As the number of businesses for sale increases, so does demand for information about valuation. This insightful post originally appeared in two parts on OneAccordPartners.com; we are re-posting it here with permission.
We’ve all heard of multiples or rules of thumb that help benchmark a company’s value—four times earnings, six times free cash flow, etc. But what do these multiples mean and how do they relate to valuing businesses?
Formal business valuations are conducted for a variety of tax and legal reasons and the IRS and courts have provided guidance and rulings for reference. These types of valuations are required in many situations but are generally not necessary for estimating the price a company is likely to fetch on the open market. Different methodologies lead to different results because valuation is both art and science. These methods rely on judgment and experience and can yield a wide range of conclusions based on the perceived risks and potential opportunities in each case. In other words, value is subjective.
Extensive books, courses and careers have been dedicated to business valuation, but my intent in this post is to provide a high-level overview of the factors that go into valuing privately held businesses for the purpose of facilitating a smooth transition of ownership down the road, regardless of the company’s current stage or direction. Often, valuations of this kind rely on multiples of historical earnings.
We rely on multiples in valuations for many reasons, including:
Multiples are shortcuts. They take into account patterns you see across an industry and give you a way to arrive at what is likely an accurate range of values without having to go through extra steps. While shortcuts are not necessarily bad, it does help to understand their strengths and limitations. Back in the day when I was a college summer intern at an Army Corps of Engineers construction project in New Mexico, the project manager once told me to walk around the site with a tape measure and just measure things at random. The idea was the construction workers would see me and figure I knew what I was doing. I’m not sure I elevated the status of summer interns with this tactic, but it sure made me look relevant. In some ways, using multiples as rules of thumb in valuation is a little like the tape measure—a great tool, but far more effective when you understand what the measurements actually mean.
There are three methods frequently used in valuing private companies. The asset approach is, believe it or not, based on asset value, which is simply the market value of all assets minus the market value of all liabilities. Generally, this applies to companies with little to no profits or a low return on assets. The second method, the income approach, is based on how much income the company generates. This means the value is derived from the risk-weighted return on investment that the company provides, just like most other financial investments. The third method, the market approach, relies on comparing a business to the known value of other, similar companies which have recently changed ownership.
The income and market approaches are widely used methods for valuing profitable companies. Their strength is that they both incorporate fairly robust quantitative analysis and time tested methodologies to calculate value. The drawback is they both rely on assumptions, judgment and less than perfect information. Accuracy is more important than precision when it comes to business value, so the right multiple correctly applied can give as good or better an indication of value than a detailed discounted cashflow model with unrealistic projections.
Regardless of the method used, business fundamentals are always going to be central. Some of the most common value drivers include outlook for growth, margin strength, revenue diversification, management strength and depth, quality of financial statements and customer retention to name just a few. Focus on what you can influence and realize that it takes time to build value. There are some things that are out of your control, such as the health of the overall economy, but you can increase value either by increasing revenue and profits or by decreasing perceived risk.
In a prior life, I was involved with M&A work in the oil industry for ConocoPhillips, and I saw many substantial deals at least get narrowed down to the final few buyers simply based on eight times net cashflow. This seemed to be an industry standard unless there were unusual circumstances involved. Don’t get me wrong, management required a thorough discounted cashflow analysis before final approval (no need to sell your oil stocks!), but there was some validity to using rules of thumb. I mentioned above that there are three widely used methods for valuing privately held companies—the asset, income and market approaches. Let’s look at the income approach in more detail.
Income Approach Theory and Future Income
The theory behind the income approach is that an investment is worth the value of the expected future income discounted back to the present at a rate appropriate to the riskiness of the investment. Discounting is the process of determining the present value of a future stream of income. For privately held businesses these discount rates are frequently in the 20-30% range to account for the inherent uncertainty associated with future income streams of private companies.
The challenge with using future income to measure value is coming up with a reliable forecast. Nobody knows what income a business will bring in the future. Since we don’t have a crystal ball to tell us, we rely on either historical financial performance or realistic, supported projections (or a bit of both) to estimate the future income of a business. The reason for using past performance to predict future performance is that it’s based in fact. I can look at a business’ past performance and see without a doubt, in black and white, the income it brought in over time. If I see a positive trend of more income over time, I have reason to believe the business may continue in that direction. Valuations of this kind commonly look at the business’ performance over the last 12 months or so, but it’s also a good idea to look at trends over a longer term, ideally a full business cycle, to see how the company performs in both favorable and unfavorable conditions.
For most established companies, past performance is the best indicator of future performance unless there are specific, tangible reasons to believe otherwise (new markets, products, patents, contracts, etc.). Business owners often tell me that the value of their business should be based on potential and, even though it might be a 20-year-old company with flat growth, they believe all the new owner needs to do is increase marketing or hire a couple of sales reps and profits will skyrocket. Without a proven track record, I have no way to measure the company’s real potential and cannot base value on a hunch with no data to support it. There’s also the case where a company has grown profits 20 percent per year for the past few years and the owner believes the value should be based on the assumption that the business will continue growing at the same rate. To put that in perspective, 20 percent annual growth implies the company will be six times its current size in 10 years. Though technically not impossible, this is unrealistic. Sustainable, supported, realistic forecasts are essential for deriving a sensible value.
In the case of early-stage companies and those going through a turnaround, projections will be more important than past performance, but you can also expect a higher discount rate because of the greater risk involved with forecasts that are not in line with historical performance. So the more you can prove the market potential, even if it’s just a few years of growth, the more valuable the company is going to be. For you Shark Tank fans, this should sound familiar.
