Exit and Growth Strategies for Middle Market Businesses

The Good, The Bad, and The Ugly in Mergers & Acquisitions

By John Holland | Nov 14, 2019

In the classic Western film The Good, The Bad, and The Ugly, the “good” character portrayed by Clint Eastwood rode off in the sunset with bags of gold after arduous escapades. After working for years to build their businesses, many business owners dream to sell the businesses and then head off in the sunset with the well-deserved wealth. Some business owners achieve that dream with financial security, but many business owners are unable to ever attract a buyer for their businesses. The private equity groups and strategic buyers (large corporations) that acquire businesses are sophisticated, discerning, fastidious, and fickle. Let’s explore the criteria that buyers consider when they distinguish “good” businesses from “bad” or “ugly” businesses. Business owners who understand buyers’ acquisition criteria are in a better position to build up the “good” aspects of their businesses while purging the “bad” or “ugly” aspects of their businesses over time and thereby making their businesses more attractive and more valuable.

The Good
As an international investment banking firm, CFA receives hundreds of email messages each month from private equity groups and strategic buyers searching to acquire businesses with the following features: consistently growing revenues and earnings, recurring revenues, high switching costs for customers, earnings (EBITDA) above a certain level such as $5 million, low capital expenditures, low customer concentration, and solid management. Some of these buyers focus upon “hot” industries like cyber security or software-as-a-service, but there are private equity groups and strategic buyers searching for acquisitions in every industry.

In general, businesses with higher earnings attract a larger audience of buyers. Hence, businesses with higher earnings tend to sell for higher multiples on earnings. For example, according to the Q2 2019 Market Pulse Report from Pepperdine’s Graziadio Business School, businesses with EBITDA of $2 million to $5 million sold for an average multiple on EBITDA of 4.0 in Q2 2019, while businesses with EBITDA of $5 million to $50 million sold for an average multiple on EBITDA of 5.9. In the information technology (IT) industry, we can observe this phenomenon on a larger scale by comparing the largest IT solutions player in the industry, CDW (CDW) with $17.5 billion in annual revenues and a multiple on EBITDA above 16, to an IT solutions company named Dyntek (DYNE) with roughly $200 million in annual revenues and a multiple on EBITDA of merely 4.

The Bad and the Ugly
Strategic buyers and private equity groups are repulsed by businesses that are plagued with litigation, unreliable accounting records, labor unrest, extraordinarily high insurance or workers compensation claims, or investigations by governmental authorities for matters such as infractions of labor or environmental regulations. Buyers discount or reject businesses with high customer concentration, unstable or declining revenues or earnings, elevated customer turnover or churn, weak management teams, and high sensitivity to economic cycles. A business valuation report might show a theoretical value for a particular business with a multiple on EBITDA consistent with previous sales of similar businesses in that industry, but the reality is that companies with “ugly” problems rarely find a buyer.

Just as the character “Blondie” portrayed by Clint Eastwood persevered through dehydration in the desert and incarceration in a Union Army prison and achieved his goal of riding off in the sunset with his bags of gold, business owners can overcome their businesses’ deficiencies by inviting objective investment bankers, management consultants, and CPAs to identify the deficiencies of the business while charting a path of corrective action. For example, a business with one customer representing 50% of revenues could develop and execute an aggressive business development and marketing strategy to attract new customers. Likewise, a business with irregular accounting practices could find a reputable CPA firm and recruit a Chief Financial Officer to review and refine accounting processes and improve the quality of the financial statements. With a concerted effort over a few years, a business owner can overcome such “ugly” business deficiencies to make a business very attractive for buyers and thereby very valuable.

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