Growth Decreases Risk

Dear Owner:

We now have a basic understanding of income and risk and the relationship of income to risk is the foundation of any valuation  model. A basic valuation model was demonstrated already being income divided by the required rate of return an investor would need to invest. This blog introduces the application of growth into the valuation model.

Growth is a new concept and it relates to the future increase of income. We know that growing income increases value of the company, but the growth rate also decreases the risk of the company.  Growth is introduced in the Dividend Discount Model:

Dividends

(Risk – Growth)

This model takes the EAT we learned in the last blog entry and divides it by risk LESS growth. We have discussed the value multiplier “5x income” to be the same as “income divided by 20%” and that comes from this model.  If we assume all after tax income is distributed to shareholders, then dividends equates to income and this model is a good reflection of corporate value.

There is one consideration when making decisions to grow corporate value; growing income has to come without increasing business risk.  Making a decision for one at the expense of the other could decrease corporate value or at the very least grow it slower.

The DDM assumes perpetual growth at whatever rate put in the model. For the long term, this is typically inflation. Therefore, if a company is growing but the growth rate is decreasing, it will lose value. This is why new products/services or new markets are important just to sustain value.

As an illustration, when you introduce a new product into the market, you typically increase your income by increasing your revenue AND margins on that new product. So income is higher and growing. The DDM thus sees income and growth higher having a double benefit to value. Long term however, competition will come into the market and bring down the margins and growth to normal market levels. Corporate value will decrease by virtue of slower growth prospects even if operations are doing well and company is making money.

Tags: Business risk, corporate value, Dividend Discount Model, dividends equates, growth, income, inflation, multiplier, perpetual growth, required rate of return, Risk, shareholders, sustain value, tax income, the long term, valuation business model

What is Income?

Dear Owner:

My blog has really focused on increasing corporate value through risk reduction and I will continue to preach this value gospel, however, reviewing “income”, earnings” or “profit” definitions that comprise these terms are necessary to ensure we are talking about the same cash flow stream. Further, it is hoped that you will be able to better identify which income definition is best suited for your company.

EAT: earnings after tax. All definitions start with earnings after tax. In my opinion, this is the Holy Grail of definitions. As we say in hunt camp, “You EAT what you kill!” and in  business it is the same; you only can spend what you get after tax. It is the last word on the profitability of your company. That being said, there is good reason to have other definitions for comparability among companies.

EBT: earnings before tax. This is a profitability measure that excludes the impact or decision making in tax planning. When there is a need to compare companies and the manner in which taxes are planned for are not relevant; EBT is used. For example, private companies plan for tax minimization, public companies typically do not or to compare companies in different taxing jurisdictions, EBT may be preferred.

EBIT: earnings before interest and tax. EBIT is EBT with interest added back. Many practitioners refer to EBIT as operating income. It is the profitability indicator without consideration for how you have organized your capital structure in terms of debt and equity. In comparing firms, capital structure (the mix of debt and equity) is a management decision that can be viewed as discretionary not dependent on operations. If so, EBIT is a valuable tool for making comparative decision when you want to take tax and leverage out of the equation.  EBIT tells the practitioner about operational profitability.

EBITDA: earnings before interest, tax, depreciation and amortization. EBITDA is EBIT before the consideration for depreciation and amortization; these accounts are added back to EBIT. EBITDA focuses comparability between companies to operational cash flow. Depreciation and amortization are accounting entries to recognize the decrease in useful life of assets already purchased. They are non-cash flow items in the income statement and therefore are added back to get a picture on the cash generated from the company.

These are commonly used definitions for income used for various internal analysis  applicable to the metrics specific of a business and/or industry. A service company with no material tangible assets to amortize will have EBIT and EBITDA materially no different and thus may derive a higher comparable benefit using EBIT. Companies with high tangible asset levels will have large depreciation charges potentially yielding different income results if different amortization rates are used, so EBITDA may be preferable.

What you should notice as you move away from the bottom line, the income analysis sheds away decisions you have made to not only operate the company, but structure it for production and capitalization as well as tax planning. Notwithstanding various income definitions can add comparative value, to maximize the sale of your business, the best decisions have to be beyond the operations but in the capital structure, investment and tax decisions. Even in defining income, non operational decisions have influence.

Tags: capital structure, cash flow, company risk, comparability, corporate value, debt and equity, depreciation and amortization, discount rate, Earnings, earnings after tax, earnings before interest, earnings before interest and tax., earnings before tax, EBIT, EBITDA, financing, Holy Grail, income, income analysis, is EBT, leverage, multiplier, operating income, private companies, profit, profitability, risk reduction, tax, tax minimization, tax planning, valuation mode, value indicator

Decrease Risk or Increase Income?

