Driving the Valuation Multiple Higher

At its core a business’ value is simply the historical cash flow times a MULTPLE.  So, given an historical level of cash flow, how does a business owner increase the multiple that is applicable to his or her business?  First of all, it is important to understand that imbedded in this MULTIPLE are a multitude of factors about the business, the industry the business operates in, and the overall nature of the economic environment that affect the risk profile of a particular business.  Lower risk of ownership equates to higher valuation multiples and vice versa.  So, the key to increasing the multiple applicable to your business is to reduce the risk of ownership. 

Let’s explore what makes some companies worth only 4X cash flow while others are worth 7 – 8X or even more.  The key is to reduce buyer risk.  A more confident buyer is a more generous buyer and a less risky deal is a more highly valued deal.  Here are some of the factors that can reduce risk and increase the valuation multiple.

Quality of earnings is probably the most important factor for any buyer.  A history of consistent, reliable earnings can go a long way in making the potential purchaser comfortable that they can count on the historical level of earning continuing in to the future.  One of the factors that impacts this consistency of earnings analysis is the type of revenue generated by the business.  Revenue generally comes in one of three types; project based revenue, repeat revenue and recurring revenue.  When revenue is project based, each time a project is completed a new customer or project needs to be identified and won in order to continue the revenue stream.  This is the least valuable type of revenue.  Repeat revenues is characterized by a stable set of customers who do place repeat orders but there is no real certainty as to when the next order will be replaced.  The best way to describe this is a business with a loyal customer base.  Obvious examples of recurring revenue models are cable TV companies or home security monitor companies where the customers’ payments repeat periodically (typically monthly) and are frequently on auto-pay.  Ideally customers do not have to make a purchase decision every month.  The purchase is automatic.  To the extent a business can move from project base revenue to repeat or to recurring, they will see an increase in their valuation multiple.

Consistent positive trends will also have a positive impact on the valuation multiple.  Whether this consistency is in revenue growth rate, profitability margins, asset utilization or required annual capital investment, consistent trends reduce risk and increase the multiple.  Any volatility in any of these area increases risk to the potential buyer and reduces the valuation multiple.  I have frequently said that growth rates do not have to be large; but that slow steady growth rates are much more valuable than a large increase in one year followed by drops in the next.  Consistency is critical to value.

An established management team that does not rely heavily on the existing owner is one of the most important things a business owner can do to assure a potential purchaser that the business has a high probability of continuing on without a hiccup after a purchase.  By having a professional management team in place, the buyer has every reason to believe that the critical functions of the business will continue even after his or her purchase. 

Diversification is also critical to reducing risk and increasing the valuation multiple.  When you stop and think about it, we have all been taught to invest in a diversified portfolio to reduce risk.  The same principle applies here when preparing a business for sale.  For business owners, diversification can be a factor in many aspects of their business.  Two of the most common areas where diversification is a focus include the customer base and the supplier base.  Nothing hurts valuation multiples more that large customer concentrations.  The risk of losing one big customer or having one of your critical raw materials controlled by a single vendor can have a huge negative affect on valuation multiples.   

Well documented systems and business processes will also reduce the transition risk for a new owner and will increase valuation multiples.  To the extent that a selling owner can demonstrate they have a well-documented selling system, an established supply chain, well-documented procedures for hiring and on-boarding new hires, that they have key performance indicators (KPIs) that are monitored and drive action, and have up-to-date IT systems, they should be rewarded with a higher valuation multiple. 

Asset quality is also an important factor in increasing valuation multiples.  Companies with high quality accounts receivable (no collection problems), inventory that does not include any stale or obsolete inventory and that consistently invests fixed assets should see higher valuation multiples.  Businesses that have a high degree of deferred capital expenditures will see their valuation multiple depressed.  

Companies that can protect their market position with intellectual property should also benefit from higher valuation multiples.  Buyers are always interested in the barriers to entry that a company can create to keep competitors at bay.  To the extent that a business has patents, trademarks, copyrights or even trade secrets, they will be seen by potential buyers as reducing risk and should result in higher valuation multiples. 

