Business Valuations

Many people would argue that the “market” is the best judge of a business’s value. While true, it is not very helpful if business sellers or buyers go to market with unrealistic expectations.

For sellers, having the business professionally appraised or alternatively, assessed/evaluated by a professional with industry-specific M&A experience, is an important first step.

There are many ways to estimate the enterprise value of a business based on its historical financials, asset values (costs to replace or build), projected cash flow/earnings, comparable analyses, precedent transactions, or some combination of each. All approaches have their advantages and disadvantages with the true market value influenced by the prevailing conditions both in the general economy and the specific industry vertical the business operates in. There is no universally accepted best way to estimate the value of a private company in advance of a sale.

There are, however, a lot of resources that private company owners should think about utilizing before considering a sale. Whatever valuation approach is used, it should be a prerequisite for any sale process or direct dialogue with buyers. Taking the time to have an outside professional assess the value of the business will provide owners with some important insights on what will drive its value in the future. It is never as simple as growing the topline and bottom line, although growth is an important valuation driver.

A business appraisal by an accredited professional is often the best approach when there is a high percentage of the business value tied up in real estate and hard assets, in which the condition of those assets and their replacement value is crucial. Commercial/Industrial real estate values are largely driven by local economic forces, so hiring an accredited appraiser with local knowledge and experience is advisable.

M&A advisors and Investment Banks are likely better at assessing the current market trends and valuation multiples in specific industry verticals they participate in and are more likely to have insider information on actual trading multiples based on their prior experience. While analytics, models, databases, and projections are important and helpful, experience, insight, and knowledge of the industry dynamics, the buyers’ strategies, and the underlying market trends will provide sellers with needed perspective in advance of a potential sale.

Business Valuation Myths

Myths about private company business value abound in the private capital markets. Part of the reason for this is that there is often very little data to make accurate comparisons, or when the information is available, it is either out-of-date and/or there is little contextual information available. Another reason is that business value is not something most business owners think about regularly as they are often not talking to buyers, private equity groups, and other types of investors daily.

While precedent transactional data and non-publicly available deal insight by M&A advisors can be helpful, it is only part of the solution. Most buyers will spend considerable efforts to build out the financial models to carefully assess what a potential business is worth to them, and act/bid accordingly.

Myth #1 Myth #2 Myth #3 Myth #4 Myth #5 Myth #6 Myth #7

Myth #1 – The more valuable the business’s assets, the more valuable the business

While quality assets are a component of a business’s value, it is their ability to generate cash flow that drives value. Cash flow can be used to reinvest and grow the business, pay down debt, or be paid out to shareholders.

Typically, asset-light businesses trade at higher multiples than asset-heavy businesses, for the simple reason that cash flow is not tied up in replacing assets as they wear out.

Owned real estate can be an exception. It can also be a tricky component of the valuation assessment, as sometimes the value of the real estate has appreciated over time, but there have been no corresponding rent or lease expense increases that are based on the market. A highest and best use assessment of the property may indicate that most of the value of the business is in the real estate itself, rather than the operating business.

Myth #2 – Industry-standard EBITDA multiples or “rules of thumb” metrics can establish business value

Average multiples or “rules of thumb” metrics can, at best, crudely estimate value, and really should only be used as a “check” once a proper valuation assessment is made. By definition, an average means that most businesses are worth more or less than the average.

There are dozens of interacting factors that are unique for each business that impacts the future cash flow it can reliably generate, and therefore its value. Two companies with the same sales and the same EBITDA may be worth entirely different amounts based on differences in customer/revenue quality, supplier relations, location, etc.

Myth #3 – Enterprise value equals equity value

Private company M&A transactions are normally on a cash-free, debt basis, regardless whether it is structured as an asset or share deal. In other words, the buyer will pay the seller what they think the business is worth to them (the enterprise value), but the seller will have to use the proceeds to pay off any debt, including lines of credit, term debt, loans from shareholders or related parties, tax liabilities, etc. On the flip side, if the business has no debt and there are cash or cash equivalents on the balance sheet, the seller normally will keep the cash, or it will be added to the purchase price adjustment at the close.

The enterprise value equals equity value myth is most common when the buyer’s offer is to acquire the shares of the business. Of course, there are situations where a buyer purchases the existing shares of another shareholder and thereby assumes its pro-rata share of any liabilities, including debt. This is more common in minority deals, or when the debt terms are more favourable than what a buyer could obtain on their own. But remember, the pro-rata share value does not equal the pro-rata enterprise value.

Myth #4 – Working capital assets such as inventory and receivables are added to the business value

The logic here is how can a buyer know the inventory and receivables value if they are changing daily. Therefore, they must be added to the purchase price at close. The truth is that current assets used to operate the business are part of the business value, however, they are offset by current liabilities such as trade payables, prepaid operating expenses, etc. In other words, it takes a certain amount of working capital to operate the business, and the enterprise value includes an appropriate and negotiated amount of working capital, regardless if it is financed by a line of credit or cash on hand.

