M&A - Investment Grade Advisory

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.

Chris Weingartner 22, Sep, 2021

General

Risks of Selling to a Competitor

For many owners, deciding to sell their business is one of the biggest decisions they’ll make in their lifetime. The company’s value represents the amassing of their life’s work. Successfully selling the business at a premium price is crucial for owners to finance their dreams or fund their retirement. Finding the right buyer or investor will help you obtain premium valuation, but that person could be a competitor.

A quick Google search for “Risks of Selling to a Competitor” returns a litany of articles containing advice and personal stories, both good and bad, from entrepreneurs who were faced with this issue. Owners are wise to be familiar with these risks, and mitigate them as much as possible.

However, these risks must be weighed against the knowledge that oftentimes a competitor or strategic acquirer is the buyer willing to ascribe the highest valuation for the company. The reason for this is simple. Strategic buyers, buyers operating in the same industry and space, often can realize the most synergies from the acquisition. These synergies can including economies of scale, acquisition of talented employees and intellectual property, cross selling opportunities, and geographic expansion.

There are several key considerations that any seller and their representative should be taking to protect the existing operation and assets of the company, in the event a transaction doesn’t go through or the competitor doesn’t end up as the eventual buyer:

– Send Blinded Teaser – In order to protect and mask a company’s identity when first approaching a strategic buyer, teasers are created that reveal enough about the business to enable your competition to know if they’re interested or not, but not enough to identify what company is being sold.

– Execute a Non-Disclosure Agreement (NDA) – Ensure that any material shared will be used only for the purpose of evaluating a prospective transaction. NDA’s and Confidentiality Agreements protect the company from having its employees hired away, intellectual property replicated, customers poached, and suppliers undercut.

– Share Information Two Ways – While your competitor isn’t for sale, it is important for them to share important information with you for multiple reasons. First, viewing their financials can confirm they have the financial ability to undertake the acquisition. Second, understanding their operations can validate that the operational synergies they’re hoping to achieve are realistic. Finally, through sharing material both directions, it ensures that the other company has “skin in the game” to uphold and adhere to the NDA.

– Provide Requested Detail Gradually – There is no need to open up all company records the moment an NDA is executed. The seller will know better than anyone what they’re comfortable sharing at each stage of the process, and the advisor should completely honor and trust their intuition. Think of it as dating. You want to release the least sensitive information first to continue confirming interest and the buyer’s desire to acquire. You typically don’t get married after the first date.

– Blind Sensitive Material – Vendor and customer lists, pricing sheets, and other competitively sensitive material can be sent over with key items redacted. Customer concentration is a big concern of all buyers; you can easily send your top ten list over without the explicit names associated with each amount.

– Implement a Breakup Clause – As you get to the point where you are close to signing a Letter of Intent (LOI), consider including a binding breakup clause with the LOI that results in financial consequences to the buyer if they walk away from the deal without cause. This ensures they’re not entering into the no-shop diligence phase with the intention of just walking away after they’ve gathered intelligence.

Overall, the key consideration is risk mitigation. An experienced advisor will ensure that the correct amount of information is shared to keep competitive buyers interested without exposing their client to any potential pitfalls or threats.

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.

Chris Weingartner 25, Aug, 2021

General

Five Checks to Determine if Your Financials Are in Order

When selling a company or seeking investment, there is no larger deterrent to a premium valuation and a smooth closing than messy financials. For growth companies running at full speed, maintaining accurate and up to date financial statements can easily slip to the bottom of the task list. While it is a common mistake, poor financial reporting will hinder your ability to make informed decisions on managing and growing your company. It will also destroy buyer/investor trust in your company as a potential investment.

The Five Checks

Financial reporting may be a problem for your company if you have any of the following issues:

You do not have up to date monthly financial statements readily available

You do not track financials monthly and/or you are several months behind in reporting. Strong financial departments often produce monthly financials by the 10th of the following month. Closing later in the month reduces the usefulness of financial reporting.

