I went to a realtor’s open house last weekend and—knowing the area house prices pretty well—I asked the agent why the house was listed at such a high price. The agent’s exuberant answer, as she pointed to the undeveloped backyard and rooms crying out for updates: “Well, just think what you can do with the place!”
Thing is, I was looking to invest in the current value of the home, not a future value, which would be up to me to attain with my capital and time.
Occasionally, our firm sees a similar sentiment with how sellers perceive their business’ value. “Well, just think how that land could be developed into covered space. There’s room for a truss plant over there, and you could hire outside sales staff.” They might add, “We’re not selling unless we get an acquisition value that reflects what could be done here under new ownership.”
The problem is that acquirers pay a multiple on past performance, not what could be done with the company in the future. Surely, acquirers are not blind to a business’ potential; it’s why they’re interested in the first place! (In some cases, they will actually pay a premium for that potential. I cover that below.) But acquirers are entirely unsentimental about the acquisition valuation process. As “The Godfather’s” Michael Corleone says to Sonny, “It’s nothing personal, it’s strictly business.”
The fact is, acquisition values are based on multiyear trends and trailing-12-month performance across five leading KPIs: revenue; gross profit margin; OPEX as a percent of sales; EBITDA as a percent of sales; and EBITDA. You’ll immediately recognize that those KPIs are all examined historically, not as forecasts.
No one should ever diminish the pride that sellers have for what they’ve built up, often over many decades. That said, any expectation that a company’s as-yet-unearned potential should be honored with a premium acquisition value today is usually looked upon this way by acquirers: “By all means, achieve that growth with your own capital and time, and we’d be delighted to take another look in the future.”
I mentioned that, in some cases, acquirers will pay a premium for a business’ potential. Here are two examples:
1. The dealer/seller has a longtime production home builder customer. They’re extremely loyal and usually start 250 homes per year. With confidence in lower interest rates, and land options in-hand, they alert the dealer that they’ll be doing 500 starts in the next 12 months. In that case, the prospect for higher earnings is strong; moreover, this increased business came as a result of years of building up that relationship. In this case, it’s reasonable to expect the acquirer to offer an earn-out, where the dealer/seller would receive a pay-on-performance additional amount in acquisition value, say, 12 months post-close, if the earnings from those 500 starts become a reality.
2. The dealer/seller has a component manufacturing plant. They’ve invested in upgraded saws, make-up tables, and software, all of which is work whose benefits would almost immediately accrue to an acquirer, post-close. With that gear in place, the dealer is adding a second shift, and looking at a third shift, yet still running one shift when in talks with the acquirer. The seller should expect an increased acquisition value to reflect that investment. But no acquirer will pay in advance for earnings that have not been booked. A pay-on-performance earn-out is appropriate here, as earnings are achieved, or, if the earn-out is beyond the dealer/seller’s risk tolerance, the seller’s investment banker could negotiate a “good will” amount at close that largely rewards the work/time/capital that the seller has invested in the plant.
The consistent themes here? Acquisition values are not pegged to the potential for growth and opportunity; instead, they are based on earnings as they are achieved. It’s nothing personal, it’s strictly business.
