Author: Stephen Prendeville
As a broker of advisory practices, I was keenly interested in Rod Bertino’s article on valuations in last week’s Reality Check.
My recent experience in the marketplace affirms Rod’s research findings that EBIT valuations are in fact outperforming recurring revenue valuations.
I’ve found this trend can be largely attributed to two factors:
- Businesses in the last five years have focused on cost structures and profitability for survival. Moreover, with the increase in average FUM in recent months owners have been rewarded with higher EBIT’s.
- In the last 12 months the industry has witnessed the return of new investments being made, and in many cases, done so in a new fee for service environment.
Rod’s research using the No More Practice Business Valuator found that the average valuation multiples for Recurring Revenue was 2.8 times and EBIT 6.7 times.
Our experience at Forte Asset Solutions has supported Rod’s findings within 10% of these nominated values. Specifically, we have found the average Recurring Revenue multiple to be three times and Adjusted EBIT (allowing for market average principle remuneration of $120K and add backs of one off expenses) of six times.
However, I believe there is an important point of clarification worth mentioning. No transactions have been contractually entered into on an AEBIT basis.
All transactions in the past two years have been done exclusively on Recurring Revenue basis, and the transactions currently in negotiations are also being assessed on a Recurring Revenue. Keep in mind this is primarily for practical and contractual purposes.
However, this is not to suggest AEBIT has not been a key focus or orientation for the buyer.
The primary reason(s) for the continued dominance of Recurring Revenue as the preferred methodology is one of contractual convenience, monitoring and risk assessment.
When a business is acquired, the ownership and decision making in regards to expenses is transferred onto the purchaser. The vendor does not have management control and there will not be individual P&L’s to tract the previous business performance from the merged entity. All transactions have a deferred consideration that reflects performance for a nominated period(s) post first settlement.
The one area the vendor can control is Recurring Revenue as this is directly influenced by client retention. Both vendors and purchasers seek client retention and it is for this reason that Recurring Revenue is the dominant methodology used for determining actual deferred considerations.
However, AEBIT is a very significant consideration in what recurring revenue multiple is applied. A business that enjoys high profit to Gross Revenue will be awarded a higher recurring revenue multiple, while a business that does not enjoy high profits will be awarded a lower multiple.
Forte has found that both methodology’s are used by a perspective buyer and the lower assessment will drag the other methodologies multiple down.
An example may best illustrate this point –
|Scenario||Gross Revenue||Recurring Revenue||AEBIT||Rec. Rev. Value 3 X||AEBIT Value 6X||Likely Outcome|
Scenario A. The outcome of $1m reflects the high demand for FUM and the Purchaser will look to synergy benefits via lower costs (rent, staff savings). The debt servicing will be approximately $100k therefore synergies are critical for free cash flow. The low profit reduces the multiple down to 2.5 times.
Scenario B. Price Convergence of the two methodologies and free cash flow before synergy benefits. Note AEBIT 40% to Gross.
Scenario C. On a Recurring Revenue basis $1.8m AEBIT valuation equates to 4.5 times. The Purchaser will see this as out of step with the market and will offer around a 3.3 times Recurring Revenue with potentially a higher salary for the retained vendor.
The above table illustrates the interconnectivity of the two methodologies. The message to business owners is to run your business at above 35% AEBIT to Gross Revenue to maintain future value.
The table also illustrates that businesses are not currently being rewarded for higher profitability as they are being dragged down by Recurring Revenue. This is illogical, and the market will at some stage change from its current position.
Given FOFA’s impact to Volume Overrides and increased compliance costs, aggregation or synergy benefits are reducing and it is likely that AEBIT or capitalisation of profit valuations will increase in acceptance.
Business owners should have an awareness of future values and will always be rewarded by running better, more profitable businesses.