The variables for the pest management mergers and acquisitions (M&A) process have changed over time. Here’s what you need to know to maximize your firm’s potential as a seller (or buyer).
Over the past 10 to 15 years, U.S. pest management professionals (PMPs) have seen their industry undergo a dramatic transformation, fueled by rapid growth and recognition by the “smart money” people on Wall Street that a recurring revenue model provides an ample return on investment (ROI) in a low-risk and stable industry. What used to be a $5.6 billion industry in 2002 is now approximately $14 billion with solid growth projected by market analysts for the decade to come. Concerns over pest-related diseases, increased government regulations and a stronger focus on environmentally friendly pesticides and safer service techniques also have helped spur the growth in this space.
Over the years, the mix of players in the pest management industry has shifted from a small group of nationals, smaller regional competitors, a “big-box” retailer and thousands of local independents to a handful of multi-billion-dollar national and international brands. They’re leaving behind a shrinking pool of mid-sized regional companies and local mom-and-pop firms. In addition, private equity firms have been making investments in the industry using affluent investors’ capital, where the diversification into portfolio companies having above-average investment returns outpaces available alternatives for greater overall investment returns.
The smart players fully recognize that a proper revenue mix, dominated by contract-based recurring revenues, is paramount to success in the pest management industry. Success in this regard drives up business valuations, as investors see steady annualized 8 percent to 12 percent ROI as desirable — as compared to investing in bonds or other fixed instruments earning less than 3 percent per annum.
In today’s market, investors have more realistic expectations about ROI after having faced the banking crash, internet bubble and real-estate market crash. Expectations are lower, especially when the risk of losing capital is minimized.
Over the past 10 to 15 years, the prices paid for pest management company acquisitions have risen based on the above — as well as local, national and international events; changes in tax laws; cheap money in the form of low interest rates; the ease of cross-border transactions; access to global capital markets; e-commerce; and overall expectations of where to achieve a safe and stable ROI. A number of technology efficiency improvements, as well as the ease of communication, also have made a significant impact on the way business gets done.
Fifteen years ago, it was not uncommon for companies to sell for half, or even one-third of the valuations that some of the highest quality pest management companies are selling for today. For more than a decade, the valuations have been climbing steadily. Larger domestic companies — such as Terminix, Orkin, Arrow and Massey — desire significant growth. While organic growth is always desirable, purchasing quality companies that are highly profitable and have continued revenue growth helps quench this thirst for the required growth targets. In addition to the large U.S. companies and regional strategic players and private equity funds that acquire companies, there are now foreign firms — such as Rentokil and Anticimex — that see the U.S. as a fertile market for their global pest management expansion opportunities.
Types of acquisitions
When contemplating an acquisition, a buyer outlines a strategy in terms of moving into a specific geographic market. A buyer will identify suitable target acquisitions and develop a range of acceptable purchase prices for such targeted acquisitions. The smart players refine this strategy; they are deliberate and use quantitative methods, demographic information and various pricing methodologies to constantly tweak the overall strategies.
Case in point: When speaking to one of the larger players not too long ago, my colleagues and I were told they actually observed the U.S. market for a couple of years before finding the “right” time and the “right” company to acquire that fit their strategy for making an entry into the U.S. market.
As part of an overall strategy, buyers look at three types of potential acquisitions:
- Platform company — Purchasers acquire a platform company to enter a new market where it has little or no activities. By acquiring the platform company, a buyer quickly gets an established management team, local infrastructure and an existing customer base. Expansion is easier with a platform company at the core of the overall strategy.
- Bolt-on company — A smaller company that can be “bolted on” to a platform company. It has fewer customers, management and administrative capabilities than the platform company.
- Tuck-in company — A smaller company that operates in the same geographic area as the buyer. It is purchased to fill in route gaps, making customer routes more efficient from a technician labor cost perspective, and/or expanding customer sales.
The real story on valuation
The key to understanding an enterprise’s value is more complex than the rule-of-thumb approach of some multiple of annual revenues. It is, of course, easy to express the sale price for a business as a multiple of annual revenues. But in fact, the process is more like calculus than algebra: Buyers all have their own algorithms and formulas when they dissect a target during the valuation process.
