Iain Campbell and Ben Brierley are directors of FC Corporate Finance, a mergers and acquisitions boutique specialising in the IT channel industry.
This is the latest in a series of articles we have written based on our experience of making acquisitions in the IT channel industry. These ones look at what happens once you have approached the target (or been approached by a possible target) and started discussions, and you decide you want to make an offer. How do you value the target? The first instalment is about pitching your initial offer.
Arriving at a valuation for your offer
In the mid-market, you very rarely see a business being marketed with an asking price. If it is, it will very probably also have stuff like “early viewing recommended” and this will indicate that the vendors’ advisers don’t know what they are doing. This could be either a bad thing or a good thing for the purchaser but our experience is it’s usually bad and if you are trying to build or maintain momentum in an acquisitions program that end of the market is best avoided.
It is in the nature of things that neither party wants to fire first on the valuation issue. If the vendors indicate an asking price or a view on valuation, the purchaser will (usually entirely correctly) assume that the actual acceptable price will be some lower figure. Similarly, if the purchaser makes an offer the vendors will assume (usually entirely correctly) that this is an opening gambit and the purchaser will be willing to pay more. If you say “I am going straight to my final offer, best price and this offer won’t be increased”, they will be even more convinced that it will definitely be increased. If you try to compensate for this, for example you’re the buyer so you go in with an obviously low offer in the expectation that you will have to increase it, you may be accused of an insult and dropped from the process or at least put on the back burner.
If you’re a seller, beware the obviously lowball offer which when rejected prompts the response from the buyer “Well we’ve made an offer. If that’s not acceptable you need to tell us what would be.” That’s just trying to get you to name your price and then you need to go back to the start of this article.
In the end, the prospective purchaser almost always has to go first. This could be because the vendors simply will not give any indication of price expectation. We get that – if we are acting for the seller we never do. Not formally, and not informally either, when the buyer’s adviser calls up and asks for “just a steer”. It isn’t just a steer. It will be interpreted as what we said before – a figure that is higher than what our client will take. Or perhaps the vendors’ advisers are process-obsessed and are driving a hard, tight timetable. This is something that is fine if you are doing an IPO of Saudi Aramco but isn’t always for the best when you are selling a small/medium-sized IT business. The reason why we think that from our experiences is kind of hard to explain, but (for example) the IPO wouldn’t ever get delayed because someone’s dog died. If you are acting for the seller in a mid-market deal and you drive it too hard you genuinely can lose bidders for that kind of reason. Why would you do that? But some people do.
Our clients of course have to promise us that they never talk valuation without one of us or a colleague being present.
So, at some point, the purchaser has to make an offer. If it isn’t a managed process, we prefer to do this verbally, ideally face to face or, failing that, in a video call, so we can attempt to gauge reaction. If it is a managed process then don’t assume that it’s like a sealed-bid auction and the highest bidder wins (or the highest three go through to the next round, or whatever). Expect to be contacted informally and told you need to increase your bid. Maybe even (at last) with an indication of how much. In the end, every case is different. You need to assess the personalities of the vendor and the advisers, ask yourself how much you want the deal and how much it would matter if you lost it, and work out the delta between your offer and your best price.
Business culture is in the mix too. Our experience from the places we happen to have done deals is that the deltas are higher in the MENA region and some parts of Europe than they are in the UK. That’ s probably true in other places too which are beyond our geographic experience. In some business cultures, going in with what looks to a corporate financier experienced in doing UK deals like an absurdly low opening bid might be expected, so if you go straight in with anything like your real price straight away you will run out of room for manoeuvre.
Valuation technique – Enterprise value
In order to ensure apples are always being compared with apples, corporate financiers and others in the mid-market M&A game invariably express a target company’s worth measured as “enterprise value” (or “EV”). The technical definition of EV is something like the market value of a company to all of its stakeholders, not just the equity holders, the principal difference being that debt providers are regarded as stakeholders too. In practice that means that EV is the theoretical value that 100% of the shares in a company would have if the company had no cash and no indebtedness and its working capital was in a normal state. Those are the assumptions you make in your valuation and your offer will be expressed as being subject to that. Validating the assumptions will be part of your later due diligence and you will take protection against the assumptions being incorrect or varying in customary mechanisms that are included in the eventual share purchase agreement.
