Wesley Legg - Investment Grade Advisory

Wesley Legg 18, Oct, 2021

General

A Great Company and a Great Life Begin with the Right Team

There has been speculation that Apple is looking to get into the automotive industry. Exhibit number one for the speculators is the fact that Apple has been on a hiring spree for auto industry talent. In fact, Apple’s poached so many car battery engineers from A123 Systems, that A123 sued Apple claiming foul play. So what exactly is Apple doing? Are they looking to make an Apple branded automobile, are they working on operating systems that would play in another maker’s car? I certainly don’t know the answer to that question, and I suspect neither does Apple.

You may remember Jim Collins’ findings in the research he and his team published in “Good To Great”. One of the key elements for taking a company from good-to-great was getting the right people in the right seat on the bus. That wasn’t really a profound idea, but what was more interesting to me was the “First Who…Then What” concept. The key point there was that the “who” questions come before the “what” questions.

In other words, build the right team, give them leadership and general direction and you’ll have a better “what”, i.e., vision, strategy, organizational structure, etc. I’m willing to bet Apple is putting the “First Who…Then What” idea to the test. Assemble a great team, put them on the bus and then decide the destination.

Recruiting, training and retaining the right talent takes focus and intentionality. Yes, it is a big investment, but it will cost you real money if you don’t make it a key discipline for your company. How much will it cost you? Go to Caliper Corporation’s “Cost of Turnover Calculator” to explore the cost of turnover for your company. You might be surprised to see the practical costs of hiring the wrong person or losing the right person, and this is before considering opportunity costs not measured in the Caliper’s formula.

The benefits of hiring and associating with the right people are endless. The right people will bring the same passion you have to the business and steward it with the same rigor. They’ll find a way to capitalize on opportunity and navigate the times of challenge. It will not only lead to great business, but also a great life. Finally, having the right team can pay big when you bring on an equity partner or make your exit.

Finding companies with strong management teams is the strategy of most smart investors, including Warren Buffett. If you want take it from me, take it from him, “When you are associating with the people you love, doing what you love, it doesn’t get any better than that.”

Wesley Legg 4, Oct, 2021

General

Strategy or Execution, What’s More Important?

A lot of emphasis is put on having the right strategy in business. Strategy is important, but I wonder if we spend too much time talking about vision and fresh ideas and not near enough time on good ole fashion execution. Sun Tzu, author of The Art of War wrote, “Weak leadership will destroy the finest strategy – while forceful execution of even a poor strategy can often bring victory.” In other words, bad decision managing destroys even the best decision making. When you don’t achieve the results you desire, don’t be too quick to blame the strategy, but instead first put a microscopic eye on the execution.

I recently heard a great presentation from Dan Barnett, CEO of The Primavera Company. The presentation was called Make or Break Execution: The Core of Success. A “make or break” is the one thing your company must do extraordinarily well to achieve your vision. Dan started his presentation by saying every company has a make or break and the best business leaders drive toward their “make or break” with great focus and detail. Dan isn’t talking about reviewing results a month after the fact to see how your company performed. By then it is too late to change the past and likely too late to shape the near future. What if you could see how you’re tracking toward your “make or break” results on a regular and real time basis and with enough lead time to see the problems standing in the way of desired results?

Getting the results you desire doesn’t just happen. If you need to lose 100 lbs in 5 months, it is going to take more than a good exercise and diet plan. Reaching your goal will take executing the plan with disciplined activities. If you have the proper plan and you’re executing the plan, you don’t even have to get on the scale. You’ll know you’re going to achieve your results by measuring your activities.

Let’s say you’ve asked a weight loss expert to review and hold you accountable to your weight loss plan. They review it and approve the plan, but the way they decide to hold you accountable is to meet you at the end of every month to record your weight. If at the end of the month you’ve lost no weight, there is nothing your accountability partner can do to help you make up for that lost month. You now have only 4 months to lose 100 lbs, a much lower probability. What if instead of checking the scale every month, you’re required send your weight loss expert a daily report of your exercise activities and everything you ate? Assuming you’re honest about your exercise and eating, they can now give you near real time feedback and have better insight into whether or not you’re going to achieve your goal. This is a key way to ensure you are enhancing the value of your business on a daily basis.

