Commentary & Analysis
Pouring Another “Cup O Joe”: the Essentials of M&A Valuation
"What's my company worth to a buyer?" Easy to ask, but not so easy to answer correctly. This month, New Direction Partners and Margolis Becker explain the multiple-of-EBITDA formula that's used to determine pricing in many conventional acquisitions. They also discuss asset-based valuation for tuck-ins and note the commission structures that sellers can expect to receive in M&As of this type.
By Patrick Henry
Published: March 16, 2011
Editor’s note: each month, the partners at New Direction Partners join their colleagues at the financial management firm MargolisBecker in a “Cup O Joe”: a conference call with printers on a selected topic of interest. The call’s namesake is MargolisBecker founding partner Joe Becker, whose brainchild the monthly teleforum is.
Recently, with the participation of Peter Schaefer, partner, NDP, and Stuart Margolis, partner, MargolisBecker, Cup O Joe examined the subject of valuation for mergers and acquisitions (M&A). Addressed were valuations in traditional M&A transactions based on multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization); and valuations in asset-based transactions for tuck-ins. An edited version of the discussion is presented here.
Why does the industry use multiple-of-EBITDA to determine the value of printing companies? It’s because this method provides a good and relatively simple way to estimate cash flow. Multiple-of-EBITDA also is the best parameter for comparing one company’s financial condition with that of others in the industry. It removes distortions by adding back interest expense (which could be due to different capital structures) and depreciation (which could be a function of depreciation policies or write-offs). Other EBITDA adjustments—valuation professionals refer to them as “normalizing”—account for excess payroll and other factors that could affect earnings.
Where the multiple-of-EBITDA is exceptionally high, the company is probably doing something that sets it apart from its competitors.
The number of the EBITDA multiple expresses the degree of risk associated with the investment. For example, an EBITDA of $1 million multiplied by 4 yields an enterprise value of $4 million and an expected return on investment (ROI) of 25%. If the multiple is 3, the ROI is 33%: a higher return, probably because the buyer is taking on more risk. With a multiple of 5, the ROI is 20%, a return that a secure buyer might be comfortable with. In each case, the multiple represents the expected percentage of ROI as an inverse of the calculated return.
As the economy improves and credit markets loosen, the general range of multiples for printing companies is 3.5 to 5. Many factors determine whether a company finds itself in the lower or the higher end of this range. Sometimes, extenuating circumstances produce an unusually high multiple—for example, when a motivated buyer wants to buy a company that will enable it to enter a narrow niche market in a serious way.
Fortune Favors the Specialized
It can be painful to admit, but a printing company without a specialty is the type of business that typically is assigned one of the lower multiples. In the opposite case, where the multiple is exceptionally high, the company is probably doing something—digital printing, for example, or wide-format output—that sets it apart from its competitors. Capabilities that differentiate printer A from printer B across the street, or a very specific client niche: factors like these are what buyers look at in determining the multiples they are willing to pay.
The number of the EBITDA multiple expresses the degree of risk associated with the investment.
Something else that affects the range of the multiple is the size of the company. In general, the smaller the company is, the lower the multiple it can expect. With a larger company, on the other hand, there is less risk, so buyers are willing to pay a higher multiple. For example, in one transaction managed by NDP, the buyer was willing to pay a multiple in excess of 6 for a company that would enable it to enter a specialized niche. The other factor, however, was that company the buyer was trying to acquire also had signifcant critical mass in terms of revenues. Companies operating on this scale tend to command premium multiples even if they are general commercial printers.
But, “critical mass” is a relative term—the criteria are different in each segment of the industry. For a large-format printer, critical mass might be $10 million or less because this segment contains few large businesses. For a book printer, on the other hand, $100 million is a more realistic definition of critical mass.
The seller’s level of technology also plays a role in determining the multiple. Looking at an acquisition target, a buyer will ask, how sophisticated is the production workflow? How much digital printing capability is there? What about web-to-print? The more automation the buyer sees, the higher the multiple is likely to be. And, don’t forget the customer list. If the buyer sees a good potential to sell more products to those accounts, the willingness to pay a higher multiple goes up.
Estimate, Liquidate, Set Royalty Rate
Asset-based valuation—the tuck-in valuation method—may be the best route for a business that is underperforming or has low earnings. Sellers using this method basically look at the balance sheet to determine what its assets can be liquidated for. It doesn’t mean liquidating the company per se, but it does require the owner to estimate what the sale of the equipment will bring. As every printer knows, there is a glut of printing equipment on the market, and used-equipment values are considerably lower that they were a year to a year and a half ago. Sellers, therefore, must be realistic.
With a larger company, there is less risk, so buyers are willing to pay a higher multiple.
The next step is to examine accounts receivable and assign a probable percentage of collectability. Having estimated what is likely to be received, the seller then can propose a royalty rate—the commission on future sales that represents payment to the seller in a tuck-in transaction of this kind.
As a rule of thumb, NDP and MargolisBecker recommend setting a royalty rate of 5% for three years, although they have seen rates range from 4% to 7% for up to five years in some transactions. They expect to see tuck-ins grow in popularity because they give buyers the opportunity to deal only with variable expenses, not fixed costs. Tucking in the seller’s book of business also helps to fill up the buyer’s excess capacity—an advantage that most printers can use these days.
In some cases, buyers try to put a ceiling on royalty payments, but trying to cap the commissions in this way, say NDP and MargolisBecker, is counterproductive. Why? Because paying more in royalties than originally anticipated means that sales also are above expectation—a preferred position to be in. By the same token, the firms also disagree with the idea of putting in a floor for the seller—a minimum needed in order to liquidate their business. In fairness, they argue, a buyer who has been led to believe that the acquired company will bring $3 million in sales should not be obliged to pay a floor when only $1 million actually comes over.
How Well Can We Produce What They Sell?
An important part of due diligence in a tuck-in is examining estimates and sale prices to determine whether the seller’s pricing structure conforms to the buyer’s. The better the pricing match, the more the royalty rate is worth. Another, even more important consideration is how well the seller’s book of business fits the buyer’s equipment. For example, if a web shop acquires another shop that produces half of its volume as sheetfed work, that business will not be worth as much to the buyer as a 100% web operation would have been.
In an asset-based valuation for a tuck-in, the seller looks at the balance sheet to determine what its assets can be liquidated for.
That’s why it’s essential for the buyer to look closely at the seller’s accounts and ask, “What can I do with these sales? What technologies will they use?” In the best cases, where the buyer is looking for a way to move into digital printing or some other specialty, the seller’s relationships can open that door—an opportunity worth paying a premium for.
But, say NDP and MargolisBecker, the incentive doesn’t have to be as complicated as a technological improvement. It simply could be that the seller knows how to do something, such as mailing, that the buyer doesn’t, making that expertise more valuable to pick up. All of these things factor into the correct valuation of the acquisition target in any M&A transaction.