Valuations – Page 2

Childcare Facility: How Much is it Worth?

March 19, 2011 By Ney

I received the following question from my national blog:

NAME: XX
COMPANY: YY
TITLE: Owner

COMMENTS: I have owned my childcare facility for 15 years and I am carefully considering buying an existing childcare for sale. I found your article about how much a business should sell for. This business for sale grosses 550k @ 70% capacity and the sellers records showed 75k profit. The are asking 300k. I feel 200-225k might be more appropriate. Any advice? Thank you, I emailed because your article has been the most imformative incising people I have talked to and research conducted!

Sincerely, XX

My response:

Dear XX,

Thank you for the note. I would agree with you.

First, you need someone to make sure about that earnings number. But if it is seller’s discretionary earnings of 75K, that means one owner made $75K per year owning and running that business. That isn’t all that much. Really they are selling a job (as opposed to something that is creating cash flow that you can save for a return on investment). A nice job with some perks, but also some hard work. A multiple of 4 is too much. Often companies with earnings under $100K go for 2 to 2.5 earnings.

I admit I don’t know much about the market and multiples for small childcare facilities. However, there are many that are sold each year and that data is accessible. My associate Fred Hall does business valuations for banks and business owners. He recently launched an inexpensive appraisal business that will give you comparable transactions around the country, and will really narrow down that multiple for you for that level of earnings. You can reach him at: www.affordablebusinessappraisals.com. I’ve copied Fred on this message in case you want to ask him questions.

If you are serious about buying this business it would be well worth the few hundred dollars to find out what these businesses really sell for.

Regards, Ney

How To Increase the Value of Your Business: Top Ten List

March 12, 2011 By Ney

Don’t wake up one morning and decide to sell your business. Wake up and decide to plan for your exit. Because if you have a year or two to plan, you can tangibly increase the value and the selling price of your business. How?

1. High Earnings = High Selling Price. Pretend nothing else matters, because, well, nothing does. At least not enough that if you had one thing to focus on to increase the value of your business, this is it.

2. Depreciate. Earnings (both discretionary earnings for small companies and EBITDA for larger ones) don’t include depreciation expense. For tax reasons business owners tend to expense rather than capitalize and depreciate, but in the year or two before a sale? Depreciate.

3. Reduce Working Capital Needs. A midsize company is sold with enough working capital (current assets minus current liabilities) to continue to operate the business. Think of it as having to sell your car with gas in the tank. Prove you can reduce this amount now (e.g. lower AR, lower inventory, increase payables, etc.) and you can take more cash home in the deal later.

4. Nix the C-Corp. If you think it will be a number of years before you close a deal, see if you can take an S-Corp election. Most buyers will want to do an asset sale (more on this later) and the double tax created by a C-Corp can be extremely painful.

5. Concentration Is a Bad Word. Businesses with high customer concentration or supplier concentration (or knowledge concentration, etc.) attract fewer buyers and this lowers the price. What’s too high? Having a customer with 25 percent or more of your business, or having a supplier with 40 percent of your business is too high. Diversify if at all possible.

6. Make Yourself Unimportant. What business would you rather buy? The one where the owner takes frequent trips and takes every Friday off, or one where the owner has to come in even when he is sick because the place will fall apart without him. A company that relies on the owner gets far less cash up front and often less overall.

7. Pay Some Taxes. Yes, everyone plays the tax avoidance game, but only to a degree. A broker/advisor can only adjust earnings only so much, so it is far better to just pay your taxes for a few years before a sale than the complications that can arise otherwise.

8. Understand What “Adjusted Earnings” Means. Well before a sale is the time to understand what adjusted seller’s discretionary earnings and/or EBITDA means. For example, some expenses will be valid adjustments, so there would be no need to work on reducing that expense, while other areas may need some real focus.

9. A Risky Business Is a Cheap Business. A legal issue dragging on? Environmental problem lurking? Buyers hate risks and risks tangibly lower the price. Identify and attack these areas before a sale.

10. Pick That Low-Hanging Fruit. We hear many business owners say things like, “Pay me X, because you can easily grow this company by doing Y, but I didn’t want to do that because of Z”. For example, “All you have to do is hire a sales manager but I didn’t because I don’t manage people well”. If you have an easy way to boost sales, do it, because you are not going to get X otherwise.

Note

This list came from an extended list of “101 Things You should Know about Selling Your Business”.

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.