Lastly, size can be a critical factor in reducing risk for potential buyers.  Universally, buyers perceive larger business enterprises as having a better chance of surviving threats from competitors, dependence on single vendors or even the negative affect of economic downturns.  To the extent that a business owner can continue to grow their business, they should be rewarded with higher valuation multiples.

Reducing the risk of acquisition as perceived by the buyer is critical to increasing valuation multiples.   

Alan D. Austin, CFA

2017 is a Seller's Market; If You Want to Sell, Now is the Time

We are frequently asked, "when is the best time to sell my business?"  There are many factors that go in to answering that question but they generally fall in to two broad categories:  Internal Factors and External Factors. 

The internal factors are factors that relate to the specific circumstances of the business and the business owner(s).  Some of these factors include where the business is in its lifecycle, the level of profitability, growth trends, the age and health status of the owner(s) and their need or desire for liquidity and the owner’s desire to reduced business risk.  These are topics we will discuss in a late article.

Today we want to discuss the external factors that are in play today that make 2017 possibly one of the best times to sell a business in last decade.  If you have been thinking about selling, we believe now is the time to pull the trigger.

Why are we so optimistic about the market opportunities today?  It does not happen very often but it seems that the stars are aligned to maximize value for the selling owner.  This is truly a “Seller’s Market.”  Here are some of the factors that lead us to this conclusion:

Business Expansion – We are in the 9^th year of the current business expansion.  I would be the first to acknowledge that it has not been the most robust expansion but that slow, steady growth is one of the reasons it has lasted so long.  Most businesses are performing as well now as they have at any point in the last decade.  In addition, most businesses have had a steady continued growth in revenues and profitability; two extremely important factors that increase value in the eyes of the buyers.

Economic Cycle – Synonymous with the business expansion described above are the economic cycles that are inevitable in any economy.  We are clearly still in a growth cycle but it will eventually turn the other direction, it is just a matter of when.  It is always better to sell a business during a growth cycle because at that point in the cycle the outlook for the buyer is better and they perceive less risk in the acquisition.  The perception of less risk for the buyer translates in to a higher price for the seller.  We don’t know how much longer this expansion will last so sooner is better if you are thinking about selling in the next several years.  If your industry is particularly susceptible to economic cycles, like home building or the related lumber and building material distribution business, then this is even more of a concern for your business.

Cost of Capital – Although we are beginning to see interest rates increase slightly they are still at historic lows.  Prime rate is currently 4.25% and 3-month LIBOR is only 1.30% both of which represent relatively cheap funds for business purchasers.  When buyers can access inexpensive capital like this to complete business acquisitions their overall cost of capital is lower.  As you know, a lower cost of capital equals higher value for the seller.  As interest rates continue to rise and the buyer’s cost of capital goes up the same business generating the same level of cash flow will become less valuable to these same buyers.  If the economic down turn is just around the corner, your business may be worth more now than it will be for many years to come.  

Access to Capital – Closely related to the lower cost of capital is the abundance of capital available for acquisitions.  Generally speaking, strategic buyers have benefitted from this long and profitable economic expansion resulting in reduced debt, stronger balance sheets and more cash reserves available for acquisitions.  Similarly, private equity and sub-debt funds continue to have successful fundraising experience and consequently have an abundance of capital available, specifically for business acquisitions.  Thirdly, the bank lending market is still hungry for loans and are anxious to lend for business acquisitions.  Consequently, buyers have access to the equity and low-cost debt-capital to fund desirable business acquisitions.

In summary, the access to abundant and low-cost capital and a continued business expansion makes 2017 a ‘Seller’s Market.”  In addition, avoiding the inevitable cyclical downturn that is certainly in our future makes 2017 the time to go to market.

When selling a business, engaging the right advisors is critical.  Here are just a few reasons why Mt. Vista Capital is the right M&A advisor for your business.

• A team of senior transaction advisors that handle the transaction from inception to close; no hand-of to junior associates.
• A broad cross section of industry experience including manufacturing, distribution, business services, technology, etc.
• A dedicated focus on serving the needs of owners and shareholders of privately owned middle-market companies, small-cap public companies and orphaned divisions of public companies. 
• A proprietary transaction process designed to bring multiple buyers and maximize value.
• The ability to provide in-house business valuations.

We are pleased to offer a complimentary business valuation analysis to any business owner that is considering a sale transaction in the next year or two.  Please feel free to contact us to discuss any of your specific valuation or transaction questions.

