CHAPTER 23

The Rules of Five and Ten and the Super Rule of Five in M&A Valuation

I never could figure out just what it is that people like about this city, except as a lifelong avid skier I knew that it was the gateway to some of the best skiing in the United States, just 30 minutes away. But it was September, no snow up there yet, and I was teaching mergers and acquisitions (M&A) investment banking all day anyway. The Salt Lake Valley is stunning, with it’s surrounding Wasatch Mountain peaks, and that is clearly what people like about it. That and the other outdoor sports that are abundant here year round.

I guess I would have to get used to the fact that there was not that much to do here at night . . . and even if there was, I was not sure I would have had the energy for it. It was going to be a long week. But I love teaching this stuff. I was in the first hour of the first day of a weeklong training course.

One of my students, Larry—a great guy, but somewhat of a skeptic—raised his hand for a question. “Dennis, I have to tell you, I am not exactly a neophyte when it comes Middle Market M&A deals, and I rarely read about a deal that is priced at your so-called Rule of Five multiple. I just read in the paper the other day that company (ABC) bought company (XYZ) for an estimated eight times EBITDA multiple. Are you crazy, or are they crazy?” Larry was a business broker studying to climb up the ladder to Middle Market M&A transactions.

I checked my watch and then cleared my throat. This was going to be a good, if long, week after all. Curious students make it all worthwhile.

Larry eventually became a believer, and I hope you will too.

EXHIBIT 23.1 The Super Rule of Five

A Foundation for the Valuation of Middle Market Businesses

There is a rule of thumb, actually two rules that we will combine eventually, that are invaluable in Middle Market investment banking and business sales—and not bad rules for buyers, either. I am referring to two variants: the Rule of Five and the Super Rule of Five (see Exhibit 23.1). In addition, there is the Rule of Ten.

The foundation Rule of Five is not very technical, but it is not devoid of finance theory either, as opposed to most of the rules of thumb used in Mom-and-Pop business transactions. When combined with the Rule of Ten, it is very useful as a starting point, whether I am launching a complex formal business valuation for an expert opinion or simply getting my arms around the preliminary value of a client’s Middle Market company for the first time.

The Rule of Five holds that any Middle Market business will be worth approximately five times its cash flow before interest expense and income taxes (EBIT, EBITDA, etc.), until demonstrated otherwise. The fun, of course, is in the “demonstrating otherwise” part.

A review of Middle Market M&A transactions closed over the course of many years substantiates the argument that the majority of Middle Market businesses sell for between 4.5 and 5.5 times their normalized EBITDA cash flows. Were one to plot cash flow valuation multiples on the traditional bell curve, two-thirds or so of the time, the correct multiple is approximately five. All other Middle Market transaction multiples can be understood as constituting deviations from the standard. Understanding this point—and why the deviations occur—provides a gateway to powerful insights into transaction valuation. By the way, when discussing valuation in this way, we are usually referring to Enterprise Value (the cash-free, debt-free value of the business), which has little to do with valuing the entity that owns the business. Businesses are not entities, although they are owned by them. Sorry to have to keep repeating that but it is important, especially in this context.

The Rules of Five and Ten, Cocktail Party Conversation, and . . .Quick Calculations

Sometimes at cocktail parties and other social gatherings, Middle Market investment bankers often are asked (free advice? ... well, no problem there), “What do you think my company would be worth if I sold it?” I really do not have much time to spend on the question—as if it were even possible to come up with such a figure on the fly, with no particular points of reference! When someone presses the question, I usually tell him about the Rules of Five and Ten. And I certainly reference it in my answer, especially if I want to go get another glass of Scotch and/or meet the attractive blonde (my younger bachelor years) across the room.

EXHIBIT 23.2 Bell Curve—Rule of Five

Two Bell Curves

The first bell curve (Exhibit 23.2) indicates that most Middle Market M&A businesses, especially those in the lower one-third of the Middle Market (i.e., values of $5 million to $150 million) sell for more or less a five times EBITDA multiple. While this book often refers to EBITDA for convenience, other variations on pretax cash flow proxy figures like EBIT also might be employed, depending on the circumstances (see Chapter 24).

