September 5, 2013
A seller wants to improve the business to drive higher EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples. EBITDA indicates the profitability of a company and is considered when assessing its valuation during the sales process. As a company’s EBITDA consistently moves higher, so will the value of the company.
Earlier this year Kopetz Manufacturing, a pressure vessel and heat exchanger fabricator, completed a recapitalization provided by a private equity firm. A few months prior, Mueller Industries, a high-volume manufacturer and distributor of flow control and industrial products, acquired Westermeyer Industries, a specialty fabricator in the HVAC space. These are just two recent examples of fabricators that were able to successfully sell or recapitalize their companies.
Although fabricators may be extremely profitable, many generate less than $10 million in revenue, a fact that makes selling or restructuring a challenge. However, fabricators that truly are profitable, even small ones, typically will have an audience of potential buyers. Currently investment bankers are seeing renewed interest from large corporate buyers with strong balance sheets seeking growth and improved margins by acquiring specialty manufacturers.
A seller wants to improve the business to drive higher EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples. EBITDA indicates the profitability of a company and is considered when assessing its valuation during the sales process. As a company’s EBITDA consistently moves higher, so will the value of the company. For example, the multiple on a $3 million EBITDA company will not be as high as the multiple on a growing $10 million EBITDA company.
Before even contemplating a sales process or EBITDA multiples, though, a fabricator should take steps to help ensure a smooth process while maximizing value.
1. Determine the Reason for Selling. A fabricator should determine its reasoning and motivation for selling. Do the owners want to retire or reduce personally guaranteed debt? Do assets need to be diversified? Is there a need for growth capital or talent? No matter the reason, identifying the underlying motivation will help guide the sales process.
It is equally important for owners to determine their collective and individual goals. What is the ideal timing for a sale? Will the owners retain any ownership post-transaction, and if so, what percentages are they comfortable owning? If they do not plan on retaining ownership, do any of the owners plan on remaining involved at all, and if so, in what capacity? What do owners expect in terms of valuation? How do owners want to be compensated for the sale? These are just a few of the questions that should be asked as part of a much longer discussion before engaging in a sales process.
2. Grow Revenue and Profitability. Fabricators should do everything possible to grow revenue and profitability in the two or three years prior to engaging in a sales process. Specialty manufacturing is very fragmented with many small players. The buyer market is broader and will reward those companies that are larger in scale with a size premium. A broad audience and greater scale both help to drive a higher valuation.
Regardless of the type of buyer, high growth potential is attractive. If a buyer can see opportunities to sell into additional or tangential markets, the value placed on that business can move significantly higher.
3. Overcome Customer and Product Concentration Problems. Fabricators need to conduct a thorough analysis to identify customer concentration problems and ways to mitigate them. Dependency on only a few customers will weigh negatively on the company’s valuation. Think about it through a buyer’s eyes. Would you buy a business that has only one customer? Imagine the scenario where that single customer terminates its relationship with the company. Without quickly replacing that customer with a new one, the business would likely fail.
Not only will customer dependency issues decrease a company’s valuation, it will also adversely affect the universe of potential buyers. So if a company is dependent on only a few customers, it should determine its best course of action in obtaining as many new customers as possible, and refrain from going to market until such time as the dependency issue is mitigated, if not entirely rectified.
Although uncommon, a company may operate in an industry that does not have a significant number of customers. In that case, merely adding one or two new customers may be enough to allay concerns about customer dependency.
Many contract fabrication shop owners also may want to develop their own product line. Over time the business may grow, and eventually that one product may provide a majority of shop revenue. To a buyer, this also can be a red flag. Having but a few products is as problematic as having very few customers.
With that said, fabricators should take the same action to address product dependency as they would with customer dependency—refrain from going to market until the company can add multiple products to its mix. Preferably, this would include creating a product line for which the company owns the intellectual property. Consider a fabricator who makes a part for an OEM, then proposes a new part design that ends up saving that OEM millions. The fabricator then protects that design with patents. With this money-saving idea, the fabricator becomes the go-to source for this part.
In general, having a unique offering—such as a protected niche, intellectual property, or patented processes or designs—can increase the company’s valuation and attractiveness to prospective buyers significantly.
4. Build a Strong Management Team. A fabricator should evaluate its management team and make adjustments if necessary, or create a strong team where none currently exists. Unfortunately, many fabricators are too small to afford complete management teams, but a strong management team is a key consideration from a buyer’s perspective, particularly a financial one.
Ideally, the team will form well before the sales process begins, allowing the company to develop a track record with the management team and mold the members into a cohesive unit. Additionally, if something happens to the owner, or the owner or key senior leaders plan to exit the company after the sale, it is important to have identified potential, top-quality successors to fill those positions.
