Home Health & Hospice: How Valuation Works in M&A

When it comes to mergers and acquisitions (M&A) in the healthcare industry, we get asked the same questions all the time; “What is the value of my business” and “How much will it sell for?”

Business valuation in the healthcare industry is a nuanced topic with many factors to consider. As the first entry in a series, this article will provide a foundational understanding by explaining the most common equation used for valuation, the variables that go into the equation, and the importance of perspective in the buyer-seller dynamic. By exploring these concepts, we aim to provide the basic tools you need to understand valuations and give you better insight into the process.

Additional articles in this series will dive into concepts like the structure of deal terms, valuation in Certificate-Of-Need (CON) vs non-CON states, navigating Urban vs Rural markets, and much more. Please visit “News & Insights” for our latest articles https://www.stoneridgepartners.com/news/.

Simple Formula, Complex Variables

The best place to start is by understanding the most commonly used equation in the valuation of healthcare companies. The formula goes like this:

Value = (Adjusted EBITDA) x (The Valuation Multiple)

Pretty simple, right? But we need to be careful- the variables in this equation can be deceptive. Does the time frame used to calculate Adjusted EBITDA (AEBITDA) affect valuation? What goes into the “adjustments” in AEBITDA? How do buyer-seller synergies affect the Valuation Multiple? Keep this formula in the back of your mind while we dive into answering these questions and more.

Example: Simple Formula at Work

Imagine a healthcare related company for sale with the following financial performance.

Company

• $1 Million in Revenue
• 20% AEBITDA

Valuation based on 3x

Value = (Revenue) x (% AEBITDA) x (Multiplier) = ($1,000,000) x (20%) x (3) = $600,000

Valuation based on 5x

Value = (Revenue) x (% AEBITDA) x (Multiplier) = ($1,000,000) x (20%) x (5) = $1,000,000

EBITDA: The Foundation of a Strong Valuation

How is Adjusted EBITDA “Adjusted”?

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) serves as the foundation for valuation during the M&A process. It measures a company’s operating profitability and gives an indication of the business’s financial performance.

However, EBITDA doesn’t account for non-recurring or non-essential business expenses. When selling your business, non-recurring costs (think certain legal fees, one-off technology upgrades (i.e., new tablets or computers), etc.) or non-essential costs (personal expenses run through the business (i.e., personal travel) or amounts above market rent charged on owner leased real property, etc.) are unique to your operations and won’t either impact ongoing profitability or the new owners the same way. Because of this, these expenses can be added back to EBITDA, boosting your bottom line.

These “addbacks” are how we go from EBITDA to the adjusted EBITDA (AEBITDA). Thinking back to the valuation equation, addbacks can be a crucial method for improving the value of your business when preparing for a sale.

The Time Period Matters

The period that is used to calculate AEBITDA can play into valuation just as much as addbacks. Depending on whether you use a trailing twelve months (TTM), trailing 6 months, annualized period, or some other method, your AEBITDA (and therefore your valuation) can look very different. Let’s dive into a couple of these time-period reporting methods individually:

• Trailing Twelve Months (TTM): This method of calculating AEBITDA considers revenue and expenses for the twelve months preceding the current date. If you have a stable business and revenue cycle, the TTM period can be the ideal method for reporting Adjusted EBITDA. However, if your business has grown significantly over the past 12 months, reporting those first few lower revenue months will decrease your reported AEBITDA amount. In this case, it may be better to annualize or use a shorter trailing period.
• Annualized based on Year to Date (YTD): This approach takes the current year to date performance and annualizes it. Assuming that the performance of the business is somewhat stable without seasonality and no anticipated change in performance for the remainder of the year, this can be a good approach based on year-to-date performance. Often this method is given more reliability as the year progresses: i.e., there is more confidence in a 10-month YTD annualization than a 3-month YTD annualization as you have more reliable data when you are relying on 10 months’ worth of data versus 3.
• Modeling or Projections based on a Trailing Period shorter than 12 Months: This modeling takes a given period, like your trailing 3 months or trailing 6 months and projects this revenue across a whole year of operations. For example, let’s say your business had been stagnant for some time but you have seen recent sustainable growth. In this case, you may want to annualize based on recent months because they reflect a more accurate picture of your business operations compared to the time period prior to the recent growth your business experienced. However, if there is seasonality to your business or if you’re usure whether the growth is sustainable moving forward, annualizing this period may not provide the best estimate of your earnings and or profitability.

While there are multiple time periods that a party can look at to calculate Adjusted EBITDA, the buyers and seller in a transaction will each calculate AEBITDA independently of one another based on their methods, confidences in the data, and risk tolerance. It’s important to be aware of these various time periods for calculating AEBITDA so you can choose the one that paints your business in the best, most accurate light.

The Valuation Multiplier: It’s all about Finding the Right Buyer

A Brief Overview

The other half of the valuation equation is the multiplier. Simply put, the multiplier reflects the ultimate value a buyer places on an investment based on among other things their desire and motivation to obtain the investment. The higher the motivation, the higher the valuation multiple will be. Valuation multipliers for healthcare businesses typically range from 3x-5x for smaller businesses and up to 7x-10x for larger ones, yet there are always outliers both above and below.

