Small Company Growth Trends

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The median sales of a company going public has gone from an average $15 million in 1999 and 2000 to $164 million in 2004.  Smaller companies have decided not to go public as often as in years past, and they reap the quick – and cheap – money as a result of that decision.  The question is “why?”

A company with only $15 million in annual revenues would most likely not want to have an IPO and absorb all of the attendant costs and the on-going fees related to going public.  They also would not want to have to spend the money necessary to comply with the Sarbanes-Oxley regulations.  Smaller companies have to pay a hefty price to go public – and remain public.  In fact, a recent Business Week article reported that “Bankers expect a record number of U.S. companies to go private this year, topping last year’s 86.”

Many CEOs, in order to rapidly grow their businesses, merge or acquire other companies.  However, many of these do not work out and the acquired entities eventually get sold off.  But as long as mergers and acquisitions are in vogue, large companies will acquire smaller ones in an effort to grow as rapidly as possible.  Therefore, many smaller companies that won’t go public because of the costs and subsequent compliance issues will be absorbed by larger companies.

The trend today, at least in manufacturing, is to provide complementary services.  For example, General Electric manufactures aircraft engines and medical equipment, but they also provide financing and maintenance services for the things that they manufacture.  These ancillary, but complementary, services are big profit makers.  Small service companies that provide these services may be excellent acquisition targets for manufacturers.  If smaller companies want to grow, adding complementary services such as GE does may be the best way.

On the flip side, many large companies are divesting themselves of companies that don’t fit into their core strategy.  For example, McDonald’s purchased Boston Market and several other food franchises in an effort to continue their growth. McDonald’s discovered that they were much better off focusing on their core business than they were trying to grow new concepts.  It is believed that these other franchises will be sold or they may already have been.  Smaller companies may want to divest themselves of products or services that aren’t complementary to their core business.

Some companies have almost reinvented themselves by adding new, more profitable, and “sexier” services or products.  This can increase the value of the company.  Smaller companies, because of their size and the fact that they usually have one manager, can shift quickly.  They can get rid of products or services that don’t generate commensurate profits, or add new products or services that can add to profits, much more quickly and efficiently than their larger counterparts.

Small companies, at least for the short term, will not be likely to go public, will be able to shift gears quickly to improve profits, but may also become acquisition targets by larger companies.

A Board of Advisors

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In most jurisdictions, a board of directors is not required for privately held companies.  However, many of these companies have appointed what might be termed advisory boards.  Although they may not have any legal authority, owners of these privately owned companies have discovered that this team of outside advisors can assist them in many ways.

One important way they can help is just by having their name and/or company affiliation attached to the company.  This can open doors to new customers and new relationships.  Appointing advisors from both the accounting and legal fields can help insure that the company maintains strong controls on these important areas.  This board can also assist in developing company strategy and systems.  A business-savvy board can also help in management succession and can help prepare the company for sale.

In order to create a strong and helpful advisory board, “cronies” should not be included. The advisory team can consist of two to four people. They should meet several times a year, or in emergency sessions when necessary, and be available by telephone.  They should also be compensated for their time just as any consultant would be.

Closing the Price Gap

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The deal is getting down to the wire, the price differential is close, but the parties are not yet in agreement. Following are some ideas that might get the ball rolling and help bring the parties together.

  • Let the seller retain the real estate and rent it to the buyer, thus reducing the price. The same could be done for major pieces of equipment. Let the seller lease them to the buyer reducing the price. The lease should, however, like most leases, provide for a buyout at the end.
  • Structure a royalty on sales rather than an earnout on gross margins or EBIT.
  • Have the parties create a subsidiary for the fastest growing part of the business in which the buyer and seller share 50/50.
  • Let the buyers acquire 70 percent of the business with the requirement that they purchase 10 percent more each year on the same multiple of EBIT as in the 70 percent sale.
  • Arrange a consulting agreement with the seller to provide additional compensation to be paid annually.

Certainly, any agreement or deal structure should be approved by the party’s professional advisors.

M&A Trends

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A  recent article in M&A Today offered some observations concerning current and future M&A trends.

“The business world is constantly changing.  For the first half of the 20th century, vertical integration was the objective in which, oil companies, for example, owned the entire process from drilling to retailing at the gas station.  From 1950 to 1980, diversification was in vogue.  Recently, the trend is to outsource everything except the core business.  One of the new business models known as the new profit imperative is to go downstream and get closer to the ultimate customer.”

Today’s M&A Climate

Many companies still look to acquisitions as the best way to increase both capability and market share.  Acquisitions generally add complementary products, new technology or increase geographic coverage.  Interestingly, today’s companies are investing in new ventures, while, at the same time; divesting themselves of some of their original businesses.  Since these “original” businesses now have low margins and slow growth, they are being sold off.  Quite a few of the large public companies have spun off some of their original core businesses.  One company – Perkin Elmer – sold off all of its businesses including its name and reinvented itself as PE Biosystems.

“The previous M&A drivers, such as the need to grow externally as well as internally; the pressure for industries to consolidate; and the ongoing globalization, are all prevalent.”