The same concepts can be applied to business. For every inch of strategy and vision/goals, you need miles and miles of solid execution. Good results come from doing the right activities. Yet we’ve all been guilty of painting a vision without devising a plan, devising a plan and not executing or holding other accountable to do the same. When we don’t get the results we want we wonder what happened. Fulfilling a vision requires you to determine what activities it’s going to take to meet your goal and measuring those activities on a daily/weekly basis. This simple, but important discipline will provide clarity for you and your team and keep everyone focused on the things that matter most.

Wesley Legg 28, Sep, 2021

General

Am I Enhancing or Hindering the Value of My Business?

Unlike listed public companies, private businesses don’t get a daily ticker tape telling them what they’re worth. But imagine you did. Would that daily feedback from buyers and sellers make you think differently about how you operate your business? While I know public company CEO’s don’t always agree with the market’s perception, the good ones are focused on increasing value for their shareholders and know ultimately the ticker tape is the scorecard. Private owners would be wise to do the same.

Private company owners should focus on increasing enterprise value, not just the day-to-day bottom line. An enterprise value focus may sometimes negatively impact short-term profitability for the purpose of minimizing risk and increasing long-term profitability. For that reason enterprise value should be the focus, whether you plan on selling today, tomorrow, or never.

Valuing your company

I know, you still are curious about what your company is worth. Be leery of general rules of thumb or an internet tool that spits out your value after only a few questions. Determining valuation is very technical, but is also part art. A lot goes into valuing a company, and there are a lot of nuances. Most, but not all, companies trade on a multiple of EBITDA (Earnings before Interest, Depreciation and Amortization). Determining the EBITDA and the appropriate multiple is the trick. Companies can also trade on a multiple of revenue, asset value, or a combination of valuation techniques. A reputable and experienced M&A advisor, especially one with relevant industry expertise can usually give you a good idea of the valuation of your company. However, while an experienced professional can provide a good valuation opinion, the only way to know the true value of your company is to sell it and see what buyers are willing pay. And the only way to know to assure that you get the highest valuation for your company is to run a competitive market process. While it is helpful to understand the value of your company, it is more important, especially for those not intending to sell short-term, to understand how a buyer would go valuing your company. With this buyer perspective, you can better know how to increase the value of your company when and if you do decide to sell.

What Buyers Want

You may think what a buyer wants is obvious – growing company with good profitability. While that is part of the equation, it is not nearly that simple. A growing company with good profitability relative to what? An intelligent buyer is not going to be looking at your company in a vacuum. They will view your company alongside other opportunities, comparing the risk and expected returns of each one. The expected return is a function of the predicted future performance of the business and price paid to obtain the business. Said another way, the higher the risk to future performance the less a buyer will be willing to pay, if they want to buy the company at all. Also, not all buyers are the same. Expected returns can vary depending on the buyer’s perspective. In the case of a strategic buyer (versus financial buyer), expected returns can be higher if they expect to gain synergies in the acquisition, like lowering cost or leveraging their distribution.

Companies that provide a buyer with a lot of confidence in their future performance get a higher valuation relative to their peers, assuming all things equal (i.e. similar size and market external market conditions), and that they run a competitive market process. As you might expect, the past performance of the company and current financial metrics will be examined carefully when a buyer is considering purchasing a company, but there are many qualitative factors also being examined both consciously and even subconsciously. These qualitative factors include the quality of the management team, financial controls, market share, competitive advantages, customer diversification, the company’s market, the defensibility of the pro forma, quality of employees, documented processes and procedures, a solid strategic plan, just to name a few.

If you want to know how to increase the value of your company, you should seek to gain understanding on how buyers would view your company. Determine the current value enhancers and detractors, and understand what you can improve and/or change that would increase your value. Again, a reputable and experienced M&A advisor can give you great perspective on what buyers are looking for when purchasing companies like yours. They can do this because they talk to buyers on a daily basis, and whereas you may only do one or two major transactions in your lifetime, they do transactions for a living.

Wesley Legg 13, Sep, 2021

General

How Do I Know When to Sell My Company?

