Growing Businesses Using Valuation Principles
Professional business & valuation analysts have access to large amounts of market data that can be a tremendous benefit to most businesses. A skilled analyst can use this information to help shareholders aggressively launch or grow a business.
A couple of years ago, I was asked by a California based tech startup to assist the management team in building their online company. The founding shareholders firmly understood that creating shareholder value from the ground up was a prudent plan in luring venture capital and prepping for a most likely IPO or reverse merger in the coming years. With a clean start, it was easy to eliminate risk issues before they became more difficult to manage. I focused on reasonable forecasting, branding, patent filing, a shareholders’ buy-sell agreement, thorough documentation and record keeping, depth of management and key personnel issues, diversification among the international technical team, quality of the service product, technological efficiencies and contractual agreements. All of these decisions directly addressed the removal of as much Specific Company Risk as possible to build value from the start. A reliable valuation assessment now, and a forecasted valuation for the future, will keep their Board of Directors cohesive when making future decisions.
Knowing how a company is valued by determining cash flows and identifying risk components, along with gathering industry ratios and Guideline Company transaction data, is many times just what shareholders need to get refocused on building value. Privately held businesses often spend their day engrossed in personnel, marketing, or product issues. They have no idea what drives the value of their business.
3 INITIAL QUESTIONS FOR SHAREHOLDERS
When sitting with the shareholders of a privately held company, I implement the practice of calling a meeting and asking them to independently write down the answer to these three questions:
1) In your opinion, what is the total value of your company?
2) What percent of the company do you personally own?
3) What would you take as a cash settlement for your shares today?
Note: It is important I keep each shareholder’s answers confidential by not sharing their figures with the others.
Using this practice, I find most business owners overvalue their business. This usually results from: a) over-inflated growth projections; b) over-confidence in future earnings; and the most common mistake of all... c) not understanding the outside world’s view of risk. A business owner is reluctant to see the intrinsic risk of their business because they subconsciously manage it daily. An outside investor sees it much more clearly and objectively.
DELIVERING THE “WHAT” vs THE “WHY”
Next, I show the shareholders “WHAT” their equity value is today and then analytically tell them “WHY” my valuation holds merit. The “WHAT” gets the shareholders back on the same page while the “WHY” keeps the shareholders together allowing them to make good decisions well into the future. If shareholders understand the “WHY” then I can have a conversation about how to make changes to the business so their business can grow in a healthy manner, building value.
Many business owners don’t realize that a good analyst can compare their company to IRS ratios and RMA ratios of similar companies within their industry. This can help them get their company’s financial structure in order by adjusting to, or trying to beat, the industry median ratios. When using these ratios two things I often see are:
1) The business was doing well but management has gotten negligent letting the ratios slip.
2) Management’s projections are outside the norm and sometimes above the 90th decile of IRS data.
I like to help a management team understand why they have not been meeting their projections and give them reasonable goals based on industry data.
Having this industry data helps an analyst get multiple owners on the same page. If shareholders understand what is causing their company to be undervalued then work can be done to correct it. Privately held companies tend to be focused on selling and putting out fires. Many business owners (and CEOs) have no concept of how their dependence on key personnel, their financial structure, their product diversification, their product seasonality, or their customer base and A/R diversification affects their value.
Completing a valuation engagement and setting that as the baseline to make future changes allows owners to build their companies in a more efficient manner. The foundation must be solid so the company can grow in a healthy way. Most shareholders want to build value so a business valuation is the first step in setting a solid foundation for future growth.
Here are a couple of real cases:
I was recently working with a company that needed a valuation. They were looking at selling their company because the owners (four siblings) were not on the same page regarding management decisions. Through all the stress, the owners decided that selling the business was the most logical resolution to their differences. The owners did not have a buy-sell agreement in place, which further complicated their struggles.
The owners were gathered together and I asked them to write down the answer to the three questions outlined above. After collecting their answers, I shared only the lowest and highest estimated total equity value figures among them; that being $1,000,000 to $10,000,000. Wow! A factor of 10 difference between their estimates. Certainly these owners were NOT on the same page. Adding insult to injury, my Fair Value opinion of the total equity was only $680,000. It was time to get these owners on the same page.
