As investors in lower middle-market companies, valuation is a fundamental question we grapple with in every transaction. The short answer to the valuation questions is “what the market will bear.”
Then the next question is, “Which market?”
Company valuations typically are discussed in terms of multiples of trailing 12-month EBITDA. The higher the “multiple,” the more the company is worth. While there are exceptions to using trailing EBITDA multiples — for instance, software company valuations often are discussed in terms of multiples of revenue, and companies with predictable contracts going forward may be valued on projected EBITDA — the valuation of the majority of companies will be discussed in terms of multiples of trailing EBITDA.
Cash and debt
Strategic buyers often pay the highest multiples. As they generally are in the same or related businesses as the acquired companies, these buyers often can identify significant synergies that will effectively grow the acquired company’s post-acquisition EBITDA and thereby lower the effective multiple. Another factor currently pushing up valuations paid by strategic buyers is the amount of cash many companies have on their balance sheets.
To the extent that companies are able to deploy this cash in an acquisition with a higher return on their invested dollars, the acquisition then can be considered “accretive” even if the multiple paid for the acquired company is higher than the multiple at which the acquiring company is valued.
However, often outbidding strategic buyers these days are financial buyers — typically the larger private equity funds.
While these buyers will look at many of the same intrinsic aspects of a target company as strategic buyers (except for synergies), there are other external factors that can move their valuations up or down. The most important of these is the availability of debt.
If lenders are aggressively lending, then the financial buyers will use that leverage to justify and pay higher multiples.
Another factor is the life cycle of fund buyers. Often, fund managers are anxious to deploy their capital before their investment periods expire, and thus, they will pay higher multiples to win transactions.
Your company’s multiple
So, the final question then is what is the multiple for your company? Multiples vary greatly based on company size, industry and specific company characteristics. As for size, there are rough EBITDA breakpoints where companies will be valued at higher multiples merely because of their size. These are at $5 million, $10 million and $20 million.
As for industries, multiples vary greatly. For example, a $5 million EBITDA software company may be valued at an eight multiple, and a nonvalue-added distributor may be valued at a four multiple.
Underlying these multiple variances, however, really is recognition of the predictability and scalability of a company’s EBITDA. A company that produces commodities and is vulnerable to competition and market fluctuations will be valued at the low end of the multiple range.
Conversely, a company that is solving a unique problem, with little or no competition, that is not cyclical and that has a very steep growth trajectory in a very large potential market will be valued at the high end of the multiple range.
Other than these EBITDA considerations, another important factor in the quality of a company is its leaders. Is the company well organized with good processes? Is there a great leadership team that will come with the company? Is there a clear strategic vision? If the answer to those questions is “yes,” the company will be awarded a higher multiple than other companies of the same size in its industry.
Dan Lubeck is founder and managing director of Solis Capital Partners (www.soliscapital.com), a private equity firm headquartered in Newport Beach, Calif. Solis partners to build great business in the lower middle market. Lubeck was previously a transactional attorney, and has lectured at prominent universities and business schools around the world.