Chapter 12

Crunching the Numbers: Establishing Valuation and Selling Price

In This Chapter

Looking at a company’s value

Settling on an asking price

Addressing differences in valuation

Considering renegotiation

Unlocking the mysteries of how to know what to pay for a company was one of the reasons I became interested in entrepreneurship. Valuation is at the core of mergers and acquisitions. After all, if both sides can’t agree to price, no deal happens.

In this chapter, I introduce you to the concept of valuation: how to determine it, why it’s important, why Buyers pay what they pay, and how Sellers can create a more compelling valuation.

What’s a Company Worth? Determining Valuation

Valuation (the price one party will pay another for a business) is based on what you can negotiate. That’s why I include some negotiating thoughts in Chapter 11. And, as with most negotiations, valuation is more art than science. In fact, I call it alchemy because valuation is often subjectivity masquerading as science and logic.

Valuation is really the intersection of cash flow and time. In other words, how long will the Buyer take to recoup the cost of the investment? And how many years’ worth of profits is the Seller willing to take today in exchange for giving up an infinite flow of profits from that business?

If you want extra credit for this valuation section, keep in mind that cash flow and time aren’t the only contributors. You also need to factor in the following:

Future prospects of the business: Is the business growing rapidly? Is growth stagnant and flat? This growth (or lack thereof) may affect how much Buyers are willing to spend.

The risk associated with the specific business: For example, are the company’s products high quality, or has quality slipped? Is the company able to recruit, train, and retain good employees, or does it have a problem with excessive employee turnover?

Systemic risk: Systemic risk is risk affecting everything in the economy. The recent economic meltdown is a perfect example (unfortunately) of how the economy can affect everyone and every company. Plenty of well-run companies offering good products and services suffered due to a widespread downturn. Buyers feel a lot less generous in the valuation process when systemic risk is high.

Cost of capital: Cost of capital is another name for “what else Buyer can do with that money.” If Buyer has other options, he deploys that capital in those deals that offer higher returns and less cost.

And, on top of all that, valuation depends on negotiating prowess. In other words, are you a good poker player, or do you fold and collapse when someone puts a little pressure on you? (Chapter 11 offers you helpful negotiation strategies.)

You can craft all kinds of fancy algorithms and complex mathematical formulas, read every trendy business book and the writings of the ancients, and spend copious amounts of time searching for comps (comparable transactions) to see how other M&A deal-makers determined valuation. In my view, though, that’s all overkill.

Most often, valuation boils down to a small, simple valuation range: four times to six times EBITDA (or 4X to 6X in M&A code). The magic number in the M&A deal-making world is smack-dab in the middle: 5X. These numbers are known as multiples, so when you hear someone say “a 5X multiple of EBITDA,” that person means a company with EBITDA of $3 million would have a $15 million valuation.

Five times EBITDA is an industry standard, a convention of deal-making. Nobody knows where 5X came from, but all you need to know is that it’s a de facto standard. In good or bad times, that multiple may be a bit higher or lower, which is why I give you the 4X to 6X range.

As Seller, you can get a valuation higher than 6X, but you need to have a strong negotiating position. The best negotiating position is to have a highly profitable company in a rapidly growing industry. For example, venture capital deals usually garner far higher multiples for Sellers than lower middle market and middle market deals do. In a venture deal, Buyer is willing to pay a higher price because he’s expecting the company to grow rapidly; he’s betting on the future prospects of the business. See the nearby sidebar “Other valuation techniques” for more on types of valuation.

Other valuation techniques

Although multiples of EBITDA is a typical valuation technique, it’s not the only method to determine a company’s valuation. Various industries may use different valuation conventions, including the following:

Asset value: In this example, the Buyer pays a price based on the value of the assets on the company’s balance sheet. This technique works best for companies with a lot of inventory and/or manufacturing equipment. Asset value is usually not a good idea for service businesses because they don’t have inventory and manufacturing equipment.

Multiple of gross profit: Gross profit (the difference between revenue and the cost of goods sold) can be a suitable method to determine valuation, especially if the company is losing money. Using gross profit can also be a suitable method to determine an earn-out (which I cover later in this chapter).

Multiple of revenue: This simple valuation method is a good choice for a company that’s losing money. Just apply a multiple to the revenue of the company. Top line revenue is also used in many earn-outs.

