Ian: Welcome to the Business Coach Podcast, an advice-oriented series that tackles the hot issues and opportunities facing Canada’s small businesses. I’m your host, Ian Portsmouth, the Editor of PROFIT Magazine and we’ve developed this podcast in cooperation with BMO Bank of Montreal.
Perhaps the most important move any entrepreneur can make is selling their business. Yet, too many entrepreneurs leave planning the sale of their business too late and that leaves factors beyond their control to determine the amount they receive for their company.
Joining the Business Coach to provide advice on maximizing the value of your business before you have to sell is Trevor Lwin, Managing Director of Mid-Market Investment Banking at BMO Bank of Montreal. Trevor, welcome to the Business Coach.
Trevor: Thank you.
Ian: Now Trevor, most entrepreneurs will probably tell you that they know how much their business would fetch on the open market today and Profit Magazine has recently done a survey of some entrepreneurs and that proved to be true. But what percentage of entrepreneurs actually do know the value of their business and why do they tend to overvalue their companies which we see happen?
Trevor: I am not sure I have a clear percentage for you but I’d guess its play less than half. However due to the increased information that we see some of our clients and customers having access to, including the internet, entrepreneurs do seem to be more aware of their company’s value today versus probably about ten years ago. But I would say you’re correct in that entrepreneurs do tend to overvalue their companies.
And there is a number of reasons for this. I would say the most basic reason is because the owner of a business understands their business very well and have become comfortable with the risk where as a buyer has a fraction of the seller’s knowledge and, you know, they typically discount the company’s value trying to mitigate those risks. There are other reasons of course, some of them might include that, you know, they tend to look at disclosed M&A data which typically reflex the larger publicly traded companies and those companies carry premiums over less liquid smaller companies and that premium can be as much as twenty to forty percent.
Another reason is that they think the buyer will pay fully for the synergies created between the combination of the businesses which isn’t always the case. And I guess another reason, you know, they typically compare themselves against the best M&A transaction versus the average transaction, you know. About ten years ago during the peak of the dot com era, we saw several clients comparing themselves to Ebay or Hotmail, as you know, few would have achieved their successes.
Ian: What are some of the other key factors that influence the market value of a company. I know that one is going to be the knowledge that the entrepreneur holds and whether or not they’ve incorporated that knowledge into the actual systems and processes of the business.
Trevor: Yes, you know, it can be a complex question. There could be numerous and tons of different reasons why one company is worth more than another. But I would say, fundamentally it boils down to cash flow and really two aspects of cash flow, growth and risk. I mean, the primary reason why someone buys a business is to make more money in the future than they initially invested. So obviously, the greater the opportunity to grow those future cash flows, the more the buyer can push the initial valuation and still maintain a good return.
However, I’d say if the opportunities only come at great risk, for example, let’s say you’re in the food business or one of these health medicinal types of businesses and you’re waiting for approval by the Food and Drug Administration for a new product that has a fifty fifty chance at best, well you know your growth could be explosive and those future cash flows categorically and that’s your valuation.
Now other businesses might have very modest growth prospects but maintain, you know, high competitive barriers to entry, you know such businesses might have patents or niche products. These low risk profiles offered by these businesses, you know, they can offset the modest growth of the company and still provide for a strong valuation. And I know that, you know, the terms cash flow, growth and risk seem very generic, it’s a generic response but pretty much any specific item that influences valuation falls into one of those buckets. The only other thing I should mention Ian is that scale helps too because, you know, the larger your business, you know, you have a wider audience, sophisticated buyers and financiers as well, that can play quite a difference in your valuation.
Ian:So Trevor given how complex it is to valuate a company, how important is it to have a valuation done by a third party such as a Chartered Business Valuator?
Trevor: I would say it depends on the situation. Most mid-market transactions, you know, a formal third party valuation with a legal opinion isn’t always necessary. Those types of valuations are more use in fairness opinion, you know, they help shareholders and boards gauge the appropriateness of a deal. However, more general valuations, you know, those without a legal opinion can be done by a Chartered Business Valuator as well.
