September 6, 2006
News & Opinion: Sell Your Business Your Way by Rick Rickertsen, Robert E. Gunther, Michael Lewis (Foreword)
THE ART OF VALUATION
Once you have done the research, you will have gathered a range of multiples on comparable firms. You have defined the bounds of the universe, but you still dont know where your specific business fits in this universe. You need to look beyond generic features to see what makes your business more or less valuable. This is where the art comes in, of course. Now that youve crunched the numbers, you turn your attention to the critical nonfinancial issues to determine where you should sit in the range of multiples (or outside of it). Among the issues that might adjust the multiples are:
- Pretax Margins. If your company has lower margins than the industry average, you should likely discount the multiple. If it has higher margins, it may command a premium.
- Growth. If all companies are growing at 12 percent and your company is growing at 20 percent, it should receive a higher multiple. Buyers will be careful to see that the growth rate hasnt been artificially inflated (for example, by special selling programs implemented by the company) and that it is sustainable. If it survives these tests, the company should fetch a higher price.
- Future Prospects. If the company has some tremendous future events coming on line, such as the award of a large contract, you might boost the multiple. You dont want to create too glowing a picture, but if there is a realistic argument for a rosy picture, you should make it. If you just landed a multiyear government contract that will double your business, this has to be factored into your price. Strong future prospects will allow you to extract a higherprice.
- Customer Diversification. As noted in the discussion of risk, if half the companys business comes from a single, dominant customer, this increases risk and decreases value.
- Scale. If the company is generating revenues of $200 million or higher, buyers should expect to pay public market multiples. If it is a $20 million firm, the purchase multiple will be discounted by 15 to 30 percent from public market multiples to adjust for the smaller scale (and therefore more risky company). A smaller firm typically doesnt have the quality of management, systems, customer relationships, or clout of a much larger company. But to the extent you can demonstrate that you do have this high-quality managementand bringing in professionals and brand-name advisers can help in making this caseyou can bump up your multiple a bit.
- Control. Sellers of private firms sometimes will argue that buyers should pay a control premium because the buyer gains operating control over the company, rather than just a financial investment in it. Sellers contend that buyers should pay extra for this, but it is usually countered by the fact that the investment, unlike stock in a public firm, is an illiquid security. It can be a catchy argument and sometimes will bump the multiple a tad, but todays markets are so competitive, buyers generally pay multiples very close to the public market. Besides, as every business owner knows, controlling a company can be a double-edged sword.
- History. As noted above, buyers will look for several years of history in growth and earnings to make sure they are not just sleight of hand. If there are tarnishes on this record, that will reduce the price. Buyers dont want to set the value from peak earnings. If the company has earned 6 percent historically, and the year before the sale the earnings spike up to 10 percent, they will be very skeptical and are likely to set the value based upon the 6 percent historical earnings level.
- Sellers and Buyers Motivation. The motivation of the sellers and buyers also affects the price. Are you desperate to sell or do you need cash quickly? Do the buyers have tax consideration or strategic imperatives that make them want to get into the deal quickly? Will your company allow them to reach a segment or market they desperately want to add to their business? This added motivation couldincrease the price.
- Rival Bidders. The psychology of rival buyers also plays a role in determining how much a business is worth. In one deal, a management team competing against an outside buyer was surprised at how high the outsiders were willing to go. It turned out that the CEO who was bidding for the firm had lost out on a previous deal and decided he had to have this one, no matter what. It was a point of prideso reason took a holiday. While such a rival can be hell for a more level-headed competitor, there is often nothingbetter for aseller.
All these factors, and others that may be idiosyncratic to the deal, are used to adjust the value of the firm. How much of an adjustment should be made for each? That is the art. In addition, some of these factors will interact with one another. A company with a dominant customer may also have lower margins due to this customer, and these issues should compound a reduction in value against prevailing market multiples. You just need to systematically identify the issues, look at ranges for comparable firms, and then adjust your initial scientific estimates accordingly.
The outcome of this process is never a single price but rather a range. You decide at the outset what the top dollar and bottom dollar are. When you reach top dollar, you can smile. If you reach your bottom dollar, you need to be able to walk away.
The Balance Sheet Matters Too
Most business valuation analysis rightfully focuses on the income statement. This is appropriate, but sophisticated buyers will also carefully evaluate the companys balance sheet. They wont just look at the most recent balance sheet. Just as with the income statement, theyll expect to see the last three years of historic data and analyze the key working capital accounts to see how theyve been changing. Have the days of accounts receivable outstanding been getting longer or shorter over time? If the receivable days outstanding are getting much longer over time, you may have a collections issue. If theyve gotten much shorter in recent months, it might mean that you have accelerated the collection of receivables in advance of a sale. This may indicate that there was some kind of financial hole to fill.
