07 Aug Multiples in M&A Deals: More than a Simple Number
In M&A deals, multiples play a crucial role in determining enterprise value. Matt Lockhart, Ryan Barnett, and Mike Harvath discuss the importance of valuation and adjustments in M&A transactions, the various factors that influence the determination of enterprise value, including synergies, equity, strategic fit, and valuation multiples. Understanding business valuation and deal making is key to successful M&A transactions.
EPISODE SUMMARY:
- Multiples, such as a multiple of EBITDA, are commonly used in M&A deals as a simple way to gauge the value of a company. However, they are not the sole determinant of a company’s valuation.
- Adjustments to EBITDA, known as “add backs”, can be made to account for one-time expenses or other factors that will not continue post-transaction. The agreed-upon adjusted EBITDA is a critical factor in determining the multiple.
- Many factors beyond just the EBITDA multiple impact the final enterprise value in a deal, including strategic fit, cultural fit, and buyer synergies. The multiple is more of a planning tool than a definitive valuation.
- Higher profitability tends to correlate with higher multiples, while lower profitability may not support a revenue multiple above 1x. Finding truly comparable companies can be challenging.
- Deals sometimes trade outside of typical multiple ranges due to strong strategic fit or other unique factors, highlighting that multiples are not the only consideration in valuation.
Listen to Shoot the Moon on Apple Podcasts or Spotify.
Buy, sell, or grow your tech-enabled services firm with Revenue Rocket.
EPISODE TRANSCRIPT:
Mike Harvath 00:06
Hello and welcome to this week’s shoot it to moon podcast, broadcasting live and direct from Revenue Rocket World Headquarters in Bloomington, Minnesota. As you know, if you tune in regularly, and maybe if you don’t, revenue rocket is the world premier growth strategy. And M&A advisor to tech enabled services companies with me today are my partners, Matt Lockhart and Ryan Barnett. Welcome guys.
Matt Lockhart 00:36
Thank you, Mike. Good to be here. As Mike was saying, We’re world headquarters here in Bloomington, Minnesota, stay a first ring suburb of Minneapolis. And when people hear that that that we’re in Minnesota, they wonder if it’s snowing in June and July and August and and they people should come here now, where it is like 92 degrees and humid and whoo, summer is on. And not only that, but it’s heating up. Congrats. We’ve we’ve had a few closes on on deals here recently, and we’re feeling pretty good about the activity. So good time to talk about our topic today. Ryan,
Ryan Barnett 01:25
It’s a great time. And the ski season, I remind you, is only 100 days away. So it’s, it’s always something look forward to Minnesota. But nevertheless, yeah, great topic today, and it’s something we hear a lot in, oftentimes in in our industry, in M&A within tech services, you, you tend to hear a lot about how deals are calculated for enterprise value. And one thing that most companies will come back to is a multiple of a revenue, or EBITDA in, in how that can be conversed. So however, that that simpleness in a multiple, let’s say a multiple of eta, is also somewhat of a danger in that there’s much more that goes into a deal that’s perhaps outside of a multiple. So today’s topic really, what is a multiple? What you know? What’s important about them. What do we want to how should we be using them, and in which ways can buyers and sellers align using a multiple? So, Mike, why don’t you get us kicked off? You know, what is a multiple, and why are multiples used in M&A deals?
Mike Harvath 02:37
Yeah, sure thing. Ryan, so a little bit on multiples and the history of them and why we talk about them. And you know what? They’re not so multiples have long been used in the world of mergers and acquisitions as a simple and I’ll emphasize simple way of gaging value for certain types of industries or companies based on their kind of vertical market and based on their size, and generally, they are, in most industries, a multiple profit, defined as EBITDA earnings, before interest, taxes, depreciation and amortization, EBITDA and and generally, There’s a range within any individual industry like nit services, what makes sense based on size, based on micro markets, focus variety of other things that impact demand in any particular sort of micro market within IT services, and it’s a simple way for people To talk about generally, the value of their respective businesses or another business, or kind of how they see value in the space. What it’s not is it’s not a valuation evaluation is different. We’ve talked a little bit about that in our our podcasts in the past, that there’s much, much more that goes into an individual valuation. It’s not as simple to just look at your EBITDA or your adjusted EBITDA, which we’ll talk more about in a bit, and apply the multiple and then say, well, that’s what we’re worth. It’s much more involved in that. It’s just a simple way for people to generally coalesce around sort of averages for companies like yours, or companies of a particular ilk to talk about enterprise value.
