freevaluationsonline.com

We get a lot of calls from business owners who say that a broker has told them that foreign buyers are willing to buy their businesses for truly astounding prices. These alleged “buyers” are usually located in Europe or Asia and just dying to buy American businesses.

Here’s the flaw in the logic. Usually when a buyer purchases a business they continue to operate it in the same way that it had been operated. That means that if your business generates profits in dollars now, it will continue to generate profits in dollars after the sale – the same cheap dollars. When those profits are converted back into Euros or Yen, the exchange rate that worked for them during the purchase reduces their return. So, unless the buyer is betting that the dollar will soon rebound a cheap dollar doesn’t help raise their rate of return.

Next time I’ll talk about other reasons that an overseas buyer might purchase a U.S. firm and how those scenarios affect the price.

Often when a buyer is purchasing a business to get into a new geographic area or expand his product offerings, the buyer uses the cost to create or a buy versus build methodology to evaluate the price that the buyer should pay. The cost to create methodology is explained in detail on our Guide To Selling a Business website, so I won’t repeat it here, but I’d like to point out a pitfall in the methodology.

Unlike in a previous post, where I discussed the problem of the buy vs. build methodology producing a value that is too low because the probability of failure is underestimated, I want to talk about a problem with the buy vs. build methodology that results in overpayment for the acquired company.

Often a buyer will calculate the value of an acquisition by just totaling up the costs that would be incurred to create the new product and/or services or to expand into the new geographic area. Then, they assume that they are done with the valuation.

However, there are a number of costs associated with acquiring a business that you need to put into the equation:

Acquisition Costs

There is a cost to acquire the target company. These costs may include fees and commissions to business brokers, attorneys, can accountants. Costs of taking physical inventory. Due diligence can also be expensive to perform.

Opportunity Costs of Acquisition

An acquisition takes time of senior management, which may be better used for other purposes.

Potential Failure to Close

No closing is ever assured. You may decide that there was misrepresentation as you perform due diligence or the owner may decide to keep the company for reasons that have nothing to do with the deal.

Integration Costs

There are potential expenses related to integrating two companies. For example, you will probably rename one of the companies to have a single brand. Doing so requires marketing, printing, and communication expense. You may also want to standardize on a single pension, health insurance, or other benefit plan, a single accounting system, and so on. To do so you may incur legal, accounting, or IT costs.

You may also need to integrate your products and services with those of the acquired company. This is especially true when acquiring software companies. Seamlessly integrating software packages that were not designed to work together can be extremely difficult.

Being Stuck with Past Decisions

When you start something on your own, you can tailor your decisions to your target market and/or to the needs of your existing customers. In acquiring a company you need to accept the decisions that they have made in the past or pay to undo them.

So, if you are the president of a software company and your VP of business development comes to you and says “We think it would take $10 million to develop an ERP package, but I’ve identified three ERP companies that we could probably buy for $8,000,000″ you need to determine the costs of acquisition that are discussed above and add them to the price. You may find that the $2,000,000 savings disappears when you’re done.

We have added three new websites to our growing family of mergers and acquisitions websites. The first stie, our Business Broker Locator which allows you to locate a business broker based on the location, size, industry and other specific characteristics of your company. The second site, Ownership Transitions showcases services available to either buy or sell a business, at either an affordable hourly rate or at a fixed fee. The third site, is a companion to our Guide To Selling a Business. This site, a Guide to Buying a Business is written from a buyer’s perspective and has a plethora of information on how to purchase a company.

In my last real post I talked about some of the problems with using comparables, namely that there is not enough information in most datasets to determine how comparable the data really is. It’s a bit like trying to value an orange by knowing the price of 30 small round fruits.