The other part of the equation is determining what income stream to measure. EBITDA (earnings before interest, taxes, depreciation and amortization) is commonly used because it allows for comparison between similar companies regardless of capital structure or tax strategies employed. However, multiples can be applied to a variety of benefit streams including revenue, gross margin, operating income or net cashflow, depending on the industry and situation.
So how do discount rates and projected income relate to the multiples?
The simple answer is that the inverse of the discount rate minus the growth rate is the multiple. For example, a 25 percent discount rate applied to a company with 5 percent long-term, sustainable EBITDA growth equates to a value of five times EBITDA. For the mathematically oriented, that’s 1/(25%-5%). Yes, discount rate minus growth rate is a capitalization rate commonly used for real estate valuation. The only complexity in applying this to business valuation is that income from most companies rarely grows in a linear, predictable fashion, but the concept is the same (that’s also why Excel has a net present value, or NPV, function).
Multiples are great shortcuts to value, as long as you understand what they represent. Be realistic about your assumptions and don’t be afraid to validate them with feedback from others.
Business owners looking to exit their business are often curious about setting up an Employee Stock Ownership Plan. An ESOP basically allows an owner to sell the business to his or her employees, who then become shareholders of the company. This can be an attractive option when you read about the potential tax benefits and implications for your employees–not to mention your legacy–but proceed with caution. ESOPs are not a good move for every business. They are complex, expensive and, for some businesses, not viable. ESOPs can also open a business up to legal action, so be sure you understand the risks of an ESOP and know your options before moving forward.
We’ll lay out some basic information in this post, along with some of the pros and cons. If you’re considering an ESOP, be sure to research your options thoroughly with the help of your trusted advisors before deciding the best option for your business.
The ESOP was invented in the 1950s, though it was largely unheard of until the 1970s. The basic idea was to sell shares of the company directly to employees. This served as both a reward for years of hard work and motivation for employees to act in the best interests of a company in which they were literally and figuratively invested. The first ESOP was a protective measure meant to preserve the legacy of a newspaper business when its owners retired. Today the ESOP is the most common form of employee ownership in the U.S.
ESOPs are an attractive option for several reasons.
For the large number of baby boomers looking to sell their businesses, an ESOP can solve the contentious issue of finding a buyer in a market on its way to saturation with businesses for sale.
ESOPs can offer a number of tax advantages—provided the business meets a long list of regulations. And while setting up an employee stock ownership plan is very expensive, it can be less costly than selling the business, depending on the business, its structure and a long list of other factors.
For employees, an ESOP represents an opportunity to take ownership of the company, potentially with little upfront personal expense.
Middle-market companies can usually accomplish their ESOP goals with a carefully planned exit strategy. The ESOP then has the potential to reward key managers and employees for their performance and loyalty while maintaining the legacy and stability of the business. The company remains in the hands of people the owner knows and trusts. This can reflect very well on the owner who chooses to put his or her employees at the helm and sale to an ESOP can be gradual or all at once, giving the owner flexibility in how to exit the business.
As attractive as all this may sound, ESOPs are not for everybody. They come with exacting conditions and many limitations and liabilities. Your company’s ability to utilize an ESOP depends on its structure and not every company meets the legal requirements necessary to institute such a plan. The tax benefits, while attractive, are also carefully regulated and depend on their own variables, including the structure of the business.
ESOPs are extremely complex and comparatively expensive to administer. For the simplest plan, an owner can expect to pay a minimum of $40,000 just to get the ball rolling. For the life of the plan the business will encounter legal, administrative, compliance, valuation and trustee fees due annually to third parties. There are also transaction fees surrounding the addition of new employees and the retirement of established ones.
In addition to these fees there’s the matter of repaying the loan that bought the shares in the first place, because in an ESOP a trust borrows money to buy the company and then uses cash to repay that loan.
When an ESOP purchases the shares of a business, it does so based on a theoretical valuation report from a qualified firm. This valuation can be significantly lower than what a competitive selling process could achieve with multiple interested buyers and investors. It depends on the business, but in the majority of cases a company can receive a valuation for the purpose of selling 20-30 percent higher than an ESOP valuation.
These fees and payments, plus the repurchase obligations of an ESOP, mean less cash is available to invest in growing the business, hiring talent, exploring new markets, etc. The constant strain on cash flow and liquidity can stifle the business’ ability to invest in growth and innovation, which now take a back seat to funding the ESOP.
ESOPs are extremely complex and getting an unbiased opinion about them from the industry is challenging because many of the parties involved benefit in the form of third party fees. To avoid conflicts of interest, many plans hire an independent trustee to serve participant interests as well as outside firms to manage plan administration and record keeping. On top of this, Fiduciary Liability Insurance is recommended to protect the business against any claims of mismanagement of employee benefits.
Despite these precautions, the number of lawsuits associated with ESOPs are on the rise. And if an ESOP fails, it can create significant legal risks for the trustees.
ESOPs are very difficult to unwind because participants have broad voting and shareholder rights. A single participant has the ability to derail a fair transaction. Even raising capital is problematic, as new investors often prefer to avoid diluting employees’ shares or opening themselves up to lawsuits claiming they undervalued the equity of the company.
Ultimately the decision of whether an ESOP is right for you depends on your unique situation. It could be ideal or it could be a legal disaster. There is no formula. Only a careful look at your personal situation can determine what’s right for your business.
Like any business transition, setting up an ESOP takes time and planning. With so many regulations and complex requirements, talking with a professional first to determine the best path for your business will save you time, money and legal trouble. If you’re wondering whether an ESOP is right for your business, give us a call. OneAccord Capital specializes in the sale and acquisition of small to medium sized businesses in the Pacific Northwest and can help you decide whether an ESOP is a good option. Contact us today via email or call 425-250-0883 to speak with an expert about your transition plan.