California’s AB5 Law May Impact Small Business Values

Assembly Bill 5 (AB5), signed into law last month by governor Gavin Newsom, will impact the valuation of many small businesses in California that have grown to depend on independent contractors.  For impacted owners intending to sell in the near term, this new law may require a change of plan.

The new law, which goes into effect on January 1, 2020, creates an explicit three-part test for whether a worker can be classified as an independent contractor.  A worker can only be considered an independent contractor if:

  • (A) the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact; and
  • (B) the worker performs work that is outside the usual course of the hiring entity’s business; and
  • (C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

AB5 exempts many occupations including doctors, dentists, lawyers, engineers, architects, accountants, real estate agents, travel agents, graphic designers, human resources administrators, grant writers, marketers, fine artists, investment advisors, broker-dealers and salespeople provided their pay is based on actual sales, rather than wholesale purchases or referrals. However, many small businesses in California that regularly employ independent contractors for work that is within the usual course of their business are not exempt.  For these businesses reclassifying workers could add as much as 30% to labor costs.  Labor intensive service businesses will be most impacted. Court reporting, janitorial and delivery services are typical examples.

Valuation Impact

Non-exempt California businesses that have to reclassify independent contractors to employees will likely see a contraction in enterprise value as buyers (and banks and appraisers) apply the expected increase in labor cost to proforma financials and guess at how much of the increased cost can be passed along to consumers. As businesses in a particular non-exempt industry convert from independent contractors to employees, the competitive playing field will be re-balanced.  Some who choose not to comply will go out of business. Those who already comply could see an increase in business, and value.

Owner Options

Business owners are considering their options to respond to the new law and its impact on valuation, including:

  1. Mount legal or policy challenges – The major gig-economy platform companies will challenge the law and small businesses may follow suit.
  2. Relocate work outside California – Can work currently being done by local independent contractors be transferred to contractors outside of California?
  3. Ignore the law – Some owners will no doubt continue with business as usual in the hopes that they don’t face a legal challenge.
  4. Reclassify workers and absorb the additional costs – The new law will raise costs for those who reclassify workers, and likely for the consumers of their products and services. There is a lot to consider here.  Which workers should be reclassified?  How will worker roles change? What are the cost implications?  How will these changes impact supervision, accounting, compliance and insurance requirements? Will the change result in a more committed and productive work force?

Regardless of how they respond, business owners who have spent years building their businesses under an independent contractor model and are impacted by AB5 are at crossroad. Hopefully this article raises awareness of the issues and helps some owners evaluate their options. If you are one of these owners, be sure to get professional legal and HR counsel.

Adam Wiskind is an M&A advisor at Exit Strategies Group and is a Certified Business Intermediary based in Sonoma County California.  If you are interested in better understanding this topic or in selling a $1-50 million revenue California business, contact Adam at awiskind@exitstrategiesgroup.com.

Understanding the Value of Intangible Assets

As a follow-up to our recent post on profiting from intangible assets in a business sale, this post introduces intangible asset valuation. As our last post outlined, “intangible assets are identifiable, non-physical in nature. They are something you can describe, document … and, most importantly, transfer.” Once identified, there are several ways to value intangible assets. I’ll discuss a common approach called the “with and without” method, using a simple and recognizable case study.

Let’s say you have a headache and you’re walking down the pain relief aisle of your local Walgreens pharmacy. You see Bayer Aspirin, “The Wonder Drug” to the left and a Walgreens generic bottle on the right. Same ingredients, strength and pill count. However, the Bayer Aspirin is $7.99 and the generic brand is $5.29.

What is the value of the Bayer brand name?

The shopper comparison suggests that Bayer believes that a buyer will pay $2.70 more for a bottle of its aspirin than a generic equivalent. What does this $2.70 represent? In this simple example it represents the premium attached to the Bayer name.  Bayer is able to capture a 34% premium WITH the use of this brand and no premium WITHOUT it. But why?

The Bayer brand has a history that dates back to 1863. They developed the drug in 1897 and sold it under the Aspirin brand name. Only after Bayer’s rights to that brand name either expired, were lost or sold in other countries, did the Aspirin name become a generic descriptor for the drug. This history creates brand recognition and helps the company command a higher selling price than generics to this day.

