This is the second part of Blue River’s educational series entitled “Straight Talk to Owners About Business Valuations” written by Blue River’s Managing Partner, William Loftis. The series is designed to help middle market business owners and their transaction advisors (i.e., attorneys, CPAs, investment bankers, M&A brokers, and others) appreciate the importance of accurately understanding business value before going to market. Wrong expectations lead to undesirable outcomes, while right expectations always improve transactional results for owners.
If you missed the first article, click here: Part 1: What Is My Company Really Worth?
The first article cautioned owners to avoid embracing valuation expectations that deviate from financial reality, because wrong beliefs can produce at least three unfixable consequences:
- Underestimated Value – When owners sell their businesses at prices lower than fair value, the buyer achieves a windfall gain at the seller’s expense. The seller’s lost value is gone forever.
- Course Correction Opportunities Lost – When owners depend on transaction proceeds to fund next chapters of life, they need to know what the real business value is long before it is time to sell. If insufficient, they can take corrective actions to enhance value. However, if a business sale fails to deliver against expectations, reconciling to unforeseen economic realities can be painful.
- Overestimating Value – When owners take their businesses to the market insisting on financially unachievable prices, it chills market demand and actually drives business value down. To rekindle interest from buyers, sellers must demonstrate they have abandoned unrealistic notions, which often requires meaningful price discounts.
This article addresses the mistaken approaches and methods owners use to arrive at and justify unrealistic valuation expectations.
Valuation Approaches that Lead to Unrealistic Expectations
Every business transaction has at least 4 components: 1) the buyer; 2) the seller; 3) the buyer’s transaction consideration paid to the seller (a.k.a., the purchase price); and 4) the seller’s assets or securities conveyed to the buyer in exchange for the transaction consideration.
Buyers of privately held middle market companies (e.g., private equity firms, corporations, and family offices) and their lenders ultimately set prices using the acquired company’s expected free cash flows. Free cash flow, as used here, is defined as:
EBIT X (1 – t) + Depreciation and amortization – Changes in working capital – Capital expenditures = Free Cash Flow
EBIT – Earnings before interest and taxes (a.k.a., operating earnings);
t – the marginal tax rate of the c-corporation or the pass-through entity’s owners;
Depreciation and amortization – non-cash expenses;
Changes in working capital – increases or decreases in net working capital (typically , accounts receivable + inventory – accounts payable); and
Capital expenditures – the cash investments necessary to maintain property, plant, and equipment or other fixed assets arising from the ordinary course of business.
Free cash flow – the remaining cash available to equity stakeholders and lenders produced by the operations of the business.
While examined in more detail in a subsequent article, a buyer’s transaction consideration will always be constrained by its assessment of free cash flows. Free cash flows must cover operating expenses, working capital requirements, capital expenditures, taxes, transaction debt service, and deliver appropriate returns to investors. If investors and lenders don’t believe free cash flows are adequate to satisfy debt service and deliver risk adjusted returns to investors, there won’t be money to fund the deal. If a deal won’t bank, it won’t close.
Owners, on the other hand, frequently use unconventional methods that lead to mistaken valuation expectations like:
- Market rumors
- Wrong comparisons
- Reverse engineered value from perceived personal post-closing needs
- Excessive zeal for potential
- Replacement costs
- Career benchmarking
- Dependence on valuations created for non-transactional purposes
- Dependence on the wrong advisors
It is natural for owners to think the best of their businesses, but when expectations are built on faulty methods and assumptions, the resulting valuation opinions are usually wrong. Unfortunately, the longer incorrect expectations go unchallenged, the more entrenched wrong beliefs become.
Mistake #1: Market Rumors
Owners carefully guard the confidential information of their businesses, but they do talk to other owners with some transparency – at the country club, at CEO roundtables, on the sidelines while their kids play soccer… When the topic centers on mergers and acquisitions (“M&A”), some owners like to share their inside anecdotal insights to others who are eager to apply the information to their own situations.
