Recently, I was asked to speak to a group of CEOs of mid-sized companies regarding EBITDA and its importance to them as business owners. Several questions from the group centered on what I will loosely call “tax avoidance” and “tax deferral” practices commonly employed by owners of privately held companies. The questions focused upon the impact of these practices on the value of a business. The common theme from the audience was, “buyers understand owners do not want to pay taxes and they are willing to adjust for these practices.”

I reminded the group that buyers, or anyone who is reviewing the performance of their companies, will only be able to evaluate what they can see. If you are writing off inventory, expensing personal items, or employing any of the myriad other “tax avoidance” practices, you do a nice job of lowering your tax burden, but you may not be able to get a return on this “investment” when you look to “withdraw” these funds. All of these practices impact your cash flow positively for you, but not necessarily for those evaluating your company.

One of the CEOs said to the group, “I never thought about this until I needed to borrow money this year to support our business. We have plenty of assets, and I thought a loan would be easy. Every bank we spoke to turned us down because our cash flow was so low. I tried to explain about our inventory being undervalued and the family vacations I paid for out of the business, but the bankers were not interested. You can be sure in the future, I will show the profits, pay the taxes, and make my life easier.”

If you never plan to sell your business, never plan to borrow money and never plan on being audited by the IRS, you have no worries. However, if you might ever consider selling your business (even to an insider), might find yourself in a position to borrow money, or have the unfortunate opportunity to meet with your local IRS agent for an audit, the more transparent your earnings, the better off you will be. Of course, you can pay yourself a huge salary and/or bonus, everyone can see the impact of this on the business. This adds to transparency. We call this investing in taxes. Otherwise, with limited transparency, your options are limited as well.

posted by Jim Zupursky

I think Gary has done an excellent job of summarizing the valuation process. However, I feel that he and many others that have written about “valuing” your company have made the explanation too complicated or mysterious.

This writing is an attempt to simplify the explanation of this process and to provide a conclusion that hopefully gives potential clients more comfort that professional “intermediaries” like CFA can provide very reasonable estimates of what their company will be worth.

I am “certified” by NACVA (National Association of Certified Valuation Analysts), which required a great deal of study, testing and experience and as such, I feel I have learned to navigate the valuation “maze” more effectively.

The first and in many respects the most important question of a valuation is “what is its ‘purpose?’” While there can be many reasons for a valuation, the purpose for our clients is the sale of their company (all or part) and as such we will be using the Fair Market Value Approach. This is defined to mean “willing buyer, willing seller both acting with the same information and no compulsion to act”. While academic it is very practical when combined with the market experience of professionals like CFA that have seen hundreds of transactions during their careers. I will only say that other “purposes” such as estate planning will use different approaches, which lead to different methods mentioned in Gary’s article.

The second important point is the clarification that “valuing” companies for sale involves demonstrating that the company is a “going concern” and has a value greater than the “liquidation” value of its assets which as Gary pointed out is generally accounted for as “goodwill”. This eliminates the Cost Method and the Adjusted Book Method which is simply my recommended method in disguise.

The last important point is that a “certified” valuation is based on a debt free basis and that the payment to the seller is all cash at closing, which of course rarely happens.

With these clarifications (or are they complications?) I will now provide my explanation on how to estimate “value” in the real world.

The value of a company is the value of its “future” profitability to a willing buyer. Now there is the real rub! What is the “future” profitability going to be? That could be another Blog topic.

For now, let’s assume that future profitability will reflect a reasonable correlation with the historical results.  Two notes at this point: One, most Business Owners strive to minimize taxes and as such the “profits” will have to be “restated” to reflect profits if certain expenses had not been incurred. Two, the term “profits” is more fundamentally meant to be “cash flow” (another blog topic).

Let’s assume that sales and “profits” have been up and down over the past five years but generally they are moving in a positive direction. By developing a “trend” line of the past we can project the “future” sales and profits. The value of the company (debt free) will be determined by discounting future “profits” to determine their “present” value. While determining an appropriate discount rate is not precise, a company’s “cost of capital” (discount rate) falls within a fairly narrow range. One additional factor that influences the discounting is the companies “growth” rate of its profits.

As an example, most companies that CFA deals with in the lower middle market ($5 to $50 mm valuations) will have a “cost of capital” between 20 to 25% depending on its size and the nature of its business. This discount rate will be lowered by the company’s growth rate (if positive). Let’s assume the growth rate is 5% and that its cost of capital was 25%, then its discount rate would be 20%.

