InSight

Exit and Growth Strategies for Middle Market Businesses

Preparing For An Exit – Part 1

By Matthew Bishop | Jul 14, 2015

Preparing for an ExitIs your Company worth what it should be?

When we meet with business owners, we always find it interesting to hear what they think their company is worth.  We have a slide in our pitch book that has two words on it – “EXPECTATION” and “MOTIVATION.”  This slide always generates interesting conversation.  Often the owner has an inflated expectation of his company’s worth and when asked how they came up with that value, the response has nothing to do with the company’s operations but what the owner needs for retirement.  As such, we should probably add a third word to the slide – “REALITY!”  We thought it would be germane to discuss three things: 1) how to value your company to determine if that amount is sufficient for you to retire on, 2) what drives value, so you can take actions now to increase your value, and 3) when is the best time to sell a privately held company.  We might be biting off too much, so for the blog post we are breaking this into two parts:  1) how to value your company and 2) how to increase the value of your company and the timing issue.  Is it time to sell?

Valuation:

When valuing your company, there is only one value that truly matters: the one someone will pay you for your company. You can hire the best valuation firm in the world to derive what they think your company is worth, but that valuation is not worth the paper it is printed on until a buyer makes a genuine offer at that value. We are not saying that a formal valuation is a waste of time. There are numerous legal reasons that effectively mandate a company to hire a third party firm to perform a valuation. However, the valuation does not determine the value of the company – the market does. Until a willing buyer and willing seller agree to a price, fair market value has not been achieved. Another nuance to understand is that when we discuss the value of a company, we are referring to Enterprise Value (“EV”). EV is not the equity value that the owner gets to pocket upon the sale of his company. EV is the total value of the going concern and includes a company’s debt and cash. Formula 1 below calculates EV and after a little manipulation, Formula 2 solves for Market Equity (“ME”).

EV=ME+Debt-Cash   (formula 1)

ME=EV-Debt+Cash   (formula 2)

The first thing to notice in both formulas is that if your company does not have any debt or cash, then EV equals ME. If you have too much debt, your ME could be zero. To calculate ME use Formula 2 and plug your company’s total debt and cash from your most recent quarterly balance sheet. The only remaining unknown is EV, which we will show you how to calculate later in this paper. Once you calculate EV, you will know the ME of your company, or the pretax amount that you pocket post close. There are three basic ways to calculate EV, and we will discuss each in the following paragraphs. While all have merit, the different methods have specific applications and provide better results depending upon the circumstance in which each is used. Valuation firms typically incorporate all three methods by using a weighted average to determine your specific EV.

The first method is the discounted cash flow (“DCF”) analysis, a forward-looking methodology generally used by Wall Street analysts to place a value on a publically traded company. When you hear that XYZ’s analyst has a buy rating, and gives the stock a target price of $100, the analyst has used a complex DCF model to determine his estimates. This way he can make the appropriate call to buy or sell a stock based upon where it is trading in the market. The analyst projects a company’s future cash flows (usually five years out), a terminal value, and then discounts these to derive today’s value and value in a year’s time. The other portion of the DCF is estimating the discount rate to use. The discount percentage is based upon a whole slew of economic indicators and corporate issues that could change over the time. Regardless, there is a lot of art to this science. How many of you can predict, with any certainty, your revenue for the next year let alone the next five? How many of you reading this are publicly traded? Even large, publicly traded companies have difficulty predicting the future. For example, Tesla just announced quarterly car sales of 11,507, but most analyst that follow Tesla had factored only 10,500 cars. As a result, their valuation models were off and needed adjusting, so the market pushed the stock price up 4% for the day. Since the second quarter beat expectations, will Tesla continue this trend and blow away their annual estimate? Who knows? My point is that it is very difficult to predict the future. Due to the added difficulty of predicting the future performance of a small to midsized business (“SMB”), valuation firms typically under-weigh this method when calculating the weighted average of the three valuation methodologies. Further and more importantly, no buyer will pay you for the future value of your company. This is because the buyer will take credit for the future cash flows of your company, not you.

The second valuation method is the public comparable analysis or public comps for short. To complete the analysis, one must select a set of similar (industry, size, and performance) publicly traded companies. Use the financial statements from these companies and the stock market value of each. From this data, one can calculate ratios such as EV/EBITDA, EV/Sales, and P/E (both forward looking and trailing twelve month) and then average each metric to apply to your company. Public comp analysis is straightforward and simple to produce. For example, a widget maker with $100 million in revenue should not use Amazon as one of its public comps. Amazon is too large, does not have similar operations, nor is it in the same industry segment. One should use small, publically traded widget makers to achieve the best results. Since the valuation ratios are calculated from market values (buyers and sellers agreeing to a price), this technique is quite accurate for a company within the same industry and same size as the comparable set. Investment bankers rely on this method when valuing a privately held company preparing to go public. However, companies that are not about to go public have to adjust the resulting valuation downward for liquidity and any other metric that is not on par with the public comps. A NYU Stern School of Business paper quantified the liquidity discount. It found that the discount ranges from 30% to 35%. Valuation firms will usually place greater importance on a public comps analysis than a DCF because it uses verifiable financial numbers and market values.

The third method uses databases of actual acquisitions that have closed, meaning they are based on fair market values. Companies aggregate this data to sell to companies like CFA. These databases can be sliced and diced by industry, company size, transaction date, and other inputs. Corporate Finance Associates subscribes to multiple databases to aid in our valuing your company. Similar to creating the public comp analysis, the acquisition comparable set of companies is very important for creating meaningful results. The old adage of garbage in, garbage out holds true. The actual analysis is very similar to the public comp analysis, only there are no company names. Further, by using only similarly sized, privately held companies, one does not need to use liquidity discounts. This method for valuing a company is highly accurate when there are sufficient comparable transactions of like companies. Valuation firms typically assign the greatest weight of the three valuation methodologies. Additionally private equity funds almost exclusively use this method when valuing a company to place an offer.

The following formula is a very good rule of thumb you can use to calculate the EV of a basic manufacturing company that has at least a 15% EBITDA margin and is operating smoothly:

EV=Adjusted EBITDA ×5   (formula 3)

We use adjusted EBITDA as most owners of privately held companies run expenses through their P&L for tax or personal reasons that another buyer would not.  As such, we back out these expenses to provide a buyer with an idea of how the company would perform if they took it over.  Typically, these add backs increases EBITDA and subsequently your value.  Using Formula 3, you can calculate your EV and plug it into Formula 2 to determine your ME.  We included an example to the right for you to see how we determine your value.  On an after tax basis, is this enough to retire on?  If not, Part 2 will discuss valuation drivers.

Posted by Matthew Bishop.

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