Have you ever visited a friend or family member who lives in a city with major traffic congestion? I live in a smaller city. When hunger strikes my wife and me, and there is no desirable food in the pantry, we get in our car and we go out to eat. That decision is not so simple in congested cities. When visiting family in Atlanta for instance, every discussion about going somewhere turns into a 15-20 minute intense strategy session. We debate when and how to go, not based the internal desires of the group, but on one very powerful external factor, TRAFFIC.

Most business owners plan to sell their company when they are ready. That usually means it is based on an internal desire or factors, such as owner energy, business performance, business lifecycle, retirement, personal needs of the shareholder, etc. These are all internal factors that should definitely be considered when deciding when to sell. However, like traffic in the example above, there are powerful external factors that should be considered as well. Some of those external factors include:

– Government policy

– Capital markets

– Macro-economic forces

– Industry life-cycles

– The company’s life-cycle

– Personal needs and desires of the owner

Each one of these factors is important to consider, but credit markets have historically proven to be one of the most powerful external forces in both inflating and deflating valuations.

There are two reasons why:

Rate of Return

Each source of funds is obtained at a different cost, so the “weighted average cost of capital” is used to determining the discount rate. As interest rates go down, present values go up, making valuations higher. A small change in the discount rate can result in large changes in valuation. Summed up simply, when paying higher interest rates, the investor requires a higher rate of return, which makes valuations go down, and vice versa.

Money Supply

Early investors start to see good returns and those on the sidelines, not wanting to miss out, come in to drive valuations even higher. Sometimes, fundamentals yield to speculation and for a period “the sky is the limit.” But then, fundamentals return, companies default on their debt, capital markets get scared and stop lending, and in a small fraction of the time it took to inflate, asset values crater.

Conclusion

Market cycles are real and are primarily driven by the availability and cost of debt. Market cycles have historically lasted on average 5-8 years. When markets are on the upswing, valuations rise as investors are willing to take more risk and pay higher multiples. When markets crest and move down, investors pay less if they buy at all. Understanding this external force is important when deciding when to sell or recapitalize your company. That said timing your transaction at the peak of the market is tough.

Timing the market can be compared trying to take the perfect picture while riding the London Eye (the giant Ferris wheel). You know you can get the best picture of the London skyline at the peak, but if you miss your opportunity because your batteries went dead or you got distracted by an incoming email, you have to wait a long time before that same opportunity comes back around. It is the same with selling all or part of your company. If you miss the upcycle, you may have to wait 5-8 years to see a similar valuation for your business. Like navigating traffic in Atlanta, the risk of missing your optimal selling window warrants strategic planning.

If you would like to discuss optimal timing for your company, we are happy to talk with you. Please schedule a time.

Wesley Legg 30, Aug, 2021

General

What Are Addbacks and How Do They Affect My Company’s Value?

In founder or family-owned businesses, it is common for owners to run personal/non-company related revenue or expenses through the business or to expense certain items that would normally be capitalized. While these practices may come in handy during tax season, they can seriously impact a company’s valuation.

If you are a business owner considering an exit or recapitalization, we strongly recommend that you a) gain an understanding of what add-backs/adjustments are, b) understand how they impact valuation and c) begin the process of identifying and tracking them within your business.

What are addbacks/adjustments?

Addbacks and adjustments come in many forms (typical items and examples are shown below), but generally they can be described as any item on the income statement that is non-core, one-time, or personal in nature. Put simply, addbacks and adjustments are items that should be “added back” to net income and/or zeroed out on the income statement due to one of the previously mentioned reasons. A good rule-of-thumb is to imagine that your business was acquired by a publicly traded corporation or private equity group – any item the acquirer a) would not expect to be part of the business going forward or b) would not include on the income statement is likely an adjustment.

What should I do about addbacks/adjustments?

If you plan to pursue an exit or recapitalization, you should identify any potential addbacks or adjustments to your financial statements and begin tracking them regularly. This can be done however it is easiest/most efficient for you and your team, but we recommend the following:

– Record addbacks on a monthly basis – When looking back quarterly or annually to identify addbacks, it is easy to forget when/where these items appear on the income statement, and you might forget about some items entirely. You reduce the risk of leaving out some items and as a result, leaving additional value on the table, by recording addbacks each month.