My conclusion is therefore, that I am comfortable stating that a skilled intermediary such as those at CFA should be able to use your historical financials (past 5 years) and a brief interview with you about your company and its industry to give you a very reasonable estimate in a narrow range. This will take some time but should involve less than 10 hours. As an example let’s assume that a company’s profit (cash flow) was expected to grow at 5% rate from $3 million in 2008. With a cost of capital of 25%, a 20% discount rate would produce a reasonable estimate of $15 million (i.e. a 5 multiple). Typically, I use a plus or minus 10%, yielding a range of $13.5 to $16.5 million.

One of the important services that intermediaries like CFA provides is the creation of a competitive process whereby several “very interested” buyers drive the price to the high side of the range. Lack of competition tends to move the price to the lower side of the range which typically happens when sellers negotiate with a single buyer.

All of the other methods mentioned in Gary’s article are interesting but somewhat academic. The “Market Approach” is very limited in its real world applications, although heavily used for practitioners who do not have the experience of many CFA professionals. All transactions that do not involve a public company are not made public. 98% of CFA’s transactions are in the private domain and are confidential. Most private company “databases” are suspect for several reasons. First, they do not adhere to the all cash at closing requirement because of earn-outs or seller financing. This typically overstates “multiples”. Because the information on private transactions is confidential and unverifiable, this typically leads to overstatement. While I do think transaction databases are useful by “skilled’ intermediaries, I think the DCF Method is the most reliable.

The single period Capitalization Method is nothing but a simplification of the Multiple Period Discounting Method if you understand the math.

In closing, I want to use today’s economic environment to explain how the DCF Method makes “common sense”. Most companies “profitability” are down and the cost of capital for most companies is up because of perceived higher risk. This yields a lower valuation than would have existed in late 2007 and early 2008.

Don’t let intermediaries leave you in the dark on your company’s value. While you may not like the answer; hopefully, you will respect the competence of the messenger.

posted by Lee Crawley

Traditional business models and financial investments have lost effectiveness, allowing a higher demand for alternative strategies and investments.  Private Equity groups are tentative to invest because of the risk coupled with difficultly accessing debt to leverage the scale of their investments.  An alternative investment like a Management Buyout (MBO) presents an appealing opportunity to private equity. Why?
First, the “baby boomer” generation is reaching their retirement age and ripe for an exit strategy with a structure that creates choices for owners. Second, investing in the current management team to take ownership allows for a familiar and friendly transition, and in turn a more reliable and sustainable future for the company. Lastly, the trends in buyout valuation, debt capital, and equity capital are all enablers of MBOs for owners who want to control their destiny at the times they wish to exit, as well as the values at which they prefer to monetize their business’ value.

Baby Boomers make up 28 percent of the US population and 77 percent of the financial assets in the US are controlled by the baby boomers.  Baby boomers in ownership do not have to conform to company retirement regulations and plans, so they are free to retire when they desire, most likely sooner rather than later in this current environment. However, retirement in the current marketplace is more uncertain than it has been in the past. Asset management firms investing in “safe and reliable” stock and bond portfolios have historically managed typical retirement funds. USA Today reported in October 2008 that retirement portfolios have lost 2 trillion dollars (20%) in value, and that workers are beginning to withdraw funds from retirement accounts in fear of more losses.

An MBO provides a comfortable alternative exit strategy because of the secure financial gains heading into retirement and the comfort and familiarity of passing the company reigns to the current management team. Creating a greater level of certainty is mutually valuable to both private equity investors and owners wishing to exit at the values they desire for retirement.  For all owners, it is not only a question of price when selling your business, but also about structure of the terms agreed, which are more optimum in an MBO transaction, given the familiarity with the risks and the upside of the target company between seller and management/owner.  It is very valuable to discuss your options on the value and structure one can achieve in this market via an MBO transaction opportunity.

posted by Gianpiero (JP) Balestrieri

Those numbers don’t sound like good news for company owners who are ready to sell their companies, but that’s past.  The question is, what is coming?

While the history is dark, the silver lining is in the external market factors, like these:

• Strengthening public stock market values are waking up strategic buyers who need to make acquisitions to grow
• Low buyouts over the last 18 months mean that private equity investors are more hungry than ever to put their $400+ billion of uninvested funds to work by doing deals
• It is beginning to look like the worst of the recession may be behind us
• Valuation multiples, reported by AM&AA at 4.7X EBITDA can only go up

The market for under $100 million companies has always been cyclical.  This may indeed be the bottom and we are in the beginning of the upswing.

posted by John Hammett

Reality Sets In

In 1999 or early 2000 at the height of the dot-com boom, this scenario may have ended with a happy outcome.  Venture Capitalists, having read all the publicity and anxious to get on the train, fund a Series A round based on generous pre-money valuations, little to no due-diligence and guidance that the money is to be used to expand hiring and spending at an even greater rate.  That was then - now we are in a different world.