Discounted cash flow (DCF): This technique is one of those fancy-pants MBA valuations often used in the venture capital world. You estimate or project a business’s cash flow (usually earnings minus capital expenditures) for a period of time, often five years. You then determine the terminal value, the expected future sale price of the business at the end of that period, and figure out the present value of this expected cash flow by discounting, or lowering, the future value of those cash flows. (Basically, you’re figuring out the current equivalent of that future cash flow figure.) That becomes the price the Buyer is willing to pay. The higher the cash flows, the higher the price.

Multiple of contribution margin: This advanced valuation method utilizes the contribution margin, the amount of cash flow a Buyer can expect after making changes to the business, such as eliminating some expenses by moving operations from the Seller’s facility to the Buyer’s facility. This approach isn’t for beginners.

These sundry techniques often don’t use the standard 4X to 6X multiple range I describe in the nearby section “What’s a Company Worth? Determining Valuation.” Multiples may be 2X, 1X, or even less than 1X. Revenue, gross profit, and contribution margin will all be larger than EBITDA.

Meeting in the Middle: Agreeing on a Price

Valuation is never a given. Valuation is not self-evident, nor is it obvious. Instead, valuation is an abstract concept open to interpretation. So how do a Seller, who wants a high price, and a Buyer, who wants a more reasonable price, find common ground?

During the valuation process, Sellers should signal strong valuation expectations, but fight against their own biases toward their companies. An owner who has spent years or a lifetime building a business is going to be rather subjective about the greatness of his company. But he must remember Buyers look at many potential deals every year and don’t have the same emotional connection to his company that he does.

On the flip side, no matter what else they do during valuation, Buyers should be careful about bragging about how much money they have at their disposal. Sellers are liable to think a Buyer can liberally deploy that money on their deal and may develop unreasonable valuation expectations. In this section I offer suggestions for both Buyers and Sellers approaching valuation.

Testing the waters

Many Buyers ask me, “What does the Seller want?” This question is a test; I know that because when I’m buying companies, I always ask the same question! And I’m amazed at how many people (often other intermediaries) cough up a number.

As Buyer, asking for a valuation never hurts. If Seller demurs, though, be prepared to offer a valuation.

I don’t recommend that Sellers offer up an asking price (the price they’re hoping to garner). In fact, I don’t provide an asking price in my deals for a simple reason: If I provide a Buyer with a certain price and she submits an offer with that price, she may be miffed if she later discovers another Buyer paid more. That first Buyer will, with good reason, say I provided bad information.

Instead, I ask the Buyer to review the information I provide in the offering document (see Chapter 8) and come up with a valuation that she can support based on that information.

I usually remind the Buyer that I am talking with other potential Buyers and try to point out certain key strengths of the business that this particular Buyer should consider as she formulates her valuation.

I also caution Sellers to have reasonable expectations. Reasonable expectations (no, that’s not a mediocre Dickens novel) don’t mean a Seller should undervalue his business. Instead, he should expect the Buyer’s offer to be based on today’s reality — financial performance, company and industry trends, market conditions, and so on — and not necessarily what that business may have been able to fetch a few years ago when sales and profits were higher and Buyers were paying higher multiples of earnings.

By the same token, though, Buyers should make an offer that is sufficient for the Seller to pay off the debts of the business. Study that balance sheet; if the offer doesn’t provide the Seller with enough money to pay off debt, he probably won’t be willing to essentially write a check in order to sell his business.

Buyers: Measure returns

Buyers utilize various measurements for their investments, or at least they should. A wise investor weighs the price of the investment against the expected return and then compares that expected return against other uses of that money. Simply put, the more money you pay to acquire a business, the lower the potential return. The following sections provide some common figures you can use as you measure returns.

Walking away is always an option. In addition to weighing several possible investments, you may decide that doing nothing is the best course of action, an option you may exercise with greater frequency as Sellers ask for higher and higher prices.

Internal rate of return (IRR)

Internal rate of return (IRR), or the percentage of return that causes the expected cash flows from an investment to be the same as the cost of the investment, is one of the favorite calculations for Buyers, particularly private equity (PE) firms. Buyers usually have a minimum target return they’re seeking, and if an investment’s expected IRR is greater than that minimum, they do the deal.