Tomorrow’s M&A Climate

1. “Strategic acquirers will not only be more particular and demanding about the fit of the target company, but they will continue to divest divisions with the least potential or with low returns.”  Edward C. Johnson of Fidelity Investments summed it up best: “My own rule of thumb is that a business has to be good for the customer (quality), good for the company (profitable), and good for the employees (rewarding).  If we only achieve two out of three, we have not succeeded.”

2. Gone are the high prices of the late 1990s.  “The structure of the transactions will have a higher cash component, but there will be an emphasis on more contingency factors or tighter representations and warranties in an attempt to minimize risks inherent in the deal.”

3. Intangibles will be more important than ever.  Areas such as “the brand” will be more important.  Branding represents a company’s “credibility, its true identity, its meaning, its uniqueness.”

4.  “The use of strategic alliances and joint ventures will be used more frequently as a forerunner or in lieu of acquisitions.”  Technology changes so quickly today that one company, especially in hi-tech, can’t do everything.  Alliances and joint ventures provide earnings without the dilution of acquisitions.

5. The requirements of the new Sarbanes-Olxey regulations will impede a lot of acquisitions, according to industry experts.  This increase in regulatory requirements due to this new law may not only slow down the process, but may actually kill a lot of deals. This is especially true when public companies acquire a privately held one.  Sellers of these companies are going to provide a lot more audited financial information.

6. Over the years, many mergers and acquisitions have been within the same industry.  There is a trend towards merging companies that can “piggy-back” ancillary services.  The recent attempt by Comcast to merge with Disney is a good example – distribution merging with content.  Another excellent example is General Electric.  They manufacture jet engines, turbines, medical equipment, finance it through a GE finance unit, and then service it through another GE division.  The trend seems to be that more manufacturing companies “will acquire relevant service companies as a way to capture more profitable businesses.”

More recently there has been a trend to outsource everything but the basic business.  One thing is sure in the world of mergers and acquisitions – change will always be taking place.  It is important that sellers and their advisors stay abreast of these constantly changing trends.

How Many Businesses Are There?

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We suspect that the answer to this question depends on who you ask! The Internal Revenue Service (IRS) reports that they received some 24.8 million business tax returns for the year 1999. We can hear the joyful sounds emanating from new business brokers and those considering the profession. Wow, almost 25 million businesses! We can hear them adding up the commission dollars. This is a very misleading figure. Many of these tax returns are for hobby-type businesses, one-person consultants, writers, artists and the like. In fact, one source reports that there are 18 million non-employee businesses, and they account for only 2 percent of total sales. INC, in their Small Business issue, reports that Sole Owners generate only 3.3 percent of all revenues and have annual sales of about $38,000.

Home-Based Businesses

According to INC magazine, 61 percent of the firms in their 500 fastest-growing companies list started out as home-based businesses. And, on average, 15 months after they started, they moved to outside space.

We dont want to take anything away from these non-employee businesses, many of which are home-based, as obviously some of them will grow to be large businesses. Quite a few of these businesses, rather than have actual employees, use independent contractors or outsource work needed. Many others are making an excellent living for the owner, and still other owners are quite content with the results of their business. However, they are not the kind of businesses that business brokers and intermediaries normally sell. Certainly, there are a few exceptions — some one-person businesses generate sufficient revenues that would be quite salable. And, it’s not really that business brokers couldn’t sell them or that people wouldn’t buy them.  Quite frankly, they are just not commissionable.

Most business brokers, out of necessity, have a minimum fee;  adding $10,000 to a selling price of $10,000 would price many small businesses out of the marketplace. There may be a way of handling them, but these small businesses can’t afford full-service brokerage services. This is coupled with the fact that obviously many, many of these non-employee businesses dont generate enough profit, if any, to make them salable. A total annual sales of $38,000 isn’t going to create a lot of excitement among prospective business buyers.

What Is A Real Business?

As we have discussed earlier, we are really only interested in those businesses that have at least one employee. When we are asked how many businesses there are, we assume the person is asking how many possible businesses are available for sale. The above figures give a false impression of the overall marketplace of businesses that might be for sale at some point. Certainly, many of the businesses that have no employees might be available for sale, but most will not.  Secondly, business brokers and intermediaries will most likely not be involved in a sale if one does occur. Since most people who call are interested in the business brokerage profession, very few of the businesses that file business income tax returns are really businesses that would sell, especially by business brokers.

Our feeling is that to qualify as a real business, it must have at least one employee. As we mentioned above, we suspect that some no-employee businesses use outsourcing rather than go through all of the red tape required by governmental agencies to have even one employee.

An article in the Boston Globe March 4, 2001 stated that there were 7.7 million small businesses with less than 100 employees. Last year’s Business Reference Guide reported that there were 5.5 million businesses with one employee or more. INC in their Small Business issue said that there were 5.8 million with at least one employee. One other source reported 7.2 million.

BizStats reported that there were 5.547 million businesses with at least one employee. We’re going with that figure.