Why does this all matter? Because the value of the Bayer brand can be determined to be the value of the premium that company is able to generate by owning this brand.

Quantifying brand value is based on the “relief from royalty” concept. This concept suggests that brand value is the value the owner gets by being “relieved” of the royalty payments they would otherwise have to make if they did not own the brand; a more detailed With and Without scenario.

How the numbers work in the Bayer example:

  • Sales: Assume Bayer sold $500 million in aspirin and other related products over the last year. (This is an estimate; Bayer doesn’t disclose sales by product.)
  • Royalty Payment: Assume the Bayer brand, including artwork, colors and logo, can be licensed for 10% of sales. (Bayer has royalty agreements for its various brands but doesn’t disclose specifics.)
  • Royalty Stream of Payments: If you multiply $500 million by 10%, the owner of the brand would generate a royalty stream of $50 million.
  • Long-Term Growth (g): Let’s assume that the growth of this revenue is 3%.
  • Discount Rate (i): Assume, with a stable company and a low interest rate environment that the discount rate (or required rate of return for an investment is this company and therefore its brand) is 10%.
  • Capitalization Multiple: The theory of capitalizing a payment is to multiply next year’s payment by the inverse of its cap rate or as noted above, (i – g) or (10% – 3%) or 7%. The inverse is 1 / 7% or a capitalization multiple of 14.28x.
  • Value of Brand: Assuming the $50 million grows by 3%, the next year’s royalty stream is equal to $51.5 million or $50 million times (1 + 3% growth rate). Value is therefore equal to this next year’s royalty stream times capitalization multiple times 14.28 or $735.4 million.

It may seem strange that the value of a brand that generates only $500 million a year is equal to almost 1.5 times that revenue but if you look at from the point of Bayer, it makes sense. Because Bayer has a “relief from the royalty” payment it would need to make if it did not own the brand, it is able to generate an additional $50 million in value by owning it.  The value of that rising income stream over time is worth a great deal to a stable company like Bayer.

However, if the holding company was smaller and less stable, we would increase the discount rate to reflect that additional risk. Using the above math with a 15% discount rate (an extra 5% of required return to compensate an investor for accepting this additional risk) produces a value of $429.2 million (equal to (i – g) or (15% – 3%) or 12%.  The inverse is 1 / 12% or a capitalization multiple of 8.33x times $51.5 million).  All other inputs are the same except for this risk which has a direct and significant impact on the value.

Think of other intangible assets in the same way.

What would my business be worth if I didn’t have:

  • My customers
  • My supplier relationships?
  • The non-competes with my senior management team?
  • My workforce?

While the approach to valuing these other assets is a bit more complicated, the concepts are fundamentally the same — what is value with and without the asset?

My goal for this blog post was only to introduce this concept. Hopefully reading this didn’t give you a headache. But if it did, reach for your favorite brand of pain reliever! Or for a deeper dive into intangible asset valuation methodologies, read this blog post from the CFA Institute.

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Exit Strategies values intangible assets for a variety of purposes including divestitures, mergers and acquisitions, purchase price allocations, financial reporting, corporate restructuring and planning. If you’d like help in this regard or have any related questions, you can reach Joe Orlando at 503-925-5510 or jorlando@exitstrategiesgroup.com.

 

Profit from Intangible Assets in a Business Sale

The sale of a business includes intangible assets. This article explains what intangible assets are and how articulating, supporting and protecting them enhances business sale outcomes. Let’s get started.

What is an Intangible Asset?

Intangible assets are things that are non-physical in nature that you can identify, describe, document (e.g. a contract, list, logo, drawing or schematic) and, most importantly, transfer. Intellectual property is an example of an intangible asset.

The Financial Accounting Standards Board (FASB), in its ASC 805 standard for reporting of Business Combinations, separates intangible assets into these categories:

  1. Marketing-related: such as trade names, trademarks, non-compete agreements and URLs
  2. Customer-related: customer lists, contracts and relationships, order backlog
  3. Artistic-related: works of art, magazines, books and articles
  4. Contract-based: permits and licenses, licensing and royalty agreements, franchise agreements
  5. Technology-based: trade secrets, databases, patented technology

Do all intangible assets have value?

