Volume 10, Issue 2, January 17, 2023
It's January, so many of you may be reading this article for guidance on your 2023 M+A plans. Right about now, your internal dialogue may sound like, "I want to retire soon but the economy seems unstable, so why would I sell before it corrects?" Indeed, economic and industry indicators are mixed, almost like an economic whodunnit mystery with fingers pointing around the circle of suspects, all awaiting Sherlock to tell us when to initiate an exit. But if you step back from the scene of the crime, you will notice the partygoers are all buyers and sellers who share the same intention: to complete M+A transactions.
As your attention shifts from Colonel Mustard to Professor Plum, you may notice sellers pointing to industry tailwinds and premium business characteristics, while buyers are pointing to interest rates and staffing challenges. This is a murder mystery that should not end with one party being declared the winner as they slap handcuffs down on a nefarious culprit. Rather, partygoers from the buyer and seller sides will need to seek a win-win if they are going to close M+A deals in the foreseeable future.
I predict the most overused sentence in 2023 M+A processes will be "that's not market," in reference to biased deal terms that benefit either the buyer or seller. The problem with that sentence is it is subjective. Said better, any deal term can be market or off-market depending on how it relates to other deal terms. For example, a seller might believe an earnout representing 20% of the total transaction is off-market, but if the total enterprise valuation is 20% higher than market, the earnout might be justified. Telling a buyer that a 20% earnout is not market may result in a 20% lower enterprise valuation.
One of the preeminent reports highlighting market deal terms is the 2022 Pepperdine Capital Markets Report (the "Report"), which most M+A professionals review annually. This article will examine five deal terms in the Report that are most important in lower-middle market transactions and show how they relate to each other. The objective of this article is to leave readers with better knowledge of five of the most important deal terms sellers should understand before or as they bring their company to market. Your VERTESS advisor will provide you with much deeper insights into how this relates to your specific healthcare vertical.
As sellside advisors, we often refer to the cash paid to acquire a business in the form of a multiple of EBITDA. Buyers use this language as well, but behind closed doors they are talking about rates of return. The Report suggests that private equity groups (PEGs) were seeking a 30% rate of return on investments of ~$5 million EBITDA private healthcare companies last year.
What does that mean for a seller? When we refer to a transaction as 5x EBITDA, that means the buyer is paying five times the trailing 12 months of EBITDA. Applying the formula that's used to calculate the projected rate of return would see us taking that five and putting it in the denominator and then placing a one on top (1/5), which results in 20%. That's a 20% projected rate of return the PEG would achieve by paying 5x EBITDA to acquire the company. At the 30% rate of return PEGs were seeking, it's roughly 3.33x EBITDA. So that means PEGs were intending — on average — to acquire businesses last year at a 3.33x multiple of EBITDA. That's probably not the price you want to sell your healthcare business for (and a price lower than we want to secure for our clients).
On the other hand, the Report suggested the average ~$5 million EBITDA healthcare company traded at 4.0x (25% rate of return) last year, so there's a gap between what PEGs seek in returns and what this formula suggests they will pay, which is contingent on how the overall deal is engineered. Other deal terms pushed up the transaction multiple from 3.33x to 4.0x (+0.66x EBITDA) while allowing PEGs to still secure their desired 30% projected rate of return. Even more variables may have played a role in this gap, including synergies that may reduce the expense load your business currently carries.
Many healthcare companies are trading at higher multiples than what is suggested in the Report. In behavioral health, for example, many sellers would not trade at the 4.0x average because they operate in a hot segment. To that end, an important highlight from the Report is that PEGs did not change their rate of return requirements from 2021, so unless your particular segment is experiencing a significant head/tailwind, you might anticipate that buyers will be offering similar prices for companies in 2023 as they did in 2022.