Dear Owner:

Risk is the prime determinant in the value of your business, so let’s look at corporate risk and what is included in its composition. Many practitioners segregate corporate risk into; specific company risk, economic risk and industry risk but for our purposes, we are including these risks under one roof as to some extent, these are controllable factors within a business.

The terms are self explanatory, economic risk analyzes the risk in the overall economy that will affect your business. If you have a trucking company and there is a recession, you will be transporting less, if fuel goes up, your margins will be compressed. Industry risk;  greater government regulation in transporting goods across borders directly affect your trucking industry. Company specific risk has to deal with your business, the age of your fleet will have an effect on the capital expenditures in the near future.

Many risks, whatever they maybe, may not be in your direct control, however, your preparedness for them directly affects the risk inherent in your business; thus its value. If the general economy is going into a recession, do you have strategies to take market share from competitors, are you well capitalized so you can acquire cheaply struggling competition and emerge from the recession more valuable? Is your industry transitioning to new technology, are you ahead of this curve, is there untapped foreign markets when yours may be constricting?

So although you don’t control the storm, you can set sail to best navigate it. When there are shocks to the system; economy, industry or corporate, the greatest opportunities present themselves.

From the last blog you remember corporate risk, numerically, is what you would add to the 10% RFR and ERP. You can expect the corporate risk range to be between 3% and 30%. Realistically, the high end can be infinite but in most commercial transactions, if your corporate risk is higher than 30%, you don’t have a business. So the expected multiplier on income would be between 2.5 and 7.7 not considering growth assumptions.

If your company has an income of $1 million, it’s assumed to be worth between $2.5 million and $7.7 million. Assume your company is worth the $2.5 million and had an option to reinvest $1 million to either double income to $2 million or risk reduction by 25%, which would you do? The income increase would bring your business value to $5 million; the risk reduction would bring your business to $6.7 million.

Then you ask yourself, what is easier to do, double income in a year or learn how to set up brand, systems and processes within your business to decrease operational risk and the risk associated with economic and industry shocks for the income you already have.

Tags: capital expenditures, cheap price, competition, competitors, controllable factors, Corporate risk, declining market, economic risk, economy, growth, industry risk, margins, market share, optimal value, recession, regulation, Risk, risk reduction strategies, specific company risk, strategies, untapped foreign markets, valuable, well capitalized

Components of Risk

Dear Owner:

As a continuation from the very first blog, the talk is all about risk and I would be remiss to not discuss what risk is from a theoretical finance perspective.  The next few submissions will focus on this topic. We know, the higher the risk of the business the lower the value and what we are hoping to understand is that in many instances, there is more bang for your buck by lowering risk than growing income from a valuation perspective. Let’s see what makes up risk.

Risk Composition

Now that we are cognoscente of how risk affects value, the composition of risk is necessary to implement any strategy. You may have heard of value multipliers such as 5 times EBITDA, 12 times income and so on and you like most people wonder where they get these numbers.

Look at the conversation in the blog, “Sell Your Business For Millions” where the HRC had a discount rate of 20%. If we invert this, you get a 5 times multiplier (1/.20). The value of the HRC is 5 times income. So this number is a specific risk value associated with the company; a 20% risk. You see why you can’t use other ROTs for your valuation. The use of EBITDA may be appropriate for your business or industry, but not the multiplier, AKA, risk rate.

So how do valuators get to this 20%? It is a compilation of three main risk factors:

1. Risk free rate (“RFR”)
2. Equity risk premium (“ERP”)
3. Corporate risk (“CR”)
   

The risk free rate is an arbitrary benchmark typically the long term government bond rate and represents the return an investor can get if he puts his money into government bonds. Because businesses are long term investments, the long term government rate is used, typically 10 years or more. Bonds represent the RFR (notwithstanding current market conditions). The equity risk premium is the additional return an investor can get if he invests in the stock market.

Assume, the ERP is around 6% and the RFR is 4%, the investor is assumed to be able to get a 10% return in his investment with very little risk or with normal market risk. Your 20% discount rate would then be made up of the market risk of 10% and 10% for your own company risk.

For our purposes, the RFR and ERP are not relevant as we can’t control them. But you have to understand, everything being equal, an investor can sit on his boat fishing and make 10% with a broker. So to invest or buy your company, he will require a higher return because there is more risk. Your job is to get risk under your control to be reduced as much as you can. This will boost your multiplier.

