The majority of our sell-side M&A engagements are in representing software, information technology, healthcare technology, and other tech firms where a good deal of their value may not be reflected in their financial statements alone. Owners of these types of companies want to receive value in excess of the standard EBITDA multiple based on owning intellectual property that could be leveraged by a larger company with greater distribution capabilities. I must admit that in my earlier years my perception of PEGs being very “by the book” in terms of company valuation, discouraged me from marketing to them as aggressively as I typically approached a strategic buyer. I always felt that my strategic positioning fell on deaf ears and they just wanted to see the numbers.
Private Equity is Changing the Way they Look at Tech Companies
There has definitely been a shift in the approach that PEGs are taking to evaluating, bidding on, and ultimately buying tech companies. PEGs are already formidable bidders because of their deep pockets and financing capabilities. Now that they are matching or exceeding the bids of strategic industry players, they are winning more deals in the technology space. So the availability of funds risk is largely removed for the anxious seller who may receive a similar valuation from a strategic industry buyer, but questions whether they can come up with the cash.
Tech Deals Provide Growth Opportunities for Private Equity Buyers
The interest of private equity groups in technology companies recognizes that there is tremendous potential for growth. In the old days, PEGs would negotiate and attempt to paint all their acquisitions with the EBITDA multiple brush. This is a totally inadequate valuation methodology when comparing a slow growing bricks and mortar company to a rapidly growing digital company. In fact, Wall Street has developed an improvement on the PE multiple with the PEG multiple. It stands for the Price/Earnings/Growth multiple and attempts to quantify the value of rapid growth into the valuation metric. It helps explain why a rapidly growing company like Facebook or Google sells for a higher PE multiple than a more mature slow and steady grower like Xerox or Walgreens.
PEGs Are Involving their Platform Companies in Tech Acquisitions
Another subtle shift in the PEGs behavior is that they are involving their tech platform companies in the acquisition very early in the process. In the past, this involvement was more behind the scenes and more of a division of functions. The attitude of the PEG was we are the experts on acquiring businesses and their platform company was the provider of operational excellence. I suspect that after numerous deal losses at the hands of the strategic industry buyers, the PEGs had to become more like an industry buyer by involving their subject matter experts from their technology platform company. This has had an amazing impact on the sellers. Having someone that understands your company and its potential is much more pleasing than defending every nickel of your transaction value to a financial buyer.
Change in Acquisition Approach Was Needed
So the new and improved PEG approach to acquiring small tech companies was necessary because they were not winning enough deals. The win percentage has gone up considerably because they are shifting their focus to growth potential and recognizing that they will have to pay for some of that potential. In our last two deals for Managed Services Providers, (one in 2016 and one in 2017) the winning bidder was a PEG with an MSP as a platform company.
A Little More Room for a Higher Bid
The private equity groups have a secret weapon that should enable them to be more competitive in these deals that previously were won by the strategics. It is called the large company premium versus the small company discount. Their model is to originally acquire a platform company with a value of $30 million. For this example, let’s say that the baseline EBITDA valuation is 8 X. Now they go out and seek ad-ons that may be in the $3-$8 million dollar range. Those sized companies will generally sell at a discounted EBITDA multiple compared to the large company multiple. In this example, let’s say that is a 5.5 X multiple. Here is where their magic happens. By virtue of acquiring the smaller company and adding it to the larger company, its EBITDA now is valued at the much higher multiple of the larger company. So if the selling company had EBITDA of $1 million and were valued prior to the acquisition at 5.5 X the value is $5.5 million. On the day of closing, that company (as a part of the bigger company) adds $1 million X 8 for a value of $8 million. $2.5 million in value was created out of thin air.
So next time you are in heavy negotiations with a PEG, remember they have built in upside and a little more room to come up with some additional strategic value.
Dave Kauppi is the editor of The Exit Strategist Newsletter and author of Selling Your Software Company – An Insider’s Guide to Achieving Strategic Value Dave is also a Merger and Acquisition Advisor and President with MidMarket Capital, Inc. MMC is a private investment banking, merger & acquisition firm specializing in providing sell-side M&A services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry. His varied background includes positions in hardware sales, IT Services (IBM’s Service Bureau Corp. and Comdisco Disaster Recovery), Software Sales, computer leasing, datacom, and Internet. The firm counsels clients in the areas of merger and acquisition and divestitures, achieving strategic value, deal structure and terms, competitive negotiations, and “smart equity” capital raises. Dave is a Certified Business Intermediary (CBI), is a registered financial services advisor representative and securities agent with a Series 63 license. Dave graduated with a degree in finance from the Wharton School of Business, University of Pennsylvania. For more information or a free consultation please contact Dave Kauppi at (630) 325-0123, email firstname.lastname@example.org or visit our Web page https://www.midmarkcap.com/mmc