Using Acquisitions to Eliminate
a Business Owner's Value Gap 

Bill Quish, Senior Managing Director

By Bill Quish, CEPA
Senior Managing Director, Lyons Solutions LLC

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Some business owners who are starting to think about the sale of their business aren’t aware that they have a “value gap.” A value gap is the difference between a business’ fair market value today and the price a business needs to be sold for in order for a business owner to fund a pre-determined post sale lifestyle. Many business owners underestimate the magnitude of the gap. Yet determining an accurate value gap is an essential part of the exit planning process.

Determining a Value Gap

To determine if a value gap exists, a business owner should start gathering some important information based upon these key questions:

  • What will your lifestyle be like after you leave your business?
  • What will your post-exit annual expenses be based on the lifestyle you envision?
  • What capital expenditures will you incur (e.g., second home, boat, etc.)?
  • What is your business realistically worth today?

Ways to Shrink the Value Gap

Business Owner's Value GapOnce the value gap has been established and the business owner has committed to a future business sale date, the owner in conjunction with his advisors should develop a realistic action plan to increase the business’ value. Businesses with larger valuation gaps will typically require a longer period of time (e.g., 3-5 years) to make-up the value gap. Depending on the size of the value gap, increasing revenue (i.e., growing organically) and gross margin, reducing selling, general and administrative expenses, and reducing business risks (e.g., customer concentration) may not be enough to eliminate the value gap. It is in this situation that acquiring a business or product/service line should be carefully considered.

How an Acquisition Can Reduce the Value Gap

Acquiring a company is not for the faint-hearted. It involves time, money for transaction expenses, a significant investment of cash and likely personal guarantees for debt associated with the acquisition. To reduce risk, acquire a business or product/service line where you have strong expertise, industry insight and contacts. In other words, it is best to stick to your knitting.

The following is an example of how an acquisition can eliminate the value gap:

Company A is a specialty trade contractor with $20 million in revenue and $2.4 million in adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). The company’s revenue has grown 5% on average over the past three years. The company’s operating profit margin has remained near its historical average of 10%. Over the years, the owner has accumulated $3 million of liquid investable assets outside of the business.

After consulting with his wealth management advisor, the 57 year old owner determined he will need to spend $500,000 in today’s dollars to sustain his post sale lifestyle. To accomplish this, the owner will need approximately $13.5 million in investable assets. The majority of the owner’s potential investable assets are tied-up in the business. The owner’s merger & acquisition advisor believes Company A is worth approximately $10.8 million (representing a valuation multiple of 4.5x adjusted EBITDA) on an enterprise value basis. Pre-tax and transaction expenses equity value is $8.8 million because the business is carrying $2 million in interest bearing debt which will need to be paid-off by the owner at closing. Assuming an overall transaction tax rate of 25% plus transaction related expenses, the after-tax and transaction expenses proceeds received on the sale of Company A are estimated to be $6.2 million. Assuming the entire $6.2 million is collected, plus the $3 million in other investable assets, the owner would have $9.2 million in total investable assets. Because the owner needs $13.5 million in investable assets, this leaves an investable asset shortfall of $4.3 million to fund his or her lifestyle.

Company A services the New England area. Its owner decides to acquire a similar company servicing the New York and mid-Atlantic area. Because at age 57 the owner doesn’t want to risk all his or her investable assets held outside the business, a decision was made to acquire as smaller, quality company (Company B). After consulting with his or her M&A advisor, it was determined that Company B should have a minimum adjusted EBITDA of around $750,000 to $800,000. At a valuation multiple of 4.0X adjusted EBITDA, Company B would cost $3.2 million. Add in transaction expenses and it would cost Company A $3.5 million to acquire Company B. The transaction would be financed with a cash investment of $1.2 million from Company A’s owner, $1.6 million in senior bank debt and $700,000 in the form of a seller promissory note. The bank debt and seller note would have terms of five and three years, respectively and require Company A’s owner to sign a personal guarantee.

Pay Day!

Fast forward 5 years later. Company A’s and Company B’s adjusted EBITDA have grown to $2.6 and $1.0 million, respectively for a combined total of $3.6 million. Company B’s acquisition debt has been paid-off by cash flow generated over the past 5 years. Company A’s interest bearing debt remains at $2.0 million. Because of its larger size, the combined companies’ enterprise value is estimated to be a multiple of 4.75x adjusted EBITDA. Currently age 62, the owner sells the larger company for an enterprise valuation of $17.1 million. The after-tax and transaction expenses proceeds received are $10.93 million. Add the owner’s other investable assets of $2.8 million ($3 million plus $1 million saved over past five years minus the $1.2 million invested in Company B) and the owner’s total investable assets are $13.73 million, which is higher than the $13.5 million required to sustain his or her lifestyle throughout retirement.

In Summary

Business owners need to be aware of their company’s value gap at any given point in time. The shorter the time period to their target business transition (sale) date, the more difficult it will be to implement measures to improve profitability and thus eliminate the value gap.

If you have any questions regarding this article or would like to determine if your company has a value gap, call Bill Quish at (860) 391-8672.

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