I met with the owners of an automotive supplier who believed their company was worth $24 million. The company’s most recent historical year produced $2 million earnings before interest, taxes, depreciation, and amortization (“EBITDA”), which meant they used an EBITDA multiplier of 12 ($24 million/$2 million). When asked how they identified 12 as the right multiplier, one of the owners reported a friend at the country club knew a guy who just sold his aerospace company for 12 times EBITDA. In many ways, the parts manufactured by both companies were similar. Only their customers were different. Therefore, it seemed reasonable to the owners that both companies should have the same multiple.
Transaction accounts are often like fish stories, they are frequently embellished and each retelling improves on earlier versions. In reality, sellers usually contractually prevented from sharing transaction terms with the public. That is why press releases typically state: “The terms of the transaction were not disclosed.” Consequently, it is difficult to verify or depend on rumored transaction terms.
Mistake #2: Wrong Comparisons
Previous private company transactions are difficult to rely upon when determining value, because, unlike real estate, businesses are not commodities and are rarely perfectly comparable to one another. Is a hair salon products supplier comparable to a janitorial supply company? No, yet they are classified in the same industry and databases report transactions by industry. Is a landscape company from Florida or California comparable to a landscape company in Wisconsin or Michigan? Of course not, but the preponderance of transactions in databases overwhelmingly come from Florida, Texas, and California. For these and many other reasons, few valuation analysts rely on previous transactions as a primary approach to determining value.
In the illustration above, the owners of an automotive supplier compared their business to an unsubstantiated rumored transaction in the aerospace industry. Even if the referenced aerospace supplier did achieve a 12X multiple, the prevailing multiples in the automotive supplier sector ranged from 3.75 to 4.25 for companies of that size. In other words, the valuation range for the auto supplier was likely between $7.5 million and $8.25 million using like-kind comparisons – nowhere near the $24 million they expected.
Mistake #3: Reversed Engineered Value from Perceived Post-Closing Needs
Successful businesses permit owners to enjoy the fruits of their labor through income, perks, and other benefits. Owners grow accustomed to company-paid conferences to exotic places, luxury cars, car insurance, gas, country clubs, tickets to entertainment venues, health insurance, and many more. Some owners set the sale price of their business by estimating the cash a sale must deliver to produce an equivalent lifestyle after the closing.
The problem with using the seller’s post-closing needs as a valuation method is that it fails to account for an essential ingredient to the transaction – the buyer. Professional acquirers base their purchasing decisions on a number of factors, but the seller’s post-closing financial needs is not among them.
Mistake #4: Excessive Zeal for Potential
Some owners base their valuation expectations on the business’ potential. Owners frequently say in one form or another:
“Sales and earnings are bound to go through the roof if only…
- the Defense Department comes through on that contract
- Amazon embraces our product
- GM begins buying parts from us…”
Optimism is necessary in business, but potential, as my grandpa used to say, means you haven’t done it yet.
To be clear, buyers purchase future financial performance and not the past, which means potential must be taken into account. Even so, the past is often a better proxy to predict the future than hope, and most buyers will not write checks for unrealized potential.
With the above said, there are ways for sellers to capture the value if previous initiatives are likely to produce future cash flows. For example, if the business planted apple seeds several years ago and the orchard will begin producing apples next year, the seller deserves some value for future cash flows. Buyers will sometimes pay for expected future financial performance through earnout agreements where the seller shares risk with the buyer. Earnout agreements make transaction consideration contingent upon future events.
Mistake #5: Replacement Costs
A frequent argument owners use to justify higher business values is that the sale price should be the cost it would take in today’s dollars to replace all the assets put in service through the years. While I was touring a 75-year-old business, the owners pointed out original machines still in use on the factory floor. The vast majority of equipment was more than 30-years-old. The owners proudly stated that it would cost over $50 million to replicate the factory, which was the price they wanted for the business. Unfortunately, the company’s EBITDA was under $1.5 million in an industry where EBITDA multiples hovered around 4X, which implied a value of approximately $6 million. The company’s balance sheet did not reflect $50 million worth of assets either. Instead, most assets had been fully depreciated, and net book value was under $3 million.