The exception may be for very small “main street” type businesses where the owner sells the business plus the inventory on hand at close at cost.

Myth #5 – Owner-benefit add-backs

It is not uncommon for closely-held businesses to accrue some benefits to their owner(s) as business expenses, to minimize taxes. After all, no one likes to pay more taxes than necessary. Legitimate owner-related expenses such as a company car, travel, meals, etc., should not be added back to earnings when the financials are presented to a potential buyer unless they are “above market” or it can be demonstrated that they will disappear under new ownership.

While personal items such as the family cottage renovation expenses or the country club membership should be added back, it forces buyers to distinguish between a legitimate future business operating expense and those that will be non-recurring. This can create uncertainty and can impact a buyer’s perception of value as well as their appetite for completing a deal. It rarely is as simple as identifying and adding back the personal historical expenses.

It is always best to have clean financials, (or even audited statements), purged of any unjustifiable personal expenses, for at least a few years before the sale of the business. This may mean the business will pay more in taxes but it will help bridge any gap between taxable income from the company’s tax filings and the financial statements. Most professional buyers will value the business based on GAAP (Generally Accepted Accounting Principles) or some other accounting standard such as IRFS (International Financial Reporting Standards) rather than OAAP (Owner Accepted Accounting Principles).

Myth #6 – Growth projections – The buyer will pay for the business’s growth potential

While this is partially true, the proverbial “hockey stick” projections presented by an overly optimistic seller is usually highly discounted by a buyer, especially if it is based on a strategy that the seller has little experience in executing. Buyers will make some assumptions on growth as they build their valuation models, however, those assumptions will be mostly based on historical trends. Anything above this trend will be treated more as “ideas” rather than viable projections. While ideas create optimism on what may be possible for a new owner, any tie-in to the financial projections should be layered-in and presented more as speculative potential, rather than true projections. It is important to separate what is doable based on track record and what is possible based on new ideas, wherever possible.

Myth #7 – The buyer will pay the seller for potential post-acquisition synergies

Synergies can be cost savings, such as when redundant personnel are eliminated post-acquisition, or revenue synergies, such as cross-selling opportunities. While the magnitude of synergies varies by each potential buyer, their value may not be reflected in an offer to the seller, since there is a risk that the synergies will not materialize. Of course, there are always exceptions. For example, where a big industry player makes a highly strategic acquisition and pays an outsized multiple for a scarce asset. But in normal M&A transactions, the buyer will tend to pay the least amount they can or at least no more than fair market value (FMV). They will often only make offers that exceed FMV when they are pushed via a competitive marketing process. Even then, many strategic buyers exercise discipline and will not pay more than their perception of FMV, particularly if have a robust pipeline of potential acquisition targets and can simply “move on” to the next target.

There can be situations when there is a strong case for a buyer to use some of the future expected synergies to sweeten an offer beyond FMV to knock out other competitors from acquiring a target. However, in most cases, both cost and revenue synergies are used primarily to justify the acquisition with internal stakeholders, such as lenders, outside shareholders, or investors.

Bridging Valuation Gaps

Business sellers often think their business is worth more than what a buyer is willing to pay for it; at least, what they will pay as an upfront payment of “all cash.” That’s not to say that either party is right or wrong, it’s just both parties view the risk/reward balance from a different frame of reference. Deal negotiations almost always involve some degree of compromise.

Earnouts Milestone payments Holdbacks Seller financing Equity rolls carveouts Commercial Relationship Protections Real Estate transition plans

Earnouts

The use of an earnout is one common mechanism buyers and sellers of private businesses can use to simultaneously satisfy both parties differing viewpoints on business value and its growth potential. Since buyers often remain skeptical of the sellers’ projections, particularly when there are a lot of market uncertainties, the earnout can help mitigate those concerns, as payment is made when expected results materialize. Earnouts are usually based on meeting certain future financial metrics, such as sales, or EBITDA.

Milestone Payments

Similar to the earnout, a milestone payment is when a buyer agrees to make additional cash payments to the business seller(s) after the transaction closes, contingent on the occurrence of a certain agreed-upon event(s). Normally, it applies to situations where the seller has laid the groundwork for a significant event that will positively impact the business and thereby negotiates a cash payment should that event occur under new ownership within a given time frame. For example, if the business obtains a new “game-changing” customer, a patent is granted, a new product is granted regulatory approval, etc.

Holdback in Escrow

When the buyer and seller disagree about the potential financial impact or risk associated with a potential future event, the parties can agree to place a portion of the purchase price in escrow, subject to payout to the seller if the event remedies itself, or repaid to the buyer if it doesn’t, within an agreed-upon time. Examples could include the outcome of a lawsuit or a product regulatory review. Holdbacks are standard practice in the M&A negotiation process as protection for the buyer against misrepresentations by the seller, but can also be used as a tool to bridge differences in perspective of the likelihood of certain negative events occurring in the future.

