AE Market Multiples: How M&A Shortcuts Leads to a Dead End
Selling or acquiring a business is one of the most complex undertakings that exists in the private sector, and for architecture and engineering firms, there is no exception. But it’s complex out of necessity – there are vastly more variables than buying a piece of real estate or selling a vehicle. For starters, the parties involved in any merger or acquisition must consider the selling firm’s financial performance, client contracts, the condition of equipment, a variety of liabilities, and how to handle the transition of employees (especially critical for AE firms). There are countless other factors in the M&A process, and many can be incredibly time-consuming and resource-intensive. It comes as no surprise that M&A shortcuts have become attractive to many sellers and buyers.
What are market multiples?
Perhaps the most popular way participants in an M&A transaction attempt to simplify the process is to rely on “market multiples” rather than a more comprehensive business valuation. In short, market multiples are the average price a business in a specific industry sells for in relation to its earnings based on available data from past transactions. This approach is similar to a price-to-earnings ratio, which you might see when analyzing the stock price of a publicly traded company.
Market multiples for private businesses typically range from 2 to 10 and are often expressed with an “x” or “times.” For example, 4.5x or 5.8 times. Usually, multiples are calculated using compiled industry transaction data and put forth by advisory firms to garner sell-side interest from business owners. Other times, multiples are merely the result of industry gossip that becomes distorted as it’s passed along.
How are market multiples used?
Given that shares of a private business aren’t available for public purchase, the total value of a firm to an external buyer is unknown. Since a firm’s owners and its potential acquirers are interested in determining its value, they may turn to market multiples as a quick way of assessing its worth to get to the offer stage faster. In this rudimentary process, a multiple that is thought to be appropriate is applied toward the firm’s earnings, most often its Adjusted EBITDA (Earnings Before Interest, Taxation, Depreciation, and Amortization).
Why is it dangerous to only use market multiples when valuing a business?
There are many pitfalls for buyers and sellers relying on market multiples, potentially leading to a merger or acquisition that never gets off the ground, falls apart midway, or leaves value on the table.
Multiples are based on industry averages.
Every firm has unique attributes that can significantly add or take away value. Ignoring these can lead to buyers and sellers overvaluing or undervaluing a firm. Further, they are backward-looking and don’t necessarily represent the latest state of the industry or where it’s headed.
Multiples use incomplete data.
There are many transactions in which the terms are kept discrete or price-affecting details are omitted. For example, a firm may have had prominent assets on its balance sheet that resulted in an elevated purchase price but weren’t necessarily needed to maintain its EBITDA.
Not all EBITDA is calculated the same.
Different philosophies regarding adjusting a firm’s earnings to calculate true profitability exist. These varying approaches skew market multiple data and any self-calculated EBITDA it is being applied against. In other words, two faulty inputs are going into an equation that is oversimplified to begin with.
Multiples seldom consider deal structure.
Rarely are the proceeds from a private business sale delivered entirely in cash at closing. Typically, there is some combination of cash, stock, equity rollover, seller note, earn-out payments, or other considerations. Even if two deals have the same purchase price, the makeup of the deal structure can present two very different value propositions.
The more specific the multiple, the less reliable it is.
The further a multiple is defined, the fewer available data points to support it. For example, if it’s been reported that a civil engineering firm doing $1-2 million in EBITDA garners a 6x multiple, there may have only been a few transactions to back up this hypothesis.
Sellers can face collateral damage.
Too often, business owners hold onto inaccurate or outdated assumptions of value, which, if overstated, could lead to them taking a passive approach to growing the business. Further, when they determine the right time to sell, their inflated value expectations could deter advisors from taking them on as clients or lead to higher advisory fees.
Buyers may lose some deals or overpay on others.
Market multiples are commonly expressed in ranges, but even if a seller and buyer are looking at identical figures, a gap in perceived value could be too large. Offering too close to the floor of a multiple range could cause a seller to walk away. Alternatively, consenting to a seller’s proposed price at the top of the range, under the guise that it is still considered reasonable, could mean the buyer overextends themselves financially.
So, does industry transaction data have any meaning?
Yes, considering transaction data for mergers and acquisitions within the industry is still an important component of any business valuation. However, it requires nuanced research and analysis. The selected comparable company transactions should be tailored to the valued firm. The evaluator should review every available detail of the transactions they consider to measure similarities and differences, including, but not limited to, revenue, operating profit, EBITDA, assets, liabilities, services offered, and deal structure. For example, an architectural design firm doing $50 million in revenue should not be compared to an engineering firm doing $5 million in revenue. The evaluator should be able to convincingly argue why they included any particular transaction.
A balanced business valuation should also consider other approaches. The market method should be used in conjunction with or to back up income-based methods, such as Discounted Cash Flow and Capitalization of Earnings, and asset-based or hybrid methods if applicable. The valuation report should give the seller or buyer more than just a dollar amount; it should provide insights into the specific factors that increase or decrease value and benchmark the firm’s many performance indicators against industry peers if accurate data is available.
M&A transactions are a long, winding road. Every deal involves two or more unique businesses coming together with the ultimate goal of synergistic value creation. Shortcuts mean reduced visibility and the chance of getting stuck in mud or driving off a cliff.
If your firm is considering a merger or acquisition as part of its future, we encourage you to gather as much information as possible early in the process. SN provides informational webinars to help firms navigate the M&A process, including this one on AE firm valuations. And, as always, reach out to us with any transition solutions questions.