Valuation approaches

‘Corporate finance’ as a discipline tries to maximise the value of the firm by (a) investing in assets that earn a return above its hurdle rate, (b) optimising the mix of debt and equity to fund the firm, and (c) returning money to shareholders in the form of dividends or share buy-backs if the firm can’t succeed at (a). The ability to do this depends on treating your business like any other unemotional investment and also on having sound financial information through regular management accounts and audited financials. Reliable data allows rational decision-making.

This week we’re going to discuss valuation, something most people only think of when they are trying to buy or sell a business, or when raising capital. We like valuation for another reason: there is really no other number that reflects how the decisions we make and the actions we take today affect the value of our business in the long-term. So when we have a means to calculate the valuation of the business at any time, and when we understand what drives this number, then we have a way to test the effectiveness of the ValuationUp tools mentioned above, and which we’ll go into in depth in the weeks to come.

You’ll be pleased to know that valuation done properly isn’t actually that hard when you understand the principles behind it. So bear with me and lets go through those first:

When valuing a business we try to determine “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts”. This is called its Fair Market Value (FMV) and there are two important points buried in the definition above:

Firstly FMV measures what a “financial” buyer would pay for the firm; it does not measure the degree of fit (aka ‘synergy’) between a particular buyer and the firm. An industry player may value your firm more than a financial buyer because they know more about the industry and your business (so have less risk) and also because they can do more with the asset (typically to do with increased market shares, wider application of technology, scale effects, etc.) than a pure financial investor. While this means that one generally finds industry buyers pay more for businesses than pure financial investors, it doesn’t affect the importance of treating your business like a financial investment in terms of how you think about and manage it.

Secondly, FMV talks of a price in ‘cash equivalents’. The reality is that in many smaller business sales, the buyer pays only a portion of the price in cash and the seller finances the balance (up to 60% of the deal, depending on country and industry – its not very popular in South Africa). Here the seller typically charges an interest rate on the financing that is lower than what the bank would, and compensates for the lower interest returns by charging a price higher than the FMV on the actual sale. From the perspective of using the firms valuation as a long-term management tool, ‘cash equivalent’ is again ideal.

So how do we actually measure the value of a business? There are 3 broad approaches:

  1. The Asset approach: which measures the value as ‘assets net of liabilities’
  2. The Market approach: which compares the business to other recent transactions of a similar nature, and
  3. The Income approach: which attempts to measure value by converting the stream of expected economic benefits (profit after tax, cash-flows, or dividends) into a single present-day amount.

Asset and Income approaches are based largely from the firms’ own financial data, whereas the Market approach is more reliant on external data.

We will discuss each of these in detail in next weeks’ article. You need to understand the weaknesses of each before you can appreciate their usefulness in providing an accurate FMV in either the transactional (buying/selling/raising capital) situation or for use as an on-going management tool.

For those of you wondering where we’ll end up – there is only one method that we recommend: the Discounted Cash-flow valuation (the DCF), which is an income-based approach. The DCF will be the subject of a whole article on its own, for a few weeks time…but we need to debunk some myths first!

This article originally appeared in Finweek.

Failure rates and an intro to Finance for Entrepreneurs.

The US dept. of labour statistics shows that 44% of small businesses fail within 2 years, and 66% within 4 years…within 10 years, 95% have failed.

In terms of risk, that’s like flipping a coin and waiting 3 years to know whether you’ve failed already or will almost surely fail in the next few years instead. Put simply, the odds of your success as an entrepreneur are dismal.

If you were badly advised and ‘bet the farm’ by putting all your life savings into your first venture, then you’re probably reading Finweek at the reception of the company where you’re applying for a job. On the other hand, if you “kept some of your powder dry”, cut your losses and tried something new, then chances are that it would also have failed. In fact, most successful entrepreneurs have failed 3 or more times before they eventually succeed. (This is one of the reasons why despite what you read about a few lucky young dotcom millionaires, most the founders of successful businesses tend to be 40+).

So why are these failure rates so high? Over 80% of failed entrepreneurs surveyed cited a “lack of an understanding of finance and financial management” as a major factor.

That’s where this column comes in: over the next few months I’ll be writing a weekly column in Finweek through which we aim to help entrepreneurs like you use the principles of what large companies call ‘corporate finance’ to improve your own businesses.