Just because an intangible asset exists, doesn’t automatically give it economic value. To have value it has to produce some form of economic benefit. For example:

  • Generate operating or licensing income
  • Reduce operating expenses or future capital spending
  • Reduce business risk

Of course, an intangible asset must be transferable in a sale to have value to a new owner. (Intangible asset valuation is a topic for another day.)

Goodwill is excluded from the above list because it is considered to be a blended residual asset. Goodwill is influenced by factors such as high profit margins, barriers to market entry, competitive advantages, a regulated protected position or lack of regulation, longevity in the market, a trained work force, etc.  Synergistic value associated with premiums paid by strategic buyers are often considered “blue sky” value above a “justifiable” goodwill value.

Document to Impress

After you take an inventory of your company’s intangible assets, the next step is to be sure that the key ones are documented in a manner that will satisfy buyers. For example, support for customer-based intangibles may include: a well-populated CRM database, master supply agreements, vendor quality audit records, open quote files, important correspondence, sales and contribution margin by customer history, AR aging schedules, purchase orders, etc.

Protect Your Assets

While documenting your company’s primary intangible assets, you are likely to uncover some that need better protecting through public registration (e.g. patents), securing or improving contracts, or better restricting access.

For many of our clients, trade secrets are their most valuable intangible assets. Suppose a significant portion of your company’s profitability is attributable to a proprietary production process. Ask yourself these questions: Is the process perfected and well documented? Are you taking appropriate measures to keep the process secret? Is access sufficiently limited? Do you have appropriate data security? Do you have non-disclosure agreements with third parties?  Do you have confidentiality agreements with your employees? If not, you know what to do.

Capitalizing on Intangible Assets in a Sale Process

Your intangible assets become the focal point of the Confidential Information Memorandum (CIM) prepared by your M&A advisor. The CIM can also articulate those intangibles that are underutilized and have potential to produce economic benefits to a new owner. We use our knowledge of your intangible assets to decide which target strategic acquirers are likely to derive the greatest benefit from them. We tailor our outreach strategy and communications accordingly. In the end, this generates more interest and better offers for the company in an M&A auction process. The M&A advisor can also advise on how and when to disclose sensitive details about key intangible assets during the discovery and due diligence phases of a merger or acquisition process.

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An investment in perfecting, identifying, documenting and protecting intangible assets is usually well rewarded in a sale. Exit Strategies helps clients take full advantage of the intangible assets in their businesses when going to market. If you’d like help in this regard or have any questions, you can reach Al Statz at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Phase I Environmental Assessment in M&A Transactions

A Phase I environmental site assessment is commonly required by buyers and lenders in merger and acquisition transactions that include commercial real estate. One may even be called for when the target company (seller) uses or stores hazardous materials at a leased facility.

Sellers are generally rewarded for conducting a Phase I assessment before taking a deal to the marketplace. Understanding environmental risk allows sellers to argue for a higher price and increases the likelihood of closing a deal. This article explains why.

What is a Phase I Environmental Assessment?

A Phase I environmental site assessment (ESA) consists of a thorough inspection of a commercial property and research into its current and historical use to identify potential environmental contamination liabilities. These assessments are conducted by independent, certified and trained professionals. The environmental expert produces a written Phase I report. When site contamination is found to be likely, a Phase II investigation follows, which involves taking soil, groundwater or material samples.

What All Buyers Want

When acquiring a business, buyers want to understand the potential liability for environmental contamination on facilities owned or operated by the target company; any past non-compliance with environmental laws and regulations; and costs to comply with any post-closing environmental compliance obligations. An understanding of their potential liabilities as a parent or successor dictates their acquisition strategy.  The scope of a buyer’s potential liability for existing environmental contamination issues can influence the basic structure of the transaction — asset or stock purchase — and proposed purchase agreement provisions.

How Sellers Benefit

Obtaining a Phase I report before putting a business with real property up for sale provides several benefits to sellers. It flags potential problems that the seller can mitigate or remediate in advance. If contamination is reported to be present or likely, the seller can better compare the value of bids and make better decisions regarding indemnities and potential insurance products. Having a Phase I report increases a buyer’s comfort, and results in better offers, less renegotiation and a smoother LOI-to-closing process.

