Friday, December 5, 2014

Preparing for a Business Sale or Capital Raise - Business Valuation


Business Valuation Calculations

Most business valuation instruction calls for determining the enterprise value of a business by adding together the present values of several forecast years’ free cash flow and the business’s terminal value (final forecast year free cash flow times a multiple).  An often used, shorthand, less rigorous approach to calculating value is to multiply a company’s actual or forecast year-one EBITDA times an average market multiple as reported by many investment banks and other sources.  This later approach completely ignores pretty much all of the unique characteristics of a business, most importantly its prospects for revenue and profitability growth.  In the public company realm this approach would be the equivalent of stating that all Nasdaq-traded common stocks should sell at the same multiple of earnings per share.

Among other deficiencies, many valuation approaches like those above leave out critical pricing factors which are extremely important to professional investors and sellers alike, i.e., they do not compute the buyer’s expected return on its equity investment as a result of paying a computed enterprise value.  In order to calculate the buyer’s expected return on its equity investment one needs to factor in the nature of the sellers assets (some of which may be used as loan collateral); the buyer’s likely capital structure to accomplish the specific acquisition; and the financial forecast for the business during the buyer’s expected ownership period.

Remember, most businesses are purchased using a combination of equity capital and (non-recourse) debt as the sources of funds.  It is the expected return on the equity portion of the capital structure that strongly influences investor offering price decisions and, therefore, business valuation from the buyer’s perspective.  When VCs say that they made a five-to-one return on an investment (e.g., 38% per year compounded, over five years) they are referring to the return on their equity investment in a business, not the gain in the business's enterprise value.

Corpfin.Net’s Business Valuation Software

Our Web-based software (www.corpfin.net) computes the maximum purchase price a buyer can offer for a business, given the buyer’s target rate-of-return on its equity investment.  Its starting point is a five-year financial forecast for the business, with a nested application that creates the acquired company’s opening balance sheet showing the buyer’s sources of capital; forecasted financial statements of the newly formed company during the buyer’s ownership period; and several reports that prove the results of the valuation analysis.

Our software approaches business valuations and transaction pricing as an algebra word problem (i.e., compute a maximize business value, given a number of variables and constraints; and provide a proof).

The elements of our analysis are as follows:

Problem Statement

A financial buyer wishes to purchase a business using both equity and debt to fund the purchase price [or the CEO of a business is preparing to sell the business and is educating himself on how buyers value acquisition candidates.  Comments below view the problem from a buyer’s perspective].

The business has supplied the buyer with a five-year forecast of operations (income statements, balance sheets, cash flow statements), along with the set of assumptions giving rise to the forecasted financials.  The buyer has modified the assumptions and related forecasts to fit its expectations for the future performance of the business and wishes to make an offer to purchase the business based on the buyer’s forecast and other relevant information.

Using discounted cash flow (DCF) methodology, what should be the maximum amount of the buyer’s offer (maximum enterprise value), given:
  • The buyer’s financial forecast for the business.
  • Current M&A and credit market conditions.
  • The annual pre-tax rate of return required on the buyer’s equity investment and by a provider of subordinated debt, if any.
Solution

Objective Function:  Compute the maximize purchase price (enterprise value) of the business paid  by the buyer to the seller (forecast year-one EBITDA times a derived EBITDA multiple equals the maximum purchase price).

Variables and Constraints (not in order of importance):
  • Buyer’s version of a five-year financial forecast (income statements, balance sheets and cash flow statements) for the business.
  • Auction value of plant, property and equipment (fixed assets).
  • Operating expense adjustments, if any, post acquisition.
  • Amount of purchase price seller will finance.
  • Annual pre-tax rate of return required on buyer’s equity investment.
  • Percent of purchase price provided by common and preferred stock.
  • Preferred stock amount.
  • Annual pre-tax rate of return required by the provider of subordinated debt.
  • Estimated terminal EBITDA multiple the business will sell for at the end of the buyer’s ownership term.
  • Estimated interest rates to be paid on senior and subordinated debt during the ownership period.
  • Intangible asset amortization period (years).
  • Transaction expenses as a percent of the purchase price.
  • Senior loan advance rates for accounts receivable, inventory and fixed assets.
  • Income tax rate for business during buyer’s ownership period.
  • Current maturities of long term debt during buyer’s ownership period.
Proof

Our reports cover not only the business valuation and the details of the estimated purchase and sale transaction, but also the financial performance of the business before and after the sale.  This feature makes our software useful to both sellers and buyers because it acts as a proof of the estimated transaction pricing; capital structure employed by the buyer; and the returns on equity and subordinated debt.

