“As shocking as it may sound, I believe that most owners of middle market private companies do not really know the value of their company and what it takes to create greater value in their company … Oh sure, the owner tracks sales and earnings on a regular basis, but there is much more to creating company value than just sales and earnings”
Russ Robb, Editor, M&A Today
Creating value in the privately held company makes sense whether the owner is considering selling the business, plans on continuing to operate the business, or hopes to have the company remain in the family. (It is interesting to note that, of the businesses held within the family, only about 30 percent survive the second generation, 11 percent survive the third generation and only 3 percent survive the fourth generation and beyond).
Building value in a company should focus on the following six components:
- the industry
- the management
- products or services
- comparative benchmarks
The Industry – It is difficult, if not impossible, to build value if the business is in a stagnating industry. One advantage of privately held firms is their ability to shift gears and go into a different direction. One firm, for example, that made high-volume, low-end canoes shifted to low-volume, high-end lightweight canoes and kayaks to meet new market demands. This saved the company.
The Management – Building depth in management and creating a succession plan also builds value. Key employees should have employment contracts and sign non-compete agreements. In situations where there are partners, “buy-sell” agreements should be executed. These arrangements contribute to value.
Products or Services– A single product or service does not build value. However, if additional or companion products or services can be created, especially if they are non-competitive in price with the primary product or service – then value can be created.
Customers – A broad customer base that is national or international is the key to increasing value. Localized distribution focused on one or two customers will subtract from value.
Competitors – Being a market leader adds significantly to value, as does a lack of competition.
Comparative Benchmarks – Benchmarks can be used to measure a company against its peers. The better the results, the greater the value of the company.
Three keys to adding value to a company are: building a top management team coupled with a loyal work force; strategies that are flexible and therefore can be changed in mid-stream; and surrounding the owner/CEO with top advisors and professionals.
There is the old anecdote about the immigrant who opened his own business in the United States. Like many small business owners, he had his own bookkeeping system. He kept his accounts payable in a cigar box on the left side of his cash register, his daily receipts – cash and credit card receipts – in the cash register, and his invoices and paid bills in a cigar box on the right side of his cash register.
When his youngest son graduated as a CPA, he was appalled by his father’s primitive bookkeeping system. “I don’t know how you can run a business that way,” his son said. “How do you know what your profits are?”
“Well, son,” the father replied, “when I came to this country, I had nothing but the clothes I was wearing. Today, your brother is a doctor, your sister is a lawyer, and you are an accountant. Your mother and I have a nice car, a city house and a place at the beach. We have a good business and everything is paid for. Add that all together, subtract the clothes, and there’s your profit.”
A commonly accepted method to price a small business is to use Seller’s Discretionary Earnings (SDE). The International Business Brokers Association (IBBA) defines SDE as follows:
Discretionary Earnings – The earnings of a business enterprise prior to the following items:
nonrecurring income and expenses
non-operating income and expenses
depreciation and amortization
interest expense or income
owner’s total compensation for one owner/operator, after adjusting the total compensation of all other owners to market value
Here are some terms as defined by the IBBA:
Owner’s salary – The salary or wages paid to the owner, including related payroll tax burden.
Owner’s total compensation – Total of owner’s salary and perquisites.
Perquisites – Expenses incurred at the discretion of the owner which are unnecessary to the continued operation of the business.
Developing a Multiplier
Once the SDE has been calculated, a multiplier has to be developed. The following (just as a guideline) should be rated from 0 to 5 with 5 being the highest. For example, if the business is a highly desirable business in the current market, “desirability” would be rated a 4 or 5. If the business is in an industry that is quickly declining or nearly obsolete, “industry” would be given a 0 or 1 rating.
Age: Number of years the seller has owned and operated the business.
- Terms: Is the seller willing to offer terms? For example, will the seller accept 40 percent as a down payment with the seller carrying back 60 percent at terms the business can afford while still providing a living for the buyer?
- Competition: Consider the local market.
- Risk: Is the business itself risky?
- Growth trend of the business: Is it up or down?
- Desirability: How popular is the business in the current market?
- Industry: Is the industry itself declining or growing?
- Type of business: Is the business type easily duplicated?
The average business sells for about 1.8 to 2.5. Obviously, if the SDE is solid and the multiple is above average, the price will be higher. Keep in mind that the price outlined includes all of the assets including fixtures and equipment, goodwill, etc. It does not include real estate or saleable inventory. The price determined above assumes that the business will be delivered to the buyer free and clear of any debt.
When all else fails, the words of a veteran business broker will work.
Asking Price is what the seller wants.
Selling Price is what the seller gets.
Fair Market Value is the highest price the buyer is willing to pay and the lowest price the seller is willing to accept.
Sellers should keep in mind that the actual price of a small business is about 80 percent of the seller’s asking price.
