Machine Shop Owners, Keep Your Eye on Your Equity

If you’re a precision metalworking shop owner, things are looking good right now. Your biggest problem may be keeping up with demand. But does that mean your business is destined to continue to get more valuable as revenue grows? Not necessarily. It is complicated. 

Many shop owners have been contemplating selling because valuations are now at record levels. But with business so good, some of them are thinking they should wait and cash in down the road. But just because you want to remain in business doesn’t mean you should.

The basis of competition is evolving, and owners are strongly encouraged to develop a strategy that is equity-focused, not sales-focused. An equity strategy focuses on maximizing your invested wealth, after taxes, come to your retirement date. It explores all your options to grow the value of your business interests and overall wealth over time. It keeps the eye better trained on the strategic risks of the business and the risks to the family balance sheet over the long term.

Where many owners err is in thinking that their equity in the business is growing just because their sales are growing. But they lose sight of the fact that company valuations — what prospective buyers are willing to pay — are based on a complex combination of company-specific, industry-specific and macroeconomic factors — some you can influence and some you can’t. Your equity strategy needs to be founded on a realistic assessment of both risks and opportunities, and a forecast of how these factors may affect future value.   

An Equity Strategy for a Consolidating Industry. The precision machining business today has all the classic drivers of a consolidating industry. Driven by money, technology and the supply chain itself, the industry is “in play.” If it follows the classic pattern, the strong will get stronger and the weak will get weaker. In a highly fragmented industry entering into major consolidation, the bottom third of participants are typically most at risk and many won’t survive. Partnering may be a necessity, not a choice. 

The usual pattern is as follows: The larger, better capitalized (PE-backed) regional players invest for cost efficiency, attract the best talent, expand their capabilities and, generally, make life easier for their customers. Infotech and connectivity increase transparency, putting pressure on old relationships.  Margins will come under pressure to the point where owners will have to make costly investments to remain competitive — and profitable. But, if you can’t afford to make that investment, it’s a path to eventual trouble. It’s hard to compete at the poker table with the shortest chip stack in the room. 

The M&A Cycle Matters. Today, private equity sees the precision metalworking business as fertile ground for investment. That’s what is driving the recent run-up in valuations to the highest they have been in the last 10 to 15 years.  We’ve recently seen as many as 20 offers on smaller machining companies. This combination screams “peak cycle” to us.  

The question is, how long will this last?

It’s hard to compete at the poker table with the shortest chip stack in the room.

We don’t pretend to have a crystal ball. But one thing we do know as investment bankers is that the M&A (mergers and acquisitions) market, like the stock or housing markets, is cyclical. Company valuations can change significantly, even if the overall business grows.

Here is a scenario to avoid: Let’s say you have 20% profit margins today and your plan is to sell in four or five years. But then your margins drop to 15% or less because of competitive pressures. If interest rates rise (which is likely), which raises the cost of capital to PE buyers, and they drop the multiple, they can pay from 7 to 6 times or 5.5 times (the historic average). You may have lost 40% of your equity over that time, even while growing your business. The M&A cycle matters to the equity strategy.  

One way this could be avoided is not by exiting the industry, but by partnering with strength. Putting some of your chips into more diversified investments also reduces your risk. 

Still, owners who love the game and want to continue independently in a consolidating industry need a different strategy — perhaps by raising mezzanine capital and being the acquirer — and building sustainable scale and value for an exit 15 years down the road. That can work, too.  

Every owner should sit down with their advisors (and family) and formulate an equity strategy and business action plan. If you are at the lower end of the revenue spectrum, we think that is especially critical because the organic growth model that worked before is going to get increasingly risky going forward.