Reports are as follows:
  • A multi-page narrative report that organizes and provides an interpretation of the individual valuation scenario.  The report is organized in a manner to help the user understand and logically describe the key elements and results of the valuation to a third party.
  • A comprehensive statistical report that depicts the valuation result and the financial outcomes achieved by the seller and buyer of the business.
  • The primary financial statements - annual income statements, balance sheets and cash flow statements showing the financial performance of the business prior to and after the purchase by the buyer.  The forecast information is at approximately the same level of account detail as an accountant’s standard year-end report.
  • A financial assumptions report. Our valuation model contains 190 assumptions in total (that’s 35 income statement and balance sheet assumptions for each of the five forecast years, plus 15 assumptions relating to the capitalization and rate of return objectives of the buyer).
  • Two financial metric and performance reports.  The first report is organized into six management sections (working capital; assets; liabilities; profitability; debt; and bank borrowings).  It contains 43 different metrics for each historical and forecast year.  The second report is a subsection of the first report and focuses on debt service metrics that are particularly important to lenders.
The above iteration of our business valuation software solves for maximum purchase price, given a buyer’s required rate of return on its equity investment.  A second iteration computes the buyer's rate of return on its equity investment, given a buyer’s purchase price offer or a seller’s specific price target.

Both iterations’ assumptions can be set to reflect the sale of the business to either a financial or strategic buyer.  See our post, Strategic Buyer Purchase Valuation, for details.




Monday, September 16, 2013

The “Venture Capital” and “First Chicago” Methods for Valuing Private Company Investments

For those who are interested in an in-depth discussion of the “Venture Capital” and the “First Chicago” methods for valuing private company investments, we recommend reviewing Method For Valuing High-Risk, Long-Term Investments The “Venture Capital Method” by Harvard Business School Professor William A. Sahlman and Associates Fellow Daniel R. Scherlis.  The revised article, published on July 24, 2009, is available for download at Harvard Business Review.

For an additional, summary explanation of the methods, please see Valuing a Business: The Venture Capital Method, National Association of Certified Valuators and Analysts (NACVA) 1999, offered by The McLean Group at http://www.mcleanllc.com/pdf/vcarticle99.pdf.

The “Venture Capital” and the “First Chicago” methods, which are considered by many to be the most appropriate methods for valuing private company investments, can be implemented in minutes using the Corpfin.Net’s Web-native Private Equity Placement and LBO Valuation models.     

Thursday, December 13, 2012

Strategic Buyer Purchase Valuation

Recently I was asked by a strategic buyer to estimate the purchase price of an acquisition candidate which was being sold through an auction run by an investment banking firm.  Based on the financial forecast (unrealistically optimistic) provided by the acquisition candidate, I used the Corpfin.Net LBO model to estimate the purchase price that private equity groups might submit as their first round bids.  The strategic buyer bid that estimated purchase price and made it into round-two of the auction.

As a result of qualifying for round-two, the strategic buyer was given access to the acquisition candidate's management and records and, based on that input and analysis, revised the round-one forecast to fit its (the strategic buyer's) outlook for the business.  The question at that point was: what should the strategic buyer's final bid be, knowing that its investment hurdle rate (required pretax rate of return); sources of acquisition funds; and debt recourse obligations are very different from those of the usual private equity buyer?     

To calculate the suggested round-two strategic buyer purchase price bid I used the Corpfin.Net LBO model and reset the required pretax rate of return target and the cost of those funds.  Specifically, I set the required rate of return on both equity and subordinated debt to equal the strategic buyer's hurdle rate; and set the current-pay interest rate on subordinated debt to 0%. 

The revised required rates of return assumptions reflect the reality that all strategic buyer acquisition funding in excess of senior bank debt is equity investment (due to use of corporate cash and/or debt with recourse provisions to accomplish the acquisition).   

