Is the M&A Window Closing?

So here we are, halfway through 2019 and judging by the commentary from various talking heads, press releases, and my good friends in wealth management, it seems we really have no idea how strong the economy is. Maybe I’m just not a careful listener, but it sure seems like on one day the news is dire (tariffs! Iran! The jobs report!), and then the next day everything is fantastic (the stock market! GDP! The jobs report!) Within all of these mixed messages I think all of us have one nagging question – just how long can a good thing last?  

This leads me to probably the most frequent question I get from business owners and entrepreneurs that are thinking about selling.  The question is almost always a two part-er: how is the M&A market? And should I sell now or wait a bit to do X, Y, or Z? (And damn that last one is a doozy.  You can always wait for the next good thing to happen… but should you?).

Thanks to this constant stream of questions on this subject we’ve developed a playbook for sorting it out.  

 

Can You Afford to Sell Right Now?  

First off, this is hands down a generationally best sell side market.  If you want to sell a company and you can afford to, then by all means go to market.  How do you know if you can afford to sell right now? You need to answer two questions: what is the current value of my company?  And how much do I need? The former is best answered by a valuation – it’s a relatively modest investment to get clarity from an independent expert on how the market will price the asset you have built.  The second question should be answered by working with your financial planner. Getting granular on how your financial situation will look after the sale (using your current valuation as likely the largest input to that analysis) will help answer the question.  

Recapping: if what you have (i.e. the current value of your company) exceeds what you need (i.e. the capital that your financial plan requires in order to meet retirement goals), then by all means do-no-pass-go and go to market now.  

 

What Do I Gain by Waiting?  

For some folks the outcome of the first step will clear: you absolutely cannot afford to go to market. And clarity is great. But what seems to happen more often than not is a gray area. Perhaps the numbers are close but not quite there. That’s not a fun decision framework.

If you are in this category the real question is what do you gain by waiting? I’m constantly saying “the passage of time is not a strategy.” Waiting alone will not fix a value gap – we are already at the peak of the market. Values likely aren’t going to materially increase. Or put another way, there is at least an equal likelihood that values start to decrease.  

With this dynamic in mind, consider this: if you have an actual strategy to grow value and pursue that plan diligently, then waiting may make sense. On the other hand, if you are hoping that the market further matures and delivers a great value for your company… well I’d politely suggest that that isn’t the best strategy.    

 

What is the Probability of Success?

Let’s assume that you decide to pursue a value growth strategy to close your value gap. How confident are you that you can execute on plan?  

Similarly, entrepreneurs are constantly chasing the next big thing. We all do this – the next big project, the upcoming contract win, or maybe the new product launch. Healthy businesses always have a next new thing- it’s what feeds the beast and underpins growth. But that same cycle can feel like a hamster wheel with owners constantly chasing the next increment of success.   

In either case, it’s time to start handicapping the likelihood of successful execution. On our end, when we work with clients on value engineering assignments we do just that: by correlating actual impacts to enterprise value to both the probability of success and time to execution we can start to understand how value might change over time.  For instance, a given initiative might result in an additional $250k of income, require 18 months of time, and have a high likelihood of success. If the market currently would value that company at 5x, that initiative is worth $1.25M in enterprise value.  

 

What is the Probability that the Market Turns First?

Of course all this assumes that we have time to execute.  The market, being a nebulous collection of individual participants, doesn’t care about our plans whatsoever.  Take our example from above. What would happen if you executed on plan and in 18 months … but the market turns and now prices the company at a 4x? Well… it’s not going to feel good, that’s for sure. See below: 

 

In our example – that quarter million dollars of hard fought gains would yield exactly zero dollars in improved enterprise value in a market downturn. That’s not to say it’s not a worthy project – the company would still be delivering those earnings back to shareholders. But in terms of pursuing a sale you very well could be literally missing the market.  

 

Takeaways

We are always talking about how “timeline is everything.” If you have a short term horizon you can only impact so many things. Your decision to go to market now means you aren’t going to massively increase enterprise value suddenly. And that’s okay if the numbers work for you – it’s a great market! If you do decide you need to wait – be it for that next big win or to put in some hard work – that’s okay too. Just understand that you are on the clock and that a market downturn may erase the gains you’ve been holding out for. Finally, if you run the numbers and realize that you need to grow value beyond what can reasonably be expected in the short-term then it’s time to buckle in for the next 3-5 years and enjoy the ride.  

Need some help working on this decision matrix? Drop us a line.

