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In Acquisitions, Does Size Matter?
Blog, Industry Commentary
Over the past 10 years, the electrical industry has seen the creation of hundreds of new companies offering new approaches to the expansion of technology in our industry. Many of these companies have created a sustainable and profitable business structure that has delivered a comfortable lifestyle to the owner(s) of those companies. Many of these companies were investor-funded, based upon the appeal of the technology and the founder’s vision and zeal or software companies that have emerged to support the growth and interest in the technological changes of larger initiatives; such as: smart grid, energy conservation, smart buildings or the more recent Internet of Things development. Within every initiative, there are hundreds of small companies that have carved out small niche strategies and provided jobs and profits for employees and owners alike. And now the acquisition market is ripe for those entrepreneurs… or is it?
Over the past 17 years, Egret has had a small M&A practice that has assisted small manufacturers and service companies in marketing their companies to prospective buyers. We’ve been fortunate to conclude several of these introductions; but our market has always been with smaller companies that have little attention or ‘voice’ within the business brokerage industry. But in all acquisitions, size does matter.
We have strong relationships with companies that range from pre-revenue to multi-billion dollar revenues. And in every case, the quest for an acquisition is always based upon size. The multiples paid for a $100M company are far stronger than a company that is $5M; despite the profitability. And the interest level in buying a company that is less than $10M is negligible; unless there is a significant IP or software solution that is a natural fit within a larger company’s strategic product plan.
The hundreds of small companies that are $2-8M in revenue have very little likelihood of selling their company to a strategic buyer, or investment company and face a difficult decision when the owner is interested in retiring. Sadly, many of these companies will simply close up, due to the financial risks that a buyer would face. Let’s take two examples:
- Rep or service firm. A rep firm that sells $10M in products annually is in reality a $1M company to their accountant. A typical rep firm will average around 10% of sales; as they don’t directly transact the $10M of orders to the manufacturers, their P/L reflects solely the commissions earned; i.e. $1M. Whether a rep firm is a net $1M company or a net $10M company (i.e. $100M in revenues), the challenge to sell these companies to an outside strategic buyer is fraught with issues:
- Assuming a 1X revenues ‘price’, the purchase price of a rep firm generating $1M of internal revenues would collapse under the weight of adding $1M in debt financing. The math holds just as true for the $10M net revenue firm (i.e. $100M product sales).
- Customer relationships. Most rep principals have strong personal relationships within their territory. When the principals retire, those industry relationships are at risk.
- Operating expenses. Most rep firms have a proportional large headcount to support their services: quotes, order entry, order tracking, labor claims, product applications, training (both internal and customer), and outside sales efforts, including T&E, travel, etc.
- Small manufacturers with revenues of less than $5M have similar challenges in identifying prospective buyers. Even with high profits in excess of 10% EBITDA, the challenge a small manufacturer has is that the acquisition costs of integration, financing and training are too burdensome to strategic buyers to interest them in acquiring, unless there is a specific strategic rationale to do so. That limits the prospective buyer community to a single investor/owner, and the above issues become apparent again:
“Price” becomes an issue if the buyer is funding this through his/her own resources or debt financing the transaction: Let’s assume a 5X multiple of a 10% EBITDA for a $5M company; at $500,000 of profit and 5X= $2.5M ‘price’. Adding $2.5M of debt onto a $5M company wipes out the earnings success of the company, leaving the new owner cash poor to invest in the company and grow. Whoever is holding the debt will face a huge challenge to out earn the debt load.
So, what’s the state of the acquisition market today? Large buyers are strongly interested in making acquisitions with a sweet spot of $20M and up. The ‘preferred’ magnitude is to be north of $100M; and therein lies the challenge… in the lighting industry, there are less than 30 companies, including the global players, that have revenues over $100M. While the number of companies between $20M and $70M is much higher, the appetite for buying drops precipitously once you’re less than $30M. A large strategic buyer, with revenues above $1B won’t ‘move the needle’ of the company forward with a $30M acquisition, it will likely be a footnote in their annual report. So the M&A market today is busy in terms of looking, but scarce in terms of transactions.
So what’s a seller to do? Our advice is straightforward:
- Be realistic. Your company has provided you and your employees with a certain lifestyle. That isn’t an ‘asset’ to a buyer. You need to properly price your company and disabuse yourself of a strategy of ‘cashing out’. If your company couldn’t survive with a debt load of your asking price… it will fail with a new buyer under those same terms.
- Seller financing. If you’re retiring, one of the best things for retirees is a defined cash flow, outside of your personal investment portfolio. Offer seller financing with extended payment schedules of 7, 8 or 10 years.
- Create a succession plan. Hire a capable leader who can eventually take over the company under your tutelage and with a long-term buyout strategy that doesn’t plunge the company into an undercapitalized failure.
In short, be proud of the success you’ve attained and be reasonable in your expectations of selling.