Here Is A Further Breakdown:

4,467,900 represent 80.5% of the total and have sales under $1 million

790,600 represent 14.3% of the total and have sales of $1-5 million

265,600 represent 4.8% of the total and have sales of $5-100 million

23,311 represent 0.4% of the total and have sales of $100 million +

Total Businesses =5,547,400

*Courtesy: BizStats
Here’s A Breakdown By Type of Business:

Services – 40% (87.8% Of Those Have Revenues Under A Million)

Retail – 19.8% (80.3% Of Those Have Revenues Under A Million)

Wholesale – 7.5% (50.7% Of Those Have Revenues Under A Million)

Manufacturing – 6.0% (61% Of Those Have Revenues Under A Million)

Construction – 12% (81% Of Those Have Revenues Under A Million)

Finance, Insurance & Real Estate – 8.3% (83% Of Those Have Revenues Under A Million)

Transportation/Utilities – 3.9% (81.3% Of Those Have Revenues Under A Million)

Agriculture & Mining – 2.4% (89.8% Of Those Have Revenues Under A Million)

Size Breakdown of Businesses

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Here is a common and much-used breakdown by the federal government:

Small Business Administration (SBA):

Very Small Business = 19 or fewer employees

Small Business = 20 to 99 employees

Medium-Size Business = 100 to 499 employees

Large Business = 500+ employees

Checklist for Valuation

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1. Start with the business
–  Value Drivers:  Size, growth rate, management, niche, history
–  Value Detractors:  Customer concentration
Poor financials
Outdated M&E
Few assets
Lack of agreements with employees, customers, suppliers
Poor exit possibilities
Small market
Potential technology changes
Product or service very price sensitive

2. Financial analysis: Market Value – comparables
Multiple of Earnings – based on rate of return desired

3. Structure and terms: 100% cash at closing could reduce price 20%

4. Second opinion: Even professionals need a sounding board

5. Indications of high value:
– High sustainable cash flow
– Expected industry growth
– Good market share
– Competitive advantage – location/exclusive product line
– Undervalued assets – land/equipment
– Healthy working capital
– Low failure rate in industry
– Modern well-kept plant

6. Indications of low value:
– Poor outlook for industry –
foreign competition
price cutting
regulations
taxes
material costs
– Distressed circumstances
– History of problems – employees, customers, suppliers, litigation
– Heavy debt load

Checklist for Valuation

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1. Start with the business
– Value Drivers: Size, growth rate, management, niche, history
– Value Detractors: Customer concentration
Poor financials
Outdated M&E
Few assets
Lack of agreements with employees, customers, suppliers
Poor exit possibilities
Small market
Potential technology changes
Product or service very price sensitive

2. Financial analysis: Market Value – comparables
Multiple of Earnings – based on rate of return desired

3. Structure and terms: 100% cash at closing could reduce price 20%

4. Second opinion: Even professionals need a sounding board

5. Indications of high value:
– High sustainable cash flow
– Expected industry growth
– Good market share
– Competitive advantage – location/exclusive product line
– Undervalued assets – land/equipment
– Healthy working capital
– Low failure rate in industry
– Modern well-kept plant

6. Indications of low value:
– Poor outlook for industry –
foreign competition
price cutting
regulations
taxes
material costs
– Distressed circumstances
– History of problems – employees, customers, suppliers, litigation
– Heavy debt load

Checklist for Valuation

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1. Start with the business
– Value Drivers: Size, growth rate, management, niche, history
– Value Detractors: Customer concentration
Poor financials
Outdated M&E
Few assets
Lack of agreements with employees, customers, suppliers
Poor exit possibilities
Small market
Potential technology changes
Product or service very price sensitive

2. Financial analysis: Market Value – comparables
Multiple of Earnings – based on rate of return desired

3. Structure and terms: 100% cash at closing could reduce price 20%

4. Second opinion: Even professionals need a sounding board

5. Indications of high value:
– High sustainable cash flow
– Expected industry growth
– Good market share
– Competitive advantage – location/exclusive product line
– Undervalued assets – land/equipment
– Healthy working capital
– Low failure rate in industry
– Modern well-kept plant

6. Indications of low value:
– Poor outlook for industry –
foreign competition
price cutting
regulations
taxes
material costs
– Distressed circumstances
– History of problems – employees, customers, suppliers, litigation
– Heavy debt load

Simplifying the Valuation

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“There are many reasons for valuing an entity, and those circumstances can lead to different outcomes…For instance, a business’s value for sale on a going-concern basis will differ from its value for liquidation purposes.  It similarly makes a difference if the valuation is for an orderly liquidation as opposed to a forced one.  For example, the value of a company for estate-tax purposes (fair market value) likely will differ from its value for a sale to a specific purchaser (investment or strategic value).  In some instances involving litigation, the courts or the law may dictate which standard of value to use.”

     Source: Journal of Accountancy , August 2003

Introduction

The two variables – EBIT and DCF numbers – are affected by not only the financial aspects of the business but also the non-financial aspects, which can be both objective and subjective.  For purposes of buying or selling a company, it is important for the seller to determine the floor price (the lowest acceptable price) and for the buyer to determine the walk-away price (the highest possible offer).  Valuing companies may be more of an art than a science, but there are three basic factors that buyers focus on when trying to establish a price for a target company.

1.  Quality of Eearnings

i.e., not a lot of “add-backs” or one-time events like the sale of real estate which does not reflect on the true earning power of the company’s operations.  It is not unusual for companies to have some non-recurring expenses every year, whether it is a new roof on the plant, a hefty lawsuit, write-down of inventory, etc.

2.  Sustainability of Earnings After the Acquisition. 

The key question a buyer often asks is whether he is acquiring a company at the apex of its business cycle or whether the earnings will continue to grow at the previous rate.

