Let the Seller Beware

Kenneth F. Stern

The large and fast-growing sensors market is driven foremost by the increasing use of electronics to monitor and control equipment. While the capital requirement for designing and manufacturing semiconductor- and capacitive-based sensors is high, the requirements for bonded-foil, silicon, thin-, and thick-film sensors is fairly low. As a result, numerous small to medium-sized companies compete in the sensors market. Should these smaller companies become targets for acquisition, the seller must understand how to properly value his or her company to maximize its value.

Over the years, larger companies—aided by deep pockets, experienced merger and acquisition (M&A) experts, and outside advisors—have broadened their product portfolio by acquiring smaller sensor companies, identifying likely candidates and acquiring them at less than their true value. As a prospective seller of a sensor company, it is important to understand the true value of your company to such prospective acquirers.

Understanding EBITDA
In classic terms, the value of a business is the net present value of its future cash flows. Many buyers use the value of earnings before interest, taxes, depreciation, and amortization (EBITDA) as a proxy for cash flow. While not perfectly correlated to cash flow, EBITDA has become synonymous with the earnings by which companies are often valued.

Many small sensor companies are privately held, owner/operator businesses. The owners of these companies often pay themselves above-market salaries, expense perks (e.g. company paid vacations and dinners, premium car leases), and, to minimize income and hence income taxes, expense excess material purchases and capital goods that would otherwise be capitalized on the balance sheet. As a result, the reported EBITDA of the company is often significantly depressed from its true value. It is critical, therefore, that the true historical EBITDA of the company be determined prior to entering into a sales process.

Once the true EBITDA of the company is known, the next step is to develop a financial model for future EBITDA. This model is driven by a revenue forecast and the underlying costs associated with that revenue. The revenue forecast should be based on historical product, program, and customer sales and on new product, program, and customer activity based on recent quote and design activity. Armed with a defendable revenue forecast, the costs associated with the revenue can be derived. The cost of goods should be segmented by variable material, variable/direct labor, and fixed and variable overhead. Overhead that is fixed should be expected to increase with inflation, not revenue. Selling, general, and administrative expense (SG&A) should also be segmented by fixed and variable costs. By developing a detailed cost model, the forecasted EBITDA should grow at a much quicker rate than revenue, taking advantage of the operating leverage on the fixed costs.

An Example
The model below (Figure 1) illustrates a sample forecast of a stand-alone business, showing elimination of owner perks and the leverage of increasing revenue on fixed costs:

Figure 1

For a company acquired by a strategic buyer, the performance should be greater still. On the revenue side, a strategic buyer should be able to increase revenue by leveraging their larger customer base and sales channels. From a cost perspective, there should be significant cost savings, derived from a) achieving economies of scale on material purchases and employee health benefits, b) eliminating duplicate expenses such as field sales and outside legal and accounting expenses, and c) the avoidance of costs to develop products or infrastructure that the acquired company already possesses.

The forecast below (Figure 2) assumes that the strategic acquirer can increase revenue by cross selling and leveraging a larger sales/distribution organization, save 10% on material purchases, reduce 5% of variable overhead, eliminate the manufacturers' rep selling organization and reduce $50,000 in advertising expenses.

Figure 2

In this scenario, the 2013 EBITDA of the business acquired by a strategic buyer is over twice that of the business operated as a stand-alone entity. The present value of future cash flows is then reduced by a discount rate, which is the risk adjusted financial return that an acquiring company expects to earn on its investment. The greater the discount rate, the lower the value of future cash flows (for example, $100 five years from now at a discount rate of 10% is equal to $62; at a 20% discount rate, the value is $40.)

The discount rate is calculated by adjusting the financial return to reflect the perceived risk to an acquirer of these future cash flows. Factors that drive risk include customer concentration, the proprietary nature of the company's products, and the stability of the business, among others.

The chart below (Figure 3) summarizes the net present value of the cash flows for the stand-alone entity versus ownership by a strategic acquirer, based on the financial forecasts above, with a range of discount rate assumptions (20%–35%).

Figure 3

As illustrated, as the discount rate increases, the net present value of the company declines. The more strategic an acquisition is to the buyer's business, the lower is the perceived risk of an acquisition and hence the lower its discount rate. Additionally, the greater the operating synergies created through an acquisition, the greater the future profitability (EBITDA), and the higher the valuation.

Over the past decade financial buyers (e.g., private equity groups) have targeted sensor businesses. As financial buyers, they expect financial rates of return greater than those expected by strategic buyers but they do not provide the operating synergies that a strategic buyer can bring to an acquisition. As a result, in competitive bidding processes, the financial buyers tend to present the lowest offers. It is for this reason that financial buyers prefer to contact companies that have not yet contemplated a formal sales process.

Be Prepared
Given the anticipated number of acquisitions in the sensors market, it is highly likely that a large, acquisitive company may approach your business unsolicited. To maximize the value of a potential transaction, it is critical that you a) understand your true profitability, b) understand the potential profitability your company can provide the strategic acquiring company and c) engage in a competitive sales process in order to convert a portion of the acquirer's created value to the seller.

About the Author
Kenneth Stern is President of Synxronos, LLC, Simsbury, CT, an M&A advisory firm focused on selling privately held technology oriented businesses. He can be reached at 860-408-9666 or via Synxronos' Web site.

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