May 21, 2012

Creating Maximum Business Value

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Understanding what drives value in your company will pay you dividends when you decide to sell.

Every business owner wants the maximum value when he or she sells a business. Not many succeed. What prevents business owners from generating higher value? By looking at several critical factors, we can see what creates higher (or lower) value in a business.

The problem stems from the fact that most sellers do not fully comprehend what drives value for buyers of a particular business. More importantly, they do not usually consider or know the best “windows of opportunity” for selling. Many sellers today are fixated on terms and conditions that will never be accepted, rather than trying to understand the nuances of legitimate compromise.

Sellers today are also usually not prepared to fully support the mercurial adjustments to EBITDA (Earnings before interest, taxes, depreciation and amortization, or the cash-flow basis to which a pricing multiple is applied). Private firms typically co-mingle some personal and business expenses. The true reflection of EBITDA would include adding back “personal” items not readily apparent in the financials. These items can have a dramatic impact on the true financial picture of a company.

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Finding Value Drivers

So, how does a seller prepare for and execute the appropriate deal? The first step is to assemble competent and trusted advisors. Using a well-qualified valuation firm and investment banker (IB) are often necessary. Together, they can determine the exposures and carry-over liabilities most acceptable to the seller, as well as understand and explain the value drivers to the buyer(s).

A value driver is one aspect of a business that is crucial to overall value. Somewhat in order of importance are the following:

  1. Management: A well-run firm has experience and expertise at several levels. In addition to the visionaries and top-level leaders, mid-level executives are key to effective, daily operations and execution of business strategy. If one or more persons in senior management does not remain after the sale, the buyer typically wants the next layer of leadership to fill that void. The key aspect of the post-sale transition is the meshing of cultures. Nothing harms or destroys an organization faster than in-fighting or politics and a culture of uncertainty and negativity.
  2. Cash Flow: A strong gross margin (GM) is a key ingredient of a high-value company. Has the seller improved the GM in the last few years? Solid and flat is fine for established sellers; but nicely growing firms should find methods to improve gross margins. Is the seller affected by seasonality of sales? For some buyers, this is a detriment to business value. Adequate working capital is another key aspect, as is the growing (or declining) need for capital expenditures. Solid growth in cash flow or EBITDA (and not peaks and valleys) is probably the most important factor among value drivers, after the breadth and depth of management.
  3. Market Share: The position in the industry (ranking in terms of revenue) or industry niche is a critical aspect of value. In addition, how strong is that position? Is the firm strongly affixed at ­Number 2, for example, or is it on the decline? The intensity of current competition could detract from one’s value, as well as the ease of entry for fast-charging newer firms.

A More Complete Picture

While the management of a company, its cash flow, and its market share are critical value drivers, there are more. So to paint a more complete and accurate picture of the value of a business, let’s look further at some additional value drivers and factors.

Product/Service Uniqueness: If a seller has very distinct products or services, the company should ensure that the intellectual property (IP) is protected. That protection should include all locations where revenues are generated (U.S. states and foreign countries). IP protection encompasses many facts—from patent applications to copyrights; from brand names to goodwill; from proprietary technology (not patented) to R&D; and from clear ownership positions to restricting employee access to or theft of IP.

Well-documented and secure IP allows for and enhances the seller’s increased value. It may preclude easy entry to a market, as well as lengthen the time it takes for a competitor to capture profitable market share. The longer the length of time a company has been in business is just another feather in the hat of the selling candidate.

Issues of Size: Larger companies usually have more customers and are better able to lose a few than a smaller competitor. For example, companies larger than $25 million in revenues command higher multiples than those below this level. Again, without significant customer concentration, larger firms are usually more stable and less risky.

Diversification: Diversity of products or services is usually a plus, in that product life cycles overlap and revenue growth can be sustained. Other factors that drive or detract from value are the size and prior years’ volatility in the industry, as well as long-term prospects and viability. Buyers always want more stable, predictable outcomes, with improving metrics for per-customer revenues, costs and profits.