3.  Verification of Information

i.e., the concern for the buyer is whether the information is accurate, timely and relatively unbiased.  Has the company allowed for possible product returns or allowed for uncollectible receivables?  Is the seller above-board, or are there skeletons in the closet?

Measuring Earnings

When a seller talks about earnings, earnings really needs to be defined; e.g., EBIT or EBITDA; last year’s earnings or this year’s projected earnings; EBITDA – CAP X; restated without prerequisites but with add-backs, etc.

When a buyer is analyzing earnings, is it for one year, three years, interim earnings annualized, combination of reporting periods, projections, etc.?  What is the timeframe for measuring earnings and what is the trend of earnings?

Another concern in measuring earnings in the future is related to what changes might affect earnings, such as increase in rent, family members off the payroll, loss of key customers and/or vendors, etc.  Beware of companies that are locked into long-,term contracts in which they are unable to raise prices or companies in a commodity-type business in which there is unrealistic market pricing.

Key Considerations

The following questions are useful to understand the business and thereby value the company more prudently:

  • What’s for sale?  What’s not for sale?  Does it include real estate?  Are some of the machines leased instead of owned?
  • What assets are not earning money?  Should these assets be sold off?
  • What is proprietary?  Formulations, patents, software, etc.
  • What is their competitive advantage?  A certain niche, superior marketing or better manufacturing?
  • What is the barrier of entry?  Capital, low labor, tight relationships?
  • What about employment agreements / non-competes?  Has the seller failed to secure these agreements from key employees?
  • How does one grow the business?  (Maybe it can’t be grown.)
  • How much working capital does one need to run the business?
  • What is the depth of management and how dependent is the business on the owner/manager?
  • How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?

Conclusion

Much of the information above will influence the person’s perception of value. Valuation is often in the eyes of the beholder, whether the price is rational or not.

Simplifying the Valuation

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“There are many reasons for valuing an entity, and those circumstances can lead to different outcomes…For instance, a business’s value for sale on a going-concern basis will differ from its value for liquidation purposes. It similarly makes a difference if the valuation is for an orderly liquidation as opposed to a forced one. For example, the value of a company for estate-tax purposes (fair market value) likely will differ from its value for a sale to a specific purchaser (investment or strategic value). In some instances involving litigation, the courts or the law may dictate which standard of value to use.”

Source: Journal of Accountancy , August 2003

Introduction

The two variables – EBIT and DCF numbers – are affected by not only the financial aspects of the business but also the non-financial aspects, which can be both objective and subjective. For purposes of buying or selling a company, it is important for the seller to determine the floor price (the lowest acceptable price) and for the buyer to determine the walk-away price (the highest possible offer). Valuing companies may be more of an art than a science, but there are three basic factors that buyers focus on when trying to establish a price for a target company.

1. Quality of Eearnings

i.e., not a lot of “add-backs” or one-time events like the sale of real estate which does not reflect on the true earning power of the company’s operations. It is not unusual for companies to have some non-recurring expenses every year, whether it is a new roof on the plant, a hefty lawsuit, write-down of inventory, etc.

2. Sustainability of Earnings After the Acquisition.

The key question a buyer often asks is whether he is acquiring a company at the apex of its business cycle or whether the earnings will continue to grow at the previous rate.

3. Verification of Information

i.e., the concern for the buyer is whether the information is accurate, timely and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectible receivables? Is the seller above-board, or are there skeletons in the closet?

Measuring Earnings

When a seller talks about earnings, earnings really needs to be defined; e.g., EBIT or EBITDA; last year’s earnings or this year’s projected earnings; EBITDA – CAP X; restated without prerequisites but with add-backs, etc.

When a buyer is analyzing earnings, is it for one year, three years, interim earnings annualized, combination of reporting periods, projections, etc.? What is the timeframe for measuring earnings and what is the trend of earnings?

Another concern in measuring earnings in the future is related to what changes might affect earnings, such as increase in rent, family members off the payroll, loss of key customers and/or vendors, etc. Beware of companies that are locked into long-,term contracts in which they are unable to raise prices or companies in a commodity-type business in which there is unrealistic market pricing.

Key Considerations

The following questions are useful to understand the business and thereby value the company more prudently:

  • What’s for sale? What’s not for sale? Does it include real estate? Are some of the machines leased instead of owned?
  • What assets are not earning money? Should these assets be sold off?
  • What is proprietary? Formulations, patents, software, etc.
  • What is their competitive advantage? A certain niche, superior marketing or better manufacturing?
  • What is the barrier of entry? Capital, low labor, tight relationships?
  • What about employment agreements / non-competes? Has the seller failed to secure these agreements from key employees?
  • How does one grow the business? (Maybe it can’t be grown.)
  • How much working capital does one need to run the business?
  • What is the depth of management and how dependent is the business on the owner/manager?
  • How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?

Conclusion

Much of the information above will influence the person’s perception of value. Valuation is often in the eyes of the beholder, whether the price is rational or not.

Simplifying the Valuation

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“There are many reasons for valuing an entity, and those circumstances can lead to different outcomes…For instance, a business’s value for sale on a going-concern basis will differ from its value for liquidation purposes. It similarly makes a difference if the valuation is for an orderly liquidation as opposed to a forced one. For example, the value of a company for estate-tax purposes (fair market value) likely will differ from its value for a sale to a specific purchaser (investment or strategic value). In some instances involving litigation, the courts or the law may dictate which standard of value to use.”