Al Statz is founder and President of business valuation and M&A brokerage firm Exit Strategies Group, Inc., which has offices in California and Oregon. For further information on this subject or to discuss a valuation or M&A question or need, confidentially, you can reach Al at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Roundup of Recent Sale Transactions

Sitting down and writing quality articles on business valuation, exit planning, mergers and acquisition strategy has taken a back seat this year, thanks to a strong M&A market. In this post I will recap many of the transactions for which Exit Strategies (ESGI) provided sell-side advisory services during the first half of 2019.

I haven’t included deals that we were asked not to announce. Nor have I included the internal buy-sell transactions, management buyouts and generational transfers for which ESGI provided an independent business valuation. As always, deal terms are not disclosed to respect the privacy of our clients.

Sale of Eldercare Services to Home Care Assistance

Eldercare Services is one of the San Francisco Bay Area’s top professional eldercare management and home care services providers. The baby boomer owners of ES were looking to turn their business investment into cash (i.e. “liquify” their investment), maximize value and retire. Home Care Assistance is a leading provider of home care for seniors in 150 regions throughout the United States, Canada, Puerto Rico and Australia. (service, health care)

Sale of DC Precision to Tecan Group

DC Precision, established in 1999, manufactures high precision plastic valve assemblies for life science OEMs and metal products for Silicon Valley high-tech manufacturers. Our client was ready to pursue other business interests. Tecan Group is a Swiss manufacturer of automated workflow equipment for pharmaceutical and biotechnology companies, university research departments and diagnostic laboratories. (contract manufacturing, CNC machining, proprietary technology, turn-key assembly)

Sale of Precision Asphere to II-VI Optical Systems

Precision Asphere produces aspherical optical components (lenses and mirrors) using proprietary surface-forming technology. The majority owner wanted to retire. II-VI Optical Systems develops and produces highly engineered materials and material systems for medical, defense, aerospace and military clients.  (manufacturing, technology)

Sale of Axis of New England and New York to Motion Industries

Read the ESGI announcement here.  Our clients were looking to take advantage of industry consolidation and maximize value through a competitive M&A sale process. (distribution, manufacturing, robotics, technology, service, system integration)

Sale of DZINE Living to Haworth

DZINE is an interior design services and contemporary European furnishings retailer in San Francisco. Our clients were looking to align with a major industry player that would help DZINE to expand its footprint. Haworth is a global company that designs and sells furniture, furniture systems, architectural products, textiles, wall surfaces, and ergonomic and technology tools for workspaces, education and health care. (retail, service)

Sale of You & Me Children’s Center to an Industry Investor

Founded in 1981, You & Me Children’s Center is a local preschool committed to providing a nurturing, safe and educational environment for children. The owner wanted to retire, liquefy her investment and see her legacy survive. The buyer is an experienced preschool operator. (service, education)

Sale of Home Tutoring Plus to a Private Investor

Home Tutoring Plus is a tutoring company serving schools and home school families throughout much of Northern California. Professional tutors provide individualized lessons, in-home and online. Our client engaged us to locate a buyer that would preserve her legacy while maximizing her investment so she could pursue new interests in retirement. (service, education)

Sale of Redwood Building Maintenance Company to Silicon Valley Building Services

Founded in 1965, Redwood Building Maintenance is a full service janitorial and building maintenance company serving the North San Francisco Bay Area. The family owners were ready to retire.  Silicon Valley Building Services primarily serves the south and east Bay Area and this gave them an opportunity to expand. (B2B services, contract maintenance)

Sale of Banner Enterprises to Valley Comfort

Banner Enterprises and Valley Comfort Heating and Air are both full service commercial HVAC companies serving the Bay Area. Our client was looking to sell his business and building in order to retire and reinvest. (construction, services, real estate)

