Roll-up valuation question and investor fairness
July 19, 2024
by a searcher from Columbia University in Miami, FL, USA
Hello all,
So our early stage roll-up, focused on a specific industry, has an LOI on a good business. We have sourced some great family office debt for the acquisition. But on the equity side, there's a challenge: I'm confident we can raise the small amount of equity we need (350k) but I'm wondering how we come up with a fair valuation for both us and investors?
Here's why this is a challenge: Our model is to buy majority stakes in smaller businesses -500-1m EBITDA as we have a model to add substantial value to them, can get them at good prices, and we avoid competing with larger acquirers in this space. Our preference is for investors to get equity in the holdco, rather than in individual acquired companies as that's cleaner from an incentive perspective. This first business is on the small side and the seller is rolling over equity and staying on so we are not even buying 100% of it. Most search-style investors will think about valuation just in terms of the first acquired company and the EV of the majority stake we are acquiring is ~1..5m.
Don't think it's a good idea for us to value the holdco at that amount as this is a roll-up and we need to think strategically about how this raise impacts subsequent acquisitions. I think there is already some significant value in the holdco, beyond the first acquisition target: We have a team of people that have built and sold some of the largest businesses in this industry. We have a crystal clear plan for how to improve the first acquisition, and we have a large pipeline of 8 others we are in talks with and are on the cusp of a second LOI.
Are there standard and accepted ways to value those elements of the holdco, even at this early stage? Any suggestions for how to have this conversation with investors? Am curious if anyone has thoughts on this specific question but also how to value early stage roll-ups more generally. Academic articles would be great if you have any.
Appreciate you all.
in Montreal, QC, Canada
- The value of the equity fund raise will usually be set on the pro-forma equity value after acquiring the targeted businesses. If you need 2M in equity to acquire company A, B and C, the 2M will be raised against the value of what is existing prior the fund raise + equity value of A+B+C.
- In order to value the hold-co, I have seen investors use a premium over the multiple you are paying for the targeted companies. For example, if in the sector you are targeting you plan on paying 5x EBITDA, investors might accept paying a valuation at 6-6,5xEBITDA (premium of 1-1,5x). The 1-1,5x extra is your sweet equity for building the hold co, putting the work, building the mngt team etc.
- Investors want you to have significant skin in the game so they usually invest in preferred equity for the first deals and then fund you with non-dilutive financing such as convertible obligations. The conversion ratio will usually be set with a premium (as explained above). It might be something like this: if in year 5 you reach 8M EBITDA, we will convert with a 1,5x premium. If in year 5, you reach 5M EBITDA, we will convert with a 2,5x premium. Their goal is to incentivize you to reach a bigger EBITDA in a shorter, but realistic, time frame. The faster, the bigger, the less dilution you have.
- All of this should come with a management package such as options, ratchets and other incentives. I have seen fund offering for example an accretion of 5% for the founders if the fund achieve a certain target of IRR.
I see that you were a montrealer, I live in Montreal myself! Happy to connect and/or introduce you to some funds doing what I explained above.
Cheers
from University of Auckland in Auckland, New Zealand
Perhaps in the shareholder agreements, you contain a clause/mechanism to require equity in each trading entity to be transfered to Holdco equity. If you have operators that are retaining some equity in each business (which I think is a good idea) they should retain their entity equity and not be forced to transition to holdco equity.
As an investor, I would struggle to invest in a quasi SPAC at a higher valuation without any track record. Maybe your initial holdco capital raise is at a lower valuation (i.e. you raise the minimum) and as you grow your numbers and value drivers, you can raise at higher multiples going forward.
You are an investor too, and if it were me I would aim to be participating on the same terms of the investors at least initially from the investment side, while still earning management fees or salary (not sure how you're looking at that piece 2/20 or something else, but probably won't work at these smaller levels initially).
Step 1 - get the first one over the line. Good luck!