Thursday, 27 October 2011

How Do I Attract a High Multiple for My Business: The Sale Process

I noted in the previous post that there are two broad answers to the question of: how do I attract a high multiple for my business.  The first concerns the business itself and the second concerns the sale process.  The when, to who, why and how much of selling.  I will address the sale process in this post.  The sale process cannot transform an average business into a high multiple business but, by following a few guidelines, it can result in a higher transaction value.
When to sell is the most important item to discuss here.  Not only in the context of the economy in general but also with respect to the business’s performance and the owner’s objectives.  The ideal time to sell is when there are positive trends in revenue and earnings with the expectation of more to come.  Growth is very influential in attaining a strong multiple and, while valuation is determined by future prospects, historical performance is the most common way to get comfort with those prospects. By historical performance I mean at least two years of consistent growth. Many businesses grow in steps.  A pattern of revenues at $20 million for several years and then jumping to $25 million does not present a convincing growth trend. Another jump to $30 million the next year will go a long way to realizing a growth multiple.  Ultimately, whether a buyer is convinced depends on how the growth was achieved and what the current prospects are.
The selling process is one that takes seven to ten months to complete and therefore you will always run into the question of: “are you on track”.. “can we have a look at the latest quarterly numbers?”  To underperform at this point is a worst case scenario. If you are four to six months into the process, then you will have already received a number of expressions of interest and are likely working with a small group of seriously interested parties.  A quarterly profit number below expectations will open up the possibility of a revision to the value/structure in an LOI and may cause serious delay in the process as an alternate buyer may need to be found.
The second most important consideration in the selling process is who to sell to?  I have written several posts about how to identify the best buyer (and I will address management as an option shortly) but, as an overriding comment, I would say your M&A advisor needs to run a thorough and diligent process.  The four phases of a divestiture are: plan, prepare, market and complete (I will expand on how an advisor can add value in each phase in a later post).  A critical factor in achieving a successful sale is to keep as many options open as long as possible.  The seller has power when he/she has choice.
Finally, the why of selling is not a key driver from the perspective of realizing the most value in a transaction but it is a factor in the form of consideration and how long the process will take.  Remember, if the business is dependent on the owner-operator, he/she will not be able to leave the business upon its sale.  If the owner-operator has spent 20 years in the business, is nearing retirement, has made him/herself redundant, then he/she is in a position to structure the transaction to include as much cash as possible and make the transition period as short as possible.  However, if the reason to sell part or all of the business is to take advantage of an opportunity to accelerate growth then, by partnering with a well capitalized entity that can bring investment, sales or distribution resources to the table, you may expect to spend many more years with the business.  Finally, the best time to sell may have passed if the owner is no longer interested in the business (he/she is spending more time on other interests) or, he/she is compelled to sell for health reasons or, as a result of changing competitive/technology dynamics that are substantially reducing the economic prospects for the business.
The sale process, from consideration to 100% out, can take many years and with economic uncertainty as it is, it is best to start the planning from a position of strength.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Friday, 21 October 2011

How Do I Attract a High Multiple for My Business: The Business Factors

There are two broad answers to this question.  The first concerns the business itself and the second concerns the sale process.  The how, when and why of selling.  I will address the business issues in this post; not to say invent a new mouse trap but from the perspective of what factors you can influence in your existing business to improve value.
In “The Basic Math of Valuations” I presented the risk return curve.  A company will attract a higher multiple if it moves to the left on the risk return curve; i.e. a higher multiple is paid for lower risk, but, the biggest driver in attaining a higher multiple is a company’s profitable growth prospects, and, this should already be evidenced by a historical growth record. 
Let’s look at the public markets for an illustration.  The dividend discount model asserts that the fair value of a stock is the present value of all future dividends.  The formula is as follows: fair value of a stock = DPS(1) / Ks-g, where the expected future dividend stream is divided by the required rate of return (Ks) minus the expected growth rate (g).  If a dividend is $5.00 and the required rate of return is 20% then the fair value of the share price is $25.00 ($5.00/0.2) according to this model.  If the expected growth rate is 10% then the fair value jumps to $50.00 ($5.00/0.1).  The growth rate lowers the required rate of return and increases the fair value of a stock.  In this case, 10% per annum growth translates into 100% price improvement.  That is a tremendous amount.  The real world experience is not as exact but the illustration demonstrates the logic and impact of growth prospects on company value.
The same logic applies to EBITDA growth for private companies.  Returning to the example provided in the previous post - a company sustainably generating $5 million in EBITDA is valued at $20 million, four times EBITDA, the equivalent to generating a 25% return on capital per annum - if this company were growing at 20% per annum, the multiple could quite readily improve to 6 or 7 resulting in a valuation of $30 to $35 million.  Again, not quite as exact as the formula but the results are still very substantial.
Now, turning our attention to reducing risk, here are some factors to consider:
Is the owner redundant?
The first thing to address when considering selling a business is to put a strong management team in place that can run the business without the owner.  An owner-operator who is the chief product developer or maintains all of the customer relationships will not be able to exit the business upon its sale.  He/she will have to commit to staying with the business until a suitable replacement solution is implemented.

Is the customer base diversified?
The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a smaller company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration.  While the growth that it drives will increase value the associated risk of these revenues will reduce value.

Are the revenues recurring or project based?
Does every fiscal year start at zero?  What I mean by that is, if your revenues are project based then you are always searching for the next deal.  Consulting companies typically face this challenge.  Along the same lines, a one product company is more risky than a diversified product and services company. 

