Insights – old - Investment Grade Advisory

Wesley Legg 11, Aug, 2021

General

The Highest Offer Doesn’t Always Seal the Deal with Founders

Cash is king; however, the highest offer doesn’t always seal the deal. This is especially the case when the seller is a founder-based company, i.e., the seller is the founder or an heir of the founder. Most founders, of course, want to maximize value, but that is generally not their sole focus, particularly when they are doing a recapitalization with a private equity group.

Founders can be focused on a variety of other factors, including certainty of close, reputation/culture or the buyer, expertise and track record of the buyer, the fate of their employees, their role post transaction, business synergies, deal structure, etc. Buyers who are only differentiated by price are at a disadvantage for several reasons, primarily because someone else can always outbid you. Smart buyers seek to understand the desires of the seller and craft their offer accordingly, not just focused on price but also on the seller’s overall objectives in a transaction.

This is another compelling reason for sellers to run a competitive market process. Using an M&A advisor to run a process provides the seller with more options and a higher probability of reaching the terms they desire in deal. It also allows the seller to see buyers side-by-side to compare the different individuals and cultures involved. This is extremely important when doing a recapitalization, because you’re not just seeking liquidity, you’re also picking a partner.

As a founder, a crucial component of the sell-side process is setting aside time to determine your priorities. There isn’t a right answer as it differs for each person. Gaining clarity on the desired outcomes early on in a process can help tremendously once you get into the weeds of a transaction later on. It also helps to set expectations with your advisor, so you’re aligned on what variables you are optimizing over.

Chris Weingartner 4, Aug, 2021

General

Growth or Profitability – Which Should I Choose?

One of the most frequent questions we are asked by founders and entrepreneurs is whether their focus should be on growing revenues or achieving profitability, especially when it comes to the impact on Enterprise Value. It is a complicated question that presents meaningful tradeoffs unique to each company and one that companies should always feel a healthy amount of tension over. There is a difference between choosing profitability over growth and not having the ability to grow efficiently. To build Enterprise Value over time, a company has to be able to execute on an efficient growth model. Efficient growth is what drives Enterprise Value.

At Founders Advisors’ annual Silicon Y’all SaaS and Internet Summit, this question is asked to the Private Equity panel each year, and each year 100% of these extremely sophisticated investors indicate that they are more excited to invest in a company growing 50% and breaking even than one growing 10% with 20% EBITDA margins. However, they universally acknowledge that for operators and owners in the trenches, it isn’t that simple of a decision.

The Case for Profitability

The simplistic purpose of every company is to produce returns for its owners. Beyond that ultimate goal, turning a profit is required to sustain a company and its employees. While serial entrepreneurs may have a war-chest from an earlier exit to fund early losses, bootstrapped companies do not have this luxury and often have to focus on getting to a breakeven level quickly before cash available for operations dries up. Recognizing this, there is no harm in managing to breakeven, especially if maximizing profitability would require taking in capital at an unappealing valuation or bringing on debt with restrictive terms (personal guarantees, risky covenants, high rates, etc.).

The Case for Growth

A true single-instance, multi-tenant SaaS platform has the capacity for unlimited scalability. Once the product and tech are well-developed and hardened, the success of a SaaS company shifts from overcoming product and execution risks (does it work and is the team strong?) to demand and capital risk (is it needed/used and how can we grow even faster?). Because of this, if SaaS companies can show strong bootstrapped growth with manageable churn, investors love to pour capital into a platform that has grown but is constrained by its own capital availability. Private equity investors are great to help think through strategic decisions and guide based on their experience, but they are looking for investments where much of the heavy lifting has already been done. With low churn and high ARR, PEGs can eventually dial back the sales and marketing spend for customer acquisition and significant profitability often results for the company for years to come.

What is the Right Balance between Profitability and Growth?

While they all acknowledge that it is somewhat rudimentary, PEGs examine SaaS companies based on the “Rule of 40” – that is, Growth Rate + EBITDA Margin should be greater than 40. The strongest companies are often scoring greater than 80. Each industry has its own rule threshold. Therefore, as owners weigh their current options to fund growth or focus on achieving a profitability hurdle, they can determine how to effectively budget growth-driving expenses like sales and marketing, development, conference sponsorship/participation, etc. against the anticipated impact to their bottom line.

