What makes a good small business acquisition?
“Buy on the way down and sell on the way up” – this is the generic advice you often hear when asked the question when is the best time to buy shares on the stockmarket. There is an element of “picking winners” and “timing the market” in this advice. And some people apply the same advice to buying and selling a business. But the generic advice can give a cheap buy – but the fundamentals of the business mean it is likely to remain a “dog of an investment”.
In a recently announced acquisition, private equity firm Gernis Holdings has acquired cabling business 4Cabling with turnover of more an $10m because it had some positive fundamentals that indicated solid cash flow and returns in the future, rather than just a “cheap buy”.
The key features that attracted the buyer were:
- “Fantastic returns”.
- Growth opportunities for the business and the industry.
- Attractive business model.
- Good culture within the business.
Gernis is very clear that the plans for the business are growth focused and they want to “….take [the business] to a new level over the next five years”. So they expect the value of their investment to increase, and from that perspective they have bought an inexpensive asset and plan to grow the value. But it wasn’t a “cheap price” that necessarily attracted the buyer.
Many merger & acquisition experts will explain that the key features Gernis found in 4Cabling are critical components to making sure any acquisition is a success. So how do these features show up in a business valuation?
Business valuations are often related to “the P’s and Q’s” of a business – price and quantity. The “Q” reflects the level of adjusted earnings and the trends in adjusted earnings, whilst the “P” reflects the attractiveness and risk profile of the business (this is reflected in the “price of capital” or the earnings multiple).
The “fantastic returns” feature may be reflected in one or a number of the following parameters:
- Overall net profit margins are likely to be higher than the industry average.
- Net profits and/or net profit margins have shown an increase over time.
- Return on invested capital is significantly higher than the cost of capital for the acquirer (which for a private equity firms that often factor in a lot of risk, the cost of capital is likely to exceed 15-20%).
In other words 4Cabling had a great “Q”!
But the other attractive features that Gernis found influence the “P”. They support an increased earnings multiple, and hence a higher business valuation.
Every buyer wants to snare a bargain – but they also want to mitigate risk. The best way to do this is to buy a business with good returns but also a solid base to build from. This reduces the risk of something going wrong. If the fundamentals in a business (such as the business model, growth prospects and employee culture) are strong, then there is less likelihood that the business will perform poorly.
How these key features rank in your business?
What other features does your business have that might attract a buyer?
How long would you need to work on the business in order to bring these features to the surface?
A business valuation can help provide the answers and the start of a journey to a good sale price.