The zero current-pay interest rate assumption on subordinated debt ensures that all cash generated by the acquired business is taxable and either reduces senior debt or is invested with a return equal to the senior debt interest rate.   This assumption eliminates the optimistic assumption in some analysis methods that cash generated by an acquisition's operations is reinvested at the (higher) investment hurdle rate.  

The round-two purchase price bid resulted in the strategic buyer being asked to participate in final sale negotiations.
*****

Please see the Corpfin.Net LBO model tutorial and our LBO model blog post for additional information about LBO valuation.

If you are a business looking to buy another business please consider using the Corpfin.Net LBO model in your purchase valuation.  If you have any questions about the model, please contact me at tgf@corpfin.net.

Wednesday, November 16, 2011

Start-Up Financial Forecasting

Introduction
Start-up and early stage businesses underperform or fail largely because they run out of money (cash and credit).  In some instances entrepreneurs start businesses that will never generate the profit margins needed to pay for committed fixed assets and recurring operating expenses; and sometimes they run out of money after starting-up because they do not completely explore the possible financial consequences of what appear to be very sound operating decisions.

For example, starting a new retail store and spending most available funds (cash and credit) on fixtures and space improvements can place a great strain on remaining funds to pay employees, suppliers, rent, etc; and to weather the period it takes to build a profitable clientele.  Likewise, growing too quickly relative to a start-up’s available funding - evidenced by too high an investment in accounts receivable and inventory - can cause the same financial strain.

In any case, it is tragic to see promising businesses die, causing family wealth to be decimated, because of financial issues and obstacles that could have been identified and possibly overcome before operating plans were executed.

Financial Forecasting
Businesses are dynamic financial systems.  Changes in financial viability arise because a set of actions (operating initiatives) create effects (balance sheets and cash flow) that, in turn, cause other effects.  A primary task of sound financial management is forecasting the possible financial effects of business initiatives before the initiatives are undertaken and, based on forecasted outcomes, rebalancing choices to best protect the sustainability of the business. 

Forecasted income statements, balance sheets and cash flow statements are the financial dashboards that can assist entrepreneurs in exploring the financial effects (the “what-ifs”) of business initiatives.  Financial managers need to have a feel for the financial effects of business decisions - how decisions are monetized into the dashboards, and insight into the impacts on the dashboards after the decisions are implemented. 

The goal is to identify the unintended financial consequences of planned business initiatives; and to develop action plans, in advance, to mitigate their negative effects.

Forecast Software
If you do not already have a method to produce forecasts for your start-up or early stage business, please consider Corpfin.Net’s  web-based, easy-to-use business financial planning software.  The software helps create five-year financial forecasts, and 12 monthly forecasts for each of the five forecast years. 

Our start-up forecast model is used by businesses that have no operating history.  Our early stage model is used by businesses that have very limited (i.e., less than 12 months) historical financial information. 

Because start-up and early stage businesses have little or no historical financial history, we use SIC code financial data to help create the first draft of a forecast.  The models create a first draft forecast using a few user sales assumptions and the financial metrics for businesses in the primary industry in which the start-up or early stage business expects to compete.  The user can modify that draft’s assumptions to customize the forecast to suit her unique business circumstances. 

The major benefits of using the SIC code data are first, it provides guidance with respect to the profitability and asset investments by mature businesses in the industry of interest; and second, it is a very quick and easy way to get the financial planning process started. 

Our five-year forecasts are documented with eleven reports which include:
  • An S I C extract showing the financial data on which the first draft forecast is based.
  • A narrative report that is organized in a manner to help present the key elements and results of the forecast to a third party.
  • Multiple versions of forecast financial statements (income statements, balance sheets and cash flow statements) and forecast assumptions reports.
  • Comprehensive financial metric reports.
Our single-year model is nested within the five-year forecast models and enables the user to create single year forecasts (i.e., split a single year's forecast into twelve (12) individual monthly forecasts) for any year's forecast.  Reports generated by this model are similar to those documenting the five-year forecast.

Thursday, January 13, 2011

Private Equity Model and Valuation Basics

Background
Private equity placements are minority (less than majority) investments in the ownership of private businesses that need capital for a variety of reasons, including: to expand operations; to restructure their balance sheets; to enter new markets; or finance major business acquisitions.