Systems and Pro­­cedures: Buyers do not expect the ideal systems and procedures (S&P) will be in place at the seller. ­However, without solid and viable S&P, there is an added cost to improve them, and probably a loss in value. More important to the buyer is that the lack of good S&P is a red flag for other potential problems. Possible questions a buyer will raise include:

  • Can I trust the internal accounting records?
  • Are personnel records accurate or are there looming lawsuits?
  • Is the property and casualty insurance coverage adequate? Effective against future product effects, etc.?
  • How current and accurate are the various contracts? Agreements? Supplier chain/pricing?
  • How overstated or understand is the inventory?
  • How reliable are the seller’s identified adjustments (add backs) to EBITDA?
  • Which assets are pledged? Collateral?

The list goes on from here, but you get the idea.

Selling In Today’s Environment

Several factors bode well for selling a business today. The sale cycle has elongated since 2008, likely adding three months to the 6- to 12- month norm. However, there are these very positive reasons for deciding to sell your business now:

  • Mergers and acquisitions (M&A) activity was up for 2010 and 2011, versus 2008-09. The expectation for 2012 is at least the same as 2011 and the overall pricing is above average, adding to a generally good climate for an exit.
  • Since most prognosticators believe that the current economic climate is the “new norm,” sellers do not need to wait if they really want to sell.
  • The threat of higher capital gains (from 15% to 23.8%) and ordinary income tax rates in 2013 is a real motivation to close a deal before year end. Of course, this action assumes that EBITDA has not declined in 2011 or currently.
  • Capital is available. First, banks have been prodded by the regulators to loan more money. Second, while more costly than senior (bank) financing, mezzanine funds are readily available for cash flow lending. Third, there is an ample supply and appetite for private equity capital to be put into deals.

While this is not exactly the perfect M&A storm, it is likely the economic environment we have seen in the past four years. Business owners who have been waiting on the sidelines can be more confident of sale intentions, but still have to take adequate steps to building a strong advisory team, and building strong value in their companies.

By understanding what drives value, particularly from the buyer’s perspective, business owners can seek to maximize business value and thereby maximize the sale potential. •

Turning Value Drivers Into A Successful Sale

The owners of a company in business for more than 40 years recently made the decision to begin positioning the company for sale. They knew that they would need a year or so to prepare the company for sale. The powers that be began the process of organizing and improving internal affairs to maximize the sale price.

The company provided specialized, high-quality products and services for a sector within the construction/remodeling industry. Products included many types of sealants for retaining inside temperatures; heat/cold; fire retardation; driveways and pavements; and general caulking. In addition, the company manufactured specialty and ornate doors and windows, framing products, industrial ramps, and mechanized inventory access systems.

The company enjoyed steady growth in revenues and profits the last five years, and integrated several acquisitions into their national firm. The Mentor Group was first engaged by the company to help identify and analyze the company’s value drivers and understand their impact on a sale. After thorough research in the company’s financial aspects as well as their industry standards, we looked at management and operations. ­We provided suggestions to improve operations and consolidate the diverse but related business lines. We also counseled them to put in place the appropriate senior- and middle-level management to make potential buyers more confident of a purchase.

Once our initial business and IP valuation was complete, the company hired us to initiate the sale process and execute a sale of the company. Our first task was to raise $20 million of senior debt to retire the unfunded ESOP repurchase liability and improve working capital. From there, we were then able locate potential buyers, negotiate terms of the transaction, and complete the successful sale of the business This was accomplished largely based upon the clear presentation of the value drivers and EBITDA add backs.—D.B.

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About the Author

Davis Blaine
Davis Blaine
Davis R. Blaine is the Chairman of both The Mentor Group, Inc. and Mentor Securities, LLC (FINRA registered) as well as the founder of ProVisors and CEO of The Legacy Forums. He is an expert in the accounting, tax and financial aspects of acquisitions, recapitalizations, valuations and appraisal. He has frequently lectured and written on technical valuation issues. Davis has counseled many clients on buying, selling, or raising capital. In addition, he has prepared companies for public and private investment, strategic partnership, and joint ventures. You can find more information here at The Mentor Group, (818) 991-4150. Read more about Davis R. Blaine...


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