Taming unrealistic valuation expectations

The LBM and housing sectors are experiencing relative success these days, yet with a recession potentially on the rise in the future, some business owners are getting itchy to sell their businesses at a peak time. As a result, here’s something interesting that we are seeing in today’s merger and acquisitions markets. When selling at a time of strong growth, some owners want the valuation of their businesses pegged not where they are now with financial performance. They have valuation expectations based on future performance, as yet not achieved. They want a buyer to reward them with a higher contemporary valuation for the prospects of growth. And that’s a concern for investment bankers like us who manage the seller’s valuation expectations. The root of the concern is clear: Some sellers have fantasy company valuations in mind that are not based on historical revenues or trailing EBITDA. Those sellers want to be rewarded for future revenues and future EBITDA that are by no means guaranteed to materialize.

Valuation expectations basics

Before we proceed, let’s backfill on some basics. Most companies that are acquired have been valued by a multiple of historical EBITDA, typically a trailing 12-month time period. This multiple of EBITDA is determined by dividing the total enterprise value (TEV) paid for the company by the EBITDA. The formula looks like this: TEV/EBITDA = multiple paid. For example, if a company sells for $10 million and it had an EBITDA of $2 million, then the multiple paid was 5X, or $10 million / $2 million = 5.

By the way, if the company being acquired has no EBITDA currently, but has a history of revenues, a.k.a. “top line,” a company can be bought on a multiple of revenues, typically discounted (often heavily) from what would have been paid if the company were profitable. Acquiring a company that is not profitable is a high-risk investment, since it is nearly impossible to predict how well a company will perform in the future with any degree of certainty. Accordingly, those company values will reflect that uncertainty, compared to a company with around the same top line, but with profitability. (At some price, buyers and sellers will always find each other, even for unprofitable operations, especially if they show promise or could benefit from an acquirer’s turn-around skills.)

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With the economy in the state it’s in now—relatively healthy with a recession on the horizon—it’s only natural that some company owners, eager to take their chips off the table, will call up an investment banker and say, “I’d like to test the market by putting my company up for sale.”

How much you thinking?

Inevitably, our first question is this: Have you considered what value you’d like to obtain in a sale?” The owner may respond: “Well, I’m around $2 million in EBITDA now, but my projections show that at the end of 2022, we will have a $4 million EBITDA. I’d like to base the value on that future EBITDA, since it’s such a sure thing. I see that companies like mine are selling for 5.5X EBITDA, and so, I’d like 5.5X on that $4 million and sell my company for $22 million.”

This seller really needs to be more realistic.

The 5.5X being paid today for profitable companies is being paid on historical EBITDA. In this example, this fellow’s company would sell for 5.5X $2 million, not 5.5X

$4 million. If there is an intrigued acquirer—maybe a dealer across town who’s been waiting for the chance to snap up a competitor—he might agree with the seller’s projections of

$4 million in 2022 EBITDA, yet not pay on that today. If there are multiple buyers and a bidding war (our two favorite words!) breaks out, that intrigued acquirer might pay 5.5X on $2 million, and then pay a series of earn-out payments, based on delivered performance. This is typically agreed to when the seller stays on, or has a succession plan to keep a team in place to achieve the projections.

When we explain this scenario to sellers who might have a fantasy valuation in mind, some simply say that we are wrong, and they look for an investment banker who agrees with them. But it’s been our experience that the sophisticated acquirers in the LBM space today have tight rules for acquisition, and low appetites for risk. This drives discipline in valuation, with a bias toward historical performance, not bets placed on prospects that are uncertain to be achieved.

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