The Illusion of Merger & Acquisition Valuation Multiples

By Jack Lyons, Mergers & Acquisitions Advisor and Certified Exit Planning Advisor (CEPA)

Everybody likes to talk about merger & acquisition valuation multiples. When they’re high, they take on a life of their own and people think they’ll last forever. When they’re low, many expect that they’ll go back to their high point and their company will be worth significantly more money than the present value.

For those of us that are engaged in the mergers & acquisitions business, it’s common to hear something like the following from potential clients: “I read that ABC Company, a competitor of mine, sold to XYZ Company for six times earnings. And I heard that Old Line Group sold for eight times earnings. So if I go through a mergers & acquisitions process shouldn’t I to be able to get seven to nine times earnings for my company?” Read on, and you’ll see that the answer is maybe yes and maybe no.

I Say EBIT, You Say EBITDA

A multiple of earnings can be a dangerous thing to focus on during a merger and acquisition because it usually tells only part of the story. There are so many accepted measures of earnings that one first must know what definition is being used. Here are a few common ones:

  • Net income (after tax income)Valuation Multiples
  • Pre-tax income
  • Earnings before interest and taxes (EBIT)
  • Earnings before interest, taxes, depreciation and amortization (EBITDA)
  • Free cash flow (EBITDA minus capital expenditures)

A multiple of earnings can be a dangerous thing to focus on during a merger and acquisition because it usually
tells only part of the story.

In addition, earnings could be adjusted earnings or unadjusted earnings. And sometimes earnings in mergers and acquisitions are defined as gross profit margin.

All are commonly accepted measures, and it’s seldom understood what measure has been used or over what period of time the earnings were being measured. Was the measurement of earnings on the trailing 12 months? The last reported fiscal year? This year’s projected earnings? Next year’s projected earnings? Were the earnings reported in compliance with generally accepted accounting principals or were they pro forma? Seldom does an outsider have the answer to these questions. But depending on the answers, earnings, and hence purchase price multiples in a mergers & acquisition, can vary significantly.

Merger & Acquisition Purchase Price: Part of the Story

Often, the published merger & acquisition purchase price is the cash paid at closing, but that again tells only part of the story. Was the purchase price for the entire company or only parts of the company? How was debt treated in the purchase: assumed by the M&A buyer or left to the seller to pay off? For example, a news release announcing a merger & acquisition will often read something like “Company ABC received $24 million in cash at closing.” Most people would assume that the company sold for $24 million.

But what if the M&A buyer assumed $4 million in debt that was on the seller’s books? Didn’t the M&A buyer really pay $28 million? Or what if the seller had to pay off the $4 million in debt? Some people might argue that the purchase price wasn’t what the M&A buyer paid.

And what if the seller had $2 million in cash and $4 million in accounts receivable that the M&A buyer didn’t acquire? Wouldn’t they have an effect on what the seller got for the company? What about contingent payments? They’re clearly part of the merger & acquisition purchase price, but they can’t be measured at closing.

Many companies are acquired in down years when revenue and earnings are depressed and so the mergers & acquisitions valuation multiples may be artificially overstated. Also, many companies are acquired at times when revenue and earnings have peaked and can’t be sustained, so mergers & acquisitions multiples may be artificially understated. How can an outsider have accurate knowledge of where a company is within the business cycle?

More Than Mere Mergers & Acquisitions Multiples

The following examples show that there is much more to acquisition value than mere mergers & acquisitions multiples of earnings. Assume in these examples that the company being sold in a merger & acquisition has a tax basis of $4 million, $4 million in accounts receivable, and $4 million in long-term debt.

The company being sold in Deal A is a C-Corporation and has two alternative merger & acquisitions transactions from which to choose. The first alternative is Asset Deal A at $24 million with the seller retaining the $4 million in long-term debt. Second alternative is the Stock Deal at $16 Million with the M&A buyer assuming the $4 million in long-term debt.

In Deal B, the company being sold is an S-Corporation with a $20 million offer. It must collect its accounts receivable and has to pay off the $4 million in long-term debt from the mergers and acquisition sales proceeds and can choose between Asset Deal B and the Stock Deal. The transaction data are presented in Table 1:

Table 1:

Merger & Acquisition Alternative Transactions

  Asset Deal A
(millions)
Stock Deal
(millions)
Asset Deal B
(millions)
Total cash consideration $24.0 $16.0 $20.0
Assumed long-term debt $0 $4.0 $0
M&A purchase price $24.0 $20.0 $20.0
Revenue $40.0 $40.0 $40.0
Gross profit margin $10.0 $10.0 $10.0
EBITDA $4.0 $4.0 $4.0
EBIT $3.5 $3.5 $3.5
Pretax income $3.0 $3.0 $3.0
New income $2.1 $2.1 $3.0

 

Multiples

Item Asset Deal A Stock Deal Asset Deal B
M&A price to revenue 0.6 0.5 0.5
M&A price to gross margin 2.4 2.0 2.0
M&A price to EBITDA 6.0 5.0 5.0
M&A price to EBIT 6.9 5.7 5.7
M&A price to pretax income 8.0 6.7 6.7
M&A price to net income 11.4 9.5 6.7

 

 

 

 

 

The table shows that Asset Deal A has an M&A purchase price of at $4 million more than the M&A purchase price of Stock Deal ($24.0 versus $20.0) and that Asset Deal A looks more attractive than the Stock Deal from a mergers & acquisitions multiple perspective as well. Asset Deal B looks similar to the Stock Deal from both the M&A purchase price ($20.0 versus $20.0) and mergers & acquisitions multiples perspectives. Should the shareholders rely solely on this information to decide between the two mergers & acquisitions transaction alternatives? They might regret their decision if they do.