Quantive Welcomes Susan Trivers!

We are so pleased to announce that Susan Trivers has joined the Quantive Team!

Susan brings 20 years of experience working with small to medium business owners to help them increase the financial value of their company. She engages with owners to ensure their focus and energy are aimed towards innovations for future growth and nurturing relationships with buyers in order to allow them to exit on their own terms.

You can read more about Susan here.

Welcome Susan!

Thinking About an Exit? Begin with the End in Mind.

Statistics tell us that for most entrepreneurs and family business owners, their operating business makes up about 80% of their net worth.  What’s more is that most business owners that we work with are what we think of as “business rich and cash poor.”  They’ve built a very valuable – yet very illiquid – asset.  The vast majority will rely on the liquidation of this asset in order to meet their retirement goals.  While that liquidation may be a traditional M&A exit (i.e. a sale to a strategic or financial buyer), other viable options could also be a sale to family members, to management, or even to employees.  Regardless, if the proceeds from the transfer are needed to fund retirement, creating a financial plan focusing on the liquidation outcome is the cornerstone of sound transition planning.

Why Traditional Financial Planning Often Fails

In one sense, it’s hard to knock financial planning.  For the most part, financial planning embodies every bit of sound advice we’ve ever received: be prudent with your money, save well, invest wisely, and plan for the future.   Most financial planners utilize sophisticated modeling techniques that are designed to help their clients understand what their retirement will look like based on their anticipated spending level, savings rates, and their current assets.  In fact, most planners frequently use a Monte Carlo simulation, running 10,000 simulations of their financial plan in order to help assure a 95% (or better) outcome.  What could go wrong?

Modeling using Monte Carlo – or any other technique for that matter – follows the old adage “garbage in, garbage out.”  Remember we discussed that for most business owners, the preponderance of their net worth is tied up in their business, and that liquidating that asset is required to fund retirement? That’s an incredibly important input to any financial model: how much will they actually be able to walk away with when they transition ownership?

In my experience, most financial plans for business owners are constructed using a “guesstimate” for this number. Putting a finer point on this: the most important input to the model that helps guide retirement is a guess.  Having been involved in thousands of valuation assignments, I can tell you with incredible certainty that this guess is almost always too high.

Getting it Right

Well before going to market, entrepreneurs need to understand two numbers.  First, after all taxes and fees, how much do they need to walk away from any transaction with?  This is where traditional financial planning shines.  A good planner will work with them to understand their lifestyle needs and turn that into a financial plan that makes sense for them.  Second, the owner absolutely must have a realistic understanding of the current market value of their company.  The key word there is realistic – having a best guess isn’t helpful and potentially undermines the whole financial plan.

With these two numbers in hand – what business owners need from a sale plus where their current market values stand – they have essentially created a road map for where they need to drive the company.  Is their company currently worth $15 million while their financial planner helps determine they only need $10 million?  Great – they’re well positioned to transition at the time of their choosing.  On the other hand, what if the numbers are reversed?  If the business is only worth $10 million but they need $5 million more, then it’s obvious that there is some significant work to do.

So, what’s next?  They need to create a growth plan that is geared not just towards revenue growth, but also towards growing enterprise value.  We’ll cover that in our next article.

Exit Planning: When to Engage a Business Valuation

If you are considering selling your company step 1 should be understanding what the company is worth. Just like selling a car: before you go to the dealership you consult Kelley Blue Book, right? The same logic holds for a business: you can’t price it well if you don’t know the value.

Why a Formal Valuation?

  • Your business is probably your largest asset. Now isn’t the time to work on the back of a napkin.
  • A qualified, certified Valuation Analyst can help get the RIGHT number for your business
  • A formal valuation serves as a blueprint for demonstrating value in your company
  • A certified valuation helps back up your asking price during negotiations

So When to get started?

Now. If you are considering a sale (or perhaps received an unsolicited offer), you can’t negotiate from a position of strength if you don’t know your value. Worst case scenario, you engage a valuation, the value is lower than you would like, and you have a roadmap for how to get to the number you need.

Using a Valuation for a Shareholder Buyout

Shareholder buyouts occur frequently in closely held businesses and often are costly for parties that feel that the payout is unfair – whether too high or too low.

