From mega mergers handled by the power brokers on Wall Street to the local dry-cleaning operation being sold after 50 years of family ownership, selling and buying companies represents big business. But how does this whole exit strategy thing work? Or more importantly, how are the values for these transactions determined? Is it similar to residential real estate, where appraisals are often used as the basis for the valuation? Or is it as simple as looking at a balance sheet to determine what the net owner’s equity balance is? This post explores the basics of business valuations, as well as summarizes the most common business sale types and structuring issues and the risks associated with each.
Your business’s financial statements represent the heart of the business valuation discussion. If you don’t understand your financial statements and, more importantly, how much cash flow is generated from your business, then you won’t understand the business valuation process.
Why One Needs Business Valuations
Business valuations are critical to managing an operation. On the surface, they tell you how much a business is worth and (more importantly) how much you can make from owning all or a portion of it. Everyone has heard the stories about the young entrepreneur, starting a business in his garage, selling it years later for millions of dollars, and living the good life in sunny Southern California. There is no question that determining your potential windfall represents an important reason to calculate the value of a business but it’s just one of the many uses of this all important piece of data.
Assuming that a business valuation is needed only to support the eventual sale of your company can be dangerous. Business valuations represent an essential part of the ongoing business management function in terms of properly protecting business assets.
The “Why” part of valuing a business (beyond the obvious) is often more important than the “How” for many reasons:
- Business insurance: All businesses utilize insurance to manage operating risks. The most widely used insurance types are general liability (to protect against a customer claiming damages from using the company’s product or service), workman’s compensation insurance (mandated by almost every state in the country to cover injuries suffered by employees), directors and officers (to provide additional liability coverage to the directors and officers of the business), and medical/life (coverage provided to employees for health, medical, and death-related claims). In addition, almost every business utilizes property and causality insurance to protect the company’s assets from damage and/or loss of use. The basis for determining the property and causality insurance premium is a function of both tangible and intangible assets. Understanding the value of a business assists in securing the proper type, form, and amount of property and causality insurance, which includes the value associated with loss of use. Companies often mismanage this issue in an effort to reduce expenses at the risk of exposing the organization to lost income and cash flow streams. Improper insurance coverage can cost a company mightily in terms of impairing its business value.
- Life insurance and business planning: Most businesses are privately held by a family, small group of owners, or individually. Quite often, a need arises to value the business for planning purposes. For example, a corporation may be owned by three partners, all of which are married. In the event one of the owners dies, the remaining owners may want to purchase the deceased owner’s interest in the company from the surviving spouse rather than have the surviving spouse become a partner (which can often lead to significant management problems). Often, companies purchase term life insurance on each owner to provide enough coverage to purchase the interest held. Hence, if a company is valued at $10 million and the deceased partner owned 25 percent, term life insurance of approximately $2.5 million is required. Rather than utilize internal resources to purchase the interest (which the company may not have or would place it in a difficult operating environment), the partners can use life insurance to help protect all the parties’ interests. Clearly, having a business value established becomes an essential part of the planning and management process.
- Individual estate planning: Estate planning is similar to life insurance and business planning. Large, illiquid individually held investments can wreak havoc with estate planning and taxation issues if they’re not properly planned for and understood. Having a firm and fair business valuation available that supports the worth of the investment can assist with both the estate management process, as well as provides for a solid data point for financial planning purposes. Estate taxes that aren’t planned for are not only a problem for the estate, but may even be more of a problem for the business itself as a result of a forced or premature sale. That is, if the estate can’t secure the necessary funds to cover the estate taxes, it may have no other option but to sell its interests in the business, which may result in new partners/investors or, worse yet, a complete business liquidation.
- Business management: Business valuations represent an essential element of almost any employee equity participation plan. Businesses often provide long-term compensation incentives to their employees via various forms of stock option or equity participation plans. Basically, the goal is to provide employees with an opportunity to generate future income and compensation in exchange for committing their services to the company for an extended period of time. Business valuations are multibillion dollar defense and technology company headquartered in San Diego, used to establish (before the company went public) a fair market value for its stock on a quarterly basis so that all its employees, investors, and other interested parties have a fair basis on which to base investment decisions. If an employee needs to liquidate shares owned and sell them back to the company, a fair value or per share price is readily available. Determining the business valuation in this case supports an invaluable management tool.
