What is Your Company Worth? II

Last week we discussed how business owners frequently use hearsay or incomplete information to estimate the value of their companies. They give the number to their financial planner, or include it on a personal financial statement for their banker, neither of whom bat an eyelash at the estimate. Having the amount “accepted” by financial experts, the owner starts to treat it as fact. How do you know whether it is realistic or achievable?

alchemistValuation of a small business is a combination of art and science. No two small companies are alike. A multiple of profits or cash flow is only the starting point. Take two small companies, each with $4,000,000 in revenues and $500,000 in profits. Each pays the same salary and benefits to the owner. One does it by having systems that control most day to day activities, recurring revenue from contracts, and long-term employees who are incented by profit sharing. The other does it with an owner who works 70 hours a week, hasn’t had a two week vacation in ten years, and makes every new sale personally. Which business would you pay more to own?

Beauty lies in the eye of the beholder. The multiples paid for businesses depend on the type of buyers they attract. Commonly, those that sell for less than $2,000,000 are considered “Main Street.” Their target buyers are individuals who are purchasing an income. They intend to work in the business, and to earn a regular paycheck by running it.

Main Street businesses are valued by a multiple of Seller’s Discretionary Earnings (SDE). The value of the business is based on the sum of the financial benefits resulting from ownership. That includes profits, salary, benefits and any of a long list of possible perquisites like a company car, travel, or insurance. (For more on calculating your SDE and selling a business in general, you can read my book, 11 Things You Absolutely Need to Know about Selling Your Business.)

Main Street pricing is typically between 2.1 and 2.8 times SDE. It is based on simple arithmetic. The closer you come to 3 times SDE, the less able a buyer is to pay both the bank and himself. You can run your own numbers here, to see how it works (registration required).

For larger companies, those that attract financial and industry acquirers, the multiples are higher, but the multiplier is lower. Those buyers anticipate paying for professional management, so the owner’s compensation is less of a consideration. They look at EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to calculate available cash after all the expenses of running the business (including executive talent) are paid.

Competitors will calculate the savings they might realize from consolidation, but are usually reluctant to multiply those savings in a purchase price. Private Equity Groups (there are 7,000 in the US) and the acquisition arms of large companies seldom look at businesses with earnings of less than $1,000,000. As amazing as it seems to a small business owner, their due diligence and legal processes are too expensive to make smaller acquisitions worthwhile.

Private Equity Groups pay an average between 4.7 and 5.2 times EBITDA, year in and year out. That makes sense, because they are financial buyers with a targeted Return On Investment (ROI). Large company acquisitions of smaller businesses can range from 4 times EBITA up to around 7 or 8, although in a few cases strategic considerations (competition, exclusive contracts, proprietary methods) can drive that up substantially .

All of these are real numbers, based on actual sales data and industry surveys. Sellers often confuse the terms revenue and income, or apply EBITDA multiples to SDE. They are greatly disappointed and angry when legitimate offers fall far below their expectations. Just because your planner or your banker didn’t challenge your valuation estimate doesn’t make it fact.

My new book, Hunting in a Farmer’s World: Celebrating the Mind of an Entrepreneur, is now available on Amazon in paperback, hardcover and Kindle. It is an ownership book, not a management book, and is illustrated with the stories of real entrepreneurs who faced challenges that apply to us all.

Posted in Building Value, Entrepreneurship, Exit Options, Exit Planning, Exit Strategies, Top Blog Posts | 1 Comment

One Response to What is Your Company Worth? II

  1. John Smith says:

    I work for a small/medium sized family owned business as their CFO. When the owner went out and received his eye-widening “professionally prepared” valuation of his business I asked him the simple question; “would YOU pay that much for the right to run this place?” The follow on question is “you can pay x amount because you already know the players, products and producers. Would a buyer who does NOT have that information at hand need to discount that number to generate similar earnings ?”

    Every valuation is prepared with an end use in mind: Seller’s POV, Buyer’s POV, Tax prep POV. Each end use will result in a different number. From an owner’s perspective, look at all of them and ask yourself “would I pay that?”

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What is Your Company Worth?

A business owner hires a financial planner to help him with his retirement options. They review the owner’s current assets, his house, stock portfolio and other investments. They go over his insurance coverage. Then the planner asks, “What about your company? How much is that worth?”

The owner replies with confidence, “Oh about five million dollars. Maybe a little bit more.” The planner dutifully adds it to the asset list, and includes it in his calculations. In years of questioning financial planners about this, I’ve found that about 80% accept the owner’s estimate of the value as fact. They assume that the owner must have a pretty good idea of what his largest asset is worth. It is his business, after all.