Triggering events for buyouts happen all the time, yet as a business owner they are often not events you spend time thinking about every day. They include:

  • Retirement of a shareholder
  • Shareholder seeking to exit partnership
  • Death of a shareholder
  • Inability to continue working together
  • Shareholder involved in a divorce

They can also be costly if the ownership interests transferred are not valued properly, primarily due to the time and expense associated with litigating shareholder disputes or resolving transactions with the Internal Revenue Service. Even when a buy-sell agreement exists, it may be prudent for the shareholders to engage the services of a trained and accredited valuation professional.

Valuation professionals help mitigate the risks associated with a shareholder buyout by preparing a supportable, well documented valuation report that is based on a well-defined assignment, comprehensive data gathering, and a thorough analysis of the factors affecting the value of the business. The failure to engage a professional to work through valuation leaves the parties involved open to acrimony, drawn out negotiations, and the potential for costly litigation.

Defining the assignment

Confusion and misunderstandings arise in shareholder buyouts when the valuation assignment is not carefully defined between the appraiser and the shareholders for whom the valuation is being prepared.

The most critical aspects of defining the assignment are choosing the appropriate standard of value and properly addressing the impact to value of control and minority interests.

A common standard of value is fair market value, under which a minority interest is valued with the appropriate lack of control and lack of marketability discounts. However, shareholders in a buyout situation may prefer that 100 percent of a company be valued regardless of the ownership interest that will be transferred, since they may be negotiating based on the pro rata value of the entire corporation.

Another standard of value used in shareholder buyouts is fair value, which is commonly used in dissenting shareholder valuations and minority oppression cases. Because fair value is a statutory standard defined by state case law, the business appraiser should further clarify in the engagement letter what discounts will or will not be considered in a valuation under the fair value standard.

Tip: Understanding standards of value is critical, as various discounts for control and marketability can have an enormous impact on the value of the interest appraised.

Gathering the data

Once we have defined the parameters of the assignment the appraiser must gather data, to include both company specific information and industry information. Part of this process normally includes a management interview to both gather data and clarify any of the information provided.

Of concern is access to reliable company data. Depending on the context that the valuation is being performed under, management may have a vested interest in the outcome of the valuation and their answers may be skewed.

A skilled appraiser will determine whether management’s statements makes sense based in context of the company’s within its industry and the market factors that drive the industry.

Analyzing the data

The next step in the appraisal process is for the appraiser to analyze the data gathered and to develop valuation models. An appraiser must ordinarily consider each valuation model or method that is likely to be applicable to the subject company.

Approaches will often include the asset approach involves determining a value indication using the value of the assets of the business less the liabilities. Since the net asset value does not include the intangible value of the company, the asset value will often “set the floor” for any valuation.

The income approach involves ascertaining the value of the future economic benefit stream of the company in today’s dollars. The anticipated benefits are usually based either on historical income statements, adjusted to reflect the ongoing earnings of the business, or forecasted income statements.

Of critical importance is making normalizing adjustments. As small business’ financial statements are often managed to a tax purpose normalizing adjustments are often required to indicate the true economic benefit of ownership. (That being said, minority owners may not always be entitled to such adjustments based on their lack of control. This is a critical point to understand when Defining the Engagement.)

Tip: Normalizing adjustments can have a very large impact on value. Discuss with your valuator if they are appropriate for your situation.

Using the Market Approach, the appraiser will use actual market transactions involving either sales of entire businesses or minority interests. This can provide objective, empirical data for developing value measures that apply to the valuation. This empirical data is critical in valuations for the purpose of shareholder buyouts, because it provides support for values derived under the income approach.

Timing Considerations

Ok, so you get the idea as to how the process works for a shareholder buyout.  But when do you get the valuation?   In our experience shareholders often take a “wait and see” approach, often letting the other party take the lead in pricing discussions.  Negotiating theory tells us that this is a bad move.  But even more importantly, waiting tends to exacerbate the gap between parties – both financially and personally.  More often than not this leads to more strife – which leads to more lawyers, accountants, and valuation folks driving up expense!   With many years working on these matters time and again, we strongly feel that it’s best to be proactive when it comes to getting the valuation completed.

Conclusion

Even if a shareholder does not agree with the opinion of value, the shareholder is less likely to challenge a comprehensive, well documented valuation report by an accredited professional.

When the shareholders involved in a transaction understand and agree with the valuation process, they are more likely to negotiate successful transactions and avoid potentially costly and lengthy litigation.

Takeaways:

  • What is the standard of value?
  • Fair Market Value, Fair Value, or something else?
  • What Discounts will be taken? What portion of the business will be valued?
  • Involve your analyst early
  • Insure data discovery is robust
  • Avoid the “wait and see” approach!

