Exit Strategy -
Business Valuation is a Tool, Not Just a Number
Originally Published on the Beyster Institue Online Magazine
We value companies. We value strategies. We help business owners groom their business for sale. Over the next decade, demographics virtually assure that there will be many businesses sold or transferred to the next generation. Will you be ready? Will you have a competitive offering? Do you have any idea who might want to buy your business? Or why? Or for what price? Or how you would even suggest that your beneficiaries find out the answers to these questions in the event that you’re not around to answer them?
The fact that you are reading this article in a Beyster Institute forum suggests that your management and employees already do or may soon own equity securities of your company. Be it through direct holdings of stock (restricted or not), options, phantom stock, appreciation rights, etc., this represents a powerful incentive for them to grow the value of the business. It is also a possible exit strategy for you through the sale of all or a portion of the business to an ESOP.
As the owner, you should be thinking about your exit, whether it be years away or as soon as you receive that “offer that can’t be refused.” Making sure that the business is attractive and stays attractive is a worthwhile goal for owners and employees alike – because that impacts strategies and strategies impact business value.
What makes a business attractive?
What lets one business move quickly through the sale process and benefit from competitive bids while another sits with its current owner and languishes for years?
Consider a real estate analogy. Some businesses are fixer-uppers. These are bought with the hope that things haven’t gotten too bad and that the combination of a low entry price, a new coat of paint, necessary repairs and a lot of sweat will produce an attractive investment. Others are already in great shape. New kitchens, baths and family rooms have been tastefully updated and all operating systems are in perfect working order. Naturally, this latter combination will demand a higher price, but for those in a position to afford it, it’s worth every penny. The same considerations apply to a business. Some investors will relish the challenges of turning around a struggling business, but others will prefer to build on the strengths of a healthy operation. So, how do you make a business more attractive? You go ahead and fix problems in advance. How do you know you’ve got a problem? You compare your business with every other offering out there on the street and you compare it on the basis of fundamental value drivers.
The interplay between valuing a business and helping a business owner plan for its eventual disposition is interesting. Discounted Cash Flow (DCF) analysis and valuation methodologies show you what’s important in creating value and gives you a way of measuring it. Comparable company analysis and the analysis of similar acquisitions give you some metrics and guidelines as to what’s possible and also gives you targets – something to exceed if you want to be more attractive than the next guy. In this way, “What ifs…?” can be evaluated and turned into options. It also forces you to identify and address constraints. These are insights that you don’t get with static value indications suggested by a formula or an industry rule of thumb.
We have long worked with a family controlled multinational technology company, in which an ESOP holds a minority interest. Due to the number of employees, the fair market value of the stock is determined quarterly. Further, we present our analysis and conclusions to family owners and key managers/employees. Through questions (and challenges), owners see where and how value has been created (or lost) and gain a fresh perspective of how their collective efforts and investment turns into value. This interaction can be key to the aligning of interests between owners and employee/owners.
Operating, Financial and Ownership Strategies
A business valuation will generally address both operating and financial strategies. When grooming a business for sale, ownership strategies should also be addressed. Let’s explore these steps in light of an owner who would like to consider an array of possible exit strategies, including:
- Keeping the business in the family;
- Sale to a strategic or a financial buyer; or
- Sale to an ESOP.
From an operating perspective, the owner and any potential buyer (including the family) would want to understand how quickly the firm might be able to grow its revenues, what profit margins might be achievable and sustainable, how much investment would be needed in the way of working capital and net fixed assets to support the planned growth. These are the fundamental components of return which, when compared with risk, illustrate the attractiveness of a business. The continued attractiveness of a business, however, is always subject to change. As a result, both the owner and a potential buyer would also pay close attention to the availability and capabilities of management. A good management team (which includes both current managers and either successor management or at least a process for installing successors) will understand the unique competitive position enjoyed by the business and be able to modify that position as required by changing circumstances. Providing your team with an equity stake in the business is an added incentive, aligning the interests of all the owners.
Financial strategies should be designed to support operating strategies of the business while remaining consistent with ownership strategies. For instance, rapid growth opportunities for the business may require additional capital, which is inconsistent with the ownership strategy of taking capital out of the business. In the proper sequence, however, both may be accomplished.
Finally, ownership strategies should be developed with an eye toward risk, tax effectiveness and appropriate time horizons. An ESOP can be an invaluable contributor to a business owner’s understanding of his alternatives. The reason for this is straightforward. A business can be valued on the basis of its existing ownership and strategies, but there is no guarantee that a strategic or a financial buyer will be available at that moment to buy the business. In many circumstances, considerable comfort can be taken that an ESOP could be created to purchase some or all of a business. If this is a possibility, a significant benchmark is created.
More than a Number
So, a business valuation provides a realistic starting point for the market value of your business. A business valuation will also satisfy the regulatory requirements of the IRS or the Department of Labor (for an ESOP transfer) for a determination of fair market value at the date a transfer (gift or sale) of stock is made. But the real power of a valuation is as a strategy tool to build the value of the business such that when the exit finally takes place, it is at an enhanced value and your management team is focused with the right incentives to accomplish your objectives.