves supply chain, manufacturing, customer service, sales and operations planning, logistics, and product service. Unfortunately, delivery is thought of as a cost center not a growth engine for the business. Manufacturing improvement is frequently viewed as a path to cost containment, inventory reduction and waste elimination. In a competitive global market, delivery can be a significant differentiator when supplying product or service to a consumer base with increasing demands for immediate gratification. Perhaps looking at the antithesis of delivery will assist in understanding why delivery is a contributor to the income side of the margin equation: A pattern of not shipping or shipping later than the competition can impact customer retention and future business growth.
As part of the due diligence process, all three roles of revenue generation (development, sales, delivery) must be validated. A business is only as profitable as it’s least effective and efficient function. Further complicating the acquisition process, both current and future performance must be quantified. This means the due diligence team must assess all processes associated with growth. Example questions include the following:
1. How well does the company develop products today?
2. Are best practices deployed uniformly?
3. Is there a history of performance in development and what is the roadmap for future products?
4. Does existing intellectual property have value based on trends in the market?
5. If there are areas of weakness in sales, what will it take to improve them?
6. Is delivery performance competitive relative to other providers in the target market?
7. Is the market segment becoming crowded with new entrants?
Not only are answers to these questions fundamental to negotiating a purchase price for the business, they will also shape the “100-day Plan” for the management team accountable to implement change in the company. The more relevant and detailed the pre-sale intelligence regarding growth-generating processes, people, and products, the less risk an investor assumes. Because so many acquisitions today are categorized as high technology, the front end functions require specialized skills to evaluate.
Functional expertise should be on every due diligence team to manage risk: Knowledge of the development processes required to sell to the target market including expertise in the technology roadmap, experience selling and marketing in the target market, and understanding of the competitive landscape for delivery. If the team lacks any of the three assets, additional advisors or consultants should be added to supplement the team. A company acquiring the average $185M USD high technology company cannot afford to miss pertinent details affecting the future revenue generation potential of the target company. Remember, past financial performance does not guarantee future competitiveness. Businesses are sold for a reason. New technologies don’t always satisfy unmet market needs, some are just great ideas that have little revenue potential.