These are the kinds of questions savvy buyers will ask about your business. You owe it to yourself to ask themand answer them first. Otherwise you may not have the right answer when they come, which could be an expensive mistake. Many dollars have been lost by sellers who have been caught flat-footed by a sharp question from a buyer. In the ensuing embarrassment, you can almost see the value of the business bleeding onto the pavement. It can even spook the buyer and kill the deal.
Inventories and accounts payable also will be scrutinized. Have the inventory days lengthened or shortened recently? If theyve gotten much longer, perhaps theres lots of old inventory there that the new buyer will have to eat. If inventory days have gotten much shorter, perhaps it means that youve been tightening inventories to take cash out of the business. Same with payables. Are they stretched? If so, you may have some angry suppliers out there and a financial gap to fill. If the payables are very short, perhaps you have an opportunity to generate cash by extending the payables.
Buyers also will be wary of capital investment deficits in a company thats for sale. Just as its natural for a seller to try to optimize the cash on the balance sheet prior to a sale, its natural for a seller to underinvest in capital equipment Sadly, its a little bit like selling a car. Maybe you left on the tires with just enough tread or put off changing the coolant. In looking at your business, you can bet buyers will have their mechanics crawling all over the place to see that capital expenditures match historical levels. If they identify concerns, you should have an explanation.
Buyers will also look at debt outstanding. They expect to purchase a balance sheet with certain working capital accounts. Theres a natural working capital level for any business, and thats part of what they are buying. They may also be buying a company with some existing bank debt on the balance sheet. This is fine, but certainly impacts valuation. Remember the old, simple formula:
Total enterprise value- equity value+ debt value.
You need to be clear with the seller how this debt will be treated. A $10 million deal where the buyer assumes $5 million in bank debt is quite different from a deal in which the debt is excluded.
Balance sheet analysis is complex, and it will pay to have a good finance person on your team. Other issues that may arise are the seasonality of the balance sheet. Many companies have highly seasonal working capital needs (like a swimming pool company or a florist), and its important for you to understand these seasonal fluctuations. In general, buyers will use a twelve-month average working capital and debt level as a baseline. If they can buy the business when the balance sheet is at its fullest, thats fine, but they will be wary of buying in the quiet months. If you are in a seasonal business, your best time to sell may often be heading into your busy season.
Debt raises some more esoteric questions, such as how to define debt. Are leases debt? Should leases on the balance sheet reduce the purchase price? In general, the answer there is no. Most leases can be rolled over in a sale and behave more like working capital. But all forms of bank debt and subordinated debt are clearly debt, and are a dollar-for-dollar reduction on equity proceeds in a transaction.
Of course, all these balance sheet anomalies have logical explanations. Look carefully at all the metrics. If theyre consistent over time, youre probably in good shape. If theyre bouncing around, youve got lots of issues to analyze and questions to ask. Again, seek out industry comparables to see where competitors inventory turns, days of receivables, and days of payables are set. There is always both opportunity and risk in balance sheet management, but in my experience, buyers will normally see more risk than opportunity.
Why Not Use P/E Ratios?
The P/E ratio is the ratio of the price of the stock of a public company to its net income per share. It is also equal to the total equity valuation of the company divided by its net income. Buyers will certainly consider net income in their valuation review, but it is not often the driving multiple because the net income at the bottom of the income statement does not equate to cash flow. Net income comes after noncash charges, such as depreciation and amortization and taxes. These metrics may be different at each company and not useful because they may be wildly affected by old acquisitions or irrelevant amortization. Also, tax rates for all companies differ.
Cash flow is what matters: Its cash that the buyer will use to pay the piper, not net income. Thats why buyers use EBITDA minus average capital expenditures to value their companies. As always, cash flow is king.
What If There Is No EBITDA?
Weve talked a lot about valuation based upon EBITDA, but what if the company is losing money or is currently a not-for-profit business and there is negative EBITDA? In this case, naturally, you rely on metrics other than EBITDA to value the business. As always, look at all the industry comparables to see which metrics make sense. Do most companies in the sector trade at some multiple of revenue, such as 50 percent of annual revenue? If so, thats a guideline that can be useful. One rule of thumb in a situation where the company is not making money is to go to the balance sheet for valuation guidance. In this case, the net worth or net equity line on the balance sheet is a good guide for valuation. You might also look at liquidation value of all the assets and liabilities as a guide.
There are some businesses that simply have no value or negative value. With any luck, your business is not one of them. But if it is, there still may be opportunities to create a sale. If the company is losing money and has a poor balance sheet, perhaps you will have to pay the buyer to take the company. Believe it or not, there are hundreds of deals done that way every year.
If the business happens to be a not-for-profit company that is converting to a for-profit model, the same rules as above apply, such as looking at comparable multiples of revenue as indicators of value. In this instance, though, other matters than financial issues would be of paramount importance, such as asking whether a previously not-for-profit company has the mentality, human resources, and capital base to venture into the for-profit world to compete with long-standing for-profit competitors.
Excerpted from Sell Your Business Your Way by Rick Rickertsen, Robert E. Gunther, Michael Lewis (Foreword); AMACOMSeptember 2006