Is Your Company an Investment or a Job?
By Bill Bitterli, Mergers & Acquisitions Advisor
The answer for most entrepreneurs, of course, is that it’s a little (or a lot) of both. But, what’s the difference really? If you keep your eye on the ball and the earnings growth coming, your job and your investment are both doing better, right? Almost.
Certainly, the earnings or cash flow of the company, which drives the owner’s income, is a key piece, but not the whole of the investment value equation. To illustrate, let’s look at the actual equation. Or, one of them, at least.
The Business Value Is Equal to Its Discounted Future Cash Flows
For many businesses, a simplified valuation model can be expressed as:
Consider the three components of the equation:
Income can be expressed a number of different ways, including free cash flow, EBIT, EBITDA, pretax income, “owner’s discretionary income” or some other financial metric, depending on the type of business. (It is critical that the measure chosen is consistent with the discount rate chosen.)
Growth is the sustainable, long-term Income growth rate of the business. It’s hard for most businesses to argue that they can grow faster than GDP forever. The growth rate is in the numerator to calculate next year’s adjusted (but real) income, which is the income a buyer can expect to earn once they buy from you (including the costs of replacing you). In the denominator, it reflects that a growing company is more valuable than one with the same risk profile that isn’t growing.
Discount Rate can be expressed as the annual return the buyer requires to take on the risks inherent in your business. Professional business appraisers will “build up” the discount rate by aggregating a host of discount factors with dizzying precision. A simplified build-up is shown in the table below, where a sizable piece of the discount rate applied is market driven and entirely beyond your control. However, a very meaningful piece of the discount rate may be risk specific to your company.
In our valuation formula, the denominator (Discount Rate-Growth Rate) is the Capitalization Rate, and its inverse is better known as the Valuation Multiple. If, for example, a company has a long-term, sustainable Growth Rate of 2%, the likely range of the Capitalization Rate is 13% to 28%. This yields a range of Multiples of free cash flow of (1/.13) = 7.7X to (1/.28) = 3.6X. The seller’s immediate reaction is, naturally: “Nice range. So how do I get one of those 6 to 8 times multiples, instead of a 3 to 4 times multiple?”
Discount Rate Build-up – Middle Market Business
|Rick-Free Rate||4.2%||Long-term (20 Year) Treasury|
|Equity Risk Premium||5%–8%||Equities are riskier than Treasuries.|
|Small Company Premium||4%–9%||
Small public companies are riskier than
large public companies.
|Company-specific Risk||2% –10+%||
YOUR company is probably riskier than
small public companies.
|All-in Discount Rate||15%–30+%|
|Hypothetical Growth Rate||2%|
|Capitalization Rate||13%–28+%||Discount Rate – Growth Rate|
Good question – which brings us back to whether you treat your company as a Job or an Investment.
Reduce a Buyer’s Risk to Increase Business Value
As a Job, your major day-to-day concern is to maximize the numerator (income and growth). As an Investment, some attention also needs to be paid to the denominator (discount rate). It’s a question of identifying and assessing business risks from an outsider’s perspective. A few areas where Job and Investment can sometimes be at odds are:
The Indispensable Man
As a Job: Whether it’s the business owner himself or that key go-to employee, it is easier to keep all the key details and decision making in one place. You have more control, better communication and coordination, less expense, fewer personnel issues, etc.
As an Investment: In order for you to sell the money-making machine that is your business, the buyer obviously needs it to keep making money. If the owner or key employee has all the knowledge, experience and relationships, how easily can all of this be transferred to the new owner? How many people outside the firm hold the necessary qualifications, and how much will it cost to hire them? How long will this take, and does the business suffer in the transition?
The businesses that are most ready to be sold and that command the highest valuations have “institutionalized” their business model. Their people are capable and important, but no one individual is “the key” to those businesses’ growth or profitability. The “special sauce” of each company is the way job functions and processes are delineated, the way that corporate goals are communicated, and how incentives are structured so that the company reaches those goals.
As a Job: Successfully doing business on a handshake is admirable, in the best tradition of the American entrepreneur. Your word is your bond, and you try to deal with people who are the same way. You are concerned that having formal contracts might add unnecessary delay, expense and distraction, and might kill some relationships altogether.
As an Investment: If employee, customer and vendor loyalty is largely based on a personal relationship with the owner, it is very difficult to transfer all that goodwill to a purchaser. A buyer will almost always expect key relationships to be detailed in formal contracts (non-solicitation/non-competes, joint venture agreements, etc.), and having to formalize them at the time of sale can add substantial time and risk to a transaction (your time and your risk). Ideally from a buyer’s viewpoint, key contracts will be in place, on file and assignable.
Most buyers’ due diligence will require disclosure of all written and verbal contracts. If key contracts are not or cannot be formalized, the seller faces a potential double-whammy of a lower price and a higher purchase price hold-back/indemnification/contingency to account for the increased risk to the purchaser.
As a Job: If you sign every check that goes out, open the bank statement when it comes in and trust your bookkeeper implicitly, it can be very tempting to minimize outside involvement in your financial statements, so your financial statements may be only a tax return or QuickBooks and a tax return. You are confident there is no fraud, so putting every item in the perfectly correct bucket for GAAP (Generally Accepted Accounting Principles) and having formal financial statements may seem wasteful, expensive and an overkill.
As an Investment: The financial statement hierarchy goes from Internal to Compiled (by a CPA) to Reviewed to Audited. Banks and potential buyers put increasing amounts of faith (read: perceive lower risk) in the numbers as the financial statements move up this hierarchy. A large portion of the universe of buyers for your company (larger strategic acquirers, private equity funds, etc.) will have to comply with GAAP audit standards after the acquisition, so they have no choice but to address the compliance risks a previously unaudited company presents. In the sale process, having Audited financial statements (by a reputable CPA firm) for at least three years can more than offset the costs of the audit by generating a lower discount rate (and therefore higher valuation multiple).
In addition to lowering the purchaser’s discount rate, annual audits can provide other benefits, including another set of expert eyes on the financials, assistance with internal controls, best practices/benchmarking with comparable companies, lower borrowing costs, etc.
As a Job: A dollar of earnings is a dollar of earnings, whatever the source. You have substantial and leverageable investments in physical plant, back-office personnel and a good location, so why not open a T-shirt shop in the front of your tool and die company, as long as it doesn’t distract anyone from the main business?
As an Investment: To business buyers, not all earnings are created equal. Most will be interested in your core business for “strategic” reasons, i.e., they have a favorable view of its prospects or want to merge it into similar operations. Connecting dissimilar operations, especially with overlapping personnel or facilities, can lead to a situation where potential purchasers give little or even negative value to the secondary operations. (Negative value because they will have to unwind and dispose of the secondary operation if they only want the core operation.)
The Bottom Line
Stepping back to view your business as an investment, separate from its identity as your job, will help you make your business more attractive to buyers and economically “harden” your company’s value. At the time of a planned sale, this will be important in terms of maximizing value and minimizing both indemnification amounts and time frames associated with transition and earn-out. You should address these risks three to five years before you plan to sell, to give yourself time to make adjustments without disrupting operations.
The possibility of premature death or disability argues that you should be addressing these risks no matter when you plan to sell. The disposition of your business will have to be addressed eventually. If it sounds daunting to make these changes now, imagine the challenges your successor would face if you weren’t around to help.
Bill Bitterli is a Mergers & Acquisitions Advisor. He can be reached at 860-217-1738.
Copyright 2011 William Bitterli. All Rights Reserved.