Multiple Expansion - How You Can 4x Your Money from Day 1

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1. Multiple Expansion - How You Can 4x Your Money from Day 1

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Multiple Expansion - How You Can 4x Your Money from Day 1

Did you know that you can actually acquire a business and from day 1 that company or asset can be worth 4x from the moment you acquire it?

Sounds nuts - but let me introduce you to multiple expansion

In past newsletters, we have discussed businesses valuation being a multiple of some metric

That metric can be EBITDA (or adj. EBITDA), revenue, recurring revenues, sellers discretionary earnings

Quite a few different metrics

The reason being is, based on the size, sector, and business model, the valuation metric varies

A small carpet cleaning business with 60% gross margins will most likely be acquired on an EBITDA or sellers discretionary earnings multiple

A large SaaS with gross margins of 85% will likely be purchased based on their topline / recurring revenue

Why?

SaaS businesses typically are highly scalable, meaning for every $ of sales you don’t have a direct cost associated with it like when selling widgets and they often have recurring revenue which provides for predictability of the business

If I have a SaaS business with 10 customers on 3 year contracts, I have a pretty good idea of the minimum amount of revenue I will generate over the next 3 years

On the other hand, the mom and pop carpet cleaner has no clue what customers or what their business may look like next year as it’s not a recurring multi-year contract (most likely), and is instead 1 time services

With that being said, let’s discuss multiple expansion

Multiple expansion is when you can acquire a business for a certain multiple, and then grow it and sell it for a higher multiple than you bought it for

Say - you paid 3x EBITDA for the business and then 4 years later you sold it for 5x EBITDA

Example

You buy Fred’s autobody shop for $15m, which is 5x their $3m EBITDA

You scale Fred’s over the next 3 years and now EBITDA is $10m

Well, now that your business is substantially bigger, the multiple someone is willing to pay likely has gone up

So you purchased Fred’s for 5x EBITDA, but now you may be able to sell it for 8x EBITDA

That’s multiple expansion

So how is it possible to buy a business and have that EBITDA be worth 4x on day 1?

Let’s say you own 10 of Fred’s autobody shops

The conglomerate of the businesses does $20m in EBITDA or $2m each

That is a substantial amount of EBITDA and the multiple someone would be willing to pay on that may be 10x or more

A lot higher than the 5x multiple for the $3m of EBITDA

Why?

You have multiple successful locations doing a large amount of EBITDA, which is worth a higher multiple than 1 location doing $3m of EBITDA

So now, let’s say you want to go out and buy more auto body shops to add your 10 shop arsenal

You are looking to buy shop’s with EBITDA of $3m

Those smaller shops are likely selling for 3-5x, while your conglomerate adding up to $20m EBITDA is selling at 10x

So if you look at the example below, you paid $12m for that $3m EBITDA as a standalone business 

BUT

Once your acquire Bill’s shop, that same $3m EBITDA as part of your $20m EBITDA conglomerate is going to get a higher multiple applied to that same $3m of EBITDA

So on day 1, that $3m of EBITDA is worth 6x more to you (purchase multiple of 4x and your potential exit multiple of 10 = 6x)

You “created” $18m worth of value

Do you see how powerful that is?

Simply by having a bigger business that has a higher potential exit multiple when you go to sell, if you are acquiring smaller businesses for a much lower multiple, you are likely in the $ from day 1 due to multiple expansion

Now -> I will caveat then when looking at acquiring an opportunity and underwriting it or building out a financial model, it’s very rare you assume multiple expansion

You typically assume you buy and sell for the same multiple

Why?

Because that’s a more conservative why to analyze a deal

Private equity firms doing leveraged buy outs (using debt and equity to acquire a company) will actually analyze in their model where the returns came from in the model

What they do is below

Look at how much of our return is from EBITDA growth aka growing the business, how much is because of exit multiple is higher than our purchase multiple, aka multiple expansion, and how much is due to debt paydown

What this is analyzing is 

1. How much of returns are from growth of the business (EBITDA growth)

2. How much of our returns are from just a multiple expansion

3. How much of our returns are from our capital structure aka using debt rather than equity to acquire the business

When you look at this ^, there’s something important about 2 and 3

2 and 3 can literally happen with 0 growth of the business and you can still get returns

If the business stayed flat, you used debt, and you sold a higher multiple than you purchased, you’d still generate a return

That takes almost 0 skill

That’s what makes this even more powerful

You can generate returns without business growth

The wonders of multiple expansion

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.