But what if the owner is wrong? Not only wrong, but completely deluded about the value of his company? Then the planner is basing all his assumptions about retirement, family security, and future income based on assumptions that may be 50% or more off from reality. It happens far more often than you may think.

bragAn owner runs into a long-time colleague at a trade show. In reply to the “What’s new?” question his friend says “Well, I just sold my company. I got $4,000,000.” The owner knows that his company is about 25% larger than his friend’s, so $5,000,000 must clearly be his market value.

Any seller will always claim the highest number he can justify. After a lifetime of building a business, our egos are heavily invested in the bragging rights. The pleasure lies in telling the number, not presenting the details. So that $4,000,000 includes assumption of the company’s $700,000 working capital line, purchase of $1,000,000 in accounts receivable (which were collectable by the seller anyway), and payout of $500,000 in loans that the owner made to his company with post-tax dollars. Of the remaining $1,800,000, some may be conditional on future company performance, tied to continuing employment, in the form of an installment note, or in restricted stock.

Yet our business owner confidently walks away knowing that his company is worth $5,000,000. It must be accurate, since his friend wouldn’t lie and that selling price was determined in an arms-length transaction. Our owner begins planning his future around the day he receives a check for $5,000,000.

In my work with hundreds of business owners, this is a more frequent scenario than not. We have a deep-seated need to believe that our years of sacrifice and hard work are going to pay off handsomely.

Valuation, like most financial benchmarking, is an uncertain art. The professional small business appraisers whom I work with consider assets and cash flow, but also use future industry prospects, local or regional economic trends, the company’s historical revenue and profit variability in developing their opinions.

They usually don’t factor in the financial markets, but those are the most critical influencers of all. Whether lenders are seeking to finance business acquisitions (2006-2007) or avoiding them as if they were the Black Plague (2009-2011) can dramatically affect selling prices.

The buyer is also a determining factor, and not just for credit-worthiness or price negotiation. Individual buyers, competitors, private equity groups and publicly traded companies all have differing ideas of where the value is in an acquisition. They pay a wide range of  multiples, and even calculate those multiples on different financial benchmarks.

How much is your company really worth? We’ll go deeper into that next week.

My new book, Hunting in a Farmer’s World, Celebrating the Mind of an Entrepreneur, is now available in paperback and hardcover on Amazon. (Kindle next week.) It is an ownership book, not a management book, and is illustrated with the stories of real entrepreneurs who faced challenges that apply to us all.

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Who Owns the Portal?

We are 30 years into the computer revolution, which I am arbitrarily marking as beginning in the mid-1980’s, when Apple II and IBM compatible (286) computers began to show up on the desks of people who weren’t in the “computer room.” We are 20 years from the mid-1990’s, when the Internet became easily available to anyone with a modem and AOL CD’s began filling our mailboxes.

I remember chastising an employee for unnecessarily adding a 30 megabyte hard drive to a PC that already had 20 megabytes of storage. That seemed like such ridiculous overcapacity for our sole computer. It handled our manufacturing production, inventories, customer records and accounting. Now my IPod shuffle puts 50 times that computer’s capacity into the little change pocket of my jeans.

As technology has become ubiquitous, it’s created another issue. Anyone with money, processing power and software can duplicate the technological prowess of anyone else with money, processing power and software. Proprietary advantages have narrowed, and the time cushion of being “first to market” has almost disappeared.

vaultMost businesses can’t function without their computer capabilities. When a major outage brings the whole company to a dead stop, redundancy becomes a critical part of survival. That is driving more technology services into the cloud. Our lifeblood information is increasing kept where we can’t see it. In fact, we probably don’t know where it is. A small business in Dallas may be taken out of commission by floods in Iowa or a power outage in Pennsylvania. We don’t know where the threat is until something happens.

Everyone wants a customer relationship that is “sticky”, where the barriers to exit are so challenging that the buyer becomes dependent on the vendor to run his business. In technology, that means owning the portal — a single point through which the data flows.

The fight for the portal has become the battlefield of giants from many industries. The telephone companies, cable television operators and (soon) the power utilities all want to own the pipeline. How many of us buy our telecommunications from a cable TV provider, or our television from a phone company?

Content is another portal. The Apple and Android apps markets offer simple, low cost programs to help run a business. Google, Amazon and Apple are pushing into television content portals. That is a search engine, a retailer and a device manufacturer fighting over the exact same space.