Corporate finance is a discipline that aims to maximise the value of the firm. It’s as applicable to large corporates as it is to the smaller more entrepreneurial business, albeit with some modification and a lot less complexity. To make it clear that we’re addressing entrepreneurs with rolled-up sleeves and customers at the door, and not a bunch of bean-counters in suits at a soulless head office somewhere, we’ll call this stripped-down version ‘Finance for Entrepreneurs’.

Here’s what we are going to cover in the next few weeks and what I hope you’ll learn and apply to your business over the time:

Firstly, despite all the passion and emotion that is such a vital part of being an entrepreneur, when it comes to your business and money you need to step back and treat it like any other investment you could make. We’ll show you how to value your business in a way that allows direct comparison with other investment choices you all have, so that you can make unemotional financing decisions.

Secondly, you can only manage what you measure. If you’re not preparing monthly accounts in your business then now is the time to do so: get a bookkeeper or account on board in your business now. For those who are we’ll show you how to get the most use from the effort you’ve already made. Sound decision-making requires sound underlying data and there are no ways around this.

Once you have the numbers and the approach right we can get on with using ‘Finance for entrepreneurs’ to maximise the value of your business. In a nutshell, this is what it entails:
1. The Investment decision: to grow your business you need to invest in assets that earn a return greater than your hurdle rate. This hurdle rate should reflect the risk of the investment and the mix of debt and equity used to finance it. The return should take into account the size and timing of cash flows and side effects.
2. The financing decision: the value of the firm is optimised when you have the right kind of debt for the firm and the optimal mix of debt and equity to fund your operations.
3. The dividend decision: if your business cannot find investments that make the hurdle rate, then it should return cash to the owners. How much cash depends on the opportunities it faces, and it can choose to return cash as dividends or share buy-backs.

The good news is that the principles of what we’re going to discuss here are universal and that while they require a logical mind, they don’t require any formal accounting or statistical training. We’ll keep the language simple and the break the learning into weekly bites. I’m looking forward to it!

-G

Feel free to share your story or ask questions @valuationup

Introduction to the Finweek article series

We like people who support entrepreneurs and are pleased to announce a partnership with FinWeek: we’ll be writing a weekly article called ‘Finance for Entrepreneurs’ in which we try to help smaller businesses learn from the way big corporates use finance as tool to increase the valuations of their businesses.

The first article is on the Finweek site here http://finweek.com/2012/08/20/when-failure-means-success/

Nice to see some positive responses on Twitter, including this one @GrantThorntonZA (yes, the accountants/auditors) who tweeted ‘Great initiative’

Thanks. Lots more to come.

PS: Full articles will appear in our blog a week after they appear in the print edition of Finweek.

Why buy a business?

Summary: 

A business needs to offer you opportunities for personal fulfillment & growth along with market-beating financial returns. As an entrepreneur, you can achieve this through starting a business from scratch or through buying an existing business. Buying an existing business is far lower risk as there is far more information on which to base your decision to buy and how to run it. It’s quite possible to buy business after business and build something as large as your dreams and ambition will allow. Anyone can buy a business: with the exception of professions such as Accounting, Engineering and Law, most businesses don’t require any qualification but they all require common sense, capital, focused effort and loads of personal drive. Most people sell businesses because they lack someone to hand-over to, their health has deteriorated, they are getting divorced, they are moving town or they wish to realise a return from their efforts. On the other hand most buyers look to a business to provide a certain lifestyle in a desired location while also making good financial returns. The macro-economic conditions affect the market for businesses: in good times average business performance is better and buyers have easier access to credit which drives up prices. In times when the outlook is generally negative there is tighter access to credit, so buyers with more cash get better opportunities for a lower price, and sellers with stable cash-flows become relatively more attractive as they are easier to finance. The most important step in buying a business is in understanding your own personal strengths, weaknesses, financial strength and ambitions. These are discussed at length in the next chapter. 

Personal development through buying a business:

For the hands-on investor or entrepreneur, the right business will play to your strengths and help you overcome any weaknesses; you will learn, grow and profit through the journey:

  • It will give you something to focus your energies on and something that will be the source of that energy.
  • Your daily decisions and actions have direct impact on the success of the business and it’s financial returns; you will feel the excitement and responsibility that comes from being in control (and sometimes feeling entirely out of control!). You will be ‘at cause’ of the eventual success or failure of your business, and you will be totally empowered to make life or death decisions.
  • You will learn to deal with fear and joy each day, often within the space of a few minutes. Learning to take control of your emotions is a key step towards personal mastery.
  • You will help your staff to grow and develop into their full potential: there is little more rewarding that helping others succeed.
  • The right business will help you improve the lives of your customers by offering them value in exchange for their cash, and if properly managed it will provide financial returns that are better than other investments, often by a substantial margin.