Generally, businesses that seek private equity funding generate revenue and operating profits, but are not able to produce sufficient cash flows to support new initiatives, or to borrow needed funds from senior lenders.

Private equity investments can be in the form of ownership units (common stock, preferred stock, partnership units or LLC units, depending on the legal structure of a business); or in subordinated debt with warrants, also referred to as mezzanine capital, which are loans which require periodic interest payments and allow holders to buy business ownership units in the future for a de minimis price per unit. 

Issuing new ownership interests in a business is usually very costly to existing owners in terms of the ownership give up, the likely loss of management’s prerogatives to run the business as they wish, and the potential for additional ownership dilution if the business plan, on which the new equity investment is based, is not accomplished. 

On the positive side, additional equity capital allows a business to pursue opportunities it could not otherwise undertake.  The important issue for existing owners is to weigh all of the costs and risks associated with the issuance of new equity against the potential increase in their personal wealth resulting from accomplishing the business plan that requires the new equity capital.   

Private Equity Valuation
Key metrics in a private equity analysis are the estimated "pre-money" and "post-money" values of a business, and the ownership splits immediately after the equity financing. 

The estimated pre-money value is the value of a business (that is, its enterprise value less its liabilities) before the new equity funding is added to a company’s balance sheet. 

The estimated post-money value of a business is equal to the sum of the pre-money value, plus the amount of new equity investment, minus issuance expenses. 

Subordinated debt with warrants is a hybrid security.  The principal amount of the subordinated debt is not added to the post-money value of a company because subordinated debt is a debt obligation.  It adds identical and offsetting amounts of assets and liabilities to a company’s balance sheet and therefore provides no net change in the value of a company.  While the value of warrants "attached" to subordinated debt are expected to be valuable to subordinated debt investors, their value to a business at the post-money valuation date is immaterial.

Estimated pre-money and post-money values are unique amounts that are derived from the interaction of a large number financial forecast assumptions and investment inputs.  Accordingly, changes to assumptions or inputs will result in changes to both values. 

Building a Private Equity Model
The amount of equity and /or subordinated debt sought in a private equity placement is usually an amount that bridges the gap between a conservative estimate of the amount senior lenders will lend a company and the total funding a company needs to achieve its long-term financial plan.   

We suggest forecasting, by month, the first two years subsequent to the planned private equity placement to determine if the amount of equity capital sought is sufficient to withstand expected monthly variations in net sales and cash flow; and to satisfy intra-year compliance with debt covenants.  Funding and compliance that may appear satisfactory on an annual basis may not be so during yearly interim periods.

Key assumptions and investment inputs used to create a private equity analyses include:
  • The sales, profit, asset and liability assumptions contained in a business’ five year forecast.  Because additional equity capital usually supports higher growth rates than can be accomplished without that funding, it is possible that the original five-year forecast (without the new equity capital infusion) should be adjusted to reflect increased business opportunities.  
  • The amounts, investment types and pretax annual rates of return (RORs) required by new investors on their equity and subordinated debt investments.
  • The EBITDA multiple used at the end of the forecast period to estimate the gross value of a business at that point in time.  That gross value, minus the liabilities of a company retained / paid off by the investors at the end of the investors’ ownership period, is a proxy for the pretax value of all investors’ future interests.  That residual value is the amount that is divided among the original and new equity investors in accordance with their respective percentage ownership interests.
New investors annual pretax rate of return target on common and preferred stock investments is effected by a number of factors, including: the level of competition among investors for private equity investments; the perceived risk associated with an investee’s industry and the likelihood of achieving the forecast results; the rate of return target for the investor’s private equity fund; and possible dilution in ownership percent due to possible follow-on financing rounds. 

Generally, the higher the pretax rate of return required by new investors, the lower the pre-money valuation of a company and the lower the percent of ownership retained by the original equity investors. 

Providers of subordinated debt typically want to earn a total rate of return on their investment in the 20% range, with that return coming from the combination of quarterly interest payments and a share of the sales proceeds when a business is sold.  As such, the higher the coupon rate on subordinated debt, the smaller the share of the sales proceeds paid to subordinated debt holders when the business is sold. 
                 