Source: Journal of Accountancy , August 2003

Introduction

The two variables – EBIT and DCF numbers – are affected by not only the financial aspects of the business but also the non-financial aspects, which can be both objective and subjective. For purposes of buying or selling a company, it is important for the seller to determine the floor price (the lowest acceptable price) and for the buyer to determine the walk-away price (the highest possible offer). Valuing companies may be more of an art than a science, but there are three basic factors that buyers focus on when trying to establish a price for a target company.

1. Quality of Eearnings

i.e., not a lot of “add-backs” or one-time events like the sale of real estate which does not reflect on the true earning power of the company’s operations. It is not unusual for companies to have some non-recurring expenses every year, whether it is a new roof on the plant, a hefty lawsuit, write-down of inventory, etc.

2. Sustainability of Earnings After the Acquisition.

The key question a buyer often asks is whether he is acquiring a company at the apex of its business cycle or whether the earnings will continue to grow at the previous rate.

3. Verification of Information

i.e., the concern for the buyer is whether the information is accurate, timely and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectible receivables? Is the seller above-board, or are there skeletons in the closet?

Measuring Earnings

When a seller talks about earnings, earnings really needs to be defined; e.g., EBIT or EBITDA; last year’s earnings or this year’s projected earnings; EBITDA – CAP X; restated without prerequisites but with add-backs, etc.

When a buyer is analyzing earnings, is it for one year, three years, interim earnings annualized, combination of reporting periods, projections, etc.? What is the timeframe for measuring earnings and what is the trend of earnings?

Another concern in measuring earnings in the future is related to what changes might affect earnings, such as increase in rent, family members off the payroll, loss of key customers and/or vendors, etc. Beware of companies that are locked into long-,term contracts in which they are unable to raise prices or companies in a commodity-type business in which there is unrealistic market pricing.

Key Considerations

The following questions are useful to understand the business and thereby value the company more prudently:

  • What’s for sale? What’s not for sale? Does it include real estate? Are some of the machines leased instead of owned?
  • What assets are not earning money? Should these assets be sold off?
  • What is proprietary? Formulations, patents, software, etc.
  • What is their competitive advantage? A certain niche, superior marketing or better manufacturing?
  • What is the barrier of entry? Capital, low labor, tight relationships?
  • What about employment agreements / non-competes? Has the seller failed to secure these agreements from key employees?
  • How does one grow the business? (Maybe it can’t be grown.)
  • How much working capital does one need to run the business?
  • What is the depth of management and how dependent is the business on the owner/manager?
  • How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?

Conclusion

Much of the information above will influence the person’s perception of value. Valuation is often in the eyes of the beholder, whether the price is rational or not.

What Is a Business Worth?

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Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.

The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.

So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.

However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.

Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.

Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.

What Is a Business Worth?

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Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.

The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.

So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.

However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.

Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.

Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.

What Is a Business Worth?

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Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.

The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.

So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.

However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.

Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.

Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.

A Different Look at Valuing Your Company

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Is there pricing elasticity?
What’s proprietary?
What’s the company’s competitive advantage?
Status of employment agreements and non-competes?

Post-Acquisition:
Are there cost savings after purchase?
Are there significant capital expenditures pending?
Is there synergy with the seller?
Is it perceived the integration will go smoothly?
Are there substantial cross-selling possibilities?
Will the cultures blend?

The Financials: By training and education, many business appraisers emphasize the numbers. They will look at the past, current and future numbers. They will consider all the basic financial figures such as:
• growth rate
• return on investment
• gross profit percentage
• EBITDA percentage
• industry metrics
• debt to net worth
• book value

Fundamentals: Business appraisers should also consider the company’s history, its management, products, distribution, etc. The following should also be seriously considered: multi-products, different markets, wide distribution and the quality of management.

Value Drivers: These are important business elements that are most often ignored or completely overlooked by business appraisers.  However, they are very important to a potential buyer.
• product differentiation
• defensible position
• technology
• dominant market share
• well-known brand(s)
• cost advantage
• proprietary customer

Creating Value in Privately Held Companies

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“As shocking as it may sound, I believe that most owners of middle market private companies do not really know the value of their company and what it takes to create greater value in their company … Oh sure, the owner tracks sales and earnings on a regular basis, but there is much more to creating company value than just sales and earnings”
     Russ Robb, Editor, M&A Today

Creating value in the privately held company makes sense whether the owner is considering selling the business, plans on continuing to operate the business, or hopes to have the company remain in the family.  (It is interesting to note that, of the businesses held within the family, only about 30 percent survive the second generation, 11 percent survive the third generation and only 3 percent survive the fourth generation and beyond).

Building value in a company should focus on the following six components:

  • the industry
  • the management
  • products or services
  • customers
  • competitors
  • comparative benchmarks

The Industry – It is difficult, if not impossible, to build value if the business is in a stagnating industry.  One advantage of privately held firms is their ability to shift gears and go into a different direction.  One firm, for example, that made high-volume, low-end canoes shifted to low-volume, high-end lightweight canoes and kayaks to meet new market demands.  This saved the company.

