Posted on: January 29th, 2018
The middle market ecosystem contains companies ranging in size from $10 to $500 million in revenue. Middle market companies are primarily private, closely held companies. They can be owner operated or professionally managed and conform to one of two growth models. Some are lifestyle businesses that exist to provide income to support the lifestyles of the owner and their families.
Lifestyle businesses tend to be cautiously managed enterprises where growth is funded through cash flow. Other middle market companies are growth platforms with ambitious new business development. These businesses see strategic value in gaining scale and need outside capital to grow in size.
The growth component usually requires these companies to invest heavily across the enterprise. These companies must have deeper benches of people, better IT systems, and larger budgets for innovation and marketing. Usually, these businesses have frontloaded these expenses, to give them the ability to scale at faster rates and absorb large chunks of new revenue.
These growth expenses usually comprise a large portion of the Opex, and are clearly related to supporting dramatic growth steps. The true profitability of these growth platform companies is understated due to the presence of growth expenses in the P&L.Conversely, lifestyle businesses are usually light on the expense side.
Due their pursuit of modest growth, they have leaner expense structures and tend not to invest heavily across the enterprise. These manifests itself through less sophisticated IT systems, shorter benches of people and less discretionary spend on innovation and marketing.
Their opex as a percentage of revenue is significantly less than a growth platform company. When the time comes to sell, the life style business looks considerably more profitable, yet its consistent underspend has resulted in an enterprise less likely to grow fast.
The growth platform looks less profitable than the lifestyle business, yet it has a larger growth engine and can scale more easily. At the time of exit, the growth platform will attempt to add back their growth expenses to present a higher EBITDA.
This may normalize its profitability with the lifestyle business, and level the playing field. However, to most financial buyers, the lifestyle companies looks leaner and more profitable. The growth platform company may appear to be disadvantaged based on financial metrics.
However, it presents a proven, scalable model and greater growth optionality for a strategic-minded buyer. It is worth more to a buyer due to its ability to drive growth. The exit value differential for a growth company more than offsets its incremental growth opex.