M&A Offering Document: The Contribution Margin Thesis
With the contribution margin thesis in an M&A offering document, Seller is essentially telling Buyer, “Pay no attention to the lack of profits behind that curtain.” Instead of focusing on the bottom-line profitability, Buyer considers the effects (that is, benefits) of adding the Seller’s “contribution” to the Buyer’s existing operation.
What is contribution? Definitions vary, but essentially, contribution is sales minus direct costs for those sales. Direct costs include the cost of goods, as well as any sales or marketing costs in SG&A (selling, general, and administrative).
As an example, say a company has revenues of $40 million and is losing $2 million a year. Assume the direct costs associated with those revenues are $18 million. The gist of this thesis in this case is to say to Buyer,
“Look, we know our company as-is is unprofitable, but instead of taking the entire company, what if you only take the client relationships and corresponding revenue and move operations to your facility?
“If you do that and subtract only those expenses directly related to those revenues, you pick up $40 million in revenue and realize a $12 million contribution before your costs. I know you’d have other expenses, but how you run the business is up to you. What is that $12 million of contribution worth to your company?”
The key to this approach is the realization Buyer is already spending money on operations, and adding the acquisition’s contribution to the mix will have little or no impact on expenses.
Buyers are unlikely to pay the standard 5X multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA) on a contribution margin, but 2X may be a reasonable amount.
Companies with thin profits (or losses!) are typically prime candidates for the contribution margin thesis because a company with thin profits or losses doesn’t fetch much if the valuation is based on the bottom line. Contribution margin focuses on something other than the bottom line and asks Buyer to pay based on that alternative.
However, companies with a product that clients view as a commodity aren’t suitable candidates for a contribution margin approach because their products aren’t considered different or unique, a situation that makes a contribution margin approach difficult. Buyer is unlikely to pay a premium for a company that’s a dime a dozen.