The purported Illuminati love their symbolism and use it as a 'secret' means of communication that the uninitiated cannot comprehend. The most well-known symbol that is asserted to be linked to the Illuminati is the Pyramid and All-Seeing eye found on U.S. currency. More interesting is the claim that the Illuminati get thrills out of hiding truths or puzzle pieces in plain sight as the rest of us remain largely ignorant.
In the world of mergers and acquisitions we have no ruling blood lines or occult symbols. However, there is something significant hidden in plain sight that buyers and sellers should understand. Contrary to the Illuminati practice, this is not intentionally hidden. Rather, it has remained elusive simply because no one in the M&A world has given it a name or taken time to explain the importance.
Hidden in plain sight, and an absolute factor in any buy-sell transaction, is the Opportunity-Delta©. This term was coined by Rick Murphy, CEO of Cogent Growth Partners, but rest assured, he's not breaking with any M&A 'code of the cloth' by revealing this. Instead, Murphy believes that by educating potential buyers and sellers of the existence and dynamics of the Opportunity-Delta that both will be empowered and more capable to complement one another's position and improve transaction results.
As illustrated in the figure below, the Opportunity-Delta represents the difference, or space, between the seller's and buyer's perspective of a sale/purchase price of a business. These perspectives are different because the seller understands their own multiple of EBITDA based upon their most recent twelve-month performance and the buyer views a different multiple based upon their investment horizon, need for return, and projected improvement to free cash flow after the sale. Both are correct for each party, but this delta represents the critical leverage necessary for a transaction.
Let's do a little math to illustrate the Opportunity-Delta…
For example, let’s start with a seller's trailing twelve month period adjusted EBITDA. Adjustments meaning addbacks for one-time expenses or owner benefits with owner salary compensatory for role in the company as a proper expense and the term EBITDA meaning Earnings before Interest, Taxes, Depreciation and Amortization. In our example, that figure is $500,000. Let’s also assume that the seller’s free cash flow (FCF) is equal to this adjusted EBITDA. Using a very simplified calculation, let’s assume a buyer is willing to pay $3,000,000. The seller's perceived multiple would be 6X ($3M/$500K). Now, assuming the buyer can project a forecasted free cash flow, otherwise known as an adjusted forward free cash flow or AFCF, of $750,000 that would be in place after the purchase due to consolidations, synergies and conservative projects (if any), then the buyer's multiple would equate to 4X ($3M/$750K).
The Opportunity-Delta© is the $250K difference between how the seller and buyer view the basis of the purchase price, creating the 2X difference in multiples. The number itself is not so important, but the relative size drives the leverage necessary for the buyer to achieve their target time horizon for return on equity (their investment), of which combined horizon and return calculations are represented by the 4X buyer’s multiple in this example. The Opportunity-Delta is impacted by many factors, the three most common being; consolidation, synergies, and growth potential. In more detail:
Consolidation benefits are cost savings from items such as; combining office locations and data centers, deploying new administrative automations, the reduction of duplicate staff roles, and consolidating tools and processes. Some may happen right away and others over time. Consolidation poses the least risk to a buyer, the more they can come up with, the better for everyone.
Synergies can result in cost savings through efficiency, improved margins and new revenue. Examples may include; moving the outsourced cloud solutions of one company to the in-house solution of the other, complementary verticals, or competency in areas such as sales or NOC management. Synergies are a mid-level risk to a buyer in being able to accomplish, do with expediency (typically longer term to enact), and realize the desired cost reduction/gain.
Growth potential is projected, in part, based upon the seller's existing momentum and capability to continue that growth post transaction plus the confidence the buyer has for further leverage in opportunities such as solutions cross-sold to consolidated customers. As it is projected often with educated guesses, growth potential poses the largest risk to the creation of Opportunity-Delta and must be handled accordingly in the overall transaction. Usually by way of a less risky deal structure and/or reducing the buyer’s investment horizon timeframe (thus, reducing the purchase price).
Advice to buyers…
An important trait of a 'good buyer' is if their head can fit through the door to meet the seller in the first place. In other words, get rid of the buyer-swagger. For you to get to a 'deal,' that gives you a worthy return on investment, the seller will make meaningful contributions for this to occur.
Advice to sellers…
A smart seller is someone that understands the leverage that must be created for a buyer to pay you the big bucks. The fact is, they are likely to do things with your business that you cannot achieve on your own. Yes, your business must be in great shape and be poised to continue growing as currently structured (likely without the owner still there) to fetch a higher price, but it is your willingness to work with the buyer to strengthen the Opportunity-Delta© that will foster the best outcome.
The Opportunity-Delta© has now been revealed to you. Given this insight, buyers and sellers should embrace the reality that both parties play a key role in maximizing the sale/purchase price and the likelihood for the transaction to be completed. Ultimately, the famous adage holds true in that “a company is worth what a buyer willing to pay for it.”
If the seller is reasonably rooted in reality (i.e. no such thing as a hard and fast seller multiple of anything) including understanding what is going through the mind of a good buyer, the buyer understands what a fair price to pay is (i.e. a reasonable return on equity), and they both agree that the opportunity and fit between them makes for a good transaction, then a fair and good purchase price will be agreed on based upon the Opportunity-Delta© created. Next step is the deal structure that includes how the purchase price gets paid to the seller, which is an entirely different and interesting subject…
About the Authors: Scott LeRoy, VP of Operations and Business Analysis at Cogent Growth Partners, LLC, has over 20 years of experience in finance, marketing, operations, brand development to go along with his M&A chops. He spent a decade in the IT and managed services industry reengineering what IT means to small business and since 2014 has project managed transactions and led business analysis and due diligence efforts for Cogent. Co-author George Sierchio, EVP & Sr. Partner at Cogent is well versed in many areas of M&A including growth strategy, acquisition targeting/evaluation, valuation, due diligence, deal structure, agreement development/negotiation, and corporate governance, leading over 25 transactions in the IT Services space.