Tags: composition of risk, theoretical finance, value multipliers

Knowledge Brings Maximum Corporate Value

Dear Owner:

The FMV definition assumes both transacting parties have reasonable knowledge of the relevant facts.  What facts though? Do facts refer to all the details of the target company? How about the industry, economy and the future thereof? What about the intentions of the vendor/purchaser post transaction? I would propose it means all of the above and more. Knowledge is power in the transaction world and why millions are spent on due diligence in every deal.

The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Reasonable knowledge of the relevant facts

As you build a company, you must consider what you have to build to maximize value to potential purchasers. You have to gain knowledge on the industry and market as to where it is going and which companies will be best positioned to pay the most for your shares. It is incumbent on the vendor to perform the due diligence in the market to determine which suitor will desire the company more. At the time of negotiation, your understanding of his and your business will get the highest price if that negotiation is with the company that is willing to pay the amount and you have full understanding of the deal from both perspectives.

Buyers interested in your business will perform the requisite due diligence to reduce the risk in the transaction and come to a final offering price.  They should be able to get all the information they need virtually on demand, you have to be prepared for what they expect. Your ability to add professionalism to their due diligence process will provide confidence in the business, reduce their perspective of risk and increase their interest and price willing to pay. Their full knowledge and understanding of your business will decrease the restrictions on the sale. Does your ERP system provide all relevant financial information in real time?

If you desire to maximize sale price of your business, your understanding of all the facts surrounding the deal have to be investigated. Most vendors don’t consider to perform due diligence on the buyer. What is the reason he is interested in the business, what opportunities will be presented to him, what synergies does he expect, does he have the money to buy or will this be a vendor take back, and on. While reasonable knowledge will get you FMV, the facts will put you in a better negotiation position to maximize your selling price.

Summary

If you look again at the blogs that began deconstructing the definition of FMV, there is a silence that is deafening; there is no reference to income. There are only value attributes that relate to risk. Now this definition was developed by really smart guys; accountants, lawyers, financing professionals fighting it out in courts and board rooms and it is these guys who advise business owners on what they should buy and for how much. It is incumbent on you to understand FMV; it is not about income, it is about risk surrounding that income.

Tags: Buyer, confidence, deal, due diligence, economy, ERP, final offering price, FMV, industry, Knowledge is power, knowledge of the relevant facts, maximize value, potential purchasers, professionalism, real time, reduce risk, redundant, relevant financial information, target company

Premium Price Under Complusion

Dear Owner:

This blog deals with compulsion to buy or sell. It is self evident if there are external or internal pressures on a business such as bank calling a loan, divorce or whatever, the urgent needs to liquidate will not allow for the highest price to be obtained, you will receive a discount to FMV and that is why “FAIR” is in the definition so we don’t get ourselves in a position where a discount or premium is required to close the deal. That being said, as a seller of a business, you want a premium so you want to the purchaser to pay extra for your business.

The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Neither Is Under Compulsion To Buy Or Sell

You want your buyer to “overpay” for your business. You want to create a bidding situation where more than one buyer is not only interested but sees the opportunity as a must have. Many companies have high sales and income, that will attract the tire kickers, but having an efficient run operation with low corporate risk will be the premium factor. Therefore, you have to create this opportunity.

Have you identified the  potential purchaser(s)  for your business and know what it will take for him to overpay for it? To get the premium price, you want to build a company that does put pressure on either competitors or other synergetic buyers  to pay over the highest for your shares.

For example, if you are competing head to head with a larger competitor, you will have to be more efficient to compete. In most circumstances, the larger companies have economies of scale and more financial resources to battle it out. If however, you went for a niche aspect of the market exploited it and dominated in that area, you now have the attention the competitor, a foreign company looking for an entry point in the market and a private equity investor looking for a high return niche business he can use to go international. Now you may be a, “have to have” business.

The strategies for being the market leader or best of breed, are company and industry specific. There are two indicators your company is in the premium space and that is if your revenue and margins are growing when the primary shareholder is on a 6 month safari in Africa.

Tags: best of breed, bidding situation, close the deal, compulsion, compulsion to buy or sell, discount, divorce, economies of scale, efficient run operation, entry point, exploited, FAIR, financial resources, FMV, highest price, international, liquidate, loan, low corporate risk, market leader, Neither Is Under Compulsion To Buy Or Sell, niche market, opportunity, overpay, potential purchaser, premium, premium factor, premium space, private equity investor, strategies, synergetic buyers, tire kickers, urgent needs

Don’t Restrict Your Market

Dear Owner:

The definition of FMV gives insight to getting the highest price for your business and the components of the definition are the road map to producing these results. Again, the open and unrestricted market does not deal with income, but the risk environment in which a transaction will take place.

