Nurturing a business is a bit like raising a child. With considerable investments in time, money and emotion, every resource a business owner puts into the company adds value. But does it pay off when it’s time to sell?
When a business is for sale, both the seller and buyer may have different views on its worth, says Mike O’Malley, president of Overland Park-based mergers and acquisitions firm O’Keeffe & O’Malley. There are a lot of variables to consider when determining the value of a business.
“No single formula can be used to determine the value of every business interest in every situation. It is much more technical in nature,” O’Malley said. “We have to drill down to many areas of the business and look at a variety of methods.”
Typically, O’Malley says, the formula for determining the value of a business rests with re-casted earnings, or EBITDA (earnings before interest, taxes, depreciation and amortization). Used to analyze and compare profitability between companies and industries, it eliminates the results of financing and accounting decisions. However, while EBITDA is a good metric to evaluate profitability, it does not consider cash flow – particularly the cash necessary to fund working capital and the replacement of equipment.
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There are other things, too, that can help determine value, like comparing companies that sold in a similar industry.
“If a similar company sold at a high price then the subject company might too,” O’Malley said. “It is important to consider that the future benefits of business ownership must come from earnings or cash flow – either from the operation or the investment, liquidation or hypothecation of the assets, or sale of the interest.”
Using a variety of methods, O’Malley says three primary business appraisal approaches have evolved over time – the asset model, which evaluates the means for continuing earnings and prepares some defense against periods of low earnings or losses, the income approach, which considers current income and cash flow as an indicator of future benefits that will accrue to shareholders, and the market models, which calculates the price-to-earnings ratio, a price-to-book value ratio or some other relationship derived from market data.
According to O’Malley, one or some combination of the three models can provide key business valuation data.
Cash flow history was critical for Mike Walrod when he acquired the Kansas City-based process server firm, HPS Process Services & Investigations in February this year. Walrod’s offer was based largely on company projections. However, he also considered the company’s stable business record, solid reputation and the value of the business overall.
“This is such a unique industry that there weren’t a lot of transactions to compare it to at the time,” Walrod said. “As a general rule, in Kansas City and the Midwest, a service oriented business is priced three to four times the cash flow. This deal ended up being more than that.”
Walrod spent four months assessing the value of the business, using a variety of analytics, touring facilities, reviewing the firm’s existing contracts, and reviewing its overall records. The deal required an additional third-party valuation and took about four-months to complete, based on the terms of Walrod’s Small Business Administration (SBA)-financed loan.
There was very little “haggling,” Walrod said, thanks to his thorough research, realistic expectations and the terms of the SBA financing. The only real challenge, he said, was negotiating the deal over a holiday season, where vacation schedules slowed the work of other professionals, such as attorneys and accountants.
“There are really only two or three things you can haggle over – purchase price and terms,” Walrod said. “If you want to get a deal done in Kansas City, you have to be flexible. The seller and I thought alike and tried to understand each other’s perspective. We both compromised on a lot of things, so there was very little bluffing.”
This was Walrod’s second business. He purchased the college testing company, Get Smarter Prep, in Overland Park and Leawood three years ago. And while it differs significantly from HPS Process Services & Investigations, Walrod learned a few things along the way.
“Figure out what kind of business you want to buy and be disciplined about what you want to pay,” he said. “Do your homework, not just on the business valuation, but on what plans you have for it after the purchase. Think about what you’ll do next once you have the key.”
Business valuation expert John Korschot, president of Stern Brothers Valuation Advisors describes the process as “trying to hit a moving target.” With shifting personal, tax and economic conditions, the market is a buyer or seller’s best guide.
“Normally, a valuation is based on a point in time,” Korschot said. “We don’t start out assigning a price to a business without doing the homework first because it can change at any time.”
David Cacioppo is president and CEO of emfluence, a Kansas City-based interactive marketing agency, and he has been a buyer and seller. Cacioppo was a partner with the advertising agency, CHRW Advertising. Although the agency was not looking to sell, opportunity came knocking.
“At that time, I was the partner who primarily managed the digital marketing arm of the business, emfluence. We were just a few years into the development of our marketing technology. Because the buyer didn’t have as much direct need for digital marketing expertise or technology at the time, I believed that they would under value that portion of our business,” Cacioppo said. “I also was looking five to 10 years into the future and I very much over valued it. It would have taken more than any reasonable buyer would have paid to get me to sell it.”
Cacioppo met O’Malley through the Helzberg Entrepreneurial Mentoring Program, and as his mentor, O’Malley suggested that the digital side of the business be carved out of the deal so he could keep it. It worked. The other partners sold the traditional side of the business and Cacioppo kept emfluence.
Cacioppo admits the process of valuing and selling a business was “completely foreign” to him and that he had no idea of what the business was worth.
“Without a reality check we would have overvalued the business and never completed the transaction. We were also fortunate that we had a strong relationship with the buyer, so conversations were amicable throughout,” Cacioppo said.
Cacioppo’s acquisition experience is recent. This year, Cacioppo acquired Spiral16, an analytics technology company focused on listening, monitoring and analysis, and a book of business from a large full service agency that allowed emfluence to get into the business of lead generation and brokering. This time, Cacioppo was more involved in the vetting process, but still relied on third party support.
“It’s easy to find reasons to over or under value something when you let emotions get in the way. Having a third party is a great reality check,” he said.
Cacioppo also leveraged his own metrics to assess the value of the business when acquiring Spiral16. Because he was primarily interested in that company’s technology and talent, everything else, revenues, profits, processes, etc.., was a close second.
“Buying made more sense because we ended up bringing in a much more powerful technology than we would have built. We also saved at least 12 to 18 months of development time and money,” Cacioppo said.
Transaction terms were also an important factor in Cacioppo’s acquisitions. In the case of the book of business, the terms included a performance goal. If Cacioppo doesn’t reach the goal by a certain date, he will either need to pay out additional funds or relinquish the business back to the seller.
Regardless, the experience always nets new learning, as Cacioppo discovered.
“Take your time and make sure you really have the time it will take,” Cacioppo said. “I could not have made any of it happen alone. I was heavily dependent on a very strong internal team and my advisors.”