The Maths Behind Acquisitions

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The Maths Behind Acquisitions

Looking to buy a new business?

Everyone has their own reasons for buying businesses. Some want more independence in the way they work, others want to make money.

Strategic buyers, however, look to acquire more businesses for their economies of sale, as well as the fact that acquiring a new business and absorbing it into their own allows them to grow faster while gaining access to more markets.

How does all this work?

It comes down to the maths behind acquisitions, and it’s known as the variation multiple which is the basis for this article. The fundamental idea is that growing a business via acquisition allows strategic buyers to increase the value of their own business in powerful (and fairly rapid) ways.

The Variation Multiple

How big or small a company is will largely determine its valuation multiple.

For example, a medium-sized business might be valued at 8x earnings, while a smaller business operating in the same industry might be valued at just 3x earnings.

Let’s consider the small business first. In our example, it has revenues of £1,000,000 and EBITDA of £200k. It’s valued at £600k (3x multiples of EBITDA).

The medium-sized business, meanwhile, yields £20,000,000 in revenue. Let’s imagine it has a 7x variation multiple and is valued at around £28,000,000. Should this business decide to acquire the smaller business, it will boost its revenue by an extra £1,000,000 while adding £200,000 to its earnings, thus turning it into a £8,000,000 revenue company that can now boast £4,200,00 earnings.

If we base this business on the 7x valuation multiple, it is now valued at over £29,000,000, which means it has boosted its value by more than £1,400,000 simply by purchasing a £600k business.

Naturally, this isn’t the only benefit that the medium-sized business will reap. It will also benefit from economies of scale and cost synergies, which will help profits increase further.

Not just that, but it’s also worth mentioning that an acquirer can boost their valuation multiple whenever they purchase and absorb another business. This is because the variation multiple naturally increases when businesses get bigger.

For instance, if a business has £900,000 turnover, and revenues eventually pass the £2,000,000 milestone, the variation multiple will increase.

Now, to reach the £2,000,000 milestone, the business will need to grow 2x. If the company decides to do this via just organic growth, it will have a huge task on its hand.

So what can it do?

It could grow much faster via acquisition.

The company can acquire one, two or even three smaller rivals in their niche that are turning over – let’s say – £100k, £250k and £400k, which will help the company’s turnover soar beyond £2,000,000 far more quickly than if the company focused just on organic growth.

Moreover, once the businesses are fully integrated and stabilised, its value is then based on a higher multiple.

How Do The Mathematics Work?

Let’s imagine that the smaller businesses we referred to just now had an EBITDA which was 20% of their turnover.

Let’s also imagine that the medium-sized business had a £180,000 EBITDA, and that the EBITDA of each acquisition was £20,000, £70,000 and £80,000.

Because the valuation multiple of the medium-sized business was 2.5, its £180,000 EBITDA meant that it had a value of around £450,000.

Imagining that the smaller businesses had variation multiples of 1.5 – 2.5, their average variation multiple was 2. As such, they would be purchased for £40,000, £140,000 and £160,000, which means total cost would be pegged at £340,000.

This figure means we can add around £170,000 per annum EBITDA to the medium-sized business (the acquirer), which now brings its EBITDA to £350,000, while its total revenue increases to just over £2,000,000.

If we use just these numbers, and ignore for now economies of scale and cost synergies, and use the valuation multiple of 4, the new valuation of the medium-sized business is £1,500,000.

In short, the business has managed to increase its value by over £1,000,000 by spending less than £400,000 on acquisitions. The benefit is achieved by increasing total value to a higher valuation multiple.

Sources of Financing

When we talk about the maths and numbers behind acquisitions, they might yield fantastic (and rapid) benefits to the acquirer, but the amount of money needed to acquire a new business is still high.

When it comes to raising funds for a new business acquisition, a company typically has two main options:

  • Equity financing
  • Debt financing

A third option would be family and friends.

Equity Financing

Equity financing is when an investor helps you acquire a business with their funds on the understanding that they’ll receive a percentage of ownership.

Investors are usually angel or private investors, although they can also be friends or family members. Essentially, you’re selling shares to them. However, there are occasions when an investor is given a say in how a business is run.

Debt Financing

Debt financing generally involves a loan, which typically comes from a commercial loan company or a bank. Sometimes it may come from a family member or a friend.

The scenario is simple: You borrow capital from a lender, which you agree to pay back over a specific period of time. Interest is added (the price of the loan), and once your debt is repaid, you and the lender part ways.

Debt financing is a popular way of raising funds to acquire a business, but it can hamstring a company if they aren’t able to meet the agreed deadlines when it comes to repaying the debt with interest.

Final Thoughts

Acquiring smaller or mid-sized businesses is common practice among strategic buyers who know that there are several benefits involved – one of which is, as we’ve seen, a mathematically-derived advantage that helps to add more value to their own existing business, while at the same time representing a fairly straightforward path to growth.

There are, of course, other ways to grow a business and fatten up its value. But if you’re planning to operate as a strategic buyer, it’s really important that you understand the maths behind acquisitions, and especially the fundamental concept that value created by a purchase is mostly garnered by the impact of the valuation multiple.

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