Sale of Communique Interpreting to DCARA

Since 1994, Communique Interpreting has provided in-person sign language interpreting services from Monterey to the Oregon border, in medical, employment, education, legal, performing art and social services settings. Our client wanted to sell her business and building and retire. DCARA, a 501(c)3 charitable organization, provides interpreting, advocacy and employment services for hearing impaired children, adults and families in Northern California. (services, non-profit, commercial real estate)

Sale of a Dietary Supplements Producer to a Strategic Buyer

A producer of herbal supplements sold through U.S. medical practitioners. The owner engaged us to find a strategic partner that could scale the company and allow him to reduce his involvement in operations and transition to retirement. (health care, manufacturing)

Market Observations

Two themes jump out at me: most acquirers were strategic and most sellers were looking to retire. Indeed, we’re seeing tremendous strategic acquisition activity in most industries. Most sellers are well positioned to maximize value through a structured auction (competitive bid) process run by a professional M&A brokerage firm like ours. As long as baby boomers continue to age out, Exit Strategies will be here to facilitate their retirements.

Action Items

If you are considering exiting your company for any reason, call or Email us to discuss your goals and circumstances, and how you can leverage Exit Strategies’ process, resources and experience to improve your results. If you are waiting for market conditions to improve, stop waiting and start the process!


Al Statz is founder and President of business valuation and M&A brokerage firm Exit Strategies Group, Inc., which has offices in California and Oregon. For further information or to discuss a valuation or M&A question or need, confidentially, you can reach Al at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Steps in a Management Buyout

As a friend of Exit Strategies you know us as M&A brokers and appraisers, but you may not know that we advise on management buyouts.

By management buyout (MBO) I mean selling a company or business unit to managers and key employees using a combination of equity and debt. The assets and cash flows of the company are used to finance most of the purchase price, with the equity portion supplied by management or a Private Equity investor, depending on the size, profitability and nature of the company.

Business owners who choose the MBO exit option typically have strong non-financial motivations. Don’t get me wrong, price is important to them. However, factors such as company legacy, employee welfare and local community are often equally and sometimes more important.

Typical MBO Steps

When advising company owners on management buyouts, we start by understanding our client’s short- and long-term goals, needs and circumstances. If an MBO appears to be appropriate, we will:

  1. Prepare an independent business valuation (fair market value) to provide guidance on pricing and feasibility
  2. Work with financial, tax and legal counsel to determine a deal structure that achieves the owner’s liquidity and income goals
  3. Obtain confidentiality agreements from interested parties
  4. Meet with managers to understand their interest level, goals and resources; educate them on the MBO process; confirm feasibility
  5. Develop a transaction roadmap
  6. Collect details on buyer experience, credit, funds and collateral
  7. Prepare a confidential information memorandum, source documents and disclosures to fill management’s knowledge gaps and explain the merits of the transaction to their advisors and lenders
  8. Recommend wealth management, legal and tax professionals (if needed) and coordinate with them
  9. Evaluate debt financing options (including seller note) and the potential of “rollover” equity
  10. Determine if private equity capital is necessary or desired, and available
  11. Recommend and liaise with best-fit debt and equity providers
  12. Propose terms and facilitate sensitive negotiations while buffering emotions
  13. Draft a nonbinding memorandum of understanding on key deal terms, transaction process and timeframes
  14. Facilitate buyer, seller and lender due diligence
  15. Assist buyers with financial models, business plans and shareholder agreements as needed
  16. Work with the parties’ legal teams to finalize definitive agreements
  17. Advise on leadership transition
  18. Coordinate satisfaction of closing conditions, resolve problems that arise, and maintain momentum for a timely deal closing

Every buyout is unique. We add, remove and rearrange steps as needed, and help both sides navigate the process. In some cases, management, not the owner, initiates the buyout.

Biggest Challenges

Owners and management employees usually lack the time and deal experience to complete successful buyouts on their own. The interdependent owner-employee relationship raises the stakes for all parties and magnifies the consequences of a failed negotiation. Three areas seem to be especially challenging for owners and management:

  1. locking in a fair purchase price (business valuation),
  2. determining the right deal structure, and
  3. financing

Most Common MBO Mistake

For a management buyout to succeed, a business usually has to have a solid earnings track record in order to prove it can service the debt. Management must demonstrate the requisite skills, experience and commitment. Putting everything in place can take months or years of preparation. Waiting too long to begin this process is the most common mistake I see owners make.