Imagine your business is a piece of fine art that you’re planning to put up for auction at Christie’s. Let’s say that your particular piece is a rare and unique work done by Salvador Dali. Not every buyer is a fan of Dali. A room full of only those buyers would probably result in low offers or potentially no offers at all.

On the other hand, if a renowned Dali collector is also attending the auction, and your item is the missing masterpiece that will complete their gallery. This buyer would see value that other buyers will not. As a result, they’re willing to pay a larger valuation to get their hands on it.

Healthcare M&A is no different; each business is unique, and the buyer pool is limited. The unique interest of any particular buyer will greatly impact interest level of your business and ultimately its valuation. A buyer with a strong desire for your service lines and geography will presumably be willing to pay more for your business than another buyer whose desire for your geography isn’t as strong or who has no interest in your geography at all.

Example: Simple Formula at Work

Take the example above.

Company

• $1 Million in Revenue
• 20% AEBITDA

Less Motivated Buyer: Valuation based on 3x

Value = (Revenue) x (% AEBITDA) x (Multiplier) = ($1,000,000) x (20%) x (3) = $600,000

Higher Motivated Buyer: Valuation based on 5x

Value = (Revenue) x (% AEBITDA) x (Multiplier) = ($1,000,000) x (20%) x (5) = $1,000,000

You can see from this example that a higher motivated buyer that is willing to pay a higher multiple has a significant impact on valuation.

Buyer-Seller Synergy: They’re not Addbacks, but they Impact Valuation

Let’s dive into corporate synergies and their place in Healthcare M&A. First off, Addbacks and Synergies are NOT the same. To review, addbacks are the non-recurring and non-essential business costs that factor back into EBITDA to get Adjusted EBITDA. Addbacks are somewhat objective amounts unique to your business that presumably won’t change from one prospective buyer to another.

Synergies, however, are much more subjective. Like many aspects of M&A, synergies are almost entirely dependent on each given buyer. Synergies are expenses or costs that you incur that a potential buyer may not. Think G&A costs that a small independently run organization incurs that won’t transfer to a larger regional or national buyer with a fully loaded corporate structure. For example, IT or Billing related costs that could be stricken as the larger organization absorbs those functions into its already fully functioning departments. Alternatively, consider CFO related costs that are stricken as those functions are absorbed by the Buyer’s CFO’s department.

These costs incurred by the Seller may be either partially or entirely eliminated by a synergistic buyer. Each Buyer will look at these potential savings based on their own unique organization. These “savings” will not bump the AEBITDA, but instead will allow individual buyers to place more value on a given seller based upon their unique synergies. Buyers with more synergies are able to be more aggressive in their valuation by offering a larger multiple than a buyer with less synergies.

What is the Multiple: Perspective is Everything

Example:

ABC Home Health & Hospice

– TTM Revenue: $8 Million

– TTM AEBITDA: $1.2 Million

A buyer makes an offer for $7.2 million. From ABC’s perspective this seems like a solid 6x multiple:

Multiple = (Valuation) / (AEBITDA) = ($7,200,000) / ($1,200,000) = 6x

*Notice how we’ve rearranged the valuation equation to solve for the Multiple.

However, the buyer knows that ABC currently has a COO with an inflated salary of $300,000. The buyer plans to absorb the COO’s role with its existing management that has this capacity without the need for additional resources. This absorption will effectively remove $300,000 from ABC’s expenses. By removing this expense, the buyer will be able to increase ABC’s total AEBITDA from $1.2 Million to $1.5 Million. Now, from the buyer’s perspective, they can purchase the company for a 4.8x multiple:

(AEBITDA) + (COO Salary Expense) = ($1,200,000) + ($300,000) = $1,500,000

Multiple = ($7,200,000) / ($1,500,000) = 4.8x

So, from the seller’s perspective, they are receiving a solid 6x multiple for their business, while the buyer, from its perspective, is only paying a 4.8x multiple.

It’s important to keep this concept in mind as you prepare your business for sale because finding the right buyer is key to maximizing valuation. Typically, a competitive process with multiple buyers pays dividends. These synergies are unique to individual buyers. In addition, each Buyers total motivation in moving forward with a transaction is unique and will ultimately impact interest level and the total valuation. By failing to engage the “right” buyer, you have failed to maximize your business’ valuation.

Closing Remarks

Hopefully by this point you have a solid understanding of what determines Adjusted EBITDA and the valuation multiplier during healthcare M&A. These two factors are the primary ingredients for understanding valuation. There are still, however, additional items that you will need to know to maximize the valuation of your business at the time of sale. Please keep a look out for additional blogs in this series that will touch upon those items.

An M&A Guide You Can Trust

Stoneridge Partners is a national healthcare mergers and acquisitions advisory and strategic consulting firm that manages complex transactions for home care, home health, hospice, and behavioral health companies.

We’ve been in business for over 24 years and have assisted owners just like you sell their health care related businesses. We have accumulated a deep network of motivated buyers during our 20+ years and we have years of experience as operators, attorneys, and development professionals. We’ve been in your shoes, and we know the daily challenges you face.

If the thought of a potential sale is of interest to you, let us help you optimize your prospects for a successful transaction and the highest valuation.

So how do you start? Please visit our website at www.stoneridgepartners.com or contact us at 800-218-3944 for a confidential conversation.

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