There are a multitude of lower middle-market businesses across the country like yours that drive our economy. Maybe it comes as no surprise that there are almost as many lower middle-market businesses that either need capital right now, or whose owners wonder about an eventual exit/buyout. Almost every single owner is somewhere on that spectrum. It’s an inevitable outcome of the evolution of a successful, growing business. Growth requires capital, and founders eventually want to “take chips off the table”. In either scenario, founders have to look to the market for that capital event, which means their businesses will be valued.
Unfortunately, many founder/CEO’s become blinded by their inherent bias and love for what they’ve built – it’s hard for them not to think that someone will value their business at 2x sales. Seems reasonable, and it’s a great business right? Wrong. I’ll leave the discussion on valuation methodology to another time. For now, let’s talk about the things you should think about to make your company more attractive to outside capital from investors and banks, and to get a higher valuation. I promise you, these are the kinds of things they’ll be looking for …
1. Profitability (EBITDA)
The obvious answer, and I’ll spend the most time here. Notice I did not start with sales. Sales are important because they do reflect volume, viability, and potential for profits. However, you can have great sales and no profits – in which case, your sales don’t mean much of anything.
Profits of private companies are usually measured by investors, banks and potential acquirers (we’ll call them all “investors” going forward) using the EBITDA number, that is, Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA goes hand-in-hand with valuation. Suffice it to say for now, EBITDA is used by investors as a proxy for cash flow and private-company valuations are typically presented and discussed as a multiple of EBITDA (i.e. 4x, 5x ... EBITDA). If you are generating annual EBITDA north of $1.5 million, you'll attract attention from equity investors. Industry acquirers may very well be willing to buy you out with lesser EBITDA volumes. Creditors are less tolerant of risk than equity investors and generally don't start getting excited until that $2.0-$3.0 million annual EBITDA range (presupposes a credit facility NOT secured by a personal guarantee). They need comfort that you can meet your debt service obligations while adequately providing for day-to-day cash-flow needs.
You’ll want to consistently show positive EBITDA, month after month, for at least the twelve months preceding your capital event. That twelve months is hugely important, and is often referred to as the “Trailing Twelve Months” (TTM) or “Last Twelve Months (LTM). Consistently showing profitability over time begets confidence and trust in the business. An exception to this might be a company that has endured losses that were marked by an unusual set of circumstances, or were the result of being a start-up. In the exception cases, there should be enough evidence of profits going forward to compensate for the losses in the rear view mirror.
It stands to reason that, in addition to consistent performance, the larger the EBITDA, the less risk everyone sees and the more value is attached. The idea of “risk” is inseparably connected to value, and how your business will be viewed by outsiders. Profits, or EBITDA, need to be significant in relation to your sales, or as a percentage of sales. The higher the percentage, the less risk. Investors LOVE businesses that generate EBITDA north of 20% of sales. They are warm to businesses that generate EBITDA at or north of 15% of sales. Below 10% and it gets much tougher – not impossible, but investors are definitely more squeamish and in order to pull the trigger, will likely need experience of their own in the industry along with your validated forecast for growth and increased profitability.
2. High Gross Margins
Closely linked to #1, investors love businesses with high gross margins -- or, at least, high gross margins relative to industry average. As a quick reminder, gross margin is calculated as sales minus cost of goods sold and is synonymous with gross profit. There is definitely an argument that if EBITDA is adequate, who cares about gross margin! My response is, that the concern in a business’ cost model and profitability should always start with cost of goods sold – i.e. can you sell your product or service at market prices and make an adequate profit to cover overhead? Higher gross margins are a good predictor of higher EBITDA, as there is more room, or “margin”, to cover the fixed overhead costs that make up so much of Selling, General and Administrative (SG&A) expenses.
Pharmaceuticals, software, and some service businesses are classic examples of businesses that often reflect high gross margins across all industries. Some manufacturers, particularly in niche industries with proprietary products (like medical devices or specialized machine tools), also feature high gross margins. Moving down the gross margin “food chain”, you have industries like bulk-item manufacturing, retail, distribution, and construction, generally in that descending order.
Construction companies often face gross margins of 10%-15% of sales or less, whereas software companies often enjoy gross margins in excess of 70%. If gross margins are low, it doesn’t mean your EBITDA is automatically too low to attract investment; however, the simple math says it’s going to be more of a challenge and overall volume will be a key driver. Operational measures that can lower cost of goods sold over time should be a hyper focus, in addition to maintaining low overhead expenses. In the construction industry, for example, bidding on jobs with an accurate estimate of cost is critical, in addition to having a maniacal obsession with controlling jobs costs by eliminating crew and equipment downtime. Consider also that things like safety focus, employee training, and industry experience/reputation can all bolster the value of lower-margin businesses.
3. Sales Growth
Like profitability, everyone wants to see a growth story. It doesn’t necessarily need to be “hockey stick” growth, but it needs to be sustained over a period of time – preferably, during that magic TTM period. If sales have flattened, or are in decline, you’ll need to be able to show it as the bottom of a trough, or as the result of an unusual set of circumstances … with a very believable growth pattern directly ahead. As a percentage of sales, 5% to 7% year-over-year growth is healthy (and what many companies will show in a forecast model), and 10% is strong. Forecasting sales growth above 10% is exceptional and will often require more substantive explanation in the form of “bottoms-up” (i.e. by customer) sales growth analysis.
4. Forecast Is Believable And You’re On Track
Closely related to #3, your forecasted results need to be rooted in sound assumptions that can withstand scrutiny:
Active purchase orders from customers are the best source of evidence for future business, and most investors will want to see this “backlog” of orders.
Anecdotal evidence from customers, such as oral promises and discussions of their forecasts, are also critical to constructing the narrative of your forecast.