– Record the exact dollar amount, and which account it affects – This is particularly true if only a portion of an account is added back. For example, if $20,000 out of a $30,000 “Travel and Entertainment” (T&E) expense was for your family’s vacations, that $20,000 could be added back to EBITDA; however, it may be helpful for buyers to know where that $20,000 was originally recorded. By doing so, they can see that the T&E line was artificially inflated.

– Keep notes explaining why the item is an addback – If you find yourself in a discussion over whether certain addbacks are reasonable, it will be beneficial to keep careful notes on why you chose to add back the expense. For example, if you add back “marketing expenses” of $50,000, a buyer may question this choice since marketing expenses are considered normal business practices. However, if you are able to explain that these expenses were related to a marketing campaign for a trial product that was discontinued (and therefore, will not be incurred again next year), the buyer is more likely to agree with your rationale.

How do addbacks/adjustments affect valuation?

Since companies are often valued based on a multiple of EBITDA, the primary way addbacks and adjustments affect valuation is when they alter EBITDA. If making these alterations to the income statement leads to large fluctuations in EBITDA, the company’s valuation can vary accordingly.

Hypothetically, if you receive an offer for your company based on a multiple of five times trailing twelve months (TTM) EBITDA and your company’s unadjusted EBITDA is $4 million, the buyer has essentially valued your company at $20 million.

Now assume that your company has the following addbacks for the past 12 months:

– Your family’s travel expenses: $20,000

– Donations to a local charity: $5,000

– Salary that you pay your son (who does not work for the business): $75,000

– Fees paid to a law firm you hired during a legal dispute: $100,000

– Implementation/installation fees for a new on premise software system: $20,000

– Renovation to your new office: $30,000

Some of these expenses may seem immaterial on their own, but if combined, they increase your EBITDA by $250,000. At a 5x multiple, this translates to a $1.25 million bump in your total valuation.

Conversely, if your business earned $500,000 of that $4 million in EBITDA from a one-time special project, some buyers might argue that EBITDA should be adjusted down to $3.5 million (therefore reducing total valuation to $17.5 million).

Note: While all of the examples mentioned above may rationally be considered adjustments or addbacks, it is important to keep in mind that once valuation discussions begin, buyers may disagree with certain adjustments or even make adjustments of their own. Addbacks and adjustments are often evaluated on a case by case basis, making it important to carefully track and provide explanations for each item.

Addbacks and Adjustments in Negotiation

When positioning a company for a recapitalization or sale, the seller wants the highest EBITDA or multiplier they can defend. The buyer wants to pay the lowest value possible to mitigate risk and maximize financial returns. When negotiating a deal, both sides will position what should be an addback and/or an adjustment. This is an area where an experienced and reputable M&A advisor can provide tremendous value. An M&A advisor’s experience allows them to not only have the advantage of seeing what are customary and non-customary addbacks and/or adjustments, but also the knowledge and experience to appropriately defend the position of the seller or buyer with data and financial analysis.

Are you considering an exit or recapitalization and have questions about addbacks affecting your company’s valuation? Contact Investment Grade Advisory; we will gladly discuss your concerns and ways you can increase your company’s value.

Wesley Legg 11, Aug, 2021

General

The Highest Offer Doesn’t Always Seal the Deal with Founders

Cash is king; however, the highest offer doesn’t always seal the deal. This is especially the case when the seller is a founder-based company, i.e., the seller is the founder or an heir of the founder. Most founders, of course, want to maximize value, but that is generally not their sole focus, particularly when they are doing a recapitalization with a private equity group.

Founders can be focused on a variety of other factors, including certainty of close, reputation/culture or the buyer, expertise and track record of the buyer, the fate of their employees, their role post transaction, business synergies, deal structure, etc. Buyers who are only differentiated by price are at a disadvantage for several reasons, primarily because someone else can always outbid you. Smart buyers seek to understand the desires of the seller and craft their offer accordingly, not just focused on price but also on the seller’s overall objectives in a transaction.

This is another compelling reason for sellers to run a competitive market process. Using an M&A advisor to run a process provides the seller with more options and a higher probability of reaching the terms they desire in deal. It also allows the seller to see buyers side-by-side to compare the different individuals and cultures involved. This is extremely important when doing a recapitalization, because you’re not just seeking liquidity, you’re also picking a partner.