Ryan Barnett 04:31
And I think that that gets us going. Mike, I love to address what you mentioned right away. So if it’s a multiple of EBITDA, and that’s your earnings before interest, taxes, amortization. We often use the term adjusted EBITDA, and that essentially means there are going to be adjustments to your profit based on typically one time related things or. Options that would not continue post transaction in the industry, we typically call those add backs, and those add backs lead to the adjusted EBITDA. Matt, can you give an example or two of how ad backs start to play and how, how that adjusted EBITDA is perhaps different than EBITDA.
Matt Lockhart 05:23
Yeah, and it’s important right there. There typically are a number of ad backs, which, you know, play into the overall adjusted EBITDA number say, you know, in sometimes in founder led businesses, especially those businesses that haven’t advanced to a, you know, gap based accounting method, you know, full accrual based accounting, they’re, they’re more of a cash based method. They may be running personal expenses through the business. It’s, it’s quite common, it’s okay to do so, but that those are, those are, oftentimes add backs. If there is a capital event, that that really is a one time scenario, you know that that could be an add back, if there’s memberships, if there’s members of the team that have been on salary, and they’ve been yet, they they really haven’t been producing, you know, in a day to day capacity, it’s oftentimes the case again, Within privately held businesses where they keep somebody on salary as a means to until there’s an event, until there’s a recapitalization or a sale event, and and those can can certainly be appropriate add backs as well. You know, oftentimes it’s a discussion between the buyer and seller as to why and what is valid, right in terms of those adjustments, but some of the examples.
Ryan Barnett 07:10
Thank you. Matt, that makes it makes sense. So if, when I hear something like a deal is going to trade at, let’s say, seven times adjusted EBITDA, Mike, what does that mean? Does that how does that calculated? Does that include things, let’s say, like a capital harvest or cash harvest, or does that include, perhaps a CEO who’s ongoing? Does it include their employee comp plans?
Mike Harvath 07:42
Well, I think the best way to think about it is expenses that a simple way to think about it, that are one time or occurred in the past, that will not continue post transaction could, and I emphasize the emphasis on could, be eligible add backs. Oftentimes that doesn’t account for mistakes that were made in the business, like you’re at a bad hire, or, you know, maybe we, you know, paid a bunch of money for marketing that didn’t produce any results. So I want to add that back, but those things wouldn’t necessarily qualify, but, but you do have, like, if you had some legal costs, for example, associated with, I don’t know, so, development of your buy sell agreement, or you had a between partners in the business, or you had, you know, some one time expenses that you know, you can attribute to being not occurring again after the transaction, then you can justify that. Now, in some cases, you can add back part or maybe all compensational specific roles if they’ll be eliminated post transaction. Pretty hard to do, however, if that’s a needed role, and I know a lot of owners like to say, well, we’re not going to be around post transaction. We want to, we want to leave. So we’re going to take out all the staff post transaction, and those are should all be eligible add backs. Well, that’s not really the case, because post transaction, someone’s going to need to do those roles. And just because the company that’s acquiring you, let’s say does that those are what’s called buyer synergies, or lift that the buyer gets because they’ve already built an infrastructure they can deploy against your business. It’s not one that the sellers get. So it’s a little bit nuanced from an add back perspective, but assuming that the Add backs are what’s called defensible, or ones that would make sense, and these are expenses that won’t occur post transaction or generally one time, then yes, and the multiple of that adjusted EBITDA number is generally where those five. Kinds of companies trade, but I’ll emphasize again that that is not the specific valuation for the business. And I don’t really like real estate analogies and M and A because they’re not directly correlated, but in this case, it kind of does apply. So for example, you might say that houses in a particular neighborhood generally sell in this range of prices, right? And yet, to get a number for your house, if you want to put it on the market, it requires a specific appraisal, right? You will need, you’ll need to have someone come in who does this for a living and appraise your residents, so you could know where to bring it to market in a specific price point. And the same thing applies for companies here, right? You know, generally companies of a certain size of revenue and profit and micro market within the IT services world will trade at this multiple. And if you have defensible add backs, you can expect that this will be about the number, but it’s simply a planning number. Is the best way to think about it, just like you would plan. If you were looking at houses in a particular neighborhood, you were a buyer, you might say, Well, how’s this neighborhood generally? Average price is about this. So when I look around, you know, some might be higher, some might be lower, but you know, average will be less well look in this area, and you can apply the same sort of logic here.