Backup Plan

Of course, there is always the possibility that the MBO will fall through, and you should be prepared for that possibility. That may involve creating incentives for management to stay on and being ready to market and sell the company to third party strategic and/or financial buyers.

The First Step

If you are considering selling your company to management some day, feel free to call us to discuss your goals and needs, confidentially.

Al Statz is the founder of Exit Strategies Group and a senior M&A advisor in the firm’s Sonoma County California headquarters. Email Al or call him at 707-781-8580.

Financial exit planning, Is your business ready?

I recently had a client looking to sell their medical supply business and retire. I worked with management to pull together all the documentation and financials needed, and conducted conduct a probable selling price analysis. With report in hand I met with our clients to review the results and plan a go-to-market strategy.

Unfortunately, the probable selling price fell slightly short of what the client needed to retire (after taxes). We identified excessive inventory as one of the factors that was limiting enterprise value. How did inventory reduce value and spoil our client’s exit strategy? What can they do resolve this limitation? Read on for the full story.

The company had thousands of SKUs, colors, shapes, types and sizes of medical supplies in inventory. Fully 78% of its assets were in inventory. Current assets exceeded 99% of total company assets. We compared our client’s financials against 10,000+ companies in the industry. The industry was averaging 35 days of inventory on hand (11 turns per year). By comparison our client turned its inventory less than once per year. Keep these figures in mind as we continue.

Cash Flow is King

It’s no surprise that buyers of going concern businesses buy primarily to get returns on their time and money invested. Tying up cash in inventory means less cash to operate or invest in the business (or pay dividends to investors) and increases the risk that you won’t get your money back out of your inventory. But there’s more to this story about how inventory affects value.

The income approach to valuation is based on the concept that a business is worth the present value of its expected future cash flows to its owners. The other approaches to value (market and asset approaches) are also important, but cash flow is ultimately king.

A common income valuation method involves dividing the forecasted net cash flow by a capitalization rate (Cap Rate). The capitalization rate is a function of the expected growth and risks inherent in a company. There’s a lot that goes into calculating appropriate risk and growth rates, but here’s the basic formula:

Value = Net Cash Flow / (Risk – Growth)

Crunching the Numbers

Working Capital = Current Assets – Current Liabilities

  • With minimal current liabilities and high current assets, the company had high working capital requirements.

Working Capital Turnover (Sales / Working Capital)

  • I previously mentioned that the company turns over inventory less than once a year. This suggests either too much inventory or not enough sales, or both.
  • The working capital turnover for this company was an average of 2 (i.e. sales were 2x working capital cost).
  • Industry data showed an average working capital turnover ratio of 7-8.

Net Cash Flow Calculation

  • Net cash flow to equity (NCFe) measures the cash flow to shareholders in a company (equity interest holders).
  • NCFe = normalized after-tax net income + depreciation – less capital expenses – increases in working capital +/- changes in interest-bearing debt.
  • Notice the NCFe formula subtracts increases in working capital. As a company grows, working capital increases, which means less cash for shareholders. For this client, working capital growth reduced cash flow by 25%.

Enough Numbers – Back to Our Story

Our client’s business has a high risk of not selling through years of inventory before that inventory becomes obsolete, expired, lost, stolen or damaged. Therefore, the value from the income approach came in lower than the market approach and asset approach results. In fact, the cost of inventory was higher than the value of the company on a going concern basis. Even in liquidation, the full value could not be realized after the costs of liquidating.

The moral of this story is that a hard-earned business exit can be busted by excessive inventory and inefficient use of working capital. In this case, we advised our client to put their exit on hold for a few years and work strategically to reduce inventory and increase sales. Not only will the reduction in inventory increase future value, but it will also put more cash in the client’s pocket along the way.

If you’re considering a sale and wondering what financial shape your company is in, Exit Strategies’ team of M&A brokers and business appraisers can help you determine value, evaluate strategic alternatives and maximize results.

