Archive for the ‘Deal Structure’ Category

Valuing Companies With Erratic Earnings

Thursday, January 17th, 2008

What is the right metric?

 

A significant number of businesses that come to market do not have consistent stream of earnings. Inconsistent earnings history makes it difficult for acquirers to predict future earnings and create a valuation challenge. Using an “industry earnings multiple”, the most common metric used to value mid-market companies can be meaningless in these situations.

Which earnings number does one pick? The highest? The lowest? Most recent? The average? Weighted average?

On the surface, using weighted average may seem like an appealing answer. However, using weighted average typically leads to overvaluing or undervaluing the company by a substantial margin to the detriment of either the acquirer or the seller.

Assuming a reasonable earnings number can be picked using weighted averages, is “industry earnings multiple” a valid multiplier to arrive at a valuation? In not, how does one value these companies?  

A keen appreciation of financial methods and industry knowledge are essential to answer these questions. The first step in the process is to gain a clear understanding of the reasons for the earnings variability. Some common reasons for earnings variability are:

v  Economic changes in the target market

v  Development phase of the company

v  Large non-recurring income/expenses

v  Loss/gain of large customers

v  Entry/exit of major competitors

v  Changes in management or key employees

v  Changes in physical environment and target market

v  Substantial changes in level or amount of operating equipment or people

v  Changes in COGs that are out of line with changes in final product/service prices

Acquirers may see some of these reasons as problems that reduce the future earnings. They may also see some other reasons as opportunities that increase the future earnings. It is imperative that both the reasons and the impact be well understood early in the valuation process. Once the reasons are identified and their impact assessed, appropriate adjustments can be made to recast the financials to get a more meaningful picture of the company’s revenue and earnings stream. Quite often, these recasted numbers indicate a stable or predictable earnings or revenue stream.

If the earnings stream is predictable, the acquirer can use industry price/earnings multiples to arrive at a reasonable valuation.

If the earnings stream is somewhat erratic but the revenue stream is predictable, the valuation may have to rely more heavily on industry price/sales multiples.

If neither the earnings nor the revenues are predictable after recasting, the valuation process becomes highly subjective. In such a situation, the transaction price should either show a substantial discount to a market multiple or be tied to future performance of the business.

Valuing Growth Companies

Thursday, January 17th, 2008

The folly of industry multiples

 

I routinely see individual buyers coming up with low valuations for growth businesses based on simple multiple of the most recent year’s profitability and, worse yet, based on a multiple using a weighed average of the profits from the preceding 3 years. I usually offer them this simple way of looking at the problem.

Let’s take the example of 3 different businesses with identical last 12 month revenues and earnings:

v  Business1 has a history of cash flow growth of 10% over many years and the target market is continuing to grow.v  Business2 has a history of a steady cash flow for a long time with relatively minor variation from year to year and the target market is a stable.v  Business3 has a history of steadily declining cash flow for the last several years and the market outlook appears to be unfavorable.

Using industry standard multiple of most recent year’s earnings, all these business are valued the same. Would you value these businesses at the same level? Of course, not!

How about using multiple based on weighed average of last 3 years profits? A quick check would show that this would lead to the conclusion that Business3 has the highest valuation and Business1 the lowest valuation! In most scenarios, this answer would be preposterous!!

So, why did industry multiples and weighed averages give wrong results for these companies? How can you value these companies? I will cover the answer to the former question in a different blog entry. For now, let’s focus on how you can better value these companies.

Setting aside the strategic or synergistic value of these companies, there are a couple of good answers to this question:

v  Use Gordon Growth model to arrive at a growth adjusted value of the earning stream. 

V= E / (R-G)

Where: V= Value of a company

E = Annual earning stream

R = Required rate of return

G = Projected long term growth rate of the Earning Stream

v  Develop a forecast of long term earnings stream and conduct scenario analysis based on discounted cash flow. This method is more sophisticated and requires spreadsheet skills but can be useful in establishing a range of values under different scenarios.

The valuation arrived by these methods gives acquirers a reasonable starting point in many small to mid-market business acquisitions. The acquirer should aware that the real value of these companies has more to do with the strategic or synergistic value of these companies and can be much higher than what these simple methods suggest. We will cover this topic in a different article.

Business Broker, M&A Advisor Or Investment Banker?

Thursday, January 17th, 2008

Picking The Right Intermediary For The Sale Of Your Business

 

You are ready to sell your business. You ask around and find that some businesses are sold by Business Brokers, some by Mid-market M&A Advisors, and some others by investment bankers. The difference in intermediaries can make difference of 20% to 40% or more in what you can take away in many situations. So, picking the right intermediary can have a major impact on your nest egg. Which one of these is right intermediary for selling your business? Who should you use?

The following table shows the applicability of these intermediaries based on various metrics.

  Business Broker Mid-market M&A Advisor Investment Banker
Size Of Business

Less than $2M

$1M – $100M

$50M and higher

Type of Business

Mostly Retail

Distributors, Manufacturers, Healthcare, Technology, Large retail, B2B companies

Public or large private companies

Typical Representation

Seller & Buyer (DUAL AGENT)

Either Buyer Or Seller

Either Buyer Or Seller

Typical # Of Employees

Less than 10

Tens or Hundreds

Any size

Typical Acquirers

Individuals

Corporations, PEGs

Public Companies or Large PEGs

Typical Sale Type

Asset

Asset or Stock

Stock or Mixed

Business Valuation

Street Multiple / Rules of Thumb

Strategic Value, DCF

Strategic Value, DCF

Transaction  Complexity

Simple

Complex

Very Complex

Size of contracts

A few pages

Tens of pages

Hundreds of pages

Typical Fee Structure

10-12%

Double Lehman / Negotiated

Negotiated

Upfront Fees

No

Maybe

Yes

Typical Multiples

2-3x DCF

3-7x EBITDA

P/E>10

The deciding factor in selecting the right intermediary is type of business you have. For small companies with revenues under $1 million and for large companies with revenues over $100 million, the choices are obvious.

If your business is a small retail or service business and there is no strategic value in the business, any competent business broker may be able to get the job done. However, since there is a substantial  negotiating component in deals this size, your interests are likely to better served if you choose an intermediary to represent you exclusively (i.e. not a dual agent).

An M&A Advisor is the right choice if your business is larger, complex or has a high component of product or service specialization. A competent M&A Advisor can unlock the value in your business, represent you exclusively, and get your business the higher value it deserves. This is extremely important if your business has untapped strategic value or has intellectual property subject to a broad interpretation of value in the marketplace.