Nearly all agency acquisitions are a function of a value multiple times, either EBITDA (Earnings Before Interest Tax and Depreciation) or OPAT (Operating Profit After Tax). Also, many agencies will use an earn-out valuation, especially if they have real value and are bought by one of the ad groups.
Determine the Business Value
Typically, OPAT is used since agencies and consultancies are not capital and debt-intensive organizations nor carry inventory. OPAT allows you to really understand the company’s cash flow and how efficiently it generates profit, which is what they are acquiring. Sometimes, this is a challenge since it often excludes outstanding receivables.
Have your fiancé team run both calculations of X times EBITDA and X times OPAT (EBIT) or X times Sales then you can see the difference in the formulas. Given the labor intensity of the digital business, OPAT typically works in your favor unless you have a lot of debt.
Determining the Multiple (Enterprise Value)
There are a few factors the acquiring company will use to determine the multiple or enterprise value of the business. Some think of this as the near-future profitability potential of the business.
Factor 1 – Industry and Similar Business –
As most have told you, the typical agency valuation multiple is between 1 and 5 – more typically, 1.5 to 3 times OPAT so you can assume that as a rule of thumb. Many non-agency business valuators will use a multiple of 6x to 15x times EBITDA for traditional businesses because most are debt-heavy by nature, which reduces the right side of the equation.
Factor 2 – Goodwill (Acquisition Premium)
The Goodwill factor is typically the value of non-balance sheet items that contribute to the value of the business.
Goodwill Contributor – Differentiators
These factors are all the intangibles that you cannot value but do contribute to your success.
Unique Capabilities – do you do things others do not, process, patents, tools – we had a few patents, and one of our largest clients called us the McKinsey of Search due to our enterprise workflow.
Software – do you have any recurring revenue from developed/owned software – two of our patents were for search technology that we developed for another company we had a joint venture. We also had licenses for our Intent Modeling Software with 5 Fortune 20 companies. Note software can also be a liability if you conflict with software; the purchasing company already has exclusive deals or a revenue target. While the software might have some value, if the purchasing company does not have development capabilities or believe in it, they will shut it down or force a sale and, in a worse case, contractually prevent you from further investments.
Payment Sequence
Most agency acquisitions, especially those with an earn-out, will have three potential payment events.
Closing Payment – this is the initial base value of the business Multiple X OPAT (what it is worth today and similar to a one-time payment deal). Sometimes, they only buy a majority share to incentivize you further to grow. In my second agency they bought 70%
Advance Payment (AP) – Typically after year 1 to incentivize integration, profit, and growth.
AP = [Share of Business x [Multiple x (Acquisition Year OPAT + Year1 OPAT]] – Closing Payment
Typically, the multiple for a digital agency is 1.5 to 3, depending on several variables. One of the biggest contributing factors is an “Acquisition Premium ” described below.
Earn Out Payment – this is the final payment at the end of the Earnout period
EP = [70% x [Multiple x (Acquisition Year OPAT + Year1 OPAT + Year2 OPAT + Year 3 OPAT + Year 4 OPAT + Year 5 OPAT]] – (Closing Payment + Advanced Payment)
This multiple is typically lower, but every situation is different. Most go higher for the initial and advance payment to incentivize merging and growth in the initial years.
Typically, OPAT is used since agencies and consultancies are not capital and debt-intensive organizations nor carry inventory. OPAT allows you to really understand the company’s cash flow and how efficiently it generates profit, which is what they are acquiring. Sometimes, this is a challenge since it often excludes outstanding receivables.
Have your fiancé team run both calculations of X times EBITDA and X times OPAT (EBIT) or X times Sales then you can see the difference in the formulas. Given the labor intensity of the digital business, OPAT typically works in your favor unless you do have a lot of debt.
This is hard to pin down since this is open for interpretation. M&A calls this Goodwill (non-balance sheet items), but I like to refer to it as (Acquisition Premium) – where you get to demonstrate that your business is worth more than just the money it makes. There is value in how you are able to generate and maintain your growth.
Factor 2a – Portfolio Value
During the valuation process, variables are applied to each “contract” or business engagement for anything generating revenue.
These are given a score of 1 (low), 2 (med), 3 (high) with 3 the best
Longevity – this is how long they have been a client. The assumption is the longer, the better, and the lower the risk of ending an engagement.
Security – How secure is the business? In an interview with the client, how do they rate it? Depending on the score below, they would reduce the revenue expectation of the business accordingly.
- Highly secure – clients love them, and no changes in scope (100% of value)
- Secure – Happy and no changes expected (80% of value)
- Concern – The client is not necessarily happy or open to options (50% of value)
- Distressed – The client is not happy and potential for termination (0% of value)
Contracts – Similar to security how much business is contractually secure and the quality of the contracts.
Is there an AOR? What is the exit provision?
How much notice for termination?
Provisions for change of management or owner?
Higher points went to
1. Having a contract,
2. 90-day notice
3. Not having a strict change of management/owner provision
In our case, we had 7 enterprise clients shared by the acquirer that could be folded into an existing AOR, exponentially increasing security and revenue potential.
Growth Potential – What is the potential for growth in revenue and/or profitability
Service Synergies – What is the potential to cross-sell purchasing companies’ services?
Conflicts – Are there clients/brands that are in conflict with the acquirer?
This needs to be dealt with early and written into your contract for the duration of the earnout. It is revenue, so it needs to be counted, but the amount adds risk to the business. If the acquiring company has a non-compete in the AOR one of you will need to resign the client. Typically it will be you who has to do it. What is the make-good for that loss of revenue? It is nothing you did wrong but their agreements. In some cases, they can move it to a neutral entity and your team can work on it. In other cases, you can offer your services to their client.
This was a problem for us. One of the clients was a direct competitor and we had to resign the account. The acquirer’s client was looking for a solution and we were added in via the AOR. In that case the new project was an increase in revenue.
We had a bigger issue with a CPG company client. We had 50 brands, which was a direct conflict with their CPG client. Since their client had an AOR with another agency that exempted us from the conflict, that also prevented us from pitching them.
Brand Value – Do the brands you have add value to the portfolio? Our 7 shared enterprise clients were good, but we added another 7 F100 brands they did not have.
Industry Verticals – We had clients in 3 target verticals they identified as growth areas, and all had the potential for upsell.
Factor 2b – Differentiators
These factors are all the intangibles that you cannot value but do contribute to your success.
Unique Capabilities – do you do things others do not, process, patents, tools – we had a few patents, and one of our largest clients called us the McKinsey of Search due to our enterprise workflow.
Software – do you have any recurring revenue from developed/owned software – two of our patents were for search technology that we developed for another company we had a joint venture. We also had licenses for our Intent Modeling Software with 5 Fortune 20 companies.
Note that this can also be a liability if you conflict with software; the purchasing company already has exclusive deals or a revenue target. While the software might have some value, if the purchasing company does not have development capabilities or believe in it, they will shut it down or force a sale and, in a worse case, contractually prevent you from further investments.