In our experience working both 'buy side' and 'sell side' across numerous Small to Medium Business (SMB) transactions, we frequently see 4 valuation issues encountered by SMBs during the Merger & Acquisition (M&A) negotiations:
1. Limited understanding of how businesses are valued in practice:
In practice, most SMB’s are valued by capitalising the ‘Future Maintainable Earnings’ (otherwise known as sustainable earnings) of the business, by a market appropriate multiple, to determine an Enterprise Value. The typical adjustment to get from Enterprise Value to Equity Value (typically what is available for the seller from a transaction) is to subtract Net Debt (being Total Debt less Cash).
In capitalising the Future Maintainable Earnings by a multiple, the valuation inherently assumes that all assets of the business are required to generate those earnings and therefore, the seller will not get paid separately for assets used in the business (e.g. stock) as that value is already included in the valuation (see the working capital point below). However, the position is different for non-operating assets (i.e. assets not used in the business), which need to attract separate consideration (purchase price) if they are not carved out of the transaction.
In the instance of a share sale (rather than a business sale), the Buyer’s valuation will typically assume that the business is left with a ‘normal’ amount of working capital at completion. To the extent that more or less working capital than the agreed normal is left by the seller, there will be an upward or downward adjustment to the purchase price paid by the buyer.
In SMB transactions with owner operators, the seller has often not been through a business sale process or negotiation before, and in the absence of proper advice for that seller with respect to valuation, there can be a disconnect between the parties as to how to determine value which is often difficult to overcome.
2. Fixation on price (valuation) and ignoring other key deal terms:
Both buyers and sellers need to understand that valuation isn’t determined in isolation. Price generally goes hand in hand with other key deal terms e.g. upfront vs. deferred consideration, cash vs. scrip (shares) consideration, how long the founder will need to work in the business, restraints of trade, level of warranty and indemnity protections etc.
All other things being equal, a higher price typically means greater risk for the buyer, so if the seller is wanting a higher price, the buyer will likely want to manage that increased risk through other deal protection mechanisms.
While price is likely the most important factor in SMB M&A negotiations, both buyers and sellers need to ensure they properly consider and negotiate other key deal terms at Term Sheet stage, to minimise the risk of the transaction falling over at the time of negotiating the long-form, binding transaction documents.
3. How size impacts the capitalisation multiple:
Often a SMB seller may reference capitalisation multiples achieved by large private or public entities in M&A transactions, with an expectation that the same or a similar multiple should apply to their business.
The ‘size effect’ in the context of valuation refers to the phenomena whereby larger businesses typically attract higher valuation multiples. Reasons for the size effect are numerous and varied; however, it fundamentally relates to the acquisition of larger businesses being considered less risky than that of smaller businesses.
Sellers need to be reasonable and understand that for SMB transactions, there will typically need to be a discount to the valuation multiples achieved on larger M&A transactions that may be reported in the media or publicly available online.
4. Understanding when an Earn-Out is appropriate:
An earn-out, otherwise known as deferred or contingent consideration, is a good tool to bridge the valuation expectations between a buyer and a seller; however, earn-out’s generally only make sense in certain circumstances.
Earn-outs are typically used in scenarios where the target business is in a strong growth phase and therefore, the seller is looking to capture some of the value in connection with their efforts that would otherwise be wholly received by the buyer post-completion.
Alternatively, earn-outs are also useful where the seller or a key individual will continue to work in the business post-completion, and the earn-out consideration is used as motivation for the seller to deliver the performance outcomes that the buyer is seeking.
A holdback is a form of earn-out, whereby consideration is deferred (held back) and released based on time or certain events occurring. Holdbacks are typically used by a buyer to manage identified or perceived risk, but are often looked at unfavourably by sellers given the existence of other negotiated protections in favour of the buyer (such as warranties and indemnities).
A buyer or a seller trying to negotiate an earn-out as part of a transaction that doesn’t make commercial sense, is a common barrier to potential SMB transactions proceeding.
Obtaining advice from a corporate advisory or transaction specialist ahead of, or at the time of negotiating a transaction, is key for SMB buyers and sellers, in order to achieve the best possible outcome for the relevant party and maximise the likelihood of the transaction being able to complete. At Zealth Advisory, we have extensive experience in M&A for SMB's across various industries and on transactions with purchase prices ranging from $1m to $300m.
Get in touch to see how Zealth Advisory can add value to your next business acquisition or sale.
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