The portal to your business is the biggest prize of all. Keeping your financial records, your customer information and your operating capabilities in one place is the holy grail of those who serve small business. That relationship is being chased by software makers (Intuit), credit card companies (Amex and Visa), stock brokers (Schwab and E-Trade), insurance companies, and every bank in the country.

What is your portal strategy for customers? How are you using technology to build their dependence on you? Do you keep their information in a way that is helpful to them? Can you tell them when to stock up based on prior business patterns? Are you the trusted source for product or industry information? Do you make your connections available to them for new business opportunities?

If you engage in consultative sales, do you provide information beyond just the features and benefits of your product? Can you become the go-to source for best practices or learning new methodologies? Can you build a relationship that provides so much value that price ceases to be a purchasing consideration?

It sounds like a tall order for a small business, but the tools are readily available and relatively inexpensive. Your differentiation lies not in having the technology, but in how you use it.

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A Tiered Minimum Wage for Small Business

Recent strikes by employees of McDonalds and Wal-Mart demanding a higher minimum wage have gained headlines on all the news feeds. The strikers claim that they can’t live on the Federally mandated $7.25 an hour. The California legislature recently voted to raise that state’s minimum wage from $8.00 to $10.00 hourly.

Certainly for a full time worker (40 hours for 50 weeks a year) making $14,500 a year isn’t a viable living wage. Add in approximately $1,800 Earned Income Tax Credit, and assume only 8% in payroll taxes (SSI and SUI) and we are still only at $1,260 a month. Take out $500 for shared rent and utilities on a small apartment, $50 a week for gas, and a $250 payment on a used car, and a single person is left with about $75 weekly for food, clothing, cell phone and entertainment. Not an impressive lifestyle.

Under the new California minimum, you’d have $136 a week, assuming you could find a $500 apartment in, say, San Francisco. In either scenario, there isn’t much left for a doctor’s visit or an oil change.

Unfortunately, raising wages doesn’t always help. According to The Economist, the effective marginal tax rate (combined loss of credits/benefits and income tax) by increasing annual income from $18,000 to $20,000 a year is 95%! That’s right; making $2,000 more would earn $100 for the worker, and net the government an additional $1,900.

mcdonalds-workersNow, let’s look at the employer side. Using rough published numbers,  Wal-Mart earned about $4.50 for every employee hour worked last year. McDonalds’ earned about $1.60. Part time workers might make those numbers substantially higher, but it’s in the range. So a $2.00 increase in hourly wages would theoretically reduce Wal-Mart’s profit by 40%, and force McDonalds’ to rethink their entire labor model. (Self-serve kiosks, anyone?)

The minimum wage is not a living wage, and increasing it by a few bucks doesn’t make it so. Politicians are candid about their objectives with minimum wage levels. They believe raising them raises all wages. If entry level folks make $10.00 an hour, then the workers who were being paid $10.00 will have to be paid $13.00. They are swinging at a skin rash with a meat axe.

There are many reasons why trying to make the minimum wage into a living wage is problematic. Small business is often the first training ground for young people. Fast food restaurants are where millions of kids learned to show up on time, do things a particular way, and simply pay attention to what they are doing. That costs the employer money in addition to the wages.

Students, retirees and spouses may seek part-time “play money” work for supplementary income. They aren’t dependent on a living wage from the job.

Some employers really can’t afford it. Minimum wages aren’t means-tested for small business. What if an owner is bootstrapping a start-up? He or she might not even be earning minimum wage personally.

Placing a 15 year old high school kid, living at home and eating free food, into the same classification as a 30 year old single mother of two is dumb. Just as nonsensical is joining a small employer struggling for break-even in the same bucket as Wal-Mart. We need a system that recognizes the realities of the marketplace. Here are a few ideas:

  • A lower “Training wage” for the first year of employment. Everyone pays social security , so the employment records already exist. For someone who can’t keep a job, or works only a few hours a week, that might be tracked as the first 2,000 hours of employment.
  • A discounted minimum wage for those who are claimed as dependents by others.
  • A tiered minimum wage for smaller employers, with tranches by number of employees. Existing ERISA regulations would apply to prevent chain operators from segmenting their business into many “small” employers.
  • A stepped minimum based on continuous service. If an employer keeps a worker full time for a year, he/she is either deserving of a raise, or the employer has a problem with developing people.
  • A special work/study minimum wage for workers who are interning in a field that matches their current enrollment in a job training program.

In a recent conversation with an official at the Federal Reserve, he expressed the Fed’s concern with the relationship between two statistics. The USA has the highest sustained unemployment in 70 years, while simultaneously recording all time highs in the number of help wanted ads. We are not training folks in how to qualify for, obtain and hold decent jobs. The meat axe of raising minimum wage levels across the board isn’t going to fix that.