You are not able to track revenue with expenses

You are not sure if your expenses are generating sufficient revenue to achieve profitability goals. Properly recognizing revenues and expenses in the month they are earned (known as accrual accounting) gives a better picture of profitability than cash-based financial reporting. Cash based financials can hamper management’s ability to make decisions.

Your financial statements are difficult to follow

Someone outside of your accounting team cannot easily understand your business model and financial position from looking at your financials. Clean reporting is organized by business unit or division and is consistent over time. Instead of making users scratch their heads, clean reporting enables high-value conversations around the business.

Your financial team does not have clearly defined processes

Lacking a standard set of procedures, such as bank account reconciliations and a monthly budget meeting, your financial reporting may contain significant errors. A written set of financial controls creates peace of mind.

You run personal expenses through your business

Lastly, running significant personal expenses through a business can further complicate matters, as buyers want to understand solely the costs to operate a business. The more of these non-business related expenses that flow through the P&L, the less credit a buyer will be willing to give to the seller for each addback.

Without clean financials, prospective buyers/investors cannot conduct the level of financial analysis required to determine if they want to move forward with an opportunity. If you are unable to provide monthly financials, buyers may be forced to pass or delay a decision. Without confidence in financials, buyers often hedge their offers downward to compensate for the risk of the unclear and inaccurate financials. The duration to close a transaction may also be elongated, as significant effort must be exerted in the diligence phase to validate the accuracy (or get as close as possible) of the unkempt numbers.

Maximizing Value

For business owners seeking to maximize their valuation and minimize the stress of financial due diligence, we advise being sure you can answer yes to the following four questions:

– Do I have audited and GAAP compliant (or at minimum prepared and organized per industry standards) financials?

– Are monthly income statements, balance sheets, and cash flow statements are readily available?

– Does my company regularly update and track performance against a budget/forecast?

– Have I established monthly financial Key Performance Indicators that are used to track and evaluate performance?

If you can answer yes to all, breathe easy as you have positioned yourself well. If your answer to any of the questions were no, we can help understand your current operations and set you on a path to success. Schedule a meeting today!

– Guest Article by Chris Weingartner

Zane Tarence 18, Aug, 2021

General

Five Things to Consider When Selecting an M&A Advisor

There is much to consider when deciding to pursue a merger or acquisition. Anyone contemplating a transaction should be consulting with, and ultimately engaging with an M&A advisor. When choosing an M&A advisor there are at least five things to consider:

Trust

This is the foundation of relationships, and the relationship with your advisor shouldn’t be any different. Whether you are pursuing a sale or purchase, it is likely to be a once-in-a-lifetime process, so you want to ensure you trust who is guiding you through the process.

Experience

Experience is of course key. The M&A advisor you work with is there to create value with a competitive process, and it is best if the advisor has expertise in your industry. An industry expert will better understand the key drivers of your business, the market dynamics and the potential buyers. Be sure to inquire about their deal experience to learn more about how many deals they have closed and what experience they have in your industry and with businesses similar in size.

Process

Understanding the process and how it’s run is also important. The process takes a lot of discipline, and you don’t want your advisor cutting corners. Great advisors don’t skip steps and are diligent about representing your company well and working hard throughout the entire process.

Team

You’ll also want to understand what the team looks like – their experience and backgrounds. Make sure you know who will be working on your deal and get commitments to that effect. Running the process requires a focused team of professionals, so you need to know that your deal is getting the time and attention it deserves.

Fee

Price is always a consideration, but you should look at this in the context of the service you are being provided and the value being created by the process. You want to make sure the advisor is properly aligned with the result you desire. Reputable M&A advisors make the vast majority of their fee after you’ve succeeded in an acceptable transaction.

Many M&A advisors take a transactional approach to their engagements. While it is a transaction, we have seen Founders Advisors leverage a relational approach. This involves really understanding the goals and objectives of the client by getting to know their company and listening to their personal desires. Not all advisors operate this way, so be diligent while interviewing M&A advisors to ensure a great fit for you and your business objectives.

Newsletter – Sign Up to Receive Future Content

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.