Matt Lockhart 11:34
Well, I think that’s great Mike and we guide our clients that there is a range, right? And, yeah, that range just for simplification purposes. And this is truly most often the case in in tech enabled services, that range is a multiple of EBITDA that we had talked about earlier. Often at times there can be multiples of revenue, but it’s it’s a range, because you gotta then go through the other factors, which then come up with the ultimate enterprise value that is agreed upon by the seller and the buyer. And there’s a lot more factors that will go into that ultimate number. But still, I think great analogy. Hey, houses in, you know, in your neighborhood, Mike, they go for for x. In my neighborhood, they go for y, and that’s a good way to start the discussion. Similarly, a managed services business versus a cloud digital transformation business versus they have different sort of baseline ranges.
Ryan Barnett 12:58
I think both of you two really tied that back to the question I was getting that, which was the the, if you hear a range of an EBITDA, let’s say your your friend sold their company, and they were able to to get a great price for that business. And it happened to be 14 times even, in some something that is just a bit outside of a range. There might be a lot that goes into that, and so things like synergies that that you’re not necessarily seeing, that could be outside of the category, or it could be that the deal comprised of some kind of equity that allowed it for it to to swell to a different number. These are all things that are impacting the deal, and to both their points, a deal is not strictly a multiple of a number, typically. Now we have seen this. I know that we had other deals are can or how often do you start? Do you see a deal tied to a multiple of EBITDA and and if so, how you agree what that EBITDA actually is? And I know Matt, I think you’ve seen a couple of these lately, but Mike, feel free to jump in.
Matt Lockhart 14:27
I’ll jump in, Mike. So there’s a there’s a baseline range that is a fairly well understood, you know, range, and set aside the agreement of the eventual EBITDA, right then, then you’re working to, you know, sort of manage expectations of both the sellers, but then, if yes, we’re representing sellers, managing the expectations of buyers in terms of. What they should expect that range to be, and, or what the quote, unquote clearing price will be, which, again, is we’re standing firm on an EBITDA number, and we are saying that the multiple range is, you know, x to y and, and then there’s a oftentimes, the buyers are going to dig in and, and sort of further the strategic fit for their particular mandate. And they’re going to go, Okay, here’s all of the things in the plus column that that match up to our strategic fit. And, you know, here’s a couple of things in the in the minus column, as they’re doing that, they are going to validate the EBITDA and have any discussions or questions, you know, answer any questions related to that. And then they are going to arrive at at their determination of a valuation, right, based upon the strategic fit, the cultural fit, how that matches their mandate, as well as their as well as their value validation of the EBITDA expectations. And so that’s where a firm is going to, you know, sort of end up in terms of their enterprise value. Now we often, we will guide all of our clients that we’re representing on the sell side, that when that number comes through, don’t, don’t think that that’s the final number, because then there is the negotiations and the comparisons against additional offers and so on and so forth. So it’s sort of all of those factors, and I’m sure I’m missing some Mike, which will arrive at the final determination of enterprise value and the corresponding ultimate multiple that is paid on the business?
