Value is not ethereal, nor is it in the eye of the beholder. Warren Buffet rightly notes:
This is especially true as it relates to SBA 7a lending for business acquisitions. The SBA has some of the best rates around, if a given buyer can 1) get comfortable with the personal guarantee clause, 2) accept the SBA first-lien position and 3) find a business with the cash flow to support the requisite debt service. Number three is perhaps the most critical piece of the whole equation, especially as buyers and sellers consider business value. Without the ability to service the debt, the deal is dead on arrival. Unfortunately, most small business sellers completely misunderstand how value is calculated.
Debt Service Coverage or DSC is a simple equation. It's the annual free cash flow (FCF) of the business divided by the annual gross cost of debt service (SBA interest + principal and any subordinated seller notes). The rule of thumb for SBA lenders is, at a minimum, a 1.5 DSC ratio. That is, the annual cash flow must be at least 150% of the expected annual debt service.
Keep in mind that Free Cash Flow (FCF) can be very different from EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). In fact, actual cash flow from a Statement of Cash Flows (corroborated by the tax returns) is what the SBA loan underwriters will most likely demand to see. Where there is more DA that EBIT, true cash flow can be more easily obfuscated by silly non-cash add-backs. We have seem multiple deal failures because a buyer based their valuation assumption on EBITDA in a business with large non-cash add-backs.
When it comes to buying and selling businesses that fall within the purview of the SBA, your company's value will be based on a very calculated process--a process that will ultimately hinge on the numbers you provide to the buyer and the buyer's lender.
Many a seller may try to rationalize in his/her mind a valuation that falls outside of the normal bell curve. It's the corporate equivalent of the illusory superiority -- the logical fallacy that causes people to think they are smarter than the average. The fact of the matter is, most businesses will be average and most are worth what they are worth and do not venture far out of a tight range.
Seller note -- Debt Service Coverage component
Fully negotiable, but with max terms set by and subordinated to the SBA component.
There are multiple moving parts to this calculation, many of which, if moved, can adjust the relevant DSC ratio. However, most are ancillary and work in the buyer's favor to ratchet the value down, not the other way around.
While most SBA lenders have a hard-and-fast rule for 1.5x DSC, most like to see north of 1.7x. The aforementioned sensitivity table shows how the various annual debt service stacks against the cash flow. In this case, we assume cash flow and EBITDA are synonymous (again, which is not always the case).
Yes, there are more private equity groups than ever. Yes, more private equity groups have vast amounts of dry powder and liquid capital for making lower middle-market deals of this size. And, as we have discussed before, many private equity groups today are acting more like strategic acquirers. That is, they are looking for good fit bolt-on and tuck-in targets for a larger platform play. Unfortunately, that does not mean that 1) they want to overpay either or 2) they want to put in more equity than their lenders may require.
An ultimate premium will need to come from more equity from the would-be buyer. Any underwriter with a good process will cap the amount of serviceable debt by a very specific amount. That means that any potential seller premium brought by a synergistic buyer must be derived from more equity. More equity means "more money down," "more cash at close" and "more skin in the game." Premiums are a zero-sum-game in that the seller only wins (in his/her mind) when the buyer loses. Value was not actually exchanged for value. If you want buyers to pay more, you will have to convince them to cough up more equity. It's that simple.
In many cases, buyers hold unrealistic valuation expectations. I have found that the smaller the business, the higher the likelihood that the owner thinks his/her business is worth more than what the market would ever pay.
If like everyone else, you are seeking a premium when selling your business, there are several considerations which you will have to consider. Firstly, size matters. The smaller you are, the less likely you are to capture a large delta from true fair market value. Where buyers have smaller pocket books, particularly with individual buyers, the aforementioned rules will absolutely apply. Large premiums come to small companies typically only when they own some other controlled asset (IP, business model or relationship) that the buyer could leverage for much greater scale. Second, run a process. Most sell-side M&A advisors who run a controlled process can capture more of the value for the seller than the buyer--especially if they are able to bring multiple buyers to the business at the same time. Finally, understand that a buyer premium can only come from more equity, which you can gauge on ability to pay based on the buyer(s) which you have at the table.
For those looking to perform their own analysis of the above, you can find the Debt Service Coverage (DSC) calculator here.