I skipped over “arm’s length” as very little discussion is needed to point out that a non arm’s length relationship may not produce a FMV transaction because the objective of selling to your kid may be not be to maximize your own profit.

The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Open and Unrestricted Market

The open market assumption refers to all potential purchasers having access to bid on your company. Many owners desire to build up a company to be valuable enough to be bought out by a larger competitor. However, you will never maximize price and therefore undercut your efforts to build corporate value if you restrict your market to only bigger fish.

The FMV definition assumes no one is prevented from buying your company; the corollary is your own efforts are not preventing the any one from buying your company. Stupid example; if you don’t show a potential purchaser your financial statements, you are preventing that purchaser from accessing needed information in which to decide to buy your company; restricting your market. Better example, if you have not prepared your business for sale, you are restricting many businesses from looking at your company thus restricting your market and therefore you will not get the highest price.

Implicit in a plan to be swallowed by a big fish, is the plan not to have venture capital or private equity players compete for your business. You are excluding the high net worth investor looking for a turnkey to gain access your market. The private equity investor may never give you the highest price, but their competition to the bigger fish raises the bar on how low the fish can bid. Alternatively, the private equity investor can position your company for going public to access real money, Gordon Gekko money, I am talking LIQUIDITY!!

How do you restrict the market by your own efforts mentioned above? The unrestricted value premise relates to operations, tax, corporate or legal structures, etc., that inhibits the maximization of corporate value. This could relate to restrictions on the sale of shares, client contract or lease transferability, suppliers contracts, there is a myriad of internal issues that complicate any deal. It could relate to huge tax consequences if the sale was to happen today or the lost opportunity take advantage of tax breaks that could be structured into; the list goes on.

Bottom line, you have to package your company for maximum market exposure to as many buying interests as possible. This does not mean a competitor will not buy you, but it will mean that whoever does will do it at the highest price. Your take away is that our discussion is not on your product or service, it is about how to manage the BUSINESS for maximum value by reducing risk.

Tags: arm’s length, big fish, bigger fish, business for sale, corporate value, Financial Statements, FMV, Gordon Gekko, high net worth investor, highest price, LIQUIDITY, market, maximize price, non arm’s length, open and unrestricted market, open market assumption, potential purchaser, private equity, profit, risk environment, road map, turnkey, unrestricted value, venture capital

Are You a Willing Seller

Dear Owner:

This entry to the FMV definition deals with willing buyers and sellers. Remember, FMV is about getting the highest cash price and our business here is to find out how.  Referencing the FMV definition again:

The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Willing Buyer

The willing buyer will provide the highest price and if we walk a mile in these shoes, we will understand how to maximize the selling price. A willing buyer is one that wants your business for his future goals and will look at your business to see the potential for growth and profitability to meet these goals when you are no longer in the picture.

The buyer understands the industry and the industry as it relates to the economy, he will try to determine if your business is well positioned by assessing your company’s ability to take advantage of opportunities. The buyer has to be in position where he understands the risks of your operations enough so he can focus on growing operations and taking advantage of opportunities. A buyer will not pay the highest price if there are operational challenges.

Think of buying a home, you have a choice to buy a fully renovated dream home created by a leading designer or a home that needs these renovations for you to do yourself on weekends.

Willing Seller

Assuming you have all your ducks in a row; good profit, great growth story, ample potential buyers, etc., the question will arise, are you ready to sell? Do you have your estate ready for tax minimization, family issues and the myriad of other issues that could arise when selling your company? Maybe your kids did not want to run the company before, but now do?  Because of huge debt or health reasons, you find out you need more to retire?

You may have the best deal you will ever get on the table, but can’t close because of other issues. Your personal life is not a main topic of this blog but should be a thinking point for you to ponder. You always have to be in a position to be a willing seller or missed opportunity can happen. In most owner managed business, this concept has not entered their mind and it is a fundamental component to get the highest price.

Point to note, here is that maximizing value does not deal with income, but the risk of not having sellers and buyers to willing to transact.

Tags: ample potential buyers, economy, FMV, future goals, good profit, great growth story, highest cash price, huge debt, industry, operational challenges, opportunities, potential for growth, profitability, tax minimization, willing buyers and sellers

Sell Your Business For Cash!!