Valuation technique – Earnings valuations
For most mid-market OMB’s and, we think, for all of them in the IT channel, the valuation methodology will be earnings based, ie the Enterprise Value or “EV” (as discussed in our previous article) is established by applying a suitable multiple to the normalised maintainable profit. There’s quite a lot happening in that sentence, and we will come back to it, but first we will mention discounted cash flow valuations. For us that is really just a spuriously-accurate, highfalutin way of doing an earnings valuation. (It honestly is if you think through the maths.) But it is beloved of MBA graduates and junior analysts in the private equity industry so you might have to translate at some stage for them by dividing your multiple into 100.
If you think about the concept of what it is you are valuing using enterprise value, the assets that generate the earnings are in there but the debt that is serviced from them is excluded. The measure of profit you use should therefore be normalised EBIT (earnings before interest and tax) so the cost of asset utilisation is in there but not the cost of the debt. (Amortisation of goodwill and similar intangibles would then be a normalisation adjustment if you want to get technical.) However, these days everyone talks in terms of EBITDA multiples (earnings before interest, tax, depreciation and amortisation). This trend annoys at least one of us not just because it is theoretically impure. It perpetuates the modern myth that depreciation is somehow not a real cost and that asset utilisation is irrelevant. This can be the case if you are modelling cash cover debt covenants or something like that over a short time frame, which is why the UK corporate finance industry started using EBITDA back in the noughties, but that’s got nothing much to do with valuation. Anyway, we have to go with the flow so our firm will talk EBITDA multiples these days like everyone else. In relation to valuation, the truth is it doesn’t really matter that much as long as you have the right multiple and are comparing apples and apples, and as long as you take any abnormal capital expenditure requirements into account somehow in the calculation.
Earnings valuations – normalisation of profits
Normalisation of profits (sometimes called establishing the underlying profit) is another of the dark arts of M&A, beloved of the sell-side adviser and usually fairly amusing for the buy-side adviser. More about that in a minute but what’s the starting point in the calculation (ie the pre-normalised profit)? Usually, you will have as a minimum all the historic accounts for recent years, the management accounts for the year to date and the current year budget. Sometimes, especially if it’s a managed sale process, you will have projections. Usually these look forward a couple of years. If they go further forward than that it’s all the more reason than normal to ignore them as made-up.
We usually start with trying to establish what the current year earnings are going to be. (If it’s getting towards the end of the year and there’s a decent budget or forecast for next year, we might use that instead.) Based on the year-to-date performance and any other know issues, we then interrogate the budget and adjust that to what we think is the current profitability. For us, if you are averaging historic performance or discounting distant projections for an acquisition in the IT channel space you are doing it wrong. Historic and prospective earnings growth and consistency are something that should be factored into the multiple, not the earnings.
Normalisation involves making adjustments to the EBITDA to reflect any income or costs that would not recur or would be different in the future under new ownership. The classic ones are directors’ remuneration in excess of the commercial rate for the job, discretionary lifestyle expenditure (like the box at Man United) and significant one-offs like restructuring costs, professional fees or bad debts. All of this is fair enough. If the vendors aren’t staying, or aren’t staying long, sometimes the vendors’ advisers will try to say that all of the directors’ remuneration should be added back. Sometimes they present it like that even if the vendors do want to stay. It’s up to you how reflect it in your own valuation.
One potentially contentious area you will sometimes see in IT channel trade sales is synergy benefits. A creative sell-side adviser may include in its presentation of normalised profits the benefits of synergies that will accrue post acquisition.
