So, why all the fuss about $1 million?
Quite simply, the million-dollar mark is a tipping point at which the number of buyers interested in acquiring your business goes up dramatically. And, the more interested buyers you have, the better multiple of earnings you will command.
For example, according to the research at The Value Builder System, a company with $200,000 in EBITDA might be lucky to fetch three times EBITDA (a 3X multiple), or $600,000. A company with a million dollars in EBITDA would likely command at least five times that figure, or $5 million. So while the company with $1 million in EBITDA is five times bigger than the $200,000 company, because of its higher multiple it’s almost 10 times more valuable!
There are a number of reasons that companies with a higher EBITDA get higher multiples, including:
Frictional costs are the total direct and indirect costs associated with the execution of a financial transaction. The friction cost comprehensively takes into consideration all of the costs associated with a transaction. Calculating the friction cost provides an investor with a full range of expected costs they can expect to incur.
It costs about the same in legal and banking fees to buy a company for $600,000 as it does to buy a company for $5 million. In large deals, these “frictional costs” become a rounding error, but they amount to a punitive tax on smaller deals.
But, here’s the reality for you. The greater the frictional costs, the less someone is willing to pay for your company or to invest in your company. Why? They have to consider these costs in what they pay and whether it’s worth it to them.
The 5-20 rule
There’s a rule in mainstream mergers and acquisitions that is just as true in the cannabis industry. And, it comes from M&A firms who have discovered that in many deals, the acquiring company is between 5 and 20 times the size of the target company.
I’ve seen this 5-20 rule at play in many situations. And, more often than not, your natural acquirer will indeed be between 5 and 20 times the size of your business.
Why? If an acquiring business is less than 5 times your size, it’s a “bet-the-company” decision for the acquirer. If the acquisition fails, it will likely kill the acquiring company. So, lot’s of risk right?
Likewise, if the acquirer is more than 20 times the size of your business, the acquirer will not enjoy a meaningful lift to its revenue by buying you. Most big, mature companies aspire for 10 to 20 percent top-line revenue growth at a minimum. If they can get 5 percent of organic growth, they will try to acquire another 5 percent through acquisition, which means they need to look for a company with enough girth to move the needle. You want that to be you.
Private equity and venture capital
Private equity groups (“PEGs”) and venture capital firms make up a large chunk of the acquirers in the mid-market. And, the interest of venture capital and private equity on the cannabis industry is growing and will continue to grow. It’s the reality of the industry. As we inch towards federal legalization, we also more toward mainstream acceptance, which brings with it investable capital from more mainstream sources.
And, in 28 years of working in accounting and finance, I know for certain that the value of your company will move up considerably if you’re able to get a few private equity groups interested in buying your business. But most PEGs are looking for companies with at least $1 million in EBITDA (remember, we’re talking finance in this article, not federal taxes).
Yes, the $1 million cut-off is somewhat arbitrary, but it’s also very common. Similar to homebuyers who narrow their house search to houses that fit within a price range, or colleges that look for a minimum SAT score, if you don’t fit the minimum criteria you may not be considered.
If you’re wondering when is the right time to sell your cannabis business, you may want to wait until your company is generating $1 million in earnings before interest, taxes, depreciation, and amortization (EBITDA).
So, what’s next?
If you’re close to $1 million in EBITDA and getting antsy to sell, you may want to hold off until your profits eclipse the million-dollar threshold. The universe of buyers—and the multiple those buyers are willing to offer—jumps nicely once you reach seven figures.
Now, there are things to do now to help you get there. Continue to assess vendor relationships to make sure you’re maximizing profitability on a vertical-by-vertical basis. That can help get you over the hump. Oh, and did we mention getting those cost accounting records sorted out? Because if you’re thinking of exiting, it’s worth it.
There’s trillions of dollars of capital in private equity and family offices. And, many of them focused solely or primarily on the cannabis space. They’re looking for good cannabis companies for investments or growth capital. We read it everyday in the pages of industry publications like Cannabis Business Times or Ganjapreneur.
So, if you’re thinking of exiting your cannabis business someday, there are real opportunities out there for you, and the way to maximize those opportunities is to get laser focused on that $1 million EBITDA mark.
Want to learn more? Speak with us about how we can help you with increasing EBITDA while staying compliant with the myriad rules and regulations, including helping you grow the value of your business.