Small Business Combinations – “Value” is in the Eyes of the Buyer

By Larry Ventimiglio

 

Is This a Business or a Career?

Many small business owners develop the “urge” to sell the business when things are going very wrong, and the business is in trouble.  Unfortunately, this is the worst possible time for them to consider a transaction because business “value” is at a low point.  When things are going well, most small business owners couldn’t be less interested in selling the business.  Only the true entrepreneurs understand the best times to sell the business is during the upward rise of the performance cycle.  Small business entrepreneurs understand, and invest in the building blocks of value, while “career” owners maximize their “personal benefits” from the business without adding any value.

The business enterprise being valued must be clearly defined and fully analyzed.  Investment appraisers must first determine whether a business exists. In some instances, the business enterprise may really be an individual’s career, and there may be no business enterprise of transferable value beyond the individual’s “tools of trade.”  The appraiser must also ask whether the business would continue under new ownership and whether the business generates earnings above and beyond a fair salary paid for the owner’s services to the business.   If it is determined that a business exists apart from the owner’s career, the appraiser must then determine what contributes value to the business.

Any business enterprise is only partially described by its financial statements.  Accounting conventions employed in preparing standard business financial statements are based upon “cost” (not market value) and focus on “tangible” properties (not intangible properties).  Intellectual properties like software, patents or databases may be the most valuable property rights owned by a business but may not appear as an asset on its balance sheet.  Appreciated real estate worth millions may appear at its depreciated asset cost of a few thousand dollars.

Building Blocks of Value

Every transferable business enterprise is built of well-defined structural components. The chart below illustrates these value components.  These building blocks of value will be different for every business enterprise. The capacity of each block is as important as the seller’s history of utilization of that capacity.

 

Foundation Tier – Personnel / Market Share
2nd Tier – Facility / Liquidity
3rd Tier – Management & Marketing Plans, Systems, and Networks
4th Tier – Research & Development
Top Tier – Profits

The structure of a business enterprise and its capacity to produce profits may yield significant value that cannot be seen in the financial statements if current owners and managers have not fully exploited this capacity.  Financial statements are prepared according to certain generally accepted accounting principles that are not intended to indicate the value of a business enterprise. Financial statements reflect only the historical utilization of this capacity.

In addition, the growing importance of services and the declining emphasis on manufacturing in our economy are accompanied by a declining importance of tangible assets and increasing importance of intangible assets.  In many business enterprises, the most significant building blocks of value are such intangible assets as:

• marketing and distribution systems
• personnel having appropriate education, talent and experience
• computer programs and databases
• management systems

These “value components” are not readily identified from financial statements and are only evident from a thorough understanding of the operations of the business enterprise.

Dynamic External Conditions Can Change Value Quickly 

A business enterprise does not operate in a vacuum.  It is affected by the economic conditions of its industry and market and by the economy in general.  The valuation approaches outlined below illustrate the ever widening environment in which a business enterprise operates and which affects the value of the business enterprise.

A business enterprise is dynamic and changes over time along with changes in its environment. Similarly, the value of a business enterprise changes over time. A thorough analysis of a business enterprise provides information for pricing the business enterprise. Common pricing methods under the three approaches to value include:

Income Approach to Value  

Capitalization of earnings – The price obtained by applying to a business enterprise’s established annual earnings base a factor that reflects:

• the risk-free rate of return available to investors in United States Treasury obligations
• the additional rate of return required by the particular risks associated with the business  enterprise being priced
• the growth rate that can be expected in the business enterprise’s annual earnings in future years

Discounted Cash Flow – The price obtained by projecting the expected cash flows produced by the business enterprise during the investment period and determining its present value using a discount rate that reflects:

• the risk-free rate of return available to investors in United States Treasury obligations
• the additional rate of return required by the particular risks associated with the business enterprise being priced.

The discount rate differs from the factor applied in the capitalization of earnings pricing method because the projected cash flows directly reflect expected growth in annual earnings.

Market Approach to Value

Guideline Company – The price indicated by applying pricing ratios derived from publicly traded companies that are similar to the closely held business being priced.  Pricing ratios for the guideline companies are derived from stock price information related to appropriate financial data.  These pricing ratios are then applied to similar financial data of the closely held business to arrive at an indicated price of the business as if it were traded as a series of publicly traded minority shares of stock.  Common pricing multiples include:

• Price/earnings
• Price/sales
• Price/cash flow
• Price/book value

The prices indicated using this method must be adjusted to reflect the fact that the stock of the closely held business is not publicly traded and that the ownership interest in the business being valued may be a controlling position and not a minority one.

Formula – The price obtained by applying a “rule of thumb” specific to a particular industry.

Acquisition – The price indicated by applying pricing information obtained from sales of similar closely held business enterprises.

Previous Transactions – The price indicated by previous arm’s length transactions in the subject company’s stock.

Asset Approach to Value  

Orderly Liquidation – The dollar amount realized from sale of the business enterprise’s assets in an orderly manner (not an auction) followed by payment of all debt.  This pricing method usually assumes that the business will not continue as an on-going business, which may mean that any intangible value associated with the business will be lost.

Replacement Cost – The dollar amount necessary to reproduce the business enterprise’s tangibleand intangible assets and liabilities as part of an on-going business.

Business Value is a Relative Thing 

Identified below is a helpful list of ranked value factors from the vision of prospective buyers.

Your business may be worth more if a buyer views it from the higher-ranking factors:

Highest Enterprise Value   

9   Strategically Positioned Business in the same industry or market which would employ their own business plan to: 1. realize the added economic benefits of vertical or horizontal integration (synergy) or 2. realize the economic benefit of eliminating competition.

8   Diversifying Businesses that have their own business plan to aggressively enter competition in the seller’s industry and which desire the seller’s business and management as the nucleus of this planned growth.

7   Competing Business within the same industry, concerned that sale of the business to a more aggressive competitor would adversely affect their own market position and business plan.

6   ESOPs that will be organized to utilize the income tax and borrowing benefits of an Employee Stock Ownership Plan to enhance their proposed purchase offer.

5   Outside Investors/Managers who will be owners/managers and who possess deep management skill, knowledge, and experience within the seller’s industry and markets.

4   Insider Management Group who has intimate knowledge of the seller’s business, which greatly reduces the investment risk but also may give the group potentially intimidating leverage if the seller lacks management alternatives.

3   Diversified Passive Investors who have no interest in a job, who will take on the seller’s management team and business plan, and who have a diversified investment portfolio.

2   Investor/Job Seeker who desires both the investment opportunity and an executive position within the seller’s business.

1   Undiversified Passive Investors who have no interest in a job, who lack a diversified investment portfolio, and who will take on the seller’s management team and business plan.

Lowest Enterprise Value 

The Bottom Line 

Every potential acquisition is unique.  Each comes with its own set of opportunities and challenges.  The principle concept, however, is the same – two independently owned businesses unite as one, and operate under the same roof to achieve a strategic and synergistic goal.  There are many deal structures, and the valuation of a target company can be driven by multiple factors.  Anytime emotions are combined with science, the “deal” turns out as more of an art form.

 

What about YOUR business?

What “value” will your exit strategy bring to you?

What does “success” mean to YOU?

Please contact me for more information on how I can assist YOUR team achieve greater business “success” and tangible enterprise value.