Next year is shaping up to be a very strong year for M&A activity in the Knowledge Economy. In order to assist your preparation for 2021, take a look at our M&A Preview, in which we discuss the following eight key trends:
- The adoption of digital is accelerating
- Emerging technologies are being commercialised rapidly
- There is a convergence across the sector and delivery models are blending
- Private equity participation in the knowledge economy is increasing
- Next-generation technology platforms are emerging
- Vertical software solutions are playing an increasing role
- Buyers are returning to nearshore locations for access to new skills
- Shareholders are aligning expectations and addressing structural risks
Buyers’ Approach to Valuation
We discuss Equiteq’s 4-step process to get to a target price for a business in the knowledge economy sector.
Often the stimulus for a company sale starts with an understanding of the value of your firm in the current market. As market conditions change from year to year, timing a sale can make a dramatic difference to the price achieved. Some firms however are just interested in the current value in order to create the benchmark for value improvement over the coming years.
Our work not only involves sale and acquisition transactions, we also help firms grow equity value over the long term. The valuation methodology we use calculates a current value, but it also makes the link between cause and effect on company value. As you will see this goes well beyond just an understanding of the financials.
Calculating your equity value as an EBITDA multiple
Our valuation method is a 4-step process that starts by looking at averages: an average firm in your sector sold in average market conditions over the past 5 years to the average buyer. We then adjust that value up or down depending upon your financial profile, your investment risk profile, current average market conditions and our view of the buyer’s appetite for your firm if it was on the market today.
Our knowledge economy industry M&A database that provides us with a lot of the base data used in the valuation process, is 50% historical information on previous M&A deals in the industry and 50% company information. The latter is broken down to include financials, sector and service expertise profile of all firms in the UK and other places across the world. Our 4 steps to a company valuation are as follows:
1. Financial Analysis
We look in detail at your historical and projected financials. We make adjustments for any one-off expenses that could be argued as not part of normal trading costs. We also adjust for abnormally high or low compensation levels. We calculate the year-on-year growth in this ‘adjusted’ EBITDA and assess your ability to generate free cash flow from profits in a sustainable way. We then apply a multiple to this adjusted EBITDA to generate an investment return commensurate with the risk profile for the average knowledge economy firm.
2. Equity Risk Assessment
We use our ‘8 levers of Equity Value’ model to determine if there are any risk factors associated with your firm that would make it a worse or better than average investment opportunity as compared with the average for the industry. For example, under the section ‘Quality of fee income’, if you could demonstrate long-term contracts with clients then you would have a lower risk profile than most knowledge economy firms. Alternatively, if more than 25% of your fee income was with one client and with no long-term contract then we would judge you to be higher risk than average. This would affect your score in this segment of our equity value wheel and may increase or decrease the multiple applied to your EBITDA in calculating value.
Our 8 levers are based on extensive experience and research into those factors that buyers assess when looking to value a knowledge economy firm. We review them regularly. This is important because buyer sentiment does change over time. For example, even 5 years ago, it would have been difficult to get a good price for a knowledge economy firm where 50% or more of its consultants were freelancers or ‘associates’. Today this is seen by many buyers as attractive because it infers an ability to reduce costs fast – and thus protect earnings – if the market takes a downturn.
3. Market Premium
The EBITDA multiple used in step 1 assumes average market conditions. We hold data on multiples in our sector going back to the year 2000. We have also correlated this data with general market data going back 75 years. At any point in time we are able to calculate a discount or a premium to the market average.
4. Buyer Synergy Premium
So far all of our calculations are independent of the type or specific buyer. However, the price premium associated with finding the right synergistic buyer can swamp any premium associated with your growth, profit levels or even market premium. We have seen significant synergy premiums and so it really does pay to research the right buyer for your firm. Buyer synergy means that you have persuaded the buyer that your firm can grow their firm faster than it could grow without you. In these circumstances the investment return calculation becomes more than just based on your financial forecast. You are selling the story that together ‘2+2=5’ so that the buyer can justify paying a higher multiple of your profits to get this joint growth. It is in this area that Equiteq’s data excels. We can calculate a ‘buyer synergy premium’ based on our comprehensive database that we outlined above, which indicates the relative attractiveness of your firm to the potential universe of buyers.
The resultant valuation from the above 4-step process gets as close as you can get to a target price based on actual deals done in the knowledge economy sector, comprehensive sector market data and the experience of hundreds of buyers of knowledge economy firms.