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Follow up on attrition and multiples
October 14 2022
Follow up on attrition and multiples
          We had talked about the effect of attrition on multiples.  Here is how I compute them when I do a complex valuation that could be headed to court.
          Let’s look at two discounted cash flows of a fictitious alarm company.  One with 10% attrition, and one with 15%.  The first has a value of 38X the second 32X and here is why:
          Both models assume $40,000 of RMR with a 10% direct (central station cost).  If this is higher or lower it doesn’t matter because it affects both models equally.  Both have a 15% expected return on investment.  Again this factor is applied to both models.
          The difference is that the first has attrition of 10%, the second 15%.
          Both models start out with $40,000 of RMR.  At the end of the first month the model with 10% attrition has $39,667 left, and the model with 15% attrition has $39,500 left.
          At the end of the first year the 10% model has $36,178 left; the 15% model has $34,396 left.
          Gross cash flow Cash flow for year 1 for the 10% model is $433,685, and for the 15% model 422,357.   Net cash flow is down, but not by the same amount, because the central station bill is reduced by cancellations.
          We then take the net cash flow for each year and reduce it by the expected rate of return (i.e. the $390,317 that we will receive throughout the year is not worth the whole $390,317 due to the time value of money – very similar to discounting for inflation).
          We discount each year to arrive at a present value of the cash flows over 12 years and arrive at a discounted value.  In this case the model with 10% attrition has a value of $1,500,576 or approximately 38X the $40,000 of RMR, and the 15% model has a value of $1,270,260 or approximately 32 times.
          I use this for a base value.  I then adjust it by items such as type of company, quality of contracts, geography, etc… But attrition plays a major role in the value.  That is one reason why a fire company that does $40,000 installs and has 8% attrition is more valuable than a mass market residential company doing free systems.
  Mitch Reitman 
  Reitman Consulting Group
  Fort Worth, TX
  817-698-9999 XT 101
          This is an interesting way to do a valuation.  I can’t dispute the arithmetic but I do take issue with the underlying premise; several of them in fact.  The arithmetic calculation is more appropriate for buying a Promissory Note with fixed payments.  Theoretically you know exactly how much is going to be paid over the life of the loan provided there isn’t a default.  All you need to know in order to decide what you’re willing to pay to acquire the Note is what return you’re looking for, 10%, 15% or something more or less.  We see this when real property is sold based on an anchor tenant who pays rent.  The buyer decides what “cap rate” he wants to make to come up with a purchase price for the building.  Of course the cap rate works only as long as the rent is paid and owner obligations don’t increase so that the “bottom line profit” isn’t affected negatively.
          While some alarm companies, especially those owned by hedge funds, likely view the acquisition opportunity in cold arithmetic calculations, alarm companies buying alarm accounts have many other issues to consider, and they do consider these probably more than the anticipated “cap rate” or projected return on the investment.
          For example, one of the hottest and most important considerations for the acquisition may be how many technicians and other talented personnel the seller has that are likely to transition to the buyer as part of the deal.  Maybe the acquisition introduces a new territory or opens up a new market that will complement the buyer’s existing operation.  For example, a fire alarm business may want to acquire a fire protection business, or an alarm company that focuses on commercial may want to open up a residential division.
          A “book of accounts” also needs to be analyzed for potential symmetry and growth opportunity.  Maybe the accounts have monitoring RMR but no repair or inspection RMR, something the buyer hopes to add once the deal is complete, thereby potentially doubling the RMR [yes, giving up the per call revenue of course – unless the service plan won’t cover the repairs].  Perhaps the accounts will need upgrades that will also add increased RMR. 
          Attrition is always an issue in the alarm account acquisition transaction.  Analyzing the historical attrition rate of the seller is a good start.  A buyer’s attrition experience may of course be much different than the seller’s historical experience.  Some buyer’s may want to shake out the less desirable accounts following the acquisition, especially if there is an attrition guarantee, which there usually is.  The guarantee, how much and how it works is a topic for another time. 
          Let me conclude by observing that the buy-sell market for alarm accounts is alive and well.  Multiples are high for those companies who have adhered to the best business practices and from inception of the operation positioned the business for the inevitable sale. 
          If you’re thinking of selling or buying K&K is here to represent your legal needs.  We will also provide a broker service to find a buyer or look for a seller.  Contact me directly.

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Ken Kirschenbaum,Esq
Kirschenbaum & Kirschenbaum PC
Attorneys at Law
200 Garden City Plaza
Garden City, NY 11530
516 747 6700 x 301