"Smaller" small and medium-sized businesses cannot be sold
Now that the future plans of many small and medium-sized enterprises had to be put on hold due to the pandemic, the topic of business succession is gaining momentum again. On the one hand, this is about ensuring the company’s continued existence; on the other hand, many owners want to pass the baton on to capable hands and, at the same time, reap the rewards of their many years of “hard work.”
According to current estimates by KfW, around 600,000 business succession plans are expected to take place in Germany by 2025. Of these, 430,000 companies (71%) employ fewer than 5 people, and another 85,000 (14%) have up to 9 employees. According to the German Bundesbank, the average return on sales for micro-enterprises is 5.5%—meaning that, with a maximum of €2 million in revenue in this size category, the maximum annual profit is €110,000!
This makes it clear that micro-enterprises are not very attractive from the perspective of a traditional financial investor. The transaction costs are disproportionately high, the dependence on individual persons—primarily the managing owner—is too great, and the “economic appeal” is too low. Even from the perspective of strategic investors (typically competitors), the acquisition costs more than it yields: the customer base is too small, synergies can be achieved only to a limited extent at best, and from a financial standpoint, a real contribution to equity value can rarely be determined.
In principle, the only succession option remaining in this size category is a takeover by the company’s founder, whether from within the family or the company itself. Since this source has increasingly dried up in recent decades, more than 50% of such companies are now planning to shut down.“M&A”in the traditional sense plays no significant role in this segment, and no change is foreseeable.
What about “mid-sized” small and medium-sized enterprises (SMEs)?
Many people associate “SMEs” with companies that have revenues between €2 million and €10 million. These are typically successful and well-established founder- or family-run businesses. On the one hand, they are too small to attract the attention of financial investors. At the same time, these companies are often too large—and thus “too expensive”—to facilitate an external succession by founder-led successors. For the “mid-sized” SME planning an external succession, the only option is usually a sale to a strategically active competitor. The competitor’s goal: to expand its customer and revenue base or to acquire and integrate technology and expertise. Through consolidation and structural optimization, a larger, more efficient company is created that achieves a stronger market position and thereby generates value and stability.
In this regard, it becomes clear once again: succession planning is a long-term project that sometimes requires more than five years of preparation. Those who adhere to this longer planning horizon can consider a “self-initiated buy-and-build approach” for their own corporate succession. Through targeted acquisitions of (smaller) competitors, revenue—and thus company size—can be rapidly increased. This boosts the company’s attractiveness and broadens the pool of potential successors—not limited to financial investors alone.
The Buy-and-Build Approach: Larger Companies Command Higher Valuations Than Smaller Ones
Traditionally, buy-and-build begins with the acquisition of a market leader or other relevant player as a nucleus, to which competitors are added through targeted acquisitions (“add-ons”). From the perspective of a medium-sized business owner, the owner’s own company would serve as the starting point. Horizontal integration—for example, to expand the product portfolio, sales reach, and realize economies of scale—is often easier in this context. Of course, forward and/or backward integration to extend the value chain makes just as much economic sense, but it is also more complex.
The buy-and-build approach has its origins in the private equity sector and is based on the financial-mathematical effect known as multiple arbitrage and multiple expansion: transaction multiples are often closely linked to company size; the smaller the company, the lower the transaction multiples tend to be—conversely, increasing revenue or company size is accompanied by rising transaction multiples. In other words: Larger companies generate higher valuations than smaller ones. In practice, this means that “add-ons” are acquired at low (and therefore attractive) multiples. Upon successful integration and subsequent sale, the transaction takes place at a multiple that has now increased. This creates disproportionately high value in terms of company valuation. In many cases, this is what creates the possibility of a sale in the first place!
From the perspective of a (financial) investor, there are now two incentives: With its strengthened market position, the company has a more robust platform for further organic growth. Furthermore, the company has proven itself as a successful buy-and-build platform, and there is nothing standing in the way of continuing this strategy with further (an)organic growth.
