Ted, a small business owner, spent the last week bringing in three new customers, ordering raw materials, working with his advertising agency, handling personnel problems, meeting with his banker about increasing the line of credit, talking with a customer about quality issues, meeting with a logistics company about late shipments and damaged products, and asking customers to pay their invoices. Sounds like Ted is running in a million different directions and getting a lot accomplished.
The next week Ted gets a phone call from a competitor in a neighboring state asking if he has ever thought about selling his business. Ted tells him, “I have a great business and have not thought about selling”
The competitor replies, “Yeah, I was in the same boat until I got this call from a national company. They made me a great offer to buy my company and we should close the deal next month. The guy I am dealing with said they may be interested in purchasing other companies. Are you interested in talking with them?”
Ted is excited and calls his attorney and accountant to tell them the news. The national company and Ted talk about the deal; however, Ted is disappointed in the offer as it is much lower than what his competitor received. Ted’s attorney puts him in contact with a business valuation expert and Ted asks the valuation analyst to look at his business and tell him why the offer was lower than he thought it should be.
The valuation analyst and Ted discuss the three approaches to value—asset, market, and income—and agree that asset valuation is not the best approach to value operating entities such as Ted’s.
The market approach considers data from public companies whose operations might be comparable to the company being valued and from the sale of private companies. The market approach generally involves determining some price multiple of earnings, for example Price to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
In valuing Ted’s business, the valuation analyst could not find any comparable public companies due to differences in size and structure. However, he was able to find transactions in the private databases that were similar to Ted’s. The sales price of these transactions ranged from two times EBITDA to eight times EBITDA.
The income approach uses some form of earnings (EBITDA, net income, cash, etc.) and either discounts or capitalizes the future earnings stream to arrive at value. Based on the valuation analyst’s review of Ted’s historical financial statements and discussions regarding the future of the business, the company’s future cash flows yielded a value with an implied EBITDA multiple of three. This multiple was near the lower end of the range of multiples derived from the market approach; it was also lower than the sales price his competitor received, which was six times EBITDA.
The valuation analyst identified several factors impacting the value of Ted’s company:
• Profitability has suffered due to poor quality, late shipments, and inefficiencies in fulfilling customer orders. Profit margins are below the industry benchmarks.
• New customer sales are driven exclusively by Ted; there is no other sales force.
• The Company’s inventory turnover is half of what is normal in the industry.
• The Company’s average collection period is twice the industry norm.
• Financial information is difficult to pull together; information had to be constructed to complete the analysis. There are no formal financial statements.
The above factors caused the prospective buyer to decrease the value of Ted’s business compared to the amount he offered the competitor. A quick look of the facts indicates cash flows have declined (due to the decline in profitability and poor working capital management); there appears to be an overreliance on Ted; and the company’s financial information may not be reliable.
Thus, Ted may have missed out on the best chance to maximize the value of his business by being able to sell to a large company. How can a business owner make sure he does not fall into the same trap as Ted? Know the value of your business by working with an independent business appraiser.
Work on these value drivers that can enhance the value of your business:
1. Know your company’s cash flow and work to maximize cash flow that is sustainable.
2. Keep good financial records.
3. Build a knowledgeable and skilled workforce and management team.
4. Develop good processes and systems (quality, personnel, information, etc.).
5. Know your industry—keep abreast of changes and merger and acquisition activity.
6. Look for growth and niche opportunities.
7. Develop a diverse customer base and product/service offering.
Small business owners can avoid being caught in a situation like Ted’s by operating their business each and every day as if it is for sale. By concentrating on the key value drivers of their business, owners can enhance value and maximize the price they get when they sell. Consider meeting with your team of advisors (attorney, accountant, investment, etc.) to develop a succession plan or strategy.
Content contributed by the Charlotte office of Elliott Davis, PLLC, an accounting, tax and consulting services firm providing clients the solutions needed to achieve their objectives in 10 offices throughout the Southeast. For more information, contact Dan Warren at 704-808-5210 or visit www.elliottdavis.com.