Valuations for Search Funds are overcomplicated
April 08, 2022
by an investor from University of Texas at Austin in Austin, TX, USA
The question of how to value companies comes up pretty regularly in this forum. While it's tempting to seek comfort in detailed models and long lists of comparable acquisitions, the reality is that the nature of the search fund model creates are relatively tight multiple range (~###-###-#### 5x EBITDA) and where you fall within that range tends to only be a small driver of the outcome of the investment.
Small businesses tend to have much more volatile financials than large companies resulting in most of the either growing or shrinking significantly over the typical search fund hold period. Therefor, buying a business with growth potential is more important than buying cheap.
Additionally, paying up early in the process can be worthwhile. Since the business is generating ~1x EBITDA in cash per year (excluding taxes), paying 4.5x EBITDA in year 1 is comparable to paying 3.5x EBITDA in year 2.
The full breakdown of what drives the multiple range and more details about this concept can be found in the new blog post:
from Oklahoma State University in Memphis, TN, USA
I have seen many examples in which a searcher has focused on an interesting industry because it has positive characteristics such as a high percentage of recurring revenue, significant growth potential, identified "low-hanging fruit" and other factors and then be disappointed that it is very hard to get a deal done at 3.5x.
All other things being equal, business owners are rarely going to be excited at selling at 3.5x, except in limited circumstances when they are both ready and well-prepared to retire (or in other similar situations) and iotherwise motivated. This is true across markets, but especially so in consolidating industries where prevailing market values have risen due to synergies that strategic buyers will anticipate.
Certainly, there is evidence that it may well be possible to get an extraordinary deal on an off-market business, but you still have the risk that the owner or his advisors will decide at some point during the process that they really need to look at other opportunities.
This is not really a comment about what small businesses may or may not be "worth". It is really a comment on what may or may not make sense economically to a business owner. If you don't take that into consideration in your search process, you have a good chance of being disappointed, sometimes when you have already expended considerabe time and resources on a potential deal.
from University of Virginia in Richmond, VA, USA
1) when people pay 4.5x for businesses that raises the fixed strain on the business for debt service making it more likely to go bankrupt. Capital structures (market instead of purely accounting) absolutely correlate with going out of business.
2) sometimes the entity dissolves but the business continues. Think of asset sales of entire businesses or think of restaurants and how much their entrance and exits in the market skew these figures.
If the data were controlled for those it’s reasonable to draw the conclusions drawn.
Regarding the large swings in small business performances, isn’t that itself a major indicator of significant potential to grow in general?