Valuation in Buying or Selling a Business
By Matt Dickstein
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Both the buyer and the seller should value the seller’s business (the target). Buyer does so for obvious reasons, and target does so to determine the asking price for the business.
In buying a service industry business, there are 2 common methods for valuing the business: discounted earnings, and comparable change of control transactions. To the extent both methods are available, buyer will use both. Usually, however, buyer will rely more on the discounted cash flow method, because insufficient market information will be available to fully use the comparable sales method.
You ordinarily don’t buy a business as an “investment” (you invest in the public markets instead). You buy a business because you want to run the business or you see a special fit between the business and your current operations.
Now, the basic question for buyer is, given its projected uses for target and its objectives in acquiring target, what is target worth to buyer? The earnings method explained below helps make more clear target’s intrinsic worth, and the comparable sales method helps buyer know that it’s in the right ballpark. Although both valuation methods can assist buyer, the real analysis for buyer will concern buyer itself – what are buyer’s objectives for the acquisition, and what does buyer hope to obtain by virtue of the acquisition? Target should know buyer’s objectives as well, because target will receive a premium purchase price to the extent it can help buyer meet those objectives.
Discounted Cash Flow Method.
In valuing a service firm, the No. 1 factor is determining the earnings potential of the firm. There is no magic formula, buyer simply takes earnings and multiplies it by a factor that takes into account risk and premiums. In other words, buyer bases price on a multiple of EBIT, and to determine the multiple, buyer considers factors like the stability and skills of the worker base, the stability and attractiveness of the customer base, and market penetration. In the end, buyer wants a firm with an established client base, a proven revenue stream, and a stable core of employees.
That said, I do have a model for valuation that helps you see the factors and how they fit in. Real world valuation is much more complex than my model, however. Use the model only to see how the pieces of a valuation analysis can fit together.
Basic Principal: Value a business at the present value of the expected income stream over a term of years. That is, quantify the future income stream, then discount for risks and add in for premiums, then calculate present value.
Step #1: Calculate Earnings. Start with complete financial statements for the past 3 years, the owners’ tax returns for the past 3 years, and current agings of accounts receivable and accounts payable.
EBIT does not take into account how target’s financing, leverage and taxes have affected its earnings.
Now adjust EBIT, because service firms usually are smaller companies that can and will be flexible in financial matters. For example, the owner may have been anticipating a sale of the business, and therefore may have been pumping up earnings by not making needed capital expenditures. Reduce EBIT for capital expenditures that should have been made. Also reduce EBIT to account for the cash needed to bring working capital up to a secure level. On the other hand, owners try not to show a profit for tax purposes. Instead they expense out profits in the form of salary and perks. Increase earnings to the extent paid out as extra salary and perks.
Step #2: Project Over a Term of Years. Next, estimate the duration of the EBIT income stream. For a service firm, you can base the duration of income stream on the average retention of each client, where you weight the clients based on their dollar billings, and on the average retention of billing employees. Because a stable client stream and a stable employee base are difficult to build, buyer might consider applying a multiple to the average retention.
Step #3: Calculate a Projected Income Stream. The result of the above calculation is a number that reflects target’s projected income stream: “EBIT X years.”
Step #4: Discount for Risks. Here you express risk as a capitalization rate, that is, you express each risk as a percentage and apply it to the “EBIT X years” number.
Client Loyalty to Individual Principals. It’s not easy replacing an owner / operator. Target can mitigate this risk by having the principal stay on as a consultant, retaining the principal as an employee and using no-compete agreements.
Employee Mobility. Target and buyer can work together to see that key employees will remain with the firm after the transaction.
Corporate / Legal Issues. All shareholders should have clear title to their shares, and be willing to sell. Target should have cleared up all litigation and other claims against it.
Earnout. Because it’s so difficult to quantify risk, most buyers adjust for risk by using an earnout. Target should take all measures possible to mitigate risk prior to negotiations. Target’s preparation can reduce or eliminate the earnout.
Step #5: Add in Premiums. Just as with risks, you express reward as a capitalization rate. Target gets the maximum purchase price by showcasing its value. Different buyers will see different values in a company, and will be willing to pay different amounts. For example, a buyer that only wants the hard assets of a business will pay a low, liquidation value price. Buyer will pay a premium if it wants to take over target’s business and income stream, or if it sees a critical fit between target and buyer’s future growth.
Attractive targets have a value that is hard to replicate. Buyer will buy target to get the value, that is, buyer cannot practically or quickly develop the value on its own. Examples of factors that create a premium purchase price include:
Synergies between Buyer and Target.
Special Expertise. A service firm’s primary income generating asset is its skilled, billing employees. The question is, how much are the people in the firm worth in terms of their ability to generate income? Typically, the more specialized and technical the skills of the employees, the more valuable the firm is.
Turnkey Operations. Look for a stable employee base and stable operations.
Attractive Client Base. Look for stable “institutionalized” clients, with cross-selling opportunities.
Good, Long Term Lease.
As for finding a buyer that is willing to pay a premium, target’s best hope is its own hard work. Well in advance of the estimated time of sale, target’s principals should be out talking to friends and competitors in the industry. The subject of conversation is not target’s impending sale (which should not be revealed), but rather about the industry itself and how a firm can grow to best take advantage of opportunities. Merger and acquisition ideas will naturally come up, based on strategic fits. And now target has found its premium.
Step #6: Calculate Present Value. Calculate the sum of money that today would equal the total purchase price calculated above over the term of years. The discount rate can be the 1-year Treasury Constant Maturity.
Comparable Sales Method.
The market / comparable sales method for valuation requires an active, transparent market, and an exchange of comparable businesses. The best example is the home real estate market, where comparable sales exist just down the street. Unfortunately, for us, no two firms are the same, buyers have different purposes for the acquisitions, and the market is not transparent. In sum, it is very risky to base a purchase price on a comparable sale. That said, however, we recently have seen and heard 2.5X (more or less, but prior to the recent downturn) as a common multiple over EBIT for the sale of an IT firm.
You also can use the following websites for transaction data and comparable prices:
Factor in Costs of Financing the Acquisition.
Buyer should take into account its costs of financing the acquisition. That is, the expected rate of return from the acquisition should well exceed its costs (such as interest or equity dilution) in obtaining the funds used for the purchase price.
Additional Calculations for Purposes of Comparisons within your Industry.
Once you have the basic measuring stick (EBIT), you can do more calculations. First determine the service firm’s profit margin. Use profit margin for comparisons with target’s prior years to see if it is getting more profitable, not just bigger. Also use profit margin to compare with other service firms in the industry. You are looking at profitability and operational efficiency.
Next, use EAIT (earnings after interest and taxes) to get to target’s bottom line. Here determine taxes at the standard rate, not target’s actual rate.
Finally, determine the service firm’s net profit margin. Net profit margin shows how much profit buyer can expect to derive from target on a yearly basis.