June 2014, Mergers & Acquisitions magazine has an article titled “Loosening Up” that discusses how intense competition has forced lenders to be more aggressive on pricing (lower) and have covenant-lite loans.
Summer 2014, the lead article in Seattle investment banking firm Zachary Scott’s newsletter, Insight, is titled, “”8” is the New “6” – For Now, Lenient credit has contributed to higher prices for businesses” (the 8 and 6 refer to the multiple of EBITDA Private Equity Groups are paying for businesses).
While both of the above deal with middle market deals, and while middle market deals have different driving forces (think Private Equity Groups with too much money chasing too few deals), the above does carry over to smaller deals. In my world where the 80-20 rule says most of my clients’ deals will be in the $2-10 million range it’s not that there’s too much money. The challenge is, as always, finding a profitable business that fits the buyer’s skill set and has a willing, motivated seller.
I represent a lot of business buyers and often I hear something like the following, “I won’t pay more than X times cash flow” (or profit, or EBITDA – pick your term). For the buyer stuck on a low number, my comment is to “get over it.” That was then, this is now.
Let’s look at a couple scenarios, which are based on two client deals. For this example we’ll use the term “free cash flow” (FCF) and define it as EBITDA less capital expenditures and after owner salary.
- FCF (1) = $1,000,000
- FCF (2) = $1,250,000
- Price = $5,333,000
- Bank debt = $4,000,000
I’m showing two similarly priced deals with different FCF to point out that different companies, in different industries, and both highly profitable can be priced differently. (For more on this see the chapters on the non-financial factors in my books and the second article in the Zachary Scott Summer 2014 newsletter titled, “What’s in a Multiple; It is necessary to look under the hood to find the factors driving value.”
The above examples have the bank lending either 4X FCF or 3.2X FCF. The buyer who says something like, “I won’t pay more than 3, or 3.5 or 4, times cash flow” won’t get the deal when the bank will lend that amount or more. Another buyer will offer more, given the generous terms, or, the seller’s advisors will inform them on how much banks will lend and the seller will leverage that information to get a higher price.
So, what can change this? The obvious answer is if interest rates go up. If interest rates escalate more of the payment goes to interest, less to principal and there will be downward pressure on price. Another answer is if the anticipated bubble of businesses on the market appears, creating more choices for buyers. (As per SunTrust Bank in 2010, over 40% of owners have delayed their exit by at least two years because of the recession; and as now times are good, I’m guessing a lot of them are enjoying their highly profitable years).
For buyers, you can’t just look at the price and especially the multiple. As one of my Rules of Business Buying states, “Cash and cash flow is King.” If your payments are $500,000 a year it doesn’t matter if your payments are based on the fact that you paid $5,000,000 or 5% more/less or 10% more/less, your payments are your payments.
For sellers, thinking of selling, this may be the best time ever to sell. There are great buyers out there, money is super-cheap and that means prices are high.