IRR is very important to PE firms because those firms raise money from investors by touting their stellar returns. Therefore, if the investments are too pricy and the resulting yields too low, a PE fund’s returns are low, and that makes raising more funds from investors difficult. Investors simply choose to invest with funds that have returned higher rates of return.

For a strategic Buyer (a company looking to acquire another company for synergistic reasons), the same principle applies. If a deal is too costly, the strategic Buyer doesn’t do the deal. The firm looks at its other options, which may include buying a different company, investing those funds in its own company, or doing nothing. A firm may decide investing some money in the market is a safer bet than the company purchase.

Return on investment (ROI)

Return on investment (ROI) is another favorite calculation of Buyers. You calculate ROI by dividing the company’s earnings by the Buyer’s purchase price. In other words, a company that generates $10 million in earnings and cost the Buyer $50 million has a 20 percent ROI.

Sellers: Create a compelling valuation

Seller should make the case for valuation and not expect Buyer to look for reasons to pay a higher price. Lucky for you Sellers, I have a four-pronged attack that, when executed properly, has fetched a figure higher than the usual upper limit of 6X. (See the earlier section “What’s a Company Worth? Determining Valuation” for more on this common valuation multiple.)

But first, keep the following pointers in mind as you consider what you think your company is worth:

Take control of the process. Sellers should be proactive in setting appointments and setting the tone for all discussions. Letting Buyer run the show doesn’t usually result in Buyer willing to pay a premium.

Have reasonable expectations. As I note earlier in the chapter, Buyers aren’t as interested in how great your company was a few years ago as they are in its current financial performance, its future prospects, and the general state of the economy. Too many business owners hold on to peak year valuations, believing that those valuations should still apply.

Don’t expect the Buyer to pay more for no good reason. From my experience, one of the biggest mistakes Sellers make is falling prey to the “just because” fallacy — that is, expecting Buyer to pay more “just because.” Here’s how it manifests itself in the mind of Seller:

• Just because Buyer has money, she should pay more.

• Just because Seller has a great business, Buyer should pay more.

• Just because Seller is asking for more, Buyer should pay more.

• Just because the sun rises in the east, Buyer should pay more.

Buyers don’t pay more “just because.” They pay prices they can support.

Don’t assume Buyers have unlimited amounts of money. Even if they did, they wouldn’t be willing to pay unlimited prices for your company. A wise Buyer carefully measures the relative value of an investment, comparing it against other options, before proceeding with a deal.

Make sure the company is a noncommodity

First and foremost, if the company you’re selling is going to garner a compelling valuation, it needs to have some sort of intangible quality, a super-special secret sauce. This quality that sets it apart may take the form of a recognizable brand name, outsized revenue and profits, great growth, a hot industry, or anything that differentiates the company from the drab and boring competition and provides something unique and different for Buyers. If a company is little more than a commodity — one of many faceless companies offering similar and interchangeable products — getting a favorable valuation can be a challenging proposition.

What also works is if your company has its very own Ahab, someone who has been pursuing it for years and is willing to do anything — and perhaps pay a high price — to obtain that elusive sperm whale of a company.

Gotta have competition: Shop around

If you’re negotiating with one potential Buyer, you’re at the mercy of that Buyer. Even a company that offers a unique and differentiating product (see the preceding section) will have a challenging time convincing a Buyer to pay a premium price if that Buyer is the only suitor.

Speak to as many Buyers as possible. The more the merrier. And if a Buyer balks at being part of a process that involves competition, don’t view the loss of that potential suitor as a problem. That Buyer probably would not be willing to pay a premium price.

Provide a road map of value for Buyer

Seller needs to show Buyer where the value is, especially in down markets. Seller should clearly and explicitly point out the value proposition (how the company will create value for Buyer) and not expect Buyer to figure this out on his own.

Although it may be a bit of guesswork, Seller should make some assumptions as to how the deal can improve Buyer’s bottom line and provide those assumptions to Buyer. Buyers may grumble that Seller has reverse engineered their financials, but this step helps signal that Seller has a grasp of the business’s value to Buyer.