This deal term is not necessarily something you, the seller, will negotiate, but it tends to have a material influence on how much you can sell your business for. It refers to the amount of bank debt a buyer will use to pay for your business. In Business 101 we learned about the "Theory of Operating Leverage." This is where companies can use their own cash plus cash from loans to do more business than if they relied solely on what they have in the bank. As an example, a buyer may have $200 million set aside to acquire businesses but rest assured, they plan to spend much more than that in dealmaking. They will use loans and the amount of debt they can secure to buy your business. This will often reflect the transaction multiple they offer you.
You might already notice a concept coming to light: If PEGs are seeking a 30% rate of return (3.33x EBITDA multiple) but were completing the average transaction at 4.0x EBITDA, the Theory of Operating Leverage must have been at play. They used debt to still achieve the desired 30% rate of return while buying at 4.0x. Alternatively, the buyer may have ways of enhancing the performance of your business under their business model (e.g., synergies, payor contracts, staff, real estate) that may allow them to pay much higher than 4.0x and still achieve the desired 30% rate of return.
You might also notice that more debt in a transaction is correlated with a higher transaction multiple. The Report suggests that the average senior leverage multiple for healthcare companies with ~$5 million EBITDA was 3.5x EBITDA. The leverage multiple most banks were lending at appeared to drop significantly in 2022 and is expected to rebound in 2023 (though not likely to reach 2021 levels). Deals financed with ~3.5x senior leverage multiples gives us more latitude to negotiate a higher purchase price.
Why do buyers sometimes fail to secure a 3.5x EBITDA loan to buy your business? It's usually when a quality of earnings (Q of E) report suggests your cash flows are not as strong as you thought. It can also be due to the buyer's debt load on other assets, the size of your company, customer concentrations, or other challenges. This is an area your VERTESS advisor will be focusing on greatly, working to understand the buyer's ability to secure financing, your company's ability to service debt load, and ultimately how to use the buyer's ability to secure debt to your advantage.
On the other hand, if you are considering a recapitalization, you might not want the buyer to overlay substantial debt on your company to acquire it. To this end, you may be more interested in a lower purchase price to avoid taking on too much debt.
A rollover allows you, the seller, to "roll" some of your equity into the new post-transaction company. Rolling some of your equity in the transaction can be a fantastic way to defer income and postpone taxes, achieve a second liquidity event (called the "second bite of the apple"), prove to a buyer you believe in the long-term success of your business, and keep skin in the game if you intend to continue serving your business after the sale. The Report suggests that 46% of all transactions last year included an equity roll. We think there will be more rollovers in 2023 as deals require more give-and-take to complete. Being such a common tactic in M+A transactions makes this an inevitable discussion point when negotiating a sale.
When thinking about rolling over equity, the points we want to leave you with include that not all buyers want you to roll equity and some buyers cannot offer rollovers; in many scenarios, rollover equity will benefit you as the seller substantially (spreading out your taxes, potentially higher second bite of the apple, etc.), and rollover equity tends to have a positive effect on the transaction.
What is market for equity roll? That would be a question that can only be answered in the context of your interests as a seller, the buyer's interests, and the overall deal. For example, rolling over 40% of your equity might not be advisable since you're selling control without realizing enough liquidity (and lowering risk). Ultimately, rollover equity is a piece in the puzzle that can materially affect purchase price and is difficult to analyze in a vacuum.
Earnouts are usually looked on unfavorably by sellers, yet still occurred in 44% of all transactions last year, according to the Report. That is down from 2021 where 50% of reported transactions contained an earnout, although we anticipate earnouts to increase in 2023. Do not feel that a buyer is undervaluing your business if the purchase agreement includes an earnout. It's usually considered a "bridge" between your expectations for a purchase price and the buyer's expectations. The buyer is essentially saying, "You believe the company is worth $5 million more than I do, so prove it with an earnout." It's money set aside for you, the seller, in the event your business continues to perform well after new owners take control. The earnout should not be contingent on net income or EBITDA, though, because you do not have much control over how the new owners structure expenses. Tie it to revenue, gross profit, census, or other simple metrics that everyone can agree on.
