Inside the Surging Acquisition Market

This article originally appeared on the September 2022 issue of Security Business Magazine. When sharing, don’t forget to mention Security Business Magazine on LinkedIn Y @SecBusinessMag On twitter.

In the life safety industry, it is no less surprising that when a popular ranking of the top 100 electronic security companies for 2021 was published, seven of those companies had already been sold. The four buyers of those seven companies represented very different parts of the human security ecosystem.

There is huge amounts of private equity money pouring into all parts of the life safety sector right now, and these companies are looking to buy integration, fire and alarm companies.

For integration companies, it is an extremely active market. In previous years, when we brought an offer to market, there were three or four buyers that we knew we wanted to talk to. Now, we talk to nine or ten at a time, because these buyers want to quickly expand into different markets and in different industry segments.

As one buyer told me, we’re seeing once-in-a-generation valuations, which is very good for the industry. Buyers really do come from everywhere.

The buyers

If you’re ready to sell, your first imperative is knowing where to find direct buyers. Typically, business owners who are ready to sell their businesses turn to competitors or buyers they find through their industry association. Sellers today have many more options, including:

Non-private equity owned integrators – These are strategies in the industry. They are companies with which you probably compete. They are often limited in what they can afford in a multi-buyer process, as they do not have the deep pockets that private equity backing provides.

Integration companies owned by private capital – Often these are rigs that were originally purchased with the goal of growing both organically and through acquisition, only to be turned around by the private equity firm in 5-7 years.

fire companies – These buyers were not as active in the integration market three or four years ago. Their purchase has increased dramatically as these companies get a broader range of services by acquiring a security integrator.

Adjacent industries – Other industries that are buying integration companies include guard companies and gate companies. The opportunity to cross-sell has a huge advantage for these buyers.

Private equity companies not belonging to the sector – They call themselves industry agnostics because they focus more on revenue growth and profitability than the industry the seller is in. If the buyer can see strong growth in both size and profitability in 5-7 years, he is interested.

Alarm industry buyers: This group tends to want integrators with significant recurring revenue. The buyer wants a lot of managed services and is concerned about the perceived risk that revenue per installation will drop and he has overpaid for a lower amount of EBITDA.

Need seller-side representation?

The easy answer is no: you can sell your business on your own without a sales-side representative; however, you are going to leave a lot on the table. Those who use sell-side representation typically go through an auction process, which means attracting multiple buyers from different geographies and different markets that a seller is highly unlikely to find.

You spend all your time running a company; Sell-side reps spend all of their time selling businesses to buyers. They take the emotion out of a deal and allow the buyer to ask difficult, and sometimes perceived as insulting, questions about the company they want to buy. They are better prepared to negotiate with buyers, as they have likely engaged with them in several previous transactions.

Elements of the CIM (or the Book or the Deck)

Once you decide on representation and have narrowed down the list of buyers, it’s time to gather information about your company. This is usually called a Confidential Information Memorandum (CIM) or “the book”; however, the younger generation and the venture capitalist side call it “the slide deck.”

There are several key elements of a CIM (described below); however, before the CIM is sent to buyers, a non-disclosure agreement (NDA) must be signed to ensure that anyone who sees the inner workings of your company will not share the information.

Within the CIM, buyers want to see the company’s earnings and growth history. A great story sells a company much better than you think: buyers buy what they feel comfortable with; they are buying the culture of your company. They want to see how the market is doing, what markets you specialize in, how you’re doing from a financial and growth perspective, etc. Other items include:

• Business generation – Some companies run on autopilot and work on referral; others go directly or through a general contractor. Is most of your business on offer or negotiated?

• Sales – Most companies have commissioned sales teams, but some do very well with non-commissioned inside sales. All of these details are important to a buyer.

• Vertical markets and technologies offered – What percentage are your top verticals of total revenue? What providers do you use and is it free for the buyer?

• Geographic service area – Some areas offer more significant growth opportunities than others. This is more important for private equity, which is very focused on growth.

• Top 10 clients by percentage: A buyer needs to understand their top customers (no names at the beginning) and the percentage of total revenue each makes up.