Mike Harvath 17:07
Yep, absolutely. I mean, I think there’s about 20 attributes, right? So, you know, you have to keep that in mind. It’s not as simple as you know one thing, and it’s always based on, you know, what’s discovered in diligence, if you get in a letter of intent that’s got a multiple of EBITDA, there’s always some discussion and negotiation around what’s antidotes at EBITDA, as you point out, man and what’s not, and what’s eligible and what’s not. And you know that’s a very regular communication, even for deals that don’t have an LOI that’s based on a multiple of EBITDA, because in order for the buyer to calculate the return rate, they have to understand what is a defensible and adjusted EBITDA for them to count on, aka, what kind of profit is this business going to generate post Close for us to be able to calculate our internal rate of return and ROI calculations post close. So there’s a lot of analysis. That’s why, you know, many buyers, particularly financial buyers, you know, hire a firm to do a quality of earnings analysis to further fortify that, that EBITDA right to further fortify what the expected EBITDA will be moving forward. And it, I think it just happens a little earlier in the diligence process. If it’s based on a multiple, if the LOI is based on a multiple, we see loi is based both ways, actual offer and dollars and cents and structure, yeah, as well as those that are more sort of multiple based. And I think obviously, for those buyers that put forth offers that are multiple based, that gives them a little bit more flexibility and comfort than in diligence, are going to be able to make the case for a certain level of EBITDA. It’s again, you know, to put a plug in having a Quality Advisor that has good finance team on your side so they can defend your EBITDA and get to a number that would make sense. Is super critical here, because otherwise you may have a buyer that you know comes, you know comes, comes with a gun to to a gunfight, and you come to the to the fight with a knife, it’s going to be tough, right? And so you need to make sure you have competent counsel and people that know how to, you know, work their way around a financial statement, defend the EBITDA and the Add backs so that you can get to an optimized number. And no, it’s ultimately a negotiation in the end, when you get those types of Lois to determine what is adjusted EBITDA.
Ryan Barnett 19:57
Great, great point. And I would say that. When we see Lois or produce them themselves, I would say it’s more rare for them to be tied directly to an EBITDA number. Certainly, it guides the range, but to be tied exactly to a multiple is more rare than, I would say, than an enterprise value that someone comes to is what we typically seen. Mike, I’d love to get I think this goes your way. But Matt, again, feel free to jump in. But Mike, are there correlations between revenue and EBITDA multiples? I’ve seen a case in where if the multiple on the EBITDA side is high, and the firm is producing percentage of EBITDA that’s that’s in 30, 40% you start to get deals that are perhaps two or three times revenue. And how do those, how do those multiples are, or at least explain to me, and there can be a multiple of anything. So keep that in mind. But if we think about revenue, and even in multiples, how do those interact or correlate with, with with deals?
Mike Harvath 21:10
Yeah, you know, it has everything to do with profit. I think what’s interesting is a lot of the revenue multiple conversation is sort of faded a little bit into the background, and it was originally a legacy from software companies that used to trade on revenue multiple regardless of their profitability, particularly early stage software companies. And for a while I kind of slopped a little bit into the services business side of technology, but tech services businesses always have been indexed on them, even a multiple. Now, if you’re really profitable, it’s pretty north of 20% EBITDA. Just by nature of where most of these multiples go, there is going to be a revenue multiple that applies like you can pretty quickly see that to be the case. Like, if you if you’re over 20% EBITDA, and you trade at seven times multiple, you know, you’re going to trade at a 1.2x revenue multiple, so pretty, you know, straightforward stuff. Likewise, it can go higher if there’s a higher multiple. So, you know, it does come to be that, you know, you get to a revenue multiple, but those are just a function of whatever the heck you’re even a multiple is. Now, if you have relatively low profit, you’re not going to get to a multiple of revenue. You can do the math on that. It’s just not going to occur. And I think you’re you just need to be, you know, prepared for that. Profit is kind of king here when it comes to determining value and whether you’re counting based on a revenue multiple or even a multiple, you don’t even get to a revenue multiple until you have higher than a 5x even a multiple that would be at a pretty high profit level. So you want to make sure you’re clear about that and understand that. You know, without high profit, you don’t, you’ll, you’ll, you’re, there won’t be a multiple of revenue that’s higher than one times.
Ryan Barnett 23:05
Okay. It makes sense. Makes sense, yeah. And I, when we think about this space and the information that’s available, finding a comparable company, I think that’s where multiples really come into play. So if I, if you’re, trying to find similar or like transactions. And Mike used that the housing analogy earlier, and it’s fairly easier. It’s a lot easier to find house comps than it has company comps. I think part of the challenge with company comps is that every company is extremely different, so matching that strategic fit and cultural fit is is so critical, and the industry or category itself has a lot to do with the range of the multiple that a deal may may be within. And I guess my question comes is, how important is having the right comparison when a financial analysis doing their work and looking at companies, and where do you where do you find data to help build the right assumptions and build the right comparison models to so multiple analysis Can can help out in understanding the valuation range?
