I recently spoke on a webinar on the topic of how business owners can increase the chances of improving their valuation multiple. As a follow up to a previous article on is this a buyers or sellers market, and as a promise to those on the webinar, below I share my notes on the features of businesses that we see achieving valuation premiums.
This is based on a run rate over the last two years of undertaking around 55 valuations per year and advising on around 25 M&A/MBO deals on a 12 month rolling basis – that may or may not be a good sample size, but it is what we have!
For most business owners, in 2023, we see there are four areas that lead to valuations in excess of the mean or median of their sector. In some circumstances the valuation premium on average multiples can realistically double, or even more.
These areas are:
- Sound fundamentals against all three financial statements. There are five elements to this.
- Very good management who are well incentivised to grow value.
- Commercial fundamentals today (not the hope for next year). There are five elements to this.
- Real growth capabilities.
Are these the same four areas as every year? Maybe. We certainly see far heightened attention to them and the premium paid for businesses with these features are now more stark. Perhaps, therefore, it is more accurate to say that, whilst these features have always been desirable, the premium benefit to them is increased at the moment.
Taking them in turn:
Sound financial fundamentals
Sound financial fundamentals is effectively using current and past financial statements to demonstrate the following:
- That revenue growth has occurred at a meaningful premium above the higher of inflation and peer growth rates. If you can’t get hold of the data then ask your accountant, or us.
- Superior gross margins (measured properly) compared to peers and even better, than likely acquirers. This shows you can balance three things 1) volume, 2) price and 3) purchasing decisions in a way that drives advantage. Price elasticity from the product range, bundling or novel service offerings all play into advantage here.
- EBITDA that is above the relative risk of the capital needed to run the business – in other words, if you need a big or risky balance sheet to run smoothly because people pay you slowly, because of the need to take on debt to operate or because you need lots of kit, then higher margins should be structural to compensate for that risk. What valuers and negotiators are paying more attention to now is rather than thinking about the overhead base being ‘lean’, which is a common thing we hear, we prefer to hear about the overhead base being valuable – how does it enable superior margins and revenue growth, or better service, or a lighter balance sheet for example? EBITDA is an outcome of all of this, by luck or judgement. What the right proportion of EBITDA to size of risk is a judgement call, – you can compare to peers and larger businesses to help – but what should the margin be depends on the experience of the people making the judgement which comes down to the experience and quality of those on the Board and the advisors.
- Debt is being limited for use in growth projects like organic expansion, M&A, buying valuable assets etc. – debt is not needed for normal trading and the interest burden does not restrict the ability to invest in new growth projects. We have seen several examples recently of businesses who were once very profitable now experiencing eroded profits, perhaps only by 10% or 20%, but now the debt burden is a real challenge even if they’re doing well operationally. This is likely to depress value, even if on a debt-free cash-free basis, there is a shift in value because the freedoms to stay current are curtailed and buyers will lock onto this when judging if a business really is premium or not. Capital restructures and reinvesting into your business are very appropriate considerations at the moment to address this.
- Finally, on sound financial statements, have attractive levels of cash generation from operating activities – it’s always good to be able to show you spin off cash at an attractive rate.
Very good management who are well incentivised to grow value
Very good management that cover off the basis of at least sales, operations and finance as specialists. This should be the management team who are staying after a sale situation, not the ones leaving. Ideally they have a meaningful equity incentive too, if value is growing at a premium.
Interestingly, most owner-managed businesses that I have worked with over the years have said their potential MBO team has not been ready to take the reigns – who’s responsibility is it to change that? When should that investment in development start? The answer depends on what value the owner wants to seek and how much risk they expect to experience in the deal structure. Private Equity (PE) backed businesses seldom experience the same issue as they more readily change those that they do not believe in (which may or may not be a good thing, depending on your bias’!). Personally, I think the most valuable businesses follow the classic phrase of ‘change the people or change the people’ and, now perhaps more than the past, large buyers recognise the value of buying talent.
Commercial Fundamentals today
(Aka. not jam tomorrow… that’s not to say jam tomorrow isn’t valuable, but this article is specifically about business model features that have a high probability in achieving significant premium’s today)
- Operating in an attractive market – the big trends surrounding the people you are selling to and who you are about to sell to in the next few months are positive, enabling and in the direction that the world is moving to. The best way to consider this is through the eyes of a buyer. The best way to see through the eyes of a buyer is to ask them, ask their advisors or watch listed company quarterly earnings reports on where they see opportunity.
