It’s a common enough scenario – an entrepreneur learns that the buyer of their business has acquired several similar businesses and plans to combine them for a bigger payout down the line. The response? “I could have done this, but I didn’t know it was even an option!”
As competition for quality businesses grows, our experience is that industry consolidators are playing an ever-increasing role in successful transactions. Consolidators are often private equity or similar firms which entered the target industry with a goal to consolidate, rather than entrepreneurs who have founded and operated a company within it. This leads many to wonder – are entrepreneurs leaving money on the table by not acting as consolidators themselves?
Our belief is that the answer is yes, and that uncertainty about the acquisition and consolidation process is preventing many entrepreneurs from maximizing the value of their businesses. In today’s post we are going to explain the logic behind industry consolidation and discuss some benefits and drawbacks to acquisitions.
At its core, the concept of industry consolidation as a value-building strategy arises from one key observation: smaller businesses tend to be valued less than larger businesses.
Now at first glance, you might think this is obvious – of course a smaller business will be worth less than a large business, it generates less cash flow! But even after adjusting for level of earnings, smaller businesses tend to attract lower pricing multiples. For example, a business with $5 million of EBITDA may sell at a multiple of 6x, while a similar business with $1 million of EBITDA may sell for a multiple of 4x.
Why is this the case? Well, it may partially have to do with the fact that smaller businesses can be riskier than larger business. For example, they tend to be more reliant on the owner or key individuals, and less diversified across factors such as product/services, customers and geography. However, our belief is that the valuation differential is also driven by buyer dynamics – specifically, buyers have limited time and resources to dedicate towards acquisitions and they are more likely to focus on those that offer more “bang for their buck” in terms of potential upside, capital deployed and acquisition costs as a percentage of purchase price. This leads to greater competition, and higher valuations, for larger companies.
This discrepancy in pricing multiples can create arbitrage-like opportunities for buyers to acquire one or more smaller businesses at low multiples, merge them with each other or an existing “platform” business to form a larger business and then sell to a larger industry player at a higher multiple.
For example, a private equity firm could acquire five $1 million EBITDA companies at an average multiple of 4x ($20 million total valuation), integrate them and, if successful, sell the resulting $5 million EBITDA company at a multiple of 6x ($30 million total valuation). In this scenario, the whole is worth $10 million more than the sum of the parts.
While it might not be practical for any one of the smaller businesses to acquire the other four given the financial and operational requirements, there may have been a missed opportunity for one of them to acquire another and then sell the resulting $2 million EBITDA business for a multiple of, say, 5x. This would result in a value uplift of $2 million in the pocket of the entrepreneur.
The above analysis ignores a variety of other potential upside opportunities from consolidation besides the valuation uplift from increased size. These include:
These opportunities can also be of value in a buy-and-hold strategy since they will tend to improve a business’ competitive position while reducing risk.
With that said, acquiring a business is not without risks. These include:
Generally, these risks are not insurmountable and can often be mitigated through careful acquisition due diligence and integration planning supported by trusted transaction, tax and legal advisors.
Entrepreneurs typically achieve success in their businesses not from avoiding risk but by managing it. Why not take the same attitude when it comes to acquisitions?
If you are considering buying a business, reach out to one of our trusted transaction advisors for ideas on how to make the acquisition a success.
 The multiples referenced in this post are for example only and aren’t intended to reflect “typical” multiples for businesses.
CPA, CA, CBV
Partner - Advisory Services
Mike has over 25 years of experience providing accounting and business advisory services, with a focus on the Canadian insurance industry.
CPA, CA, CBV
Alex Wong is a partner at Smythe Advisory and is focused on being a trusted business advisor to his clients.
CPA, CA, CBV
Director of Valuation Services
Paul Woodhouse focuses on providing financial advisory and litigation support services to clients.
CPA, CA, CBV
William Tam is a manager at Smythe Advisory, and is focused on providing valuation and financial advisory services to his clients.
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