Ultimately, having a proven growth model is the key for investors and drives valuation upward. Sophisticated investors recognize that some companies may have had to choose profitability over spending for continued growth, but their capital can assist by efficiently increasing sales and marketing expenses in channels that historically have yielded fruit. If it is not clear to an investor that a company has a model for growth, the investment will be less attractive and valuations suppressed. In understanding the growth model, they’ll key in on unit economics – if you can point to past trends around successful sales and marketing campaigns, they’ll be excited to pour fuel on that fire.

– Guest Article by Chris Weingartner

Brad Johnson 26, Jul, 2021

General

What Is Your Market Share and Why the Answer Matters

“How large is your market, and what is your share of it?” If you haven’t been asked this question yet, you can certainly expect it if you ever consider any sort of transaction. This is one of the most common questions from both strategic and financial buyers, yet we typically find that business owners have not spent sufficient time on this topic to develop a data-driven response.

Market share is usually defined as the percentage of total market sales that is earned by a company over a defined period of time. It is a commonly held belief (and nearly proven fact) that profitability and market share go hand in hand. Whether you are operating in a high-growth industry or in a market that is on the decline, it is critical for business owners to understand the dynamics of the market in which they operate as well as the share which they have amassed.

Based on our experience as transaction advisors, here are four items to keep in mind when investigating market share:

1. Define Your Market and Your Segment

Many owners will simply lump their companies into the top-level industry they operate in. While overall market dynamics are important, potential buyers will want to go deeper on the key nuances related to the company’s specific market segment it serves. Keep in mind, there are also cases in which certain sub-markets are performing well while an overall industry is struggling, so owners should understand and define both.

2. Security of Market Share

The defensibility and long-term security of a company’s market share is a key driver of value. The market’s competitive landscape and customer contract terms are two primary characteristics that contribute to the protection, increase, or decrease in market share. These components can provide a moat around a company protecting its market share from competitors. Generally, if a company has the ability to execute long-term agreements with customers (or demonstrate consistent renewals or re-use) with minimal interruption from competitors, buyers are more willing to pay a premium. While most companies have some level of competition in the markets in which they operate, one way for owners to mitigate this risk is to clearly articulate what distinguishes their company from competitors.

3. Where Do You Go From Here

In order to gain market share, will it require takeaways or is there still a significant number of potential customers who have no solution in place? As most owners will agree, selling to a first-time user is generally easier than unseating the incumbent player. Consumable product companies have more opportunities to convert new customers. However, excluding some markets such as pharmaceuticals, this high usage may lead to lower switching costs.

4. “I’m Not Sure” is NOT an Answer

If it’s not particularly easy to compile the data necessary to define market share, we encourage owners to use disparate sources of information to triangulate an answer. While buyers certainly prefer explicit details, these groups will understand if the information is not readily available, yet they will value an owner that approaches the topic from various angles.

At the end of the day, it is typically impossible to have full information on market share, but an owner that has command over this topic will increase the value of his or her company. Keeping these four items in mind, we hope you’ll be better equipped to answer that inevitable question about the size of your market and what your share of it is.

– Guest Article by Brad Johnson

Wesley Legg 23, Jul, 2021

General

Does Your Company Have a Moat?

Moats are often water filled ditches around castles and other fortified structures creating obstacles for would be attackers. Moats make it difficult for those wanting to siege the protected structure, both thwarting attacks from the ground and preventing the practice of mining, digging tunnels under the castle to cause it to collapse.

Like the castles of old, your company’s market share and profitability is under constant attack from competitive forces.

Michael Porter, author of Competitive Advantage and several other stellar books, developed something called, “Five Force Analysis”, which says companies face competition from five forces:

– Rivalry Among Existing Competitors
– Possible Entry from New Competitors
– Bargaining Power of Suppliers
– Bargaining Power of Buyers, and
– The Threat of Substitutes

An effective moat gives you a hedge of protection and even competitive advantage against these outside forces. Like the moats used to fortify a position, your business’s defense can come in all shapes and sizes, and will often depend upon your industry, business model and the weapons used by your competition.