These could be simple cost synergies through efficiency and de-duplication but might go further and include commercial synergies (like cross-selling opportunities). When we are acting buy-side we normally advise clients that, for the purposes of pitching an offer, we should value the target on what it objectively worth, not on what it’s worth to our client in particular. Any upside of that isn’t something we should normally be paying for and as 70% plus of acquisitions are unsuccessful (as per a previous article) then the chances are the envisaged synergies won’t happen anyway. That said, it depends how much you want the deal and what competition you think you have (particularly if it’s a managed sale process). If you discount synergies entirely in your offer and other bidders fall for it, you may end up losing a deal at a price that was more than you wanted to pay but could have lived with.
Earnings valuations – establishing the multiple
OK so the last article was about how you establish the earnings for an earnings-based valuation. What about the multiple you apply to these earnings? Unless you are acquiring something really niche that genuinely has a unique value to you and you’ve simply got to have the deal, then the multiple is simple, at least in theory – it’s the highest multiple someone else would pay for the business. We will come back to that.
If, exceptionally, it is in fact the case that the target is something of unique value to you then you will have to work out how much value it will add (you could use discounted cash flow here if you must or just use the prospective increase in your earnings that will result from the acquisition and capitalise it using what you think your own multiple is), then see how much less you can get the target for in a negotiation. That will come down to how much the owners want to sell and how good the respective advisers are. A couple of times in the past we have sold quite small, not obviously eye-catching businesses for serious double-digit multiples because we could see we had something unique in the market that the prospective buyer just had to have, and they didn’t hide it very well. Our clients were open to sell, but didn’t need to. Those are tap-ins for the sell-side adviser.
If, as will usually be the case, the target isn’t of unique interest to you and has wider market appeal, then how do you establish what is the best price someone else would pay? In our firm we do this through a combination of experienced gut feel and comparable multiples.
Where the gut feel comes in is that is the SME and mid-market space, if the multiple is less than about 4.0 there’s something especially unattractive about the business and if it’s more than about 7.0 there’s something especially attractive about it. That’s a sector agnostic starting point, but for SME and mid-market we don’t think IT channel businesses are much different -maybe a slightly higher average range, but not much. We think the rationale is sort of that if you owned a business and could only get (say) 2.0 or 3.0 times earnings, why would you sell it? (Other than maybe a tax-efficient retirement situation.) You wouldn’t normally, would you? You would just keep it and keep the earnings. If you are an acquiror paying much north of 7.0 then unless your own company is especially highly-rated or you have a well thought-through time-limited plan to an exit (like in a private equity play) then it’s going to be really rather difficult to create shareholder value from your acquisitions programme, and the odds-against-you risk of the acquisition being unsuccessful will be amplified.
Size is an obvious feature that could be something that’s unattractive – maybe the target is too small to attract many corporate acquirers except very small ones and far too small for private equity, so maybe that would be the driver of the multiple going below 4.0. Or size could be something attractive – large enough to attract the premium that private equity will pay for the right businesses and push the multiple into double-digit. Then there are the qualitative factors around the earnings. We haven’t seen much going for less than about 4.0 in the IT channel unless it really is small so it’s other things typically that drive the multiple. Other than size, the factors that can increase the multiple up to and beyond 7.0 are growth and growth prospects, margins (not too high or too low – we will come back to that), revenue retention, recurring revenue (not necessarily the same thing), vendor and customer profile and spread and the quality of systems, compliance and governance. For an owner-managed business, the extent of dependence on the owners needs to be factored in, regardless of whether there is an intention for them to stay post-completion or not.
We said we would come back to margins. It might be counter-intuitive to mark down the multiple you apply to a business because it has high margins, but in a business like that, which in the context of the IT channel would be one with a high element of services or value-add mixed with the software and/or hardware sales, danger lurks. Remember (as per a previous article) 70% plus of acquisitions are unsuccessful. If things go wrong in a business with high margins, then the effect on net profit and cash generation will normally be sharper and quicker. If the margins are so high because the business has been exceptionally tightly managed by its founders personally, will you be able to keep that up? Or is the balance of risk that the margins will slip?
