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Background
Valuing a private business is a complex multi-stage process. Since private companies are not regulated by the Securities and Exchange Commission (“the SEC”) and are not required to publicly post periodic reports, their financial statements usually do not adhere to the same stringent guidelines publicly traded firms must follow. Although they should follow Generally Accepted Accounting Principles (“GAAP”), there is no legal obligation to do so and most privately-held businesses record operations and business transactions using variations on GAAP standards that best and most practically apply to their own particular situation. Unfortunately, as a result, as noted by the finance-savvy website Investopedia: “private companies make up a large proportion of businesses in America and across the globe; the average investor most likely cannot tell you how to assign a value to a company that does not trade its shares publicly.”
While business owners may know and measure and continually evaluate their firm’s financial, sales, and operational KPI’s, very few owners know how to answer this simple question: How much is my company worth?
To arrive at a proper valuation one must address the following components:
Normalize financial statements
Determine the potential market
Identify potential concessions
Identify potential premiums
Normalizing the Financial Statements
Public companies try as much as possible to boost financial statement profits in order to please current shareholders and entice new investors. Private companies tend to drive financial statement profits lower so they can minimize corporate income taxes. This behavior may lead to distortions in the financial statements when compared to public firms. More importantly, this practice can disguise the true cash generation capacity of a business.
For this reason financial statements must be “normalized” or restated as if the privately-held company were a publicly-held one. A new investor will want to see how much cash a business can generate with no distortions from personal financial transactions. The investor wants to see how much cash your business can generate in “normal” conditions.
The most common accounts that need to be normalized are:
All these normalizations are necessary to uncover the real cash generation ability of the business. Cash generation is the primary factor that determines the valuation of your business: restated, the actual free cash flow that your business is able to provide to its shareholders. The result of these normalizations is what is known in the market as Seller’s Discretionary Earnings (“SDE”).
The math is simple. Add back all expenses that are not strictly related to the business. Then add back all excessive expenses that are not “normal” for this type of operation.
All the shareholders work at the company and their salaries are way above the going market rate. The shareholders also pay themselves royalties on parts they have developed for the company in sums not compatible with the market. As we can see, the profit generated by the business is significantly higher when “normalized” to public market conditions.
Of course there are many other accounts that must be examined in the normalization process, such as non-recurring events (natural disasters, sale or purchase of fixed or intangible assets, etc.), inventory methodology (FIFO or LIFO), and depreciation and amortization schedules, but the process of financial statement normalization is the same.
What Will the Market Bear?
“Everything is worth what its purchaser will pay for it.” So wrote a Roman in the time of Julius Caesar. And the saying was probably thousands of years old when he first heard it. The owner asks, the buyer bids, they come to an agreement. In our complex world, general market norms tend to dictate the price of goods and services, including your business. One of the most commonly used methods for evaluating a private business is an assessment of its EBITDA in relation to other businesses.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization (some professionals joke that EBITDA stands for Earnings Before anything bad happens). EBITDA is a more useful number than net profit because it measures the cash generation capacity of a business independently of the various accounting and financing decisions it has made. EBITDA is a rough proxy for free cash flow, Warren Buffet’s favorite measure of value of a business.
The valuation of a private company is usually expressed in multiples of its EBITDA in relationship to the following factors:
The industry: certain industries are more attractive than others. The New York University Stern College of Business periodically issues a list of the multiples of EBITDA paid for companies in different industries. For instance, alcoholic beverage companies, traditionally less sensitive to recessions in the economy, are able to be sold at an average of 19.93 times their EBITDA. On the other hand, upstream oil companies are being sold for an average of 5.59 times their EBITDA given current low oil prices.
The amount of EBITDA itself: the higher the EBITDA, the higher the multiple an investor will give for your business. This is because it is harder to find a company that generates 10 million dollars of EBITDA than one that generates 1 million dollars of EBITDA. A business with a higher EBITDA communicates to the market that it is a stronger business with more access to capital and less sensitive to the variations of the economy.
Timing: the economy is not static. The economy is dynamic and there are peaks and valleys. Peaks will drive up multiples of EBITDA and valleys will drive down these same multiples.
EBITDA is the figure you want to know and the figure you want to keep growing and growing year after year.
Identifying the Concessions
After you find what the market generally is paying for a company like yours, the next step is to discover if there are weaknesses in your organization that will require you to make concessions on your desired selling price. The technical term used by the market regarding concessions is “discounts,” and below we have a list of some of the factors that will drive some “discounts” on your selling price:
Owner Dependency: if the business cannot run without you, how is your company going to interest an outside investor?
Strong Concentration of Sales with Few Customers: you do not want to lose one customer and your business at the same time. Experts point out that you should not have one single customer responsible for more than 8% of your total sales.
Strong Concentration of Purchases with Only a Few Suppliers. Do not become the slave of a supplier!
Quality of Accounts Receivable: any potential buyer will apply an aging analysis to your accounts receivable and ask for a discount for any with an above-average number of days outstanding.
Expiring Patents: if your business model depends on a patent that is about to expire, you may not have a business anymore.
AgingFixed Assets: the need to replace outdated machinery will definitely cost you in the valuation of your business. A buyer will not pay this bill for you.
New Regulations: regulations can depress the profits of any industry. Think about the potential business impact of about-to-be-issued regulations from Congress on the electronic cigarettes industry.
These are some of the areas where you might have to apply “discounts” to the value of your company, but this list is not exhaustive. Every business is unique and has its own factors that will detract from its profitability.
Identifying the Premiums
If weaknesses drive the value of a business down, strengths do the opposite: they drive up the multiples an investor will pay for a business. Indeed, all the opposite factors to the previous list will work as sweeteners that will motivate buyers to pay a hefty premium for a company. Perhaps the simplest way to think of it is this:
Run your business as though you would sell tomorrow, even if your business is not for sale.
Imagine a car or a house that is for sale. So clean. So organized. In its prime. This is also true for a company.
If the answer is affirmative, you will be able to get investors to pay a premium for your company. Happily.
Summary
Becoming aware of the broader market value of your business is very important as it allows you to focus on the real factors that drive the value of your company. This process starts by normalizing the financial statements and by applying GAAP rules in order to have financials that can be audited by any CPA firm and easily compared with publicly-traded companies. The second step is to calculate the EBITDA of your business and find out what the market is paying for a business like yours. Last, but not least, factor in the concessions implied by the particular weaknesses of your company and potential premiums from your strengths. Knowing the true value of your business will give you an edge over the many other business owners in the market.