Following the dot-com bust and two recessions between 2000 and 2009, most entrepreneurs understand that raising capital is now a significant challenge and not every company has a business model like Google, Facebook or Twitter – with the ability to command sky-high valuations and investor money.

Five Winning Strategies

Successful or not as an early stage company, consider these five winning strategies that will keep your company in the game through good and bad times:

• Stay focused on Revenue Traction – savvy investors demand and look at revenue traction as the most important metric in their decision to invest in early stage companies.  Consistent growth in revenue is more important than the immediate quest for profitability.  Investors aside, having revenue streams that are stable and growing will also be a satisfying affirmation of the value proposition embodied in your business model.  And, don’t be shy in thinking “outside the box” or in revisiting your business model to keep this notion alive and well at all times.

• Manage Cash Burn – this has to be more than just keeping head-counts or other expenses under control.  The management team has to pro-actively find ways to outsource work to lower cost centers, maximize their use of partner resources and even structure deals that provide customers the incentives to do some of the work.

• License the Technology – most early stage companies are unlikely to see customer or revenue traction from overseas operations if the primary focus of operations is the domestic market.  Unless you have a product or service that can immediately attract customers from around the globe, consider licensing the technology platform to an overseas partner – for one-time licensing fees and a royalty revenue stream – on a country or regional basis – and let your partner manage the headaches in that country or region.  If your business model supports it, consider licensing technology from another company before you build it in-house.

• Use Board Members for Strategic Work – a great way to manage the cash burn is to use Board members, especially with specific skills – legal, business development, technical – that can provide an assist in a pinch.  If necessary, compensate Board members with additional equity.  And, always use Board members to raise capital.

• Hire a great Investment Banker – to raise capital and to provide an assist with technology licensing among other tasks.  Hiring a banker can be a wise investment and free you to focus on your business. Fees are largely success based and in some cases equity participation may be included in the fee structure to reduce capital outlays. Investment Bankers with a good understanding of technology and finance can really make a difference in accelerating your success as an early stage company.

Case Study

Situation: Twenty years following the launch of ConArt, a manufacturer and erector of precast architectural and structural components, Mr. Lyle found himself seeking to sell his company during the height of one of the country’s worst economic and construction industry downturns in recent history.

Solution: Faced with an unusually difficult engagement, CFA prepared a detailed geographic and industry sector analysis, which was effective in presenting the fact that ConArt was not suffering from the effects of the construction industry downturn. Bolstered by the in-depth report, KT Capital Partners, a private equity fund, acquired a company that is strategically located and positioned to take advantage of a vast number of growth opportunities in Southeastern United States.

Akin to the underlying transformation in corporate objectives, the challenge with the project finance strategy is that the investment is made upfront while the anticipated benefits of the initiative are realized in the much longer term.  It is imperative to identify and prequalify sources of funds that can thoroughly understand the underlying changes being implemented by the prospective borrower(s) and project sponsor(s), and to achieve a comfort with the future cash flows arising from the collateral package of project investment or captive acquisition.

Originating and arranging long term financing in the current global credit environment is a daunting task when trying to get lenders comfortable with such a complex and flexible project financing strategy.  It is critical to create financing structures that include a collateral package of assets and contractual arrangements that capture a bankable flow of cash to service the debt, operating and capital expenses of project, while providing robust returns to the sponsors/company.  It is equally important that companies or project sponsors meet their objectives of keeping such capital intensive assets off their balance sheets and that the financing structure and terms limit or preclude recourse to their corporate balance sheets.

In sum, project finance is usually based on non-recourse or limited in recourse structures to the balance sheet(s) of corporate sponsors, whereby project debt and equity (and potentially leases) used to finance the project are paid back from the cash flow generated by the project, with the project’s assets, rights and interests held as collateral. In other words, it’s an incredibly flexible and comprehensive financing solution that demands a long-term lending approach not typical in today’s credit strapped marketplace.

