ESOP Authority Resource, Exits, Uncategorized, Valuation
Business valuations are calculated a number of ways, as outlined in our business valuation blog post here. What’s important to note, though, is that typically an owner who is selling his or her business will want to maximize value.  Our goal with this post is to break down the factors that make the largest impact to company valuation.

Recurring revenue / subscription revenue.  Recurring revenue gives confidence to the longevity of the business.   If there is any way to have recurring / subscription oriented revenue, this will command a higher valuation multiple, which will then result in a higher overall valuation.

Profitability.  I have to kind of laugh as I write this, given all the publicity that silicon valley gets.  Most people have read about the unicorn tech startups that sold for double- or triple-digit millions pre-revenue, or while running at a loss.  Sadly for the remaining 99.5% of business that want to be acquired, running a profit is pretty important. A great way to kind of see this in action is to actually watch the TV show “Shark Tank”.  Shark Tank is portrayed as a group of loud investors yelling at businesses that are often very odd and obscure, however, if you watch a few episodes of it, a theme emerges very quickly. The “sharks” are typically financial investors — they are buying or investing in a company to see a return, and ideally sooner than later.   It is our experience that most acquirers are doing the same. If you still aren’t sold on this concept, then consider it this way. If company A and company B sell the same thing and have the exact same business, are the same size, and truly all factors are the same, except company A generates a 30% profit margin where company B generates 6%, company A will certainly be valued quite higher.

Growth.  Growing companies are healthy and have a bright future, particularly if profitable while growing AND if the company is both aware of and in control of what is driving growth.  If you can show your company is growing and explain what specifically you are doing to drive that growth, your company will receive a stronger valuation. The converse is true for flat / stalled growth, as well as companies that are shrinking.

Scalability.  An acquirer is purchasing your company to receive a return on his / her investment, and a way to expedite this return is to grow the company faster.  If your company has a specific plan, management team, culture, and processes in place to scale the company, then your company will be valued higher. If you do not have these, the acquirer will know that he/she will have to create these, and thus that will incur a discount on your valuation.   Factors to really develop for scalability are hiring processes, repeatable workflow a company value chain that is documented, repeatable sales processes for new revenue generation, established culture that sustains with the company’s growth and protects the integrity of the company’s current success, as well as other factors (links to future blog posts).   Scaling Up by Verne Harnish outlines several of the predictable revenue milestones of $1m, $2M, $10M, $50M, and $100M+, and the differences in how companies must transform and be prepared to operate differently to grow to these levels, abandoning some of the things that “worked” or were “OK” at smaller company revenues.

Culture.  As mentioned above, your company should have a unique identity and position within the marketplace that justifies your existence.  Ideally, you have a defined set of core values that you are using to unite your company around a mission statement, which explains why you exist and what your company is about.   Hiring, talent management and retention, internal work and efforts, and everything else that the company does should align with these values in a quest to further the mission of the company.  Creating these is not an overnight matter, and so if your company doesn’t have these, or you have a set of values that don’t function in the manner described above, we would encourage you to take the time to do this.   This post explains the value of why this is so important for scaling the business and thus breaking through growth plateaus.  (note: We don’t believe in doing this just to do it, or for the sake of “Kum ba yah”. We believe and have experienced that this is crucial to have in place for effective and frictionless growth.

Unique IP.  This can be truly unique technology, a unique solution, a product or process that is patented, or just an approach that is core to your company that both produces a better result when your company is engaged and is absent from competitors.

Brand.  Brand strength, particularly for larger companies, commands higher valuation.  A strong brand has loyal customers and is not easily disruptive, which has the same value principle as recurring revenue: stability.
Other valuation factors are considered, and in most circumstances, there are factors that are both unique and specific to certain industry segments.   

The goal of a company owner, whether there is a plan to sell the company now, later, or not at all, should be to maximize the above.  The irony is that the best kind of company to own is one that does the above, and in the event you are approached for a potential sale of your company, if the above are in optimal shape, you can expect top dollar for your company (and really, you shouldn’t accept any less).

