LuM&A - The Art of Bright M&A | Part 3 - What to Expect When Expecting an Offer
LUM&A IS A FORTNIGHTLY SERIES WHERE WE SHARE OUR EXPERIENCES OF THE KEY ISSUES OWNERS FACE WHEN CONSIDERING SELLING THEIR BUSINESSES.
IN PART 3, WE EXPLORE WHAT TO EXPECT WHEN NEGOTIATING A SALE
IN PART 4, WE IDENTIFY THE KEY ISSUES THAT DETERMINE VALUATION MULTIPLES
PART 3: WHAT TO EXPECT WHEN EXPECTING A SALE
When selling your business, you can generally expect the offered price to be a multiple of annual “profits”. The most common “profit” measure upon which buyers are likely to assess the value of your business is EBITDA (Earnings Before Interest Taxes Depreciation and Amortization).
The EBITDA measure is often used as a proxy for the cash generated by the business, and a multiple is often applied to value the business as an approximation to the future cashflow that the business is likely to generate for the buyer, in today’s terms. EBITDA strips out the effect on many non-cash charges such as depreciation, provisions and financing costs and taxes. It therefore represents the operating “cash profits” that the core operations of the business generates on a yearly basis (subject to growth/decline) in return for the lump sum invested, ie the purchase price.
It is important to note that the value of the business derived above is the value attributable to ALL stakeholders in the business - Equity, Debt and long term financiers (such as finance companies providing long term equipment leases, employees accruing their end of service benefits yet to be paid and so on). What most business owners fail to appreciate is the amount of attributed “value” implicitly embedded in the business of stakeholders other than equity holders.
This often leads to a number of misunderstandings and negotiating points on purchase price versus business valuation between seller and buyer. We examine below the typical adjustments made to both EBITDA and value, in order to arrive at a “fair” estimate of what the equity price should be.
ADJUSTMENTS TO EBTDA OR EARNINGS
When assessing the Earnings of a business, what a buyer is typically assessing is the EXPECTED sustainable level of earnings of the business into the FUTURE. Most owners expect that the higher the most recent year earnings are, the higher the value of this business. There are a number of instances where this may be challenged. For example:
One off or non-recurring revenues. For instance, if the business benefitted from a one off project that contributed significantly to the profits of the year, this may be adjusted downwards on the basis that this isn’t repeatable or sustainable on a future annual basis.
Similarly, one off costs or non-operational expenses incurred may be added back to show a higher level of earnings. For example, one off rebranding or marketing costs, one off legal fees incurred, charitable contributions, or a one-time cost of either expansion or closure of certain units, including staff costs.
The shareholders’ salary is another key area of examination by a buyer. If earnings have been boosted by lower than market salaries for shareholders (who are often also the key management), often buyers will make an upward adjustment to reflect a market cost of the management. Similarly, in some cases, the reverse may apply.
Every upward or downward adjustment to the “Adjusted EBITDA” will have a multiplier effect on the value of the business.
luma-part-3-graph
HOW MUCH VALUE IS ATTRIBUTABLE TO EQUITY OWNERS?
We have discussed that the value of the business is attributable to all stakeholders above (the “Enterprise Value”). Once the Enterprise Value of the business is agreed, in our example, by the methodology described above, it is now key to examine how much of this value belongs to each stakeholder. Typically this total value would be carved up into
Net Debt – Typically bank borrowings and the capital value long term finance leases outstanding less any cash in the business.
Other Long Term liabilities – Typically employees accrued gratuities or unfunded pension entitlements
Working capital requirements – The deficit or excess of current assets (receivables, inventory and prepayments) over current liabilities (supplier payments due and other short term liabilities due).
SO WHAT'S THE BOTTOM LINE?
Let’s take an example of a business which has an agreed Enterprise Value of $100mil. It has cash of $4mil, bank borrowings of $15mil, equipment leases of $6mil, a working capital deficit of $5mil and unpaid employee gratuities of $2mil.
Net Debt is $(15mil-4mil+6mil) =$17 mil. This value is attributable to the debt holders
Other long term liabilities is $2 mil. This value is attributable to the employees.
Working capital deficit is $5mil. This value is attributed to the day to day cash operating requirements of the business.
The price that is then attributable to the owners of the business are what’s left over. So in our example above $100mil – ($17mil + $2mil + $5mil) = $76mil.
Still, not a bad payday!
Wishing all our readers a Merry Christmas and profitable success in the New Year 2017.
We enjoy writing these articles and hope you will continue to read them.
Lumina adds value to owners seeking to grow or exit their business by providing external guidance on decisions that matter.To find out more about Lumina’s Transaction Advisory services offering, click here.
By George Traub
Managing Partner | Lumina Advisers
George is a senior banker, finance professional and entrepreneur who has enjoyed a global career as a Managing Director, a CEO and a Partner at multinational investment banks, global advisory firms and regional financial institutions.Having spent a substantial part of his career and personal life living and working in diverse geographies, he has a proven ability to lead culturally and geographically diverse teams across borders, markets and products to deliver exceptional performance. His professional career spans 10 years in London, 5 years in South Korea and 8 years in the Middle East.