Basic valuation principles depend, in large part, on the annualized free cash flow generated from an operating business. This is referred to as EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. This number is divided by the purchase price paid for the business. For example, if the EBITDA is 10 percent of revenues, and a buyer pays 100 percent of annual revenues (1x annual revenue) to buy the business, it means the buyer is accepting a 10 percent annualized ROI. However, if a different buyer expected a 20 percent ROI, the price paid would have to be limited to 50 percent of annual revenues (0.5x annual revenue). Accordingly, the basic valuation formula equates to a multiple of EBITDA, not revenues.
For those who want to take this example a step further and explain why some firms may be willing to pay 200 percent of annual revenue (2x revenue) or more, we can take that same company that is achieving a 10 percent EBITDA and, if we were to pay 200 percent of revenues (or 2x revenue), the buyer is accepting a mere 5 percent ROI.
Why would a firm be willing to accept a 5 percent ROI? Well, it depends on its cost of capital and the spread it is willing to accept. Cost of capital is the opportunity cost of making a specific investment. It’s the rate of return that could have been earned by putting the same money into a different investment with equal risk.
If the purchaser’s cost of capital is 2 percent, then achieving a 5 percent ROI only provides the buyer an incremental spread of 3 percent for its benefit and risk taken. Such a result is not compelling to a buyer when deciding to invest — or not invest, as the case may be.
When determining the value of a company, it is advisable to build a spreadsheet model so all these variables and assumptions can be easily changed to determine some range of expected values. In this manner, the purchaser can target an appropriate purchase price (or range of acceptable prices) to offer a selling party. The most important number the purchaser is looking at is the minimum ROI required after cost of capital is taken into account, also known as the “hurdle rate.” If the purchaser’s required hurdle rate is 10 percent, yielding a mere 3 percent net ROI as in the above example would likely result in the buyer walking away from the deal and looking for a better investment opportunity.
However, if a buyer understands the seller’s financial statements and the opportunity presented post-closing to prospectively increase revenues significantly and/or decrease expenses (called “pro forma adjustments”), then the calculation of the ROI achieved and the resulting sale price can be far different from a buyer’s vs. a seller’s perspective. This is true especially if the sale price is being expressed as a multiple of revenue.
These pro forma adjustments all have the effect of increasing the annual free cash flows of the target business. This means a buyer’s ROI goes up; therefore, the price paid may be increased (to an extent) as long as the buyer’s required hurdle rate is still achieved. It is important to note that a seller will not know the pro forma adjustments a buyer is making in its valuation analysis. This is because the buyer wants such increases in cash flows to go solely to him or her, and not pay the seller for the future efforts and strategies the buyer is going to implement in the existing business.
Gross profit margin
The gross profit margin can be calculated as gross revenues minus direct costs. Examples of such costs include salaries, insurance, payroll taxes, supplies and materials, vehicle maintenance, etc.
What if we focus on gross margin rather than EBITDA? Before we dig deeper into the numbers, let’s take a look at the adjusted free cash flow generated if we are able to tap into certain efficiencies of the purchaser.
Quality companies in the pest management industry show a gross margin between 50 percent and 55 percent. Gross margin is extremely important, because it determines how much cash is available to pay fixed costs to break even. Once breakeven has been achieved, how much cash is available to contribute to net income? If gross margin is inferior, it can be improved by increasing prices, optimizing route efficiency, reducing direct labor costs or some combination thereof.
One easy way for a purchaser to increase the gross margin of a seller in the “tuck-in” scenario is to increase route efficiency by reducing technician windshield time. Using this in our model, we are able to increase gross margin and add that cash back to calculate our adjusted free cash.
If we explore areas where we can improve other efficiencies and are able to add cash back in our model, we can look to potential duplications of fixed costs as a result of the purchase. For example, perhaps the purchaser already has an office that can accommodate the seller, so one of the office rent expenses can be eliminated. If the purchaser has an existing bookkeeper on staff, the combined entity may not need both, and the seller’s bookkeeping position can be eliminated.
The ability to finance vehicle acquisitions at a lower rate of interest and better use of cash also may add benefits. Employee benefits programs may improve by being part of a larger group and can increase annual free cash flows.
Once these costs are eliminated in our adjusted free cash flow model, the numerator in our valuation fraction can be increased significantly. In turn, it raises the potential ROI in our formula. Once the ROI exceeds the hurdle rate, the purchaser may be willing to raise the offer, as he or she is able to use the formula to actually lower the ROI to match the hurdle rate. On the other hand, the purchaser may just look to leave the same offer, and be a hero by looking to exceed the hurdle rate.
