Derek Groff

Derek: While there can be differences between small and medium sized businesses other than size, there are not nearly as many as compared to larger or even public companies. The biggest difference I see often relates to the strength of the business and its financial position. Smaller companies can frequently struggle with challenges that one would expect, ranging from financial resources to product development, and market strategy to operational efficiency. Medium-sized businesses may face the same challenges, but they have usually overcome issues like initial capital constraints, product strategy and lack of leadership. While the differences between small and medium sized businesses can still be numerous, I am assuming that these types of companies are still private and in their growth stage, so operational and competitive risks are still numerous and likely, and not that different from one another.

Derek: There are several, significant differences between valuing closely-held and publicly-owned businesses. The most notable deal with the size of the enterprises, access to capital, profitability, liquidity and marketability, among others. Given public companies do not have the same marketability or liquidity issues at play, valuing them typically does not involve those types of discounts, although not always if the business is thinly traded or is in a distressed situation. Additionally, public companies often have a full management team whereas private companies frequently have an incomplete executive team, as well as little to no Board of Directors governance. Finally, private companies can often have complex capital structures with multiple classes of equity securities including preferred stock, warrants and stock options, in addition to common stock. Depending on the level of value (control versus minority, non-marketable), discounts and variances with respect to cost of capital can vary substantially.

Derek: A “cap rate” is typically defined as a company’s cost of capital or discount rate minus its long-term growth rate. It is a measure typically used to capitalize historical earnings or cash flows in order to determine the value of a business (often in the absence of an available financial forecast for a profitable business). It is frequently used in Real Estate investments where the cash flows are steady and predictable. Another way to calculate it is to divide annual operating income by the original cost or price paid for an asset. The higher the cap rate, the lower the implied value of a business, and vice versa. If you think of a cap rate as representing risk and the growth prospect of a company’s cash flow , then it would make sense that a lower cap rate (less risk and/or high forecasted growth) equates to a higher value for a business. Said another way, a cap rate is essentially a rate of return so the higher the cap rate, the higher the potential return of an investment.

The higher the cap rate, the lower the implied value of a business, and vice versa.

Derek: Economic forces affect the value of a business in that a company’s success can often be tied to the opportunity it represents to a hypothetical buyer or investor. When the economy is as strong as it is currently, trading and valuation multiples often trend upward as companies/investors have more financial resources at their disposal and a seemingly bigger appetite for risk. This is illustrated in record highs in corporate profits as well as valuations for public companies and private companies, including implied valuations for venture capital financing. The same can be said when the economy is struggling and companies find it more difficult to increase sales and expand margins. Also, risk in a flourishing economy appears lower than it might in a down market when competitive, financial and economic forces are more challenging. Interest rates and access to debt or equity financing vary significantly depending on the broader economy as well. However, just because the economy is doing well does not necessarily mean all businesses are worth more today than say, two years ago. Businesses still need to shows positive growth, increased profitability, etc. in order for the value to increase. A strong economy often has a “rising tide floats all boats” type of impact in many industries and can skew the value of a business relative to its intrinsic value.

Derek: It depends on the business and it depends on the buyer. Each buyer is different and their motives for acquiring a particular company can significantly impact their perception of a target company. Since perception is relative and can vary substantially, companies considering selling should try to anticipate as many potential risks, concerns and deal-breakers as possible, before the sales process even begins. Some things are easy to foresee, like solid financial statements or a strong leadership team and salesforce. That may not guarantee a transaction or a high offer, but it will certainly help shape how a buyer views a company that it is considering acquiring. That all equates to risk and value in some way. However, financial buyers will differ from strategic buyers so what may be important to one party may be irrelevant to the other.