- Strategic business decisions: In today’s economic environment, a change in business direction, for whatever reason, can occur almost overnight. A market that once looked like it held all the promise in the world can quickly change, resulting in the need to liquidate or terminate the business unit. As such, having a reliable business valuation available can greatly assist management with making quick decisions. Having a reasonable business valuation available to assist management with making these types of business decisions is always helpful. Every business should have a board of directors, or at least an advisory board, to assist with managing its operations and provide guidance on more macro-level business issues. These boards can provide invaluable management advice and assistance to any size operation and/or organizational structure. Selecting board members that have had real-life experience in buying, valuing, and selling businesses brings an additional resource that you may not have ever thought about. In addition, advisory and board members can offer additional support with a vast array of business issues ranging from managing rapid growth to supporting the company during times of crisis.
The need to value a business goes well past just “looking to cash out” or determining what it’s worth. Business valuations represent an extremely important piece of information supporting a company’s strategic business planning process and management functions. The real question lies in why this information is needed and how it can be used to better plan for the future.
How Businesses are Valued
Business valuations are based on the present value of future cash flows. No matter what valuation model, methodology, logic, concept, technique, and/or principal is used, they all come back to the company’s ability to generate cash flow. Even when a company is being liquidated, the end value is based on how much cash will be left over for the equity investors. Simply put, cash flow reigns as king when valuing a business.
When placing a value on a business, you should become familiar with the time value of money concept (or the present value of future cash flows). Simply stated, the time value of money concept assumes that a dollar in your hand today is worth more than a dollar in your hand next year, two years from today, and so on.
Although many business valuation models exist, two valuation techniques are particularly common and the easiest to understand:
- Cash Flow Multiple method: This method is applicable to most small- to medium-sized business operations and is often referred to as the Main Street approach. Under this method, a cash flow multiple is applied to a company’s expected/future adjusted cash flow stream. This adjusted cash flow stream is most commonly referred to as EBITDA (see sidebar). Generally speaking, cash flow multiples range from 3 to 6 (but can be higher or lower) and are influenced by a company’s perceived risk and growth factors. In addition, it should be noted that historical cash flow information tends to be used as a basis or starting point when calculating the expected/future “adjusted” cash flow stream. For example, if a company’s average EBITDA for the past three years has been $750,000 annually and a multiple of 4 is applied, the businesses’ value is approximately $3,000,000 ($750,000 × 4). This business valuation method is more widely utilized by Main Street due to the nature of how these companies operate (a high volume of relatively small and unsophisticated businesses compared to corporate America as represented by Wall Street).
- Price Earnings Multiple method: This method is most applicable to larger, publicly traded businesses and is often referred to as the Wall Street approach. Using this technique, a business valuation is derived from taking the net after tax profit of a company and multiplying it by a market driven factor. For companies that enjoy the prospects of high growth rates, dominant market positions, significant financial resources, and other positive business attributes — all of which translate into potential significant higher future cash flow streams — a multiple of 20 or more may be applied.
For businesses that are more mature with relatively steady cash flow streams, a lower multiple, such as 10, may be applied. This is one (but certainly not the only) reason why a company such as Microsoft may be valued using a factor of 23 whereas Exxon may only be valued using a factor of 12. This technique is most prevalent with publicly traded companies listed on the New York Stock Exchange, NASDAQ, and other markets. The market quickly and efficiently establishes the total value of the company (its market capitalization) that is readily available at any point in time.
In addition, note the following key valuation issues:
- Applying industry standards: You’ll often find that within certain industries, common valuation reference points are made, such as X x revenue, Y x gross profit, or Z x book value. For example, in the banking world, business valuations are often based in terms of what multiple on the bank’s net book value (or net equity) is achieved. Although this valuation technique may appear to be different, if you look close enough and apply the lessons of valuing a business on its ability to generate cash flow, you’ll quickly understand why one bank will sell for two times its book value and another at one times: its ability to generate cash flow.
- Using EBITDA(O) as the valuation basis: Business valuations tend to be based on a company’s ability to generate real or comparable operating income and cash flows (between similar companies operating in similar markets). The idea is to identify how much cash flow can be generated from the basic business operation as opposed to how much debt the business has incurred (producing interest expense) and how much has been invested in fixed assets (producing depreciation expense) to support the business. As an example, interest expense is added back to account for the fact that similar businesses may have been financed differently (one using debt and another using equity). While one of the businesses would have interest expense that would produce lower net profits, the other would not, producing higher profits. External business valuations need to extract the impact of how a company has been financed to properly calculate a real value for the assets being acquired. After the real value has been determined, the parties can then structure how best to finance the potential acquisition. (Refer to Chapter 10 for further information on business capital sources).