Make it easy to do a deal

Don’t dwell on minor details. Counteroffers should be simple with a minimum of moving parts. If you want to get a deal done, refrain from introducing new elements into an offer. Instead, work from a Buyer’s offer, making adjustments to that offer rather than making wholesale changes.

Focus on the main deal issues and avoid getting tripped up by minor and inconsequential details. Don’t let nonissues get in the way of getting a deal done.

When Buyer and Seller Disagree: Bridging a Valuation Gap

Disagreements about the price of the company are sure to pop up in any sale process. In fact, I can’t think of a single deal I’ve worked on where valuation wasn’t the central issue of disagreement. But you have a few options for reaching a valuation agreement, including structuring an earn-out, using a note, accepting stock, and selling only part of the company. The following sections explore these alternatives in more detail.

If you’re a Seller thinking about agreeing to any or all of these arrangements, I still heartily recommend getting some cash at closing. Sellers who agree to put 100 percent of the sale proceeds in contingent payments (earn-out, note, stock) are effectively agreeing to put 100 percent of the sale price at risk. Get some dough at closing!

Using an earn-out to prove valuation

In my estimation, the venerable earn-out is probably the most common method of bridging a valuation gap between Buyer and Seller.

The earn-out allows Seller to prove the company is worth a higher valuation by agreeing to get paid a higher price only if the company achieves certain agreed-to goals. Buyer pays that higher price only if the company achieves financial results that warrant a higher price, thus providing him some protection. Essentially, Buyer tells Seller, “Okay, if you really think the future prospects of the business are as rosy as you say, put your money where your mouth is.”

The earn-out is especially useful for Sellers who want be paid for the future performance of the company. You can structure earn-outs in an almost unlimited manner. See Chapter 21 in the Part of Tens for some examples of earn-outs.

Settling a valuation disagreement with a Seller note

As I discuss elsewhere in this book, Sellers can help Buyers with the financing by agreeing to take part or all of the proceeds in the form of a note that Buyer pays off at some future date. In addition to helping Buyer acquire the company with less money down, the note provides Buyer with the benefit of the time value of money. In other words, $5 million in three years is worth less than $5 million today. A Seller willing to wait for payment is providing a benefit to Buyer.

Paying for a company with stock

In certain circumstances, Buyer may want to use stock to pay for all or part of an acquisition. And in certain circumstances, Seller may be wise to accept that stock, though she should speak with her tax advisor about the tax ramifications of that arrangement.

Issuing stock allows Buyer to make an acquisition without using cash or borrowing money (or by using less cash and borrowing less money). The downside for Seller is that the stock obviously isn’t the same as cash. Seller has to convert that stock into cash by finding a Buyer for it.

Although Buyers may be tempted to issue more stock as a way of financing an acquisition, they should carefully consider the effects of diluting their stock in that way. Is issuing more stock really the best course of action, or does borrowing money to finance the acquisition make more sense?

The pluses and minuses of accepting stock as a form of consideration really boil down to the issue of liquidity: How easily can Seller sell that stock? Here are a few issues Sellers should consider when thinking about accepting Buyer’s stock:

Is the stock traded on a public exchange, and if so, which exchange? If stock isn’t publicly traded, the owner of that stock may be severely limited in his ability to convert that stock into cash. If Seller doesn’t anticipate needing that cash anytime in the foreseeable future, perhaps she can risk owning illiquid stock. But accepting illiquid stock doesn’t make sense if Seller needs the cash soon.

Sellers looking at accepting nonpublicly traded stock should consider Buyer’s prospects of eventually going public. If those prospects are limited, Seller may be in for a long-term ownership position in a private company.

If Buyer’s stock is publically traded, the next thing to remember is that not all stock is equal. Accepting stock traded on a major exchange (NYSE or NASDAQ) is far more desirable than accepting stock traded over-the-counter (OTC) or on the Pink Sheets because the major exchanges have far stricter listing requirements.

What is the average daily volume? Average daily volume (the average number of shares traded per day over a period of time) is an important consideration, too. If a stock is thinly traded (has a low average daily volume), the Seller who accepted it may be limited in her ability to sell that stock. For example, say Seller receives 10 million shares of stock as part of the consideration for selling her business. If the stock trades at $1 per share, Seller has $10 million worth of stock.