If you are a potential seller without experience in this type of work, we recommend you employ a firm that understands the valuation and sales process when it comes to evaluating your alternatives in selling your company. As you can see, while many people in our industry speak in terms of valuation being tied to a multiple of revenues, behind the scenes the valuation process has very little to do with a straight multiple of revenues.
Other factors to consider
While the sheer mathematics involved above would make the entire valuation exercise seem quantitative, many qualitative factors also can be considered.
Such factors include:
- The potential to acquire a great management team.
- An assembled workforce, including low employee turnover rates.
- Local brand recognition.
- Types of services (commercial, residential, wood-destroying, etc.) the acquirer is looking to add to its portfolio of services.
The pizza principle
When determining overall value, acquirers often will measure profitability on specific services and components they are interested in purchasing by calculating the specific ROI on each item. This highlights the differences in the valuation of the various components that make up the value of the whole company. It allows the acquirer to understand which components of the seller are most profitable.
Using this tactic is like looking at an eight-slice pizza where each slice has different toppings and sells for a different price. However, the entire purchase price includes the entire pizza, priced at the sum of all of the differing slices.
What value can you expect?
What are they saying at the water cooler, industry events and on social media? So far, the richest (public) deal we know about was between Steritech and Rentokil in 2015. Is it realistic to think you can expect that kind of valuation in terms of that revenue multiple as a gauge?
While anything is possible, we would venture to say at this time, probably not for most companies. Remember, Steritech had a national footprint with marquee commercial accounts that included a food safety division and an excellent management team. In addition, Rentokil obtained instant growth of more than 35 percent of what was then a company with $390 million in revenue.
That said, to maximize the value of your company if you are contemplating a future sale, you want to start the process by:
- Selling recurring, profitable services. There is no better way to increase the value of your company than to present a potential buyer with a portfolio of service contracts that garner a high dollar-per-service-hour ratio.
- Solidifying your customer retention by providing great service. Most deals are predicated on guaranteed deliverable annual revenues (less some agreed percentage of attrition). When these retention rates are not achieved, a downward purchase price adjustment may occur and create bad will between buyer and seller.
- Focusing on gross margins. As stated earlier, gross margins for a pest management firm should be between 50 percent and 55 percent. To increase your gross margins, make sure your services are priced at an acceptable dollar per hour, your routing efficiency or work-to-windshield ratio is higher than 65 percent, and your material and technician labor costs are minimized.
- Working on your company culture. A company that has a workforce that works well as a team and has low turnover is always extremely desirable to a potential suitor.
- Making all employees sign a non-compete agreement. This is paramount to getting any deal done, as buyers don’t want to purchase companies that have employees who can leave, set up shop and take customers and/or employees with them.
- Focusing on your local markets. Pest management firms that are the leading brands in their local markets are always highly sought after by potential acquirers.
Are you ready to sell?
Are the increasing sale prices being paid for pest management companies sustainable, or poised for a reversal? In which direction is the economy moving?
While these are great questions, no one knows the answer. Many experts predicted the top of the market was at the end of 2012 because the capital gains tax rate increase would begin in 2013. The market made fools of the experts (in our industry, as well as others) however, as it often does. Valuations have increased significantly since the tax increase was enacted at the end of 2012.
We do know that, as purchase prices increase, we get closer to the top than the bottom.
If you are thinking about selling your business, you need to decide on your timeline. Selling your business is a big decision. It’s important to hire the right team of exit-planning specialists. At a minimum, your team should include a financial intermediary (business broker) who understands the pest management industry and can negotiate as your advocate; an M&A attorney who has handled deals in the pest industry (there are nuances to successful pest management deals that are not generic); and a CPA who is familiar with the tax laws surrounding M&A transactions.
It’s important that your M&A team takes the time to carefully craft an exit plan that defines reasons for the exit; the steps that can be taken to maximize value; and a likely timetable to get a deal done. If you’re thinking about putting your company on the market, we created a video, below, that will help you understand the types of services you will require of your exit planning team, and how to get the most from that team.
Gordan and Cooper (PMP Hall of Fame Class of 1999) are managing directors of PCO M&A Specialists, a division of PCO Bookkeepers. Douglas Corrigan, MBA, also contributed to this article. They may be reached at email@example.com.