Businesses with lower margins (think hardware box-shifting in the IT channel) don’t have the operating gearing risk but if the margins are very low the business will be unattractive for other reasons, like poor return on capital employed and how hard you have to pedal to get good growth to make a meaningful shift on the bottom line. That’s why the valuation multiples of box-shifters always cap out significantly lower than other stuff in the channel.
Whether they are high, low or in-between, the trends in the target’s margins are something you need to understand. In earnings valuation theory, “growth” means growth in earnings. Sales growth is only one component in that.
We will deal with the use of comparable multiples in the next article.
Earnings valuation – comparable multiples
Our previous article looked at our use of “experienced gut feel” in establishing what earnings multiples to use to value acquisition targets with. As we said previously, we usually use that in conjunction with “comparable” multiples?
We almost never use quoted-company comparables unless we are doing forensic accounting or fiscal valuations, which for us are reality-vacuum processes, but you do have to do them the way the rules and custom and practice of those disciplines say. You always have to discount the quoted comparable multiple to make it applicable to a private company. But the discount is something you just make up – it isn’t science. The exponential effect that this made-up discount has on the answer will usually mean the exercise is worthless for the purposes of real M&A.
Where there may be some guidance in the quoted markets though is where you can have a look at the average or typical quoted Price:Earnings ratio for the particular type of company in the market and see how that compares not to your unquoted target but to the average or typical quoted ratios for other types of quoted IT channel businesses. This won’t in itself give you a mathematical formula to calculate the multiple for your target, but it will give you guidance as to what premia and discounts the quoted market attributes to things like growth, value-add, box-shifting, net revenue retention and other qualitative features the target may have more or less of. You can then use this information in making comparisons between private company data and explain the trends. This assumes of course that you can find one or more quoted companies that is genuinely comparable to your target in terms of its likely valuation drivers and then find other suitable different quoted companies in the IT channel to benchmark against.
For us, pricing information about actual recent (or recent-ish) sales of comparable private companies is the gold standard in terms of comparisons that really have much relevance. “Comparable” takes into account specific activity, size and geographic footprint. You will have to make adjustments for any differences and possibly also for other the other quality-of-earnings factors we mentioned above. This isn’t, of course, a precise science.
The difficulty with using private company comparables of course can be the lack of ready information about deals and pricing. In this regard, it’s useful that there has been so much M&A activity in the IT channel in the UK in recent years. It’s also useful that there is so much private equity activity – the closeness of the relationships between the PE houses and the large players in the corporate finance community is such that pricing information tends to get around even when it’s “not disclosed”. Failing that, you might have to wait until the acquiror publishes its accounts and discloses the details of the deal, though in some cases you still won’t be able to find out. That might be because the acquiror simply doesn’t comply or properly comply with legal and accounting standards requirements to disclose the details of acquisitions, something that you might be surprised to know happens a lot, or because the acquiror is based in a jurisdiction where it doesn’t have to disclose this information or even publish accounts at all.
Relevance of net asset value
Previous articles in this sub-series have covered the earnings-based valuation technique that is prevalent in how you would value an IT channel business. We didn’t address net asset value in any of that and the truth is it’s something that has very limited relevance. In the IT channel, the businesses that attract higher multiples often are those don’t have that much on the balance sheet (for example because there’s a high component of services, or they are selling subscription software or, at least, electronically delivered software so there’s no inventory and no warehouse).
In these situations, the earnings valuation technique spits out an answer and the consequent goodwill premium above net asset value just is what it is. That said:
- All other things being equal, if you have two companies that have identical earnings and identical quality of earnings (not that this could ever happen) but materially different net assets values, then intuitively the one with the higher assets would be worth a bit more;
- If there is a big balance sheet then the quality of the assets that are on there could be something that affects earnings quality and therefore the multiple;
- Exceptionally (probably never at the moment in the IT channel sector) if your earnings valuation produces a discount to net asset value then you will need to modify your approach. If your offer is less than a good liquidator could realise then it’s unlikely to be accepted; and
- The working capital dynamic, ie how cash behaves relative to profitability, should be something you assess in earnings quality and therefore the multiple. This is driven by how working capital assets and liabilities move between balance sheets so you will still be analysing component of the balance sheet even in the net assets value itself isn’t important.