- Valuing businesses with negative cash flow: Quite often, businesses are assigned a value even when their cash flow stream is negative. For example, during the year after hurricane Katrina, a number of businesses lost significant amounts of money as they attempted to recover from the devastating affects of this natural disaster. Businesses would still be assigned a value given the fact that the market would anticipate an eventual return to being able to generate positive cash flow. Valuations take into consideration these situations in order to properly account for these one-time and/or extraordinary events. Business valuations are really based on two critical pieces of information. First is the expected or future cash flow the company has the ability to generate. Second is the multiple applied to the expected or future cash flow stream (by the market).
The Keys to a Successful Business Valuation
The hard thing about valuing a business lies in the great unknown of future cash flows and the risks associated with being able to generate future cash flows. While historical operations can provide a sound starting point to determine future cash flows, it can also be very misleading. For example, a biotechnology company in an early stage of clinical trials has no historical positive earnings or cash flows, but may hold an extremely high market valuation based on the promise of future cash flows from the eventual production and sales of a new drug. Or conversely, a cemetery operation may have a one-time event due to a liquidation of real estate holdings (held for a long time), which will be nonrecurring. Hence, future cash flows can be distorted by historical events that are nonrecurring (positive or negative). The key lies in the ability to calculate a core or operating cash flow figure on which to base the valuation.
The following examples, by no means all inclusive, provide a flavor for how cash flows can be adjusted to be used as a basis when determining the most appropriate business value:
- Expense savings: One company may be interested in acquiring a business that offers tremendous expense savings opportunities via implementing the concept of economies of scale. By combining the two entities, an unprofitable business now may actually produce a positive cash flow (which has value). The elimination of duplicate accounting functions, human resource tasks, distribution facilities, and so on are often cited in business acquisitions and can assist in supporting the valuation calculated for the business being acquired. Easy targets include duplicate business overhead functions, such as accounting and finance, because, generally speaking, two CFOs or even two accounting departments aren’t needed in the combined entity moving forward.
- Added expense removal: Pushing through other or personal expenses in closely held businesses has been around as long as the IRS (actually longer). Generally, these expenses aren’t necessary for the ongoing business to operate, but the owners take advantage of the tax break. Removing these expenses to increase cash flows can lead to higher business valuations. Examples of these types of items include retaining family members in various administrative or clerical positions that are more of a luxury, inflating owner salaries, or passing through various personal expenses associated with travel, autos, and so on. Of course, nobody is questioning the legitimacy of these expenses for tax purposes, but we have yet to find a company that does not test these waters somewhat.
- Potential cost increases: Certain companies may be at a stage where a significant reinvestment in capital equipment, assets, and so on is required to continue to support and generate cash flows. You need to factor in these one-time expenditures into a business valuation model to reflect the impact on future cash flows. While depreciation expense is added back to determine the proper EBITDA, this figure can also be reduced in the scenario where significant reinvestments in fixed assets are required to keep a company competitive, such as upgrading its facilities to meet new environmental regulations.
- Hidden assets: Certain assets may have a significant value present external to the core business. For example, a company may have purchased real estate years ago for future business expansion, but the property is no longer needed internally. To an outside party, the value may be substantial, and, as such, this hidden value needs to be reflected in the complete business valuation. Or conversely, this asset may be excluded from the business valuation and carved out from any potential analysis to capture the core value of the business.
- Intangible assets and/or intellectual property: Brand names, research in process, patents, trademarks, contracts for retail shelf space, and similar types of assets have the ability to generate significant cash flows if managed properly. While one company may struggle with generating adequate cash flows, another may prosper by applying its marketing or financial muscle to an intangible asset.
- Lost future business: In service organizations, a business valuation may decrease as a result of a key principal leaving or retiring. Anyone who has evaluated an acquisition within the service industry knows how critical this issue can be in terms of negatively impacting future cash flows.
If a partner of 30 years leaves, chances are a portion of his accounts will also leave, which in turn produces reduced future cash flow. This list could go on and on. When a business is valued, all elements and facts of importance must be evaluated in terms of determining what is the most reasonable future cash flow stream that can be expected. From a logic standpoint, it’s relatively easy to understand why a seller of a business would want to maximize the cash flow stream, or EBITDA, because a higher valuation would be received. Conversely, it’s also just as easy to understand why a buyer of a business would want to minimize the cash flow stream or EBITDA because a lower valuation would be provided to the seller.