Mike Harvath 24:23
Well, certainly, you know, going to a credible valuation source and an advisor would be a good way to do that. But pure play comps data, you know, it’s kind of hard to come by. Like you say, there are certainly some databases that are published. I know that connect wise maintain the database that is pretty comprehensive, and there’s many of us that contribute to those inputs to that data, and they report pretty credibly on that data. There’s other advisors that you know publish their own experience data, and you. Know if it’s a if it’s a credible advisor, and there’s many that are, I would consider credible, that data is regularly published. There’s obviously what makes it tough. The water is murky, right? So there’s advisors that aren’t terribly credible, and also public that don’t seem to make sense. There’s, you know, some private equity sources that try to do that, to set up the market. And so it becomes a, you know, a little bit of a challenge to wade through the sea of data and opinions online about it. And the best way to probably get to the bottom of this is, you know, to look at some case studies of real deals. Go to an advisor that’s credible if you’re curious about your own valuation, which I’d like to think that everybody listening to our podcast is then go through a valuation exercise from time to time. We have many clients that do one annually, just to determine what the value of that asset is, and then it covers any potential transactions they do in the following year. That’s particularly important if you have multiple shareholders in your business. You know, because things happen to people, right? I mean, people get sick or get a bad diagnosis or, you know, have an accident and pass away. You know, being able to have a vehicle for a smooth transition of equity in the event that something happens to a principal, is pretty critical, and one simple way to do that is to do an annual evaluation of the shares so that everybody knows what that is. Have, you know, good estate plans and continuity plans in your business in place, and then have that valuation stand to, you know, facilitate future transactions. It also puts a leg up for you. If you get approached by a suitor that wants to look at acquiring your business and that year, you at least have a baseline of where to start. And so certainly would recommend thinking about that as a business owner, to do that as just part of your normal kind of you know, corporate finance function and do it as a way to have good finance hygiene.
Matt Lockhart 27:10
I think of the comparisons as just a validation point on managing expectations. Again, the ultimate, the ultimate enterprise value is going to happen further on down the line, you know, once people have been able to dig in, but it is good to to validate expectations in terms of that range that that you’re providing, you know, to The sellers, as well as providing to the buyers. But to sort of our previous discussion, there’s a lot more factors that go into what is going to be the ultimate agreement, and comps can help.
Ryan Barnett 27:54
I think Matthew, I’d love to close on this question here is that deals get done between willing buyers and willing sellers at a price that is. It may be influenced by EBITDA multiple, but most of the time it’s not. What cases have you seen in which even though multiples were kind of thrown out the window because there was such great strategic fit and the deal got done. Can you give a couple example, or give an example where something was out of the range?
Matt Lockhart 28:28
Yeah, well, there’s, you know, there’s a couple of recent, you know, opportunities that we’ve been fortunate enough to to have played a role in, you know, one that comes to mind in particular was was where there was a really strong vertical go to market capability by our seller and and then, In addition to that, he was part of an ecosystem in which the buyer was was really investing heavily in that ecosystem, and then recognized that the vertical expertise was of tremendous value, right? So it he was going to have a higher on the higher end of the range valuation, just because of the strength of his business and the continuity of his business, and largely due to his vertical efforts. But then that ultimate strategic fit, really, you know, kind of, you know, made it such that everybody agreed right that it it was worth the price that was paid. And there’s another one, and this is this oftentimes can have an a real influence. You know, when sellers are covid. Unquote selling in and they are taking risk by rolling equity. Then you know, they and they’re demonstrating that they are absolutely critical to the continued growth and success of the business, then, you know, that’s another situation in which, in in which you’ve been able to to sort of move beyond that EBITDA conversation into the much more strategic and growth conversation that occurred. Now, on the flip side, luckily, you know, we don’t see these very often. There are situations in which it’s lower than expected, most often due to businesses that are in decline. There’s declining forecasts, there’s declining profits, there’s declining revenues and and you know, if that’s the case, then again, we would love to talk to you about how you can turn things around and start to maximize the value of what of what’s been created. But those are, those are, I think, some of the scenarios in which, you know, the EBITDA discussion isn’t, isn’t as valid, right?
Ryan Barnett 31:21
That’s great point. Mike, I’ll turn it over to you. I think I’d love for you to hammer on the point that a even a multiple range is not a deal, and close us out on just making sure that that simple number that we use that helps get us on a similar page, maybe even in the same M null is perhaps not what is it? It’s not going to be what’s on the paper at the end. And love for help us. Close us out.