1. Start with the business
– Value Drivers: Size, growth rate, management, niche, history
– Value Detractors: Customer concentration
Lack of agreements with employees, customers, suppliers
Poor exit possibilities
Potential technology changes
Product or service very price sensitive
2. Financial analysis: Market Value – comparables
Multiple of Earnings – based on rate of return desired
3. Structure and terms: 100% cash at closing could reduce price 20%
4. Second opinion: Even professionals need a sounding board
5. Indications of high value:
– High sustainable cash flow
– Expected industry growth
– Good market share
– Competitive advantage – location/exclusive product line
– Undervalued assets – land/equipment
– Healthy working capital
– Low failure rate in industry
– Modern well-kept plant
6. Indications of low value:
– Poor outlook for industry –
– Distressed circumstances
– History of problems – employees, customers, suppliers, litigation
– Heavy debt load
“There are many reasons for valuing an entity, and those circumstances can lead to different outcomes…For instance, a business’s value for sale on a going-concern basis will differ from its value for liquidation purposes. It similarly makes a difference if the valuation is for an orderly liquidation as opposed to a forced one. For example, the value of a company for estate-tax purposes (fair market value) likely will differ from its value for a sale to a specific purchaser (investment or strategic value). In some instances involving litigation, the courts or the law may dictate which standard of value to use.”
Source: Journal of Accountancy , August 2003
The two variables – EBIT and DCF numbers – are affected by not only the financial aspects of the business but also the non-financial aspects, which can be both objective and subjective. For purposes of buying or selling a company, it is important for the seller to determine the floor price (the lowest acceptable price) and for the buyer to determine the walk-away price (the highest possible offer). Valuing companies may be more of an art than a science, but there are three basic factors that buyers focus on when trying to establish a price for a target company.
1. Quality of Eearnings
i.e., not a lot of “add-backs” or one-time events like the sale of real estate which does not reflect on the true earning power of the company’s operations. It is not unusual for companies to have some non-recurring expenses every year, whether it is a new roof on the plant, a hefty lawsuit, write-down of inventory, etc.
2. Sustainability of Earnings After the Acquisition.
The key question a buyer often asks is whether he is acquiring a company at the apex of its business cycle or whether the earnings will continue to grow at the previous rate.
3. Verification of Information
i.e., the concern for the buyer is whether the information is accurate, timely and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectible receivables? Is the seller above-board, or are there skeletons in the closet?
When a seller talks about earnings, earnings really needs to be defined; e.g., EBIT or EBITDA; last year’s earnings or this year’s projected earnings; EBITDA – CAP X; restated without prerequisites but with add-backs, etc.
When a buyer is analyzing earnings, is it for one year, three years, interim earnings annualized, combination of reporting periods, projections, etc.? What is the timeframe for measuring earnings and what is the trend of earnings?
Another concern in measuring earnings in the future is related to what changes might affect earnings, such as increase in rent, family members off the payroll, loss of key customers and/or vendors, etc. Beware of companies that are locked into long-,term contracts in which they are unable to raise prices or companies in a commodity-type business in which there is unrealistic market pricing.
The following questions are useful to understand the business and thereby value the company more prudently:
- What’s for sale? What’s not for sale? Does it include real estate? Are some of the machines leased instead of owned?
- What assets are not earning money? Should these assets be sold off?
- What is proprietary? Formulations, patents, software, etc.
- What is their competitive advantage? A certain niche, superior marketing or better manufacturing?
- What is the barrier of entry? Capital, low labor, tight relationships?
- What about employment agreements / non-competes? Has the seller failed to secure these agreements from key employees?
- How does one grow the business? (Maybe it can’t be grown.)
- How much working capital does one need to run the business?
- What is the depth of management and how dependent is the business on the owner/manager?
- How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?
Much of the information above will influence the person’s perception of value. Valuation is often in the eyes of the beholder, whether the price is rational or not.
Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.
The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.
So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.
However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.
Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.
Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.
Is there pricing elasticity?
What’s the company’s competitive advantage?
Status of employment agreements and non-competes?
Are there cost savings after purchase?
Are there significant capital expenditures pending?
Is there synergy with the seller?
Is it perceived the integration will go smoothly?
Are there substantial cross-selling possibilities?
Will the cultures blend?
The Financials: By training and education, many business appraisers emphasize the numbers. They will look at the past, current and future numbers. They will consider all the basic financial figures such as:
• growth rate
• return on investment
• gross profit percentage
• EBITDA percentage
• industry metrics
• debt to net worth
• book value
Fundamentals: Business appraisers should also consider the company’s history, its management, products, distribution, etc. The following should also be seriously considered: multi-products, different markets, wide distribution and the quality of management.
Value Drivers: These are important business elements that are most often ignored or completely overlooked by business appraisers. However, they are very important to a potential buyer.
• product differentiation
• defensible position
• dominant market share
• well-known brand(s)
• cost advantage
• proprietary customer