Dear Owner:

In the last blog, we introduced the definition of FMV; this blog is to deconstruct the definition to determine what constitutes value. Keep front of mind the risk/reward relationship; value is determined by not income but by the RISK of that income.

The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Expressed in terms of cash equivalents

When value is expressed in cash, debt or other marketable instruments, the definition assumes the highest price is what someone will pay you on closing versus sometime payment stream in the future; cash for the business when transacted. This is important as many small business acquisitions have a cash and vender take back (VTB) or earnout component rather than the strictly a full cash price on closing.

If you sold your company and the offer was $4 million today or $7 million in 5 years, which would you do? There are two issues you should consider, do you know them? First, the time value of money or the opportunity cost of not having the money today versus receiving it in the future; the second, and arguably most important, will the guy be around in 5 years to pay you. So it is not about the money, it is about the risk of getting the money. When you get paid cash, there is no future risk.

The old adage in finance goes, “You name the price, I will name the terms”

So when determining FMV or price, it is about what is the company worth for cash, today. Unfortunately, most small business can’t sell for cash or the cash they expect. The VTB or earnout typically conditional on meeting future projections the price was based on.

Implicit in this type of covenant, either VTB or earnout, is the risk to the purchaser he has overpaid for these future cash flows. Your risk is that he will not be around to pay, or find a way to not pay, the purchaser risk is the future earnings will not be achieved. As a result, many deals don’t consummate as there is too much risk on either side to do the deal.

What you want to do when building your business is decrease the future income risk so a purchaser is willing to pay you the $7 million now. In other words, you have done the work of getting revenues high enough to get great value, now you have ensure the income from it is sustainable. If you don’t, you have achieved the high revenues with the high risk and may have decreased value not increased it.

Tags: cash flows, covenant, expressed in terms of cash equivalents, FMV, FMV; risk/reward relationship, highest price, income risk, marketable instruments, opportunity cost, overpaid, RISK of that income, small business acquisitions, vender take back, VTB

Fair Market Value (FMV) is the Highest Price

Dear Owner:

We know understand the fundamentals of every business will drive a premium value and when determining value outside of a transaction or in anticipation of one, a hypothetical value has to be determined. The discussion on Fair Market Value is to be discussed. But first as a prelude and reminder of the last blog, I want to discuss comparables which can be as a proxy value for your valuation.

Comparables

Although not as evil as ROT, comparables have to be used with suspicion. Comparable transaction approaches are used heavily real estate appraisal when real estate is very homogenous. Therefore, comparable analysis can be very useful when comparisons are very accurate but when valuing companies who are not homogeneous, this approach is not preferable. Comparables do give a good indication of the state of the market and therefore have to be considered when determining risk. Alternative investments are always considered by investors and they first look at the market to compare the risk with your company to these alternatives investments.

What has to be avoided is using comparable transactions as ROT. Comparables are a first level of analysis that provide the market for the company, the valuation approach that has been taken, who are the sellers, who are the buyers, etc., the information is very general. There are very few if any specifics of the transaction unless it is a public company and small business should not compare themselves to public market transactions.

Notional Market

In valuation circles, you may here the term, notional market. The notional market is a hypothetical construct to determine fair market value (“FMV”) which endeavors to represent a transaction price when there has been no transaction. There are times when a company has to be valued for non-transaction reasons; estate planning, family law, death, shareholder dispute, etc., and this value is to represent what would happen if the company was sold.

There is a definition that the American Society of Appraisers (“ASA”) in the United States and the Canadian Institute of Chartered Business Valuators (“CICBV”) use to determine FMV or the hypothetical transaction price:

The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Understanding the notional market definition of FMV is necessary to understand corporate valuation as you will run into the definition in the future if you have not already. It is the term financial professionals use and it is instructive as it highlights how you will get the Highest Price for your company. Let’s analyze the definition, line by line in the next blog.

Tags: acting at arm’s length, alternatives investments, American Society of Appraisers, arm's length, ASA, Canadian Institute of Chartered Business Valuators, CICBV, comparables, death, estate planning, expressed in terms of cash equivalents, Fair Market Value, family law, FMV, Fundamentals, highest price, homogenous, hypothetical value, hypothetical willing and able buyer, hypothetical willing and able seller, notional market, open and unrestricted market, premium value, public company, public market transac, public market transactions, real estate appraisal, reasonable knowledge of the relevant facts, shareholder dispute, small business, transaction price, under compulsion to buy or sell