I was in an elegant conference room with a small group of folks who owned a very nice company. I had been asked to perform a valuation as they considered going to market. I was there to share my findings. The Power Point presentation was on a large screen TV. The summary page showed a value of $40 million.
The company had been in business for more than 20 years. Its primary service was providing power backup solutions for phone-tower installations. Towers erected by mobile phone companies are attached to the power grid, and power can go down for a host of reasons, but mobile phone customers still expect their devices to operate even when power is disrupted. The company’s revenues were derived from design and installation of the backup units plus recurring revenues for ongoing testing and service contracts. Financial attributes for the most recent historical year included:
- Revenues = $27 million
- Adjusted Net Income = $4.5 million
- Adjusted EBITDA = $5 million
- Average revenue growth for previous three years = 6%
- Most recent year’s revenue growth = 7%
- Forecast revenue growth for the industry from an industry association source = 7%
- Management’s 5-year annual revenue growth forecast – 15%, 20%, 20%, 25%, and 30%. Management’s projections were aspirational and not supported with any evidence.
- Revenue content was 65% project driven, 35% recurring services with two-year contracts.
- The balance sheet was asset-light.
- Competition was strong and price elasticity was weak.
- Management capabilities were consistent with other founder-owned lower middle market businesses.
- A small number of similar privately held companies had sold within the previous three years. Available comparative data reflected the following multiples:
- Price/EBITDA = 6.3
- Price/Revenues = .8
At $40 million, the multiples implied from my valuation were:
- Price/EBITDA = 8X
- Price/Revenues = 1.38X
- Price/Net Income = 8.89X
The $40 million valuation suggested a meaningful premium over transactions of similar companies. To be clear, other relevant valuation methods were utilized to arrive at the value that are not shown here (e.g., discounted cash flow analysis of free cash flows). The point is that the valuator perceived the company to be a leader in a niche segment of the battery backup industry, and it was valued as such.
When the majority shareholder who also served as Chairman of the Board saw the valuation on the screen, his face slowly morphed into a scowl of crimson red. It was if he had eaten something particularly distasteful. His bushy gray eyebrows turned down; creases overtook his forehead; his jaw got tight and started to grind. His gaze turned from the screen back to me. As if to emphasize his displeasure, he leaned back in the leather chair and crossed his arms over his barreled chest. The other shareholders watched the Chairman’s transformation and quickly crossed their arms to mirror his body language. I quickly glanced around to make sure there were no loose heavy objects to throw at me. After a long period of silent tension, I asked for their thoughts.
The Chairman’s complexion remained blushed in spite of his deep breaths. He then leaned forward with his elbows on the conference table and said, “You missed the mark, sir.” The “sir” was not intended as a term of respect. He said, “We have a very profitable company with strong growth projections. With any meaningful research, you would have found that Microsoft’s growth is projected to be much slower than ours; yet, Microsoft’s price to earnings (P/E) ratio is 27. You show our P/E ratio at less than 9. You have done us a disservice, sir!” Again, “sir” was delivered with contempt.
He ran some quick math on his phone, looked up, and said, “By my calculations if we use Microsoft as the right comparison, the value of this company is at least $121.5 million (27 P/E Ratio X $4.5 million Net Income). However, Amazon’s growth is more like ours, and their P/E Ratio is over 50. Why have you not used other fast-growing companies in your research?” His question was rhetorical, and he really didn’t want an answer.
Still, I felt compelled to respond. I tried to point out that Microsoft and Amazon were behemoth publicly traded companies with millions of customers, recurring revenue streams, access to public capital sources (e.g., commercial paper), the best management teams on the planet, and more. In addition, Microsoft and Amazon were not even in the same industry as his company. By comparison, his company was very small. It was privately held. A large percentage of its revenues were project-oriented. Equity could not instantly be liquidated into cash. It had a small customer base. The management team was not especially accomplished and could not be compared to the management teams from the giant corporations. While no offense was intended, offense was taken. The meeting ended abruptly. I held my computer case in a protective position as I left the room fully expecting a kick in the rear.
I kept in touch with one of the minority owners through the years. The company never sold, although the minority owner wished it had. The majority shareholder passed away leaving equity and operational control to his heirs. The new management was not well received by employees or customers. Several of the installed backup systems had failed independent tests conducted by customers, which put the business in a problem-solving mode. The company never achieved its ambitious growth projections.
The point of the above story is that when owners use inappropriate comparisons, they can come up with ridiculous notions of value. While I never said it to anyone, I privately thought, “I bet the family didn’t use Microsoft or Amazon when determining the company’s value for estate tax purposes where higher values equate to higher taxes.”
William Loftis
Managing Partner
