Mergers and Acquisitions For Dummies (43 page)

Forward EBITDA:
In this case, all or part of the valuation is based on the future performance of the company. Forward EBITDA is a good thesis when an earn-out or some other form of contingent payment is part of the deal because if Seller is asking for a valuation based on the future performance of the company, he should be willing to put his mouth where his money is.

Contribution margin thesis

With the
contribution margin thesis,
Seller is essentially telling Buyer, “Pay no attention to the lack of profits behind that curtain.” Instead of focusing on the bottom-line profitability, Buyer considers the effects (that is, benefits) of adding the Seller's “contribution” to the Buyer's existing operation.

What is contribution? Definitions vary, but essentially,
contribution
is sales minus direct costs for those sales.
Direct costs
include the cost of goods, as well as any sales or marketing costs in SG&A (selling, general, and administrative).

As an example, say a company has revenues of $40 million and is losing $2 million a year. Assume the direct costs associated with those revenues are $18 million. The gist of this thesis in this case is to say to Buyer,

“Look, we know our company as-is is unprofitable, but instead of taking the entire company, what if you only take the client relationships and corresponding revenue and move operations to your facility? If you do that and subtract only those expenses directly related to those revenues, you pick up $40 million in revenue and realize a $12 million contribution before your costs. I know you'd have other expenses, but how you run the business is up to you. What is that $12 million of contribution worth to your company?”

The key to this approach is the realization Buyer is already spending money on operations, and adding the acquisition's contribution to the mix will have little or no impact on expenses.

Buyers are unlikely to pay the standard 5X multiple on a contribution margin, but 2X may be a reasonable amount.

Companies with thin profits (or losses!) are typically prime candidates for the contribution margin thesis because a company with thin profits or losses doesn't fetch much if the valuation is based on the bottom line. Contribution margin focuses on something other than the bottom line and asks Buyer to pay based on that alternative.

However, companies with a product that clients view as a commodity aren't suitable candidates for a contribution margin approach because their products aren't considered different or unique, a situation that makes a contribution margin approach difficult. Buyer is unlikely to pay a premium for a company that's a dime a dozen.

Gross profit thesis

Very simply, the
gross profit thesis
asks Buyer to value the business based on the
gross profit
(revenues minus the cost of sales). This thesis
is similar to the contribution margin thesis in the preceding section and in some cases may be exactly the same. In this approach, a 5X multiple is probably out of the running, but a 1X or 2X multiple may be possible.

The gross profit thesis may be a suitable solution for another problem: structuring an earn-out. See Chapter 12 for more on earn-outs and other contingent payments.

Top line revenue thesis

As simple as it gets: This thesis is a valuation based on
top line revenue
(gross revenue). Similar to the contribution margin thesis, Buyers probably won't pay 5X EBITDA; a 1X multiple is usually a pretty strong valuation.

The top line sales thesis makes a great way to measure an earn-out.

Asset value thesis

Instead of basing the valuation on some sort of measure of cash flow,
asset value thesis
uses the value of assets. This type of valuation is another way to create value for a profit-challenged company.

When using asset value, do not use the depreciated value of assets, use the replacement cost of assets. Companies will have accumulated depreciation on their books. Add that back or do some research and determine the replacement value of those assets. Also, for those of you delving into cross-border deals, Chinese Buyers rarely look at cash flow as a valuation technique and instead prefer asset value.

Strong customer base thesis

This thesis moves out the realm of measureable accounting results and firmly places us in the touchy-feely, “gosh darn it, people like me” world of intangible valuation techniques. So burn some incense, put on your Ravi Shankar LPs, and dig it, man!

With this thesis, Seller is asking Buyer to consider the strength of the customers.
Strength
can mean both size/purchasing power of the customers as well as the point of entry to the customer — the higher up the corporate food chain, the more valuable the relationship. A Seller who has C-level contacts (folks with
C
s in their titles, such as CFOs) has more-valuable customer relationships than a Seller who sells to low-level associates.

Recurring revenue thesis

A company with
recurring revenue
(revenue that automatically generates, such as that from fees or subscriptions) is often a more-desirable buy than a company where the sales force has to make new sales every year, month, or week. Many Buyers are often willing to pay a premium for that consistent revenue stream.

Just an old fashioned growth story thesis

This thesis is the ol' venture capital, “we're going to take over the world” story. Sure, the growth story deal often results in a flameout, but certain investors are willing to pay a hefty premium for a company that touts an incredible ability to grow.

I don't recommend the growth story thesis for owners who want to retire or otherwise take some chips off the table. When an investor puts money into a growth story company, that means the money stays with the company to pay for growth! The ability for Seller to garner a premium by selling a growth story company
and
pocketing that money are extremely remote.

Synergies thesis

Otherwise known as the “You complete me!” thesis, the
synergies thesis
is a situation where 1 + 1 = 3. Two companies, perhaps in the same industry or closely related ones, have certain strengths and certain weaknesses that complement each other such that the result is greater than the sum of its parts.

For example, suppose two companies are in the auto parts distribution business. One company goes to market through a catalog, has a world-class distribution center, and a strong customer service department. However, competitors who are excellent Internet marketers are eating it alive. The second company is an ace at Internet marketing but lacks a customer service department and relies on a very expensive outsourced distribution center.

In this example, the second company may be willing to pay a premium to buy the first company to fill in its own weak spots. The two companies are stronger together than they are separately.

Deals with this thesis can be extremely tricky to negotiate. Most often, Seller needs to tailor a specific message to each potential Buyer; after all, not every Buyer needs the same weakness addressed. Don't make up a story; just realize that different Buyers may view different aspects as the most valuable.

Seller's rationale for seeking a deal

A well-written offering document should provide Buyers with information about Seller's reasons for selling (I discuss common motivations in Chapter 2).

As Seller, communicating your motivation is important because doing so helps Buyer determine whether pursuing a deal makes sense. A Buyer who needs the Seller to stay on board to run the business is unlikely to bid if the deal involves the owner's retirement.

When selling a business, don't sound desperate when listing your rationale. Doing so gives Buyer the upper hand in negotiations because he knows you need to unload.

Seller's deal guidance

The
transaction guidance
portion of the offering document indicates the type of deal that interests Seller — that is, how much structuring (notes, earn-outs, and so on) if any he's willing to accept, whether he strongly prefers cash at closing, whether he needs or prefers an asset deal or a stock deal, and so on.

I don't recommend providing a price in the book. Doing so places a ceiling on the valuation, and Seller runs the risk of leaving some money on the table. Also, providing a price may inadvertently provide Buyer with the wrong guidance. A Buyer who submits an offer by matching the listed price will be rightfully upset if the company is sold to someone who submitted a higher bid. The snubbed Buyer may have been willing to submit a higher bid but decided to follow the guidance of Seller.