Business Development Solutions
The Merger & Acquisition Resource for Growing Companies
The value of the business consists of not just the Price (i.e., the amount to be paid for the business) but also the associated Terms and the Deal Structure. Different values for a business can exist because of different operating assumptions, deal structures, payment terms, etc., not due to use of different valuation methods.
A few of the value drivers are:
1) Future Performance 5) Deal Structure
2) Financial Leverage 6) Asset Type
3) Financial Return Expectation 7) Exit Strategy
4) Cash Flow, Not Profits
These value drivers impact business value in many different ways as explained below.
1) Future Performance. Value of a business is dependent on its future performance, not on the past performance. History of the business is relevant to the extent it helps project the expected future performance in the hands of a new Buyer. Future performance of the business depends upon the current condition of the business and what the new Buyer can and/or wants to do with the business. Therefore, values of a business will change depending upon the Buyer and his or her expectations.
Cash Flow. This is the most important factor in determining business value.
· Smaller businesses bought by an owner/operator tend to be valued based on:
Seller’s Discretionary Cash Flow (Owner's Salary & Benefits + EBITDA (Earnings before Interest, Taxes, Depreciation, & Amortization))
· Mid-sized businesses are often bought by companies that would replace the owner with an employee (usually at a much lower salary) as president of the business. These businesses are often valued at EBITDA (Earnings before Interest, Taxes, Depreciation, & Amortization)) or EBIT (Earnings before Interest & Taxes).
To help our clients establish a market value on a business they are interested in buying or selling, Business Development Solutions subscribes to the following services (or is a member of organizations) that provide actual Business Sale/Acquisition transaction data: BizComps, Prats Stats, Georgia Association of Business Brokers, M&A Source, BizBuySale, The Institute of Business Appraisers, and Business Broker Press.
These eight sources include over 25,000 transactions. Some basic observations of sales price from these transactions include:
· Smaller businesses tend to sell for 2 to 4 times cash flow. Although if the business is dependent on the owner or is very small, the multiple could be as low as one (1).
· Mid-sized businesses tend to sell for 3 to 6 times cash flow. For some businesses, the multiple could be as higher.
Revenue. Generally, revenue is a secondary factor in determining value. If two companies have the same revenue, but one has twice the cash flow, that company would, of course, have a much higher valuation. Conversely, if two companies have the same cash flow, but one has twice the revenue, that company may have a higher value.
Intangible Factors Affect Expected Performance. In determining value, financial factors only provide part of the calculation. Intangible assets determine the real value to buyers. These assets include: customer loyalty and concentration (top 10 customers), contracts, trade secrets, reputation, mailing list, skilled employees, strong management team, strong distributors, name recognition, quality of financials, proprietary products, industry growth trends, percent of capacity used by current facilities (how much growth will facilities support), geographic location, sales backlog, and warranties. For a specific buyer, a business’ value may be based on unique strategic benefits that only that specific buyer could realize.
2) Financial Leverage. Value of a business is dependent on the post-acquisition financial leverage. Higher financial leverage, generally associated with high asset base, means lower average cost of capital and hence higher value. A business with low financial leverage (generally associated with a low asset base, or an asset base with low borrowing capacity, or a tight lending market) will command a lower price due to lack of lower cost borrowing. Such businesses can command a respectable price if a cash flow lender can be found, or if the Seller is willing to finance the transaction. Financial leverage depends on the value of the assets, type of assets, size of the business, market conditions, credit worthiness of the Buyer, quality of earnings, post-acquisition management, etc.
Assets. What is for sale? Are all business assets for sale, or just a portion of the assets? Are accounts receivable and inventory included? Is just the customer list for sale or is equipment also included?
A company’s assets are an important factor in determining value. For example: Company A has new state-of-the-art equipment and does not need additional capital purchases to continue to produce its profits. Company B is just as profitable but has old, obsolete equipment that needs to be replaced soon. In this example, Company A, with the new equipment, is more valuable.
3) Financial Return Expectation. Value of a business is dependent on the Buyer’s expected financial return. The higher the Return On Investment (ROI) expectation of the Buyer, the lower the business value. Some of the factors increasing the Buyer’s ROI expectation, and hence decreasing business value, are poor quality financials, up/down sales history, unpredictable and/or uncontrollable profit margins, lack of management, narrow product line or customer base, concentration of customers, suppliers, distribution channels, etc. ROI expectations also depend upon the type of assets; for example, ROI expectations of a real estate property are lower than that for a business property.
