Valuing your business; There is strength in numbers
QUESTION: I read your previous article about preparing a business for sale in the November 2016 issue. I am pretty far down the road with making the preparations you suggested, but I’d like to know more about how to place a value on my business. I keep hearing about the different ways of doing that and I’m wondering which one is right.
Answer: Of the issues to be addressed when thinking of selling your business, placing a proper value on it is perhaps the most important. Statistics show that 95 percent of business owners get this wrong — and that they do so by an average of $3.8 million. Thus, mistakes can be hugely expensive, whether they result in overvaluations making it difficult or impossible to find a buyer or undervaluations for obvious reasons.
The primary issue is that getting to a “proper” valuation depends, to a great extent, on which side of the table you’re on. Sellers have a strong tendency to overvalue their businesses, and to take offense when potential buyers disagree and/or start requesting “entire forests’ worth” of due diligence materials. Potential buyers have an equally strong tendency to underappreciate or ignore important elements of value, and then gasp at the “outrageous” price the “delusional” seller is demanding.
Among other things, this suggests that eliminating as much emotion as possible is essential if an agreement is to be reached. For most, the best way to do that is for both sides to “go by the numbers” and create a written business valuation that is both credible and defensible. By that I mean that the ultimate value of the business must be reasonable and it must be based on commonly accepted industry metrics.
In my experience, rental industry participants and those who attempt to place proper values on their businesses tend to use the following methods most frequently:
Income approaches or multiples: Based on the income stream generated by the business.
Asset approaches: Based on the value of the business’s operating assets.
Market approaches: Based on comparable sales prices for similar businesses in the area.
Each offers certain benefits and suffers from unique shortcomings. As a general proposition, however, most sellers do best using income/multiple-based valuations, while most buyers do best using asset-based valuations. Why? The short answer is that income/multiple-based valuations generally factor in intangibles such as goodwill and focus on enterprise value, which is the value of the overall business as a profit-generating undertaking. Asset-based approaches typically limit themselves to the values placed on the identifiable assets of a business and tend to ignore intangible assets such as reputation; customer, supplier and employee relationships; experience; location; prior sales and marketing costs; brand recognition; and more. Consequently, asset values tend to be considerably lower than income/multiple-based valuations.
Separately, market-based approaches or comparables can be useful in some cases, but they tend to vary widely and are often wholly or partially inapplicable, typically as a product of the fact that rental businesses themselves tend to not be very comparable. Differences in equipment mixes, fleet sizes and ages, locations, customer types and traffic, yard space, delivery fleets, maintenance capabilities and a wide range of other factors including the above referenced intangibles can make it difficult or impossible to compare one business to another in any meaningful way. Ultimately, although a comparable can be an interesting data point, unless you’re comparing strictly controlled franchise or dealership operations, it’s fairly rare to find more than one or two recently sold businesses that could fairly be called comparables.
So, as a seller, count on using at least one or perhaps several income/multiple-based approaches. The most common of these is the multiple of adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) approach. Adjusted EBITDA is the same number with several add-backs in order to normalize it and conform with what most market participants would agree the EBITDA number would look like in a 100 percent arms-length business, acknowledging that some smaller businesses may, for example, pay more for health insurance, rent, officers’ salaries, conferences, travel-related expenses, vehicles, other perquisites and more than would a business that is operated entirely as a profit-maximizing entity.
This normalization or add-back process virtually always benefits the seller. Consider that, if a business valuation is based on a multiple of, for example, six times adjusted EBITDA — note that the multiple will be lower for most event rental operations, largely because they tend to be more labor-intensive than equipment rental operations — then every dollar that is added back will add $6 to the sale price of the business. This means that sellers should be highly motivated to review their expenses thoroughly for possible add-backs.
The following is an oversimplified example of what the process could look like:
Determine EBITDA. Using your income or profit-and-loss statement, start with your net income and add back any interest, taxes, depreciation and amortization shown. Let’s assume in this case that the EBITDA number is $500,000.
Determine add-backs. Add back extra salaries, perquisites, over-market payments, extra staff, vehicles and more. Let’s assume that number is $100,000.
