Valuation

ENL 5

Valuation, Step 4 in the Exit Strategy Process

What my business worth?

That's the question I'm asked most. And in this newsletter we will answer it. The quick and dirty answer is: whatever a buyer will pay. However, most privately held businesses sell for between three and six times cash flow! So what is cash flow? It's the cash the business generates. You can calculate it by taking pretax earnings plus interest plus depreciation and amortization plus adjustments for excess compensation and perks for the owners (or "under" compensation) less an allowance for on-going capital expenditures.

Sometimes you will see this number expressed as EBITDA less Cap. Ex. (Earnings before Interest, Taxes, Depreciation and Amortization less Capital Expenditures). Interest is added back to show the business on a debt free basis.

Each financing scheme of a potential buyer will be different, so the values are best stated on a pre-debt basis. Depreciation and amortization are added back because they are non-cash expenses.

The owner's excess compensation and perks are adjusted to show the company expenses with professional management. Note this means that an allowance to pay the professional manager must be left in as an expense. If the compensation and perk package of the owner is less than market, then the adjustment must reflect that, also.

An allowance for on-going capital expenditures is deducted to account for actual cash needs for capital expenditures.

What is the basis for the cash flow calculation? What the buyer is interested in is future cash flow. With perfect foresight the buyer would project the future cash flow and base the value on that. Since the future is unknown, the best indications of the future are usually the historical performance of the company. A typical buyer will use a weighted average of the past three to five years of history. This is a judgment call. Sometimes a projected year can be the basis if it is reasonable to assume the company will perform that way in the future. (A well-documented and reasoned business plan is very helpful in convincing the buyer of the value of the future.) How is the multiplier selected?

The multiplier is an assessment of risk on the part of the buyer. The reciprocal of the multiplier on a percentage basis is the ROI (Return On Investment) the buyer is looking at. For example a multiplier of 4 means 4 years to get their money back or 25% (1/4) ROI per year. A multiplier of 6 is an ROI of 16.67% (1/6). Why are the multipliers are so low (or the ROIs the buyers expect so high)? A tax-free municipal bond will yield 5 to 6% or about 9% on a pretax equivalent. This means one, with an investment in a municipal bond, could get a 9% ROI, relatively risk free. So an investor in a business would not base an offer on 9% ROI (11 multiplier) because he or she could get that from municipal bonds. So a buyer paying 4 times cash flow (25% ROI) is assigning 16 percentage points above the municipal bond yield to the risks of investment in the business.

These risks include among others: lack of liquidity (our average selling time is 11 months), responsibility of owning the business, the hassle of owning the business, and the risk in the transfer of the business (Is it going to perform as projected without the old owner?). So how does one determine what multiplier to use?

Professional appraisers have access to comparables of other similar transactions. To approximate, you can use the following guidelines: For multipliers of 3 to 4: Job shops, companies with high percentage of business with one customer or supplier, companies where the owner is a significant part of the business, consulting companies, contractors, cyclical businesses, small retail businesses, distributors, companies with strong unions.

For multipliers of 4 to 5: manufacturers, branded industrial products, stable growth companies, high growth companies from the above paragraph, small vertical market software companies, distributors with high value added content.

For multipliers of 5 to 6: high growth companies, consumer branded product companies. Implications of the multiplier to the seller. If your multiplier is 4, that means if you don't sell, you will have earned the value of the company in 4 years and still own a company worth 4 times cash flow. Said another way, you will make more money by keeping the company rather than selling it. So your motivation to sell must be something other than money!

When the multipliers don't work.

Obviously if you could liquidate the company for more than it's business value (as determined by your cash flow), then you would get higher value by liquidating it.

Or on the other hand, if a buyer could create a competitive company for less than your business value, then your chances of selling it for that business value are lessened.

If your company has the story and/or the numbers to go public, then the above multipliers don't work. Your market value will be much higher in the public market. This is because of the liquidity the public market brings.

A synergistic buyer might pay significantly more than the above multipliers would indicate. This is not because of increase in multiples, but because of the increase in cash flow created by the synergy of the situation. But, synergistic buyers may not be interested or available. Even if they are, their offer will not reflect the synergy of the situation unless they are forced into it by skillful negotiation or by a competitive synergistic buyer in an auction situation.

Sometimes the leverage a buyer can achieve will significantly reduce the down payment and thus increase the buyer's ROI, cash on cash. This leverage can be achieved when the business has high asset value that can be used as collateral for third party loans or when the seller agrees to finance part of the sale.

So what to do?

You are at step 4 in the Exit Strategy Process. If your value estimate meets your needs and expectations, have an appraisal by a professional appraiser to confirm the value and to have a basis for negotiating with buyers. (You should never tell buyers what your appraisal is as that tends to set the highest price you will be offered.) If the professional appraisal confirms the value, and you are willing to sell for the appraised value, then proceed with Step 5, Preparing the Business for Sale (next month's newsletter subject).

If your value does not meet your needs and expectations, You have three choices: 1) Do nothing, keep on keeping on. 2) Make the decision to sell based on the appraised value and move forward with Step 5 in the process, or 3) Make the business worth your expectations. To do that you need to do something different than you are now doing. This means you need to put together and execute a strategic plan (see my archived newsletter on Strategic Planning (ENL2) on our website, <www.sellingbusiness.com>.

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Tip of the Month

There are twenty-odd methods of valuating a business. The main on the buyer is interested in ROI, return on investment, cash on cash. How much down vs. expected return.

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Disclaimer

This publication is intended to help the reader understand the issues involved in selling a business. It is designed to provide information reflecting the experience of the editors and writers in helping sellers of businesses. It is prepared and presented with the understanding that the publishers, editors and writers are not engaged in rendering legal, accounting or other professional service. If legal accounting or other expert advice is sought, it should be acquired from competent professionals. The reader would be well advised to seek such professional assistance in the early stages of any consideration of the sale or purchase of a business.

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