18 June - 2020

Getting to the Top—and Bottom—of Understanding Multiples

A great deal of attention is given to the multiples that are paid for a business…and for good reason.  
The first question everyone asks when a transaction occurs is invariably: “What was the multiple?” While a simple revenue or earnings (profit) multiple might seem highly comparable from deal to deal, there are many considerations that determine which multiple – top or bottom line – is the most appropriate in a transaction. The size of a book of business and structure of the transaction are both key indicators of whether a revenue or earnings multiple is more appropriate. 

Smaller advisory firms and transactions that are structured as asset lifts (in which only the clients are acquired and not the employees and infrastructure of the selling firm) are more likely to be evaluated more on a multiple of revenue basis (top line), as opposed to on an earnings multiple basis (bottom line).  

This is often the case because, rather than inheriting the existing cost structure of the selling firm, the cost structure of the purchasing company is more directly applied. In fact, the overhead increase for the acquiring firm can often be marginal, especially in the case of an asset lift. In these cases, looking at the multiple of the sellers existing earnings can be misleading without a clear understanding of what the profits will look like post transaction.  As such, comparing and evaluating revenue multiples tends to be a more reliable approach.  

As AUM rises and the acquisition is of the full company (as opposed to only the client base), the selling firm’s cost structure becomes increasingly important to understand.  There are always costs that will change after an acquisition occurs, many of which are related to technology, compliance, accounting and other such costs. But large portions of the businesses cost structure can remain in place.  As such, evaluating earnings multiples becomes increasingly relevant as the retention of existing costs and complexity of the business rises.  It is important to note, however, that both efficient and inefficient cost structures can be highly valuable to a buyer depending on their ability to optimize the acquired firm and expand margins.  

While the headline revenue and earnings multiples must always be considered, every transaction is unique, and the individual circumstances must be carefully considered.  For smaller transactions, revenue multiples may be the most relevant, because the buying firm’s cost structure is more likely to be marginally applied against the newly acquired revenue. While larger firms with established infrastructure cause the earnings multiples to increase in importance to account for the accompanying overhead.  To truly allow for comparability across deals, however, the underlying dynamics must be properly understood for each transaction.  
 

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