When fending off other industry players, manufacturers of commodity products protect their market share and margins with economies of scale, a boutique retailer brand, or a technology company high switching costs for existing customers. Not allowing suppliers to get the upper-hand can be accomplished through tactics like supplier diversity and the ability to substitute inputs, and keeping buyers from pinching you is easier when you have diverse customer base and product differentiation.

Competitive advantages, like the “moats” mentioned here will not only protect your company’s profitability, but will also allow you to advance your market share and grow. Lastly, moats will increase the value of your hidden wallet, the equity value in your company. Bottom line, buyers pay significantly more for companies with a meaningful competitive advantage. If you want to understand how to protect your company’s position and take ground from others, consider reading Porter’s book “Competitive Advantage”, if you want the cliff-notes version, read Porter’s article in the Harvard Business Review here.

Madison Davis 21, Jul, 2021

General

Customer Concentration Can Be A Deal Breaker

Customer concentration is a notorious deal killer, yet many business owners fail to address this issue prior to pursuing a recapitalization or exit. After all, from an owner’s perspective, landing one household name as a client could be exactly what an up-and-coming company needs to build its credibility in the industry, boost revenue and quickly expand into additional markets.

Why, then, are investors and acquirers so concerned about customer concentration?

Simply put, “customer concentration” translates to “risk” in the mind of a buyer, and below are five reasons that this is the case. To illustrate, let’s use an example of a service company, Concentration Co., whose largest customer is one division of a Fortune 500 company. The customer, Giant, Inc., accounts for 40% of Concentration Co.’s revenue.

1. Potential Financial Loss

The most obvious risk is if Concentration Co. lost Giant, Inc. as a customer. There would be an immediate decline in revenue and net income that would be difficult to recover quickly, and may require Concentration Co. to cut costs, reduce headcount or operate at a loss. This risk is particularly problematic for a private equity group whose expected return on an acquisition of Concentration Co. would be drastically reduced should it acquire the company and subsequently lose the top customer. After all, companies are typically valued based on some multiple of EBITDA, and losing 30% of EBITDA will make it challenging to generate an acceptable rate of return on that investment. Revenue from these high-risk customers, may be valued at a meaningful discount. Review the prior article for more information here: Not All Revenue Is Valued Equally.

2. Financing Challenges

Lenders also see customer concentration as risky, and for firms who intend to fund the transaction through loans from a bank or other institution, customer concentration can make financing difficult. Lenders may pass on the business altogether, provide less than the desired loan amount, or offer the buyer sub-optimal terms on the loan in order to mitigate risk. This can reduce buyers’ expected return and lead them to pursue more lucrative opportunities.

3. Pricing Pressure

Key customers who are also large companies often have the ability to exert pricing pressure, which can erode profit margins. Responsible for such a vast percent of revenue, Giant, Inc. has significant leverage over Concentration Co. Especially if there are alternative service providers in the marketplace, Giant, Inc. could demand a price discount and Concentration Co. would have to comply or risk losing its largest customer to a competitor. Depending on its financial position, sacrificing margins may be better than losing Giant, Inc. altogether. From an acquirer’s perspective, however, lower margins also mean decreased EBITDA and future returns.

4. Ability to Dictate Terms

Similarly, large customers can exert their power to adjust the terms of service to best meet their needs. If, for example, Giant, Inc.’s policy was to pay in 45 days instead of Concentration Co.’s typical 30 day cycle, an exception would probably be made. After all, a competitor might be more than willing to accommodate Giant, Inc.’s preferences in order to pick up so much business.

5. Impact on Capacity

Large customers tend to control a company’s capacity as well. If Giant, Inc. requests that the company begin serving another one of its divisions, it may not have the capacity to meet the needs of its other customers or take on new customers. In this situation, Concentration Co. faces a decision. It can a) tell Giant, Inc. that it cannot provide the additional service as requested and risk losing Giant, Inc. to another firm who can accommodate its needs or b) fulfill the request and potentially damage relationships with the rest of its customer base and miss out on potentially more profitable growth opportunities.