Alan D. Austin, CFA

Industry Focus – Registered Investment Advisor Firms (RIAs)

The transfer of ownership of Registered Investment Advisory firms is being driven by the same mega-trend that is impacting a large majority of privately held businesses; the aging of the baby-boom generation.  Many of the owners of RIAs are simply aging out or will be over the next several years and as a result will be looking for a way to monetize the value of their business.  Unfortunately, many of them will come to find they “own a job” with very little enterprise value to sell.  Depending on the number of years remaining until retirement, it may not be too late to focus on certain key value drivers that will increase enterprise value. 

Let’s start with the end game in mind.  What are purchasers looking for?  Generally, purchasers are looking for RIAs that have the following attributes:

• $500 million of Assets Under Management (AUM), or more
• A consistent investment process that is applied consistently across all accounts
• Consistent internally-driven growth
• An efficient, technology-driven business model
• Profit margins (after a reasonable owner’s salary) of at least 20%
• No compliance issues
• 100% fee-based business model

If this does not describe your firm now, what can you do now to head in this direction with the time remaining?  There are a few operational steps you can take quickly that will make a big difference.  First, migrate all of your clients to a fee based business model and get rid of your broker/dealer affiliation.  Being affiliated with a B/D detracts from value.  Adopt a standard, technology-driven approach to customer reporting that can be leveraged across an ever-increasing client base.  Do not agree to any customized client reporting, no matter how large the client.  Adopt a consistent investment process that utilizes as few CUSIPs as possible.  Also, limit the number of custodians you will work with to only 3 or 4.  The fewer custodial relationships you must manage and utilize for trading, the better.  Efficiency is the key in all of these areas.

Next comes growth.  Purchasers like to see a firm that is consistently generating annual growth of 10% or more.  This type of year over year growth takes a structured and consistent marketing effort.  It is imperative that you tell your story to as many potential clients as possible.  Set goals for yourself, and your other producers, for the number of meetings per week, month, quarter, etc.  Use a firm-wide customer relationship management (CRM) system to track and facilitate this marketing effort.  The mere existence of this CRM system will add value as it demonstrates a systematic approach to marketing that can be transferred.  Make sure your marketing materials are up to date, this includes your website, your blog and your collateral material.  Develop a PR campaign that positions you and your firm as the expert.  This can include speaking engagements, white papers, a blog, etc. 

Lastly comes financial and legal considerations.  I give this advice to every prospective client, regardless of industry; do not run personal items through the company.  Whether these are family members on the payroll or your college alumni association dues, take them off the company’s books.  In many transactions, these personal expenses are shown as proforma add-backs but many buyers to not give full credit to these add-backs.  This can be an expensive adjustment; potentially losing 5-10X the expense amount in your ultimate enterprise value.  From a legal standpoint, consider revising your client agreement so it is assignable.  In every transaction, the buyer will want to make sure that the existing client agreements can be assigned.  If they are not assignable you may have to go to every client and have them consent to the assignment before the transaction closes.  Maybe not a deal killer but certainly a difficult and time-consuming closing item. 

The value of an RIA comes down to three main items; size, efficiency and growth.  Value multiples vary over time but generally firms with $100 million of AUM will trade for 4-5X cash flow (after the owner’s salary) while firms with more than $1 billion of AUM could trade for more than 10X.  Firms with an efficient operating model that can be leveraged by a bigger firm or with a consistent growth track-record or both; will move themselves up within their respective multiple range.

Alan D. Austin, CFA

Attractive Acquisition Attributes – Part Two, Recurring Revenue

I will be honest with you, I am not a big fan of Revenue when it comes to discussing business valuation.  Multiples of revenue are frequently used to determine business value but I generally dismiss them as misleading or meaningless.  I am a firm believer that business value is driven by earnings.  I am also a firm believer that consistency of earnings is a major factor in reducing business risk and therefore increasing value.

Even though I do not place a great deal of reliance on revenue valuation multiples, I must admit that revenue is where earnings start and therefore the consistency of revenue can be an important value driver.  The reliability of a recurring revenue model is the epitome of consistent revenue and therefore consistent earnings.  Given the choice, a buyer will be much more attracted to a business with a recurring revenue model than one that is not.  One of the biggest concerns business buyers have in an acquisition is customer retention.  Businesses that can demonstrate a high level of customer retention, lower the acquisition risk for the buyer and increase the value of their business.