These are three examples of situations where reducing the risk will increase the multiple but the concept applies in general; any combination of improving profitable growth prospects and reducing risk will increase the value of your company.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Monday, 10 October 2011

The Basic Math of Valuations – Why Mid-Market Companies Are Valued Lower Than Their Public Company Peers

For public companies, analysts express the value of a company as a multiple of earnings.  It is called the price-earnings ratio or P/E ratio.  If the price of a stock is trading at a low multiple (say eight times earnings) and its prospects are strong, it would be good value; at 50 times earnings that same company would probably be expensive.  For private companies we typically look at a multiple of EBITDA. Let’s say a company has been valued at $20 million; it can sustainably generate $5 million in EBITDA, then it is valued at four times EBITDA.  As I noted earlier, four times EBITDA is equivalent to generating a 25% return on capital per annum; more if cheaper debt is used to lever the equity (for an explanation of this see my “What Will a Financial Buyer Pay?” post).
How do you decide if that is a proper risk adjusted rate of return for your capital?  Risk adjusted is the key word here.  To figure this out we have to start at the risk-free rate and build on layers of risk to see where comparable assets should be priced.  We start with the risk-free rate.  The risk free rate is the rate generated by the most secure assets possible.  The proxy for this is typically federal governments.  They can print money at will so you can be assured you will get your money back (what it will be worth is another matter).  Countries such as Canada, Germany, Austria, and the Netherlands are rated AAA by S&P and are as close to risk free as you can get and therefore set the proxy.
Let’s say the 10 year risk free rate is 3%.  What is the next bucket of riskier assets?  State bonds, Municipal bonds, AAA corporate debt, AAA preferred shares?  All riskier, but lets jump straight to S&P 500 equity.  What is the risk premium of a top tier, multi-billion dollar S&P 500 company?  About 5% to 7% (note: even within the S&P 500, there are riskier subgroups.  i.e. cyclicals vs. consumer staples).  Adding this risk premium to the risk free rate, you get approximately 10%.  So getting back to my introduction, buying a S&P stock at 10 times earnings may very well achieve a proper risk adjusted return.
The concept of the risk-return curve is that it measures the risk premium required for riskier assets.  The idea is that you should be indifferent between different asset classes on the curve because you are being properly compensated for the additional risk.

Intuitively, it makes sense that a small private company is riskier than a S&P 500 company but what are the specific drivers of this?  A small private company typically has fewer customers, more customer concentration, comparatively a less established brand, a limited R&D budget, less access to funding sources (be it banks or equity investors) and much less liquidity for the holders of its equity to name a few key drivers and, as such it is riskier than an S&P 500 company. 
So is four times EBITDA a fair value for a small private company?  It could be, but it depends on many company specific risk-return factors such as its growth prospects, the nature of its revenues (highly recurring or project based) and the size and diversity of its customer base.  I will expand on these factors and their impact on valuations in future posts.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Thursday, 6 October 2011

Normalization Adjustments for Private Companies

Historical operating income of private companies often requires adjustments in order to present a number that a buyer can reasonably expect.  Profitable private companies will try to minimize their taxes payable.  This is simply good business practice.  However, one must be reasonable; for example, the spouse of an entrepreneur is paid $100,000 per annum for bookkeeping services.  In a small company that may be overpaying him/her and it may just be an approach to lowering household personal income tax; whereas, if he/she were to be an accredited accountant in a large company, it may even be underpaying him or her.  The tax authorities apply reasonability tests; the latter is reasonable, the former may not be.  Since tax minimization usually results in lower income (and therefore lower income tax payable); the adjustments will increase EBITDA and thereby provide the basis for a higher valuation of the company.
Adjustments are generally made for one-time events, discontinued parts of the business (or parts that are not being sold) and ongoing expenses that are either not necessary to run the business or not at market pricing.  Some examples of one-time items include start-up costs, certain product development/deployment costs, costs associated with new legislation or regulations, and lawsuits.  Ongoing expenses may include superfluous expenses such as luxury cars, boats and planes, summer homes expensed as regional offices, payments to family members not fully engaged in the business or at rates above the market rate, business trips that are really/mostly family vacations, personal tax and legal advise and personal bonuses or dividends that would be at the new owner’s discretion.  Conversely, when times are tough, entrepreneurs may pay themselves less thereby smoothing the impact of volatile revenues.  Entrepreneurs may wish to exclude bad debts or legal fees that they feel are excessive but in most cases these are recurring and necessary business expenses and therefore should not be eliminated.
Normalization adjustments are a delicate matter.  Too many and it becomes a red flag, raising concerns such as, “what are they trying to get away with here?” or, “with so many adjustments, does this reflect poor customer/supplier relationships? or, “there is probably more to it than that, I wonder what they are not telling me?”.  If your adjustments are not viewed as legitimate you lose a tremendous amount of credibility and negotiating power.  Also, what normalization adjustment should not do is make assumptions about a particular buyer and suggest that the business can run without certain expenses that a particular buyer might not incur.  This is the value to a buyer that you can point out in discussions but a buyer will rarely pay for improved prospects that it can bring to the table unless it is forced there by way of a competitive auction (see “What Will a Strategic Buyer Pay?”).
So far we have talked about income statement adjustments, because they are the main value driver, but we must also look at the balance sheet.  The company’s competitive position and economic prospects drive the valuation but then a balance sheet that is different from what is expected/required will result in adjustments to this valuation.  Redundant assets should be stripped and, on the other hand, if productive assets need to be replaced then adjustments may be required that have a negative impact on valuation.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.