The Management – Building depth in management and creating a succession plan also builds value.  Key employees should have employment contracts and sign non-compete agreements. In situations where there are partners, “buy-sell” agreements should be executed. These arrangements contribute to value.

Products or Services – A single product or service does not build value.  However, if additional or companion products or services can be created, especially if they are non-competitive in price with the primary product or service – then value can be created.

Customers – A broad customer base that is national or international is the key to increasing value.  Localized distribution focused on one or two customers will subtract from value.

Competitors – Being a market leader adds significantly to value, as does a lack of competition.

Comparative Benchmarks – Benchmarks can be used to measure a company against its peers.  The better the results, the greater the value of the company.

Three keys to adding value to a company are: building a top management team coupled with a loyal work force; strategies that are flexible and therefore can be changed in mid-stream; and surrounding the owner/CEO with top advisors and professionals.

The Value of a Business: Get to the Heart of the Matter

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What is the value of your business? There are many ways to approach that question — based on complex formulas or just a good hard look at the balance sheet, but no answer based purely on numbers is going to be exactly right. Even factoring in that most popular of abstracts — goodwill — the true essence of an operation is not likely to be revealed.

To find the real value of a business, we must go to its very heart: the attitude, work habits, managerial style, customer/marketplace savvy, and community reputation of the person in charge. The business owner or manager is the final, and most cogent, indicator of business worth. Check out the following healthy signs, and then listen to the heartbeat of your own business and its leadership style:

Optimistic Attitude

Many business owners today are more pragmatic and take pride in being less of an “incurable optimist.” The owner of yesterday wasn’t afraid to follow the words of Willy Loman in Death of a Salesman: “A salesman has got to dream, boy. It comes with the territory.” A decline in optimism is an unfortunate trend. In a world driven by technology and scientific analysis, it’s easy to forget the importance of the right attitude. If business owners aren’t positive, how can they expect customers and employers to be? The owner who believes business is bad will probably not see it getting any better. Of course, there are always the real-life factors — banks that won’t lend, customers who stop buying, services that become obsolete. However, if these problems didn’t exist, there would be something else to keep the negative thinkers occupied.

How to project a positive attitude? Begin with the easiest. Sprucing up the place of business with fresh paint, newly-cleaned carpeting, well-stocked shelves, for example, will say a lot for the health of a company. Less visible, but highly important, is a positive outlook on the future of the business. Business owners should be prepared to spend what it takes to generate new business, and should take the time to explore new possibilities for long-range success. If the company currently has no mission statement or business plan, creating one will speak volumes abut owner’s enthusiasm for the future of the operation.

Healthy Managerial Style

In the modern workplace, where you can hardly see the business through the forest of “managers,” it’s good to get back to basics. Too often, owners get bogged down in busy work, or in “managing the managers.” They should occasionally take time off to work the floor, drive the delivery truck, sell the product. Owners who put themselves in the trenches are in touch with the business — and this first-hand understanding will be evident to anyone taking stock of the company’s worth.

An equally healthy approach to managing is preparing for contingencies. The owner’s style should include appropriate delegation of duties and a backup managerial plan in case of unforeseen calamity.

And finally, owners should project a general sense of well-being and energy. This may be easier said than done, but it’s important to note. Anyone taking stock of a business will draw a quick, and key, first impression from the very posture and tone of voice the owner presents.

Customer relations say a lot about the “heart” of a business. The business owner’s approach to handling customers sets the standard for everyone down the ladder. A healthy business avoids treating the customer like a number — or maybe worse, like a stranger. For example, successful big-time operations who deal with customers by telephone make it a point to ask for the proper pronunciation of a name, or request permission to use the customer’s first name. Added to basic courtesies is the sense that salespeople are happy to take the time necessary to answer questions and/or deal with problems.

Whether products and services are sold by phone or on the floor, employees should be well-versed experts on whatever they’re selling. Again, large outfits have established high standards to emulate; for instance, the outdoor equipment chain with salespeople who can not only fit hiking boots to a T (or a toe), but also know how to clean, weatherproof and care for the leather, vibram, or nylon of which the boots are made. Every hour spent training salespeople in the product pays huge dividends for the company’s long-term success.

Conspicuous Image

To foster the image of an on-going, healthy business concern, business owners need to keep their image prominent before the public. Advertising can build image at the same time it attracts business. Anything from a display ad within the yellow pages listings, to a monthly “home-baked” newsletter, to the offering of free seminars, can portray the business as more than just the sum of its products. An example of image-making at its best comes from the owner of a natural foods store in a metrowest Boston town. She not only produces her own monthly newsletter (with product information and coupons, plus general health articles), but she also sponsors evening lectures on subjects such as acupuncture, aromatherapy, women’s health, and children’s nutrition. What’s more, she offers free tours of her in-house cookie “factory” to local schools. The samples the kids take home are the best cost-per-inch ad value imaginable!

For the less adventurous, there are plenty of conservative ways to make ads pay. Every Saturday for years, the sports section of a Los Angeles newspaper carried a one-inch ad for the “Best Hamburger in Town.” No catchy phrases, no dazzling graphics, but the ad was there — and there — and there again. The consistency sold the restaurant’s product and its image and eventually, the eatery became a 10 plus chain.