The EBITDA multiple used to value a business at the end of the five year forecast period is a key private equity valuation assumption.  Like investors’ annual pretax rate of return targets, EBITDA multiples vary over time due to changes is various economic, credit and competitive conditions affecting the market for business investments and acquisitions. 

Private equity models built with spreadsheets integrate some fairly complicated math and accounting routines.  Those who wish to build their own models may find it helpful to review How to Fix Circular Formulas in Excel (http://www.ehow.com/how_4842732_fix-circular-formulas-excel.html).

Corpfin.Net Private Equity Model
If your objective is to generate private equity analyses and valuations, rather than spend your time creating and debugging your own spreadsheet model, our private equity model may be a good fit for you. 

To create a private equity placement analysis with our software a user must first create a five year financial forecast using our forecast model for either an established, start-up or early stage business. 

Our private equity placement model is one of three robust applications nested within our five year financial forecast models.  This design feature means that once you have completed a five year forecast, you are just a few moments and assumptions away from creating a private equity analysis which is supported by eight comprehensive reports.  In addition, our model makes it easy to create and save multiple valuation scenarios, with different operating forecasts, investment return and capital structure assumptions.
  
We approach a private equity placement as if, theoretically, the original investors in a business and the new private equity investors form a new company on the private placement date.  The original investors contribute their business (on a pretax basis), which is valued at its enterprise value less its liabilities.  The private placement investors contribute cash.  From the private placement date through four years of joint ownership, both sets of investors earn the same pretax rate of return on their equity investments.   

From a timing standpoint, our private equity model assumes that a private equity placement investor intends to invest in the business at the beginning of year two (2) of the five year forecast; to maintain his ownership interest for the ensuing four (4) years; and to sell his ownership interest, along with the original owners, when the business is sold at the end of the fourth year.  Again, a key attribute of our model is that both the original and new investors earn the same rate of return on their equity investments from the private placement investment date through the sale of the business at the end of the fourth year of ownership.

With respect to project documentation, reports generated by our model cover not only the details of the estimated private equity transaction, but also the detailed financial performance of the business before and after the financing.  This feature makes our private equity model useful to both original and new equity investors because it acts as a proof of the estimated transaction pricing; and it provides the means to examine the effectiveness of the equity infusion in serving the financial interests of the original equity investors.  Reports in both HTML and PDF formats are as follows:

  • A multi-page narrative report that organizes and provides an interpretation of the private equity analysis.  The report is organized in a manner to help the user logically present and describe the key elements and results of the analysis to a third party. 
  • A comprehensive statistical report that depicts the financial outcomes achieved by original and new equity investors. 
  • The primary financial statements - annual income statements, balance sheets and cash flow statements - showing the financial performance of the business prior to and after the private equity placement.  We forecast information at approximately the same level of account detail as an accountant’s standard year-end report. 
  • A financial assumptions report.  Our private equity model contains 162 assumptions in total (that’s 31 income statement and balance sheet assumptions for each of the five forecast years, plus 7 assumptions relating to the valuation and the rate of return objectives of the new investors). 
  • Two financial metric and performance reports.  The first report is organized into six management sections (working capital; assets; liabilities; profitability; debt; and bank borrowings).  It contains forty-three different metrics for each historical and forecast year.  The second report is a subsection of the first report, and focuses on debt service metrics that are particularly important to lenders. 
For additional details concerning the operation of our private equity model, please see our tutorial at http://www.corpfin.net/newsite/models/tutorial4.shtml

If you have any questions about our private equity or other corporate finance applications, please feel free to contact me at tgf@corpfin.net. 

If you are a friend of a person who is thinking about raising private equity capital, or investing in a private equity opportunity, please send her/him the link to this post.

Tuesday, December 14, 2010

Buyout Analysis of Caterpillar’s Agreement to Acquire Bucyrus International

On November 15, 2010 Caterpillar Inc. (CAT) announced its agreement to acquire Bucyrus International, Inc. (BUCY) for $92 per share.  The transaction is expected to close in mid-2011.

I did a forecast of BUCY’s future operations assuming a 26.4% growth in revenues in 2010 and 8.0% per year for the years 2011 through 2014; and operating margins of 14.8% in 2010 and 17% for years 2011 through 2014.