Ultimately, customer concentration is risky whether you plan to sell your company or not. Each of the five reasons above can just as easily impact current owners as potential acquirers. If your business would suffer heavily from the loss of one or a few key customers, consider developing and implementing a plan to reduce this risk. These efforts will pay off no matter what your plans are in the future.

– Guest Article by Madison Davis with Elm Street Technology

Duane Donner 20, Jul, 2021

General

Not All Revenue Is Valued Equally

Most companies are valued by applying a multiple to the businesses EBITDA (earnings before interest taxes, depreciation, and amortization). However, buyers will closely examine the revenue streams generating that EBITDA and assess the quality thereof. Here are a few things buyers will look for when assessing a company’s revenue streams.

1. Revenue Consistency

The more stable and predictable the revenue stream and the profit therefrom, the more the buyer will be willing to pay. This provides forward visibility and mitigates risk, because the revenue can be counted on in the future with a high degree of certainty. Most subscription models would fall into this category. Assuming customer churn is low, and the lifetime value of the customer outweighs the customer acquisition costs, buyers will pay up for this type of business model. On the flip side, earnings generated from project based work or one-time events will typically be heavily discounted.

2. Customer Diversity

One strong customer can get a business up and going, but diversity is required to mitigate risk. This also applies to customer concentration within revenue streams. If the revenue stream would suffer meaningfully due to the loss of one or two customers, buyers will take this into account. Customer concentration will not only lower the value of a company but might scare off buyers altogether.

3. Margins

Buyers will pay great attention to a company’s margins and assess the overall business by comparing margins to like companies. Superior margins oftentimes mean a competitive advantage, which gives a buyer greater comfort that the revenue and profit therefrom is protected. In addition to looking at a company’s overall margins, buyers will assess the margin contributed by each revenue stream. Growth in revenue streams with higher margins will be rewarded, while revenue with lower margins, even if growing, will often be discounted.

Conclusion

These are important factors to consider when operating and growing your business. Yet, every company and industry is different and not every business model can have the recurring revenue and customer diversification of Netflix. If you want to know how you measure up in these areas, benchmark yourself against competitors or companies with a business model similar to your own. Taking action to improve and be the best among your peers in these areas will not only increase the value of your company, it will mitigate the risk you have as an owner.

Wesley Legg 16, Jul, 2021

General

How External Market Factors Drive Your Company’s Valuation

“I should have sold when I had the chance,” is a phrase our advisors hear much more often than “I sold too early.”
Timing a transaction is tricky, because it’s influenced by a variety of internal and external factors, such as:
– Government policy
– Capital markets
– Macro-economic forces
– Industry life-cycles
– The company’s life-cycle
– Personal needs and desires of the owner

Each one of these factors is important to consider, but credit markets have historically proven to be one of the most powerful external force in both inflating and deflating valuations. There are two reasons why.

Rate of Return

In the world of investing, return is commensurate with risk. The greater the risk, the higher the need for return. Economic risk is measured by determining the rate of return required for an equivalent investment facing an equivalent level of risk. This rate of return is called the “discount rate”. The capital used to buy a company is typically a combination of debt and equity. Equity can be in the form of either company stock or cash, and debt is borrowed money the acquiring firm/company pays interest on. Each source of funds is obtained at a different cost, so the “weighted average cost of capital” is used to determining the discount rate. As interest rates go down, present values go up, making valuations higher. A small change in the discount rate can result in large changes in valuation. Summed up simply, when paying higher interest rates, the investor requires a higher rate of return, which makes valuations go down, and vice versa.

Money Supply

Money supply also heavily influences business valuations. When the economy sputters, the fed lowers interest rates to stimulate the economy. When money is cheap and the economy bottoms out, capital markets begin to loosen the purse strings. Early investors buy cheap, but more money competing for a limited number of assets drives valuations higher, and investors, emboldened by their access to debt, and lower discount rates, start to take on more risk. Early investors start to see good returns and those on the sidelines, not wanting to miss out, come in to drive valuations even higher. Sometimes, fundamentals yield to speculation and for a period “the sky is the limit.” But then, fundamentals return, company’s default on their debt, capital markets get scared and stop lending, and in a small fraction of the time it took to inflate, asset values crater.

