Is Bigger Better?

When it comes to purchasing a business, the answer depends on who the buyer is.  I have had the opportunity to work with many companies in the home energy business from one truck operators to some of the largest companies in the industry. 

In fielding offers for one of our smaller clients, I was asked by the owner why the offers were coming in lower than four times earnings.  The owner did his research and had learned that many home heating oil companies were selling between three and four times EBITDA (Earnings Before Interest Taxes Depreciation and Amortization, AKA: Operating Income or Cash Flow).

It was an interesting question as I have always taken it for granted that smaller companies just trade at lower multiples and larger companies at larger multiples of EBITDA.  Some larger transactions in the heating oil industry have traded at over six times earnings and some companies with substantial propane assets have sold at over ten times earnings.  As a note one reason propane companies trade higher is that company owned tanks are typically included in the assets being sold.  This alone can add 1-2 X to a multiple.

In my opinion there are a couple of reasons why smaller companies sell at a lower multiple of EBITDA. The first reason is in regard to risk reward.  Purchasing a smaller company is riskier to a larger buyer.

Customers of a small company are used to speaking with the same person (usually an owner) and having the same driver or service technician come to their home (also typically an owner). A larger company will treat customers differently. Not necessarily better or worse, just differently. Credit policies, such as not accepting cash or sending out budget statements as compared to budget booklets with payment envelopes or answering the phone with an automated attendant rather than a person, are just a few examples. 

Another reason has to do with the work involved in completing an acquisition. If a buyer is looking to invest two million dollars to grow their business through acquisition, they would prefer to do one transaction as compared to five.

Each transaction involves getting management focused on the acquisition and it typically shifts focus away from the day to day business. A two million dollar acquisition takes almost as much work as a half a million dollar acquisition. 

If you did five acquisitions in a year, the management team would lose substantial focus on managing their respective business segments and the core business as well as the acquired business would probably suffer and underperform as a result. Matching the right buyer with the right seller usually results in the best return for both parties. 

There is also the question of investment dollars.  Many large institutional investors do not want to make small investments.  In the world of private equity investment, it is easier for a company seeking investment money to secure a ten million dollar investment than a one million dollar investment.

Bigger does not necessarily mean better, but it does mean more valuable.  Companies who grow through acquisition will not only increase their earnings, they will increase the value of their business when and if they decide to sell their company.