Show Me The Money! Private Equity and Small Business Explained
Updated: Oct 7, 2020
For most owners, when the subject of private equity comes up, they envision teams of MBAs financially engineering a transaction that will destroy what they have built their entire life.
Well, 20 years ago, you would right. However, the landscape has changed dramatically. For owners of smaller companies, private equity has finally arrived in a big way.
So, the question is why – why has private equity “discovered” smaller private companies and, more importantly, what does this mean to you?
This article is not intended to extoll the virtues of private equity but rather to provide you as a small business owner a foundation to understand the role of private equity in helping you grow enterprise value, and achieve your business and personal objectives.
You might ask — how does private equity help me grow enterprise value? In short, because private equity is a reliable financial partner for smaller companies. Some say that private equity is a more reliable source of capital than your local bank or potential strategic investor. Unlike your local bank or potential strategic investor, private equity is in the business of investing, which creates a deep market for owners of closely held businesses. By creating this market, private equity distinguishes the “average” from the “excellent” business and, in so doing, provides the Blueprint to Enterprise Value Acceleration.
So, by creating a market-based blueprint to smaller company value acceleration, private equity helps you grow the value of your company. Indeed, following this blueprint can mean the difference between whether your company is worth 1 times revenue or 3 times revenue. Imagine what that difference means to you personally.
WHY DOES PRIVATE EQUITY INVEST IN SMALLER COMPANIES?
Historically, private equity largely ignored smaller companies. As an example, a company with $23 million in revenue and $3.5 million in free cash flow annually would have very few options to sell or raise capital outside of a strategic investor or a local investment group arranged through a business broker. Today, the same company would attract many private equity groups competing for the opportunity to purchase or invest. In fact, today there are well over 1,000 private equity and family office groups specifically targeting smaller companies in the U.S.
Why has private equity finally “discovered” smaller companies? The short answer is superior return on investment compared to alternatives. How does private equity achieve a superior return on investment in smaller companies? The answer, private equity has formed “Operating Groups” within their funds that support the business enterprise in ways they have not done before. To accelerate value, private equity firms first relied on financial engineering then cost reduction then top line revenues. Then they established operating groups whose primary job was to monitor and report. Now their primary job is to drive measurable performance improvement through a “Value Acceleration Playbook”.
There are two important take-aways:
1. Private equity has created a deep, reliable market for smaller companies
2. Private equity relies on a value acceleration blueprint.
HOW PRIVATE EQUITY VALUES PRIVATE COMPANIES
The standard valuation multiple equation used in the private equity industry is:
Enterprise Value is defined as equity plus funded debt minus excess cash beyond working capital. Think of Enterprise Value as the price a 3rd party would pay for your company.
Adjusted Trailing Twelve-Month EBITDA is defined as the most recently completed 12- month period of earnings before interest, taxes, depreciation and amortization adjusting out or in extraordinary expenses, normalized salaries and the like.
Beyond the equation, the more common rule of thumb is smaller companies (less than $2 million EBITDA) are generally valued between 2 and 3.3 times Seller Discretionary Earnings, according to the Pepperdine University Market Pulse Q4-2019 Survey. Companies with EBITDA between $2 million and $50 million are generally valued between 4.3- and 5.8-times EBITDA, according to the same Survey. It’s fairly straightforward that the value of your company will rise if you increase your pre-tax profit. The real question is by how much. Let’s say you increase pre-tax profit by $200,000 this year, will the value of your company increase by $400,000 (2X) or $1,200,000 (6X)? That is the question. And, as you may have guessed, this is the foundation of the private equity value creation blueprint — how to turn a 2X company into a 6X company.
THE VALUE CREATION BLUEPRINT
Shortly after investing in a company, private equity will either use their own operating group or engage a 3rd party consulting specialist to systematically analyze the 18 value drivers below to evaluate how best to grow enterprise value. The process will typically identify 5 or fewer initiatives possessing the highest return on investment.
Growing value efficiently means knowing on which value driver to focus. For example, lowering customer concentration could add more to your enterprise value than continued revenue growth at historical customer mix. Or examine margins for product pricing and better purchasing opportunities.
On average, private companies can increase transferrable value significantly through a Value Acceleration initiative utilizing the Deep Dive Discovery process. Studies have shown that the top 5 value drivers alone often account for almost half of the missing value.
The critical point is that the Deep Dive Discovery process will be rigorous and comprehensive, supported by specific return on investment and executed to conclusion. With the identification of value gaps and disciplined execution of strategies targeted to close those gaps, private equity is able to consistently improve the valuation multiple of companies and, in so doing, achieve above-market return on invested capital.
HOW TO OPTIMIZE YOUR COMPANY’S VALUE
As you may have already concluded, it’s not easy to execute the value acceleration blueprint especially because it needs to be customized to your unique company and personal factors. So, how to get started? Like private equity, you would benefit by engaging a 3rd party consulting specialist to lead a rigorous and comprehensive analysis to identify the most important contributors to your company’s enterprise value. In conjunction with this step, you should also consider beginning the process of creating a board of advisors (formal or informal) to assist you in executing the highest return on investment initiatives identified in the value creation blueprint. To that end, we have put together a separate resource entitled Building the Right Advisory Board discussing the value of and critical planning steps to creating an effective advisory board. With these two steps, you’ll be well on your way.
Private equity is providing great value to owners of smaller private companies by creating a market-based blueprint to enterprise value creation. It has never been clearer how to grow the value of your company to meet your business and personal objectives. Those who act will reap the rewards.
By Barry Goodman, CPA CEPA CMAA CVGA
Managing Director, Birkdale Transition Partners, LLC
Copyright: Cannot be Reused without Author’s Permission.
Birkdale Transition Planning LLC is the objective source for those considering any business transition. Our goal is to maximize the value of their enterprise before any transaction.
Business owners without a transition plan often are unable to sell or transfer their company at its highest value. We help them to balance a company transition with the owner’s personal goals. Then we work with them to avoid problems caused by the lack of planning and/or not recognizing what needs to be added, corrected or modified prior to the event.
Birkdale is unique because it only offers an unbiased assessment and solutions for the company owner. We don’t sell any other products or services so are a fee-only firm. We work in partnership with the company’s current professional advisors and staff. Because we help companies increase their monetary value, owners view our assistance as an investment— with payback and payout occurring during and at the conclusion of an engagement.
For a no-obligation, confidential discussion, please contact Barry Goodman at 312-626-1820 or contact us.