Community Involvement

To further promote the business — and its owner — as a rock-solid and permanent part of the local scene, there are opportunities just waiting to be tapped. Taking an active role in the Chamber of Commerce, trade or service associations, or sponsoring worthy local events all lead to great public relations. In addition to the more traditional public donations — providing kids’ sports team uniforms, taking out ads in yearbooks — the business can band together to join walkathons, or volunteer to man the phones for public TV or radio fundraisers. Doing “good” makes the business owner and the employees feel good about themselves.

“Feeling good” is a good point at which to conclude our journey to the heart of a business. Dollars and cents will always be important in establishing value, but it’s a kind of people-sense that will give the truest reading.

12 Ways to Increase the Value of Your Company

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1. Build a solid management team. A business with sales of $5 million and up needs a full complement of officers and directors. Such a team might include: a COO, a CFO, a sales manager and, depending on the type business, an IT director. It is also beneficial to create a Board of Directors with at least two outside members. This professionalizing of management can remove the stigma of “the one man band.” Not only will this build a stronger company, it will increase the value to a possible acquirer. Smaller firms should also build a strong management team, and creating an outside advisor group is also a good idea.

2. Loyal employees.  Happy and loyal employees make for a strong company.  Top management should have non-compete and/or confidentiality agreements.  Solid benefits plans for all employees should be in place. A company’s greatest asset is its employees and perhaps its biggest value-increaser.

3. Growth. Some smaller companies are kept small to maximize the owner’s benefits – the proverbial “cash cows.” However, if building value is the goal, then developing new products or services, building market share, expanding markets or opening new ones, is critical. This generally requires a financial investment, but building a strong growth rate also builds value.

4. Understanding your market. The value of a company may be contingent on its industry, its place in the industry and the direction of the industry itself. How big is the industry, is it headed up or down, who is the competition and how big is the company’s market share? Is it time to change direction or diversify?

5. Size counts. Companies with less than $5 million in sales and an EBITDA of less than $1 million can be perceived as small. Therefore, they may be dependent on continuing outside financing and lack the critical mass for both buying and selling power. These companies can be perceived as too small for acquisition or are penalized when it comes to value. However, over the past few years corporate buyers, as well as private equity firms, have seen the advantages of purchasing smaller firms. Obviously, companies with $10 million or more in sales and an EBITDA of $1 million or more are considered as solid and able to stand on their own.

6. Changing direction.  Small companies can be very adept at changing course and implementing change. They have to be able to change and move quickly to take advantage of new markets, to fill voids in existing markets and even to add or change products or services.

7. Documentation. Business plans, financial plans and personnel plans should all be in writing – and kept current. Terms of employment agreements should be spelled out and in writing. Business planning and company objectives, etc., should also be in writing and reviewed periodically. Contracts should be reviewed and maintained on a current basis.

8. Diversification. A major problem with many small companies is that their business is concentrated on one or two major customers or clients. Ideally, no customer or client should represent more than 10 percent of sales. Expanding to new markets, introducing new products, and finding new customers must be considered without deviating too far from the company’s core business.

9. Name and brand identity. Nothing beats the name Walt Disney, or Kleenex® or the soft drink called Coke® – they are household names. Small firms may not have the brand or name recognition of these companies, but they can work at it. This recognition is especially powerful in the consumer product area. But franchising has expanded this name or brand recognition to many different types of businesses.

10. Taking advantage of proprietary and other assets. Patents, brand names, copyrights, alliances, and joint ventures are all examples of not only proprietary assets, but, in many cases, valuable ones. Even equipment can be used in several different ways. Large landscape companies in cold climates put snowplows on their trucks, utilize their existing workforce and become a snowplowing company for their regular landscaping customers — office complexes, apartment and condo developments, etc.

11. “Lean and Mean.”  Many companies lease their real estate needs, outsource their payroll, have their manufacturing done offshore, have UPS handle all of their logistical needs. Since all non-core requirements are done by someone else,  the company can focus its efforts on what they do best.

12. Do it now! The owners of small firms, even large ones, have an attitude that says, “I don’t have time now, I’ll do it tomorrow” or “I’m too busy now putting our fires.” So the real challenges of building the business, and value, get sidetracked or put off indefinitely. Creating value is critical to the long-term (and short-term) success of the business.

Keep in mind that the best time to consider selling is when business is good, the business is running profitably, and many of the above “value-adders” are in place. By contacting your local professional intermediary you can explore which of the above will add the most value to your firm, so it will be ready to sell when you are.

What Is a Company Worth?

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This question can only be answered by addressing other related questions, specifically: Who’s asking and for what purpose?

From the perspective of the owner, prospective buyers, the IRS, lenders and divorce & bankruptcy courts, the value of a business for purposes of a sale, estate planning, orderly or forced liquidation, gifting, divorce, etc. can be vastly different.

Intrinsically tied to the various purposes of valuation are numerous definitions of “value.” Here are a few examples:

Investment Value – The value an acquirer places on a business based on a future return on investment determined by assessing past and current performance, future prospects, and other opportunities and risk factors involving the business.

Liquidation Value – The value derived from the sale of the assets of a business that is closed or expected to be closed following the sale.

Book Value – Book value is the difference between the total assets and total liabilities as accounted for on the company’s balance sheet.

Going Concern Value – Used to define the intangible value which may exist as a result of a business having such attributes as an established, trained and knowledgeable workforce, a loyal customer base, in-place operating systems, etc.

