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Breaking Down the Numbers: Sustainable Margins

It’s tempting to prioritize near-term objectives ahead of long-term goals.  However, if you eventually plan to sell your business, recognize that buyers evaluate—and pay for—what the business looks like as if owned by them.  Buyers’ value drivers vary from expanding capabilities to accessing new customers; however, the following analysis focuses on one key value driver—sustainable profit margins.

Exhibit I illustrates two companies—Company A and Company B.  Aside from the differences in Exhibit and listed below, assume the companies’ characteristics are identical (e.g., contracts, capabilities).

Both companies want to sell and maximize value.  At first glance, Company A is more profitable and generated more cash for its owners from 2010-2012E, and therefore seems like a better business.  However, taking a deeper look into their strategies highlights a different story.

How did their strategies differ?  Company A focused purely on EV / EBITDA multiples when evaluating an exit.  Its owners tightened indirect costs—hoping to benefit from a higher EBITDA base.

Company B focused on the business drivers that result in the multiple, and especially buyer skepticism of sustainable above-market EBITDA margins.  The owners invested in business development (“BD”), recruitment, certifications, and other growth-oriented infrastructure investments.  Company B looks and operates like a large business.

What did buyers think?  Company A’s margins were higher, but acquiring the business would require investment in BD and back office.  Buyers normalized margins to a level that would be sustainable post-acquisition, and Company A was valued at $46M.

Company B’s efforts to bolster BD paid off as it (i) won key contracts that generated strong topline growth, (ii) generated a sizeable pipeline of opportunities targeted for late 2012 award, and (iii) developed back office functions adequate to support strong continued growth.  As such, Company B’s margins were not adjusted and it was valued at $57M.  These investments also better prepared Company B to compete and win full and open contracts given both companies would have exceeded small business thresholds.  Company B’s business profile was “sustainable.”

Why does it matter?  Even though Company A threw off more cash to owners, the investments by Company B drove value.  Buyers were comfortable with the sustainability of Company B’s overall business and margins, and valued the business off of reported 2012E EBITDA versus a buyer-adjusted 2012E.

Sacrifice margins for necessary investments?  Owners often view value primarily in terms of clients, capabilities, and financial performance.  However, an important valuation component in a sale process is the quality, depth, and sophistication of a company’s processes and infrastructure.  It is important to understand that many government services buyers recognize that (ii) sustainable financial performance is driven primarily by revenue and not cost synergies and (ii) there can be a significant return on infrastructure reinvestment that can drive longer-term, sustainable top-line growth.

Contributors: Marc Marlin and Robert Dowling