When a consultancy firm is planning to sell either in the short or long term understanding the size dynamics that create the ideal sale is required. Investing a large amount of time and money to grow the firm size but doesn’t impact the eventual sale price is a disappointing circumstance that should be avoided. In some cases growing larger can reduce the sell-ability and diminishes value in the process of scaling. Conversely it is key to avoid false hope that a sub $1 million practice will sell creating a number of cash millionaires of the selling partners by growing to a particular size.
Of course size does matter when selling a firm, it is one of many key variables that shape the appeal of a business to a prospective purchaser. However its importance is relative to the scale of ambition for wealth and non-money related personal objectives. When objectives are clearly set comparing the risks and rewards of selling or growing becomes easier. Typical risks include the likelihood of being able to sell now versus growing and selling few years down the line. Of course do consider the possible risks and rewards of deciding on an era of growth to sell in the future.
When weighing up the decision to sell or grow, the main reward comes in the guise of the price and terms of a deal, which could be more favourable in the future when a firm is larger. Given there is no silver bullet solution to these questions, consider the point of view of three groups to help inform the sale decision process.
These groups are:
- The market
- Buyers of consulting firms
- The potential seller
The impact of size on the market
In short, the market doesn’t care about the size of a firm selling. The below chart from the Equiteq 2014 Consulting Sector M&A Report shows that firms of all sizes sell.
Although the chart is based on deal value and not annual revenue size, given the way valuation multiples work in the consulting sector, it is a reasonable assumption that valuation roughly equals revenue. If firms smaller than $5m are considered ‘very small’, then it is interesting to note that firms of that size accounted for about 40% of the market volume.
If the $30m and above firms are considered to be the ‘mid-market to big’ category then note that only about 20% of the market occurs above this level. This type of distribution curve is not surprising as it matches the revenue size profile of the consulting industry, yet acknowledges the significant amount of activity at the small end of the market.
It is worth considering the existence of a caveat where small firms sell without actual money changing hands. This end of the market is more likely to witness paper mergers between two small players. If cash is involved, it would probably only account for a small proportion up front.
The impact of size to buyers of consulting firms
Size is certainly an important factor to prolific and regular buyers like the Big Four and second and third tier firms who make one or more acquisitions a year. These serious buyers have war chests and financial backers and can offer significant amounts of money. Experience tells us that a typical deal for a buyer of this ilk is 50-60 percent cash up-front followed by either more money or shares spread over a two or three year earn-out period. The 2014 Buyers Research Report produced by Equiteq suggests these firms typically acquire consultancies that have revenues ranging between $10m and $50m.
For these buyers, size matters. Firms that are too small are generally viewed as high risk as they can be financially unstable. Even if an acquired firm has great assets, being too small means that it wouldn’t make a big enough impact on the growth targets of its purchaser. If the assets are really worth pursuing, there is the lost opportunity cost to contend with, because M&A resources are consumed while more important acquisitions could be pursued.
However a firm can still make itself appealing to such buyers if it possesses tangible intellectual property that the acquirer can use to make strong organisation wide gains. For a buyer wanting to gain a foothold in a new space which has yet to mature enough to create a firm of scale, then a smaller player is a worthy strategic acquisition.
Does size matter to you the seller?
The question of size is a subjective point for the seller to consider. Owners should have clear goals for what they want to achieve from selling or growing a company. For example, if a $5m firm wants to realise a $20m valuation then the business must be scaled before putting itself up for sale.
The danger for a selling company is scale for scale’s sake. A better run $10m firm will most certainly be more attractive than a complex and unwieldy $50m one. Naturally a bigger firm needs a bigger buyer and specialists normally catch the eye more than generalists. It is not unusual for a bigger seller to scale by diversifying into more services and geographies, resulting in no single buyer for the whole entity.
A final consideration is the law of diminishing shareholder returns. Eventually most founders dilute their shareholding to attract and reward more senior people who can help run and grow a business as it becomes more complex. The knock-on effect of this being static value growth per founder-shareholder.
So, does size matter?
Given the complexity of any acquisition of a consulting firm, the answer to if size matters to a deal is both yes and no. Yes, because size is one of many variables factored into the decision making of prospective buyers. At the same time an answer can be no if a buyer is drawn to a company for a specific asset in this circumstance size will be irrelevant to the deal.
Realistically if a firm can reach a size of $10m and be profitable, it will certainly turn the heads of prospective buyers. As a prospective seller, there is a responsibility to ensure any personal and financial objectives are met so that a firm is in its optimum ‘sale ready’ position. But remember that size does not equal value. Although a firm may grow in a profitable way, depending on what prospective buyers are after, this growth could lead the consultancy to become unsellable or less valuable to founder shareholders. The key is to set clear sale objectives and work towards this as the end goal.
By Tony Rice, Partner, Equiteq