4) Cash Flow, Not Profits. Value of a business is dependent on cash flow, not profits. A business whose fixed assets base is high and/or requires high working capital is likely to require more of the profits to be reinvested back in the business, thus reducing the cash available for debt service. Hence, it would be valued lower. The opposite is true for a business with a low fixed assets base and/or with low working capital requirements; such businesses will be valued higher due to low reinvestment needs. (Note: A high assets business increases valuation because it provides more financial leverage, but at the same time it lowers valuation because the higher asset base generally requires higher reinvestment of profits.)
5) Deal Structure. Value of a business is dependent on the deal structure. Deal structure changes the taxes and the debt service of the transaction. In most cases, “all cash” value is going to be lower than the one with Seller Financing due to higher cost of capital associated with equity.
Seller Financing. The amount of financing the seller provides to the buyer affects the price of the business. Based on the business sale/acquisition transactions in BizComps, a database of small business transfers, businesses that are sold without any seller financing sell for 10% to 15% less than businesses that sell with seller financing.
Allocation of Sales Price. The sales price is allocated to various items such as fixed assets, goodwill, and consulting during the transition time. Consulting expenses are tax-deductible to the Buyer the year incurred, providing a tax benefit over many other items the price can be allocated to that are depreciated/amortized over a number of years. For this reason, a buyer may value a business more with a high allocation to consulting. Sellers prefer to limit the allocation to consulting because of the ordinary income tax rate on consulting income while other items are taxed as capital gains. Some allocations can help or hurt one party without affecting the other party.
6) Asset Type. Value of a business depends on the type of assets used in the business. The type of assets impacts lender advance rates and the depreciation life of the assets, which in turn impacts value of the business.
Low working capital advance rate from the lender means more cash is being used up in funding working capital (net of borrowing); hence, less cash is available to the shareholder. Inventory intensive businesses, like distribution businesses, could have lower valuation because inventory has usually lower advance rates from the lender. Businesses with stretched Accounts Receivable (A/R), like health care industry suppliers, or businesses with poor quality A/R, like construction businesses, could have lower advance rates and hence lower valuations.
Businesses requiring capital expenditures for long-life fixed assets will have lower tax benefits of depreciation in the early years; hence, they may have a lower business value. Process industry businesses and businesses with leasehold improvements have a long depreciation life of the fixed assets that negatively impact business value due to the depreciation factor.
7) Exit Strategy. Value of the business depends on the exit strategy of the Buyer. A component of the cash flow to the Buyer is the amount that would be realized at the end of the planning horizon as if the business were sold at that time. Therefore, the value of the business today depends on the value of the business at the end of the planning horizon. Most Buyers make the assumption that the Exit Price Multiple (EM) will be the same as the Purchase Price Multiple (PM). However, many Buyers assume EM to be higher than the PM if they are consolidating an industry or are planning to go public. Similarly, a Buyer may assume a lower EM than the PM if the growth beyond the planning horizon is going to be lower than the growth during the planning horizon.
Business Valuation based on the debt paying ability:
Business buyers value a business using the debt-paying ability of the business. Since most buyers finance 65% to 80% of the acquisition price, the cash flow of the business should support the debt service, return on equity invested, and the salary for the new owner. A simple example:
Acquisition Cost $2,000,000
(includes the Business Price, working capital requirements, and closing costs)
Amount of down payment from buyer(20%) $400,000
Loan amount $1,200,000
Seller Financing amount $400,000
Yearly payments on Loan (10 years @10%) $190,000
Yearly payments on Seller Finance (5 years @8%) $97,000
New owner’s desired return (25%) on $400,000 equity invested $100,000
New owner’s desired salary & benefits $150,000
Minimum cash flow needed by new owner $537,000
In this example, the acquisition cost of $2,000,000 supports the debt service, return on equity invested, and owner’s compensation as long as the cash flow is at least $537,000. If the cash flow was exactly $537,000, a higher acquisition cost would not support the debt service, unless the buyer was able to get better terms on the debt or seller financing, or would require less than $150,000 compensation or less than a 25% return on the money invested.
In this example, the total yearly cash flow available to the new owner is $250,000. Note that this example simplifies many factors, including the deal structure and the resulting effect on taxes which in turn affects the cash flow, and therefore the price.
Call if you have any questions on the above article or to find out more about buying or selling a business.
Business Development Solutions
Jay Whitney, President