Valuations

“Strategic buyers pay more than financial buyers”. But you never know…

December 22, 2012 By Ney

We have a client in Northern Nevada that we have been working with for years as they prepared their company and themselves to come to market. They always said that there was one large billion dollar strategic company (let’s call them Company A) that would love to own them. It seemed simple – we would just approach a few companies plus Company A. Company A clearly had a LOT of synergnies in acquiring our client and would probably pay a lot to get them.

But there are three words that ring true more often than not: “you never know”. So we did the normal marketing process and contacted many buyers, knowing all along it would probably just end up being Company A. But you never know. Company A did indeed jump right on it, and they were clearly excited about the opportunity. But when we received their offer we were shocked. They undervalued the company by a significant margin. At first I thought they were playing games, but it became apparent that the sky seemed to be a different color of blue in their world. We had 11 offers for this company, and Company A was number 10. Number 11 was the type of crazy low-ball offers we get where some financial buyers just throw out offers hoping something will stick.

The situation was this: Typically a large strategic buyer with clear synergies with the target can and will pay more than financial buyers; however, in this case NINE financial buyers outbid the strategic by a very wide margin. It wasn’t even close. Company A even felt a little entitled and emailed me with dates that they would show up in Nevada for meetings and due diligence. I had to politely say that unless their offer changed by quite a bit, there would be no meeting. They didn’t change their offer and there was no meeting. I am quite sure that in a year or two they will realize how short sighted they were.

What lesson can you take a away here? “You never know.” You never know who may or may not be in position to buy at any given time, and what color blue the sky is in their world. You just never know until you get into the market.

Using Third Party Services to Make Your Business more Attractive

November 5, 2012 By Ney

We had a nice company come on the market about a year ago but it failed to sell because of an inventory issue with the suppliers and to be frank, an inventory issue with the seller not knowing how much inventory he had or didn’t have.

The business is a distributor of machinery that is quite large and heavy. At the time, all inventory was held in a yard, so each time a shipment came in temporary workers were used to off load the trucks and sort the units into pallets in the yard.

We took the business off the market for year to allow the owner to regroup and reorganize how he tracks his inventory. What he did was even better. He hired third party logistics (3PL) companies to hold inventory for him. So instead of holding inventory in a single yard, the inventory is now stored in three third party warehouses across the country. Instead of having to track and manage inventory, all he has to do now is press a button (or perhaps a few) to get the inventory reports from the 3PL firms.

In addition, he has fewer employees, a smaller health care plan, fewer temps to hire and since he really hated to manage inventory, one less headache at the end of the month. He figures the move saves him about $50,000 a year by using the 3PL providers.

Finally, it makes the business much, much easier to relocate, which can be an important point when selling a business. It also opens up where the business could be relocated to. Previously, because of the size and weight of the product, the business needed to be relocated near a port city, preferably on the west coast, which mean LA, the Bay Area or Seattle. Now, it could be anywhere.

It is a nice mid-size company, and now it can go to the right buyer practically anywhere in the US. I can’t wait until it hits the market again.

What to do with Cash and AR – Asset vs. Stock Sale

August 27, 2012 By Ney

I received the following question via email:

Ney,

How do you typically treat cash in a stock sale vs asset sale. A rule of thumb tells me that me on asset sales, the seller typically keeps his cash and receivables, but not always. How about on a sale of 100% of corporate stock, what happens to seller’s cash. The buyer is buying assets and liabilities, and does that meant, that seller’s cash on the books is transferred to buyer? Please let me have your opinion on this matter.

As always, thank you for your input.

Jack (I changed the name – a little)

Jack,

It depends on size of company, not really asset vs. stock (although small companies are often asset sales). Smaller deals are typically structured so that the seller keeps cash and AR.

Larger deals, especially ones that use EBITDA for the valuation metric (typically $500K in earnings and above), are typically sold with “gas in the car”. That is, they are sold with enough assets to produce the EBITDA that was advertised. This includes current assets like AR and enough inventory. It also includes payables, but not long term debt. Some buyers insist on some cash as part of current assets, others do not. In any case, it is usually not all the cash – just enough to operate the company.

Often a buyer (having already set a price) will calculate a Net Working Capital value that must be present at close. NWC is current assets minus current liabilities (pretty much cash, AR, inventory less payables). Usually this is calculated by taking the past 12 months of balance sheet snapshots and taking an average (and negotiating). This NWC number then “puts a stake in the sand”. The seller can’t then reduce inventory, aggressively collect AR or do anything that reduces the normal NWC before close. On the other hand, if sales go up and AR goes up before the close, he gets credit for that.

