While recently advising a young company on strategy, the topic of enterprise value came up. A competitor had just sold for a ridiculous multiple of revenue. Something like 7X, which was unheard of in this sector. The founder of the company I was working with became childlike in his enthusiasm, thinking the value of “his” business just went way up! Uh oh.
These can be hard discussions to have. Like telling your son that just because your cousin got a new supersonic fast chopper bicycle painted gloss black with red trim and a neato mosquito red stripe Tiger Paw race slick on back doesn’t mean you are getting one too. (Thanks Dad for handling that one so well, but it is still a little painful to remember).
The conference room was already a little chilly, but it was about to get a whole lot chillier as I broke the news his expectations might be a tad bit overly optimistic. Systematically we broke down the possible key drivers of the competitor’s acquisition and what might have pushed the enterprise value so high. No doubt this particular competitor had landed on a well-timed strategic acquisition opportunity. It probably even had red stripe Tiger Paw tires.
Strategic versus Financial Transactions
We walked through the typical financial valuation models, discussed public comparables, three letter tools like DCF, IRR, NPV and ROI. We discussed how financial transactions are focused on capturing an investment return for the acquirer rather than attempting to grow a business or solve a market problem. We also covered the boring stuff like the book value of stock, earning and dividend paying capacity of the business, and goodwill. Yuck. Before moving on, I broke down the difference between accretive versus dilutive transactions and the definition of fair market value.
My friend had not kicked me out of the office yet, so we dove into the more intriguing and fun strategic valuation logic. Strategic transactions demand a higher value since they are synergistic to the acquirers existing business. The main enterprise value drivers we discussed were what strategic buyers are looking for in their acquisitions;
- Recognizable brands
- Niche products or services
- Intellectual property
- Desired clientele
- Double digit growth
- Recurring revenue streams
- Geographical footprint
The valuation fog began to disperse and it became clear how the competitor had achieved such a high multiple. They had checked several of the boxes listed above, specifically having double digit growth with recurring revenue stemming from intellectual property in a couple of niche products which aligned nicely with a gap in the acquirers existing portfolio.
Whew, we survived the tough love discussion and with this new information he developed a renewed passion and strategic plan for the upcoming quarter. Before I left the now warm and again enjoyable office, I threw out a few other fundamental principles;
1) The market determines your price, not you and
2) Businesses are bought, not sold.
It is amazing how the enterprise value drivers a strategic buyer looks for in their acquisitions overlap with the operating tactics which drive growth and profitability for the business being assessed.
Where does your business rank on the above list of enterprise value drivers?
Photo credit to Wayne Bishop