What's your business worth?
Tuesday, 6 November 2007
Last Updated: Tuesday, 6 November 2007
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By Tom McKaskill
I often confront entrepreneurs with a stark choice – what is the best strategy to prepare your business for a sale – build up the profits or develop underlying assets and capabilities for a strategic sale.
You might well ask: “Why can’t you do both?” I am sure that some companies can, but when you look at the processes involved and the priorities that will place on where to use your surplus cash, you often see is a clear choice – you don’t have the resources to do both, so you need to decide which strategy is going to give you the highest exit price.
Companies that are sold on an EBIT multiple are those that provide the buyer with a platform that enables the buyer to generate a stream of future earnings through the use of the resources contained within the acquired business.
While these might be augmented by the buyer through the insertion of better processes, more capable management and better funding, essentially it is the same underlying business that is generating the profit stream. Thus any acquisition valuation will be based on net present value of those future earnings.
Most businesses fall into this category. Thus financial buyers typically buy retail, wholesale, light manufacturing, transport, property and services based businesses.
You increase the value of such businesses by reducing the inherent risks for the buyer, improving the visibility and reliability of future earnings forecasts, improving on-going profitability, building growth into the business and finding ways to create growth potential for the buyer.
By contrast, those businesses that appeal to strategic buyers have some underlying assets or capabilities that a large corporation can exploit through the buyer’s own organisation. Small companies will often develop products or services that can be sold by the acquirer through the buyer’s very large distribution channels.
In the right circumstances, a buyer might be able to scale the revenue by 50 to 100 times that of the seller just by having the right access to global customers. The key to a strategic sale is to find a large corporation who can exploit the underlying asset or capability of the seller to generate very large revenues.
In these situations the size, revenue, number of customers or employees or level of profits of the seller may be entirely irrelevant. It is the size of the revenue opportunity of the buyer that is the key to a strategic value.
Thus a business that has the right type of assets or capabilities that can generate such strategic value may be much better off by putting additional effort into developing those assets and capabilities to provide greater or earlier revenue generating power for the intended buyer.
A higher exit price will be achieved if the buyer can scale or replicate the asset or capability faster and can integrate the seller’s business quicker. The only size consideration for the seller is to be big enough to provide the launch platform for the buyer to fully and quickly exploit the strategic value.
Strategic sales normally generate much higher exit values. Take the time to consider how you might develop your business to generate more strategic value.
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By Tom McKaskill
You would be forgiven for thinking that valuing your business is more art than science. Certainly, from what I have seen over the years, there seems to be more guesswork than scientific calculation in the process.
Most business owners will be familiar with sales of businesses in their own sector and will know what the typical valuation formula is.
Generally this is some multiple of profit (normally referred to as “times EBIT”, earnings before interest and taxes), but some sectors will be a multiple of revenue or a value per client or per member.
Few will, however, understand why a specific multiple applies in their sector.
When I have asked for clarification of the specific multiple which is being applied, I usually get the arguments that it is “typical” in the sector, that it reflects industry volatility and risk or that it includes adjustment for industry growth.
The truth of the matter is that most business owners, business brokers and business advisers don’t know why a specific multiple applies. They just know what norm has been established over many years and many sales. When you ask “How can I get a higher multiple?” the answer will be “grow faster!”. “How much faster?” – “well, more!!” Not very useful and certainly not very scientific.
Excluding liquidation or break up value, there are only two fundamentally different models for establishing a value for an operating business. The first is based on the future stream of free cash flow generated by the business and the other is the strategic value of the business to a large corporation.
Most conventional businesses, such as retail, wholesale, transport, property, and services businesses, achieve value by producing profits (EBIT) for the new owner.
It is the size, duration, growth and likelihood of that profit stream that creates the value. By the way, it is only ever future income streams that create value never past ones. You don’t put money into a savings account to get the interest rate the bank paid last year, the only relevant rate is the one they are going to pay.
While past profits may give you some indication of the likelihood of future profits, you can dramatically improve your valuation by creating a different future.
Conventional valuation theory can be applied to business valuations. This is based on net present value (NPV) of a future stream of income relating to the initial investment. Once we know the income streams and the discount (risk rate) to apply to them, we can calculate the value of the investment (or the business in this case).
It then follows that conventional valuation using EBIT multiples should be able to be expressed in a NPV formula. Thus 2 x EBIT is a 50% discount rate, 4 x EBIT is 25% and 6 x EBIT is 15%. A business valuation can therefore be improved by reducing the applied discount rate and improving the visibility and probability of future income streams.
You reduce risk by improving recurring revenue, account penetration, customer and employee churn and by implementing better systems and processes internally to set and monitor performance.
Visibility of future income streams is improved with long-term contracts, greater recurring revenue and deeper account penetration as well as establishing good competitive advantage around patents, brands, trademarks and deep expertise. This should gradually improve the EBIT multiple. Further increases in valuation will come from increasing sustainable profitability and building income (EBIT) growth in the business.
This process is fairly conventional. Now comes the clever part! To gain a premium on the sale you can build growth potential into the business which the buyer can exploit.
Can you identify how a much better funded, more skilled, more able buyer could grow your business, and can you provide the framework or template for that growth? Where you can set out a path for higher growth and profits and clearly demonstrate how that can be achieved, it is possible to gain some of that increased profit in your valuation. But you will need to find the right buyers and you will need to put the business into a competitive bid in order to extract that premium.
A business that has underlying assets and/or capabilities which a large corporation can exploit is a very different proposition. These are business based on patents, brands, copyright, trademarks and deep expertise.
The valuation in this case is not based on what your business can generate in future profits but how much profit the buyer can generate by exploiting your underlying assets and capabilities.