A market percentage of a deal is impossible to share in an article because it is highly dependent on the business's lifecycle, seller expectations, and/or recent changes in the business. What we avoid, however, is assigning any more than 10% of the total enterprise value to an earnout unless there is a clear reason (e.g., quickly growing revenues, recently volatile revenues, pending lawsuit needing resolution). Earnouts are challenging to enforce and can cause issues amongst management, so we negotiate them as low as possible to maintain a purchase price acceptable by our clients. Ideally, we move other deal terms around to compensate.
Seller financing is a common mechanism used to increase purchase price and eliminate an earnout. It is a loan agreement you are entering with the buyer, allowing them to use some of the business's earnings (or other cash sources) to pay for your business over time. The Report suggests it was used in 44% of transactions last year, which is much higher than in 2021, where only 36% of reported deals contained a seller note. We anticipate the trend will continue its upward trajectory in 2023. Allowing the buyer to pay you back over time for a portion of the enterprise value is similar to the concept in the section on senior leverage multiples where a buyer can increase his or her rate of return by spreading out the cash payments to the seller over a longer period. As a seller, you position yourself for a higher purchase price by offering to hold a portion of the financing, and you also enjoy the interest payments as well as favorable tax treatment. Two to five years is a typical amortization term. As of writing this article, 6-8% is a typical interest rate.
We see many buyers seeking seller financing around 25% of the total enterprise value, although, once again, every deal is different, and the amount of seller financing is contingent on the rest of the deal. In an ideal world, we like to see around 15% of the financing held by the seller, but many times sellers prefer the annuitized option for tax benefits. For sellers who prefer holding larger notes, remember that too much is bad. When combined with equity roll, you're putting yourself in a precarious position if the seller's note is paid from the profit and loss (P&L) before distributions.
While not my primary objective in writing this column, it lays out a rule-of-thumb guideline for both buyers and sellers to consider appropriate amounts of debt and cash be used in achieving proposals that will culminate in closed transactions. When sellers demand above-average pricing in their sale, they should be prepared to receive proposals that contain several components of a deal that entice a buyer to take on the risk of paying more. With several hot healthcare markets in 2023 combined with corrected economic conditions, you will see much emphasis on arriving at market deal terms to get transactions across the finish line.
If there was a way to tell you the exact proportions of each deal term that are ideal to achieve the most wealth from the sale of your business, I'd be out of a job. At VERTESS, it's our responsibility as advisors to analyze how each term relates to each other to produce the most benefit to our clients. And this analysis differs with every buyer and seller, so we must take that into account as well. There are additional terms including working capital adjustments, caps and baskets for representations and warranties, and more that all tie together in evaluating a good deal. And "market" is always changing. You can be positioned best to tie them all together with a healthcare M+A advisor who specializes in your vertical and knows what is market. Please reach out if we can help you better understand deal terms and how they apply to your company as you prepare for or consider a sale.
After working in M+A advisory and corporate financial consulting, David co-founded Spero Recovery, a provider of drug and alcohol recovery services with over 100 beds in its continuum of residential, outpatient, and sober living care. As its CFO he led the company to significant revenue and margin growth while ensuring it adhered to the strictest principles of integrity and client care. After selling Spero he remained in leadership with the buyer as its CFO and quickly realized accretion and integration. Of the myriad lessons not learned while earning his MBA with Distinction in Finance from a Tier 1 university, the most profound was the importance of investing in his staff and clients. He learned that the numbers on a spreadsheet represent humans, families, and dreams, which was a radically different paradigm from investment banking.
At VERTESS David is a Managing Director providing M+A and consulting services to the Behavioral Health, Substance Use Disorder treatment, and other verticals, where he brings a foundation of financial expertise with the value-add of humanness and care for the business owners he is honored to represent.