Recurring revenue comes in many forms and some industries benefit from it naturally.  The most obvious of these are industries such as the utilities, cable & internet providers, cell phone companies, security alarm monitoring companies and other subscription based companies.  Even software developers and IT companies have created recurring revenue models with the software-as-a-service business model and the annual service contract.  Consumers of these services are frequently called subscribers.  When you can realistically call your customers subscribers, it is safe to say you have created a recurring revenue model.

So, what do you do if you are not in one of these industries and the sale of your product is not traditionally thought of as a recurring sale?  Sometimes it is simply a matter of rethinking what you do and how you do it; and at other times it may mean you need to expand your product offering to include a recurring revenue component. 

The software development industry is a great example of rethinking their product offering.  Traditionally, software development companies would package and sell their product for a single, fixed price.  Then that industry came up with the idea of selling a maintenance contract along with the software sale.  The monthly, quarterly or annual maintenance fee became the recurring revenue component.  Then they migrated to the software-as-a-service model where they bundled the software and the maintenance as a single product with a recurring periodic payment.

A good example of the type of company that might have to expand their product offering to create a recurring revenue stream is a manufacturer or distributor of capital goods.  In addition to the one-time (or let’s call it periodic) sale of the higher-priced capital goods these companies began to offer maintenance services or even service contracts.  I recently sold a distributor of capital goods that also offered inspection services to support the equipment they sold. 

Be creative, rethink and see if there is some way to add a recurring revenue component to your business.  Recurring revenue does not need to be 100% of your revenue stream but to the extent you can create some component of recurring revenue you will definitely increase the attractiveness of your company as an acquisition candidate. 

Alan D. Austin, CFA

Buyers Buy the Future but Pay for the Past

There is a hand full of truisms in middle-market Merger & Acquisitions (M&A) and this is one of my favorites.  It explains so much about valuation and, even more importantly, sale price in one simple phrase.  Let me explain.

It is easy to understand that buyers purchase a business because they are excited about the future prospects of the business.  If they did not believe your business had a bright future they would “take a pass’ and move on to the next opportunity.  When we market your business, it is all about selling the future prospects of your business.  So, when we are successful in receiving an offer from a buyer, we have been successful in selling the future.  The buyer has bought the future.  This is critical in getting the buyer to say yes. 

How do most buyers evaluate the future?  They look at the past.  Their excitement (and our marketing strategy for your business) must be supported by the past.  Your historical financial performance must support your expectations of the future financial performance of your business.  More importantly, your historical financial performance must support the buyer’s expectations for the future financial performance of your company.  If there is a disconnect between your historical financial performance and your business’ prospects (as represented in a financial forecast), then we will have a difficult time convincing the buyer to “buy the future.”  When the financial forecast is aligned with the past, this ‘buy-in” is much easier.  Simply stated, the past is critical to supporting the future expectations of any buyer.

So, what does this mean for valuation?  As you probably already know, business valuation is simply the discounted present value of the expected future cash flows available to the owner.  The focus on future cash flows underlines the concept that buyer buy the future.  This is what they are buying; the future cash flows.  Indirectly, the negotiation of value (price) becomes centered on what is a reasonable expectation for these future cash flows.  The buyer’s expectation for these future cash flow is what will drive their perception of value.  So, when the expectation of future cash flow is consistent with the past, the price reflects both the past and the future.  But if the expected future cash flows, as represented by the seller, are much rosier than the past, we find that the buyer’s offer is based on the past.  In both cases, they are paying for the past.  In one case the past supports the seller’s representation of the future and the asking price is largely obtainable; and in the other, the past does not support the seller’s representation of the future and it will be difficult to achieve the asking price.

The take away is to make sure that historical earnings support the seller's forecasted cash flow and therefore the seller’s value expectations. 

Alan D. Austin, CFA

Low Risk is the Key to Valuation - Part One

In this two part article we will discuss what really drives business value and what a business owner can do to impact their value when they ultimately sell their business.

