John Toomay Dallas - How Much is Your Privately Held Business Worth?

John Toomay

[Email - john@johntoomay.com, Contact - 214-269-3400]

Part I – Types of Buyers

When considering the sale of a family owned business, the first question most business owners want to know is, “How much is my business worth?” It can be a tough question to answer. With apologies to my friends in the company appraisal business, the truth is a business is worth whatever a buyer is willing to pay for it.

A company appraiser’s view on various “standards of value” (fair market value, investment value, asset value, etc.) is interesting, but realistically a buyer is going to do his or her own analysis of what an acquisition is worth to them. The buyer wants to achieve a certain return, The structure of the deal and the buyer’s cost of capital are important considerations. When a business appraiser comes up with a fair market value for a business, there is a lot of inherent averaging going on. In reality, the buyer’s unique view on the owner’s business (the “target” business) will drive the purchase price.

Potential buyers typically fall into two general categories: financial buyers and strategic buyers. Understanding the decision-making process and key valuation drivers of each can help an owner understand which type fits his or her situation best. Here is an overview on each.

Strategic Buyers

Strategic Buyers are usually operating companies that provide products or services similar to the target. Strategic buyers are often competitors, suppliers or customers of the target. Strategics can also be in an unrelated industry to the target, but the buyer may be looking to grow in the target company’s market. For example, an oil and gas producer may buy a tanker trucking company to absorb the fleet and improve throughput. This is a strategic acquisition. The goal of the Strategic Buyer is to identify companies whose products or services can synergistically integrate with their existing P&L to create incremental long-term shareholder value.

Financial Buyers

Financial Buyers include private equity firms, venture capital firms, hedge funds, and family offices. These firms are in the business of making investments in operating companies and realizing a return on their investments. Their goal is to identify private companies with attractive future growth opportunities, durable competitive advantages, and limited down-side risk. Financial buyers will typically exit an investment in five to seven years with a sale or an IPO, then redeploy the capital in another opportunity.

Because these buyers have fundamentally different goals, they will value a target business in very different ways.  Unfortunately, there is no formula to determine what a business is worth. Each buyer will have a unique view on the target company’s value, and many factors go into determining that value. Considerations include:

• Buyer’s estimate of future cash flow (may differ from the seller’s projections)
• Transaction efficiencies or synergies (unique to strategic buyers)
• Industry growth, cyclicality and outlook
• Current capital markets
  • Buyer’s cost of capital
  • Amount buyer can borrow to finance transaction
• Buyer’s tax situation
• Transaction structure (e.g., asset purchase vs. stock purchase),
• Buyer’s estimate of what he or she could sell the company for in the future
• Buyer’s targeted return on the equity invested

To generalize, strategic buyers are able to pay more for a business relative to financial buyers. First, a strategic buyer can realize synergies and generate increased cash flow post acquisition relative to a financial buyer. Also, a strategic buyer may be equipped to rapidly grow the target business after the acquisition. For example, a strategic buyer may have a strong sales and distribution channel in place that can rapidly accelerate sales of the target’s products. This ability to rapidly grow sales and profits allows the strategic buyer to pay more and still achieve desirable returns for shareholders. Exploring a sale with a financial buyer can be attractive because as professional acquirers of businesses, financial buyers are typically very responsive with feedback and do not tend to drag negotiations on indefinitely. While strategic buyers are not focused on mergers and acquisitions on a daily basis, that is what financial buyers do for a living.

Coming next in part II – The EBITDA multiple

How Much is Your Privately Held Business Worth?

Part II – The EBITDA Multiple

Without taking a target business to market and soliciting offers, using an EBITDA multiple to estimate enterprise value is the most common method to directionally estimate a business’s Enterprise Value (EV). EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, is an approximation for a company’s annual cash flow. The “multiple” is the ratio of enterprise value to EBITDA. EBITDA represents “a quick and dirty way to assess the firm's ability to pay back interest or debts," says Gil Sadka, assistant professor of accounting at Columbia Business School in New York. Sadka calls EBITDA a "quasi-estimate" of free cash flow, a more traditional and comprehensive assessment of a company's performance.

While using an EBTIDA multiple is a widely used practice among buyers and sellers in mergers and acquisitions, it is a “shortcut” and it has its drawbacks. For example, EBITDA multiples ignore the impact of capital expenditures, working capital, tax structure, growth prospects and risk in the valuation equation. Despite these drawbacks, using an EBITDA multiple is a generally accepted method for estimating a business’s value.

To get a first blush view on value, we can look at EV / EBITDA multiples for transactions closed 2012.  In general, targets with larger revenue and EBITDA command a higher multiple.  Consider the data presented in the chart to the right. For transactions in the $10 – 25 million range, the average enterprise value was 5.7x EBITDA. For transactions in the $100 – 250 million range, the multiple expanded to 7.4x. Doing the arithmetic, we can extrapolate that companies with EBITDA of $2 to 4 million traded, on average, at 5.7x EBITDA while companies with approximately $15 – 35 million of EBITDA traded at 7.4x EBITDA.

To be fair, using only transaction size as the determining factor for the EBITDA multiple is a gross under simplification. Within each size range, there will be a wide range of multiples across the data set. Factors including buyer type, industry, business model, growth, customers, and quality of management are just a few. For example, a target with $3 million EBITDA in a flat / negative growth industry with high capital expenditures (e.g., a book publisher) being acquired by a financial buyer may be lucky to get a 4x multiple. On the other hand, a target with an equal $3 million of EBITDA in a high growth industry with long term contracts in place (e.g., a drone sub-assembly manufacturer) being acquired by a strategic buyer may command an 8x multiple, or much higher.

To more accurately estimate enterprise value, it is prudent to seek EV / EBTIDA multiples for actual companies similar to the target. If available, it is preferred to use recent M&A “transaction comps” from companies in the target’s industry with similar size, scope, profitability and growth which have recently been acquired. Another option is to look at EV / EBITDA ratios for publicly traded companies in the target’s industry (“market comps”). Market comparable companies are often much larger and offer liquid markets for buying and selling shares relative to most privately held businesses. As such, appropriate discounts must be applied to market comp multiples before applying to a target’s EBITDA.

Besides EBITDA multiples, there are other ways to estimate a business’s value, including a discounted cash flow ("DCF") analysis. In a DCF analysis, the analyst estimates the company's future unlevered cash flows and calculates the present value of those cash flows and the terminal value using an appropriate cost of capital and terminal value methodology. While DCF is a useful tool, there are many subjective elements that significantly impact the value. Also, estimating the terminal value of a business generally relies on an EBITDA multiple methodology and is subject to the same shortcomings discussed above.

At the end of the day, business valuation is more art than science. A business is worth what a buyer is willing to pay for it. To find out what your business is worth, a discussion with an investment banker can help frame expectations. Most investment banks are willing to discuss expected ranges of value and what a process to sell a business looks like before formalizing an engagement.

Exit Strategy Tips:

1. Theoretical value is only a point of view. A tangible deal is an outcome.
2. Don’t rely on one buyer. Engage multiple buyers to create a competitive process. Use leverage to get the best valuation and increase the likelihood of close.
3. Build your company as if you are going to sell it. Create a going concern that has long-term enterprise value.