Buying a business v starting from scratch:

You can be an ‘Entrepreneurs’ in one of two ways:

  1. Start a business from scratch, or
  2. Buy an existing business and grow it the way you want.

Starting a business from scratch is very risky and most fail: you risk wasting years of effort and all your capital:

If you desire is to change the world by inventing something substantially new and commercialise it yourself then you have little option but to start a new business to achieve this. We will be the first to admit (having been there ourselves) that there is potentially massive upside to startin something new. Although potentially exciting, this path is littered with businesses that have died within just 2 years and with a total loss of capital. Fewer than 20% of new businesses survive beyond 6 years – despite the best efforts (and capital) of the entrepreneur.

In any business venture there are risks you face however in a start-up you simply don’t have enough information to even guess as what these risks are – they are all ‘unknowns’. Things always take three times as long and cost twice as much. Most entrepreneurs run out of capital before they have found a repeatable business model and their dreams die along with most, if not all of the money they had previously saved. Certainly there are few who succeed massively and whose founders become billionaires, however these are few and far between – literally one in a million.

Buying an existing business offers far lower risk yet the potential returns are there too:

In contrast to a start-up, the entrepreneur who buys an existing business has so much more information on which to base a decision and with which to come to a price: you have real customers, suppliers, and staff…3 or more years of trading history and financial statements…established banking, legal and tax relationships, an established location, control systems and so much more. You can look at the financials and understand what actually drives performance; you can interview customers and suppliers and hear from people who pay money to use your service exactly what they like or don’t. The information available means that if you do your homework you can both accurately value and later effectively run your business.

Buying an existing business offers a far lower chance of failure and you have a far clearer idea of how much capital is required and what its returns will be. You can make investment decisions driven by insight, rather than emotion. Lastly, in many cases its cheaper to buy a business than it would be if you tried to replicate the same business by building it yourself. There are already leases, systems, trained personnel and other infrastructure.

All of this means too that in terms of actually making the deal with the seller there is far more flexibility – everything is negotiable. Given the enthusiasm, focused effort and perspective you bring to it, the company can be the vehicle for your success.

Buying businesses can lead to exceptional returns: the story of Wayne Huizenga:

One might think that with lower risk comes a lower potential to make substantial returns, however this isn’t true: some of the world’s wealthiest entrepreneurs have made most of their money buying other entrepreneurial businesses.

Wayne Huizenga built his empire by buying businesses
Wayne Huizenga

An often cited example of such an entrepreneur is Wayne Huizenga, who started with a single garbage truck in 1968 and grew Waste Management, Inc. into an entity that would become a Fortune 500 company. Wayne aggressively purchased independent garbage hauling companies, and by the time he took the company public in 1972, he had completed the acquisition of 133 small-time haulers. By 1983, he grew Waste Management into the largest waste disposal company in the United States.

Having found a formula that worked, Wayne repeated his business success with Blockbuster Video, opening a handful of stores in 1987, and becoming the country’s leading movie rental chain by 1994. Eventually, Wayne would also build and acquire auto dealerships, from which in 1996 he formed AutoNation, which has become the nation’s largest automotive dealer and a Fortune 500 company. Wayne has been a five-time recipient of Financial World magazine’s “CEO of the Year” award, and was the Ernst & Young “2005 World Entrepreneur of the Year”.

In late 2004, he sold his ownership share in a group of hotels that included The Hyatt Pier 66 Hotel and Radisson Bahia Mar Hotel & Marina in Fort Lauderdale, Florida, The Boca Raton Resort & Club in Boca Raton, Florida, and several others in Naples, Florida and Arizona.

To give you some idea of how financially successful Wayne was, in 2004 he purchased the private luxury yacht Aussie Rules from the Australian boat builder and the golfer Greg Norman. The yacht cost $77 million and was further modified by Huizenga and now features a helipad for a twelve-seat helicopterAussie Rules was renamed Floridian after his private golf course designed by Gary Player.

In 2010, Wayne reconnected with Steve Berrard, former CEO of Blockbuster Video and AutoNation, to take Swisher Hygiene public. Swisher Hygiene trades on the Nasdaq and the Toronto Stock Exchange.Swisher Hygiene was previously CoolBrands International inc. His story continues to this day!

So you can see that with ambition, drive and foresight, its possible to go from zero to being part of the Fortune 500 simply by buying businesses :)

What are the main reasons people buy businesses?

