Today, I want to talk about the crucial role of starting with the end in mind.

This is wise advice for most situations.

If you are buying businesses, it's even more important!

You want to know what a business is worth today and what it could be worth if you want to sell it. 

Enter the concept of Multiple Arbitrage.

The short version in Mergers & Acquisitions (M&A), Bigger = Higher Value

Longer version…

Many factors increase a company's value.

M&A Activity, Category/Industry, Industry Trends, Technology Risk, Growth Rate, Gross and Net Margin %, Team operated vs Owner-operated, Geographical location and more.

However, there are significant value jumps at higher EBITDA levels, with everything else being equal.

EBITDA = Earnings, Before, Interest, Tax, Depreciation and Amortization.

The biggest value bumps for small businesses (marketing businesses for sale) I've seen are at the $1mm, $3mm, $5mm, and $10mm+ EBITDA ranges.

Above $10mm there is exponential value creation and even more exit options! 

Why is this? 

It might surprise you that more money is waiting at the top of the market. 

There are four main categories of business sizes based on Enterprise Value (EV).

EV = total deal value, what the business sells for, including any deal structure e.g. not just the cash at close portion. 

Here are the four categories:

Main Street under ~$10mm, Lower Middle Market $10-250mm, Middle Market $250-500mm, and Upper Market $ 500 mm-1B+.

Value jumps even higher as you go up in each of these categories.

One of the best examples to illustrate why there is more value for larger businesses is Berkshire Hathaway. 

Side note: In 1965, Warren Buffet and his early investors acquired the majority interest in the then-failing textile company.

After decades of reinvesting profits into other great businesses, Warren & Berkshire are constantly in the news for sitting on significant cash levels (or equivalents). 

Last I saw, they held ~$153B in Treasury Bills (T-Bills).

As a public company, Berkshire needs to provide a return on capital for its investors. 

One problem with scale is that it gets harder to deploy massive amounts of cash for a decent return. 

The current T-Bill rate in the US is around 5%, so for round numbers 5% on $153B = $7.65 Billion per year!

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Say Berkshire acquired a great business, returning 20% annually, for $1 Billion.

In this example, buying a great business would return $200,000,000 annually. 

It's clear that, at this scale, adding $200,000,000 in annual profit on its own doesn't move the needle compared to a near-risk-free return of $7.65B. 

Then you have other business buyers like Private Equity Groups (PEGs). 

In 2023, PEGs raised $784.93 billion across 1,757 different funds.

However, most of this capital went to Mega Funds, and the top 10 raised $200B combined. 

These mega funds have the same problem as Berkshire, except their investors would not be happy with T-bill-sized returns. 

Why?

1/ Because they can buy them directly and save on management fees.

2/ Generally, funds work on a capital call basis. This means they only call on your investment when they have a business to buy (if a buy-out fund) 

3/ Investors are chasing the 20%+ returns their historic funds have returned. 

If you look at business size statistics across the US, a tiny percentage of businesses reach a scale that would be attractive to larger funds. 

According to the Small Business Administration (SBA), over 33 million businesses are registered in the US.

I looked up how many businesses are over $1 Billion in revenues to give an idea of how many businesses the large PEGs could acquire. 

According to Crunchbase data, only 6,344 businesses generate over $1B in revenue.

Compared to ~4,500 PEGs in the US.

To be clear, not all of these PEGs buy businesses (buy-out funds), and not all 4,500 would be targeting $1B+ companies. 

For context, the average M&A deal size in 2023 was $670mm.

However, by the laws of supply and demand, the value of these businesses goes up exponentially.

Enter Multiple Arbitrage.

Some PEGs and strategic companies look to buy smaller businesses of either the same type or synergistic to each other to create larger combined businesses. 

This is commonly referred to as a "Roll Up". 

For example, if you buy 10 businesses with $1mm of EBITDA each, you will have $10mm of EBITDA combined. 

Now, you unlock a new value universe by appealing to buyers seeking larger businesses. 

PEGs and companies are targeting to acquire businesses at different Revenue/EBITDA brackets, trying to build value this way in various industries. 

The key to unlocking this value is the business needs to operate as one entity. 

Unfortunately, you can't stack multiple companies together and immediately expect the combined businesses to be valued higher. 

Many have tried and failed with this game plan. 

In the ecommerce world, Thrasio is one example. At one point, hailed as the fastest VC-funded "unicorn" ($0-1 Billion valuation) in history, it filed for bankruptcy in February of this year. 

To conclude, if you plan to sell your company in the future or build a more valuable company, it might be worth considering an M&A Strategy.

When executed well, an M&A strategy can boost a company's value quicker than any other method. 

So it might be worth considering. 

Please keep in mind this is not investment advice. M&A is not risk-free by any means and there are no guarantees in business. 

Cheers,

Coran