- Your position in the value chain is attractive i.e. your business model (and that of your peers) is not at risk of being ‘skipped’ by well-funded new entrants, drowned out by competition or have margin erosion as others up or down stream from you expand into your space –there are experiences in most sectors about businesses trying to reposition themselves and losing value. This is quite intuitive for product businesses but it applies to service businesses too. For example, we have looked to bid on around a dozen marketing agencies over the last 12 months for clients and seen the sellers make value chain and business model positioning mistakes relative to a valuation sample of 100 marketing agency transactions in the US and UK which showed clearly what does and does not drive a value premium.
- Your specific customer group is attractive – your customers are happy, profitable, growing and financially stable. Maybe you’re even turning away lucrative opportunities because you cannot expand supply quickly enough. Great customers is a real double edged sword – in the short run getting attractive customers is challenging as they are normally hard to find and sell to, but they have a better pay P&L off (or should do!). Buyers love finding value here, so long as it does not over-concentrate your customer base, and that is why premium businesses normally always have a very attractive customer base that would be hard to replicate through time, effort and money alone (not impossible, but hard).
- Your business specific risks (also known as non-systematic risks) do not materially impact performance. Practically, for most UK businesses, systematic risks are the things everyone in your sector share in roughly equal proportion. Non-systematic risks are specific to your niche or business – that is about your balance of say, currency exposure, or the quality of people you have in different parts of the business, the software and kit you use and so on. In other words, by accident or judgement, non-systematic risks are the risks associated with your business specifically. Buyers really care about this for obvious reasons. The nuance is, this is about the proportions of risky features.
- If you put all of your customers in an ordered line where they scored their opinion of your business out of 10, your median customer by satisfaction is still at least a 7/10 advocate of using your company (perhaps this has now gone up to 8/10?). Customers are very happy.
Real growth capabilities
The business is showing, in real time, the ability to continuously sell to these attractive customers at an interesting growth rate and have the operations and supply chain to match, even if expanding supply is being knocked by the challenges the world faces today. In other words, revenue growth at an appealing rate is not just part of the backwards looking financial statements, it is right now and in the future too. This is also called product market fit. There is a qualitative measure of this too which is when you step into the business you can just hear it fizzing with pervasive energy and smashing targets. These businesses are too busy making too much money to sell now and the culture is great, so the offer better be brilliant to even be entertained.
Why is technology not in the list?
For most businesses, even many technology companies, development and technology is not a thing of value in its own right, but is instead an enabler of a service or outcome that was otherwise undertaken in a less efficient way. The relative value of that change adjusted for the risk of apathy and execution is normally the root to value.
We value a lot of IP and have a good understanding of, say, the type of AI that has value in itself, and the rest of the pack where the value still connects to forecast fundamentals (i.e. revenue and margin). For most businesses, investment in technology should play out as having some kind of performance benefit. ChatGPT plugins seldom have unique value premiums at the moment, though they may one day and many are adding value through removing cost and therefore increasing profits. This doesn’t mean that development has no value, it does, but it might simply not attract a premium today. This is actually a good thing! Cutting edge development is far cheaper to licence as a customer than it is to build.
Most businesses do not have most of these features which is absolutely fine and why the multiples are what they are – but the premium for hitting many of these markers in the eyes of a buyer (who may be trade, or an MBO/EOT team, or PE/IPO market) is extremely lucrative. As the data in the webinars we host show, multiples can double or more and we see that regularly in the outliers in the data.
Different owners take a different view on these drivers of value growth– some say:
Route 1: “it doesn’t matter, average values go up and down- I’ll take what the market gives at the time”, others say…
Route 2 “well… we’ll just sell harder and work harder and create more profit because that will increase value” – and it will, or in this market it may just get you back to where value was a few years ago. And so a final group go down…
Route 3 “we should take a more strategic approach to increasing value and hit some of these markers through deliberate change.”
There’s no right or wrong approach – across our many thousands of clients people pick all sorts of directions as a way to get to valuations they can accept – but in our recent experiences the detail behind these four themes have probably been the determining factors that the business owners can control which lead to premium valuations being paid.
To find out more, feel free to contact Chand Chudasama using the form below.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.
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