When €50m is worth more than €60m.
A conversation with the person sitting next to me on a flight to London the other day inevitably turns to corporate finance — in this case, the possible sale of his business. He and some partners have built a strong international business without any external capital, generating €4m EBITDA this year, and feel it’s time to find a larger owner in order to accelerate international expansion. The company expects strong sales growth and the management is very confident in the long-term growth plan, which will see EBITDA increase to €6 million over the next two years.
With the help of an advisor, he’s excited about receiving two offers for his business: one for €50 million from a Private Equity firm and another for €60 million from a strategic buyer. As a team, they’re working to enter exclusive discussions with the strategic buyer.
In fact, it’s the wrong decision.
The Private Equity offer is for full payment at closing. There’s also the opportunity for the management to reinvest $5m in the company, with a projected 5x return if targets are met.
The offer from the strategic buyer is $40m at closing, plus $20m subject to an earn-out: $10m in each of the next two years for achieving the planned sales growth.
(Both offers also require $10m to be placed in an 18 month escrow account, to cover claims against warranties and indemnities.)
Let’s take a look at the respective valuations:
· PE offer: 12x current EBITDA
· Strategic buyer offer: 10x current EBITDA or 10x future EBITDA
So the Private Equity offer is in fact higher, and the owners would be better off accepting that and reinvesting some of their proceeds back into the business. If the company does well, their reinvestment will do well; if the company does less well, they have received a higher entry price for their investment
Valuations are linked to the time the offer is made, based on historical performance and future prospects. An earn-out pays for future performance and is an alternative to just waiting until the company grows into a larger valuation; it is not part of today’s valuation.
Unfortunately, the M&A advisor’s probably not going to point that out. Their fee is based on a percentage of the headline number, so they are hardly going to recommend a lower offer, even if it’s better. (In fact, for an M&A advisor the #1 consideration is which offer is most likely to succeed, not the valuation, because a percentage of something is always better than a percentage of nothing.)
Entrepreneurs understandably focus on the headline number when thinking of valuation, but a lower valuation may in fact be the one to choose.
