Once you achieve Market Penetration and start generating revenue, you must immediately focus on creating equity. To obtain a better understanding of accruing equity in a GovCon company, here’s some quick and dirty math regarding a common valuation approach for established companies.
The “multiplier” valuation approach is the most common method used in the Federal Government contracting industry. The method uses a company’s annual EBITDA (everybody uses the acronym, but it stands for Earnings Before Interest, Taxes, Depreciation and Amortization). For the vast majority of small GovCon businesses, it’s your profit.
Your EBITDA (annual profit) is then multiplied by a “multiplier” to determine your company’s value. A “multiplier” is determined by the type of contracts a company has. A multiplier will be much higher for prime, full & open contracts, providing “interesting work” to “interesting customers.” It will be much less performing administrative support subcontracts in the Department of Interior.
In 2017, the average multiplier for defense industry mergers and acquisitions (M&As) was an eight. For a small business, the multiplier is typically lower since most small business revenue comes from set aside contracts that provide less value to large business acquirers. In many cases, the large business acquirer may not be able to bid on the contract recompetes held by the small company.
Here’s a simple example to see how the multiplier valuation approach works. Let’s assume you won a 3-year, $12M Prime contract. You’re burning $4M/year in revenue, maintaining a 25% profit margin, making a cool $1M/year in profit. In your third year after banking $3M in profit, you decide to sell your company after winning the recompete of your contract.
Although your revenue comes from a small business set aside contract, it’s doing interesting things for an interesting customer, providing you a multiplier of five (5). Your valuation for an acquisition would be $1M x 5 = $5M. You would have earned $3M in profit during the previous three years supporting contract plus $5M in acquisition value, totaling $8M in income.
Hidden in this acquisition methodology, is an obvious, but frequently overlooked, fact. Every dollar that you can save in corporate “overhead” will be that much more profit for you! However, the real value of being a prudent manager of corporate overhead costs is during an acquisition. That additional dollar in money saved and converted to profit will be applied to your “multiplier” during an acquisition.
In the above example, if you can outsource recruiting and obtain a net savings of $50K by not having to hire a full-time recruiter, then you not only get to pocket the $50K in profit, but you will make $250K more during your acquisition!