When you are being acquired, and you and your investment banker start to receive letters of intent (LOIs), those LOIs will set out a framework for pricing your company. In most LOIs, a dollar amount is offered for your company, but it is always either the result of a multiple of EBITDA, or it can be backed into a multiple-of-EBITDA formula. If the LOI states that the target company will be acquired for $6 million, and the company has a $1 million EBITDA, the company is being valued at 6X. That said, most companies seek acquisition when they are on an upward trend, putting up numbers each month that are higher than the previous month.
This month-over-month improvement is an ideal trend to show an acquirer. (Obviously, companies that are growing are highly desirable and get the highest value, as opposed to companies that are coasting along, doing the same business volume month after month, or companies that are contracting.) But if your company is showing month-over-month improvement, and the acquirer reveals the multiple of EBITDA they are using in the valuation within their LOI, at what point in time do you “freeze” the EBITDA to apply the multiple? Do you do it at the time the LOI is submitted? Or based on last year’s financial statements? Or based on rolling trailing 12 month reports?
Let’s say you are selling your company in the middle of a fiscal year. For a business that is growing, you would be leaving money on the table in terms of your business value if you accepted an LOI that applied the multiple-of-EBITDA valuation method to last year’s financials. That would not fully credit intervening months of solid performance. To show you the impact of the math, let’s say that your previous fiscal year’s EBITDA was $1 million, which would value your company at $6 million in a 6X formula. Now, let’s say that six months into the new fiscal year, your trailing 12 month EBITDA shows improvement, and it’s $1.2 million. Instead of $6 million, the 6X formula would value your company at $7,200,000…a $1.2 million lift in business value. (Just about enough extra to pay the gains tax and net out $6 million!)
To put an even finer point on it, some acquirers of growing companies will want to freeze the EBITDA to which the multiple is applied on the date the LOI is accepted. Let’s say you are at $1.2 million in trailing 12 month EBITDA in July when the LOI is submitted and accepted. The offer comes in at $7.2 million. But the due diligence and closing process can easily take 90 days. If you are a growing company, during those 90 days, your trailing 12 month EBITDA might climb still higher. Say it rises to a trailing 12 month of $1.3 million. Why would you take $7.2 million when the value was frozen at the acceptance of the LOI, when you really should be pricing the deal of 6X $1.3, or $7.8 million? That’s $600,000 over the value that would have been paid just 90 days earlier.
The ideal timing of the deal pricing for growing companies should be as close to the closing as possible, so you don’t lose the incrementally positive deal value generated during the due diligence process.
That said, when you agree with the buyer to price near the date of the closing, there is risk. Let’s say that at the time you accept an LOI based on 6X EBITDA, you are performing at that $1.2 million EBITDA on trailing 12 month basis. But you and your investment banker negotiate for a pricing that happens 90 days later. Let’s also say that…oh, take something really crazy…a freak pandemic sweeps through the country shutting down businesses, and you come off the mark, dropping from $1.2 million TTM EBITDA to $1.1 million. The deal value drops from $7.2 to $6.6 million. And perhaps two months later, the pandemic is still around, and you drop to $950,000 EBITDA. The deal value has now moved from the $7.2 million offered in the LOI to $5.7 million. So, when you agree to price close to closing, do everything you can to ensure that you are climbing into that event, not fighting a rear-guard action to assure the acquirer that you are “just having a couple bad months,” because at that point the buyer holds all, or most of, the cards and can request “repricing after LOI,” a topic we have covered earlier in this space.