Mike Harvath 31:52
Yeah, we regularly hear all the time from people who we may approach on behalf of buy side clients that we’re representing, or, you know, or just in general, conversations that, hey, I had a, I had a deal at, you know, x times EBITDA and I turned it down. Well, you have to unpack that. What was that does? Somebody called and said they might pay that for your business without looking at the financials, or you got far into due diligence or but oftentimes people have perceptions of value that they communicate, thinking that that’s going to somehow influence a negotiation around, you know where it makes sense to have a call or, and I don’t quite understand that. I think it always pays to understand what your business is actually worth versus what you think it might be worth. Oftentimes there’s a disconnect between your perception of value and what actual value is, and so taking the time to get the facts is probably time loss and money well spent. And also, if there’s misalignment between that number in your in your number. I think most business owners have a number in their head where they would contemplate some sort of transaction. Then there’s ways to enhance value in your business. You know, through optimization, business optimization and Growth Strategy Optimization programs similar to the ones that we at revenue rocket off for our clients, to build value in the business, to fortify growth and profit. And I think it’s important to understand, you know, those things as well. And so keeping all of that in mind will help you stay level set around. You know, what is a real valuation and value, and how does it work, pursuant to your EBITDA, and adjusted EBITDA as well as, you know, versus a perception. And I think perceptions and numbers certainly get thrown around a lot, and I would, you know, recommend you don’t fall into that trap, because it’s one that’s pretty easy to consume you. If you don’t you’re not paying close attention.
Ryan Barnett 34:11
Great. You know here, what I heard today is that even a multiples are they’re common in our market, but take them as a is a range, and be it’s a would take them with a grain of salt. And people have very different opinions about what those multiple ranges will be so and if you’re a buyer and you hear, let’s say, four to 8x you’re going to hear 4x and if you’re a seller and you’re four to 8x you’re probably going to hear 8x but please be aware that those are general terms, and deals are going to trade typically, you know, close to them, but there are lots of cases in which they’re wildly different. I heard that a deal is is most often. Um, not tied to an EBITDA multiple. However, there are cases in which there are deals tied to people multiple, in which they are you have to have your EBITDA really nailed down and agreed upon for that deal to work. I heard there’s big differences in different industries that are out there. So a staffing company is going to have a much different multiple than a custom application development company or digital transformation or a generative AI type, type role. And then I heard that there’s all sorts of cases in which deals trade outside of those ranges that we get. Again, mentioned that earlier, but that happens quite often. Matt Mike, anything else you want to cover here today?
Matt Lockhart 35:50
Who knew there was so much to talk to about multiples? I’m kidding. It is an important topic. Thank you, Ryan. And it’s all about expectation management, I guess. And this is just one of the means of of enabling and managing expectations and to the benefit of getting good deals done.
Mike Harvath 36:13
Mike, well, it’s that time. Matt, I would remind people that, you know, oftentimes we think that in some ways. You know, an owned company is a little bit like a Turkish Bazaar, where you can just negotiate a deal and everything is good. It’s hard to negotiate a deal if you don’t know the facts. And I think we can throw around broad generalities about multiples or types of industries or neighborhoods. And back to my housing analogy. It’s no different than not doing an appraisal on a particular house and coming in and say, you know, housing in your neighborhood generally sell for this. Would you take that and not really fully evaluating the property or understanding its true value, right? And you might swing and a miss broadly by doing that. I don’t think any seller would take their house to market that way. They would certainly do the diligence required to do it. Nor would I think a buyer actually do that if they were buying a house, they wouldn’t say that the average price for a house in Bloomington, Minnesota is heck. So that’s what I’ll pay for your particular house. I don’t think they would do that. So it’s important to you know, get to the specifics, get to the facts. Leverage the professionals in our industry that are available to help that will certainly help everyone, whether you’re a buyer, seller, get a better deal, though, and one that you know becomes win, win. So with that, we’ll tie ribbon on it for this week’s Shoot the Moon podcast. Certainly look forward to you tuning in next time when we’ll unpack further ideas of and observations about the market the IT services market as it relates to M&A and growth strategy. Make it a great week.