Comparable values often can give you a range of multiples that is so broad as to be meaningless. In a comparables report that I ran for Mfg. - Fabricated Metal Products with sales between $1,500,000 and $2,500,000 I got an average cash flow multiplier of 3.21, and the median was 3.52. “Great,” you say, “so my metal fabrication business with cash flow of $1,000,000 is worth about $3,333,000.” “Not so fast,” I reply, “the range of multiples in the report was from 0.16 to 5.27, so your business is worth between $160,000 and $5,270,000 – quite a range.”

Further complicating the use of multiples is that unlike in real estate deals where comparables are often used, in small to mid-sized business transactions the deal is seldom all cash. When a comparable is reported it may not be clear what the true value of seller provided notes, earn-outs, restricted stock, contingent payments, and so on really is.

There is, however, one big advantage to using comparables. Comparables represent real world transactions. So, if you are going to use comparables, how do you go about doing so in a way that minimizes the problems that we’ve discussed? The answer has two pieces. First, use comparables as only one method of valuing your business among several. Second, select a good source of multiples data. The best source is a business broker that can use past transactions of his own as a source of data. The broker will be aware of how the deal was structured and how similar your business is to the comparable. If you don’t have access to an experienced professional to help with the valuation, http://bizcomps.com has data that is more comprehensive than most. For example, the data includes a field for the percentage of the deal paid in cash at closing. Alternatively, if you’re considering selling perhaps it makes sense to talk to a broker. You can use our website (shameless promotion here) http://businessbrokerlocator.com to get up to four proposals from pre-screened business brokers. Ask them how they’ll help you determine an appropriate asking price.

I was working on doing another post about comparables, but something got in the way…

Gary Schine and I have Written a new book “Guide to Selling a Business” and created a website, based on the book. The website can be found at GuideToSellingABusiness.com The book and site are meant to be a complete guide to selling a small to mid-sized company, whether you choose to do it yourself, or hire an intermediary. As always, any feedback is welcome.

One method of valuing a business is to use comparables. In the world of small businesses, this is often a mistake. Let’s look at some of the reasons why.

I ran a report from a prominent data provider (who now offers free valuations based solely on these comparables) at the request of a buyer who was purchasing non-emergency medical transportation companies. Let’s look at some of the issues with the report. To begin with, although the data provider was a reasonably large player and the database contains about 17,000 transactions no category narrow enough to match what my buyer was interested in, so we ended up using a category titled “Services – Local Passenger Transportation.” We got a result based on 34 sales over a 5 year period, a period that included wide fluctuations not just in the market for small businesses but also in things like the price of gasoline that had disproportionate impact on this industry.

The average Cash Flow Multiplier was about 2.4, the median was 1.9. So, could my client conclude that a seller who was asking 1.5 times EBITDA was a bargain and one who was asking for 3 times EBITDA was asking top dollar? Not really. If we look at the descriptions and limit ourselves to transactions that had occurred within the last year, we find only 2 transactions are left, not enough to base any real conclusions on. Their multiples of cash flow were 2.47X and 3.64X.

What is more important than what we know about these companies is what we don’t know. In this report we have no idea how strong the balance sheets of each company was and medical transportation is a capital intensive business. Even if we had the balance sheet, there are many things that can affect the numbers on that balance sheet making two balance sheets hard to compare without an in depth analysis. For example, choosing a different method of depreciation can materially affect the value of the balance sheet.

There are also things that are never reflected on a financial statement. A business in a rural area will sell for less then one near a major city. A business that is growing is more attractive than one that is not. Unless you know a lot about the businesses being compared you can’t decide how relevant the information is.

Most business comparable reports don’t contain enough data to allow a reasonable assessment of true value. It’s like trying to assign a value to a house based only on the square footage, the number of bedrooms, the number of bathrooms, and the fact that it is in Los Angeles. To get real value you would need to know what shape the house was in, what neighborhood, etc. Anybody who tries to value a home on the basis of broad averages would be laughed at. Unfortunately, businesses that are even harder to value fairly based on comparables are often valued in just that way.

In the next post I’ll talk more about the problems with using comparables to value a small to mid-size business and the one after that I’ll talk about where they can be useful.

