Becoming Buyer Ready and Selling Your Company: Part III – The Valuation
In past articles we have discussed several facets of building a “buyer ready” business. As you’ll recall, a buyer ready business is a company that has been developed and positioned from day one to be attractive to potential buyers. These are companies that are owned by entrepreneurs who have the end game in mind: eventually exiting the business via a partial or total sale.
Several weeks ago we examined the initial decision you have to make in the process – deciding that you will eventually need to exit. Since this is an emotional decision, we suggested that once you make it, you never look back—decide to exit and then stick with the plan.
We then examined several steps you can take to develop an organization that has traits that buyers are looking for. Critical characteristics, such as a fully developed middle-management team and an organization that is constantly innovating, are important to buyers (we have expanded on these concepts in an ebook that is free for you to download by clicking here).
So, now, having made the decision to sell and having developed a well-positioned, growing, profitable company you are now ready for the first step in actually selling and exiting your company: the valuation. The importance of getting this step right cannot be stressed too strongly. If you have no idea what your company is worth, how will you be able to choose which offers to take for your company? You can’t. In fact, without an accurate, objective evaluation of your business, you could actually accept an offer that radically undervalues your company, forcing you to “leave chips on the table.” Far too many entrepreneurs do this and, unfortunately, they never realize it until too late.
Accurate Recasting – The Foundation of the Valuation
Because of the critical nature of this step, deciding to have a third party do an evaluation of your firm is well worth the investment. Of course you can do this on your own if you are well versed in the practice of “recasting.” If you have not heard of this term, or if you are not sure what it entails, I would highly recommend that you hire a professional firm do this for you.
Recasting is the accepted accounting principle of removing or adjusting items on your financial statements that are unrelated to the ongoing business. Many of you have worked hard over the years with your accountants to under-report your earnings for tax purposes. This is perfectly legal and acceptable. But it understates the true value of your company. Keep in mind one key principle: Professional buyers are buying your future, not your past. But the only way to accurately highlight your future profitability is by recasting your historical financials and then project out three to five years using the new recast baseline as your starting point.
Items removed or adjusted via recasting can be superfluous, excessive, or discretionary expenses and nonrecurring revenues and expenses. The recasting process can be quite time-consuming and tedious. The person providing the service will ask you lots of questions and will dig deeply into your historical financials to find as many legitimate recastable items as possible. Again, buyers are buying your future and will base their offers on what they see in your financials. So if they are not recast accurately, your base year could understate your profitability, impacting what buyers will pay for your company.
For example, let’s assume a buyer is looking at two similar companies in the trucking industry. Both are generating the same level of revenue, Company A is showing $500,000 in EBITDA (earnings before interest, taxes, depreciation and amortization) on its latest fiscal year income statement. However, Company B, again doing the same level of revenue was wise enough to have its financials recast and it is showing EBITDA of $750,000. Which of these companies do you think will receive a better offer? Assuming that there are no extraneous issues affecting Company B, it will most likely generate better offers than Company A. So you can see how vital recasting is in protecting you from offers that are too low.
Questions, Questions and More Questions!
But recasting is just one part of the evaluation process. In a sense, a good evaluation of your company is very similar to the due diligence that buyers will ultimately conduct on your company. Although due diligence will involve much more intense scrutiny of your company, any reputable firm that has done evaluations for years will ask you a series of questions and will delve deeply into your business. The goal in this evaluation process is to expose not only your company’s strengths but also any perceived weaknesses that could affect buyers and their future offers.
For example, some of the following questions could be asked of you during the evaluation:
- Do you have any patents?
- Does your company have an established brand in your market?
- Who are your long-term customers? Do you have contracts with them?
- How many suppliers of your raw materials do you have?
- Who are your key employees? Why are they key?
- What is your employee turnover ratio?
- Union vs. non-union employee base? If union, when does the current contract expire?
- Do you have a backlog of orders?
This is just a short list of questions you may be asked by any experienced firm evaluating your company. Business owners often become frustrated with this process because it requires quite a bit of your time and can be laborious. However, if you work closely with your advisors during the evaluation, you will be surprised what you will learn about your company. You will also be surprised at how you can improve your operations and enhance your value to buyers by implementing some very simple steps along the way.
How To Determine the Value
As I mentioned earlier, it is possible to produce an evaluation of your firm on your own. If you have an accountant that is experienced with recasting (many are not), and if you have the time to spend not only asking yourself these hard questions but also objectively documenting them, you could produce your own evaluation document. However, having done the recasting, the question now becomes how do you determine the value of your company? This is where it becomes critical to have the services of an experienced M&A advisory firm.
You may be aware of industry standard “multiples” for your industry, and sometimes these can be quite accurate. But again, professional buyers are buying the future. This means that they will project your recast earnings into the future and then will “discount” them back into today’s dollars using a discount rate that matches their internal rate of return for comparable investments like yours (the “discount rate” is based on a variety of factors including risk, stability of the investment, believability of the projected revenue growth, etc.). This is where it really gets complicated.
Ultimately, a number of methods need to be reviewed to accurately value your company. In addition to the discounted cash flow analysis, other methods that can be used are industry comparables, rule of thumb multiples, asset-based valuations, preceding transactions, etc. Each method has its strengths and can be used alone or in conjunction with other methods depending on your business. Unfortunately, time and space does not allow me to delve deeply into all of the valuation methods used. Suffice to say, this topic could be several future articles alone.
The Bottom Line
The bottom line is this: The valuation of your company sets the benchmark for where you will expect offers. If it is not done accurately, you could be undervaluing your company, placing your expectations too low. Conversely, you could also over-value your firm and end up with expectations that are way too high. These are things you can avoid if you obtain the services of an experienced M&A advisory firm at the outset of this process. Be sure to contact firms that will not only value your firm but will also stand behind their valuation and represent you in the market. This really is key. Lots of firms will value you but if they are unable to represent you in the market, how legitimate is that valuation?
Once you have developed a buyer ready business and have decided to sell, make sure that the valuation is done accurately. Don’t skimp on this step and try to save money by hiring a firm with less experience. The old adage is true: You get what you pay for.
Generational Equity has been valuing and selling businesses for years. Our team of financial analysts and evaluation managers is second to none in our industry in terms of experience and skill. Their abilities are matched by our deal-making teams that have proven over the years that they can effectively close deals. If you are interested in talking with us about your company and its valuation options, please click here to contact us.
No matter whom you ultimately use to value your company, be sure to work closely with them during the process and ensure that every possible recast is identified and documented. In the end, when the deal closes and you achieve your financial dreams, all the hard work during the evaluation phase will have been worth it.
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