Brad Johnson 26, Jul, 2021

General

What Is Your Market Share and Why the Answer Matters

“How large is your market, and what is your share of it?” If you haven’t been asked this question yet, you can certainly expect it if you ever consider any sort of transaction. This is one of the most common questions from both strategic and financial buyers, yet we typically find that business owners have not spent sufficient time on this topic to develop a data-driven response.

Market share is usually defined as the percentage of total market sales that is earned by a company over a defined period of time. It is a commonly held belief (and nearly proven fact) that profitability and market share go hand in hand. Whether you are operating in a high-growth industry or in a market that is on the decline, it is critical for business owners to understand the dynamics of the market in which they operate as well as the share which they have amassed.

Based on our experience as transaction advisors, here are four items to keep in mind when investigating market share:

1. Define Your Market and Your Segment

Many owners will simply lump their companies into the top-level industry they operate in. While overall market dynamics are important, potential buyers will want to go deeper on the key nuances related to the company’s specific market segment it serves. Keep in mind, there are also cases in which certain sub-markets are performing well while an overall industry is struggling, so owners should understand and define both.

2. Security of Market Share

The defensibility and long-term security of a company’s market share is a key driver of value. The market’s competitive landscape and customer contract terms are two primary characteristics that contribute to the protection, increase, or decrease in market share. These components can provide a moat around a company protecting its market share from competitors. Generally, if a company has the ability to execute long-term agreements with customers (or demonstrate consistent renewals or re-use) with minimal interruption from competitors, buyers are more willing to pay a premium. While most companies have some level of competition in the markets in which they operate, one way for owners to mitigate this risk is to clearly articulate what distinguishes their company from competitors.

3. Where Do You Go From Here

In order to gain market share, will it require takeaways or is there still a significant number of potential customers who have no solution in place? As most owners will agree, selling to a first-time user is generally easier than unseating the incumbent player. Consumable product companies have more opportunities to convert new customers. However, excluding some markets such as pharmaceuticals, this high usage may lead to lower switching costs.

4. “I’m Not Sure” is NOT an Answer

If it’s not particularly easy to compile the data necessary to define market share, we encourage owners to use disparate sources of information to triangulate an answer. While buyers certainly prefer explicit details, these groups will understand if the information is not readily available, yet they will value an owner that approaches the topic from various angles.

At the end of the day, it is typically impossible to have full information on market share, but an owner that has command over this topic will increase the value of his or her company. Keeping these four items in mind, we hope you’ll be better equipped to answer that inevitable question about the size of your market and what your share of it is.

– Guest Article by Brad Johnson

Madison Davis 21, Jul, 2021

General

Customer Concentration Can Be A Deal Breaker

Customer concentration is a notorious deal killer, yet many business owners fail to address this issue prior to pursuing a recapitalization or exit. After all, from an owner’s perspective, landing one household name as a client could be exactly what an up-and-coming company needs to build its credibility in the industry, boost revenue and quickly expand into additional markets.

Why, then, are investors and acquirers so concerned about customer concentration?

Simply put, “customer concentration” translates to “risk” in the mind of a buyer, and below are five reasons that this is the case. To illustrate, let’s use an example of a service company, Concentration Co., whose largest customer is one division of a Fortune 500 company. The customer, Giant, Inc., accounts for 40% of Concentration Co.’s revenue.

1. Potential Financial Loss

The most obvious risk is if Concentration Co. lost Giant, Inc. as a customer. There would be an immediate decline in revenue and net income that would be difficult to recover quickly, and may require Concentration Co. to cut costs, reduce headcount or operate at a loss. This risk is particularly problematic for a private equity group whose expected return on an acquisition of Concentration Co. would be drastically reduced should it acquire the company and subsequently lose the top customer. After all, companies are typically valued based on some multiple of EBITDA, and losing 30% of EBITDA will make it challenging to generate an acceptable rate of return on that investment. Revenue from these high-risk customers, may be valued at a meaningful discount. Review the prior article for more information here: Not All Revenue Is Valued Equally.