The short answer is never, unless it makes sense from a personal point of view.

There are brokerage firms that call people when business is booming and the economy is humming along and tell prospective sellers that now is the time to sell, while prices are high and business is good. You’ll get a higher multiple, they claim, and there is an element of truth to that. However, as we know the market environment can change in days or weeks and selling a business takes months or years. How do you know that your business will sell before the market turns down? Conversely, the good times may last years. If you are growing at 25% a year and sell today, who’s to say that you wouldn’t have been better off waiting three years and selling for double (25% compounded over three years is 95%).

When business is bad, companies consolidate and the same brokers who argued that you should sell during the good times now point to the industry consolidation and use that as a reason that now is the time to sell. They say that you should sell before the economy gets worse, before too many competitors merge and leave you as a smaller player.

Here’s a dose of the truth. It almost never makes sense to sell a healthy business based on a strictly financial analysis. If I can get you 3 times earnings today you’re better off waiting 3 years then selling (even if you can only sell for a penny). If I can get you 5 times earnings you’re better off waiting 5 years, 7 times earnings; wait 7 years and so on.

Yes, there are advantages to selling now. Selling frees up your time which is worth something. Selling allows you to diversify your financial holdings and reduce risk. However, the time to sell is when you begin to feel burned out, you’d like to travel, or spend more time with your family. In short, sell when it makes sense for personal reasons. Sell when selling makes you happy.

Bottom line: don’t try to time a process that takes months or years to hit a particular day or week. Maximizing the multiple is nice, but unless you know how long a transaction will take, what will happen with your particular business, what each prospective buyer’s finances will be like in the future, and when markets will peak with some degree of certainty, it’s not an achievable goal. If you can accurately predict markets performance months in advance play the stock market and get rich.

We get lots of calls from people who want just a ballpark view of what their business is worth. So, I put up a calculator that should be able to give a pretty reasonable valuation in about 15 minutes at http://www.freevaluationsonline.com

It’s free, requires no registration (privacy respected). Let me know what you think.

Many small business people believe that their business an unrealistically high price. Here is one of the arguments that I have heard to justify excessive valuations and the problems with that argument.

A very emotional reason is that the business owner has put his heart and soul into the business. When I asked one owner why he thought his business was worth $1,000,0000 he answered “I’ve put 19 years of my life into this business. That’s the minimum that 19 years of sweat is worth.”

As delicately as I could, I pointed out that a buyer is going to look at the business as an investment. The buyer wants a reasonable return on his investment, regardless of how much effort has been put into the business,

Imagine yourself in a buyer’s shoes for a moment. You are considering buying two businesses. Business A has a dedicated owner who works dawn to dusk. Over the last five years it has been running at break even. Business B has an owner that works 5 hours/day, and throws off $100,000 in profits every month. Which business is worth more to you?

Since buyers are interested in profits, as an owner charge your clients enough to make a fair return for your time today. Don’t count on a future buyer to make up for your lack of profits today when you sell your company. If anything, taking unprofitable clients to increase your volume of business today will decrease the price of your business when you sell it, because of the decreased margins.

There are a few exceptions that prove the rule. In certain industries, such as payroll or web hosting, the cost structure of the acquired business generally goes away almost completely post acquisition. When a large payroll company acquires a small processor they value based primarily on the gross revenues, because the largest costs, such as software, marketing, and labor, are not relevant. If a small payroll service spends 25% of revenue on software it doesn’t mean that the acquirer will incur a 25% cost for payroll software.

Another exception is in the rare instance where a company has put a lot of money into R&D that is not yet producing revenue. For example, if you own a software company that is about to release a completely new line of software, you can make an adjustment. If, however, your company produces Sudoku Software, the fact that you have a new version of Sudoku software in the works would probably not make a difference in the valuation, because a buyer will view the cost of producing a new version as part of the cost of doing business. However, if you have a new vertical market application for finance companies in which you’ve invested a substantial sum of money, that may merit an adjustment. R&D that produces intellectual property that is defensible (patents, for example) may produce larger adjustments.