EXHIBIT 23.3 Bell Curve—Rule of Ten

A second bell curve (Exhibit 23.3) tracking Middle Market businesses would establish that normalized EBITDA (or other cash flow proxies) most often equals approximately 10% of sales—actually, somewhere between 5% and 15% as a rule. So 5 times 10% equals 50%. These are not plotted on the same bell curve, just overlapping ones to some degree, but as combined rules of thumb they provide a pretty practical first estimate, and many Middle Market business owners can multiply their business revenues by 50% to arrive at a ballpark Enterprise Valuation for their businesses.

But rules of thumb, like rules of spelling (“I before E, except after C, that is so weird. . . . ”), do have their own peculiar and frequent exceptions, and the exceptions are more fun, as a rule. In the world of M&A valuation, the exceptions are the businesses that for one reason or another (usually some combination of stand-alone growth and synergies to a buyer) will produce multiples sometimes way beyond five. It should be noted that the Rule of Five suggests that from an investment point of view, the average tolerated risk rate of Middle Market businesses is somewhere around 20% when expressed as a capitalization rate, and that should not be particularly surprising to those knowledgeable about capitalization rates when compared to the returns on investment of other asset classes into which one might invest money.¹

The Super Rule of Five

The tendency towards five times EBITDA multiple valuations of Middle Market businesses over the years reflects an average stand alone Middle Market business, assuming a fairly flat growth rate and without any significant synergistic values to the particular buyer. But remember, very few prospective strategic buyers consider acquiring a Middle Market business unless they perceive significant synergies or growth that may be realized in the transaction, such as a broader client base, new product and service offerings, cost savings, new distribution channels for the buyer’s own products, and so on.

As I said, at any given time (and for obvious reasons), the most interesting Middle Market M&A transactions—the ones that make prospective sellers, buyers and Middle Market investment bankers stand up and pay very close attention—are the deals that close at substantially richer multiples than the standard five times. The key lies in understanding the reasons why particular businesses realize an EBITDA multiple higher (or lower) than five. Sellers and Middle Market investment bankers who find the key may well be able to transform the sellers’ companies, over time, to maximize their selling multiples. There are several reasons (not counting “irrational exuberance”) why Middle Market companies may realize selling prices significantly higher than five times EBITDA multiples. All of them involve aspects of the Super Rule of Five.

Stand alone Growth Rates

In general, if a Middle Market business’s earnings are growing at a rate that will make the multiple paid today, whatever that multiple is, appear to have been a five times multiple when compared to the business’s EBIT earnings approximately eighteen months² ³ to two years from now, then that multiple is probably justifiable. For example, if a buyer pays an eight times multiple for a Middle Market business earning an EBIT of $10,000,000 this year, and those earnings are growing at a 25% annual compounded rate, then the projected earnings for the business two years out will be approximately $16 million.

The buyer’s purchase price today was $80 million, or eight times the company’s trailing $10 million EBIT. But that $80 million also reflects “only” a five times EBIT multiple of the projected $16 million EBIT earnings two years out.

In other words, the company’s earnings grew into the purchase price. The eight times EBIT multiple was a reasonable multiple to have paid, given the company’s projected EBIT growth rate based on stand alone, nonsynergies incorporated growth (see Exhibit 23.4).

This makes perfect sense when considered from another perspective (a negative, in this case) as well. Assume that a company is expected to generate the same EBIT next year and the year after that (zero growth) as it did this year and last year. Assume that the company is properly valued at a five times trailing EBIT multiple. That same multiple is likely to reflect its value next year and the year after that: no change. The company may be somewhat attractive to certain parties, but its performance is average, middle of the road, middle of the bell curve. And it is unlikely to command higher than a five or so or less multiple.

