Navocate’s Business Valuation: Sell-Side, Buy-Side, and Soft-Side
The market has developed a common method of assigning value to a company, whereby a multiple is applied to the company’s revenue or profit. If the company’s financial reports comply with generally accepted accounting principles (GAAP), so the thinking goes, it seems safe to value the company based on these financial statements that represent the actual business results. After all, a ‘for-profit’ company’s most important measure is the profit that it earns. (Reliable financials seemed to be a reasonable assumption—until we learned about accounting practices at Enron, WorldCom, and most recently MF Global. But that’s a different story.)
Profit is typically measured by looking at either EBITDA (earnings before interest, taxes, depreciation, and amortization) or, EBIT (earnings before interest and taxes). Having a common language is the first step to meaningful deal communications. EBITDA multiples seem to provide exactly that. Databases are used to obtain the EBITDA or revenue multiples for each industry where companies are often listed by SIC codes.[1] The multiple is typically a spread of say three to five times EBITDA. This range represents a good place to start because the source data is based on real deals that have taken place in recent history, based on financials from the actual transaction. The multiples were defined by real-world transactions that have actually closed.
So, multiples based on past financial reports from actual transactions provide us with reliable information on how companies have sold in the past. We refer to this as a sell-side, or market transaction. But is history a good way to predict the future? Does past financial performance provide sufficient guidance for similar transactions looking forward?
Most M&A professionals would agree that you can’t just rely on history when evaluating a future deal. Having profitable past performance certainly reduces the risk vs. not having this information. But past performance does not address the all of the risks the future presents. As the saying goes, ‘change is the only constant.’ How change will affect the business performance going forward is an unknown. Can that unknown risk be reduced?
Another reason that historical sales can’t provide an accurate predictor of future company value is that every buyer — whether an individual or a corporation — is different. “Wait a minute,” you say. A buyer can’t affect a company’s valuation. “Not possible,” said the jury emphatically.
Au contraire, dear reader. A buyer can affect the valuation of a company — depending on the buyer’s acquisition strategy. For example, there are high-equity, low-leverage buyers. And there are low-equity, high-leverage buyers. And there are buyers in between. Deal structure across these different buyers will change the strike price, because one buyer wants high leverage while another buyer wants a cash deal. Doesn’t this change the value of the company? We argue that it does. If the value of a company is ‘X,’ and the debt service is ‘Y,’ X and Y are related to each other. That’s why business valuations are conducted relative to written objectives. If the objectives change, so does the valuation. Consequently, ‘value,’ like ‘beauty,’ is in the eye of the beholder. (At least to a certain degree.)
These are all valid reasons why historical valuations can’t predict future valuations. History, it turns out, can only provide us with a guideline.
Now to the buy-side valuation. Investor’s and buyer’s first and foremost interest in the business is: “What kind of profit will I make?” To that end, looking at the future EBITDA of the Business is a must. You can’t analyze profitability until you know the deal structure. As discussed above, some buyers want leverage while others don’t. This turns out to be a mixed analysis as well. Lower debt payments unquestionably reduce cash flow risk. But what is the tradeoff relative to higher taxes? (Hint: Have a good CPA firm.)
From the buyer or investor point of view, a higher ROI allows for higher valuation. To get there, a buy-side valuation needs to analyze deal structure to understand one of the key cash flow drivers (debt service) in order to model the buyer’s return on investment (ROI).
Another risk-reducer or valuation-builder, depending on how you look at it, is a business plan. If the company has a business plan that the investor can look at, you should get a more reliable indication of the company’s strengths, weaknesses, opportunities, and threats. The buyer can decide if s/he agrees with the business plan’s assessment, and decide to accept the plan or to modify it so that it more closely reflects the buyer’s assumptions. The business plan unquestionably affects future ROI, because you need to know your goals and objectives for acquiring the business, as well as the strategies and tactics for where you’re going to take this business in the future. Never buy a business expecting status quo will continue. It never does.
Now that we have both historic view and a forward looking view are we done? Not quite.
Remember that multiples come in a spread—three to five times EBITDA in our example above. The investor’s forward-looking ROI calculates return for a purchase price of 3X EBITDA to be 35% ROI. At this level the buyer should be excited about making the deal. For a purchase price of 5X EBITDA the buyer ROI drops to 19%. This is a good return but for some buyers may not be compelling enough. So we run sell-side and buy-side tests and we still do not have a clear quantitative measure of what a fair and agreeable to both sides price may be. Should it be left to negotiations, and let the better negotiator win?
You can apply additional measures to gauge the location of the company on the price range offered by financial based models. The situation is graphically presented below.
Instead of reviewing the entire spectrum of prices, we can more or less confine our focus to what we call “Reasonable Price Range.” It is safe to say that the better companies will fetch a better price while the not-so-good companies will yield a lower price. To determine the location of a specific company on the curve we need some additional information, however. What distinguishes high value vs. minimum value? Below are some of the factors that affect business value:
- Management Team. Who are they? How are responsibilities allocated across the team? What experience do they have? How well do they work together?
- Decision Making Process. Is it ad hoc or is it a real process?
- Quality of the Financial Reports and the staff that generates them. Using quick-books does not equate to a CPA-audited financials.
- Controls — defined as measurements of the business’s non-financial performance. (Examples include on-time shipping or accurate order fulfillment; and the frequency of these measurements.)
- Legal Issues: Law suits on one side; and ‘good’ contracts with vendors, customers, and employees on the other.
- Internal Risks: employee motivation, safe work environment, training etc.
- Operational Procedures as a measure of efficiency and effectiveness.
These are some of the soft-side issues that affect business valuation. The point is: the better managed, operated, and organized a company is, the higher its value should be.
So we have reviewed three different approaches to valuation: sell-side, buy-side, and soft-side. These three approaches are exactly how Navocate’s valuation model has been developed:
- Historic performance (sell-side).
- Future-looking ROI based on deal structure (buy-side).
- Operational and risk assessment (soft-side).
All three of these components are blended to develop a range of market value in Navocate’s model.
Navocate provides Business Sales and Acquisitions services for Emerging Companies with revenues from $3M to $30M. Specifically Navocate focuses on the market segment above the business brokers and below investment banks. For more information please visit our website www.Navocate.com
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[1] Created in 1937, Standard Industrial Classification is a system of four digit codes used to classify industries. The six digit NAICS replaced SIC in 1997. But the Securities and Exchange Commission still uses SIC.