As a founder, a crucial component of the sell-side process is setting aside time to determine your priorities. There isn’t a right answer as it differs for each person. Gaining clarity on the desired outcomes early on in a process can help tremendously once you get into the weeds of a transaction later on. It also helps to set expectations with your advisor, so you’re aligned on what variables you are optimizing over.

Wesley Legg 23, Jul, 2021

General

Does Your Company Have a Moat?

Moats are often water filled ditches around castles and other fortified structures creating obstacles for would be attackers. Moats make it difficult for those wanting to siege the protected structure, both thwarting attacks from the ground and preventing the practice of mining, digging tunnels under the castle to cause it to collapse.

Like the castles of old, your company’s market share and profitability is under constant attack from competitive forces.

Michael Porter, author of Competitive Advantage and several other stellar books, developed something called, “Five Force Analysis”, which says companies face competition from five forces:

– Rivalry Among Existing Competitors
– Possible Entry from New Competitors
– Bargaining Power of Suppliers
– Bargaining Power of Buyers, and
– The Threat of Substitutes

An effective moat gives you a hedge of protection and even competitive advantage against these outside forces. Like the moats used to fortify a position, your business’s defense can come in all shapes and sizes, and will often depend upon your industry, business model and the weapons used by your competition.

When fending off other industry players, manufacturers of commodity products protect their market share and margins with economies of scale, a boutique retailer brand, or a technology company high switching costs for existing customers. Not allowing suppliers to get the upper-hand can be accomplished through tactics like supplier diversity and the ability to substitute inputs, and keeping buyers from pinching you is easier when you have diverse customer base and product differentiation.

Competitive advantages, like the “moats” mentioned here will not only protect your company’s profitability, but will also allow you to advance your market share and grow. Lastly, moats will increase the value of your hidden wallet, the equity value in your company. Bottom line, buyers pay significantly more for companies with a meaningful competitive advantage. If you want to understand how to protect your company’s position and take ground from others, consider reading Porter’s book “Competitive Advantage”, if you want the cliff-notes version, read Porter’s article in the Harvard Business Review here.

Wesley Legg 16, Jul, 2021

General

How External Market Factors Drive Your Company’s Valuation

“I should have sold when I had the chance,” is a phrase our advisors hear much more often than “I sold too early.”
Timing a transaction is tricky, because it’s influenced by a variety of internal and external factors, such as:
– Government policy
– Capital markets
– Macro-economic forces
– Industry life-cycles
– The company’s life-cycle
– Personal needs and desires of the owner

Each one of these factors is important to consider, but credit markets have historically proven to be one of the most powerful external force in both inflating and deflating valuations. There are two reasons why.

Rate of Return

In the world of investing, return is commensurate with risk. The greater the risk, the higher the need for return. Economic risk is measured by determining the rate of return required for an equivalent investment facing an equivalent level of risk. This rate of return is called the “discount rate”. The capital used to buy a company is typically a combination of debt and equity. Equity can be in the form of either company stock or cash, and debt is borrowed money the acquiring firm/company pays interest on. Each source of funds is obtained at a different cost, so the “weighted average cost of capital” is used to determining the discount rate. As interest rates go down, present values go up, making valuations higher. A small change in the discount rate can result in large changes in valuation. Summed up simply, when paying higher interest rates, the investor requires a higher rate of return, which makes valuations go down, and vice versa.

Money Supply

Money supply also heavily influences business valuations. When the economy sputters, the fed lowers interest rates to stimulate the economy. When money is cheap and the economy bottoms out, capital markets begin to loosen the purse strings. Early investors buy cheap, but more money competing for a limited number of assets drives valuations higher, and investors, emboldened by their access to debt, and lower discount rates, start to take on more risk. Early investors start to see good returns and those on the sidelines, not wanting to miss out, come in to drive valuations even higher. Sometimes, fundamentals yield to speculation and for a period “the sky is the limit.” But then, fundamentals return, company’s default on their debt, capital markets get scared and stop lending, and in a small fraction of the time it took to inflate, asset values crater.