Archives for February 2011

Good News if You Converted from a C Corp to an S Corp in the Last 10 Years

February 25, 2011 By Ney

Selling the assets of a C-Corp (often buyers will require an asset sale over a stock sale for a variety of reasons) can result in an ugly double tax situation and the IRS doesn’t let one off the hook easily, instead creating a 10 year period conversion period. The tax paid during that 10 year period is called the Built In Gains (BIG) tax.

However, under the Small Business Jobs Act, if the fifth year of an S Corporation’s recognition period ends before their 2011 taxable year begins, then no tax is imposed on the net recognized built-in gain for the 2011 tax year. For example, if you are the shareholder of a “S” corp which switched from a “C” corp between more than five years ago but less than 10 years ago, you are not subject to the BIG taxes if you sell the assets of your C-Corp in 2011.

It doesn’t seem like there would all that many companies that would take advantage of this. However, I’ve written numerous times in this blog that selling a C corporation is a challenge, and those with C Corporations should seriously consider electing S Corporation status. It seems someone is paying attention to the burden of the BIG tax, so if you haven’t converted, consider doing it now.

Discretionary Earnings vs. EBITDA

February 14, 2011 By Ney

SDE vs. EBITDA

Just about everyone has heard of valuing a company by using a multiple of earnings. But did you know there are several different earnings numbers? Here is the difference between DE or SDE, used for smaller companies, and EBITDA, generally used for larger ones.

I just got an earful from a business owner. We did a valuation of his business, arranged through www.affordablebusinessvaluations.com and friend Fred Hall. The owner called me up, and blasted our valuation because the value ended up at around 5 times earnings. He said that was far too low, because he heard that 4 to 5 times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is normal, and he felt he was above normal.

He was so upset I couldn’t even explain to him that we didn’t even use EBITDA. Since his earnings were below $500K, we used seller’s discretionary earnings (SDE). I later calculated that the recommended selling price, as a multiple of EBITDA, was about 6.5. So he was indeed above the “normal” of 5x. Of course, the real problem was that the valuation was at least $1 million below what he expected.

For this short article, I’m going to have to assume you know the basics of business valuation, and how important earnings are.

BOTH DE AND EBITDA

Both DE and EBITDA attempt to standardize the earnings number by excluding items that are variable and discretionary from company to company. For example, one company may have a heavy debt load while another may have none. So we exclude interest expense from the both DE and EBITDA. A buyer then calculates what his debt load will be, if any, and can adjust the earnings number to fit his situation. Same with taxes – some companies have different tax strategies, so we use a pretax earnings number. Depreciation and Amortization is a non-cash expense, and also are more of an accounting method rather than real-world depreciation of assets, so we exclude that as well. Note: But don’t completely discount depreciation of assets! Remove depreciation, but then look at expected capital expenditures (“CapEx”) so you know you have the cash flow in the future to buy needed assets.

DE (or SDE)

Discretionary Earnings (also called Seller’s Discretionary Earnings) is used for smaller companies (generally under $1 million in earnings) that are typically owned by the manager. In this case it can be tough to separate out what the owner/operator gets vs. the earnings of the company. So we add them together into one number. Another way of saying that is to “addback” one owner’s salary (in addition to the interest, depreciation, etc. mentioned above). Thus when you are looking at a business that has an SDE of, say, $200,000, you know that you have $200K to spend on living, taxes, interest and capital expenditures. For example, if you historically have been living on a $120K salary, then you can think of the business as making $80K above that, and that $80K is available to service debt, enhance your savings account, etc.

EBITDA

EBITDA is generally used to show an investor how much a company is earning. The investor does not actively run the company, and must pay a professional manager to do that for him. Thus the manager’s salary is included in the earnings calculation. It is not added back as in the SDE calculation. Simply put, EBITDA is a way for an investor to measure the return on investment he will receive should he purchase a company.

I should mention that advanced investors go further than EBITDA and use discounted free cash flow or discounted cash flow (DCF) analysis. EBITDA is not a true cash flow, and really what an investor wants to know is how much cash a business will generate in the future. A DCF model includes taxes, working capital, growth, CapEx and anything that impacts cash flow, and then discounts those future cash flows to a present value. DCF is pretty hard to do correctly, so it usually is only used for larger deals well above a few million in value.