To increase the value of a business, a higher multiple applied to the cash flow or earnings stream is desired. Conversely, in order to decrease the value of a business, a lower multiple is used. The following list, which isn’t meant to be all inclusive, covers factors that influence the multiple applied to the cash flow stream:
- Interest rates: Interest rates, simply stated, represent the cost of capital. For our purposes, the most common reference point for interest rates is the prime rate as established by the country’s largest banks. In today’s relatively stable interest rate environment, you can expect reasonable cash flow multiples. However, when the Federal Reserve Board even mentions that rates may rise, it should come as no surprise that valuations may be pressured lower. A simple business valuation concept to remember is that when interest rates rise, business valuations decrease. This concept is based on the premise that the opportunity cost for the funds used to buy a business will be higher, and, with all things being equal (including the EBITDA of a business), the valuation must be lower to produce the desired return.
- Growth potential: Higher growth opportunities translate into stronger future cash flow potential and demand higher multiples. Just ask the dotcoms of the late 1990s and early 2000s about how they received astronomical valuations based on the premise of extremely high future growth rates. From a business perspective, the more information, support, and data that you can provide a potential buyer about the growth prospects of your business, the higher business valuation you will receive.
- Length of cash flow stream: Cash flow streams that are longer and more secure or reliable produce higher valuation multiples than shorter, uncertain cash flow streams. If a company has patent production in place for the next ten years (supporting the cash flow stream) versus three years, it’s safe to say the valuation multiple will be favorable. This concept is commonly referred to as an Evergreen income stream. Just as it sounds, if you can produce cash flow streams that are forever green, cash flow multiples will increase.
- Liquidity of investment: If an investment is readily liquid with multiple buyers available, a higher multiple is generally provided. Nonliquid investments with limited market appeal increase risks and drive down valuation multiples. This concept is especially true on Wall Street, where the most widely held and largest publicly traded corporations may receive a higher valuation given the ability to readily sell investments on the open market.
- Management continuity: Management resources, experience, talent, and continuity represent critical elements of the business valuation process. In the infamous words of Gordon Gecko played by Michael Douglas in the movie Wall Street, nobody wants to buy or invest in a company that represents a dog with a different set of fleas. If the management team isn’t qualified to operate the business and produce continued cash flow, the multiple applied to the cash flow stream will suffer.
- Concentration or diversification risks: The higher the concentration or diversification risk, the lower the multiple. Two like companies with the same cash flow stream operating in the same industry may receive different valuations because one company may generate its revenue equally from 100 accounts and the other from just 10 accounts equally. The impact of losing one account in 10 is far greater than 1 in 100 and increases the concentration risk. While it may be nice to generate 35 percent of your revenue
and earnings from the Home Depots of the world, increased operating risks are present that may actually deflate the value of your business.
- Timing is everything: Just about everyone has heard this phrase at one time or another. For business valuations, timing really is everything in terms of driving higher multiples and increased liquidity. You need look no further than the robust valuation period experienced in the late 1990s that crashed within a period of roughly 12 months with the start of the new decade. Capitalizing on or missing the window of opportunity can significantly influence the multiple received.
The determination of the multiple to be applied to the cash flow stream really boils down the risks present: actual and perceived. Actual risks are relatively easy to understand and quantify and, as such, can be applied to the determination of the cash flow multiple in a relatively logical fashion. Of greater uncertainty are the debates that inevitability occur about perceived risks. These risks are much more subjective in nature and, if not properly managed and presented, can significantly impact the value of a business. Needless to say, the higher the risks, the lower the valuation multiple received, which in turn drives a lower overall business value.
There are no set rules in the business valuation game. While a seller may want to maximize cash flows and lower the risks (thus increasing the value), the acquirer may want to deflate potential future cash flows and increase the perceived risks (thus producing a lower value). Or, conversely, an estate may want to justify a lower valuation to reduce potential estate taxes, whereas the IRS may be more aggressive and increase the valuation for obvious reasons.
While the basic principals used in the business valuation process are relatively constant, cash flow and how the EBITDA(O) and multiples are managed or manipulated represent the real basis of valuing a business.
To realize the maximum valuation for a business, you must properly package, prepare, and present the business. This preparation goes well beyond getting your financial and accounting house in order because the business valuation and sales process involves a significant amount of subjective elements beyond just the numbers. You wouldn’t expect to realize the highest value when you’re selling a home that has a leaky roof, weeds growing in the yard, and clutter thrown about. Nor would you expect to receive a reasonable offer for your business with personnel or management shortcomings, excessive expenses, or improperly prepared and presented financial information. Timing, as they say, is everything, and, while important when valuing and selling a business, preparation and presentation are just as critical!
To this point, external professionals are often used to assist with this function. Top realtors often generate higher values (even with their commissions) for real estate properties if they know how to market and sell the properties. The same logic holds true for selling a business as the top business brokers, investment bankers, and/or mergers and acquisition specialists can enhance the value of a business and produce greater returns for the seller.