Michael Lyman CVA is a certified valuation analyst and M&A broker specializing in health care, technology and education fields. With 15 years’ experience working in and building his knowledge in these markets, Michael understands the needs of sellers, buyer and investors. His background includes university positions, two successful e-commerce startups and president/CEO of a small pediatric health care business.

See our related blog post on Managing Working Capital to Increase Business Value.

Manage Working Capital to Increase Business Value

As you likely know, working capital equals current assets minus current liabilities. Companies that have a high level of cash tied up in current assets (primarily cash, accounts receivable, and inventory) without similar levels of current liabilities are not as attractive as those who tightly manage their working capital. Buyers are often leery of businesses that require high working capital to sales ratios because as sales grow the company must continually invest more cash in working capital. Conversely, companies with low working capital can grow faster and return more cash to shareholders as they grow.

One Recent Example

We were recently retained to do a fair market value business valuation of a multi-state, value-added industrial distribution company for a shareholder buyout. The company was a profitable going concern. While it showed modest EBITDA margins, its working capital requirements were unusually high, primarily due to extraordinarily high accounts receivable and inventory levels.

A prior valuation done not long ago for a different purpose had relied solely on an Asset Approach method. Specifically they used the Adjusted Book Value (ABV) method where all assets and liabilities are marked to market. Thanks to the company’s high current assets combined with almost no current or long-term liabilities, the result was a high valuation number. As part of our analysis, we naturally considered the prior valuation. We wondered how valid its conclusion was from the perspective of a hypothetical buyer of a going concern business who would be concerned with future cash flows.

Following standard business valuation practice, we considered the three approaches to valuation: asset, market and income. The asset approach using ABV gave results marginally higher than the prior valuation while the market approach (comparable asset transactions method) values were slightly lower. However, when we analyzed the income approach using a single period capitalization method (SPCM), our result was substantially lower than the asset approach. Why? Because the SPC method is based on capitalization of net cash flow to equity holders, which considers changes in working capital that are largely ignored by the asset and market approach.

We were compelled to give some weight to the income approach results as we believe knowledgeable buyers of shares in the company would have a strong  interest in their expected return on investment. The result was a valuation conclusion somewhat lower than adjusted book value.

Theory Holds True in Practice

I want to point out that this affect of working capital on enterprise value isn’t just abstract financial theory. We regularly see it play out in actual M&A transactions where buyers have no interest in paying more for companies with higher working capital. And we often see sellers rewarded (sell for higher earnings multiples than their industry peers) for having proven that they can operate effectively with less working capital.

It is also interesting to note that in this case, should the owners of the company have tried to liquidate the company’s assets to generate cash, the net amount yielded would have been substantially less than adjusted book value. Given that the company had no plans to liquidate, we didn’t consider using a liquidation value.

What Companies Should Be Doing in this Area

Company owners and management should constantly reevaluate and consider modifying their accounts payable and borrowing practices, as well as focus on ways to reduce accounts receivable and inventory requirements. All of which will reduce working capital, generate cash, enable faster growth, and increase shareholder value. Sometimes this even means making tough decisions like firing a customer or replacing a key vendor.

For further information on how working capital affects enterprise value, or to have a business analyzed for sale, acquisition or exit planning purposes, contact Jim Leonhard, CVA MBA  at 916-800-2716 or jhleonhard@exitstrategiesgroup.com. 

Business sale planning: Three lessons from Shark Tank

As an M&A advisor having participated in the sale of businesses ranging in price from $500 thousand to $100 million, I enjoy watching ABC’s Shark Tank. On the show, entrepreneurs pitch their businesses to a panel of five investors (“sharks”) who then decide whether or not to invest. Today I want to pass along three key takeaways from Shark Tank for every business owner who plans to sell their business some day.

1. The business valuation has to be realistic and defensible

Many times on Shark Tank, the valuation of a company is way too high. The asking price is not based on sound valuation principles and is not defensible. The Sharks opt out because the owner is unrealistic. This is an important lesson for business owners looking to sell their company. A realistic and well-supported valuation invites serious and capable buyers who seek a reasonable return on their investment, and an unrealistic valuation chases away buyers.

