What the past tells us about valuation changes

Business leaders who wanted to exit are now considering their options. We investigate what happened after the financial crisis and consider the implications for business planning and getting ready for exit.

At Price Bailey, our Strategic Corporate Finance team, predominantly advise on mid-market deals. While no two crises are the same, we are consistently asked what happened after the financial crisis. Therefore, to consider the lessons that we can take forward into post-Covid recovery, we have looked at 4,000 completed M&A deals, logged at Experian, from 2008/09 to 2019/20. The deals ranged in value from £1m – £25m and were all transactions where a UK company had sold to a trade buyer or buyout fund, albeit the buyer could be based anywhere.

The dip in deal numbers takes a couple of years to return

If we take deal volumes first, we can see that immediately after the economic crisis of 2008, deal volumes declined and did not return to pre-recession volumes for three years. However, as the economy recovered so did deal activity and volume grew to surpass pre-recession levels and remained consistently strong for around eight years. The number of deals completed in 2019/20 was similar to that of 10 years prior.

However, deal volumes are only part of the story and can be driven by the decisions of the seller; for example, since March we have seen several business owners putting their exit plans on hold or considering alternative options to ownership succession, such as an employee ownership. Therefore, it may just be a delay in exits rather than an out-and-out reduction.

Another aspect and one that has lasting implications for the business owners and shareholders is that of value. From the c4,000 deals that we analysed, we noted that valuations dropped by between 8% and 58% depending on:

  1. If the business was valued on a profits (EBITDA) or revenue basis;
  2. If there is an underlying strategic premium to the business, putting it in the most valuable 50% of businesses.

However, a negative swing of -16% to -27% appears to be a more reasonable conclusion to draw based on the data.

We also note that the median revenue for companies in this data set was ~£10m and median EBITDA ~£1.3m, so growing performance above these numbers could be important for securing a premium valuation. Fundamentally this is also interesting as the businesses were larger than we were expecting in a sample of 4000 small transactions. As a result, our strong recommendation is that business leaders look to put in place organic or M&A based growth plans to achieve at least this level of median profit before considering exiting if they wish to secure at least an average valuation result and they are not being approached by strategic buyers. You can watch a recording of our recent webinar series on growth here.

After an initial drop in valuation, volatility continues for 2-4 years as confidence in the market returns and valuations stabilise back into growth. For example, valuations returned to pre-recession levels after five years, before falling again and taking a similar time to recover. Therefore, we may not see valuations consistently return to pre-Covid levels for 4-5 years. Intuitively, having assisted many corporates and funds make acquisitions and investments, this may be seen as a good thing as there is little doubt that lower-mid market M&A deals were seeing valuations grow to a level where value was harder to find.

 

Revenue multiples

 

EBITDA multiples

Interestingly the average deal size during this period continued to grow which, when combined with lower multiples, suggests that even with increases in distressed purchases increasing, the size of deals gets bigger.

Average deal size (£m)

What can we take from these trends?

  1. Now is a good time to build an ambitious five-year plan in time for profit and revenue multiples to recover and to be on the right side of the average deal size;
  2. If you can build underlying strategic value that a 3rd party cares about (i.e. there is proven product/market fit), then it may be easier to secure a multiple above the median and sell for a premium in 5-6 years. You can hear more about this in our podcast here.

What will impact valuation?

The fluctuations in multiples and valuations, as the data has shown above, will be hard to predict and are likely to ebb and flow for some time. From our experience, there are two predominant aspects that we believe will impact valuations as a result of COVID-19:

  1. Some businesses will have lost significant proportions, if not all, of 2020’s expected revenue income. In the majority of instances, this will be revenue that cannot be recovered or made back up again later in the year or even into next year, e.g. in the case of the restaurant and hospitality trades. Others will have deferred revenue income, in the example of professional services; however, it is unlikely that top-line performance will still be in line with expectations for the year.
  2. Businesses have likely lost any surplus cash they had and added more debt into the business which will significantly restrict the capacity to grow in next few years (regardless of whether debt is sourced from Government support, e.g. CBILS/CCFF or not).