How does that work exactly? Well, another “true-up” NWC calculation is done based on the closing date, and is usually done within sixty days. If the NWC is above the target (AR went up, inventory went up, payables went down, etc.) then there is a purchase price adjustment upwards and the buyer would owe more money (or the seller takes home more cash). If the NWC true-up calculation shows that the NWC at close was below the target (AR was down, inventory down or payables up), then there would be purchase price adjustment downward. More cash would have to be left in the company, or money would be taken from a holdback escrow account.

This all makes sense too if you think about it. For example, if a seller accidently pays off ALL debt, including accounts payables, before close, the NWC calculation would show that the buyer would owe him for that, because that was part of the WC calculation. On the other hand, if the seller calls up a few large accounts to get them to pay their bill before close, the average AR would be down and he would be dinged on the purchase price.

Why would a buyer care so much about about AR and inventory? Because they expect to have paid a certain price for the company, and if inventory and AR are down then over the next 60 to 90 days the buyer will discover that he actually paid more as AR and inventory come back up to normal levels.

This can be a big deal, so it is usually wise to address NWC early so the seller knows what is expected at close.

So…to get back to the original questions. You have a price and you have a NWC target for close. Then, whether asset or stock sale, you make it happen. That is, you create the purchase price allocations for an asset sale, or a stock price calculations for a stock sale. But the basic purchase price and net working capital calculations are the same.

(Having said that, Asset vs. stock sales can profoundly change the tax impact of the buyer and the seller. So often the purchase price is indeed different, based on taxes)

Hope this helps, Ney

Inventory – and Why it is Included in the Purchase Price of Mid Sized Businesses and up

August 1, 2012 By Ney

Some small companies like liquor stores are purchased using a rule of thumb such as, “1x revenue plus inventory”. However larger companies, especially those using EBITDA for the valuation metric, are valued with inventory included (an average, historical level sufficient to generate the advertised EBITDA). It is frustrating for many business owners, because they know they bought that inventory with their own money, and they want that money back!

Unfortunately it doesn’t work that way. In looking at this, it is helpful to look at it from a buyer’s point of view. Put yourself in their shoes and look at the following scenarios. There are three companies, each one generating $1mm in EBITDA.

Company 1: $1mm in uncommitted inventory.

Company 2: A software company with no physical inventory.

Company 3: $1mm in presold, commited inventory.

Let’s assume 5x EBITDA is good starting point. For example, Company 2 is worth $5mm. But what are company 1 and 3 worth?

Let’s assume you plan on keeping the company for 7 years and then selling it. So you pay $5mm, then you get $1mm per year and finally you sell it for $5mm (WAY over simplified, but you get the picture). You would earn 19% return on your invested equity doing that.

Now let’s say you buy company 1 and pay 5x EBITDA PLUS the inventory. So you pay $6mm, get $1mm per year and finally sell it for $6mm (assuming you can convince someone else to pay for the inventory). If you did this you earn 15% on your invested equity. Not nearly as good because you had an additional $1mm tied up in the company.

So, if you paid for inventory on top of the base 5x value, this is what the three companies would do for you as a buyer:

Company	EBITDA	Price	ROI
Company 1	$1mm	$6mm	15%
Company 2	$1mm	$5mm	19%
Company 3	$1mm	$6mm	15%

If you are a buyer, you would probably buy Company 2. It has 19% return and costs $1mm less. Some would say, “Yes, but the other companies come with a real tangible asset, inventory”. Some would even say, “And you can shut the company down and get the inventory back!”. Well, yes, but then you wouldn’t get the $5mm back for the purchase price so the ROI would be even less. In addition, usually the salvage value of inventory is only a fraction of the value (Company 1). There is some small amount of comfort that if everyone goes bad you have some inventory, but it is typically not something the buyer is planning for.

Inventory (and plant and equipment) does make financing easier, and financing can leverage your equity and boost the returns. So it can raise the value, but not much.

When businesses are valued using EBITDA the business is delivered, “with gas in the car”, which means there is an adequate level of working capital to run the business – and this includes inventory. Now, it doesn’t necessarily include ALL inventory, but is a topic for another blog entry.

Deal Algebra: Pre-Money and Post-Money Valuation with a Twist

April 29, 2011 By Ney

If someone buys 25% of your business for $2 million, it is easy to determine the value. If someone invests $10 million in your business for 50% it is a little bit tougher. How do you determine value if someone says, “I’ll pay you $ 2 million and I’ll invest another $10 million in the company and then we’ll both own 50%”?

Equity Purchase

Let’s start with the easy example. Say you sell 25% of your company for $2 million. That means your company is worth $8 million, correct? Not much algebra there.