2. Financing Challenges

Lenders also see customer concentration as risky, and for firms who intend to fund the transaction through loans from a bank or other institution, customer concentration can make financing difficult. Lenders may pass on the business altogether, provide less than the desired loan amount, or offer the buyer sub-optimal terms on the loan in order to mitigate risk. This can reduce buyers’ expected return and lead them to pursue more lucrative opportunities.

3. Pricing Pressure

Key customers who are also large companies often have the ability to exert pricing pressure, which can erode profit margins. Responsible for such a vast percent of revenue, Giant, Inc. has significant leverage over Concentration Co. Especially if there are alternative service providers in the marketplace, Giant, Inc. could demand a price discount and Concentration Co. would have to comply or risk losing its largest customer to a competitor. Depending on its financial position, sacrificing margins may be better than losing Giant, Inc. altogether. From an acquirer’s perspective, however, lower margins also mean decreased EBITDA and future returns.

4. Ability to Dictate Terms

Similarly, large customers can exert their power to adjust the terms of service to best meet their needs. If, for example, Giant, Inc.’s policy was to pay in 45 days instead of Concentration Co.’s typical 30 day cycle, an exception would probably be made. After all, a competitor might be more than willing to accommodate Giant, Inc.’s preferences in order to pick up so much business.

5. Impact on Capacity

Large customers tend to control a company’s capacity as well. If Giant, Inc. requests that the company begin serving another one of its divisions, it may not have the capacity to meet the needs of its other customers or take on new customers. In this situation, Concentration Co. faces a decision. It can a) tell Giant, Inc. that it cannot provide the additional service as requested and risk losing Giant, Inc. to another firm who can accommodate its needs or b) fulfill the request and potentially damage relationships with the rest of its customer base and miss out on potentially more profitable growth opportunities.

Ultimately, customer concentration is risky whether you plan to sell your company or not. Each of the five reasons above can just as easily impact current owners as potential acquirers. If your business would suffer heavily from the loss of one or a few key customers, consider developing and implementing a plan to reduce this risk. These efforts will pay off no matter what your plans are in the future.

– Guest Article by Madison Davis with Elm Street Technology

Duane Donner 20, Jul, 2021

General

Not All Revenue Is Valued Equally

Most companies are valued by applying a multiple to the businesses EBITDA (earnings before interest taxes, depreciation, and amortization). However, buyers will closely examine the revenue streams generating that EBITDA and assess the quality thereof. Here are a few things buyers will look for when assessing a company’s revenue streams.

1. Revenue Consistency

The more stable and predictable the revenue stream and the profit therefrom, the more the buyer will be willing to pay. This provides forward visibility and mitigates risk, because the revenue can be counted on in the future with a high degree of certainty. Most subscription models would fall into this category. Assuming customer churn is low, and the lifetime value of the customer outweighs the customer acquisition costs, buyers will pay up for this type of business model. On the flip side, earnings generated from project based work or one-time events will typically be heavily discounted.

2. Customer Diversity

One strong customer can get a business up and going, but diversity is required to mitigate risk. This also applies to customer concentration within revenue streams. If the revenue stream would suffer meaningfully due to the loss of one or two customers, buyers will take this into account. Customer concentration will not only lower the value of a company but might scare off buyers altogether.

3. Margins

Buyers will pay great attention to a company’s margins and assess the overall business by comparing margins to like companies. Superior margins oftentimes mean a competitive advantage, which gives a buyer greater comfort that the revenue and profit therefrom is protected. In addition to looking at a company’s overall margins, buyers will assess the margin contributed by each revenue stream. Growth in revenue streams with higher margins will be rewarded, while revenue with lower margins, even if growing, will often be discounted.

Conclusion

These are important factors to consider when operating and growing your business. Yet, every company and industry is different and not every business model can have the recurring revenue and customer diversification of Netflix. If you want to know how you measure up in these areas, benchmark yourself against competitors or companies with a business model similar to your own. Taking action to improve and be the best among your peers in these areas will not only increase the value of your company, it will mitigate the risk you have as an owner.

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.