Given that forecast and other assumptions (see link below), I calculated a financial buyer’s estimated pretax rate-of-return (PROR) resulting from buying BUCY in a hypothetical asset purchase in which the sellers receive net proceeds equal to $92 per share.  The purchase price is based on BUCY’s 82.253 million fully diluted shares outstanding for the quarter ended September 30, 2010. 

The results of the buyout analysis show an estimated PROR of approximately 11.0% on the financial buyer’s equity investment.  The return would be lower if the buyer were required to grant warrants to subordinated debt providers.

The return for CAT would likely be higher due to operational synergies not available to a financial buyer.  That said, if a financial buyer were able to reduce forecasted operating expenses by 10% per year during its four year ownership period, the estimated PROR on its equity investment would increase from approximately 11.0% to 16.5% - still a low expected return for private equity investments.   

Click here to access PDFs of the various buyout analysis reports at Google Docs. The “Overview” narrative report describes the valuation method and results.

[Note:  If you sign in to Google Docs using your Google account information, Google Docs allows you to view, print and download the buyout analysis reports]

Thursday, December 9, 2010

LBO Model and Valuation Basics

Background
A leveraged buyout (LBO) is a type of business acquisition in which a buyer (typically a private equity partnership) acquires a company and uses debt to finance a significant percentage of the purchase price. 

The proportions of debt and equity capital used to finance LBO transactions depend on a number of factors, including:
  • Credit market and general economic conditions.
  • The historical and forecasted operating performance and management expertise of the company to be acquired.
  • The ability of the acquired company to meet forecasted interest and principal repayment requirements.
  • The market value of the tangible assets to be acquired.
  • The buyer’s appetite for financial risk.
In an LBO transaction, the assets of the acquired company are pledged as collateral for debt, and the acquired company (or a newly formed company containing the assets of the acquired company) is the borrower.  The debt is usually in the form of secured bank loans and, if the acquisition is of sufficient size, subordinated debt provided by investment partnerships.

LBO debt is almost always non-recourse to the business buyer, meaning the buyer is not liable if the debt is not repaid by the borrower.  If the borrower defaults on the debt, the lender(s) may seize the pledged collateral, and debt recovery is limited to the amount realized from the disposal of the collateral.

The LBO form of business acquisition is attractive to business buyers because they need to fund only a fraction of the acquisition purchase price.  This funding strategy reduces the buyer’s at-risk equity investment, and enhances his return on investment, if the acquired company performs as expected. 

If the acquired company does not perform as expected, the debt service requirements of a leveraged capital structure can range from very challenging, to a situation in which the buyer’s equity investment is worthless.

LBO Valuation
LBO valuations use the financial structure and analyses techniques employed by LBO buyers to estimate the value a business.  The valuation presumes the business buyer is a “financial buyer” (for example, a private equity partnership) that owns no other company in the acquired company’s industry and, therefore, expects all of its investment return to result solely from the forecasted performance of the acquired company.   

An LBO valuation is typically built on a five year financial forecast of the acquired company’s operations.  The valuation analysis forecasts the operations of acquired company during the forecast period, the debt and other liabilities repaid during the ownership period, and contains an assumption about the multiple of earnings a business will be sold for at the end of the ownership period.  By targeting pre-tax annual rates of returns on equity and subordinated debt investments consistent with those sought by private investment funds, an LBO valuation estimates  the purchase price a financial buyer should be willing to pay for a business to achieve those returns. 

In general, an LBO valuation estimates the minimum current value of a business since buyers who already own similar businesses, and would benefit from operational synergies with the acquired company, will usually pay more for a given business than will a financial buyer.  These synergistic buyers are also known as "industry buyers". 

An LBO valuation model can emulate industrial buyer pricing by adjusting the financial forecast of the acquired company to fit its revised ownership - generally by increasing forecasted sales and/or reducing costs and expenses of the acquired company due to its ownership by a complementary enterprise. 

Building an LBO Model
For those interested in creating their own LBO model, eHow.com provides a helpful narrative titled “How to Build an LBO Model” (http://www.ehow.com/how_5106647_build-lbo-model.html).  eHow.com is an online community (80 million visitors per month) dedicated to providing practical solutions to completing a huge variety of task.

