If you’re a business owner looking to increase your small business valuation multiple, one underappreciated way to do is by pursuing growth by acquisition.
There is no question that small businesses are a tremendous engine of economic growth and job creation. However, not all small business owners have the knowledge or resources to take their businesses to the next level.
Regardless of your current size, there are quite a few strategies you can use to maximize your valuation and optimize your business. Whether you are preparing to sell now or planning to hold for the next 15+ years, you’ll want to consider your options.
In this post, we’ll cover three small business arbitrage opportunities within the world of mergers and acquisitions. Implementing these strategies will help you get the most from your business when it comes time to sell.
I hope these ideas can help guide you as you work towards to your next stage of growth.
1. Manager / Owner Operation Value Swap
Building and growing a business is incredibly rewarding, but there are a few pitfalls:
- After grinding for years to build the business, owners often lose interest and want to pursue retirement or other projects.
- Burnout sets in which limits future growth. Often times owners are wearing multiple hats and struggling to get it all done.
- Frustration takes over when old strategies no longer work as effectively – and this leaves owners without much energy left for planning an exit strategy.
One solution and an opportunity for increasing your company’s value is to swap out the current manager or owner for a professional manager. This has multiple advantages, such as helping your valuation and making your company more marketable. A company that is less reliant on the owner is typically seen as being more valuable, as there is less risk involved.
Professional buyers know that owners tend to leave their businesses after they sell them, rather than sticking around and helping. Ideally the owner’s exit from a business is of little or no consequence for its future cash flow and value…but if it cannot continue growing in value without your help, it’s a real turn-off to buyers.
Unfortunately, owners can often be the victims of their own success. The more significant they become to a company’s growth, the less valuable that same firm becomes when it comes time for buyers and sellers alike.
Hiring professional management can help take some of the responsibility off of your shoulders and put it onto someone who is trained to handle such duties. Additionally, this will give the company a more professional appearance, which can attract investors.
Making the transition from an owner-run business to a management-run business can take time, but it’s essential to solve for this if you want to sell your business or attract outside investors.
In fact, just by making this one change you’ll see a drastic increase in the EBITDA multiple you’ll be able to sell your business at:
- Owner Operated: 2.5X
- Professional Management: 4.5X
This means the company is worth 2X more (on average, across all industries).
Through transitioning to professional management we can instantly create multiple arbitrage and have more buyers that are willing to pay a higher price.
How to Increase Business Value While Decreasing Owner Responsibility
Beyond just the increase in valuation, having a management-run business can be a great way to ensure that your company is run efficiently and effectively. However, making the transition from an owner-run business to a management-run business can be challenging.
Here are a few tips to help you make the transition:
Define roles and responsibilities.
It is important to clearly define roles and responsibilities within your company. Doing so will help ensure that everyone understands their job duties and responsibilities. Additionally, this will help minimize conflict between employees.
This often includes creating a board of directors (if not already established). This will help provide oversight for the company and ensure that it is run effectively. As a bonus, this can help outside investors get more comfortable with the company’s governance.
Hire competent managers.
As you might expect, one of the most important aspects of creating a management-run business is hiring competent managers. These individuals should have experience in their respective fields and be able to effectively lead their teams.
This will allow you to take a step back from the day-to-day operations of the business and focus on strategic planning and long-term growth. Furthermore, potential buyers or investors will be more interested in a company that has a strong management team in place. Ultimately, you’ll be able to decrease your responsibility while increasing the potential valuation of the business.
Implement systems, SOPs, and processes.
In order for your management-run business to run smoothly, you will need to implement systems, standard operating procedures, and processes. Examples include establishing employee handbooks, setting up accounting procedures, and creating marketing plans.
This limits key person dependency risk and helps the business become easily transitioned in the event of an acquisition.
Communicate with your employees.
It is important to communicate with your employees on a regular basis. Doing so will help ensure that everyone is on the same page and that your company’s goals are clear.
2. Tuck-Ins to Optimize Your Business
When it comes to valuing a private company, another strategy worth considering (often used in private equity) is called a “tuck-in.” This occurs when an acquirer buys a company that is related to the business they already own.
Tuck-ins involve expansion from a platform company (your current business), where multiple related companies are bought and rolled up into one larger entity. This can increase the value of the whole by creating synergies and economies of scale.
By acquiring companies in complementary or related industries, you can expand your reach and customer base. This can also help you tap into new markets and drive growth, expanding scale and market share in a cost-effective way. Additionally, it can give you the opportunity to cross-sell your products and services to a larger pool of potential customers. And if done correctly, it can help you achieve economies of scale, which can further increase your profitability.
Here’s the best part: as you get larger, it increases the value of the whole and expands the overall acquisition multiple you can garner in the marketplace. This creates a great multiple arbitrage opportunity for you.