Growth: Turn Down for What?

We spend a lot of time talking (and talking, and talking) about revenue trends and earnings trends and successfully selling or exiting from a small business.  A lot of people are going to successfully exit their business.  They’ll do it on their own terms and get a reasonable return for their efforts.  But how do you really knock it out of the park?

I’ll tell you:  you think like these modern kids.  The whippersnappers.  That’s how.  Turn down for what?

The absolute best way to exit a business like a boss is to sell while demonstrating fantastic growth.   The vast majority of companies are sold based on past performance. Consider Company X below.  It’s generated $2 million in EBITDA for the last umpteen years.  So the buyer values it at some multiple (say 5x) of that number, and we all go on our merry way.

Year 1 $2,000,000
Year 2 $2,000,000
Year 3 $2,000,000
Year 4 $2,000,000
Year 5 (Present Day) $2,000,000

But executives and entrepreneurs often want to get compensated for all the sweat and tears that go into getting to that $2 million in EBITDA.  A premium, if you will.  Unfortunately, a buyer can’t afford to pay a premium on this company – it’s a known commodity, earnings are consistent, and there is only so much room for ROI in the valuation.

Now let’s look at company Y:

Rev_growth_Y1

Here we have a company growing steadily.   In this case the seller has more leverage in convincing the buyer that there is further upside.  The company grows every year! Of COURSE I’m not selling it for 5x last year’s earnings.   We’re going to sell it for at least 5x of next year’s earnings.

But the rate of growth is slowing ($500k is a smaller % growth each year).  So while this is a great profile, it’s not quite Rock Star level.  Check out the chart below:

slowing_growth

Now let’s do this one more time.  We want to really crush this exit.  Growing 5ook per year didn’t quite get us there.  The earnings growth on a absolute basis looks pretty, but as the chart below shows us, Company Y’s growth is actually slowing.

{chart= % growth}

Enter Company Z.  Company Z is growing at 30% per year.  So Year of Year, every year in our observable period, the company grows 30%.  What does that do to absolute earnings?  BOOM.  That’s what.

In a company like this, we are much more comfortable basing value on earnings further into the future.  Sticking with a simple multple of earnings, we’re also potentially increasing the earnings multiple.  Why?  Think of this like running a DCF.  Company Z is throwing off a lot more future earnings… which are worth more in todays dollars.

So there you have it. Developing a Company Z is all in the execution, but if you want to exit like a rockstar you have to think like the whippersnapper.  Growth: Turn Down for What??

Final Thoughts

On Playing Offense

“…Whatever Someone Is Willing to Pay”

A phrase we hear pretty frequently is “a business is worth what someone is willing to pay for it.” And of course, this is a true statement. When a business sells… that’s the number.

But the problem with this statement is that it’s reactionary.

Reactionary is bad.

Play Offense

A business valuation enables you to gain an understanding of the most likely value of your business. It is this information that will place you at an advantage when you sit down at the proverbial negotiations table. Consider this – would you start negotiating the price on a house or a car without an understanding of likely value? Probably not. Working with a certified valuation professional arms you with the information and data to both establish value as well as back it up.

Demonstrate Value

One of the things we do when we value a company is to try to ascertain how to value a particular business relative to it’s peers. While we traditionally steer clear of rules of thumb, we’ll indulge for a moment. Let’s assume a Widget Manufacturer should sell for 1x earnings. That’s the average widget manufacturer. Is your company just average? Absolutely not. To get to a more accurate value, we work through a process to dig in and understand why your business is more or less valuable than the market average.

Increase Value

Regardless of method used to value a company, the number one concern for a buyer is their ability to generate profit. Period. The most reliable indicator of this ability is your past performance. But what is often obscured in past performance are items like “non-operational” expenses, one time or unusual expenses, personal expenses run through the business, shareholder perks, etc. We work with you to document those and build them back into the value of your business. This has a direct, significant impact on increasing both actual and perceived value.

Takeaways

Yes, we agree – value is “whatever someone is willing to pay.” But, the idea is to help someone understand why they should pay more. Change the dynamic: play offense, demonstrate value, and increase the value.

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SBA Loan Checklist

Getting ready to request an SBA Loan for financing?  Like a lot of things in life, it’s best to go into it being prepared.  That means understanding the SBA Loan Process, and doing all your homework early.

