Column: Understanding the Value of Your Small Business

By Jordan Gersh, director of M&A, Logan Flaks, analyst and Scott E. Semple, senior advisor, sbLiftOff

      Considering Mergers and Acquisitions (M&A), the key to coming to an agreement is to understand ALL the value levers in negotiations while balancing the competing priorities for each party. As expected, one of the most important factors in these transactions is the purchase price, which begets the most obvious question in a seller’s mind, “How do I value my company?”

      Most commonly, the Market-Based approach benchmarks a target company against similar entities that have recently been sold/acquired. In practice, buyers apply a ‘multiple’ to a historical financial baseline – often the trailing-twelve-months’ Earnings Before Interest, Depreciation, and Amortization (EBITDA) or Operating Income; e.g. $5M EBITDA x 4.0 multiple = $20M valuation.

      Determining EBITDA and applying a fair and appropriate multiple are critical and require an experienced valuation team to incorporate all the quantitative and qualitative characteristics of a company.

      The Income-Based valuation method analyzes future expected cash flows to derive a fair value in today’s market. This approach requires a deeper financial and technical understanding, including capitalization structures and discount rates. This valuation method is challenging for companies where the future cash flow can be unpredictable – especially for smaller and/or newer companies. We recommend that multiple valuation techniques be leveraged in parallel to triangulate a more-defensible business value.

The GovCon Market

      When thinking about company value in the Government Contracting (GovCon) market, we focus on two different markets: full and open versus set asides. In general, full-and-open GovCon companies tend to trade at higher valuations due to the greater available buyer pool. In contrast, set-aside companies require buyers to represent similar profiles/backgrounds/demographics to that of the seller to fully realize the benefits of applicable designations (Small Business, Women-Owned, Veteran-Owned, etc.). Additionally, a company’s transition from set-aside dependent to full and open competition is extremely difficult.

      Data indicates that the majority of set-aside companies are unsuccessful in making this transition upon sizing out. Thus, buyers pay a premium for GovCon companies that have successfully survived the journey.

GovCon Valuations

      Perhaps unsurprising, GovCon companies have different attributes than those of commercial companies. Accordingly, below are some fundamental factors that impact GovCon valuations:

• Quantity of Backlog – companies with greater visibility into future revenue are less risky, and thus more valuable. In many GovCon industries, buyers prefer targets with remaining backlogs that total at least two years of the current annualized revenue.
• Quality of Backlog – companies with a diversified backlog (i.e. healthy contract/agency mix and lower concentration) often command a higher multiple/valuation.
• Prime vs. Subcontracts – prime contracts are more reliable and offer greater visibility into future revenue and recompetes (i.e. higher p-wins). Subcontracts can be cancelled. Thus, companies with a higher share of prime work in backlog attract higher valuations.
• Best-in-class Contract Vehicles – IDIQs/GWACs/BPAs/MATOCs are valuable in the GovCon world as they provide opportunities and avenues for future work with limited competition. Companies that obtain and compete successfully on attractive contract vehicles are in turn more valuable. Note however, just having the vehicle without any task orders is less valuable to buyers than situations in which work has been won.
• Strong BD/Proposal Team – demonstrating a strong Business Development engine provides a potential buyer with greater confidence in winning future work. A robust pipeline with high yet feasible p-wins illustrates the strength and effectiveness of a company’s proposal team.

Additional Factors

      Of course, there are additional factors that are relevant in determining a valuation, including the prevailing macroeconomic and geopolitical conditions (e.g. inflation, interest rates, and administration changes). As previously discussed, price/valuation is only part of the discussion. Creative deal structuring can also be a mechanism in itself to add value to both parties and potentially justify a higher valuation. The four main levers in structuring an M&A transaction are as follows:

• Cash at Close – plain and simple, cash in the seller’s pocket at the time of Closing.
• Seller Rollover/Retained Equity – seller rolls over/retains equity in the post-transaction entity. This equity provides shared growth incentives for both parties and enables a secondary liquidation event for the seller.
• Seller Financing – debt/note provided by seller to be repaid with interest over an agreed-upon period. This is not a contingent payment, but almost always subordinate to any bank loans.
• Earnout – financial incentive that is contingent upon future performance (e.g. revenue targets). This lever is used frequently to bridge the gap in valuation between seller’s expectations and buyer’s willingness to pay.

      Business valuations can be just as much art as science. The ‘art’ of the valuation comes with experience and expertise. If you are a GovCon pursuing a valuation, then make sure you work with a provider that knows GovCon.

Scott Semple can be reached at scott.semple@newthinksolutions.com.

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Column: Understanding the Value of Your Small Business

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