This is how these examples look to the selling shareholders:

Table 2:

Alternatives From the Perspective of Selling Shareholders

Item Asset Deal A Stock Deal Asset Deal B
Total Cash Consideration $24.0 $16.0 $20.0
Less: Non-Compete (payable over 4 years) ($2.0) ($2.0 ($2.0)
Cash at Closing $22.0 $14.0 $18.0
Less: Amount Needed to Retire Debt ($4.0) - ($4.0)
Net Cash at Closing $18.0 $14.0 $14.0
Plus: A/R to be Collected - - $4.0
Plus: Non-Compete (Payable over 4 years) $2.0 $2.0 $2.0
Net Cash to Sellers (Pre-Tax) $20.0 $16.0 $20.0

 

 

 

 

 

 

Note that in Asset Deal B the seller retained Accounts Receivable. From Net Cash to Sellers viewpoint both Asset Deal A and Asset Deal B look preferable to the Stock Deal, but, so far, in the merger & acquisition transaction taxes haven’t been taken into consideration. Sellers would be well advised to never close a merger & acquisition transaction until competent tax counsel has scrutinized all aspects of the transaction.

The tax implications of the various mergers & acquisitions transactions follow:

Table 3:

Tax Implications of Alternatives

  Asset Deal A Stock Deal Asset Deal B
Net Cash at Closing $18.0 $14.0 $14.0
Less: Corporate Tax1 ($5.6) - -
Distributions to Shareholders $12.4 $14.0 $14.0
Less: Personal Capital Gains Tax2 ($1.9) ($2.1) ($2.1)
Net to Shareholders      
(After Federal Capital Gains Taxes) $10.5 $11.9 $11.9
Plus: A/R Collections3 - - $4.0
Plus: Non-Compete (Payable over 4 years) $2.0 $2.0 $2.0
Less: Taxes on Non-Compete4 ($0.7) ($0.7) ($0.7)
Net to Shareholders      
(After Federal Taxes and A/R collection) $11.8 $13.2 $17.2

 

 

 

 

 

 

 

 

Notes:

1 Assumes a 40% corporate tax on the $14 Million gain on the sale of assets ($18 Million Net Cash at closing less $4 Million tax basis).
2 Assumes a $0 individual basis in the stock of the company and a 15% tax on the distribution to shareholders.
3 Assumes company is taxed on an accrual-basis so the $4 Million Accounts Receivable is a non-taxable item in the transaction and later distributed to the shareholders.
4 Assumes a 35% tax on the non-compete.

The above examples have grossly simplified the tax code as it pertains to our hypothetical mergers & acquisitions transactions, yet we hope you’re able to see how structure plays a major role in the after-tax Net to Shareholders. Asset Deal A illustrates that for asset sales of C-Corporations in mergers & acquisitions there is always an issue of double taxation because taxes are paid both at the corporate and individual levels. Selling the stock of a C-corporation in a merger & acquisition transaction is much more tax efficient than selling the assets of a C-Corporation in a merger & acquisition transaction.

Asset Deal B had a Net to Shareholders that was $5.4 Million more than Asset Deal A ($17.2 versus $11.8) and $4.0 Million more than the Stock Deal ($17.2 versus $13.2) due to 1.) Asset Deal B provided for the collection of A/R, which was not part of the merger & acquisition transaction in either Asset Deal A or the Stock Deal and 2.) In the case of Asset Deal B, upon the sale of an S-Corporation, taxes are levied at the individual level only, whereas Asset Deal A was a sale of a C-Corporation and taxes were levied both at the corporate and individual levels.

 Both earn-outs and seller notes are common in merger & acquisition transactions and could make a difference between an acceptable and unacceptable transaction. We did not attempt to show examples of seller notes or earn-outs in an effort to keep our examples as simple as possible.

In conclusion we hope the above has shown the illusion of merger & acquisition multiples and that you are able to see that: M&A purchase price multiples without an accurate understanding of how they are calculated or a thorough analysis of how a merger & acquisition transaction is structured say nothing about the value of the deal; and while multiples may be attractive because of their simplicity, relying on them too much as a guide to value is potentially more dangerous than useful.

“How quick come the reasons for approving what we like!” –Jane Austen

Jack Lyons is a Mergers & Acquisitions Advisor, a Certified Exit Planning Advisor (CEPA) and president of Lyons Solutions, LLC. He can be reached at 203-642-4141 or at jlyons@lyonssolutions.com.

Copyright 2010 Jack Lyons. All Rights Reserved.