Despite the coronavirus pandemic, the pest control mergers and acquisition market remains robust, according to Dan Gordon, CPA, managing member of PCO Bookkeepers and PCO M&A Specialists. With all of the unknowns staring down the pest control industry — and the U.S. economy as a whole — Gordon said it just may be the right time to sell.
For pest control operators considering this path in the short or long term, Gordon walked attendees of the 2020 PCT M&A Virtual Conference through several key performance indicators (KPIs) that maximize a pest control company’s value. They include:
- Earnings before interest, taxes, depreciation and amortization (EBITA)
- Ratio of recurring revenue to nonrecurring revenue
Keeping an eye on these KPIs ensures your firm is a quality, high-value target in the eyes of potential buyers, Gordon told attendees.
EBITDA. EBITA is essentially adjusted cash flow. Another way to think about it is, “What can I, as the new owner, take out of the business?” Gordon said. “Because most of the targets (in the pest control industry) are family businesses or small businesses, there’s usually a bunch of owner add backs.”
These add backs include excess owner wages, travel and entertainment, certain administrative costs and other owner items.
For example, if an owner/operator pays himself a $500,000 annual salary, but he could be replaced by a manager making $150,000, that would result in a $350,000 add back.
Owner travel and entertainment costs often can be added back, and so can other owner-related costs like a spouse’s car. After all of these adjustments, cash flow should reflect how much an acquirer can extract from the business.
To further maximize EBITDA, Gordon recommended potential sellers focus on improving the following areas:
- Gross margin, including labor, material costs and other direct costs
- Selling and marketing expense
- General and administrative costs
For example, Gordon recommended targeting a gross margin of 50-55 percent.
“When a buyer is looking at a company, he’s looking at gross margin,” Gordon said. “That’s the cost to produce your service. The only way to change that gross margin is to have tighter routes, which increases your revenue, or do price increases, which may not always be feasible.”It’s beneficial to benchmark gross margin and other key metrics against fellow pest control firms and try to meet or beat the industry standard, he said, noting it’s important to make sure your chart of accounts is set up correctly so you can compare it to your peers’ books.
RECURRING VS. NONRECURRING. It’s difficult to overstate the importance of building your recurring revenue, Gordon said.
“Intuitively, it makes a lot of sense,” he said. “If I’m buying a company, I want to be able to count on the revenue that produces adjusted cash flow and minimize the revenue risk.”
Gordon illustrated this point with an example of two companies before and after an economic jolt. In the example, Companies 1 and 2 line up perfectly before the jolt, both posting healthy profits. But look at what happens when the economy falters. (See table.)
“One-time job revenue will dry up, as will some recurring revenue,” Gordon said. For the purposes of this example, he assumed the jolt would cause 80 percent of nonrecurring work to dry up and 10 percent of recurring work to be skipped. He said these scenarios are realistic based on what he saw with his accounting clients’ businesses in April and May when residential and commercial clients were reacting to the pandemic.
Looking at Company 1 after the jolt, a monthly loss of $5,000 hurts, but it’s not the end of the world. But the losses taken by Company 2 after the jolt — $31,250 per month — can put you out of business.
“This shows you the risk of not having the recurring work,” Gordon said. Buyers of pest control companies understand the power of recurring business, and that’s why it’s such a vital KPI when selling your business, he said.
GROWTH. Finally, growth is an important factor in buyers’ valuation models. Minimal growth does not prevent your company from getting an offer, Gordon said, but it will require an explanation.
Other things buyers consider are investment value, which is what a strategic buyer could pay if they apply all their synergies and use their weighted cost of capital (WACC); or fair market value, which is what a willing buyer and a willing seller will agree to based on factors like size, location and other recent deals.
Buyers don’t reveal the models they use in calculating prices, but Gordon said they use a modified discounted cash flow model, which is the basis for most M&A valuations inside and outside the pest control industry. It includes the annual cash flow derived from revenue and growth forecasts and adjusted EBITDA, including some buyer synergies. It’s discounted at the buyer’s WACC, using multiple discount and growth scenarios and potential adjustments for working capital. (See related story to learn more about WACC.)
“We can take an educated guess, but we don’t know what our buyer’s weighted cost of capital is or what they’re using (in their valuation models), but we’ve done a lot of deals and we get pretty darn close,” Gordon said.
WHAT’S A SELLER TO DO? It’s a good time to sell a pest control company, Gordon said. It’s also a good time to keep a pest control company, although there’s no promise that valuations will stay healthy, he noted. There are two risks to consider: valuation risk and tax risk.
In terms of valuation, Gordon said it’s important to keep in mind the economic reality of the ongoing pandemic. The government stimulus propping up the market can’t go on forever.
“It would be an amazing feat to see the economy do a V-shaped recovery and avoid an extreme shock to the economy and people’s personal income,” Gordon said. “However, if I’m a gambling man, on the other side of that bet is that we go into a more traditional recession and asset values fall, including the valuation of pest management companies. So be prepared.”
In terms of taxes, they are likely to rise, he said. During the campaign President-Elect Biden proposed eliminating the capital gains tax for people making more than $1 million per year. It’s possible that the seller of a pest control company will see this level of income in the year he or she sells, Gordon noted. The difference between long-term capital gains rates, currently at 20 percent, and the maximum marginal ordinary income rate, currently at 37 percent, is 17 percent.
“So, the question is, what’s your timeline?” Gordon said. “If you have 10 years or so and you want to keep your company and grow it, do it. But if your timeline is three to five years or less…it might be the right time to sell.”
To obtain a free copy of the PCO Bookkeepers/PCO M&A Specialists Pest Control Industry Cost Study or Guide to Pest Control Mergers & Acquisitions reports, email Gordon at email@example.com.