Fair Market Value
For the purpose of this article, the focus will be on transaction related valuations. Fair Market Value (“FMV”) is the most relevant definition of “value” and is of the most interest to business owners. The more knowledge business owners and prospective buyers have about the valuation process, the more likely they will come to an agreement on a purchase price.

FMV is the measure of value most used by business appraisers, as well as the Internal Revenue Service (IRS) and the courts. FMV is essentially defined as “the value for which a business would sell assuming the buyer is under no compulsion to buy and the seller is under no compulsion to sell, and both parties are aware of all of the relevant facts of the transaction.” IRS Revenue Rule 59-60 lists the following factors to consider in establishing estimates of FMV:

1. The nature and history of the business.
2. The general economic outlook and its relation to the specific industry of the business under review.
3. The earnings capacity of the business.
4. The financial condition of the business and the book value of the ownership interest.
5. The ability of the business to distribute earnings to owners.
6. Whether or not the business has goodwill and other intangible assets.
7. Previous sales of ownership interests in the business and the size of ownership interests to be valued.
8. The market price of ownership interests in similar businesses that are actively traded in a free and open market, either on an exchange or over-the-counter.

What is Goodwill?
An important element of value, when it exists, is goodwill. The IRS defines goodwill in its Revenue Rule 59-60, stating, “In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value for the tangible assets exceeds the net book value of such assets.”

Valuation Approaches and Methods
Exploring valuation techniques requires an understanding of the tools available. Which tools are utilized depends in part on the purpose of the valuation and the circumstances of the subject company. Generally there are several approaches to valuing a business. Within these approaches, there are several different methods. Listed below are the three major approaches along with some examples of specific methods that fall under each category.

• Income Approach
Discounted Cash Flow Method
Single Period Capitalization of Earnings Method
• Market Approach
Comparable Publicly Traded Company Analysis
Comparable Merger & Acquisition Analysis
• Asset-Based Approach
Adjusted Net Asset Method
Excess Earnings Method

All of the above methods and approaches are frequently used in business valuations.

Normalizing the Financial Statements
Before the approaches and methods above can be applied, it is necessary to analyze and normalize both the income statement and balance sheet of the business for the current and past periods selected to form the basis of the valuation.

• Normalizing the Income Statement

Normalizing the Income Statement generally entails adding back to earnings certain personal expenses, non-recurring and non-cash items. Examples of these “add-backs” could include depreciation, amortization, auto, boat and airplane expenses, one-time extraordinary expenses and other excess expenses such as owner’s salaries and family member’s salaries that are above fair market value, travel and entertainment, bonuses, etc. Owners usually tend to be extremely liberal when normalizing the income statement in order to bolster earnings, which can artificially inflate valuation. Each item must be carefully analyzed and scrutinized to insure that the normalization process is credible.

• Normalizing the Balance Sheet

Normalizing the Balance Sheet includes adjustments that eliminate non-operating assets and other assets and liabilities that are not included in the proposed transaction, and therefore the valuation. The book value of the assets will be adjusted up or down to reflect their fair market value. Inter-company charges will also be eliminated. Inventory may be adjusted upward or downward based on prior accounting procedures and/or obsolescence. Accounts receivable may also require an adjustment based on an analysis of collectibility.

Relevant Terminology:

EBIT – An acronym for earnings before interest and taxes

EBITDA – An acronym for earnings before interest, taxes, depreciation and amortization.

Capitalization Rate – Any divisor that is used to convert income into value. This is generally expressed as a percentage.

Discount Rate – The rate of return that is used to convert any future monetary gain into present value.

(Note: when determining FMV, the earnings stream selected to be capitalized or discounted should be normalized.)

Summary
Even with all the terminology and definitions discussed above, the answer to the original question has not yet completely been answered: What is the company worth?

The value driver of a business is the ability of the entity to generate future cash flow or earnings. Business appraisers will assign an appropriate capitalization rate (or multiple) to a selected earnings stream to derive an overall value for a business. The value of the net assets of the business will be compared to the cash flow valuation and may be adjusted upward or downward. For example: if the earnings based valuation is less than the net asset value, an upward adjustment may be in order. Conversely, if the net assets are negligible, a downward adjustment is more likely to occur.

Many appraisers typically use a common range of multiples to arrive at a “ballpark” indication of value (for example, 4 to 6 times EBITDA). While this approach is commonplace, an in-depth valuation of the subject company will produce a more accurate result. There are too many intangible factors to be considered to rely solely on the capitalization of earnings. Of course, the ultimate value of a company will be determined by the marketplace, which can greatly differ from a seller’s expectation, as well as the expectations of potential acquirers.

It is not uncommon for business owners to have an inflated sense of value of their company. This could be due to a variety of factors including emotional attachment to the business, unwillingness to accept the impact of the risk factors of the business, outside influence from previous market conditions, incorrect conclusion of normalized earnings, comparable transactions, etc. Conversely, acquirers often undervalue businesses. In their quest to “buy right” they often end up paying a lower multiple for a company with serious negative factors, while passing up on higher multiple opportunities, which, due to the quality, are actually better buys.

Valuation is a complex process. Owners and buyers will be well served if they rely on professional advisors such as their accountants, business appraisers, intermediaries or investment bankers.