Big Deal Small Business: Creation Value
February 16, 2022 | Issue #61
As searchers, a big question we face is whether or not to bring on investors. I’ve had this discussion with lots of current & prospective searchers and there are obviously tradeoffs.
Today I want to talk about Creation Values as it relates to investor-funded deals.
My sense is that searchers who don’t come from a principal investing role may not have a sense for where they are “creating” their businesses.
This is pretty academic and theoretical in nature, but I think it’s worth wrapping your arms around BEFORE you buy the business.
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What is a Creation Value?
In investing, we talk about "attachment points" and "detachment points" to reference what kind of risk you're taking in a business. Detachment Point can be used interchangeably with "Creation Value".
Let's say a business is being acquired for $100 with $50 of senior debt, $30 of junior debt, and $20 of equity.
The lenders and equity investors are all "creating the business" at different "creation values", as follows:
Senior Lender "attaches" at $0 and "detaches" at $50 of value
Junior Lender attaches at $50 and detaches at $80 of value
Equity attaches at $80 and detaches at $100 of value
In other words, your Creation Value is the value at which you have recovered your capital.
The value of the business can decline from $100 to $50, and the Senior Lender is still fully recovered. By contrast, if the value of the business declines by only $10 (from $100 to $90), the equity investors will have lost half their money.
These attachment & detachment points can also be expressed in EBITDA multiples.
If our $100 business generates $10 of EBITDA, then you can express the creation values as 5x for the senior lender, 8x for the junior lender, and 10x for the equity.
A lot of concepts in finance are super simple but just have weird lingo, so hopefully that is helpful.
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Creation Value in Search Deals
So let's apply this concept to search deals. Let's compare a typical self-funded using an 80% SBA Loan, 10% Seller Note, and then with or without investors.
(You may need to download images to see the below table).
When you negotiate a $2,975,000 price for an $850K EBITDA business, you may think you're paying 3.50x. But if you didn't get working capital, and you didn't account for deal & SBA fees, you're actually paying more like 3.74x EBITDA.
In the investor column, I assume the investors put in 80% of the equity capital and the searcher put in 20%. That investor capital goes in as a preferred equity, so it gets paid BEFORE the searcher capital.
As a result, the investors attach at 3.36x and detach at 3.66x. By contrast, the searcher attaches at 3.66x and detaches at 3.74x. You are not paying the same price (or Creation Value) for the business as your investors. For all intents & purposes, the investor preferred equity acts like debt.
On the other hand, if you don't take investors, you attach your investment at 3.36x and detach at 3.74x.
Let's take this a step further. What is your actual value the moment you close your deal?
Sale Price is the same as Purchase Price, and let's also say you get to keep your $100K in working capital (otherwise the purchase price would have been higher).
Let's see what that looks like:
Believe it or not, the impact of deal fees on a highly-levered transaction means you and your investors have "lost money" immediately. Like a lot of money.
The investors are sitting 0.46x of their initial investment, and the searcher is sitting at a big fat zero.
Even without investors, the searcher only has 37 cents on the dollar the moment the deal closes (again, this highlights how the investor equity is effectively more leverage for the searcher).
Look, this is all theoretical. You can't actually sell the business the same day you bought it. You will quickly create value by growing EBITDA, paying down debt, and hopefully increasing your exit multiple from 3.5x.
But the minute the deal closes, you have actually destroyed value because you've spent $100K in deal fees to turn liquid cash into an illiquid asset, and it's going to cost another $100K in deal fees to turn that illiquid asset back into liquid cash.
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Conclusion
So what can you do with this information?
First, you should be eyes wide open on 1) what price you're actually paying, and 2) what value you have to cover for you to even start to make money.
As a searcher, if the investors' detachment point is $X, and you get 75% of the common after that pref, then you know that you will get 75 cents of every dollar of value created after $X. But you should know what $X even is.
Further, I would encourage operators to run the above valuation math on a quarterly or annual basis for their business. I wouldn't change the multiple from your purchase multiple unless you're highly confident a different multiple is warranted, but I would update your trailing 12 months EBITDA and your debt & pref equity balances.
That analysis will allow you to confirm you're actually creating value (and how much value) for yourself and for your investors.
Lastly, this analysis, while academic in nature, does serve to highlight how the work is only beginning when you've closed your deal. You've technically created NO value at that point, you've just destroyed value in the form of deal fees.
As always, I’d love to hear your thoughts & feedback. You can hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing