You can’t open a trade newsletter, website, or magazine these days without reading about another merger, acquisition, or strategic investment between home builders. Consolidation in our industry is more active than ever, and if you’re not part of that action now, you may be soon ... whether you like it or not.
If you’re thinking about selling or your business may be the target of an acquisition, you should get an independent appraisal of your company’s value by an investment banker that knows home building—a service that will run you about $5,000. With that value established, you’ll know if a suitor is making a serious offer or just lowballing in search of a distressed sale.
What would make your company attractive for acquisition? The list is long: land positions (optioned or owned), existing design centers, and company leadership, as well as your product, brand, marketing, and reputation.
But mostly you’ll draw interest through your profitability, an indication of how well you run your operations, as measured by staff/start ratios, optimized cycle time, cost-management, margin protection, and how well you retain crucial subs.
Should you choose to test the market as a seller (or not overpay as a buyer), what metrics are important to achieve top value? The simple answer is a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization).
But before we get into EBITDA multiples, note that there are two general categories of buyer:
1] Private equity groups, or PEGs; and
2] Other home builders, called “strategics.”
Most buyers today are strategics, as there is very little PEG activity in home building due to its volatility. That said, the fact that builders buy other builders is a good situation for the sellers, as strategics typically pay 15% to 20% more than PEGs.
Learn the Lingo
To understand the valuation equation, let’s define some of the key terms, starting with EBITDA.
EBITDA is a generally accepted accounting principle (GAAP) for measuring financial and operational performance. Earnings are your net income, a calculation of gross profit (revenue after cost of goods sold) minus selling, general, and administrative expenses. A company’s EBITDA often is used in merger and acquisition deals because it’s widely viewed as a proxy for operating cash flow. Unlike gross income or gross profit margin, EBITDA takes into account how well a company moves money to its bottom line.
A “multiple” of EBITDA is a common and more reliable way to establish a company’s true worth. It’s simple math: If your company has an EBITDA of $10 million and you sell it for $50 million, the multiple of EBITDA is 5x.
The EBITDA used in valuing your company is very likely not the EBITDA on your accounting books.
That 5x figure is just an example; the actual multiple is established by what the market is paying at any given time. In 2008, at the apex of housing’s last crash, multiples of EBITDA for home building companies were often very low, but have since crept up to reflect stronger faith in a targeted builder’s potential growth and profitability to pay back the purchase price, and then some.
Another term to know is total enterprise value (TEV), which is the purchase price minus long-term debt. TEV is an important measure because, in most transactions, the acquired company’s long-term debt (not a revolver or credit line for working capital) must be paid off by the seller at the deal’s closing, just as a mortgage is paid off when a house is sold to a new owner. Unless there are special circumstances, the acquirer isn’t buying that debt unless it’s tied to something tangible (such as land) where the value will be realized by the new owner. In fact, many M&A deals today are done on a cash-free/debt-free basis.
Investment bankers use sophisticated databases to help establish a TEV range using recent deals. They’re pricey but are worth it to help determine your company’s current value.
Adjusting Your EBITDA
The EBITDA used in valuing your company is very likely not the EBITDA on your accounting books. Most deals use an adjusted EBITDA (a non-GAAP measure), which allows the seller to boost the EBITDA with extraordinary and nonrecurring expenses. For example, let’s say you used cash to build and furnish a new design center or to fix a roof leak on your headquarters building and didn’t capitalize that expense. Such costs are probably eligible as credits toward an adjusted EBITDA, so long as they are accepted by the acquirer.
Some of the most interesting conversations you’ll have with acquirers will be about the acceptability of credits to adjust your EBITDA.
Other examples of potential credits include excessive salaries and bonuses; personal expenses that won’t be assumed by the new owners; infrastructure, equipment, software, and IT upgrade investments; and nonrecurring professional fees, such as legal fees and one-time settlements or consulting fees.
Indeed, some of the most interesting conversations you’ll have with acquirers will be about the acceptability of credits to adjust your EBITDA. Cash paid (and not capitalized) for new heavy equipment is probably a slam dunk, but lease payments made for your part-time employee son-in-law’s pickup truck, not so much. Courtside NBA seats may be fair game as a credit, if the acquirer is a fan and wants the tickets.
The Effects of Adjusted EBITDA
Adjustments to EBITDA can be truly meaningful to your valuation and ultimate selling price. That’s because every dollar added to EBITDA has a multiplier effect on your company’s value.
For example, using a valuation multiple of 5x EBITDA, a company booking $4 million in EBITDA would sell for $20 million. But let’s say you find $300,000 in acceptable credits to your EBITDA, adjusting it to $4.3 million. At a 5x multiplier, the business value jumps to $21.5 million, a $1.5 million boost. So, it’s worth taking a long, hard look at possible credits and working with your investment banking advisor to determine any adjustments.
But there are adjustments to EBITDA that an acquirer may argue. For instance, if you took an EBITDA credit for the salary of a senior executive who is leaving after the company is sold, the buyer may balk because that person (and a commensurate salary) will need to be replaced.
Multiples of Value in Today’s Market
After adjusted EBITDA has been calculated, the ultimate question, of course, is: What’s the valuation multiple? And the answer to that is: It depends ... (unsatisfying as that is to hear).
That’s because the multiple isn’t just based on your EBITDA but also on other, sometimes softer, factors, such as leadership continuity, quality of earnings, cash position, land positions, geographical coverage, and even company culture, among others considered by a suitor, depending on what they value and are willing to pay for.
My advice: Engage an investment banker to prepare your company for sale, put your operations and financials in the best possible light, and work through a controlled auction to obtain multiple competing bids to extract top value. Even if you aren’t ripe for takeover or merger—as a buyer or seller—it’s a good practice to determine your valuation and get an idea of what your business is worth in the current market.
John D. Wagner is a managing director at 1St West Mergers & Acquisitions, which offers a specialty practice in residential construction. Learn more at 1stwestmergerandacquisitions.com, or contact John at [email protected].