Return on Investment Calculations Employed by Business Buyers Evaluating Privately Held Companies for Potential Acquisition

Jan 10, 2017

The purchase of a privately held company in the mergers & acquisitions marketplace is at its heart an investment decision.  However, the type of investment return desired from the acquisition can vary greatly depending on the goals & motivations of a specific buyer.   The following are three of the most common return on investment calculations employed by business buyers evaluating privately held companies for potential acquisition.

The most common investment return calculation employed by a buyer evaluating a privately held company for acquisition is the calculation of a general return on investment.   To calculate a general return on investment on a business acquisition a buyer uses the EBITDA (Earnings Before Income Tax, Depreciation, & Amortization) from the most recently completed fiscal year and divides it by the targeted acquisition price.  For example, if a company had an EBITDA of $1,000,000 in 2016 and the targeted purchase price was $5,000,000, the anticipated general return on investment for the acquisition would be 20% based on the most recent financial information.   Conservative buyers often employ a EBITDA figure based on a straight or weighted average of multiple years to calculate a return on investment to balance variances in profit in recent years.    IBA is currently seeing general returns on investment of between 15 – 50% in the middle market in the transactions we are facilitating depending on the industry of the company.  The general return on investment appropriate for a specific transaction is a function of the perceived risk associated with a transition of ownership.  It takes significant knowledge & experience as a mergers & acquisitions professional to know the appropriate general returns for specific types of companies in specific industries.   IBA, as the oldest & most productive, business brokerage firm in the Pacific Northwest has a base of over 4000 transactions we have personally facilitated to draw information from when advising our clients on the appropriate general return on investment that should be used when valuing their privately held company.   Many investors with entrepreneurial inclinations pursue business acquisitions because the general returns on investment commonly exceed what is available from investments in stocks, bonds, real estate, or certificates of deposits.  The reason higher returns are possible in this marketplace is because the investments traditionally require direct versus passive engagement by the investor.

A second return on investment calculation employed by investors evaluating businesses for acquisition is the cash on cash return.   To calculate the projected cash on cash return on a business acquisition a buyer determines their anticipated cash flow from the business after debt service and divides that number by their hard-capital investment when the business is purchased.   For example, if a business buyer purchases a business for $5,000,000 with $1,000,000 of their own money and $4,000,000 of bank financing the cash on cash return in this transaction would be 45.5% if the business had an EBITDA of $1,000,000 and the debt service was $545,000 annually (10-year amortization @ 6.50%).  This return on investment calculation is valued by many business buyers over the general return on investment because from their perspective the return on the total acquisition price is not nearly as relevant as the return received on their investment of liquid funds received because the investment of those funds resulted in them having to forego alternative investment opportunities.   Business buyers who are looking for a high cash on cash return on investment often find seller financing & earn-outs attractive in transactions because those investment tools allow them to pay for the acquisition out of the profits of the acquired company without deploying dollars from their war chest.

The third return on investment calculation employed by investors evaluating businesses for acquisition requires a subjective assessment at time of acquisition and can only be calculated with accuracy when the investor sells the business at a future date.  This type of investment return is called a capital gain and involves the difference in value of a privately held company between the date it is acquired and when it is sold in the future.  This calculation is one commonly made by private equity companies & turn-around specialists.  For example, if a business is purchased for $5,000,000 by a party that recognizes channel sale opportunities that are not being utilized; technological evolutions that have not occurred; and/or inefficiencies in the operations of the business and the business buyer has the ability to execute on their business plan and improve the performance of the business, the result should be increased revenues & profits for the company and an enhanced value for the business in the mergers & acquisitions marketplace.   If the company is sold for $7,000,000 three years later based on its improved financial performance, the investor in this situation would receive a $2,000,000 capital gain on their investment or a 40% return on their investment above and beyond their general & cash on cash returns received during the three years they owned the company.

It is generally not prudent to sell a business prior to owning it for three complete tax years to maximize sale value.  Investors that purchase privately held companies traditionally own them an average of seven years.    Regardless of the motivation for purchasing a privately held company, it is prudent investment strategy for all financial investments to develop an exit plan prior to making the initial purchase.

As a business brokerage firm that employs best practices, we believe it is important for both buyer & seller to understand transactions from the other party’s perspective and negotiate from positions of knowledge.   Regardless of whether you are selling or buying a business an understanding of the return on investment calculations employed to value a business by a buyer are prudent, so “good faith” negotiations can be conducted related to price.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.