Seller Financing or Vendor Take-Back (VTB)

Sometimes the simplest solution for a value gap can be solved when the seller agrees to help finance the deal with a vendor take-back note secured by the company’s assets and/or personally by the buyer. It helps the buyer acquire the business based on the future cash flow it generates. This is very common with “main street” deals and in the lower-middle market, as access to competitive financing is often less robust for smaller buyers. It also demonstrates confidence in the business and its outlook by the seller. While there are many ways in which deals with owner-financing can be structured, in general, most sellers will want to stay involved in the business to some degree to keep an eye on their ongoing investment and the ability of the buyer to eventually pay out the VTB.

Equity Rolls

Like the VTB, when a seller agrees to re-invest proceeds as equity back into the business, it demonstrates confidence in its future potential and therefore can be a means of obtaining a higher valuation. Unlike the typical VTB, it allows the seller to share in the upside potential of the business, however, the seller will also share in the relative risk associated with the business.

Equity rolls are common in PE-sponsored deals, but less common when the buyer is another industry participant (strategics). Full liquidity of the investment normally comes naturally when the PE-sponsored acquirer sells the business (usually 3-7 years after its initial investment) but it can be a little trickier in strategic buyer equity rolls. When a future sale of the entire business is not anticipated in the foreseeable future “Put Options” can be a solution. This is when the seller negotiates an option to sell some or all of its rolled equity to its equity partner at fair market value during an agreed-upon period in the future.

Product Line or Business Unit Carveouts

Buyers often have specific reasons why they want to acquire a business, whether it is gaining market share, scaling operations, capturing synergies, or simply putting capital to work. However, there is usually no perfect business that meets all its objectives. Sellers need to be keenly aware of the attributes of their business in which the potential buyer sees the most value, and conversely the aspects of their business in which the buyer sees little value. Sometimes, it may be possible to carve out those components of the business in which the buyer places little value, to retain or sell to another buyer in the future. For example, there may be patents, products in development, products/product-lines, business units, facilities, etc. in which a carveout could bridge a valuation gap.

Preferred Terms for an Ongoing Commercial Relationship

In some cases, buyers and/or sellers may be able to negotiate a preferential business relationship to help bridge differences in value. For example, the seller could provide products or services to the buyer at preferred rates for an agreed-upon period, in turn for paying a more attractive price for the business.

Anti-Embarrassment Protection

Some sellers are afraid that a buyer will acquire their business and simply “flip” it in a year or two at a much higher value. On occasion, it may be possible to use an “anti-embarrassment” provision whereby if a flip were to occur within an agreed-upon time, the buyer is required to share a portion of the proceeds with the original seller. This is used mostly when the seller is forced to sell for some reason.

Retention of Real Estate

Many times buyers are more interested in the operating business than any real estate that is owned by the business. Sellers can sometimes retain the real estate and lease it back to the new owner, thereby reducing the purchase price for the buyer and gaining a stream of future income. Sometimes the seller can agree to lease the real estate at preferred rates to further bridge valuation gaps. This approach can also potentially defer some taxes for the seller.

Transition Plans

A large part of the value of any transaction lies in the retention of key people, often including the owner and/or management team. Sellers that are open to working with the new owner through a transition period can help reduce the risk for the buyer and thereby help bridge valuation gaps.

Business Valuation Drivers

Financials

  • Level 1: More than $2-3 million EBITDA, Level 2 >$5 million EBITDA, Level 3 > $ 10 million EBITDA
  • EBITDA margins greater than 10%
  • Asset light and high free cash flow (FCF)
  • Short cash flow cycle (i.e. high inventory and receivable terms, favourable supplier terms, etc.)
  • Audited/reviewed financials
  • Limited owner-benefit addbacks

Company Growth

  • Solid track record with demonstrated historical growth
  • Clear growth strategy with defined path
  • Scalable business model
  • High future growth relative to required investment

Markets Served

  • Growing market with identified and known industry drivers
  • Proprietary/unique/value-added products and/or services
  • High barriers to market
  • Limited well-financed competitors
  • Specialized market position
  • Large addressable market with wide geographical reach
  • Low cyclicality

Assets

  • Well maintained and high-quality asset base
  • Strong return on fixed assets with limited capital expenditures
  • Limited working capital assets such inventory and accounts receivable

Revenue Quality

  • Long-term customer contracts with recurring revenue
  • Broad customer base with limited customer or product concentration
  • Long-term customers with low turnover and high loyality
  • Products with limited substitutes
  • Products with low cost to value

Human Resources

  • Talented management team that will remain with new owners
  • Low reliance on owners or any specific individual
  • Specialized and well-trained workforce
  • Clear succession plan with promising next-level management
  • Professionalized HR practices (recruiting, on-boarding, performance management, incentive programs, etc.)
  • Low employee turnover with long average tenure

Operations

  • Operate in a favourable jurisdiction (tax rates, labour laws, regulatory environment, etc.)
  • Stellar safety and litigation record
  • Certifications (ISO, etc.)
  • Documented SOPs