Capital Investment: Classic Pre-money / Post-Money Valuation

Now let’s say that someone offers to invest $10 million in your company for 50% of the company. What is it worth then? Well, after the investment the company will be worth $20 million, but really the enterprise value of the company itself will be $10 million (the same value as before the deal), with $10 million of invested cash on the balance sheet. In venture-capital-speak, the pre-money valuation will be $10 million while the post-money valuation will be $20 million. Another way to look at it is that the owner did own 100% of a $10 million dollar company, and now owns half of $20 million company but he still owns $10 million of value.

A Mix of Equity Purchase and Capital Investment

Now here is the tough one. We recently had a buyer make a compelling offer to our fast-growing client: “I’ll pay you $2 million and I’ll invest another $10 million in the company to fund growth and then we’ll both own 50%” (By the way, I changed the numbers from the actual deal). It wasn’t until later that the question came up: “Um, what does that make the company worth?”. It was an interesting deal because no one actually cared but the attorneys and accountants – the seller and buyer were happy with the statement above.

The first cut at this may be, “Well, the buyer just paid $12 million total for half the company, so it’s obviously worth $24 million”. In fact, that is exactly what the attorneys said. Those guys are really bright on legal matters.

However, the day after the close the buyer would own half the company and therefore half the balance sheet, which now has another $10 million in cash on it. In other words, he would have 50% of the company and rights to $5 million in excess cash, which theoretically he could take home. So really, he paid only $7 million for half because he still “owns” $5 million. That would indicate it is valued at $14 million. In venture-capital-speak the pre-money would be $14 million, and the post-money would be $24 million. Or another way of saying it, the enterprise value of the core business is $14 million, with $10 million of excess cash on the balance sheet. This method, however, is really a short cut and doesn’t use much math.

Taking it even further, what is really going on with the ownership of the company? The owner is selling some of the company to the buyer for $2 million, however the buyer is also being issued new shares for the $10 million investment they are making. At the end of it all, including dilution, they both own 50%. How much of the company is the seller selling, and how many new shares should be issued? Now this is deal algebra.

To work this out I set up some equations with variables like shares sold, new shares issued, 50% ownership, enterprise value, etc. and solve them simultaneously. To make it easy I assumed 1,000 shares existed in the company although that wasn’t actually the case. One key constraint is that the share price for the shares sold and the shares issued is the same. In other words, the buyer is buying some shares from the owner, and some from the company treasury but is paying the same per share price for both.

For this example the owner would sell (143 shares) 14.3% of his company to the buyer for $2 million and $14,000 per share. 714 new shares would be issued, also at $14,000 per share. This would mean both the buyer and seller own the same number of shares at 857 shares.

The Actual Algebra – for Those that Care

For those that actually want to look at the math, here it is:

First, let’s assume 1,000 shares are originally outstanding. Then let’s say:

X = Shares sold by seller to buyer
Y = New shares issued to buyer
Z = Total amount of shares outstanding post-merger
P = Price per share

We know the buyer will own 50%, so I set up the equation:

X+Y = Z/2

We also know that the price per share (the same for both shares sold and newly issued shares) is:

P = 2,000,000/X (or X=2,000,000/P)
P = 10,000,000/Y (or Y=10,000,000/P)

Substituting these into the X+Y=Z/2 equation:

2,000,000/P + 10,000,000/P = Z/2 Or

Z * P = $24,000,000

Z is the total shares after the merger, so Z * P is the “post-money” valuation of $24 million. The enterprise value, or pre-money valuation, is always the post-money less the investment cash, so the pre-money would be $24 – $10 million or $14 million.

We also know that the pre-money valuation is the share price (which doesn’t change pre to post-money) times 1,000 shares:

$14,000,000 = P * 1,000

P = $14,000 / share

Using the equations above for X and Y in terms of P, we can easily calculate:

X = 2,000,000 / P = 143 shares are sold to the buyer (you can also think of this as 14.3% of the company is sold to the buyer for $2 million)

And

Y = 10,000,000 / P = 714 new shares issued to the buyer for his investment of $10 million

A quick check is now the seller has 1,000 – 143 = 857 shares. The buyer now has 714 new shares + 143 shares he bought from the seller = 857 shares. Dang, it worked.

There are obviously numerous ways of solving this, but that is how I did it. I have some cap table spreadsheets I dug out, but none of them could handle both an equity purchase and investment at the same time, so it really did come down to algebra.

If you got this far, do me a favor. I would be curious if anyone actually got any use from this algebra exercise. If you did, drop me a note at ney [at] compasspointcapital.com and let me know.