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May 30

Valuation vs. Evaluation

Do You Have A Cash Cow Or White Elephant?

Just because something has value does not mean somebody else will buy it. We all know that one house in the neighborhood with the weird paint and the odd sculptures that no one is going to buy “as-is”. In the past month, I have spoken to three business owners who initially wanted to talk about obtaining a business valuation; however, after meeting and discussing their needs, we determined what they really wanted was an objective assessment of their business and a strategy to increase its value. This is actually a business evaluation.

So exactly what constitutes a business valuation? A business valuation determines a company’s fair market value, which is the price at which a company would change hands between a willing buyer and a willing seller, with neither party being under a compulsion to buy or sell and both having reasonable knowledge of the relevant facts. It is important to note the distinction between, would sell and will sell. Fair market value offers no assurances a business will sell, but rather a fair price if it were to sell. The usual purposes for business valuations include: buy-sell agreements; valuing shares of a company for gift/estate planning; or, often times, just a gut-check for the owner. However, obtaining a valuation for a gut check creates a lot of confusion, which we will discuss later.

A business valuation focuses heavily on past performance through the analysis of historical financial statements. For example a business valuation will usually include a detailed analysis of five years of the company’s financial statements, valuation of the company’s tangible assets, and creating a normalized income statement. Normalized statements add back certain items to the company’s income statement that are not essential to operating the business, such as, excess compensation to the owner, large perks such as the cost of a luxury car, country club dues and perhaps even excess rent if the owner owns the building where the company operates.

In addition to historical analysis a business valuation compares the subject company with other companies in its industry. This would include an analysis of the company’s working capital to determine if there is an excess or a deficiency. Excess working capital would be added to the value while a deficiency would be subtracted. An industry comparison would also include a comparison of the company’s debt to tangible net worth, to determine if the company is under or over-leveraged based upon industry norms. Obviously, an under-leveraged company is valued higher than an over-leveraged one. Finally, operating ratios are benchmarked to industry averages including growth rate, profit margin and return on assets to determine how the company compares to its peers.

The underlying purpose of this financial analysis is to determine the reliability of the cash flow from the company. A business valuation operates under the assumption that past performance is an indicator of future performance. The more predictable a business’ future performance, the higher the multiple it will command when value is ultimately determined. A cash flow multiple for a business is very similar to the price earnings ratio for public stocks which, as we know, have higher PE ratios when growth in future earnings is predicted. Similarly, a private company’s multiple is primarily an indication of predictability of future cash flow. However, the multiple is also dependent upon two other factors: the current market for private companies as well as the current lending market. Unfortunately, both markets are now depressed, causing business values to be lower. Once cash flow is established and the appropriate multiple is determined, value is calculated by multiplying the cash flow by the established multiple. A significant shortcoming of valuing a business this way is the lack of analysis of the business’ processes. The unique processes of a business or lack of them is a key indicator of the repeatability of a business’ cash flow. Obviously, the amount and likelihood of future cash flows is the critical piece of information for all potential buyers and is the main goal of the buyer’s pre-sale due diligence. Unfortunately, this sort of analysis of future cash flows is really more the domain of the business evaluation and is wholly absent in a business valuation.

The owner who thinks of a business valuation as a gut-check of value and therefore something they can put on their shelf until it comes time to sell is mistaken. A business valuation is more like an annual physical. It only shows a company’s financial health at a given time. Business valuations offer no assurances for what the future will bring and no guidelines for improving the health of a company other than to try to reduce risk factors. Therefore, a business valuation does not answer the question that owners should really want to know: Is my company saleable?

In contrast, a business evaluation is a proactive plan created to help an owner achieve superior value by improving the predictability of future performance. The business evaluation process addresses whether a company can either create, or sustain, profitable growth, which is the determination of real value. A company’s ability to sustain profitable growth is really an analysis of two things – 1) is the company doing the right things and 2) is the owner not doing everything? We will get to that later.

There are ten items that are necessary for a company to be considered “bullet proof”. We have gone through the full list in the past newsletters; however, key items include:

  1. Benchmarking against the industry
  2. Creating meaningful long-term and short-term compensation plans
  3. Having appropriate insurance coverage
  4. Having real-life capital and operating budgets
  5. Having growth and succession plans

You might ask “Why is all this necessary since I know I will just sell my business when it comes time and if I don’t get top dollar, that’s not the end of the world?” Well, as a matter of fact, 97% of all businesses are considered small businesses and only one out of 100 of those sell every year. In addition, only one in three businesses that are listed for sale actually sells. So there is no assurance that your business is sale-able unless you make it so.

There are four critical areas that must be addressed to guarantee that your business is worth something to an outside buyer. First, pull yourself out of the process. Make sure you are not indispensable. If you are selling, billing, collecting, it could be that you are the business. While this may give you a warm and fuzzy feeling, it is definitely not what a buyer wants to see if he is planning on buying your business.

Next, your company must have a real sales process with sales people who like to compete. Obviously you will need two or more sales people to promote competition. Understand your sales process, know your sales pipeline and conversion rate. As we know, not all sales people fall under the category of “inspirational” most actually fall under the category of “perspirational”. People who work the process hard are successful and that’s that.

Building a brand is also essential to creating value. This is the tough part. Your brand establishes your company’s position in the marketplace and it is created by every function your company performs. Branding is the art of reducing uncertainty when customers make their buying decision. Good branding is not only a means of creating new customers, but also retaining old ones. Furthermore, good branding offers proof that your company is uniquely capable of solving a customer’s problems and differentiates your company from its competition. To ensure a strong brand, your methods must be uniformly followed for each customer. If you do not have a system to ensure consistency for each customer, you are relying on luck.

Last, and probably the most important way you can create value in your business is the development of a clear vision that highlights the upside of the business. If you do not have a plan for predictable, profitable growth, how can a buyer? This is particularly true of financial buyers who do not know your business or industry very well, and therefore need to buy into your vision in order to buy your company. If buyers cannot clearly see an upside, they are going to move on to the next business for sale.

At Burke & Schindler we are able to help you with both a business valuation and a business evaluation. As mentioned earlier the instances when a business valuation is needed are pretty straightforward; with a business evaluation it is not as clear. However, any business owner hoping to sell to an outside buyer (remember our statistic) would benefit greatly from a business evaluation since it will result in higher and more predictable cash flows, which in turn results in a higher sales price.

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