Agency Value in a Digital World – Purchase Price Structures
Over the last 10 years, we have seen the value of agencies with digital business models receive extravagant valuations. And, while strong technology expertise remains a key element of value, digital expertise has become more of a familiar tactic than a point of differentiation. I heard the comment at an AMI conference that basic online digital services are part of the “table stakes” that every agency must put up in order to be seriously considered by a prospective new client, or by a current client for some types of projects. That is consistent with my experience; and with the caveat that an agency may contract the necessary expertise.
Agency values continue to be simply defined as a combination of profitability, size, the client list and the services the agency provides them. All of these may be outweighed by the strategic value the seller represents to the buyer. And, “strategic value” is generally defined differently according to the buyer’s objectives.
So, what about the seller’s objectives? Those are more important to you, as a seller. Suffice it say that the one general rule is that the sale prices has to be enough to enable the seller to achieve his or, her objectives.
For the purpose of this commentary, let’s consider one element, the structure of the transaction. How, how much, and when are you going to get paid? Oftentimes, the amount of the sales price doesn’t matter as much as when are you going to get receive it.
First of all, how much cash are you going to receive at Closing? What can you expect? And, how negotiable is it?
Well, that depends. Let’s assume that your business is profitable, with a respectable margin. Say that the Net Margin is 15%. Experienced buyers will expect that the seller’s business is going to fall off 20% to 25% in the first year following the acquisition. Every buyer I have ever worked with will consider the cash on cash return of their initial investment. Most do not wish to wait 3 years to get their money back.
Whether you think that your circumstances are different, or not. The reality is that with a 15% Net Margin, you are likely to have an EBITDA Margin over 20%. And, this is the minimum many buyers stipulate. In most cases, but not all, your Operating Margin is a good proxy for your EBITDA Margin.
The EBITDA Margin will be the principal factor in the calculation of the cash down payment at Closing. In general, the down payment will fall within 1.5X to 3X EBITDA for the trailing 12 months of the seller’s business.
In general, the higher the EBITDA Margin, the higher multiple applied to how much cash to pay at Closing. This isn’t the total cash a seller could expect to receive at, or before Closing. There will be a cash balance or balances on your Balance Sheet. You will be entitled to take part, or all of it.
Now, part of this balance is attributable to your working capital, which you may (should) have accrued for client work for which you have received payment but have not completed. Under normal circumstances, you will have a surplus of cash above the working capital requirements. You may or, may not be able to keep the entire surplus. The buyer may want to have all or, part of the surplus left in the agency for a period (normally) for 2 to 3 months.
There will be a document referred to as, “Reps and Warranties” which you will sign to account for any liabilities, which have not been provided for in the calculation of final obligations that were not accounted for in the Closing financial statements. Cash accounts are typically escrowed for 2 to 3 months to pay unexpected agency-related charges.
That isn’t the end of the world, if your Closing accounting statements are accurate. The funds are yours to collect. Later.
However, if the seller did not accrue unearned retainers, or has spent some of the cash, there will be a reckoning, and the seller will pay. I cannot recall any transaction in my experience where there has not been a discussion about cash balances as Closing approached; some more heated than others.
In general, without special circumstances, the total value of the selling agency will be calculated at 4X to 5X EBITDA. Or, buyers such as WPP have used Profit Before Taxes (PBT) as the basis instead of EBITDA. Either way, if total value was valued at 4X, and the cash down payment was calculated at 2X, there is another 2X EBITDA to be negotiated.
This balance will be paid as an earn out. The buyer and seller negotiate and, agree upon performance milestones that the seller has to achieve in order to be paid the “Earn out” over time. The Earn Out period has fallen to generally, 3 years from the 5 years that used to be the norm.
As the seller’s representative, I have normally asked for funds to be escrowed. This is more important if the buyer is another independent agency or a new network, rather than a publicly traded Agency Holding Company. It gives the seller more security when dealing with private buyers.
Another variable worth mentioning is the structure that includes equity in the buyer as part of the purchase price. In principle, this is intended to be an added incentive for the seller to receive a higher ultimate value as he and his new owner build the newly combined entity.
There are many elements to evaluate when considering the sale of a business. In the coming weeks, I will address other elements, such as:
- Crosstown Mergers
- How to plan the sale of a Marketing Agency
- The Integration of the two marketing agencies
- The Challenges for owners who sell their businesses
- Financial reporting and the calculation of Seller Earn Out Payments
- How to sell an unprofitable agency
- How to integrate a technology company into a Marketing Agency
- Purchase Price Structure