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 ( 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.

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.

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.

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