Imagine a very large corporation that has a customer base one hundred times yours, which would be highly receptive to your product or service. The large corporation may be able to quickly sell your product or service into an existing customer base reaping 10 times your revenue, or greater, in the first year of the acquisition.
Therefore, what would your business be worth to a large corporation that had a ready market for your product or service? The value of your business is based on what they can do with your business not what you can do with it. In fact, your own revenue, profits, customers and numbers of staff may be quite irrelevant in putting a value on your business. It is now all about them and not you.
Working out a valuation based on strategic value is very difficult but not impossible. What you have to do is estimate the revenue and profits that the acquirer will generate from your business.
Thus, if they have a customer base one hundred times yours, then it might be fair to say that the value is one hundred times your conventional valuation. Will you get that for your business? Probably not but you will gain some portion of that value if your set the deal up correctly with the right potential buyers and ensure you have a competitive bid running when you come to sell.
With strategic selling the task is to work out what you have or do which could be of interest to a large corporation, identify the potential buyers, set up a relationship to educate them on your potential and then manage the final competitive bid. Generally strategic buyers are prepared to pay many times the conventional value of a business.
If you compare these two models, what you will see is that the value of your business is solely in the eyes of the buyer and especially in the manner in which the buyer can exploit its potential.
What this should be telling you is that the identification of potential buyers is one of the most critical aspects of gaining the best price for your business. The best buyers are the ones which have the experience, willingness, capacity and capability to best exploit the potential in your business. Your task then is to create that potential and then find the right buyers.
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By Tom McKaskill
If you have some unique underlying assets or capabilities, you might be able to get a premium on sale if you sold to a strategic buyer. But, the key question is – what is your strategic value worth?
Strategic value is created when a buyer extracts greater value from the acquisition than can be provided by the inherent profit generating resources of the business being acquired. That is, the buyer is able to generate greater profits than those which the acquired business is able to achieve, or could achieve, in the future if it continued as a stand alone business.
The stand alone value of a business can be calculated by working out the net present value of the future stream of earnings which the business in its own right could generate. Any premium paid above this by the buyer is considered to be the value of the strategic value of the business.
Strategic value is created when the buyer utilises the assets or capabilities acquired to produce profits through the buyer’s organisation, which may mean cross selling to their customers or distributing the acquired products and services through their own distribution channel.
Other forms of strategic value accrue when the buyer is able to take costs out of the acquired company by merging activities or by leveraging their brands or unique processes in the newly acquired business.
The problem the vendor has is to figure out if a strategic premium is possible and then to work out what size the premium might be. Sometimes this is relatively straight forward and other times it is pure guess work.
For example, calculating what revenue and profit your product or service might generate in a much larger customer base or distribution channel when you have good data on take up rates might be relatively easy. But working out what contribution your incomplete technology might have is problematic.
Sometimes you can look to equivalent deals to see how large corporations have valued similar contributions. This has generally proved to be useful with recent acquisitions of internet community businesses where a price can be estimated per member.
In the end, it really comes down to two factors. First, are you certain that you can generate a price for your business above the value which could reasonably be calculated from its inherent future earnings, in which case you are better off with a strategic buyer.
Secondly, you need to ensure you have multiple buyers competing in the deal. Smart buyers will be able to undertake their own calculations of the strategic value of your business. Let them fight it out for the privilege of taking it to market.
In several of the businesses that I sold, I was clearly generating a sales price well above the fair market value of the business based on its going concern value. All I had to do was to ensure I had a number of potential buyers who could exploit the full potential of the business and let them push the price up through the bidding process.
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By Tom McKaskill
There is considerable difference between the sales strategies of businesses that sell to a financial buyer versus those that sell to a strategic buyer. But what if you have the possibility of selling out to either?
Many services businesses face this particular quandary. On the one hand they might have a thriving consultancy or support business while, on the other, they have some good intellectual property.
The IP might be of value to a global software corporation, but they are unlikely to want the local services component. Alternatively, the services component might be very profitable and have good potential and be able to attract a very good price from a local acquirer.
Clearly it would be possible to weigh up the possible exit values of each potential buyer and concentrate on the one that has the highest exit value. However, what if you could do both – that is, sell the IP to a strategic buyer and the services activity to a local financial buyer?
Such a scenario is highly probable as long as there is a clear delineation of business resources that can go with each sale, and one is not dependant on the other.
For example, you might sell the IP to a US corporation and agree that your local services business could be allowed continue to support the current customer base. The local business might be able to negotiate a longer term agreement allowing them to continue to support new customers or to act as a sales and support agent for the global corporation, which would significantly improve its own sale value.
Firms that have strong IP, which can create the basis for a strategic sale, often get confused about what the buyer really wants. They too often consider their own company as a whole entity and not a collection of income generating activities that may have greater exit value when they are split out and sold separately.
The objective should be to maximise the value on exit of the whole, even if it is sold in parts and even if sold off progressively over time. Thus one part could be prepared for sale while other parts continue being operated normally.
We often fail to take into account the perceptions of the buyer. If we ask ourselves “what is the buyer really interested in?”, we can often gain insights into how the buyer will treat the business after the sale.
If the buyer is likely to close down parts of the business because they are a distraction from the main objective, these parts may be split off without affecting the sale price of the part the buyer is focused on. In fact, it can often be the case that a stripped down business, which only passes essential resources over to the buyer, can be worth more when the buyer is not confronted with the task of cleaning up a mess or closing down the parts they don’t want.
Start with the buyer in mind. Work out what a specific buyer wants from the business and how you might best package those parts that are of interest to maximise the value to the target buyer. Now, can you find a buyer for parts which the major buyer doesn’t want?
This strategy may allow you to split off several parts of the business into different value components that can be prepared for different sets of buyers. The overall sales value can often be significantly greater than what any one buyer would generate.
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