Merger & Acquisitions:
SIMPLIFYING BUSINESS VALUATIONS
Business valuation is a process used to estimate the economic value of an owner’s interest in a business. Valuation is used to determine the price a buyer is willing to pay and the seller to receive to effect a sale of a business. The key to understanding an enterprise’s value is more complex than the “rule of thumb” approach that says a business is worth 1X, 2X or 3X annual revenues. Many in the pest control industry embrace this concept as gospel but it is indeed a fallacy. It is, of course, easy to express the sale price for a business as a multiple of annual revenues but in fact, the process is more like calculus than algebra and buyers all have their own algorithms and formulas when they dissect a target during the valuation process.
Interestingly enough, there are multiple valuation methods used in practice which could result in significant differences from one valuation method to the other. So, in order to keep things less complex, the valuation method described here should be close enough to give any owner considering a sale of their business to at least get a sense of a range of value to answer the question of what price one should expect from an interested buyer.
Determine Earnings Before Interest Taxes Depreciation and Amortization (a/k/a “EBITDA”)
EBITDA is not the same thing as net profit as reflected in an owner’s profit and loss statement. Determining what a business is worth starts with figuring out a company’s EBITDA which is then adjusted for recurring capital expenditures and Normalized Adjustments. The resulting number is the Annualized Free Cash Flow (“AFCF”) of the company that forms the bedrock to establish a range of prices that a seller should be able to expect from one or more buyers.
Remember, just because two companies have the same annual revenues does not mean they will both have the same AFCF, the difference being the amount of expenses incurred to generate such revenues. Some companies have higher profit margins than others and have better control managing direct expenditures as well as overhead expenses. Accordingly, the company with the higher AFCF will attract a higher valuation because there is more cash available to distribute to the owner.
Once EBITDA is determined, a seller should then make the following adjustments to such amount to determine what the “normalized” AFCF of the business should be on a go-forward basis to a potential buyer. Such Normalized Adjustments would serve to increase reported EBITDA to arrive at the higher expected AFCF being delivered to a buyer since the historical costs incurred would not likely continue once the buyer takes over the business.
- Owner(s) excess compensation
- Owner perquisites (e.g., cars, travel, entertainment, insurance, clubs, etc.)
- Family members on payroll holding non-essential positions
- Charitable donations and other personal related endeavors
- Non-recurring expenses such as the settlement of a lawsuit
Buyer’s Expected Return on Investment (“ROI”)
Now that the seller has determined what their company’s AFCF is, it is time to figure out what to expect a buyer will offer assuming they agree with your own presented calculation of AFCF….that is the $64,000 question as each buyer may have a different perspective of their perceived value of the company and whether seller’s AFCF calculation is acceptable as presented. For example, a buyer in their own analysis may think they can cut certain expenses that the seller did not factor into the AFCF calculation. This of course is not something a buyer would share with a seller as it would serve to drive up the price further.
As an illustration, let’s assume a seller has determined that his company’s $3 million revenue business, having a reported net income of $100,000, has an AFCF of $450,000 after making Normalized Adjustments of $450,000 and subtracting $100,000 of recurring capital expenditures (e.g., 1-2 vehicles, rigs, sprayers, phones, computers).
Now the question becomes what prospective buyers are willing to pay for a $450,000 annual annuity. A buyer who wants a minimum of 10% ROI would mean such buyer would be willing to pay $4.5 million for the business since $450,000/$4,500,000 = a 10% ROI. However, another buyer may not be happy earning just a 10% ROI given potential risk in the business. Therefore, to compensate the buyer for such risk, such buyer may seek a 20% ROI which means that they would only be willing to pay just $2,250,000 for the business since $450,000/$2,250,000 = 20% ROI. Accordingly, it is the expectation of the buyer that sets the perceived value of the business based on an expected ROI achieved from making the investment.
At a minimum, a seller should be able to establish what a range of price should be for the business given knowledge that potential buyers are not going to be satisfied achieving a mere 5% ROI nor should buyers expect to obtain a lofty 50% ROI. Regardless, a seller can at least now know what a good offer is and what a bad offer is using some spreadsheet modeling assumptions. Everything else in the middle is the subject of negotiation.
This analysis also properly aligns a seller’s expectation on price, specifically whether they have an unrealistic expectation or can likely achieve an acceptable deal. As in the above example, if the seller thinks they should get 3X revenue for the company then a $9 million price is not likely. $9 million on a $450,000 AFCF would equate to a 20 multiple and a mere 5% ROI for the buyer.
Other Factors Affecting Valuation
Notwithstanding the above example, there are other factors that come into play that affect valuation that make the AFCF concept not a hard and fast rule. Certain buyers may be willing to pay a premium to a seller and accept a much lower ROI if the following issues are present:
- Seller’s revenues can be easily expanded given a buyer’s existing location and some marketing efforts therefore future (not historical) revenues and ACFC is what the buyer is looking at.
- Seller’s book of business has higher than average gross profit margins because of efficient routing and recurring revenue profile.
- Buyer has no presence in a geographic area they want to enter and do not have the resources or personnel to do it quickly and at a lesser cost.
- Seller has management talent that could be exploited and expanded to buyer’s other business in the same areas.
- Seller has an excellent reputation and buyer’s brand has been tarnished in some way.
- Seller’s technicians are well trained and have been with the company for over 10 years and few customer complaints
In order to maximize the value of your company, if you are contemplating a future sale you want to start the process by:
- Making sure that you are selling recurring, profitable services. There is no better way to increase the value of your company than to present a potential buyer with a portfolio of service contracts that garner a high dollar, per service hour.
- Make sure that your customer retention is solid by providing great service. One of the areas that creates disagreements between buyers and sellers is that most deals are predicated on guaranteed retention rates (less some agreed % attrition). When these retention rates are not achieved there may be a downward purchase price adjustment creating bad will between buyer and seller.
- Focusing on gross margins. Gross margins in the pest control industry should be 50% – 55%. In order to increase your gross margins, you need to make sure that your services are priced at an acceptable dollar per hour, that your routing efficiency or work to windshield ratio is higher than 65% and that your material cost and technician labor costs are minimized.
- Work on your company culture. A company that has a workforce that works well as a team with low turnover is always extremely desirable to a potential suitor.
- Make sure your employees have signed a covenant not to solicit or compete. This is paramount to getting any deal done as buyers don’t want to purchase companies that have employees that can leave, open up shop and take customers or employees with them.
- Focus on your local markets. PCO’s that are the leading brand in their local markets are always highly sought after by potential acquirers.
Pest Control M&A Consultants
Daniel S. Gordon CPA
Daniel Gordon brings over 20 years of experience in accounting and managing high growth pest control companies. As an owner, manager, chief financial officer and industry consultant he has been involved with the development of several pest control companies from inception to the $15 million in annual sales levels and beyond.
John Corrigan, JD, CPA, MBA
Merger and Acquisition consultant John Corrigan is a highly accomplished M&A specialist known for his ability to negotiate and structure both “Buy Side” and “Sell Side” transactions in addition to working with private business owners on internal matters including generational transfers and trust and estate planning strategies.
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