Adjusted EBITDA: The Math That Sells Your Company

In slow periods, which we definitely aren’t in right now, buyers can try to buy based on a three-year average of adjusted EBITDA (earnings before interest, taxes, depreciation and amortization, plus surcharges). Every transaction I’ve been involved with over the last two years has been based on the last 12 months, because most integrators are having good or great years.

The market will not allow valuations based on averaging over COVID years; If you have eight potential buyers and three of them want to average over the COVID years, a seller will simply deal with the other five buyers instead.

So how do you calculate your adjusted EBITDA to reach this magic number that a buyer will multiply to create a purchase price for the company? This is where people leave a lot of money on the table.

EBITDA is net income and adds interest, taxes, depreciation and amortization, but that’s not the number your buyer will multiply by; To arrive at Adjusted EBITDA, three important elements will affect the replacement equation:

1. One-time income will not count and one-time expenses can be added back, for example collecting a lawsuit or construction issue that cost $300K.

2. Personal expenses: I have seen all kinds of expenses that sellers make in their businesses. If you can prove it’s business-related, the buyer will add them back in, since they’re presumably expenses the buyer won’t have.

3. Owner Salary Adjustments – If the owner earns $400K a year but agrees to continue working for the company for $200K after acquisition, the difference can be added back.

Both COVID payments and employee retention credits are not counted in Adjusted EBITDA.

The offers

Multiple offers are great, but the goal is to get the right offer. The first aspect of getting the right offer is anchoring, which is essentially setting an expectation of the selling price. There is no need to waste everyone’s time if you will only sell for a certain price and buyers are coming in well below that number. Some sellers simply ask to see how much buyers will pay without any indication. This often works, but it usually appeals to the widest range of buyers.

Occasionally a buyer will state what minimum is required for a sale. In this fast-moving market, bottom-line buyers have been left far behind.

The second aspect comes from the buyer, in the form of an Indication of Interest (IOI) and/or a Letter of Intent (LOI). An IOI is an informal purchase proposal in which a buyer makes an offer with a valuation range for the business to see if they are in the ballpark. This range, if acceptable, moves them to the next round of letters of intent.

Many transactions in the life safety sector go directly to LOI, which is a much more formal and specific way of bidding on the business. Most LOIs break down an offer into how much they will pay and how it will be paid, which for integrators is usually expressed as a fixed price for the company or as a multiple of Adjusted EBITDA.

Most LOIs include a freeze period, in which the seller agrees that, by signing an LOI, they will not sell the business to other buyers for a period of generally 90 days. This is because the buyer is spending money digging into the details of the seller’s business. The last thing a buyer needs is to wait two weeks from closing and the seller says he just got a better offer. When this happens, some buyers will drop out of the deal. You must maintain your integrity in order to make these deals happen, and you must work on both sides.

The LOI will also specify whether the sale is a share or an asset purchase, as well as the terms of the purchase price. There are several varieties of purchase terms and, in the end, it can be one or a combination of several of the following:

  • Cash at closing;
  • Retentions linked to items that put the buyer at risk;
  • A note to be paid over the course of the negotiated time;
  • A profit, where the owner receives additional money if certain goals are reached in specific times; Y
  • Cash with equity transfer, where an owner receives an upfront payment but does not collect a percentage of that payment and instead transfers it by obtaining shares of the buyer’s company. The balance of part of the purchase price will be paid after the private equity firm sells the portfolio company at a later date. Stock rolls can result in a sharp amplification of the purchase price if the subsequent sale doubles or triples the roll.

Once the LOI is signed, the buyer will initiate their own due diligence, often paying an outside firm to confirm the numbers the seller has represented in the financials and other items outlined in the CIM. It is a lengthy but very manageable process.

Your selection of an attorney to negotiate the purchase agreement can greatly affect your deal. You should be looking specifically for a settlement attorney and not your litigant. An industry transaction attorney who won’t have to learn the vernacular specific to our industry is optimal.

Selling your company will be the biggest monetization of your career. You have one chance to get it right. Assemble your best team and sell into an attractive market and you’ll be positioned to far exceed your goal.

Barry Epstein is President of Vertex Capital and specializes in the life safety and security industries. Visit https://vertexcapitalcorp.com for more information or contact him at [email protected]

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