To help you along that path, check out our SBA loan checklist below:

  • SBA Loan Application –: Borrower Information Form – SBA Form 1919
  • Personal Background and Financial Statement – To assess your eligibility, the SBA also requires you complete the following forms:
  • Business Financial Statements – To support your application and demonstrate your ability to repay the loan, prepare and include the following financial statements:
    • Profit and Loss (P&L) Statement – This must be current within 90 days of your application. Also include supplementary schedules from the last three fiscal years.
    • Projected Financial Statements – Include a detailed, one-year projection of income and finances and attach a written explanation as to how you expect to achieve this projection.
  • Ownership and Affiliations – Include a list of names and addresses of any subsidiaries and affiliates, including concerns in which you hold a controlling interest and other concerns that may be affiliated by stock ownership, franchise, proposed merger or otherwise with you.
  • Business Certificate/License – Your original business license or certificate of doing business.   If your business is a corporation, stamp your corporate seal on the SBA loan application form.
  • Loan Application History – Include records of any loans you may have applied for in the past.
  • Income Tax Returns – Include signed personal and business federal income tax returns of your business’ principals for previous three years.
  • Résumés – Include personal résumés for each principal.
  • Business Overview and History – Provide a brief history of the business and its challenges. Include an explanation of why the SBA loan is needed and how it will help the business.
  • Business Lease – Include a copy of your business lease, or note from your landlord, giving terms of proposed lease.
  • If You are Purchasing an Existing Business – The following information is needed for purchasing an existing business:
    • Current balance sheet and P&L statement of business to be purchased
    • Previous two years federal income tax returns of the business
    • Proposed Bill of Sale including Terms of Sale
    • Asking price with schedule of inventory, machinery and equipment, furniture and fixtures

Understand Value Now to Avoid an Uncomfortable Retirement

For most entrepreneurs their business is the largest asset that they own.  Further most entrepreneurs have built their company with an eye towards and eventual sale and retirement.  Given these facts, a successful and enjoyable retirement is largely contingent upon the successful sale of the company.

Given the importance of the business in their life plans, it’s critical to rely on more than just the subjective opinion of friends and acquaintances who have sold a business.  Again, it’s likely the largest asset in a portfolio – why leave that to hearsay and chance?

Exit planning ultimately comes down to asking (and answering) one key question: “Can my company be sold for enough money to fund my retirement and lifestyle requirements?”   In many cases the answer is no – but you are now well positioned to attack the problem and position yourself for a successful exit.

What to Do Once You Know Your Value

Involve your deal team.  Selling a business of any size is a significant undertaking.  Ideally you should have an exit planning team of trusted advisors:

  • Valuation Expert
  • CPA / Tax Advisor
  • Financial Planner / Wealth Manager
  • “Improvement” Consultant
  • Business Broker / M&A Intermediary
  • Transaction Attorney

We’re often retained by sellers looking to exit their business immediately.  We can say without exaggeration that its terrible to be the bearer of bad news when current exit plans do not meet current reality.  Getting a team in place early, understanding valuation early, and putting a plan in place is the surest recipe for success when it comes to exit planning and a happy retirement.

Enterprise vs. Personal Goodwill: How they differ and affect divorce valuations

Estimating a value of intangible assets such as goodwill can be highly speculative. This is often a significant point of contention in scenarios involving two parties rallying for a fair market value of a business. We see it all the time in divorce proceedings.

The 101 on Goodwill

Goodwill can be segmented into two categories, enterprise goodwill and personal goodwill. Enterprise goodwill attaches value to specific competitive advantages or differentiators of a company indicating that these factors attribute to the company’s earnings potential. Personal goodwill ties value to an individual’s contribution to a company’s operations such as relationships that are not deemed transferrable upon the absence of said individual. Ultimately, personal goodwill states that there is an element (aka a revenue/earnings stream) that would disappear with the loss of a particular individual.

Each state treats the inclusion or exclusion of personal goodwill as a marital asset differently. Below is a summary of how the country fairs:

  • 19 states include personal goodwill as a marital asset
  • 24 states plus DC exclude it
  • 8 states have no formal precedent

The inclusion or exclusion of goodwill can have material impact on the overall value of a business – which is more than likely a small business owner’s largest asset. However, overstating the valuation with goodwill may base divorce proceedings on a company value that may or may not be realized.

Our advice to business owners (or their spouse) involved in a divorce? Ask your divorce attorney about your state’s treatment of goodwill assets and retain a Certified Valuation Analyst to work with your team in providing a value to one of the largest points of contention during this process.