We are often asked by clients when they should begin positioning their companies for a sale or liquidity event. Many entrepreneurs have a clear view of an exit from the day they open the doors. Every strategic and operating decision is made in the context of creating value to be monetized at exit. These companies often have experienced investors and boards who have been down the road to exit before, providing invaluable advice regarding strategic focus and positioning.
This strategic clarity and direction is often lacking in the governance and management of middle-market (MM) firms. We define a MM company as a non-start-up firm with annual revenue between about $25 million and $1 billion and is approaching or in steady state growth. MM firms are often legacy businesses with dominant positions in mature market segments. Additionally, they tend to be intergenerational and family-owned. MM firms represent a typical Crewe M&A client demographic.
The pathway to exit that the high-growth, outside investor-financed startup pursues is often different from that of the MM firm, and these differences can be highly industry specific. For example, a pre-public biotechnology firm may pursue a strategy of value monetization by bulking up its intellectual property (IP) portfolio at the expense of other strategic objectives. Such a strategy would be inappropriate for a manufacturing/services firm. In the following three blog posts we’ll share our thoughts with respect to how we advise our MM clients regarding the timing and positioning required to effect a successful, value-optimizing liquidity event or sale of the enterprise.
In this first post we focus on the strategic perspective and optimizing revenue and quality of earnings given the constraints of a firm’s business model. We discuss a couple financial metrics that can be utilized as an assessment tool in evaluating a firm’s preparedness for sale. In the second post, we will discuss getting the proverbial house in order, identifying important action items to complete from an accounting, financial, operating, and legal perspective. In the third post, we will walk through the process of putting a business up for sale, the mechanics of the process, and what to expect from an advisor who can assist in the process.
Preparing for sale
So, when should a company’s board and management start thinking about preparing for a sale? There is no universal right answer, as boards, management, and shareholders often have different incentives, timing, and motivations.
Being able to cogently communicate a history of strategic focus, even if that history is brief, is key to commanding a higher multiple to the relevant transaction relative metric (e.g., enterprise or transaction value to revenue, EBITDA, or book value). The credibility behind such messaging depends to some extent on how long a company has successfully maintained its focus. The longer the better. Defining strategy, of course, isn’t done in isolation but involves an assessment of a company’s addressable market, expected growth rate, and an estimation of “market capture” or the percentage of that addressable market that the company expects to “own” once industry growth has plateaued.
What is your revenue mix?
In addition to a demonstrated history of focus, potential buyers will look closely at the nature of revenue and quality of earnings. All else held equal and assuming steady state growth in revenue, the relative mix of recurring revenue to total revenue and the “stickiness” of customer relationships are the primary determinants of the “premium” or magnitude of the relevant transaction metric realized in a sale.
Companies whose revenue can be characterized as “one-off” rarely sell for more than a value equal to their historical annual revenue, and often at a fraction of that, unless they are rapidly growing in nascent or emerging addressable markets. Instead, in those situations where a company has largely non-recurring but stable revenue, a buyer will focus on profitability, referencing operating valuation metrics such as transaction value to EBITDA or transaction value to net before tax income. A potential buyer will estimate future growth by assessing the size of the addressable market and the capacity of the seller to support such growth, then risk-adjust accordingly to arrive at its estimate of fair or transaction value.
Rarely in practice is there discontinuity in trend between growth in historical and forecasted revenue unless the potential buyer expects to realize additional market reach, economies of scale, or cost reductions as a result of an acquisition. In the period leading up to initiation of the sale process, a company should focus as much as possible on optimizing the mix between recurring and one-off revenue. While some strategic plans by nature have a large component of one-off revenue, “best-of-breed” companies will continually seek opportunities to add annuitized components to the revenue mix.
A classic example is Apple Inc. (AAPL). Early in its life, AAPL was in the sole business of selling computers, printers, and ancillary accessories. But an objective stated to shareholders shortly after its inception was to continually seek opportunities to annuitize revenue. In time, this resulted in the introduction of Apple Music, the iPhone, cloud storage, and so on. The rest is history. In all these cases, AAPL successfully migrated from a one-off, capital goods sales paradigm to a model characterized by multiple recurring and annuitized revenue streams.
Optimizing earnings
Optimizing quality of earnings prior to marketing a company for sale is particularly important if the seller expects potential buyers to believe the company’s value resides in its efficiency at generating operating income or cash flow. Unlike drivers of revenue, the generation of income requires off-setting costs, expenses, and capital expenditures to be realized.
In preparing for a sale, a company should take a hard look at its operating structure by identifying those costs and expenses that can be eliminated or minimized. In the case of the sole shareholder or family-owned business, there are typically “lifestyle” and other passthrough expenses that can be eliminated altogether. While these adjustments can be presented on a pro-forma basis at the time the company is seeking a buyer, it is more impactful if they are reflected in prior period(s) operating results. Once the expense/cost adjustments to be made have been identified, industry averages scaled for firm size can be used to target the magnitude of planned changes. An advisor with good data sources and industry perspective is often helpful in this regard.
Using financial metrics to your advantage
A very useful ratio that can be used by management to assess efficiency and profitability is return on assets (ROA), defined as the ratio of net income to assets. When ROA rises over time, it indicates that a company is more efficiently utilizing resources by generating more income relative to its asset base. Conversely, a declining ROA is a sign of possible overinvestment or asset underutilization.
While it isn’t appropriate for a services/manufacturing firm to bulk up its IP portfolio in preparation for a sale, this would be entirely reasonable for an early-stage, research-driven biotechnology firm. In the case of a services/manufacturing firm, the ROA calculation would be with respect to total assets — tangible and intangible with the exception of goodwill — while a potential buyer of our hypothetical biotechnology firm would likely focus on just that portion of intangible assets representing IP and capitalized research & development expense (beginning CY22). The appropriate metrics would then be net income to total average assets, net of goodwill, for the services/manufacturing firm and net income to intangible assets, net of goodwill, for the biotechnology firm.
By identifying and mapping revenue generation to a specific asset (e.g., IP) or asset cluster (e.g., the identifiable intangibles, such as customer lists, trade name, etc.), a firm can target improvements in asset efficiency that may enhance value in a sale. Note that management needs to be careful about comparing its particular ROA with those of publicly traded peers given the impacts of firm size and lifecycle stage on the size of the metric. However, ROA as an intertemporal assessment metric can be very effective in helping identify aspects of a firm’s balance sheet that may require attention ahead of a sale.
Considering the pool of buyers
Institutional buyers of MM businesses – both financial (private equity) and strategic – can be thought of as marbles in a v-shaped vase. There are more buyers at the top layer of the vase who are seeking companies generating $5-$50 million in EBITDA than there are on the bottom layers seeking $100 million+ EBITDA companies. It is important for a board or family considering a sale to understand the size and depth of the potential buyer pool. A smaller pool often precludes the ability of a seller and its advisor to conduct an auction whereby transaction value is arrived at through a process of competitive bidding. A limited number of buyers can also limit the ability of the seller to negotiate alternative transaction forms, such as a partnership or joint venture, that would meet its pecuniary and particular lifestyle needs.
The facts and circumstances of every potential sale scenario are different. A strong professional advisor like Crewe can be invaluable in this regard providing industry insight, identifying buyer pools, rendering valuation and pricing assistance, soliciting potential buyers, setting up and conducting a competitive process, negotiating deal terms, quarterbacking other members of the deal team, including legal and accounting, and shepherding a transaction through a successful outcome.
In our next post, we’ll discuss the house cleaning necessary before initiating the sale process, identifying important accounting, financial, operating, and legal items that may need to be addressed.