The eHow instructions indicate “the key elements of an LBO model are the three major financial statements (income statement, cash flow statement and balance sheet) as well as assumptions regarding debt levels, repayment periods and interest rates.”

The narrative suggests the following steps to create an LBO model, using Excel as the software platform:
  • Enter an outline of the company’s capital structure.
  • Build the company’s income statement to the EBITDA level, entering at least three years of historical data for the income statement and then use this data to create five years of projected income statements.
  • Enter three years of historical balance sheet data.
  • Calculate historical balance sheet ratios, and use these ratios to calculate five years of projected balance sheet information.
  • Build the cash flow statement.
  • Create a debt pay-down schedule to determine interest expense.  Link the interest expense figure back to the cash flow statement.
  • Calculate the exit value for the business based on a multiple of year five EBITDA.
  • Use the XIRR formula in Excel to calculate the annual return on investment.  Compare the return on investment to the desired rate of return based on the riskiness of the investment.
  • Make sure that the circular references setting in Excel is enabled. Linking the interest expense back to the cash flow statement will create a circular reference, which Excel will not be able to execute unless it is set to manual calculation.
The instructions indicate that a “basic knowledge of finance and accounting will be very helpful in building an LBO model”... and that the difficulty encountered will be “moderately challenging.”

Corpfin.Net LBO Model
If your objective is to generate LBO valuations, rather than spend your time creating and debugging your own Excel model, our LBO model may be a good fit for you. 

How does our LBO model differ from the (bare-bones) Excel model described above?
  • Our LBO model is one of three applications nested within our five-year financial forecast models.  This “nested” design feature means that once you have completed a five year forecast, you are just a few moments and assumptions away from creating an LBO valuation, supported by 8 comprehensive reports.
  • Our software creates an LBO valuation from the perspective of both a buyer and a seller.  We call these perspectives Cases.  Case 1, the most usual analysis, views the business acquisition from the point of view of the business buyer and solves for the purchase price of the business acquisition, given the buyer’s required pre-tax return on its equity investment.  Case 2 views the business acquisition from the point of view of the seller and computes buyer’s return on its equity investment, given the seller’s target selling price of the business.  In instances where parties disagree about valuation, we find that looking at a transaction from both points of view leads to constructive discussions and negotiations. 
  • Our LBO model makes it easy to create and save multiple valuation scenarios, with different operating forecasts, investment returns and capital structure assumptions, for a same purchase and sale transaction.
  • Our LBO model reports cover not only the business valuation and the details of the estimated purchase and sale transaction, but also the financial performance of the business before and after the sale.  Reports, in both HTML and PDF formats, are as follows:  
    •  A multi-page narrative report that organizes and provides an interpretation of the valuation results.  The report is organized in a manner to help the user logically present and describe the key elements and results of the valuation to a third party. 
    • A comprehensive statistical report that depicts the valuation result and the outcomes achieved by the seller and buyer of the business.
    • The primary financial statements - annual income statements, balance sheets and cash flow statements showing the financial performance of the business prior to and after the purchase by the financial buyer.  We forecast information at approximately the same level of account detail as an accountant’s standard year-end report.
    • A financial assumptions report.  Our LBO valuation model contains 183 assumptions in total (that’s 35 income statement and balance sheet assumptions for each of the five forecast years, plus 8 assumptions relating to the valuation and rate of return objectives of the buyer).
    • Two financial metric and performance reports.  The first report is organized into six management sections (working capital; assets; liabilities; profitability; debt; and bank borrowings).  It contains 43 different metrics for each of historical and forecast years.  The second report is a subsection of the first report, and focuses on debt service metrics that are particularly important to lenders.
If you are looking for an easy-to-use, sophisticated, presentation-oriented LBO model, please consider using ours.  You will save a lot of time vs. creating your own model - you will probably complete your first draft of a valuation, with all of our automatically generated reports, in about the time it takes to format the spreadsheet for a bare-bones Excel model. 

Please see our LBO model tutorial at http://www.corpfin.net/newsite/models/tutorial3.shtml for additional information. 

If you have any questions about our LBO or other corporate finance applications, please feel free to contact me at tgf@corpfin.net. 

If you have a friend who is thinking about buying or selling a business, please send her/him the link to this post.