When establishing valuation expectations, owners should think like professional acquirers. Buyers set prices using benefit streams like free cash flow or EBITDA. Benefit streams deliver the returns buyers seek, and assets are only the means to produce the benefit streams. Unless the purchase price delivers satisfactory risk adjusted returns from benefit streams, buyers will not commit capital. Based on the above company’s EBITDA, no investor would want to replicate the factory at the seller’s asking price. They buyer would be better putting its money in a low risk bank certificate of deposit.
Mistake #6: Career Benchmarking
Some owners believe business value is the monetary summation of their life’s work. One owner looked at a $2.5 million appraisal on his business and said with tears: “For the past 40 years, I have dedicated myself to this business. I sacrificed my time, my energy, my treasure for this business. I gave everything I had to this business, and you say it’s only worth $2.5 million? That cannot be!”
Perhaps doctors accustomed to entering difficult mortality/morbidity discussions with patients can understand the emotions owners experience when the summation of their life’s achievements is reduced to a number. Owners often don’t know the value they would apply to represent their life’s work, but it is usually much higher than actual value. When emotions contend with rationality, feelings often win. However, it is always better to reconcile with reality than to base decisions on emotions, because emotions are notorious deceivers.
Mistake #7: Dependence on Appraisals Performed for Non-Transactional Purposes
Business appraisals can be performed for a host of reasons such as estate and gift taxes, shareholder buyouts, litigation, damage calculations, buy/sell purposes, and more. Each specific purpose can produce a different value. No appraisal should ever be relied upon except for the specific purpose it was created. When setting transaction expectations, owners should only trust valuation reports produced specifically for buy/sell purposes.
To illustrate, valuations used for litigation purposes are likely to vary widely depending on whether the valuator represents the plaintiff or defendant. If a report produced for litigation purposes is used by a seller in a transaction, the recommended value will likely be far too high for most buyers or significantly lower than the seller should realize.
Mistake #8: Dependence on the Wrong Professional Advisors
A reliable valuation is foundational to good decision-making in business transactions. Therefore, professional advisors who offer valuation opinions need to get it right. Regrettably, many advisors offer indefensible quasi-professional opinions that cause more harm than good. Professional advisors tend to trust that their general education equips them to render reliable valuation advice. However, without specialized training, access to valuation resources, and other tools of the trade, advisors often step into the same traps as owners by relying on rumors, inappropriate comparisons, etc. When professional advisors render erroneous opinions, their clients’ expectations harden like cement. Quasi-professional opinions are an extreme disservice to business owners, because it sentences them to the consequences of indefensible valuation expectations.
Illustration: Owner Storms Out In Disbelief
William “Bill” Loftis is Managing Partner and co-founder of Blue River. Mr. Loftis developed a passion for M&A as a transaction principal, and has assisted buy and sell-side clients through the M&A process in multiple industries. He earned a B.A. in Business Administration from Alma College and a Master of Science in Finance from Colorado State University. Bill’s full bio is available here.
About Blue River
Blue River has been representing middle market business owners and professional acquirers through the merger and acquisition process for nearly two decades. We understand transaction values from the theoretical and practical levels like few others. Since transactions depend on funding, we blend traditional appraisal methods with advanced modeling used by banks and professional investors to support our opinions. Our findings are supported by internal and external industry transaction databases, original research, and experience.
If you plan to sell all or a portion of your company in the near term or over the next 5 to 10 years, transaction value will likely be among the most important decision variables. The sooner you understand how key internal and external drivers affect value, the more time you will have to strategically influence outcomes. Contact us to schedule an appointment with one of our Certified Valuation Analysts.