Entrepreneurs buy businesses for one of two financial objectives:

  • Income substitution: where the income they currently make in their corporate job is replaced with that earned from a business that they own. Typically the choice to buy a business here is driven by the freedom and independence owning a business can offer while still taking home the same pay, or
  • Capital gain (wealth generation): where they buy the business expecting to grow its value then sell it to someone else and realise a profit from the capital gain over the period.

Although the financial reasons play a large part and are a useful reality check, most entrepreneurs buying a business also do so for non-monetary (“lifestyle”) reasons: they like the prestige associated with being an entrepreneur, as well as the perceived freedom and independence from a boss. One entrepreneur we know makes a point of playing golf each Wednesday afternoon, just to prove to himself that he is self-employed!

Some buyers want to move to the coast and invest in a business they can run from home that will cover living costs and more – these are typically retirees who have either not saved fully for retirement or those who don’t want to ‘down tools’ just yet.  For others, owning a business of their own is the fulfillment of a life dream, and the act of owning the business is almost a reward for all the years of work done in the corporate world. In both of these cases, the entrepreneur must take care to buy a business that suits their personal strengths and weaknesses – especially for those who haven’t owned or run a business before.

What are the main reasons other people sell their businesses?

Entrepreneurs typically sell their business for one of the following reasons:

  • No heir apparent: they have built up a business but have no-one in their family or in the management team to sell it to.
  • Retirement: just as some people buy a business as they go into retirement, others sell their businesses to retire.
  • Ill-health: sudden illness or a gradual decline in health may make it impossible for an entrepreneur to carry on paying full attention to their business and consequently they decide to sell. There is often a good deal here as the business is likely to have suffered some neglect during the illness of the owner which may be possible to quickly turn-around.
  • Other opportunities: Entrepreneurs often come across new opportunities and sometimes these are attractive enough that they decide to sell one business and invest in another. This in turn may present an opportunity that is very attractive to you as the buyer.
  • Realise return: Careful financial planning should be part of any Entrepreneurs’ decision-making and at some stage we hope that you get to the point where you can sell your business and cash-out. Where this is the primary reason for selling the business, the buyer needs to make sure he is not buying at the top, and that there is reasonable growth opportunity for the business or else it will be very difficult to make any real financial returns.

Who are the typical buyers of small businesses?

Retiring executives; people displaced by corporate “downsizing”; in rare occasions people straight from college or even high-school; and people working full-time who want to develop other career options on the side. There are also those who build an investment portfolio of small businesses that they can guide but where they hire managers to oversee day to day operations.

What does it take to buy a small business?

With the exception of businesses where a professional qualification is required (e.g. Attorneys, Accountants, Engineers, etc.) no prerequisites are needed. However, you must have the desire and perseverance to succeed as the process can be difficult and frustrating and running any business comes with uncertainty and requires hard, focused work if you are to succeed.

What are the external factors that affect the buying/selling of small businesses?

The most critical issue in buying a business is access to capital. Businesses have traditionally been purchased using personal savings, seller financing and third-party sources.

The overall economic outlook and access to credit deeply affects the market for buyers and sellers of small businesses. In tough (“recessionary”or “bear” markets) access to credit is tough which means that buyers struggle to finance deals and thus the sellers struggle to sell. This means that volumes are down and prices tend to be lower. If you have money, this is a great time to buy. On the other hand, if your business produces reliable cash flows it may be worth relatively more during tough times than it would during boom times. Poor business will struggle – many will go under rather than be sold. Sellers will probably need to offer financing in the deal structure to get the price they want or accept a heady discount for a cash-sale. For buyers who have large cash reserves this is a great time to shopping – and the potential exists to buy several related businesses at this time.

During boom times (“inflationary” or “bull” markets) the “rising tide floats all boats” and volumes and prices paid both rise. The reason is simply that credit is easier to access so there are more buyers with higher levels of financing and this drives up prices. This is a great time to be a seller as you’ll probably get the price you want without having to finance much of the deal.

Who are the players?

The marketplace consists of buyers, sellers, investors, brokers, consultants and other professionals, all of whom play a unique role in the transfer of businesses.

How do I get started?

Once you’ve decided that you’d like to start the process of buying a small business, the very first step – and this is hugely important to do properly – is to assess your own strengths, weaknesses, objectives and desires. This will allow you to build an accurate profile of yourself to give to sellers and brokers, so they can find a business that is a good match for who you are. This crucial step radically increases the odds of your ultimate success and is covered in the next chapter.