This is the second installment in a three-part series Rock Fusco & Connelly, LLC will be publishing on using M&A transactions to maximize and grow your company’s value. In part one, we helped you understand EBITDA, and how to increase EBITDA and its multiplier. In today’s edition, we will address how to compare rates of return from M&A deals with internal rates of return and various M&A strategies.
Comparing Rates of Return
After an acquisition, your company may be worth more than the sum total of the seller and buyer. For example, say your company has an EBITDA of $5mm with a six-times multiple for a total valuation of $30mm. You acquire a company with an EBITDA of $2mm with a multiple of five times, which costs $10mm. The total value of your company after acquisition may be more than the sum of the two valuations ($40mm). In fact, the EBITDA of your company is now $7mm. Assuming it stayed at a six-times multiple, the value would now be $42mm, with a gain of $2mm of arbitrage.
Building on this example, imagine you would be able to recognize $250,000 of cost reduction due to duplicate costs in place in both yours and the target company. Now imagine that your EBITDA multiple would increase to 6.5 times as a result of the transaction due to diversification of customer base and increased growth trajectory. Your EBITDA is now $7.25mm ($5mm base, $2mm acquired, and $250k in synergies). The total valuation is now $47.1mm.
This example highlights why companies are so keen on using M&A to expand value. It is rare for a company to be able to make an internal $10mm investment and gain $17.1mm in value. The arbitrage ($7.1mm) represents an immediate and substantial (71%) return on investment. While not impossible, the formula and schema we have set forth in this section is the way to evaluate when to use M&A as opposed to making an internal investment.
Methodologies
By now, you have seen why so many businessowners are keen on using M&A to generate value. As a coda to this installment in our M&A series, we will discuss two different methodologies to consider when implementing your growth strategy, and when each should be used.
A horizontal integration is when you acquire a similar company, perhaps even a competitor. A horizontal integration may allow your company to increase its geographical footprint, expand its service line, realize synergies between the two companies, enhance negotiating power with customers and vendors due to size, and spread fixed cost overhead across a higher revenue base due to economies of scale. A vertical integration is when you acquire a supplier or subcontractor. A vertical integration could provide your company new project opportunities, have it viewed more as a “one-stop shop”, and increase your company’s profit margin by eliminating markup from the supplier or subcontractor.
In our next newsletter, the financial installment of our M&A series will address the due diligence aspect of entering into an M&A transaction and how much due diligence should be conducted.
For help with all your M&A and corporate securities needs, please reach out to the attorneys at Rock Fusco & Connelly, LLC.