Updated: Oct 12, 2020
After about a decade of sky-high private company valuations, prices could be starting to come back in line with intrinsic values. The spike in M&A activity in Q3 of this year is partly a catch up from deals that weren’t able to be done earlier in the year and partly a new focus on M&A as a growth strategy in our post-COVID world.
As disruption has occurred across nearly every sector, M&A has become a more prominent growth strategy for companies of all sizes. Buying growth can often be cheaper than creating it organically and the current environment may be ideal to start exploring.
Figuring out how much to pay does not need to be difficult, but it does require thinking through the right steps. Traditional valuation will spit out a value range based on a discounted cash flow (DCF) or relative valuation analysis. These are good methods and, if the correct inputs are used, a DCF analysis will give you the true intrinsic value of the company you want to buy. But deals don’t get done at intrinsic values. And if a transaction can’t be financed the deal won’t get done – no matter what a DCF tells you.
But deals don’t get done at intrinsic values. And if a transaction can’t be financed the deal won’t get done – no matter what a DCF tells you.
It’s important to model the actual transaction at hand to determine if what you are about to do will be feasible. There is usually a way to tweak almost every deal to make the buyer and seller happy. But you need to know what levers to pull and how far they’ll go.
While most people focus on EBITDA and what multiple of it they should pay, the process all starts on the balance sheet. The balance sheet can have large effects on your return on investment and not accounting for it in advance can rapidly turn a seemingly good deal into a bad one.
While each of these should be expanded and adjusted for every individual deal, here are a few steps to get you started:
1) Sum the amount you’ll likely be able to borrow using the target’s assets as collateral. The three most likely line items are:
a. Accounts Receivable – businesses with accounts receivable larger than $1,000,000, should be able to find lending companies who would be happy to finance the transaction and us the receivables as collateral. They will usually offer advance rates of around 80% but will exclude several different accounts such as those that are older or from a related party. The effective advance rate can often be between 60-70%
b. Inventory - lenders will typically extend financing based on 50% - 60% of the value of the inventory. However, like accounts receivable, they will exclude certain things. We usually use an effective advance rate of 40%-50% of the inventory value when running our valuations. Once we dive into diligence and learn more about the actual makeup of the inventory, we tighten our assumptions.
c. Fixed Assets – lenders will typically extend financing based on 50% of the value of the fixed assets but this can vary widely based on the perceived recovery values of the assets.
2) Calculate the debt service cost on these items. The accounts receivable and inventory financing is usually done through a revolver that doesn’t amortize and the fixed assets financing will amortize.
3) Figure out how much cash you’ll need to invest into the target company in the form of working capital (this part is a big deal) and capital expenditures in order to make the growth rates you are forecasting possible.
4) Now take the EBITDA of the target company and subtract out the cash needed in steps 2 and 3 above to figure out how much you have left over. This will be the free cash flow which you can use to either pay additional debt payments or take out of the company for yourself. Because you’ll likely be putting a large amount of leverage on the company in order to make the transaction happen, you’ll usually want to get debt paid down for at least the first couple of years before taking distributions.
5) Now look at the amount you think you can raise in step 1 above and think about the amount of cash you’ll need to add to that to make the deal work. If you’re lucky, the cash in step 1 will be all you will need and you can do the deal with no cash down. It can happen, but doesn’t usually happen this way. You’ll need to experiment with different levels of cash injected by you or your company to balance between 1) giving enough money to the seller to entice them to do the deal and 2) not giving the seller so much that your return on investment falls below acceptable levels.
6) If you’ve gone through all of these steps and you still don’t have enough cash to do the deal, you should explore a seller note. Sellers will often be willing to do this. You’ll likely need to offer an interest rate a good bit higher than what you’d pay a bank for two reasons: 1) The seller note will be junior to all bank debt and therefore the riskiest. If things don’t work out the banks will be paid first and the seller will want to be compensated for this risk, and 2) When the seller note interest rate is high enough the seller will want to help finance the deal because there won’t be anywhere else they can put their money to earn a higher return. Rates of 8%-10% are common. This might sound high but can be a win-win for both parties. Add the seller note to step 1 above and repeat all the steps until buyer and seller are happy.