While financial performance is important to business valuation, financials are only part of the equation of value. The flip side of financial numbers is the multiplier or discount rate.
Very simply put, Value = Earnings x Multiplier.
Simply, what is a suitable financial multiplier, 4x’s, 6x’s or 8x’s? The choice of a multiplier is driven by the perceived opportunity and risk surrounding a transaction. This is where the perceived synergies, intangibles and risks define a seller’s/buyer’s valuation.
In transaction/valuation circumstances where there is no revenue or income upon which to apply a multiplier, then valuation analysts look to the likelihood of profits and estimate them to achieve some valuation outcome (e.g. proforma with discounted cash flow). In real deals, buyers and sellers also consider the risk of how a deal is structured, thus factoring in elements outside of the business itself. Remember the saying, “Price is what you pay, value is what you get.”
In order to enable a satisfactory transaction price, terms and structure, focus needs to be placed on elements beyond simply, the earnings number. Below are some points to consider when you’re engaged in negotiations:
- Visibility And Certainty Of Revenues – work‐in‐progress, work‐in‐view, outstanding proposals, win‐loss success ratio, trends, economic outlook, client work indications, repeat business, client success and capacity and interest to demand more services, contracts, master service agreements, client satisfaction, reputation, active client base, etc.
- Growth Potential – This includes not only organic growth but synergistic growth potential (and acquisition growth potential, possibly). Remember, the larger the company the higher the multiples that are evident. Likewise, the more attractive the industry for growth the higher the multiples.
- Competitive Advantage – this is often expressed in above‐industry average gross and net profit margins, which are often the result of unique selling propositions, quality process outcomes, or a suite of services that provide a perceived benefit to our customers, e.g. savings of time, money, or risk. Proprietary intellectual property that is hard to replicate is often a very valuable asset, 2 © 20156 Calvin R. Hughes. All Rights Reserved. Paladin CMS Advisors Confidential but doesn’t necessarily show on the balance statement. Advantage could also be as a result of flexibility and speed to address client needs, pricing, method of delivery, etc.
- Simplicity, Trust and Timing – Matters such as whether counterparties trust each other, believe they’ll do what they say and what they say is honest and trustworthy. Good faith intentions. Is a deal simple to understand or is it getting too complicated? Deal fatigue after many weeks or months can damage or kill a deal. Negotiations can get tough, emotions can get high, so remember the human factor is very important. Where serious counterparties believe the deal has a sound basis they will get down to it and not want to waste time. However, sometimes delay tactics happen and they are just that, simply tactics. Don’t be in a rush if the situation warrants it. Be tough and also professional.
- Critical Dependencies – Where we depend too much on one or a few employees, suppliers, customers, regulations, simple to reproduce competitive advantages, economic cycles, or other critical elements of our business, we are more susceptible to risk and lower valuation. Where we can show our business has flexibility, alternates and choices to recover from any major shift or loss of a key element of the business the stronger we are and the higher our business valuation.
- Customer Satisfaction – A wonderful way to look at your business is to ask yourself whether your business is doing better or worse if you can’t look at your financial statements. Now you must look to other key performance indicators that can tell us the answer. Factors such as knowing and tracking your customer satisfaction, repeat business, pricing authority, pricing elasticity.
- Operational Efficiency, Autonomy & Documentation – Well defined and efficient operating processes throughout the organization’s critical processes is a boost to a company’s value. Good documentation, processes that support competitive advantage, collect revenue opportunities and control expenses help the buyer see the value and gain confidence things will run after post‐ closing. Consider also that well organized data and documents and financials make a company easier to run and to buy.
- Shareholder & Principal Management Independence – When a business is driven solely or predominantly by one or a few shareholder‐principals there is a high degree of risk. In such circumstances, business owners have created an enviable job for themselves but not an investment worthy business because a change of ownership or new senior management may cause erosion of the business and consequently its value too.