These two reasons alone will likely have a significant impact on a business’ valuation as, typically, the starting point is to look at past trading performance. However, at the moment we would argue that history will provide a fairly weak guide to future performance, particularly if taking into account trading performance for 2020. Firstly, this has been an abnormal year. Business owners may have taken the opportunity to include bad news that wasn’t necessarily fully recognised in previous years, e.g. bad debts, to have a ‘clear up’, and secondly, there is nothing to say that businesses can’t return to similar trading levels once social distancing falls aware. Nevertheless, a loss of trading, a lower level of trading going forward, debt burden to carry and, because of the debt burden, a lack of capacity to do other things like acquire businesses or grow organically, valuations are likely to significantly reduced.

Reductions in surplus cash are mostly unavoidable when income reduces, but fixed costs structures remain rigid. Business leaders during this time should focus on reducing unnecessary costs and negotiating payment terms/holidays with suppliers and creditors to sustain cash reserves for as long as possible. This may also be a time for businesses to clean up their management accounts, e.g. reviewing bad debt, stock and WIP provisions that haven’t previously been made; this may also result in a reduced tax burden. Producing cash forecasts and ensuring they are updated for actual performance will both support survival during this time and demonstrate to buyers/investors how cash flow will recover over time. We discuss this in more detail here.

Man calculating the value of a business

However, regarding increased debt in the business, we’ve been asked quite a lot over the last few months about what is the most important thing to look after at the moment revenue, profit or cash. Before COVID-19, it would have been profit, but now cash is king. If, for example, you take two businesses with equal EBITDA, but one has no debt, and the other is highly leveraged then the cash position will be entirely different for each, particularly the availability of cash to invest into growth. Consequently, the likelihood of survival is different as those with large amounts of debt are ultimately in the hands of their debt providers.

A third point to add to this is the question of sentiment. As a result of any economic uncertainty, but certainly, in the case of one as unprecedented as this, there is a loss of confidence suffered in the market. Confidence will vary by sector and may be regained in some parts of the market quicker than others; however, sentiment is something that is far outside anyone’s control, and as we demonstrated earlier in the article, it can take time to return. Consequently, it is highly likely that we will see an increase in the proportion of deferred and earn out deals, where there are deals happening, similar to that which we saw following the last recession, meaning that the cash out for sellers, will come slower.

So, what can business owners do? Firstly, the current conditions highlight the need to plan for the future quite carefully through financial modelling, not least to be clear on cash flow requirements but also to understand the impact of different scenarios, as businesses will not only need to consider COVID-19; before March, Brexit was the primary concern for most business owners. By understanding the best, worst and most likely case of various scenarios, you will provide yourself with the agility to respond to trends as they emerge. You can hear our podcasts on financial modelling here.

Secondly, we’ve had a number of business owners that are considering selling and wondering whether now is the right time. The ‘right time’ is a hard balance to strike as you don’t want to sell too near the top of the growth curve because it provides a limited upside to the buyer. Being able to prove future value growth will come down to the long term strategy and scenario planning and proving the future sustainability and value growth. You may also want to consider whether you need to sell right now; you could instead wait to let some of that future growth come through and re-consider in a couple of years.

However, we do expect the current crisis to create an unexpected opportunity for owners to capitalise on the tax and process benefits of selling to Employee Ownership Trusts. We can naturally see this happening more in our caseload. You can read more about employee ownership and EOTs in our article here.

Stepping back

The problem with stepping back is oversimplification at a time when few decisions seem simple. However, our suggestion is that business owners who want to exit for a premium consider:

  1. Be prepared to wait and, while waiting, build a plan to grow either organically or by M&A. Make the necessary changes to drive growth and profitability. You can hear more about this here.
  2. Develop areas of the business that are hard to replicate and will attract a strategic premium – the bar for this is rising so we suggest that the benchmark for this should be true product/market fit for a product or service that is ahead of key trends and disruptive. You can hear more about this here.
  3. Develop second-tier management and consider MBO options, as well as Employee Ownership Trust, exist models. You can read more about this here.
  4. Have strong and integrated financial models, great management information and consider running the business almost as though you were going through a live due diligence process. You can hear more about this here.

If you would like to talk to one of our team about business valuations, then please feel free to get in touch with Simon Blake or Chand Chudasama from our Strategic Corporate Finance team on 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.

Subscribe

For more insight, events and webinars sign up to the Price Bailey mailing list…

Sign up

 

 

Have a question about this post? Ask our team…