How to Be a Middle Market Valuation Expert

February 10, 2011 By Ney

It’s finally here! The Ney Grant Lower Middle Market One-Page Valuation Guide! No need to pay thousands for a business valuation when my one page guide will give you the value of your business in a few minutes! OK, that last statement is completely false, and no one is waiting for guide. However, the guide may give you a rough sense of where your company is in regards to value.

I sat down the other day and tried to diagram out a chart that sums up my variation on the “rules-of-thumb” valuation metric for lower middle market businesses (businesses with earnings between around $1 million and $20 million). The very basic and rough rule of thumb valuation for a company with around a million or more in earnings is a value of 5 times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Why five? Because the average selling price for many businesses turns out to be 5x EBITDA (lower for companies under one million in earnings). Do middle market buyers really just use a multiple of five when buying a business? No, they will perform extensive analysis and run financial models for every deal. However after all the analysis and models, some deals end up below five, some above, and the average has remained around five.

Which brings us to the valuation guide. Why are some deals more than 5x, and some less? Here’s the guide:

What the chart says is this:

The 5x base value assumes the company has a stable history of performance and has no significant blemishes. A stable financial performance is the most basic component, the foundation of a valuation.

EBITDA can be enhanced by a buyer that can reduce costs and take advantage of other synergies, and because of that the synergistic buyer can afford to pay a little more for the company. They will not want to, of course, but with a competitive situation and negotiation they usually will.

A strategic buyer that can go further and take the company to a new level of sales growth and open up new opportunities (usually as well as the cost synergies, above) can afford to pay even more. Note that it still comes down to financial performance and earnings, but the strategic buyer is betting they can pay now for later earnings. Unfortunately, the true strategic buyer that will pay a substantial premium is somewhat rare.

However, nothing’s perfect and I’ve yet to run across the perfect company. There are always blemishes, and if serious enough to cause a risk that future earnings may not actually turn out as expected, then these blemishes work to pull down the valuation. Do you have one customer (or supplier) that contribute more than 25% of your revenue? Messy financials? Lots of adjustments (addbacks) to the earning? These can pull that 5x multiple down to a 3x. Or if you have a strategic buyer, perhaps they’ll only pay a 5x.

A professional valuation uses a similar process to the guide by taking a close look at your fundamental performance (e.g. discounted cash flow approach to valuation) and/or looking at whether your particular market has a history of strategic buyers (e.g. the market approach to valuation), and then they discount the value based on the some of the risk factors they find.

If you can stand back and take an objective look at your business, you should be able to estimate a multiple for your business.

No Gas in the Car vs. Gas in the Car: Small Business vs. Larger Business Sales

February 1, 2011 By Ney

Many small businesses are sold with no cash and no debt, while many larger ones are sold with a reasonable amount of working capital left in the business. You can think of this as buying a car with no gas, vs. buying one with gas in the tank.

Sometimes small businesses (typically those sold using seller’s discretionary earnings, SDE, as the valuation metric) are sold with absolutely nothing in the business, no gas in the car at all. No cash, no payables and no accounts receivables. The new owner needs to recognize that and leave themselves enough cash to be able to fund the working capital needs of the business.

Larger companies (typically those that use EBITDA as the valuation metric), are sold with gas in the car. That is, a new owner buys the company with the expectation that enough working capital (including cash, AR, AP, inventory, etc.) is left in the company to continue to run it.

That doesn’t mean that all cash is always left in the business. Excess cash, which would be the amount of extra cash on hand that isn’t required to run the business, is taken out and “taken home” with the seller. So how is it determined how much working capital is left in the business?

I’ve had buyers use a few different calculations, including a “net asset” calculation and a net working capital calculation (current assets less current liabilities), but the goal is the same. That is, putting a “stake in the sand” during negotiations to determine what level of working capital will be turned over to the buyer at close.

One way is to use a specific point in time along the way, say when the letter of intent is signed. Another way is to use an average of historical working capital amounts over six months or a year.