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In selling your business, focus on what buyers value most

ARTICLE  | 

If you’re planning on selling your business, you need to take steps now that will maximize its value – for a comfortable retirement, or to fund your next venture.

Key to that is realizing that a business that shows healthy growth is worth more than one that is growing less, or not at all. A track record of growth over time, and evidence that this growth will continue, attracts buyers and pushes up valuations. And, paying proper attention to how the business will grow is just part of keeping it healthy.

Experience has found that many privately-held companies miss out on two key growth-related success factors:

  • The owner or owners are reluctant to seek outside financing – debt or equity – to fund growth; and
  • They fail to develop plans for the growth of the business and put them down on paper, in the form of business plans and forecast financial models, i.e. make growth tangible.

This means that when it comes time to sell, the owner or ownership group may be leaving money on the table, because they have not shown how much growth the new owners can expect.

Why higher expected growth increases valuations

To see how expected growth affects valuations, it helps to understand how prices for privately held businesses are usually set.

Buyers usually pick the prices they will offer by applying an earnings multiple to the current financial results. The size of that multiple reflects inputs that relate to the company specifically, as well as the market it competes in.

While there are ‘rules of thumb’ that sometimes get applied, the multiple is usually determined through detailed analysis. The most recent 12-month financial results are the most common starting points. 

Since current results are being used as a proxy for future financial performance, the capitalization rate or multiple has to account for both growth in the underlying financial metric as well as the risk of maintaining current financial performance and achieving the anticipated growth.  There are other inputs to calculating a multiple, including capital reinvestment and income taxes, but none has as significant an impact on the multiple as growth and risk.

For example, if one assumes that earnings are expected to grow 10 per cent per year, the rule of 72 (the simplified way to determine how long an investment will take to double, given a fixed annual rate of interest) indicates that it would take 7.2 years for a company’s earnings to double. 

However, if earnings are expected to grow at 20 per cent per year, it will only take 3.6 years for a company’s earnings to double.  A company expected to grow at 20 per cent per year would have a higher earnings multiple applied to its financials, for a much higher price paid to the existing owners.

Why you need to show a short payback period

The payback period is a major consideration, particularly given the growth of private equity funds, which are highly sophisticated in their approach to acquisitions. One of their main considerations is how long it would take them to earn back the acquisition price, based on the earnings of the company.

Private equity firms often have a hold period on their portfolio companies of five to seven years. On this basis, and assuming they want a payback period of five years, a company growing at 10 per cent per year would be discounted on the acquisition multiple compared to a company growing at 20 per cent per year. See the table below:

Company

Earnings Growth Rate

Year 1 Earnings

Year 2 Earnings

Year 3 Earnings

Year 4 Earnings

Year 5 Earnings

A

10 per cent

10.0

11.0

12.1

13.3

14.6

B

20 per cent

10.0

12.0

14.4

17.3

20.7

 

Consider a scenario where, after Year 5, both companies had the same earnings growth prospects. This means that a potential buyer would pay a 6X earnings multiple for each company.  The question is, what is the value of each of Company A and Company B at Year 0?

If the buyer at Year 0 is targeting an internal rate of return (IRR) of 25 per cent (a typical target for a private equity firm), then in the scenario above, to achieve that return, a buyer could be expected to pay almost $17.5 million for Company B than for Company A.

Another way to consider the earnings multiple is to consider the discount rate.  The earnings multiple can be, simplistically, considered the inverse of the discount rate less the earnings yield (or target IRR for the buyer).  For example, a 10x price to earnings (P/E) ratio is a 10 per cent earnings yield. If the risk adjusted cost of capital (discount rate) for the firm is 20 per cent, then the valuation is implying a 10 per cent expected growth rate in earnings (i.e. 20 per cent - 10 per cent = 10 per cent, the earnings yield.

Further, assume Company A at Year 0, where the buyer expects a 25 per cent IRR and expects to hold the acquisition indefinitely. If the growth rate is zero, then the most the buyer should pay for the investment would be $40 million (i.e. $10 million divided by 25 per cent).

If earnings were assumed to be growing at 10 per cent, then the maximum price would increase by $26.7 million to $66.7 million -- i.e. $10 million/(25 per cent - 10 per cent) = $66.7 million. This model implicitly assumes that the earnings will continue to be received in perpetuity and that risk is reflected in the discount rate applied.

One of the most important steps that companies can take to establish their growth bona fides is to pull together the metrics that measure growth. This includes information on specific products or service lines. Often, the information is available in the accounting system, but there has been no priority placed on pulling together the data.

Potential clients will want to be able to verify the figures with credible data such as sales documentation, bank statements and income tax returns, so it is important for companies to be able to readily put their hands on credible, recent information.

Other basics are also important -- including financial systems that are clean and efficient, professional management and reducing concentration of suppliers or customers. This helps to reduce any discounts a buyer might apply to a mathematically calculated earnings multiple.  

But by far, the biggest impact you can have on your company’s value is being able to demonstrate tangible growth into the future. Just pointing to historical growth as a proxy for future growth is not enough for sophisticated buyers.

What proof of growth do potential buyers look for?

Here are some building blocks you can use to construct a case for the future growth of your business:

Market related factors

  • What is the growth rate of the overall market in which the company operates? 
  • Are competitive threats impacting the market, positively and negatively?

Company specific factors

  • Can the company demonstrate that it is growing within that overall market growth rate -- enough to justify a rate that is above the market due to competitive advantages (whether cost, features or other drivers)?
  • Is there a pipeline of sales, especially contracted sales that can be relied upon in the company’s forecast?
  • Are there scale benefits that can be verified that increase the earnings margin as sales increase, i.e. fixed costs that mean new sales go straight to earnings?
  • How rigorous is the company’s forecasting/budgeting process and what is its historical track record?
  • Are the growth expectations supported by a corporate plan that lays out the steps needed to achieve them and provides measurable progress goals?

In our work with privately-held companies, we find that many owners have not taken the time to pull together the necessary numbers to justify a growth forecast. These figures should be part of the company’s business plan in any case, which is not a file-and-forget document, but should be a living instrument that is updated as the company’s reality changes. The business plan and financial forecast should include all growth options, such as organic expansion as well as acquisitions, utilizing leverage, and investment in people and systems.

Having a current, realistic business plan that calculates growth based on realistic data is an intangible that reassures potential buyers that the owners have managed the company well and its prospects for the future are sound. That makes a potential buyer more eager to make the purchase, and do it for a higher price.

Co-authored by Ben Gibbons and Corey Philp, Business Advisory Specialist, Scotia Wealth Management.

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