You know, they can help with tax planning, estate planning and basic decision making before going to the market. If an owner is closed to selling their business, they will often invite investment bankers to look at their financials and they can give them a good sense of valuation. And you know, the investment banker’s incentive to do this is because they want to win the sale mandate of course and that’s done at no cost. You can get, you know, a feel for it without the valuation. But I think the most important thing to note is that the valuation has little influence in the ultimate purchase price. You know, really what it comes down to is if the appropriate parties are approached and you know you have the sufficient information to share with those parties, the market will be the ultimate decider of that value.
Ian: That’s great. Now, when you’re preparing to sell your business, you know, an entrepreneur will probably want to develop a realistic view of what comparable businesses are selling for. So where do they go to get information about the various multiples of which businesses in their industry are selling?
Trevor: Well, you know, I would say listen to the rumour mill. Some people hear that the company down the street or somebody they know sold for so many times revenues or so many times earnings. You know, the newspapers only list really one multiple and that’s price earning and that is not typically applicable for private companies. The most I guess commonly used multiple is enterprise value EBITDA and just really quickly, enterprise value is the market value of the company’s debt plus their equity, that might seem strange but you know, if I ask you the value of your house Ian, you know, you might say six hundred seven thousand dollars but you have a mortgage of three hundred thousand dollars against that, so you only have an equity of four hundred thousand. But when I ask you to buy the house, you don’t tell me it’s worth four hundred thousand, it is worth four hundred thousand plus the debt, right? So, same thing for a business, so we say it is worth the debt plus the equity and then we divide that by something called EBITDA which is Earnings Before Interest, Taxes, Depreciation and Amortization. So that multiple EBITDA is the most commonly used one for valuing private businesses. So where you get that? You can’t find that in the newspaper as much as far as from the stock listing cables. But you can go on things like Yahoo Finance or Microsoft MSN Money, you know, investment bankers typically use fairly expensive databases such as Bloomberg or Capital IQ but those are the two resources that can be a starting point.
Ian: That’s terrific. Now how long does the process of preparing a business for sale take?
Trevor: Good question. I would say it depends. Some companies are good to go while others might have some work to do. Some might just consider, you know, you might want to have your financial statements audited, filling your vacant or weaker management positions, make sure you have some traction on your larger growth initiatives. (inaudible) exciting but still a concept, you are not going to get a lot of value for that, so you might want to work on that a bit. I would say make sure your financial reporting systems are flexible and timely. And consider some of the add backs or normalization earnings because a lot of private businesses have unusual expenses and you know, those are valid earnings to add back. I would say, once the house is in order and the owner has decided to sell, it probably takes between four and sixth months to get the deal done, and we’ve seen faster but we’ve seen longer as well. But that is not a bad estimate.
Ian: And is there a good time to sell your business the way spring is typically a favorable time to sell your house?
Trevor: Well, seasons, I would say seasons don’t typically make that much of a difference. If a quick sell is required and you know, you want to avoid going to market during peak summer vacation or Christmas. It’s the larger macro cycles that make the difference. I would say for example the health of the economy or the financial markets, you know, that being said though, some businesses are counter-cyclical and do better in recession but, in today’s market, M&A activity will soften a bit but they’re really coming off at a record high. So they’re still pretty strong.
And there is a core base of activities that will always hold, you know, if you are an aging owner, you don’t have that much time to sell, if you are going to sell it, an opportunistic or strategic transaction is going to occur regardless.
Ian: Trevor, thanks for taking time out for the Business Coach.
Trevor: No problem thank you.
Ian: Trevor Lwin is the Managing Director of Mid-Market Investment Banking at BMO, Bank of Montreal.
That’s it for another episode of Business Coach Podcast. You can download other installments from the series at BMO.com, profitguide.com or iTunes. And as always, I’d love to hear your feedback and suggestions for future topics. Send them to firstname.lastname@example.org.
Until next time, I am Ian Portsmouth, Editor at the PROFIT Magazine, wishing you continued success.