Knowing the value of a business and delivering real value to a client company entails far more than using EBITDA multiples or going along with a rule of thumb to keep the peace. As professionals, valuators must be far more rigorous in their engagements, and focus on delivering value. The obligation to identify, measure, manage, and mitigate the risks are their responsibility. In this candid analysis, Dr. Carl Sheeler shares some insights, based on his 1,000+ engagements, where he has found problems that led to disputes, misalignment of expectations, and company-specific risks that impair value and value creation.
In addition to contributing to family and equity holder acrimony, the list below contains representative items that lead to disputes and shareholder value impairment, as well as client and advisor expectation misalignment.
Most items are not found on financial statements because a company is dynamic, and these do not lend themselves to quantification. These issues of operations and strategy require more than ad hoc knowledge of accounting and finance.
Both enterprise and equity level values must consider company-specific risks (listed below) in order to arrive at a reasonable investment rate of return! This requires intellectual rigor. It's also expensive, but the costs are outweighed by the value to the entrepreneur.
The percentages shown on each line below reflect the approximate frequency of occurrence of each risk, as I experienced them during the 1,000+ engagements I have conducted during the past 20+ years. The opportunity to identify, measure, manage, and mitigate these risks are yours; you can add value for a company if you recognize these risks.
"Think of the untapped potential. If you could demonstrate to a client not only what their value was, but why and what could be done to change the result, now that's real value!"
Company owner thinks that a $25-million-annual-sales business is worth $20 million. The controlling shareholder has no knowledge of whether revenue growth has been from higher sales due to costs passed on to clients or if the company has been losing 10 percent of recurring business and gaining a net 5 percent growth, of which most was from weaker competitors going out of business or their clients going elsewhere. In the past no effort has been made by consultants or the attorney(s) to dissuade the controlling shareholder from using rules of thumb or the golf-buddy's own price multiple, based on a 2006 sale. Furthermore, the controlling shareholder is unable to provide a rationale as to the reinvestment of discretionary cash, the type and amount of insurance purchased, or verbalize what is the optimal amount of debt. If that is not enough, this controlling shareholder has not had a discussion with his or her accountant or attorney as to future plans. Unbelievable, but this is all too common.
Based upon historic and forecast performance multiples for the past five to 10 years, the price multiples ranged from 20 percent to 80 percent of revenues and 2.5 times to 7.5 times for EBITDA. In my experience, the appropriate multiple is unlikely to be the median (midpoint) pricing of 50 percent of revenues and 5 times of EBITDA; yet again, that is all too commonly done. Equally, there are those pesky issues of market and operational performance-growth rate, existence of debt, and whether the buyer is synergistic or financial, as well as the terms of sale and tax planning. Just plugging in the numbers without identifying the whole host of considerations and understanding the buyer pool is a disservice to this controlling shareholder.
Company purchase price is based upon as is, not based upon what it could be under new ownership, except for synergistic buyers. The synergistic buyer will endeavor to gain economies of scale and reduce redundant operational costs; otherwise, the buyer has overpaid. Both entity and equity level values must consider company-specific risks in order to arrive at a reasonable investment rate of return!
The above list of risks and the pseudo rationale of selecting medians and means will likely harm clients, the immediate advisors (attorneys and accounting firms that stand by), and our profession. The purpose of the Income and Market Approaches and the methods and techniques applied is to capture the perceived level of risk of the notional investor as of a specific period of time. A paragraph or two and sometimes three or fewer sentences are all that is expended to express how the level of risk impacts the discount/capitalization rate and price multiples. I believe that this type of analysis demonstrates inadequate intellectual rigor. Purchasing books on discounts and premiums or cost of capital can't replace the genuine need to understand how operations, finance and strategy are the three legs of what makes a company tick (or not). Think of the untapped potential. If you could demonstrate to a client not only what their value was, but why and what could be done to change the result, now that's real value!
Carl Sheeler, PhD, ASA, CBA, AVA, has over 25 years of public and private company experience with business disputes/disruptions and well as transfers, transactions and transitions associated with Intergenerational Planning, Equity Transfers with Estate and Gift Tax issues, as well as Partial and Full Liquidity Event Options.
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