Valuation

“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
• customers
• competitors
• 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.

1. Start with the business
–  Value Drivers:  Size, growth rate, management, niche, history
–  Value Detractors:  Customer concentration
Poor financials
Outdated M&E
Few assets
Lack of agreements with employees, customers, suppliers
Poor exit possibilities
Small market
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 –
foreign competition
price cutting
regulations
taxes
material costs
– 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

Introduction

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?

Measuring Earnings

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.

Key Considerations

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?

Conclusion

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.