Most of our clients aspire to a similar end game; some type of liquidity event (sale). Often, such transactions lead to extraordinary material wealth, and provide a payoff for the entrepreneur’s years of sweat equity.
A recent study validates content previously published in this space. The value of businesses is not proportionate based on size. A $50 Million revenue business could be worth significantly more than 10 times that of a $5 Million business. Within the current M&A environment, the “size premium” is magnified further by a dearth of “deal quality”.
In 2009, companies with less than $5 Million in EBITDA (earnings before interest, taxes, depreciation and amortization), yielded an average 5.1x multiple, compared to those with more than $5 Million who commanded a multiple of 5.9x. The premium paid (16%) for profitable larger companies last year was five times the premium paid in 2006 (3%). A study conducted by GF Data Resources concluded that “average performers” (companies with less than a 10% EBITDA) earned a 4.3x multiple compared with 5.7x for above average performers. That is, a company that earns a $5 Million profit before taxes is a far more attractive asset than one with less revenue or lower margins.
As an organization moves through its lifecycle, there is a disproportionate multiplier effect to its value by virtue of which buyers are in play. Private Equity investors and lenders view the $5Million EBITDA business as better prepared to weather economic fluctuations. We have heard the cries of smaller, poor performing businesses that have very little access to capital. Conversely, the flight to safety has created remarkable competition for businesses of the desired scale ($5 Million+) .
Thus, the entrepreneur needs to be patient and focus on the infrastructure required to support growth. Taking the time to grow a business delivers an incredible incremental return. Assume a $40 Million business earned an 8% EBITDA ($3.2 Million) and was valued at five times ($16 Million). If the business were to leverage its infrastructure and grow to $50 Million at 10%, it would realize a $5.0 Million EBITDA. If the higher margins and scale were to produce a half turn (multiple) increase, the enterprise value would be: ($5M x5.5=$27.5M) Thus, the 25% increase in sales and 25% increase in profitability yields a whopping 72% increase in enterprise value.
The size premium should give us pause. It provides the entrepreneur with motivation, and the knowledge that his years of work and grit can provide a significant pay off.