The Valuation Gap: Many owners think their business should be worth more
In the Lower-Middle-Market, we come across many businesses that are still in their early stages. Not necessarily in years, but in the sophistication of systems and processes within the business. Although the business owner may have already put a lot of sweat equity into the business, it doesn’t necessarily equate to the dollar value they would like to receive when considering a sale. Business owners are frequently disappointed, especially when the business is doing well compared to their historical financial metrics.
What is creating the valuation disparity? How can business owners bridge the gap?
I recently performed a valuation for a niche manufacturing company that has been in business 10+ years and is doing approximately $493K in revenue and $150K in Seller’s Discretionary Earnings. (This is too small to be considered a lower-middle-market company; however, it provides a great example of “The Valuation Gap”). The company has averaged 24.8% in profit margins over the last four years, compared to the industry average of 5.2%. That’s amazing! A huge contributor to this success is that the company manufacturers the product and is its own wholesaler through a large direct to consumer platform. They have cut out the middleman and are benefitting in the cost savings. The company has also positioned itself to diversify and defend this direct to consumer platforms with preferred vendor agreements and multiple strategic target markets. They have also received unsolicited offers to place products in retail stores from a big box retailer.
These are all great things going on at this niche manufacturing company. The valuation was approximately $437K for the business. However, the business owner wanted to see a value of $800K. That’s a gap of almost double the present day value of the business!
Let’s break down the valuation.
I researched privately held companies similar in industry and revenues that were sold in the open market. After reviewing 36 transactions, 14 companies made the cut for the comps group I used to determine the revenue and SDE multiples.
The 14 comparable transactions indicated an average revenue multiple of .68x. Using this multiple, the value of the company is approximately $370K.
Using the same 14 comparables, the SDE comps indicated a 3.2x multiple, giving the market value of approximately $437k. (Ultimately the market approach was what I put 100% of the weighting on to determine the final value).
For the next two valuation methods we need to determine a capitalization rate and a discount rate. Both rates can be calculated using the same method, weighted average cost of capital (WACC) or the buildup method, however, the capitalization rate has one more step. Once the discount rate is calculated the anticipated long-term growth rate must be subtracted to arrive at the capitalization rate. For this example, I used the WACC method.
Capitalization of Earnings Method
The WACC model requires the valuator to calculate the Cost of Equity and the Cost of Debt. Cost of Equity is calculated from the Risk Free Rate, Equity Risk Premium, a Size Risk, and Beta. The first three inputs are readily available statistics from the US Treasury 20 year bond rate and Duff & Phelps. Beta is derived from comparable public market comps. Cost of Debt is calculated using the company’s effective tax rate and its pre-tax cost of debt, all information from company financials. The subjective part of WACC is the business specific risk. This is derived after conversations with the owner, review of the industry and other company information. There are a number of unique characteristics of a company that could give the valuator cause to add company specific risk premium (CSRP) to the WACC calculation.
Here are a few examples:
- Depth of Management – Is the owner wearing all the hats or are there divisional leaders?
- Importance of Key Personnel – Do one or two people hold key relationships?
- Diversification of customer base – are one or more customers more than 15-20% of revenue?
- Financial Structure – Can the company service its debt?
- Stability of Earnings – Does the company have a history of stable earnings or a reasonable pro forma explaining future growth?
For our example company, the owner is the business. He is working 15 hour days performing anything that is needed for the business. He handles HR, scheduling, ordering, manufacturing, shipping, etc. He even said that if he was hit by the proverbial bus tomorrow, the business wouldn’t last more than a week. The owner is so burnt out from handling every aspect of the business he doesn’t know how much longer he can do it on his own. The company also has customer concentration issues, with one company at 74% of revenue! All of these things spell out RISK to a potential buyer and must be taken into consideration in the CRSP.
Utilizing all of the WACC inputs, the discount rate calculated was 33.9%. A 4% anticipated long-term growth rate was subtracted to get to the capitalization rate of 29.9%, resulting in an approximate business value of $457k.
Discounted Cash Flow (DCF) Method
The DCF utilizes financial projections of the business and the discount rate to give us a present day value estimate. Working with management, we put together projections based on adding the additional wholesaling opportunities the company currently has. Using the 33.9% discount rate, the estimated business value was $560K.
Here are the approximate company values derived from the different methods:
|Multiple of Revenue||$327,000|
|Multiple of SDE||$437,000|
|Capitalization of Earnings||$457,000|
|Discounted Cash Flow||$560,000|
As you already know, the company was ultimately valued at $437,000. The higher value utilizing the DCF Method was not considered as although the company is poised to growth through those channels it has yet to be proven.
Now that we have gone through the highlights of the valuation reasoning, let’s get back to the almost $400,000 valuation gap. The company specific risk premium is the main culprit. We added a 30% CRSP mainly due to the ownership involvement and the customer concentration issues. These high capitalization and discount rates bring down the value of the business. If the owner could lower his risk, therefore the cap and discount rate, we would immediately see an increase in value. Adding a sales rep to pursue the additional wholesale avenues and/or hiring an office manager to handle HR would help decrease the business risk while also taking pressure off the owner from having to handle every task. (All things that take time to accomplish).
We already know the owner is burnt out. However, he believes in the business and did express that if he was able to take off a lot of the different hats he was wearing he would like to continue working. So what do you in this situation where the owner wants to sell now but at a higher value?
This is where Blue Sky Capital Resources can step in to help fill the valuation gap. We would offer to partner with the owner, giving him fair market value for the ownership percentage we buy in at today. This puts a little money in his pocket now and lifts the weight off of his shoulders, allowing him to pursue what he is best at in the business. All those other multiple hats he is wearing we pick up while implementing a strategy on how to fill them permanently. In this scenario, a main part of our growth strategy would most likely be to hire a sales person. They would help reduce areas of risk previously mentioned: decreasing owner involvement and transferring customer relationships and diversifying customer concentration. Our partnership with the business owner bridges the valuation gap. Once we are able to grow the company and reduce the CRSP, when it comes time to sell we both share in the success, hopefully at a value more than the owner originally expected!