5. Document, Document, Document. Company data, including financial statements and customer information, must be well-documented. Clean financial statements are of utmost importance. These days many buyers will not consider companies that lack reviewed, or even audited, statements; similarly, investment banks typically will not represent these sellers.
In most cases, a fabricator will have to provide the seller with three to five years of monthly financial statements, including an income statement, balance sheet, and cash flow statement. Ideally, the income statement will include only revenue and expenses related to the fabricator’s operations.
Many owners tend to live out of their business checkbooks, which is a mistake. While buyers often understand that some non-business-related expenses may be on the income statement, they may not make allowances for these items by “adding back” these expenses in an adjusted EBITDA calculation. This ultimately means that the sales price could end up being lower than expected.
This is why the company’s balance sheet should also contain only business items. To truly ensure that its financial statements are up to par, a company should enlist a public accounting firm to conduct an audit—or a review, at the very least—for multiple years in advance of a sales process.
A company also should have documented customer information and sales data. Keeping detailed records on customers and their purchasing habits is a competitive advantage; it demonstrates that the company is in touch with its customers’ needs and can properly plan for demand. Good customer information also will be quite helpful to guide efforts in attracting new customers. An organized company that can provide a potential buyer with access to these records will be much more attractive than one that cannot.
6. Assemble a Transaction Team. Finally, a company should assemble a transaction team that has proven experience in driving an auction process. Although this may be difficult if the company has limited funds dedicated to the sales process, an experienced transaction team will drive the highest possible value by creating a competitive dynamic among potential buyers.
Think about this in terms of selling a home. Would you receive the best deal from the first person who makes an offer on your home? Possibly, but a realtor has the expertise to promote your home, contact potential buyers, obtain and manage multiple offers, and guide the final negotiation. The same goes for a sales transaction team, typically comprising an investment banker, legal counsel, tax adviser, and wealth manager. Each of these individuals should have at least one characteristic in common: proven experience in mergers and acquisitions.
Once a company properly prepares to enter the sales process, creating a competitive dynamic is essential. Not every potential buyer will look at a fabricator for the same reasons. The best way to negotiate the highest value is by having multiple potential buyers that all want the same thing or see different things in the company that others may not. Different types of buyers have their own wants and needs, so a company and its transaction team must play to each of those by promoting the most positive attributes relevant to the individual prospects.
Buyers generally are classified in one of two categories: strategic and financial. Strategic buyers look to purchase a company for a specific reason, and they often proactively seek out companies interested in selling in order to add to their already-established operations.
Consider the Westermeyer/Mueller transaction described previously. Westermeyer’s specialty is fabricating components for air conditioning and refrigeration customers, a focus that was strategic to Mueller’s business of manufacturing plumbing and industrial products for customers in the same space. Since purely strategic buyers are more inclined to purchase a company and hold it indefinitely, they may only require the company to maintain stability, rather than demonstrate huge growth potential.
Financial buyers, on the other hand, are typically private equity groups that may own similar companies within their portfolio. Financial buyers may be willing to acquire small companies, including fabricators, but only after they have acquired a platform. A platform company is the first company in a specific industry that a financial buyer acquires. In order to be an attractive platform, a company must generate in excess of $2 million of EBITDA. If a private equity group does not already own a similar company, it may make an investment in a new platform business.
A key difference between strategic and financial buyers is that financial buyers will likely want to buy a company, grow it, and then sell it within five to seven years. For this reason, fabricators must appeal to financial buyers differently than strategic buyers, and they must demonstrate steep growth opportunities.
Although the M&A climate has heated up—anecdotally, at least—many recent reports have shown that it has been up and down in the last few quarters. At the peak of the recession, the number of strong-performing manufacturing companies was minimal, reducing the number of M&A transactions in the industry.
The good news is that manufacturing companies, including fabricators, are seeing encouraging M&A signs due to a couple of factors. One, manufacturers are able to begin rebuilding inventory to pre-recession levels; and two, less flight to foreign countries—particularly China because of its rising labor costs—is beginning to help draw work back to the U.S.
Realistically, though, fabricators and other specialty manufacturers were less in danger of losing core customers than manufacturers producing higher-volume work. Overall, while the climate is not ideal at the moment, the forecast is promising.
The bottom line is that while many fabricators are small companies, they can be very attractive to certain buyers. Custom fabricators build things—complete assemblies, subassemblies, or parts that go into other products—and they remain an important part of America’s culture. This, in and of itself, helps fabricators of any size stand out among many other companies.
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