If you’re interested in learning about how to calculate your business’s value, we’ve prepared How to Calculate ESOP Valuation.  

Finally, a very good reason to consider selling to an ESOP is that the valuation you can command for your firm is often more fair and frankly higher than you would receive via a third party exit.  If an acquirer were to approach you and ask to purchase your company, ideally you would already know what it would sell for if sold to employees (including proper and documented justification), and would then use that as a starting point for negotiation.  
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Valuation

Valuation, as defined in a dictionary, is an estimation of something’s worth, usually carried out by a third party appraiser.   In terms of a business, valuation is the dollar amount that a third party acquirer will pay for ownership of a business. 

 

An unofficial but broadly accepted rule is that something is worth what someone else will pay.  This is the underlying principle behind valuation calculation, and so the next factor that is considered is:  who is the buyer?

 

Buyers will value a business differently based on their intended purpose for it.  A simple non-business example here in the case of buying a car:

 

Buyer A  – wants a safe car for his 16 year son. The car needs to be reliable, safe, and the budget is fixed at $10k.

Buyer B –
wants a sports car for retirement.   BMW is the only brand that will do, the car needs to be new, and getting the options right is more important than staying within a fixed budget.

 

In these two (admittedly silly) circumstances, the two buyers have very different motives.   So it goes with the sale of a business. Buyers, particularly sale to another company, can have very different aspirations for your business and as such, will value it very differently.  

 

In general, there are two types of buyers of businesses:

 

Financial buyers — these folks will buy the business for an immediate financial payback and long-term financial gain, and thus will value the business based on:

    1. Paying off what the buyer paid for the company
    2. Surplus the buyer can expect once the company is paid for
    3. Comparison of this against other financial investment opportunities.   

 

In this case, the business is valued based on strictly financial performance relative to other investment options.

 

Strategic buyers — these buyers will be purchasing a company for the value it can add to their existing company in terms of strategic upside.  Example, a tax firm that is adding a payroll management service might seek to purchase a payroll service company rather than build the effort internally.   Financial performance will be a consideration in the purchase, however, other factors may be more significant (such as the need to remain competitive with other firms, or the business model is to grow client size by adding on services).

 

In either circumstance, the valuation process will be specific to the purchaser.

 

This doesn’t answer the age-old question of “how much is my business worth”, though.  “It depends” is basically the answer, and so we wanted to walk through an example.

 

Company for sale:  A $3M digital marketing firm that grosses $900k / yr profit.

 

A financial buyer  – may pay 4X EBITDA, $3.6M.   

A strategic buyer – may be willing to pay even less, say 3-3.5X EBITDA, or $2.7-3.15M.  

 

A third option, a sale to an ESOP, will value the business differently and represents additional opportunities for selling shareholders to increase valuation based on the willingness of buyers to pay for the business asset relative to other opportunities available.  

 

In an ESOP valuation, buyers are employees who are motivated by the long term retirement potential associated with ownership in the company they are helping to build.   This is an asset that can complement existing retirement savings, if qualified retirement plans exist, and otherwise create a viable retirement plan for companies that do not have one.  As such, and given the broad buyer base and shared risk as well as direct control over the asset, the premium for the sale to an ESOP for this marketing service firm could be as high as 5-6X EBITDA.

 

Let’s look at a comparison side by side.

 

 

Financial buyer

Strategic buyer

ESOP

Revenue

$3,000,000

$3,000,000

$3,000,000

Profit

$900,000

$900,000

$900,000

Valuation multiple of EBITDA

4X

3.5X

6X

Valuation

$3,600,000

$3,150,000

$4,500,000

 

Additionally, in the case of an ESOP, selling shareholders may make adjustments to financial uses company profits that further increase valuation, where in the case of a strategic or financial buyer, these factors are typically not considered.