Many project financings require credit enhancement due to the overwhelming asset class size and capital expenditure, the heightened political or credit risk in certain emerging market countries, and/or local or regional financial institution capacity to provide debt service on such projects. This entails working closely with established local and foreign relationships in government agencies and multilateral organizations to fortify the creditworthiness of a project and related asset classes. It is critical to be closely advised on the required political risk insurance, bank guarantees, public debt and equity participation, among other vehicles to provide credit enhancement for projects.

Advisors and project sponsors should work with local, state and federal government agencies as well as multilateral agencies and development organizations to support their projects. For more information, please refer to my article on Project & Public Finance Strategies (PDF) or leave a comment here.

Several CFO’s have recently asked me “When will the capital markets “return to normal?”  My answer is:  Not this year.  Therefore, if you are a C-level executive that wants to obtain funding for your company, you might consider leveraging your company’s top-line gross revenues with a new form of financing structure from Entrex, Inc., based in Chicago, and Bank of New York/Mellon, and made available to you through your corporate finance investment banker.

The current reality is that talk by traditional banks about low interest rates is not solving your cash flow needs, particularly when stricter lending requirements have reduced the amount of your working capital line or term loan.  Also, selling or giving up equity at a today’s reduced valuations is not attractive, which explains why raising equity capital in the types of private placements typical a few years ago, are not getting done.  As a result, unless your company is distressed (and, therefore, attractive to vulture investors), then you are most likely frustrated with your inability to access capital for growth and recapitalizations.

One attractive and innovative financing solution that middle market companies might consider is obtaining lump sum capital in exchange for giving the investor a monthly fixed percentage of the company’s top-line (GAAP) gross revenues for a finite period of time, or perpetually. Traditionally known as royalty based financing, this form of financing is accomplished by a company issuing securities known as Top-Line Income Generation Rights Certificates (aka TIGRcubs™) under a license from Entrex, Inc.

For private and public companies with positive cash flows, annual revenues between $5M - $250M, relatively strong gross margins, and promising future revenue growth, TIGRcubs™ appear to be a well-suited corporate finance solution. The main advantage for companies issuing TIGRcub™ securities is that there is no equity ownership dilution to the current shareholders.

This top-line focus to derive investor returns elegantly avoids today’s awkward company valuation discussions, the difficult analyses associated with estimates of future EBITDA results, and the liquidity discount often applied to illiquid private equity valuations. Instead, investors, who receive a fixed percentage of the company’s variable gross revenue, truly become aligned in promoting company growth.  Variable payments enable companies some relief if cash flow drops, at a time when they need it most.

Entrex, Inc. is institutionalizing this form of financing, and intends to operate a secondary exchange for trading of TIGRcubs™, which should cause more institutional investors to make allocations to this type of security.  However, for companies interested in issuing TIGRcubs™, the first step is to begin working with an investment bank (namely, Corporate Finance Associates) which is specialized licensed by Entrex, Inc. to sell TIGRcub™ securities, and who can show you a spreadsheet comparing the cost of capital for issuing TIGRcubs™, versus issuing other forms of securities or taking on additional debt.

Download my article titled Obtain Financing By Leveraging Your Company’s Top-Line Revenues to learn more about how TIGRcub™ financings are now getting done in the new economy, or for more information visit: financing options for middle market companies.

Under section 368(a)(1)(A), the Internal Revenue Code defines a type A reorganization as a “statutory merger or consolidation.”  Besides meeting the definition of a statutory merger or consolidation, there is a continuity of interest requirement.  As provided by the treasury regulations, this requirement will be met if at least 50% of the consideration received is stock (under case law, 40% stock consideration will meet this requirement).

Up until just a few years ago, a statutory merger or consolidation was limited to domestic transactions that are subject to the corporation laws of a state, a territory, or the District of Columbia, which are part of the United States.  In 2005, proposed regulations were released that expand upon the statutory merger or consolidation requirement.  The proposed regulations disposed of the requirement that only domestic transactions will qualify.  As long as the statutory merger or consolidation satisfies the criteria that are often found in domestic statutes, then a foreign transaction will qualify.  Since many foreign jurisdictions do have merger statutes in place, this change in the federal tax law opened the door to favorable tax treatment for cross border transactions.

In 2003, regulations were issued that expanded upon the type of entity included in the definition of a statutory merger or consolidation.  Before 2003, an entity had to be a corporation.  Under the regulations, subject to various restrictions, a limited liability company can be a party to a merger transaction in a type A reorganization.

As with any material transaction involving tax consequences, it is wise to seek counsel from a competent tax professional before entering into a merger or acquisition transaction.

Press Release on PR Leap