BACKGROUND

Recently we were engaged to help mediate between two closely held companies that were hoping to merge. The companies both produced sophisticated asset tracking software for owners of commercial real estate. The software allowed centralized tracking of the age and maintenance history/schedule for everything from alarm systems to lighting and elevators.

One company, that we will call Established Co. had been in business for more than ten years and had a stable established client base. Their code was legacy code, character based, not even truly Windows software, although it now ran on Windows. They were making few new sales, but made a great deal of profit on maintenance contracts.

The other company, which we will call Upstart Co. had written really fabulous new software that allowed the use of a web interface. Moving the application to the web not only allowed easy access for the landlord’s employees, but allowed tenants to enter and check the status of work orders.

Upstart Co., however, was having trouble making sales. Part of the problem was a lack of sales expertise. Another issue that they faced was that converting from other systems was difficult so the best potential customers, those that saw the benefits of a computerized asset tracking system, were reluctant to switch to a new system.

Established Co. argued that since there were no earnings from Upstart Co, a fair way to value upstart was to total their development cost and value the company based on those costs (a buy vs. build calculation). This would have given a value of approximately $1,000,000 for upstart Co. Since Established had a long history of earnings, they felt that the fairest way to value themselves would be to use a multiple of 4.5 times EBITDA, making their value approximately $9,000,000.

Upstart Co. didn’t feel that a 10% share of the combined company was fair, although they had a hard time articulating why. One point that they raised was that the software had taken them three years to develop and they said that the lead time was worthwhile. Established Co. countered that they believed that by basing new web-based software on their existing product’s code base they could decrease development time to between six and nine months. Upstart believed that existing customers would quickly switch to their software and that the new software, when coupled with an established player’s name and sales force would create a great deal of growth. Upstart viewed itself as the future and as such felt they should own the majority of the new entity.

Both companies wanted the merger to go ahead, because together the two companies were worth substantially more than they were worth separately. However, neither set of owners wanted a deal that was unfair to them. They came to us and asked us to help them make it work.

OUR ADVICE

We reviewed product literature, the software itself, and financial statements from both companies. Then, we spoke to management of Established Co. and pointed out a few basic problems with their methods of trying to value Upstart Co. First, we pointed out that in a buy vs. build calculation you can not just assume that the cost of development that Upstart incurred would be the same costs that Established Co would incur. In large software projects there are significant chances of significant cost over-runs and more serious failures. Upstart Co. brought in a software project on-time, under budget, and (in the opinion of everyone involved) elegantly designed and executed. There could be no guarantee that Established would be able to do the same. I pointed out that while the cost of the winning lotto ticket in my pocket was $1, the value was far greater.

Another issue with the buy vs. build methodology was that both parties recognized that the value of the combined companies was higher than the value of the two companies separately. Since much of the increase in value came from the growth that would come from the new software, it seemed fair that the owners of upstart be allowed to share in that growth.

After warning against creating incentives for one party that might motivate them to do things that were not in the best interest of the merged company, we suggested that measures, such as the rate at which existing customers adopted the new software – which Upstart and Established had wildly different projections for, could be incorporated into the deal. Both companies, however, preferred to keep the deal simple.

We did two valuations, the one for Established used as its primary methodology, the excess earnings method of valuation. The valuation for Upstart included a Buy vs. Build methodology that took into account the risk of outright failure, the savings in lead time, and the almost certainty that the results of a development effort by Established would produce less elegant software. We also calculated the value of Upstart based on discounted future cash flows, both with and without the merger.

Finally, we explained to the owners of upstart that a company with no proven ability to produce profits is generally worth little to most buyers and that in order to capture some of the value of the combined entity that it would be in their best interest to be flexible on price.

Once given the valuations and a new framework in which to look at the deal, Established and Upstart were able to negotiate a merger.