As with every human endeavor, timing is a critical element in the sale of a business. Often timing is driven by essentially involuntary factors such as an owner reaching retirement age, resignation of a key employee, an offer out of the blue from a prospective buyer, or, in a worst case, financial desperation. Lack of control over the timing of a business sale can be tremendously expensive, as the example below will illustrate.
Assumptions
For purposes of the discussion, we will make several very simple assumptions. First, we will assume that the seller — “Acquireco, Inc.” — is a profitable and growing manufacturing concern in an attractive industry. We also will assume that Acquireco’s industry is somewhat cyclical and that cyclicality affects both the rate of growth and the profit margins of the business. We also will assume that the market for businesses of this sort is driven totally by the earnings of the acquired company.
After suffering a downturn in 2001 and 2002, Acquireco, has for the past two years, experienced a sales growth of 10 percent annually and a pre-tax profit margin of 15 percent. The company expects to enjoy comparable growth and profitability in 2005. For purposes of our example, we also will assume that in 2006 as interest rates continue to rise, Acquireco’s industry will go into a downturn.
While Acquireco will do better than its industry peers, no sales growth will occur in 2006 and Acquireco’s margins will drop from 15 percent to 12 percent pre-tax due to increased domestic and foreign competition. After a relatively brief slowdown in 2006 there will be a shallow recovery in 2007, but profit pressure will increase. As a result, Acquireco will see sales growth in 2007 of 5 percent, but margins will shrink further to 10 percent.
What a Difference a Year Makes
Below, we have analyzed the effect of a one-year delay on the likely sales price of Acquireco. Purchase price multiples are currently at historically high levels for good companies such as Acquireco. With rising interest rates and a slowdown in growth, we assume for this example that multiples will decline to levels more consistent with historical norms.
For simplification we have assumed that a profitable, growing company such as Acquireco might in the current market attract bids as high as 6.5 times earnings before interest, taxes, depreciation, and amortization (EBITDA) or in some cases even higher, while in other environments, similar companies would have commanded significantly lower multiples. Additionally, companies experiencing a decline in profitability are likely to attract lower bids in relation to historical earnings than are companies experiencing profit growth.
Taking both these factors into account we can assume that a purchase multiple of 5.5 times EBITDA would not be unreasonable for 2006 and that further decline to 5 times EBITDA might occur in 2007 as funds are pulled from the market by equity investors disappointed from the returns on their mid-decade acquisitions. While this may seem extreme, it is not inconsistent with adjustments that we have seen in slowing markets in the past.
Yearly Fluctuations in Sales Price
|
Year
|
2003
|
2004
|
2005
|
2006
|
2007
|
|
Revenues
|
$25,000,000
|
$27,500,000
|
$30,250,000
|
$30,250,000
|
$31,762,500
|
|
EBITDA
|
$3,750,000
|
$4,125,000
|
$4,537,500
|
$3,630,000
|
$3,176,250
|
|
Sales Multiple
|
5 x
|
6x
|
6.5x
|
5.5
|
5x
|
|
Sales Price
|
$18,750,000
|
$24,500,000
|
$29,493,750
|
$19,965,000
|
$15,881,250
|
The sales price assumes an unleveraged balance sheet. As can be seen below, the additional assumption that Acquireco has $10,000,000 in debt would result in an even more dramatic reduction in purchase price on a percentage basis.
|
Year
|
2003
|
2004
|
2005
|
2006
|
2007
|
| Asset Sales Price |
$18,750,000
|
$24,500,000
|
$29,493,750
|
$19,965,000
|
$15,881,250
|
| Less Debt |
$10,000,000
|
$10,000,000
|
$10,000,000
|
$10,000,000
|
$10,000,000
|
| Sales Multiple |
$8,750,00
|
$14,5000,000
|
$19,493,750
|
$9,965,000
|
$5,881,250
|
Three Factors Can Affect the Value of a Business
In reviewing the tables above, it becomes immediately apparent that three factors are at work that can dramatically affect the value of a business over the course of the business cycle. The first, company sales growth and profitability, are to some extent within the control of management. The other two — industry performance and the business cycle — are not. Even relatively small fluctuations in growth and profitability resulting from the interplay of these factors can, over time, have truly dramatic impact on the value of a business in the acquisition market.
The example above does not assume disaster, either in the economy as a whole or for Acquireco. The predicted fluctuations in sales and earnings are relatively mild for a private manufacturing company over the course of the business cycle. Further, the increase in purchase multiples is consistent with that experienced in many industries over the past several years.
The predicted decline in 2006 and 2007 merely brings these multiples back to levels witnessed frequently over the past thirty years. Yet even with these relatively benign assumptions, the demonstrated swing in value of almost $14 million from 2005 to 2007 is dramatic. Should a severe recession occur over the next year or two, the reduction in Acquireco’s value could be even more dramatic, with purchase multiples potentially dropping as low as four times cash flow, or even less as occurred in the early 1990s.
2005 May Be a Watershed Year for Company Valuations
For many companies and many industries, 2005 may represent a watershed year in terms of company valuations. If your situation has parallels to that of Acquireco, it may be time to weigh the economic uncertainties and consider a sale at today’s unusually attractive purchase multiples.
John Slater, a FOCUS Partner, lives in Memphis and works with the FOCUS Southeastern Regional Team in Atlanta, serving clients in the mid-South and mid-Continent. He can be reached at [email protected].