Joseph Vinar 2, Jul, 2021

General

High Growth Rate but Low Valuation?

Many business owners would consider a company with a revenue growth rate of 40% exceptionally attractive. “Surely this is a well-founded business primed for a promising future. With a growth rate of 40%, this company will soon be a dominate player in their market.” But they’ve forgotten a key part of that equation, What’s the market’s growth rate? If the market is growing at 60%, this company is sprinting towards obsolescence as it hemorrhages market share.

However, on the flip side in the 2008-2010 recession when the markets were plummeting, we saw companies with negative growth rates receive all-time high valuations. They were gaining market share since the market was contracting faster than the company was. A company’s future cannot be summed up in a number as simple as growth rate but should be compared to its competitors’ growth rate.

Rather than only focusing on growth, business owners could benefit from benchmarking their growth rate relative to their market. Here are some ways to determine your market’s growth rate:

– Ask an industry association in your sector
– Read annual reports from public companies in your market
– Hire a local MBA student
– Have a internal analyst calculate it – here is a helpful article for calculating market grow rate

If you would like to discuss how this applies to your business, we would be happy to talk with you.

Schedule a meeting here:

Joseph Vinar 30, Jun, 2021

General

Home Services Businesses with Recurring Revenue Are More Valuable

Every business owner is asking, “What’s my company worth?” and “How do I increase its value?” As the adage goes, it’s worth whatever someone is willing to pay, so it’s helpful to view a company through the eyes of a potential buyer. Buyers pay for risk adjusted future cash flows. The two main ways to increase the value of your business are through increasing the future cash flows or by decreasing the risk associated with the cash flows.

Home services have traditionally received lower valuations due to riskiness of returns stemming from mostly one-time revenue. For example, a maintenance plumbing business does not know at the beginning of each month how many people will be calling with broken toilets and faucets. Perhaps a better plumber comes to town one month; suddenly a business that has been thriving for years could go under. The uncertainty of these revenues creates significant risks for investors.

Home services is strategically positioned to transition their operating models to generate recurring revenue. Recurring revenue is revenue coming from an ongoing contract or subscription. We’re seeing this with pest control companies which charge a monthly subscription fee for regular spraying. Plumbing companies are charging a fixed monthly rate for any plumbing issue to be rapidly resolved. These offerings provide peace of mind to the consumer and consistent cash flows to the business owner.

Transitioning revenue from one-time to recurring can significantly increase valuations. Even if an owner doesn’t want to sell their company for years, this shift towards recurring revenue meaningfully decreases risk and improves business fundamentals.

Duane Donner 24, Jun, 2021

General

Vibrant Mergers & Acquisitions Market Continues to Surge – June 2021

Optimism abounds in the 2021 M&A market, priming it for high activity. Companies, across all industries, are looking to grow as a result of increasing competition, record amounts of cash sitting on corporate balance sheets, and low interest rates. The demand for high-quality businesses is strong, and there has never been a better time to enter the market.

As the North American economy continued to rebound in Q1, so too did M&A activity with over 5,388 deals closing in the quarter. This was a 26% growth from Q1 2020. Additionally, there were 11,394 deals recorded globally in Q1.

The above chart represents M&A activity by value Q1 2020 – Q1 2021 for North America. The upward trend in volume is a direct reflection of the current, positive market conditions. The expectation is for this upward trend to continue throughout 2021.

In Q1 alone there were over 5,621 deals announced targeting companies in the U.S. and Canada. This was the second highest first quarter total this century. Currently, the North American M&A market makes up 53% of the world M&A market.

The Industrials sector undertook the most deals in 2021 with 939 deals. While the technology, media, and telecom industry led the way in terms of valuation at $204bn. With low interest rates and potential tax changes, pent up demand for acquisitions is surging this year.

Sources: S&P Global, White & Case, Pitchbook