The fundamentals of business valuation: Monetary Wisdom - Nov 2016

By Tom Decosimo

When it comes to attracting investors to your company, knowing your business’ value is a critical first step, but sometimes a complicated one. There’s no shortage of consulting firms willing to help answer this question for you with expensive presentations involving financial and operational metrics. While this approach is one to consider, owners of investable companies—including flooring retailers, commercial contractors and even flooring manufacturers—often already know how the cash conversion cycle works. 

For that reason, instead of investing in heady consultations, these business owners must weigh the opportunity costs of spending a year optimizing, say, Days Sales of Inventory against all other internal and external risks to a company’s value, including market disruptions, raw material price fluctuations and acts of God. The truth is that there is currently a flood of institutional cash that has been raised and not yet deployed—most of it in the private equity market, often referred to as “dry powder”—creating more buyers than there are businesses in which to invest. 

With that said, market conditions, aside from a Great Recession-style catastrophe, should not be a determining factor in a decision to take one’s business to market. There are numerous reasons to decide to sell a business—retirement, the desire for a new challenge, seeking liquidity or diversification of asset allocation, and the conclusion that outside investment is the most prudent way to grow. However, all of these are deeply personal and based on a business owner’s particular intuition. Trust that same judgment that brought you success in the first place, and you will know when the time is right. 

In preparation for a potential sale, business owners often want to know which key performance indicators, metrics or benchmarks need to be hit or optimized before going to market. The short answer is none of them. All business owners should be measuring as much about their companies as is feasible, but the end goal of all these analyses is—or should be—profit maximization. Even the most sophisticated institutional investor is focused primarily on the bottom line, particularly in a mature industry such as flooring. 

When looking at a potential target company, investors ask themselves three questions: How profitable is this company? How profitable is it going to be in the future? And will the amount I pay for this company generate a return on investment that satisfies my requirements? 

The main point is: don’t take your foot off the gas. There are a number of general housekeeping items that need to be considered when preparing for a sale, like those detailed below, but the best way to increase your company’s value is to increase profitability. 

For the purposes of getting a company “investor ready,” there are generally three areas where short-term problem solving is the most important: unprotected intellectual property, the prospect of major capital expenditures in the short term, and inventory write-offs. 

Intellectual property can be one of a company’s biggest value drivers, and it is paramount that any marketable intellectual property be protected by all applicable laws and regulations. The function, maintenance and suitability of property, plant and equipment assets must be properly assessed and presented fairly in any financial documents. A thorough inspection of the state and quality of inventory assets and their fair and honest presentation in financial statements is also required. 

In preparing for a sale, though, perhaps the most important task for business owners is the construction of a viable plan for talent retention—starting with themselves. If a business owner wants to retire immediately after selling his or her company, they will need to delegate essentially all of their managerial responsibilities to senior staff for a period of time prior to the sale, during which it can be demonstrated that the new management has shown the ability to successfully run the business without the owner present.

As one might expect, most privately held companies don’t have owners that have successfully “all but retired” prior to a transfer of ownership, leading most investors to require business owners to stay on in some capacity for a minimum of two years post-acquisition. Investors have an obligation to ensure they retain the owner’s experience and expertise as part of the deal. Moreover, this will likely result in a transaction that includes an earn-out provision for some percentage of the overall price—typically correlated to an owner’s role in the day-to-day operation of the company. That is, if a business owner personally cultivated a company’s client list and has long-standing, personal relationships with all of his or her suppliers, then that earn-out could be upwards of 40% of the total transaction price. In contrast, an owner who plays a largely advisory role might get an offer with an earn-out as low as 20%. 

The second piece of this puzzle is contingency payments or profit sharing for key personnel. These plans can differ drastically from transaction to transaction, but typically you can expect an inverse relationship to the structure of the earn-out. In other words, if a business owner is getting 80% of the transaction price up front, he or she will likely need to create more generous contingency payment or profit sharing packages for senior staff. 

As a sell-side advisor, a suggestion often made to our corporate clients is that a successful transaction is one in which the goals of the business owner are clear, reasonable and achievable. The market will eventually dictate the price a business commands, but a relatively straightforward valuation can provide a fairly accurate value range. If a business owner wants to sell his or her company for $100 million, and some back-of-the-envelope calculations cannot reasonably demonstrate a value range within that area, then the company clearly is not “investor ready.” In most cases, a business owner ought to be able to estimate to within plus or minus 20% of their market value based on the company’s EBITDA (earnings before interest, taxes, depreciation and amortization) and net asset value (assets less liabilities). In 2016, for example, middle market companies—generally those companies between $100 and $500 million in revenue—have sold to institutional investors for a bit more than six times EBITDA. 

Of course, EBITDA can be adjusted to account for any number of factors that an experienced sell-side advisor would identify—for example, non-market levels of executive compensation, an aggressive tax minimization strategy and post-acquisition synergistic value (sometimes called “redundancies” or tasks and line items that can be absorbed by an acquiring entity). The important thing to remember is that all of these analyses are going to be baked into the final comprehensive presentation to investors and ought not to be major considerations for owners thinking about making their companies “investor ready.” 

Before going to market, one other serious strategic decision to consider is market creation. By market creation, we mean that owners must decide whether there will be a targeted search for a limited number of potential buyers or a larger auction-style process, including investors from a wide variety of sectors such as private equity, strategic (intra-industry), family offices, hedge funds and more. To be sure, there are advantages and disadvantages with both. For example, while a wide-net strategy increases the number of bidders and potentially the price, it makes confidentiality more difficult both inside and outside the company. 

However, even if your target bid falls out of the sky in the form of a phone call or email from an enthusiastic young analyst at a private equity firm or the CFO of a formerly fierce competitor, there is an important role for an experienced sell-side advisor to play in the process. Generally speaking, if a business owner gets an offer that exceeds their expectations for the value of their company, there are going to be a number of potential investors with even loftier prospects for that company. 

Moreover, the devil is in the details. A $100 million offer might only come with a small fraction of that money guaranteed at closing and the rest contingent on the company’s ability to meet complicated or onerous projections. As any sports fan will tell you, a $100 million contract in the National Football League (NFL) is never fully guaranteed—and therefore largely hypothetical—while the same contract for a professional basketball player in the National Basketball Association (NBA) will almost certainly get paid in full. One of a sell-side advisor’s biggest responsibilities is to ensure that their business owner clients are treated more like NBA stars and less like NFL players. 

Copyright 2016 Floor Focus 

Related Topics:The International Surface Event (TISE)