Multiply your adjusted EBITDA by six. The total with add-backs is $3.6 million. The total without add-backs is $3 million.
Adjusted EBITDA numbers can vary widely based on a host of factors, including rental rates, utilization rates, labor expenses, parts and maintenance requirements, weather, local construction activity and the overall economy. That said, they commonly fall somewhere between 20 and 35 percent of gross annual revenues. In broad terms, that means I would expect to see a valuation in this vicinity for a business generating somewhere between $1.8 and $2.4 million in annual revenues. I also would expect to see those revenues generated by assets valued at somewhere between $1.4 and $2.2 million — again, with a fair amount of variation based on fleet age and replacement timing among other things.
This also supports our view of asset-based models that tend to yield lower business valuations in most cases. If you’re a seller, an asset-based valuation generally is not going to be the way to go unless you’re in a hurry to sell. You will need a more sophisticated, and accurate, means of determining the true value of your business, such as the adjusted EBITDA-based valuation.
Depending on your perspective and/or preferred terminology, multiple-based valuation also might be stated as a capitalization rate or cap rate, which is the amount of income a given investment is expected to return, or must return in order to be worthy of pursuing. Oversimplifying again, in the above example, if a target business is expected to continue returning normalized income of $600,000 per year after being purchased for $3.6 million, the cap rate would be 16.67 percent, meaning the investment would be returned in about six years. Cap rates are commonly used by investors as easily understood data points for determining whether the anticipated income to be generated by an investment meets their minimum criteria. This almost is, but not quite, the same as return on investment (ROI), the different being that ROI backs out debt financing. Established businesses with strong earnings generally can be expected to trade at cap rates of between 12 and 20 percent, whereas less stable, riskier and/or unproven businesses tend to trade at considerably higher cap rates, sometimes 50 percent or more.
Before going to market, however, remember that other valuation mechanisms also can provide material support or augment your proposed sale price. A discounted cash flows (DCF) model, for example, bases enterprise value on the present value of a business’s discounted stream of anticipated future income.
Modeling values in this way requires discounting the business’s expected future cash flows to present value at a discount rate, which typically equates to the interest rate on a treasury security with a like term, plus an industry-based risk premium. That means the riskier the business is, the higher the discount rate will be, which will reduce the business’s current value.
This can raise questions regarding the reliability of the metrics used in the DCF model, including its estimates of future cash flows, discount rates, anticipated growth rates and duration of the anticipated income stream. Investors who rely heavily on DCF models tend to place substantial emphasis on the systems the target business has in place and the breadth of its customer base, which tend to enhance its ability to reproduce revenues consistently over time, whether or not its current owner(s) remain.
Conversely, such investors tend to be more wary of businesses that rely on the personal relationships the selling owners maintain with suppliers and customers, particularly if only a handful of customers account for a material portion of the revenues of the business, largely because personal relationships tend to depart along with selling owner(s), even owners who’ve signed noncompetition agreements.
Ultimately, most sellers do best to examine a range of valuation mechanisms as well as the unique characteristics of their individual businesses when deciding on an appropriate sale price. There is no hard and fast rule, but there are a few principles that have more or less general application:
- Most industry participants use a multiple of adjusted EBITDA at some point in the process, so that should always be at least part of your valuation model.
- You should incorporate at least one other valuation mechanism if for no other reason than to support your multiple-based number and a DCF model can be particularly useful here.
- It usually is better to overvalue than to undervalue your business if you plan to offer it for sale.
- Be reasonable. Don’t let emotion cause you to go overboard in demanding the price you want. Stick to what the numbers show you. If that isn’t enough, take your operation off the market until the numbers yield a price you’re satisfied with.
- Never underestimate potential buyers’ willingness to walk away or simply start their own operations nearby.
- Determine your desired outcome(s) in terms of issues other than sale price as well, such as after-tax cash, retirement plans, post-retirement income needs, succession planning and estate planning before going to market with your business. Doing so can be immensely helpful in understanding not only what your business is really worth, but also what might be improved in order to obtain a better price, and perhaps what will have to be accomplished in order to get a sale closedOffshore investing.
In any event, for most, it’s an eye-opening experience.