The lower middle market isn’t what it once was. It’s getting more sophisticated regarding M&A, though both business owners and advisors continue to make classic mistakes surrounding building and measuring value. Experienced investment bankers agree that certain trends continue to weaken the overall market. Here’s what they say.
Unsustainable Financial Target Chasing
Many business owners continually chase a financial target in a way that’s unsustainable or harmful. Someone told them once they needed a certain EBITDA multiple, and so they slash costs in a way that actually erodes value. Owners think they can cut costs and no one will notice. But it doesn’t take customers or potential buyers long to notice what’s happening.
A similar phenomenon happens when businesses absorb revenue they can’t fulfill or retain. This revenue usually brings with it costs both tangible and intangible. So when it disappears, the company plunges into a deeper hole than before. If a seller takes delayed consideration for their business in the form of an equity rollover or earnout, these short-term measures can deplete future gains.
Unwise Short-Term Moves by Buyers
Buyers are just as guilty of making short-term moves that wreck business value and fall short of expectations. We see a lot of penny-wise and pound-foolish choices. The buyer reduces sales compensation or R&D, boosting EBITDA but creating cost savings that are illusory. What happens to your business when half of your sales force quits, or when your customers get interested in a more innovative business?
Business Valuation Assumptions
We see a lot of assumptions designed to reach deal-winning multiples. Earnouts are a common tool for bridging gaps, but buyers and sellers should be mindful of the potential to make short-term moves that backfire. Earnout issues are often taken for granted by buyers and sellers assessing risk. Then both sides can feel cheated.
It’s critical for both parties to focus on the intangibles. For buyers looking to acquire a business, it’s all about quality-of-earnings reviews. It’s usually easy to catch when someone runs personal expenses through a business. The real issues are instead lack of product diversity, poor management, and management infighting. When a deal is done, buyers must practice humility. Ask the right questions about the business rather than making unfair assumptions. There is less room for error in the lower sector of the market, since one or two mistakes can destroy an entire business.
Business owners must contemplate these issues years in advance, rather than scrambling to slap a band-aid on them at the very last minute. Most businesses can double or even triple value over three to five years if they are honest about and willing to tackle their weaknesses. They must be willing to cut to the heart of business value. Too many owners think what they did last year drives value. Buyers are looking to the future. That means owners who plan ahead and build for the future can see improved multiples and faster closing deals.