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2 Responses to A Tiered Minimum Wage for Small Business

  1. craig says:

    Thoughtful. Need more of that!
    cj

  2. Larry says:

    I vote “yes” on this plan!

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Wrestling with Ethics

The head of a rep firm approaches the owner of a small manufacturing company for whom they sell. One of his salespeople has an opportunity for a huge order with a multinational company, but the purchasing manager has indicated that the sale will go to the supplier who “takes care of him.”

The owner has never paid bribes. Just as important, the customer is renowned in the industry for having a zero tolerance policy towards any gifts whatsoever. In cases where under the table payments have been discovered, the customer has pursued a “scorched earth” policy. Anyone associated with that transaction is permanently banned from doing business with the organization.

The owner tells the rep that he will not accede to the demand, even if it means losing the sale. The rep says, “I understand. I’ll take care of it.”

What does that mean? If the rep returns with an order, should the owner refuse it? If he asks the rep whether a bribe was paid, and the rep denies it, is the risk of permanent banishment worth declining it anyway? The sale could be the rep’s largest income source for the year, and rejecting it will permanently damage the relationship between the firm and its sales force. If it is a once-in-a-lifetime opportunity, should the owner just take it, and hope that there are no repercussions?

BribesIt’s easy to include words like “integrity” in your company core values, but how far does it go? Making sales calls with a fistful of hundred dollar bills or a trunkful of color TVs is a thing of the past in most industries, but laws and globalization are making the sales relationship more complex every day.

Another vendor is asked for “a piece of the action” from a new buyer on a big order for a customer he regularly does business with. He refuses, and the order goes to a competitor. Over the next several years, the buyer receives several promotions into the executive ranks. Then the vendor receives a new policy document regarding business ethics and kickbacks. It is required to be signed by all vendors. The final line says “I hereby attest that I have informed XYZ Company of any attempts. past or present, to extract consideration in return for doing business.”

The vendor stalls until the customer begins threatening cancellation of existing business. Finally, he calls the customer’s legal department and explains his dilemma without identifying the employee. After a few days the legal department calls back with a solution. They tell the vendor to discard the agreement, and they will pretend that it was fully executed.

How far does integrity go? Blowing the whistle on the legal department clearly seems a foolhardy strategy. Should he force their hand by signing and reporting, leaving the onus on them to bury it?

The days when a mid-level decision maker expected to remain with his employer for a whole career are gone. Today, a buyer in a large organization only has to get away with something for a year or two, and then he moves on. He might be laid off before then, so loyalty isn’t much of a motivator. Some of his suppliers may come from cultures where bribes or elaborate gift giving are part of the normal business relationship.

In the 1978 Yankee – Dodger World Series, Reggie Jackson threw an obvious hip chuck to break up a double-play. I remember being shocked when the announcers praised him for such a smart violation of the rules. Now you can’t watch an afternoon of football without hearing “Boy, he really got away with one that time.” A little cheating is just good competition.

Corrupt foreign dignitaries are plied with aid that no one pretends will be spent as stated. Elected officials in the US take junkets to exotic locales, trade stocks in industries they regulate, retire with millions in unused campaign contributions, and then jump into lucrative lobbying jobs. Can the law permit corruption? Does that make it ethical?

For a small business owner, a single relationship with a large company can lift your business to an entirely new level of success. It can mean jobs, college for the kids and a secure retirement. It can be very difficult to stand on ethics when there is pressure to put bread on the table. As the Facebook status says, “It’s complicated.”

Or do you disagree? Do you think it’s really very simple?

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2 Responses to Wrestling with Ethics

  1. Rod Giles says:

    I own my company so I am in a position to decide better than some other may be , however my standard in life has always been honesty, expected of myself , my kids and my employees. It has worked for me , yes it has been a difficult choice at times but I sleep well and have never had to be looking over my shoulder. Its choice I do not regret and the great kids I have and long term employees, some for over 20 years , I think is a tribute to that as I am now appraching retirement. Integrity is everything as trust is wjhat business is and should be built on.

    • Anthony Parkman says:

      I am a recently promoted SVP at a company that still does business with a handshake. Of course we do the requisite paperwork but if we say we have a deal and shake we won’t later accept a “better deal” because no paperwork was done upfront. I also served 26 years in the military and the one phrase that sticks in mind from day one until my retirement is ” Do the right thing even if no one is looking.” Being ethical in today’s business climate can be challenging but the cost of losing your integrity can be very high.

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