However, if the average daily trading volume is, say, 10,000 shares, she essentially has an illiquid stock. Putting in a trade for all 10 million shares results in crashing the share price. If only 10,000 shares (on average) trade hands per day, the odds that she can sell 10 million shares in a short period of time are virtually nil. On the other hand, a stock with a higher trading volume is usually easier to sell.

In general, the average daily volume is higher for stocks listed on NYSE and NASDAQ than for stocks listed OTC or on the Pink Sheets.

Stock (public or nonpublic) received as a result of a business sale is usually restricted, meaning that the owner of that stock can’t sell the stock for some period of time. That length of time depends on securities regulations. In order to help prevent a crash of the stock price, Buyer may ask Seller to agree to a restricted period longer than current securities laws.

Even if securities law restrictions no longer restrict a stock, a thinly traded stock is effectively a restricted stock (it’s pretty hard to sell a stock that no one’s buying).

Selling less than 100 percent of the company

If Buyer and Seller disagree about valuation, another possible solution is for Buyer to acquire less than 100 percent of the business. Selling a piece of the company allows Seller to take some chips off the table and create some liquidity right away while allowing her to participate in the future upside of the company.

Most Buyers want to have a control stake in the business, meaning they want to acquire at least 50 percent of the company. In rare situations a minority stake (less than 50 percent) may be palatable to Buyer.

Taxation of entities

Taxing corporations is complicated because you have two basic types of entities (C-corps and S-corps/LLCs), two types of business sales (asset or stock), and three types of taxes (corporate, individual, capital gains). A C-corp’s profits are taxed at the corporate tax rate, and then any distributions to ownership are taxed again, this time at either the owner’s marginal tax rate or at the capital gains rate.

The S-corp offers the benefit of removing a layer of tax and avoiding double taxation. The profits of the entity flow to the owners. The owners must pay tax on the income, usually at their marginal income tax rate. One of the limitations of S-corps, though, is that they’re limited to 100 shareholders while C-corps have no limits to the number of shareholders. LLC’s are similar to S-corps (with some different terminology) for taxation purposes; I lump them in with S-corps here, but check with your tax advisor about some subtle differences.

But the tax issues don’t stop there; selling a business opens another can of tax worms. The following table helps break down how a business sale affects the business’s taxation:

I cannot stress this enough: Sellers need to plan ahead and speak with their tax advisors. Your specific tax situation depends on your company’s specific situation.

Warning: An owner who converts a C-corp to an S-corp shortly before a sales transaction may be in for another nasty little tax surprise: In some cases the conversion from a C-corp to an S-corp may take ten years before the owner is able to realize the full tax benefit. Ideally, conversion to an S-corp should take place years before the owner sells the company.

A Seller agreeing to sell less than 100 percent of the company is wise to include a put option as part of the sale. A put option allows Seller to sell her remaining shares to Buyer at some future date and at some future price. Most often, that price is an agreed-upon formula based on some sort of financial performance of the company.

Dealing with Renegotiation

Yes, valuation can change during the sale process. In fact, that occurrence even has a name: renegotiation. Or, as disappointed Sellers may call it, the dreaded renegotiation.

Theoretically, when Buyer and Seller negotiate a valuation, both sides want to see the deal close with that valuation. In practice, however, one side or the other may try to change the sale price before the closing.

If Buyer is trying to change the valuation, you can bet that he’s trying to lower the valuation.

Buyer may have a case to ask for a lower valuation if the company has experienced some sort of material changes, such as the following:

Decline in profits

Loss of major customers

Loss of key executives

Lawsuits

Change in regulations

Change (downturn) in the economy

However, if Buyer doesn’t have a solid reason for asking for a lower price, that Buyer may be exhibiting a little bit of gamesmanship and a lot of negotiating in bad faith, so I don’t recommend that Buyers unnecessarily try to lower the valuation. Check out Chapter 11 for more on negotiating in good faith. Similarly, if the business improves (especially profit-wise), Seller may feel that renegotiating for a higher valuation is warranted.

This proposition is tricky, and in most cases I don’t recommend it. Focus on getting the deal done. During the time Seller spends convincing Buyer to pay more, the business may take a step backward, reducing profits and thus causing Buyer to ask for a lower valuation. In this situation, the only winners are the lawyers and anyone else billing for time as the process drags on.