Let’s review the below 3 stages which illustrate this progression:
Stage 1: Acquisition Multiple: 2.5X
- Deal Size Between $100K – $1M
Stage 2: Acquisition Multiple 3.7X
- Deal Size Between $1M – $10M
Stage 3: Acquisition Multiple: 12X
- Deal Size Between $10M – $100M
For the sake of an example, let’s say you start with a $6M enterprise valuation and over a couple years, execute two tuck-ins that bring your overall value to $11M.
Beyond the increase to valuation based on size, your acquisition multiple actually increases from 3.7X to 12X. This can have a transformative impact on your final sales price.
Keep in mind that once you get beyond the $10M sales threshold (~$2M EBITDA), you’ll start to attract many private equity firms, which is another nice positive.
Examples of a Tuck-In M&A Strategy
One example of a tuck-in M&A strategy is when a company purchases another in order to expand its product offerings. This can be done by adding the new company’s products to its own product line or integrating the new company’s products into its existing product line. By doing this, the purchasing company can quickly and easily expand its product offerings without having to develop new products itself.
Another example of a tuck-in M&A strategy is when a company purchases another company in order to gain access to new geographic markets. This can be done by expanding the purchasing company’s sales and distribution channels into the new market or by acquiring a company that already has a strong presence in the target market. By doing this, the purchasing company can quickly and easily gain a foothold in new markets without having to establish itself from scratch.
A third example of a tuck-in M&A strategy is when a company purchases another company in order to acquire new technology or intellectual property. This can be done by acquiring the rights to a new technology or by acquiring a company that has developed a new technology. By doing this, the purchasing company can quickly and easily gain access to new technology without having to develop it itself.
There are plenty of reasons for small businesses to pursue M&A instead of organic growth. First and foremost, M&A can provide an influx of new customers, new markets, and new revenue streams. Additionally, M&A can also help businesses achieve economies of scale, which can lead to reduced costs and improved profitability. Finally, M&A can also help businesses gain a competitive edge by acquiring complementary businesses or technologies. In sum, there are plenty of good reasons for small businesses to pursue M&A instead of strictly organic growth.
3. Industry Multiples: Buy-Side Arbitrage
As you might know, industry multiples are one way that investors value companies. A company’s industry can have a significant impact on its multiple, which is worth considering during business expansion planning. For example, companies in the tech sector typically trade at higher multiples than companies in the retail sector. This is primarily because investors expect faster growth from tech companies. As a result, a company that changes its industry classification can see a significant increase in its valuation.
This process is known as “buy side arbitrage.” By changing the industry that your company is in, you can make it more attractive to potential buyers and command a higher price for your business.
After acquisition, both businesses are valued at the higher multiple business’ valuation.
Let’s make this real with an example:
Let’s say you own a small construction company and are interesting in growth through acquisition by acquiring an architectural firm. By looking at the average multiple for companies in a particular industry, you can get an idea of what your business is worth.
According to BVR Deal Stats, below are EDITDA multiples for these industries (2021):
Construction: 2.2
Architecture: 3.6
The new combination would then be valued at higher architectural firm industry multiples instead of lower construction company multiples. Simply by acquiring a company in a different industry, you can change the multiple used to value your business.
As you can imagine, executing this and repositioning your business can have a massive impact on the valuation of your company.
By buying a business that is undervalued in its current industry and moving it into a more favorable industry, you can quickly boost the valuation of your business. This arbitrage opportunity can be created through a variety of means, such as changing the business model, product mix, or customer base. With some creativity and effort, buy side arbitrage can be a great tool to help increase the value of your small business.
Keep in mind that at any given time, most business can be be categorized within several different industries. Some of this is based on interpretation, but there is a lot you can do to impact this.
When you are preparing for an exit, you’ll want to consider positioning towards the industry with the most lucrative multiple.
Conclusion
All three of these strategies offer small business owners like yourself arbitrage opportunities to increase the valuation of their companies through M&A efforts.
To summarize, we walked through several ways business owners can increase the valuation of their companies. These include moving from an owner-operated model to a professional manager model, doing tuck-ins, and changing the industry in which their company is classified.
Of course, every business is different and there is no one-size-fits-all answer when it comes to deciding whether to pursue M&A or organic growth. Ultimately, the decision comes down to what makes the most sense for a particular business given its unique circumstances. However, in general, M&A can be a great way for small businesses to accelerate their growth and gain a competitive edge.
If you’re looking to grow your business, consider implementing one or more of these strategies over the coming months. All three can position you for a successful payday when you ultimately decide to exit.
If you have any questions or found this helpful, drop me a note in the comments.
I’d love to hear from you.