Target valuation – other factors
In relation to valuation, there might be some special factors that are unique to the situation, so that your comparable companies might be comparable but the circumstances of the sale aren’t comparable, and the gut feel parameters don’t apply either. These would tend to be negative things rather than positive ones. The most common one would be something that is driving a requirement for a quick sale, such as potential insolvency, the vendor having an urgent requirement for liquidity or the vendor’s serious ill-health. It might be less obvious than that, though. Sometimes in retirement sale situations the vendors have made their money already, have good pensions and just want a decent-sized amount of cash so they can go as soon as possible and leave their company in good hands, without necessarily bothering to squeeze full market value out of the deal.
That really does happen sometimes and as we have said in previous articles there are a good few of these retirement sales knocking around in the IT channel both in the UK and in Europe. Part of the value we as corporate finance advisers look to add on the buy-side is an ability to spot and play out these situations. That mostly comes from experience.
Remember, as an acquiror the reason you go through a complex valuation exercise is to second guess what the vendors and their adviser will be doing and to work out what their price expectations will be (since they won’t tell you). Separately to that, you need to work out how much value you think the acquisition will add to your own business – something we alluded to in a previous article – and if you are doing it right there should be a decent positive delta between the two. All of that notwithstanding, you still want to pay no more than you have to. That’s comes down to a negotiation process that is merely informed by your valuation work.
Valuation expectations
The last item we want to mention in this sub-series of articles about target valuation is about valuation expectation rather than valuation itself. There are vast numbers of business owners out there who have no awareness whatsoever of how a business is valued and what they could get for it if they sold it. It’s not just that they aren’t corporate finance experts – that’s fine – but sometimes there is a total absence of common sense. We have made cold approaches to SME targets in the past (not necessarily in IT channel businesses) and opened dialogues with unadvised potential vendors, only to find that they genuinely expected someone would pay what worked out around 25 times profits for a small, ordinary business.
Worse than this is when the vendors do have advisers and the advisers don’t condition the client’s expectations when they take the job on so they have a realistic, committed seller. Or, even worse, they don’t seem even to care. In terms of sell-side M&A intermediation, there’s a panoply of different business models ranging from advertising-driven business-broking at one end to full-service deal management and lead advising at the other. Our experience has been that where you have vendors who are advised, the nearer the broker end of the market the advisers are the more likely you are to have a vendor with unrealistic expectations.
We would say particularly so with some intermediaries who have a hybrid model of internet/e-mail marketing, quick and dirty information memorandum (“IM”) and a bit of deal management but not much. You can waste a lot of time and valuable resource with some of these opportunities. Since, as we discussed in a previous article, the vendors and their advisers almost always won’t talk valuation until you have made an initial offer, you potentially have to do your initial assessment, including reviewing the IM, asking questions and reviewing supplementary information, doing a meeting with the vendors and potentially a site visit, and doing your valuation work only to put a genuine offer on the table that is dismissed as “derisory” because it turns out the vendors had ludicrous valuation expectations and the advisers either didn’t realise this was the case or did realise, but didn’t care.
We have had this experience more times than you could shake a stick at. (Not to mention awful deal management and communication.) Consequently, we and our clients try to avoid chasing deals from this type of source if we possibly can. The best acquisitions are the ones you originate yourself (with the help of your corporate finance adviser if you haven’t got the skills in-house. The second-best ones are the on-market opportunities where the sellers have invested in an adviser that has prepared the company for sale, anticipated due diligence and conditioned its client to have sensible valuation expectations.
This article is part of a series focussing on aspects of acquiring businesses in the IT channel industry. If you would like to explore any aspects further, please get in touch.
FC Corporate Finance Limited
Iain Campbell (Director) – email ic@fccorporatefinance.com
Ben Brierley (Director) – email bb@fccorporatefinance.com
FC Corporate Finance Limited is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Institute of Chartered Accountants of Scotland. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.