For many business owners, business value is a multiple of adjusted EBITDA (earnings before interest, taxes, depreciation and amortization).  At a fundamental level that is a correct assessment.  Purchasers buy cash flow and are willing to pay a reasonable price based on the risk associated with the continuation of that cash flow (EBITDA).  So the logical next question is "what multiple should be used?"  The multiple is an indication of the risk to the purchaser in purchasing the business' cash flow.  Whenever any of us make any investment, we hope to earn a return that is commensurate with the risk of that investment. The business purchaser is no different.  The higher the risk the lower the value and vice-versa.

So, how is a multiple an indication of the risk associated with purchasing a specific business and its related cash flow?  Not to get to mathematical here, but multiples are simply a convenient way of expressing the actual rate of return required to entice a purchaser to acquire the business; the return commensurate with the risk.  In business valuations we call this the Capitalization Rate.  For example a four (4) multiple is the inverse of the rate of return or 25% (1/4, the inverse of 4).  Similarly a five (5) multiple (the inverse is 1/5) is 20%.  A lower risk, as represented by the 20% required return, produces a higher value (5 times) than the higher risk represented by the 25% return (4 times).  In a separate article we will discuss how we develop the appropriate multiple for a specific business.

If risk is the primary driver in establishing value and more specifically if lower risk leads to higher value what are the factors that reduce the risk to the purchaser in acquiring a specific business and its related cash flow?  Stated another way, purchasers want to acquire a business where there is a high degree of confidence that the cash flow will continue on an uninterrupted basis; low risk.  At the fundamental level purchasers want to purchase consistent, diversified, recurring cash flow.  In part two of this two part article we will explore some of the specific factors that can lower risk.

Alan D. Austin, CFA
Graham Patterson

Low Risk is the Key to Valuation - Part Two

In part one of this two part article on business valuation we explained how the risk associated with the consistency of the acquired business' cash flow is the primary driver in establishing the business' value.  As we stated in the part one, purchasers want to acquire a business where there is a high degree of confidence that the cash flow will continue on an uninterrupted basis; in other words, low risk.  When the purchaser perceives a higher risk associated with the continuation of the historical cash flow of the business they respond with a lower price.

If lower risk is the key, let's explore some specific factors that can lower the perceived risk associated with the  continuation of the business' cash flow, post-sale.  Below are some of the factors that can impact this perceived risk:

Consistency - Generally, consistent positive trends in all business metrics and more specifically in revenue and earnings is probably the single most important factor in reducing risk to a purchaser.  Based on consistent positive trends, they will be comfortable that the earnings capacity of the business will continue after the purchase.

Management - Businesses that have a management team as opposed to an owner who runs the day-to-day operations of the company will be perceived as less risky.  Having a management team in place that can continue to run the daily operations after the sale, reduces the risk that earnings will decline after the sale.  It also opens the door to financial purchasers who want to buy companies with a management team in place.

Diversification - A diversified customer base; diversified supplier network; and a diversified product line, just to name a few, all reduce the risk of the business purchase for the purchaser.  Frequently described in its converse as concentration, purchasers are always interested in understanding if revenues or earnings are concentrated with only a few customers.  Likewise, they want to make sure there are adequate sources for critical raw materials or supplies. 

Asset Quality - The age and quality of the asset base can be a factor in evaluating acquisition risk.  A relatively new asset base that is well maintained communicates a culture of continuous reinvestment and attention to maintaining quality.  

Size - This is somewhat intuitive but larger companies tend to command a higher multiple simply because of their larger size.  This is because larger companies are perceived to be better able to withstand competitive pressures or financial challenges that may arise from time to time. 

Commodity vs. Value-Added Products - Clearly there is a place in the world for companies that produce commodity products.  Generally these types of companies have to differentiate themselves based on efficiency, quality and price.  Having acknowledged that, there is the perception that a company that has a proprietary process or produce is less risky to a purchaser.

This is not a complete list but it serves to illustrate some of the factors that can reduce the perceived risk for a purchaser, lower the capitalization rate and therefore increase value.  None of these items are absolutes but to the extent a business owner can develop some of these characteristics in the years leading up to a sale, it will surely add to their overall enterprise value.

Alan D. Austin, CFA
Graham Patterson