The “WHAT” was their company’s equity valuation at $680,000. As a certified analyst, I was able to give them a significant amount of evidence that my figure had merit (the “WHY”). Private Transaction data and discounted future cash flows supported my logic and soon I had the attention of the shareholders. Knowing these owners were not going to sell their company for $680,000, I moved from the analyst role to the consultant role. Theoretically, I moved from a reactive position of recording the facts to a proactive position of showing management what they can do to build value.
STEP 1: I had a conversation with their sales manager. I asked the sales manager a very important question… “What would happen to this company if you raised all your prices by 5%?” His answer was simple. He said it would not affect their sales one bit and that they would sell virtually the same amount of product at the higher price.
STEP 2: The Company was sitting on cash, so I had a similar conversation with their purchaser. I asked the purchaser, “How often do you buy product of similar goods?” She said they purchase product weekly to keep the inventory down. When asked, “Could you negotiate a 5% discount if you were to purchase product in bulk, maybe 4 to 6 weeks’ worth at time?” She said she could probably negotiate a 5 to 7% discount which would include a savings in shipping charges.
STEP 3: A series of similar management questions were addressed throughout my analysis and each answer could be reflected in an adjustment to either the benefit stream or the risk rate. (The simple explanation that Value = Benefit Stream / Risk Rate was well received by the shareholders.)
STEP 4: A site review also revealed what the industry ratios were telling me. This small company had too much overhead and they needed to reduce the number of employees by 2. Looking at their processes, I could clearly see there were a couple of employees whose daily tasks were redundant.
Taking these adjustments into consideration and knowing all the proposed adjustments could be implemented within a 6 month period, I forecasted the company to be worth $1.65 million within 12 months if they were to execute all of my recommendations. This was a 143% increase in business value in just 12 months. This is how business valuation principles brings value to a business!
I often work with dissolution cases. Many times I am hired by a client to consult them on basic business valuation theory. If the case is being mediated by a third party, the client, being walked through the process, needs to be coached or given documentation to support their position. Supporting evidence of a build-up discount rate and resulting capitalization rate can be a powerful point in negotiations. Market data from guideline company transactions can further support a case.
A recent client hired me as a consultant in their shareholder dissolution case and after reviewing the report I provided, he began to understand the principles of business valuation and with that knowledge changed his approach in negotiations. Instead of moving to sell the corporation at a discount, he elected to negotiate a buyout of the other shareholder at a premium. With full disclosure of his intentions, the other shareholder was pleased to receive a premium. My client believed he could change the risk components that were affecting the overall business’ value and change a struggling company into a thriving company. He simply needed me to show him the “WHY” so he could embrace it.
A reactive analyst is merely taking the historical decisions of management and recording their value at a specific time (the “WHAT”). A proactive analyst, if hired as a consultant, can take the data and provide valuation solutions based on industry statistics, risk components, diversification, etc. (the “WHY”). Most shareholders invest in companies to increase their value. They must know the "WHAT" and the "WHY".
Robert T. Hulet is the President of Business Valuation Solutions, LLC in Pacific Grove, California. He has consulted over 200 companies throughout the U.S. and Canada. Since 2011, he has focused on business valuations and business consulting; also acting as interim management in the positions of COO, CFO, Exec. VP, Board Member & Executive Director on occasion. He has personally started, bought, or sold twelve companies. He is also a private equity investor in multiple companies within the automotive, agriculture, and technology sectors, and is on the Board of Directors of several private companies. He has significant experience in preparing certified business valuations for marital dissolution or shareholder disagreements and for shareholder buyouts, stock sales, and preparing companies for sale. He is a national Financial Planning & Analysis (FP&A) contractor for corporations nationwide. He has completed engagements for corporate restructuring, strategic planning, budget analysis, operations management, business development, cost/benefit analysis, and mergers & acquisition while educating management and negotiating teams. Prior to 2011, Mr. Hulet was the President/CEO of a multi-million-dollar, multi-location U.S. based import/distribution company for over 20 years. He earned four business degrees from the University of Arizona; Accounting, Finance, Management Information Systems, & General Business and has taken additional course work at Cal State University, Fullerton in the area of professional fiduciary management