- Culture & Knowledge – Would the new owner of your business like to operate the business in the same way that you like to? Do they have the same priorities, same management style, and values about work, ethics and treatment of employees and customers? Where there is a clash, value can be eroded causing loss of any carried interests or thwart a deal from ever consummating. Likewise, does the buyer understand your industry? Can they anticipate the 3 © 20156 Calvin R. Hughes. All Rights Reserved. Paladin CMS Advisors Confidential challenges and problems, or perhaps they are well‐versed and can make your company a better one.
- Strategic Advantage – The nirvana of business acquisitions is when a buyer knows your industry and company inside out and can take it to the next level with a well‐thought‐out game plan. This often offers the opportunity for substantial additional gains for both the buyer and for those sellers that tag‐along.
- Ease of Transition – An important but often overlooked element of deal making is the ease of what happens after a buyer buys the company. Is it easy for the buyer to assume control, to integrate your operations and culture into their own business? Will they run it as a standalone or combine it with their business? Key elements of post‐closing integration include: governance, delegation of management authority, vision, IT, human resources, customer goodwill, harmonization of service offering, quality control, communications, financial reporting and controls, key processes, marketing (in a nutshell all areas of the internal and external value chain, but depends on the nature and character of the business and what is most important). Also to be considered are matters such as any employee dismissals, cleaning up the balance sheet and accommodating any tax optimization matters (e.g. HoCo’s and trusts can complicate things).
- What’s In, What’s Out & What’s Left? – Consider what the buyer is expecting to buy; get to know what they really want. Then you can consider what you will sell and include in the deal. The amount of a company’s net operating working capital usually has a material impact on the final outcome of a deal because we have to decide how much is enough to give the buyer. Can we improve our working capital efficiency and keep more for ourselves? Simply, there may be extra assets in the company that the buyer doesn’t need to acquire as going‐concern business to achieve their goals, so we can keep the extras as part of the deal. So, for instance, a company may have surplus assets, extra cash, shareholder loans, affiliate company loans; all these are dealt with as part of the deal and often are excluded by the buyer because they are not needed with the business. Then, instead of focussing on the top‐end “PRICE” put on a deal, you need to think about what you’ll get after the deal is done and the taxes are paid. Add‐up what you get to keep, what loans are paid back and how much and how the buyer will pay you. But, that is after tax. So careful tax structuring may be warranted and leave a lot more money for you if done properly. Many folks aren’t aware of the opportunities sound tax planning can make on their deal.
- What Can Go Wrong? – Always consider what can go wrong. Anticipate problems and liabilities. Deal with them at the front. Contingent liabilities can stem from threatening lawsuits or claims, unhappy past‐employees, legacy liabilities (unpaid vacation pay, outstanding bonuses due but unrecorded, environmental issues, poorly performing employees, long‐tenure employees, and potential under‐funded tax liabilities). Find it first and deal with it! 4 © 20156 Calvin R. Hughes. All Rights Reserved. Paladin CMS Advisors Confidential And, let’s always remember that every buyer will consider whether they are better to buy a company or build their own similar business, or choose an alternate route to achieve their goals relative to what an acquisition will cost them. Time‐Money‐Risk‐Opportunity Cost‐Capacity‐ Resources … even emotional reasons can come to play in decision‐making. And, also let’s remember that while the past is perhaps some indication of the future, buyers always buy the future. It’s just easier when the past is a good indicator of the future. Let’s make it easy for the buyer to see a great, profitable future.
- Build Competitive Interest – When you’re selling a business, your job is to make it easy for the prospects to see the value, and more than one if your circumstances allow for offering your business simultaneously to many interested purchasers. Keep in mind the offering of a company to the market is a process of price discovery. If you’ve done your job well, the rest becomes much easier for the counterparties to meet their objectives.
When a transaction reduces the buyer’s risk, it should realize a higher valuation for the seller. By considering the points above we can make a deal that meets your needs and provides the buyer with an outstanding investment. Yes, we want the buyer to do well and, you too!