Derek: Strategic buyers are typically operating companies that often provide competitive or complementary services and/or products. They can also be partners or suppliers that the company already has a relationship with. The goals of a strategic buyer can be many, but they often boil down to strengthening its product portfolio, expanding its market presence or market share, and maximizing the revenue and/or cost synergies that it identifies as part of the transaction. A strategic buyer can be uniquely positioned to leverage its existing relationship with the target company and can synergistically integrate the target company into its existing platform. A strategic buyer is often focused on synergies and how it can create more value than the existing target company currently offered as a stand-alone entity . As a result, strategic buyers can often pay more than a financial buyer whose only goal is to maximize return on investment (ROI), which frequently lends itself to paying less.

A strong economy often has a “rising tide floats all boats” type of impact in many industries and can skew the value of a business relative to its intrinsic value.

Derek: I would say that if your business operates in an industry where there are many direct competitors and complementary suppliers/services, it is likely that the business may sell to a strategic buyer. While a company might attract interest from all types of buyers, strategic buyers have the benefit of often being able and interested in paying more for a target company as they can realize synergies that a financial buyer cannot (complementary product offerings, facilities consolidation, eliminating redundant back-office infrastructure, personnel reduction, and so on).

The risk, of course, is that the brand or business goes away entirely after the acquisition , as the transaction could purely be a defensive one designed to simply eliminate the competition. Another big risk of selling to a strategic buyer is the integration of products, people and culture. The majority of mergers and acquisitions (M&A) transactions that fail are due to poor integration planning and classes of corporate culture. So, while it can be a great opportunity to sell to a strategic buyer, there are more corporate risks to consider. This may not be as much of an issue for owner-operated businesses, but there still remains more of a risk than selling to a financial buyer.

Derek: Without question, being able to provide a forecast of your business, even out just one year, is highly recommended. Not only does it indicate good operational control, but a financial forecast can be a very valuable tool for a valuation expert to assess the value of a business. Certainly a business valuation can be completed without a forecast, but it does limit the types of valuation approaches and methodologies one can employ. I always recommend that the clients and business owners that I meet, create a forecast for their business. The longer the forecast, the better, to the extent that they can reasonably project the future of their business without significant guesswork or uncertainty.

I always recommend that the clients and business owners that I meet, create a forecast for their business.

Derek: Do your due diligence , be prepared for anything and keep an open mind. Whether buying, selling, or appraising, there is always a valuation range that is reasonable and agreeable, no matter what side of the table you are on. Remember that value is relative, and can mean different things to different people, so the key is to know the exact purpose or goal of the engagement and who the key players are (owners, investors, auditors, IRS, SEC, etc.). For businesses that are considering selling, preparing for a potential liquidity event is key to maximizing the purchase price . We recommend that companies start getting ready for a sale 18-24 months before they want to exit the business. That includes insuring that the company has audited financials, clean operational systems and controls, no legal/compliance issues, etc. From a buyer’s perspective, analyzing the legitimacy of a business that is “clean” helps mitigate risk, which ultimately gets factored into the purchase price or into the offer that the buyer is willing to make.

Derek Groff’s Bio

Derek Groff, ASA
Frank, Rimerman + Co. LLP
San Francisco, CA
(707) 967-5322
dgroff@frankrimerman.com
www.frankrimerman.com

Derek is a Senior Manager with Frank, Rimerman + Co’s Business Valuation Group where he specializes in providing business valuation and consulting services for financial, strategic, tax and litigation purposes.

A frequent public speaker at professional organizations and universities nation-wide, Derek has 15 years of professional experience in investment banking, mergers and acquisitions, and fundamental business valuation. His primary industry focuses are technology, life sciences and alcohol beverages. Prior to joining Frank, Rimerman + Co. LLP, Derek was a Director in the Corporate Development Group at Symantec Corporation where he worked closely with the CEO and CFO to acquire key companies and assets, create joint ventures, invest in small startups and help formulate M&A strategy.

Prior to Symantec, he was an investment banker at UBS and Credit Suisse First Boston in their technology groups. Derek has been involved in over 30 closed equity, debt and M&A transactions totaling over $15 billion in transaction value. He is an Accredited Senior Appraiser in Business Valuation with the American Society of Appraisers and holds a Series 79 license for Investment Banking services.