2. Presentation is fundamentally important

The Sharks don’t know anything about the companies prior to the pitch, and the sellers get one shot at presenting their information in the Tank. This is the same in a business sale process. Potential buyers don’t know much about the seller’s business, and if they are familiar it, they don’t know the details of the financials, operations, personnel, markets, customer base, systems, etc. Brokers know the kind of information buyers want and need, and how to position a company for sale or investment. They prepare a Confidential Information Memorandum for use in the sale process to give qualified buyers the information they need to make their best offer, and an offer that will survive due diligence.

3. Deal negotiations – competition is key

Sharks, like all buyers, hate competing for a deal. Sellers love competition because they get to choose the best terms available in the market. Having a broker in a deal creates competition among potential investors (buyers) because brokers promote the acquisition opportunity to a broad and targeted audience. Envision a shark feeding frenzy! Even if only one buyer prospect comes along and begins the negotiation process, they know that low-balling a fairly priced business will likely not fly in a competitive open market of buyers being orchestrated by an experienced broker. In the absence of a broker, it’s anyone’s guess where things will end up, but not likely as good of a deal in the absence of a competitive environment.

Keeping these three lessons from Shark Tank in mind as you go through the exit planning and business sale process will likely lead to a better outcome for you and your stakeholders.

Not familiar with Shark Tank? Shark Tank is an Emmy Award-winning structured reality television series on ABC, now in its tenth season.  Watch Shark Tank on ABC.com

For more information on buying or selling a business, Email Louis Cionci at LCionci@exitstrategiesgroup.com or call him at 707-781-8582.

How to Build a Sellable Construction Business

With the San Francisco Bay Area building industry booming I am regularly approached by the owners of construction companies with requests to help them to sell their companies. As interest rates are low (but creeping up) and investors are still in the market for solid businesses, some construction company owners with strong financial histories and future growth prospects are looking to cash out.

However, even in the best of times construction companies are notoriously difficult to sell. Any business that requires a professional accreditation (like a California contractor’s license) to operate will logically attract fewer buyer prospects. Buyers with the requisite licenses and financial resources often prefer to start their own companies rather than buy someone else’s. Many construction companies even large ones depend heavily on their owner’s experience and contacts to attract business. When it comes to selling, the personal goodwill of the owner is tough to transfer to a new owner.

If that weren’t enough, many construction businesses have high capital equipment costs, high labor costs and because of retention are slow to receive payment for their services. Furthermore, the industry is cyclical which increases the need to maintain cash reserves. These factors increase overall working capital requirements for construction businesses and make them difficult to finance and expensive to manage.

So, what qualities in a construction company are attractive to buyers? This list is a good start:

Experienced and Dedicated Labor

Unemployment in the Bay Area hovered at just under 3% in October. The market for construction-related jobs is even tighter. For many Bay Area construction companies growth is constrained not by demand for their services but by their ability to complete the work. Some of these companies are resorting to acquisitions of other companies simply to secure talent. Owners of companies with trained and dedicated employees are well positioned to benefit from this industry wide challenge.

Committed Management Team

Businesses with multiple owners that compose the management team and want to retire at the same time are particularly challenging to sell. Business partners or spouses that both play vital roles and want to leave a business together are difficult for buyer prospects to replace. Buyers like to know that the owner can take time away from the business without it impacting performance. Ideally, a company will have a committed non-owner management team that will embrace an incoming buyer and continue to run the business after its sold.

Low Working Capital Requirements

Not all construction companies require a large working capital investment. For example, companies that provide services directly to building owners rather than general contractors often have more control over when and how they get paid. Also, companies that have regular service contracts with clients often have shorter cash flow cycles.

Qualifier Flexibility

The buyer of a construction company that is in the same business will have the required licenses to operate. But many buyer prospects for small construction companies won’t and they will have to figure out how to run the business until they are able to qualify for the requisite licenses. A business in which the seller or one of the company employees is willing and able to serve as the license qualifier during the transition will make the business easier to sell.

Construction companies with these attributes will be more attractive to buyers.

Exit Strategies Group regularly appraises and brokers the sale of companies in the construction industry. For further information or if you own a California construction company that you’d like to sell or have appraised please contact Adam Wiskind at awiskind@exitstrategiesgroup.com or (707) 781-8744.