By The Bigelow Company LLC

Every business owner who’s thinking of selling his company “someday” wants to know:

“Will a strategic buyer or a private equity buyer value my company more highly?”

There’s no one-size-fits-all answer. Nor is there a one-size-fits-allanswer to how private equity groups value their target acquisitions. Inthis Lesson, we’ll explore three hot-button issues that concern everyfinancial investor – as well as most strategic buyers.

It’s a Seller’s Market

The past ten years have seen explosive growth in private equitytransactions; there is an abundance of capital chasing a limited supplyof solid investment opportunities. With over 1,300 private equity firmsin the U.S. alone, no one can claim to know all the ins and outs of theirvaluation methodologies. Our experience with private equity groupssuggests that there’s almost always a wide value range among competing offers. We have had first hand experience that, when given exactlythe same information about a company, sophisticated financial buyers’purchase offers will vary as much as 50% from one another.

Financial Buyers Focus on Three Key Drivers

Despite the wide variance in private equity offers, they do all share the same common focus: the target acquisition’s potential for future growth. In this regard, they focus on three key indicators of that potential:

• The growth rate in your revenue and profits.

If your growth over the past 3-5 years has been static, they’ll likely look the other way, or assign a modest multiple of cash flow.

• Your EBITDA.

Private equity buyers love companies with high EBITDA margins and low capital requirements. A high EBITDA percentage on revenues validates that your customers value your product and service highly, and find it worth paying for. (The reverse is also true.)

• The amount of debt your business can reasonably carry.

The formulas for determining how much debt a business can supporthave changed significantly as the capital markets have become awash in sources of low-cost secured and unsecured debt capital.

Capital providers are willing and eager to provide both senior secured and subordinated debt to most private equity-backed buyouts. Instead of looking at your fixed assets and receivables for coverage, they’ll look at your EBITDA.

A general rule of thumb in today’s market is that investors will take on senior and subordinated debt of up to four times your EBITDA to finance a recapitalization. For example, we recently helped to sell a company with $5 million in EBITDA, but less than $10 million in total assets.

The purchase price was $35 million – 7x EBITDA. The private equity buyer recapitalized the company’s balance sheet with $20 million in debt (twice the amount of the business’ underlyingassets) in order to finance the purchase – $13 million in secured debt from a bank, and $7 million from a subordinated debt lender.

Every buyer will also look at important qualitative issues such as:

• What industry are you in and what opportunities for futuregrowth exist?

• Are you an industry leader or a “me too” player?

• Is your management team seasoned, solid, and stable?

This qualitative issue will enhance (or depress) the quantitive valuation.  Above all, however, private equity groups are driven by one thing – their potential rate of return on investment.

Given These Key Drivers, Why Do Valuations Vary So Widely?

Every private equity group has its own unique attributes. Some focus on industries in which they have experience and expertise, while others look for synergy with the existing companies in their portfolios. New funds are particularly eager to make acquisitions in order to develop a track record, while mature funds may look aggressively for one final investment in order to wrap up the Fund.  The challenge for an intermediary is to find the best-fit investor with the greatest motivation.  That investor will usually value your business most highly.

A Game Plan for Attracting Rich Suitors

Knowing what private equity buyers care about points the way to an action plan for increasing the future valuation of your business:

• Follow a business plan that represents strong opportunity for growth.  For some companies, that may mean taking on more risk than they’ve been accustomed to in the past – especially if their owners have been investing only their personal capital in order to grow (See Lesson #1).

• Focus on your EBITDA.  If you can raise your profit margin onrevenues, it will validate your attractiveness to potential suitors.

• Be careful about marginally useful capital investments in your business. A financial buyer will want to know the history of your capital requirements. A pattern of inordinately high, ongoing capital investment can scare off an acquirer.

By Thinking Like an Acquirer, Forest Frames Earned an Exceptional Valuation

When Woody Beeman tapped into the growing demand for prefabricated lumber products, he quickly outstripped his mom and pop lumberyard competitors. He developed a supply chain and processes that saved time, waste, and errors, and built a loyal customer base. After15 years of steady growth, Woody was ready to hang up his hammer, but saw that the company was not yet ready to attract its full potential valuation.  Knowing that he needed diamond blade talent to carve a compelling story, Woody hired a visionary CEO and designed a program for him to receive a 15% stake in the business.  Tom Barrett understood capital gain events, and what both strategic and private equity buyers look for in an acquisition. He started with a blueprint of buyer expectations – and worked backward to map their goals to Forest Frames’ existing business plan.  He knew that private equity groups want a solid ground floor (exceptional EBITDA over several years) with a well-designed stairway to a lofty future. He also knew that acquirers tend to devalue capital-intensive operations that are likely to demand ongoing investment in fixed assets. And they like ideas and processes that can bereplicated.

Tom developed an aggressive growth plan for Forest Frames Industries based on a strategy that changed his competitive playing field. Realizing that on-time, predictable delivery was the perennial concern for both Big Box retailers and independent contractors, he invested in equipment that allowed him to produce custom framing products on a just-in-time basis. With guaranteed 24-hour delivery, most customers were happy to pay a premium for a higher quality product, delivered exactly when they needed it. They couldn’t get this service from any of Forest Frames’ competitors.

When Woody and Tom asked The Bigelow Company to represent Forest Frames to potential investors, the company had a solid, three-year history of outstanding EBITDA, minimal capital requirements, a loyal customer base, and a concept that could be replicated in other regions. Motivated on an incentive piecework plan and profit sharing, their workers ran three shifts to achieve better throughput and productivity.

Not surprisingly, Forest Frames received more than a handful of high-multiple bids.  They picked a private equity group with other construction-related companies in its portfolio that was willing to pay 8x EBITDA. Woody cashed out and Tom continued on to build and capture an even higher value for the new majority owners and himself in a subsequent transaction.

This “Lesson Learned for Building and Capturing Value” reflects knowledge and insights we’ve gained working with dozens of privately-held companies throughout North America.  For more information about The Bigelow Company, visit www.bigelowco.com or call us at 603-433-6000 for a confidential discussion of your unique situation.