EXHIBIT 23.4 Illustration of the Super Rule of Five Stand alone Growth

But consider the aforementioned Middle Market business, with its 25% compounded annual EBIT growth.⁴ One of these two companies (flat growth or substantial growth) is going to attract far greater enthusiasm among prospective buyers than the other. And those prospective buyers, aggressively competing in the negotiated auction, will identify the premium they are willing to pay for the company with strong earnings growth prospects over the company with no earnings growth potential. It is not because the prospective buyers want to pay a premium EBIT multiple but because they have to pay a premium or lose an attractive acquisition to a likely competitor.

Synergistic Growth Rate of Target Business

But suppose a buyer knew he could acquire a business with a flat growth and achieve a 25% growth rate between the time he closed the deal on Friday and the time he opened the doors for business on Monday?

If, between his own company and the new acquisition, the buyer could theoretically eliminate enough duplicate costs or find other synergies over the weekend, he could do just that. That is the second reason a seller’s company may generate an EBIT multiple substantially greater than five. Projected earnings growth will be realized not only from the acquisition’s stand-alone growth (or lack thereof) but also, or perhaps rather, from the synergies the buyer will realize by acquiring the company. At the simplest level, these synergies might be merely economies of scale. But if a buyer can eliminate 15% of the acquisition’s overhead over that first weekend (or even the next two years), the cost savings increase earnings by that same amount. Of course, the synergies to be realized may encompass much more than the reduction of expenses via economies of scale, including access to new customers and distribution channels and so on. (see Exhibit 23.5)

EXHIBIT 23.5 Illustration of the Super Rule of Five Synergistic Growth Rate

Synergistic earnings growth increases earnings just as effectively as stand-alone growth (though prospective buyers are less likely to want to pay for kind of that growth). And although one buyer’s synergies may be utterly meaningless to another, synergistic growth is just as likely to intensify competition among prospective buyers in a negotiated auction as stand-alone growth. See Chapter 22, on Auctions.

In the actual M&A marketplace, real-world earnings growth in an acquired company usually comes from some combination of stand-alone and synergistic growth. It is up to the prospective buyer to carefully calculate the value of both and to pay as small a premium for both as possible when competing with other prospective buyers in the negotiated auction. Conversely, it is up to the seller to know the value of his business based on its own stand-alone growth and—with his Middle Market investment banker—to try to orchestrate a negotiated auction that will maximize the investment value his company will generate based on the combined stand-alone growth and potential synergies it offers the prospective buyers. This is what the auction does.

A Possible Third Exception to the Super Rule of Five: The Leveraged Deal

Assume that the buyer purchases the seller’s business for cash. The seller’s company has no existing long-term debt. Its earnings (EBIT) are $5 million, and the buyer paid a five times EBIT multiple (for a total purchase price of $25 million). The buyer can anticipate a 20% pretax return on his investment, even if there is no earnings growth.

But what if the buyer purchases the business using equity ($18.75 million) for some portion of the purchase price and using debt ($12.5 million) for the remainder, paying a total for the business of $31.25 million (or a multiple of 6.25)? The buyer pays 10% interest on his debt.

Under this scenario, the buyer might choose to pay more for the target acquisition while still realizing a 20% ROI. With $3.75 million in net earnings after interest expense ($5 million less $1.25⁵ million in interest), the buyer can put up his own equity $18.75 million ($3.75 million times 5) for the target acquisition and still achieve the 20% ROI. And it would look like the buyer actually paid a 6.25 times EBIT multiple ($31.25 million/$5 million).

Alternatively, the buyer might pay the five times EBIT multiple ($25 million) while using half debt ($12.5 million). In that case, his ROI would be 30% ($5 million less $1.25 million = $3.75 million; and $3.75 million/$12.5 million = 30%.)

