Exit Strategies, Part 7: Determining business valueExit Strategies, Part 7: Determining business value

Every business owner has at some time wished for one correct formula for calculating "true" business value. The beauty of a free market economy (and the artistry of great merger and acquisition success) is that value moves, lives, and breathes. Free market value is almost as difficult to analyze intelligently as the tax code. 

Still, in real life, business sellers and investor buyers each have to start someplace to quantify value expectations. There are dozens, possibly even hundreds, of formula approaches possible, but most sellers use the valuation process far more simply than buyers. The following are the most common approaches by sellers, in ascending order of realistic viability: 

• The seller asks himself, "How much do I need to live comfortably for the rest of my days?" (Unfortunately, this is absolutely irrelevant to any buyer.) 

• The seller seeks published information on pricing and uses aggregate sales volume to estimate value as a multiple of sales volume. (This is usually wrong, unless all possible buyers can produce uniform profit percentage returns on a given volume.) 

• The seller uses some multiple of earnings he has heard about as a norm for his business. (This is simplistic, but by far the most realistic.) 

Buyers, on the other hand, generally go through a more complex analysis. In attempting to discuss a professional buyer's eye view of the issue of valuation, we'll group the main concepts of buyer pricing issues into four segments. 

Mechanical Earnings Multiple Calculations 
Buyers almost inevitably start analysis with some variation of an earnings multiple formula. Before applying an earnings multiple, the buyer first recasts the financial statements of the seller to try to make such statements owner-neutral. Distorted financial results caused by specific seller ownership are carefully removed from the calculation. For example, say the current ceo and owner has a salary of $500,000; the buyer might calculate that this position could be filled with someone else with a salary of just $200,000. In this case, the buyer adds $300,000 to earnings. 

After measuring what is believed to be a fair performance level of the company, before owner distortions, the buyer then typically applies some rule-of-thumb multiple to resultant earnings. Rule-of-thumb multiples for injection molders range from as low as four to as high as eight times earnings, depending on the business niche. Most injection molding subsegments have a normal range. For example, medical is commonly six to eight because it's widely perceived as a growing market, whereas a turned-down market segment could be five to seven or even four to six. 

The multiple is typically applied to EBIT (earnings before interest or taxes) or to cash flow (usually approximated by EBITDA—earnings before interest, taxes, depreciation, or amortization--less normal capital expenditures). 

The first, simplest, and most mechanical element of valuation is now done. A note of caution, however: Earnings multiples are applicable only if there is a positive earnings level. For companies losing money, the more common starting point in value is somewhere between asset liquidation value and asset book value. For easy turnarounds, value goes up, and for companies in highly troubled markets, or for companies with severe problems, values drop. 

Buyer Synergy 
The next critical element is the buyer's analysis of synergy. If the buyer is confident that overall earnings can be dramatically improved by owning the target, more may be offered. 

Synergy may come from a simple cross sale of capabilities to a greater breadth of customers or from reduced overhead in the combination. The buyer has value in synergy when he knows that he can add more to his overall performance than just the simple addition of combining his earnings with those of the seller. 

Capital Requirements 
Next, the buyer must factor in possible cash required to make the purchase. If the prospective target has no potential for bank financing--which would preferably be used to cover part of the purchase price--then the buyer will need a greater capital investment up front. Less cash will be available for other needs. Alternatively, if the company to be purchased can immediately borrow part of the purchase price on its own merit, the buyer may reduce upfront cost and risk, which makes the transaction more desirable. 

Buyers need to calculate a rate of return on invested capital. They need to consider how long the investment will be tied up before payback. They should also consider opportunity cost compared to alternative uses for the investable cash. 

One common way to reduce the need for upfront cash when bank debt is not available is a longer-term payout to the seller. Such a payment can be as simple as a delayed note over a long term, or as complex as a bonus payment to the seller, contingent upon performance results. While not a favorite mechanism from the seller's view (and thus a potentially dangerous approach in a bid situation), this can sometimes be the only viable way to bridge a gap between the seller's desires and the buyer's risk tolerance, especially if the seller is a company with inconsistent results or disproportionately low borrowing capabilities. 

Market Impact 
The last major element of buyer consideration required is the estimate of market impact. The buyer must somehow assess the competitive bids from other potential buyers. If the seller has no other suitors, the buyer can afford, to some extent, to be more slow to increase price. This is not to suggest a classic "low-ball" bid. It doesn't pay to get far under normative pricing; even the seller who is not actually marketing his company inevitably begins checking around for alternatives. However, in the case of minimum competition, careful and conservative pricing is appropriate. 

If the seller is known to be talking to multiple buyers, the buyer must be more careful to place himself in the running as a clear and earnest contender with a reasonably aggressive initial bid. If there are several good strategic buyers, pricing is likely to be pushed upward for synergy. 

For example, if a company is producing $10 million in annual earnings by itself, but there are five buyers for whom it could produce $20 million per year, the pricing probably will land at a multiple on earnings between the two levels. The winning buyer likely will be the one who shares the greatest portion of the extra value with the seller. 

Naturally, these are only primers to understanding the professional buyer's view of business value. Every situation is unique, and every buyer has a different profile. The best teacher of value is competitive experience. 

Next month, in the last article of this series, we will discuss getting to close.