In addition to your specific business assumptions, hopefully you’ve invested in industry research and forecasts from independent sources that validate your optimism and give your forecast added legitimacy.
Cost data in your forecast should at least be reflective of historical averages, should account for unforeseen costs, and should be specific where possible (for example, specific increases in payroll). If you expect inflationary impacts, include that as well.
Don’t forget to account for capital expenditures required to maintain the status quo, as well as to fund your growth. These are two very different things that investors will want to see.
Putting together a robust three-statement financial forecast for one year, let alone five years (which is standard), and keeping it continuously updated, is no small matter and is a key reason why larger companies invest in internal FP&A (Financial Planning & Analysis) teams. Whatever the time and resources you put into it, either yourself or through others, forecasted results should be relatively close to what you’ve predicted. If not, be ready to answer a host of questions as to why.
5. Recurring Sales
As a rule, businesses that have customers who need (best) or want (still good) to buy a product or service over and over, as opposed to one-time, are valued higher than those that do not. Service contracts, Master Service Agreements (MSA), and subscription agreements are all examples of intangible assets that reflect repeat business from customers and increase a company’s value. You don’t necessarily have to have those in your business to still have repeat customers, but they do show evidence of a stronger sales model and ultimately, less risk. No matter your industry, the key is that the same customers keep coming back again and again.
6. Customer Diversity
I have this at #6, but it could easily be higher. Having a diverse customer base, or not, is literally “make or break” to many a financing event. It’s easy to understand why. Having all your eggs in one, or only a few baskets, presents significant risk. If that one key customer goes out of business or becomes disenchanted with you, much of your business goes with it. In addition, if you are overly exposed to one key industry, a downturn in that industry could spell disaster. No better example of that than the oilfield service industry. When oil prices tank and the drilling slows, oilfield service providers are the first to suffer.
Just as a good investment portfolio is diversified to mitigate risk, so should be your customer base. If you know you have a year or more before your exit or next financing event, I highly recommend making this a focus. Don’t jeopardize your relationships with your one or two key customers, but focus on broadening into new relationships, and potentially into new industries. And, take comfort ... this issue of customer concentration is extremely common – almost all B2B companies face it at some point during their life cycle.
7. Proprietary Product/Process (With Intellectual Property Protection)
If you’ve ever watched an episode of Shark Tank, you probably get the importance of this. Investors want to know what makes you different, what gives you an edge or upper hand over the competition – also known as a “competitive advantage”. When you’re simply repeating or “repackaging” what others have already done or can easily replicate, it’s akin to a commodity business – you’re competing in a world where prices will be continuously driven lower as you fight to maintain your business. And in the long run, customers may win, but businesses will struggle.
Having a competitive advantage that is, or can be protected by, intellectual property (IP), in the form of one or more patents, is huge. It means you’ve created a barrier to entry. You’re not constantly worrying about pricing because competitors can’t steal what you’ve created, and customers will usually pay a premium for your unique product or service. And by all means, when it comes to IP, start off by securing your unique names and phrases with trademark protection.
8. Barriers To Entry
Following on from #7, the further away from low barriers to entry and commoditized businesses you are, the better you generally fare when it comes to attracting outside capital (and being profitable!). Service businesses with relatively few assets and no proprietary anything are particularly at risk. Low barriers to entry simply means it’s easy for a competitor to enter your market. You want it to be difficult for competitors to walk onto your playing field – high barriers to entry. Whether it’s specialized industry knowledge or relationships, intellectual property, a proprietary process or customized machinery used in production, your business will ideally have a proverbial firewall to protect itself from the over-saturation of new entrants and numerous competitors.
9. Strong Management Team
Ask any early-stage, start-up investor what matters most to them, and most likely they’ll tell you it’s the management team – the people. It actually takes priority over the business idea itself. In later-stage companies, that prioritization shifts more to the business – i.e. you’ve proven you can build something, so the business fundamentals provide all the intrigue. However, there is still a focused review of whether or not the key people are in place to continue building the business. Investors will be asking themselves, “Can this particular team take the company to the next level? Are there holes that need to be filled, or “weak links” that need to be replaced immediately? Do they work well together, or do they appear dysfunctional?” And of course, there’s the classic test: What happens to the business if the CEO gets hit by a truck?
Investors will often require a “shoring up” of the Finance and Accounting department, including the hiring of a CFO or Controller. They will most likely want to meet some of your key employees before finalizing their decision. In the end, they will require that either an acceptable management team is in place or that you accept their help in hiring more key personnel post-investment. At any rate, your coming to the table up front with your management A-team says, “I’ve got this”, and will greatly enhance your prospects for the capital and valuation you seek.
10. Large Addressable Market
Hopefully in your forecasting process you’ve clearly defined the size of the market you’re serving. Investors want to know that your serving an industry customer base with healthy growth and plenty of prospects. They’ll obviously do their own due diligence, but as a general rule, investors will want to see up front that industry size is at least $1 billion in sales, and hopefully more. If the addressable market is smaller than that, then 1) it can’t be much smaller, and 2) there has to be a very compelling story about profitability and market capture – i.e. how you will take much of the market, and make a lot of money doing it.
Reasons for this follow logic. Many businesses in the lower middle market are in highly fragmented industries where capturing larger market share is difficult. Additionally, every business has competition – if not now, soon. Many start-up companies will forecast capturing market share on the order of 1% to 3% of the industry – and investors often scoff! It’s simply very, very difficult to do. The point is, your piece of the pie will likely be relatively small, but as long as you can show that the pie is big enough and there’s room to grow, that’s okay.
Certainly there are other factors to consider in making your business attractive to investors, and I’ll cover more of them in another article. However, if you can check the box on the ten key factors I’ve listed above, you are well on your way to attracting the capital you need at a valuation you want.