Such leveraged transactions do bear greater cash flow risks and leverage risks. Interest on the debt, and the debt itself, must be paid. But private equity groups (PEGs) use this approach in leveraged buyout transactions, and their offers may prove quite attractive to sellers.⁶

The Greater Fool Theory (Buyer Beware)

An acquisition candidate’s stand alone growth, or its synergistic or investment value, or its potential for leverage may justify paying an investment value greater than a five times EBIT multiple. Nothing else should.⁷ Yet every day in the Middle Market M&A world, irrational exuberance (hence, the greater fool theory) makes its delightful (at least from the seller’s perspective) presence known, and a prospective buyer, somewhere out there, loses the discipline and judgment necessary to making good decisions and offers an entirely unjustifiable EBIT premium for a target acquisition. Buy-side use of the Super Rule of Five can be a reasonable sanity check against irrational exuberance.

Negotiated auctions are quite effective not only for sellers, but also for careful, judicious buyers who have done their homework, carefully think through the process, and studiously avoid impulsive decisions to do (or not to do) the deal for the wrong reasons.

When multiple companies in an industry begin selling for prices that suggest irrational exuberance, any number of factors may be involved. Some, in the final analysis, will come down to the “Greater Fool Theory” so buyers beware. But when Middle Market business in a given industry routinely seem to be selling for prices that violate the Rule of Five (not the Super Rule of Five), sellers and their investment bankers should take note: an extraordinary opportunity to do a deal may be close at hand (see Chapter 6, Crystal Balls and Timing the Market).

Chapter Highlights

The Rule of Five and The Super Rule of Five provide a useful frame of reference for both buyers and sellers in constructing a rationale for a given purchase price.

• Briefly restated, if an earnings stream (EBIT, etc.)—with the exception of startup companies, where growth rates are frequently automatically exponential because of the low starting point of earnings and revenues—will grow at such a rate that the price paid today will be five times the earnings stream of the target in 18 to 24 months, then the deal probably made sense, everything else being equal.

• An inherent irony in the Rule of Five is that if a deal will command only a five times earnings multiple, it probably is not a very interesting deal: five times multiples suggest that there is no stand alone growth rate or synergistic growth, which reaffirms the unattractiveness of the target.

• In most transactions, price is determined by some combination of the stand alone growth rate of the target and the value of expected synergies to the ultimate buyer in the negotiated auction. That is, in fact, the application of the Super Rule of Five in practice, especially it applies to the lower Middle Market.

Notes

1 Assuming that the approximate nominal annual rate of growth for many Middle Market business is 5%, then the implied discount rate is 25% (25% - 5% = 20%, which of course makes even greater sense when comparing the risk profiles of Middle Market compared to other investments under the theory of substitution).

2 At eighteen or so months, the earnings run rate of the business will be fairly well established, so reasonable estimates can be made of its second full year’s earnings at that point to test compliance with the Super Rule of Five.

3 One might reasonably enquire as to why “two” years is selected as the measurement date. The reason is that inherently the Super Rule of Five in practice requires up front estimating and projecting not just after the fact measurement. In the M&A world very little credence is, or probably should be associated with projections that extend beyond two years.

4 I am excepting here the obvious first several years of growth in startups, which is likely to be exponential but only because of starting from a very low point in either revenues or earnings—or, more usually, both.

5 I am intentionally ignoring the tax savings effect of the deductible interest here in order to more easily demonstrate the calculation. If the tax savings are included the picture is even rosier in terms of the results to the buyer.

6 There is one caveat: sellers must very carefully analyze such transactions if they intend to retain a residual interest in the business, because the indebtedness invariably winds up on the balance sheet of the seller’s business and earnings hiccups among highly leveraged companies too often prove catastrophic.

7 Keeping in mind that the Super Rule of Five is merely a sanity check or a useful rule of thumb, as opposed to a formula that can be used for precise results, there is also the question of the size of a company. As a rule, studies have demonstrated that the larger the company, the higher the transaction multiple. This is in not inconsistent with the Super Rule of Five, in that larger companies are more likely to offer synergies to their acquirers and are more likely to have something beyond nominal or flat growth rates. The other element a larger company may possess is greater stability due to its size and, therefore, lower risk; this last factor, independent of growth rates and synergy, may contribute something to the overall higher multiples seen on larger companies. In general, though, most of the difference is likely to be seen in synergies and growth rates.