What I am about to explain is something I wish I had known much sooner in my business career.
I had my aha moment in 2017, by which time it was too late for me to take advantage of what I had just learned since I was in the late cycles of closing on the sale of my own business.
I was out for dinner with a friend who had made an acquisition of a competitor a couple of years prior. He explained the process, the numbers, the overall structure of the deal, and how he was going to profit from the transaction. In the end, it worked out exactly as he had planned. I was a curious bystander and learned throughout the process.
I have always had an aversion to debt. So much so that I never had a line of credit, my total payables were smaller than a 5 cm (2 inch) file folder, and all invoices were paid and nearly caught up every week. I had made three acquisitions throughout my business career, and all three transactions, although extremely successful, were paid for with cash.
I was raised to believe that debt is a bad thing. Now that I have seen many of my CEO friends expand their businesses with the strategic use of debt, I’ve since changed my negative debt perspective to the extent that an acquisition is accretive. When it is, and you do things right, it’s possible to make a killing.
In my friend’s case, he bought a business that was as large as his own from a revenue perspective. The EBITDA margins for the business he acquired were approximately 10%. Post-acquisition, he was able to consolidate several departments, streamline the business, cut expenses, and almost triple the EBITDA margins. When the two businesses (his initial business and the acquired business) were rationalized into a single entity, he was able to take advantage of economies of scale and improve the margins of the overall business.
How Does It Work? And How Can You Expand Your Business Through Acquisition?
In the interests of confidentiality, I’m not going to use the real numbers (and frankly, I don’t know the exact numbers anyway), but I am going to illustrate how this could work.
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Let’s say your business has revenues of approximately $5 million a year with $500,000 in profits. You make an acquisition of a similarly sized competitive business so that, when complete, your two businesses combined now have $10 million in revenues and $1 million in profits.
Let’s say the business acquisition cost was 5×EBITDA, so you had to pay $2.5 million for the business ($500,000 × 5). Since you don’t have $2.5 million in cash sitting around, you borrow 50% of the purchase price and put down $1.25 million in cold hard cash. (Note: this can definitely work with more debt, but I digress.)
The day after the business transaction closes, you realize that you don’t need two office spaces, two separate accounting departments, two sales directors, operations managers, technical support managers, and so on. I’m not suggesting that you fire all the staff from the acquired firm, but I am suggesting that sitting inside the consolidated business, there are likely plenty of new redundancies. It’s those redundancies that are going to make you a lot of money.
Let’s say you’re able to remove approximately $500,000 from the business. If your labor cost is approximately 30% of the overall revenue ($1.5 million in yearly payroll), add rent costs, internet services, cleaning services, and so on.
Keep in mind that you paid 5× EBITDA for the business you just acquired. That being the case, you just managed to save $500,000 in the business, which at 5×EBITDA, translates to an increase in valuation of $2.5 million. Not too bad for an initial $1.25 million investment (your initial cash purchase).
If nothing else changes in the business, other than combining the two entities and rationalizing the expenses, your business now has revenues of $10 million and EBITDA of $1.5 million.
Before you started this process, your business had a value of $2.5 million. After the acquisition, your business has a value of $7.5 million ($1.5 million × 5).
You still have to pay the bank back their debt of $1.25 million (assuming you haven’t paid any debt back yet), leaving you with a business that has a market value of $6.25 million.
Enter Multiple Arbitrage
Something else interesting happens the larger your business gets, and it’s called multiple arbitrage. As a business scales above certain thresholds, the market of potential buyers expands, as do debt servicing costs, so not only does your business’s multiple improve but so does the cost of the debt itself.
It’s much harder to market and sell a business with revenues of $2 million. It’s easier at $5 million, $10 million, $50 million, and the larger the business, the larger the pool of buyers.
When your business had revenues of $5 million, you were only able to obtain a multiple of 5× EBITDA (for example), but now that your business has $10 million in revenues, you might be able to get 5.5× EBITDA. If your combined entity now grows at an accelerated pace post-acquisition, then you’re now talking about exponential returns on business valuation.
I spoke with a CEO friend who recently sold his business for 11×REVENUE. Not EBITDA, but revenue. His business was a rapidly growing SaaS business. My other friend, the one who I went to dinner with, was able to obtain 8× EBITDA as a result of multiple arbitrage and sold in the first quarter of 2018. His initial value was approximately 6× EBITDA, but the combined acquisition doubled his size and significantly improved his multiple. I have another friend who has expanded his business from $9 million in revenues in 2011 to $100 million in revenues in 2019 by playing these arbitrage “games”.
If deployed strategically, debt can be a good thing, especially if you are using it as I described above.
Good luck, and hopefully this blog helped you to better understand how to expand your business through acquisition.
By the way, and before you go, I write a weekly blog and focus on three things: 1. helping entrepreneurs expand their business, 2. improve profits, and 3. how to create wealth. You can subscribe here, and I also published a book during the summer of 2018. It was number 1 on Amazon in both the business and non-fiction sections. You can get a free copy here.
Are you a younger entrepreneur? Here’s another interesting article I wrote:
My Response to an 18-Year-Old Who Wants to Become a Millionaire by the Time He’s 30.
Some recent posts you might have missed: Three Accounting Ratios You Need to Measure Your Business By. How Does Your Business Compare?
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