 

Example:

  1. There are three partners and one is moving to a non-salaried role (taking an exit).  This partner’s salary was $100,000
  2. Healthcare was another $20,000/yr paid by the company
  3. Fuel was reimbursed for vehicles at ~$5,000/yr

The total of these expenses add backs is $125,000, which when multiplied the 6X valuation variable, equates to an additional $750,000 of business valuation.

 

Revisiting the side-by-side comparisons:

 

 

Financial buyer

Strategic buyer

ESOP

Revenue

$3,000,000

$3,000,000

$3,000,000

Profit

$900,000

$900,000

$900,000

Valuation multiple of EBITDA

4X

3.5X

6X

Valuation

$3,600,000

$3,150,000

$4,500,000

Add backs

$0

$0

$750,000

Adjusted valuation

$3,600,000

$3,150,000

$5,250,000

 

In the case of a sale of the company to an ESOP, which is not always possible, the financial gain $1.65 – $2.1M in additional sale proceeds.

 

Clearly, the ESOP is preferred, and so one should consider the implications of selling to an ESOP, which are detailed here.

 

In the event of a sale or a desired exit, there are many factors to consider.  Which kind of buyer is right for you? Do you desire your company to maintain it’s values and function as a legacy, and does that legacy coincide with employees?

 

Our goal and hope is to educate business owners on the opportunity to create a legacy through their business by considering a sale to an ESOP.  We believe this so much that we did it with our company, and we can help you assess if this is the right fit for you as well.

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Exits, Uncategorized, Valuation

A private equity exit is the sale of your company (or a company) to a private equity (PE) firm.  PE firms are usually partnerships that are comprised of many shareholders that have pooled investment dollars, invested them into the acquisition and growth of privately held companies, and have a very specific goal of beating the average annual returns of the stock market index, which are typically in the 7-8% per year range.


PE firms consolidate around industry verticals and use a variety of strategies to produce returns on investors dollars.  The point here is that these firms are often potential acquirers for privately held companies, and so looking at this as a potential exit is often worth considering.


A private equity firm will have a goal of making a return on its cost of acquisition and as such, in valuing your business, will look closely at cash flows, overall profitability, and growth potential.

 

Cash flows — Simply stated, this is the business’s ability to generate accessible cash in the form of profit on a monthly and annual basis.  Free cash flow is what is used to pay back an investor, and maximizing this has the potential to increase company valuation.

 

Profitability — This is similar to cash flow but is the overall profitability of the business, including taxes and any owner discretionary perks or other overhead items that are expected to be removed after an acquisition.  Be sure to itemize these and claim them as an add back to overall valuation, as this will help improve acquisition price.

 

Growth potential — This is crucial, as a PE acquirer will want to accelerate the rate of return on invested capital as quickly as possible.  Seeing how your company can grow and that you have very specific growth plans will generate acquisition interest, as well as increase overall valuation of your company.   Additionally, expect to stay on for at least two years to ensure these growth goals are hit, and expect your valuation and buyout payments to be tied to these goals.


The type of negotiation in a sale to a private equity buyer is usually on the side of the PE firm, favoring their ability to generate options (where you only have one company to sell).  It’s important to not be married to this form of exit, and if the deal terms aren’t just right, be sure you’re OK to walk away.


Realize too that in the sale to a third party, and particularly a private equity firm that plans to grow your company and maximize its return, you will no longer have control of the business, operations, etc.   Generally, a PE firm doesn’t want to run your business, but expect tight scrutiny on quarterly performance. If things are off, expect the PE firm to impose budget cuts and even insist on management changes, inserting personnel they trust.  


This type of exit is not for the faint of heart, and you will certainly earn your acquisition price.  However, selling one’s company is a triumph of its own, and so if you do find yourself in a circumstance where you get a great offer and see that it can be successful, definitely consider it and be sure to congratulate yourself.


If you are wondering what alternative exit strategies exist consider the following:

 

 

Sell to a strategic buyer

 

Sell to a financial buyer

 

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