How To Value A Company for Acquisition

By Generational Equity

03/18/2013

Quite often we meet with potential clients in our fact-finding, initial discovery phase who ask us, “Can you give me an idea what my company is worth?” Naturally, as any professional M&A firm would do, we indicate that without a thorough and complete evaluation of the business, we have no idea of what the company could be worth. Although this does cause us to lose some clients, it is the truth: No reputable M&A advisor should give you any idea how much your company is worth before doing a complete evaluation.

Your next question is probably, “OK, so why is it so important to value a company for acquisition in the first place?”

The answer is simple: Until Generational Equity conducts our valuation of your business, we have no idea what its true profitability is; and if we don’t know that, then we have no idea what future earnings your company will produce going forward. Keep in mind that buyers will review your past, but what they really are buying is the future profitability of your company.

How does Generational Equity determine your true earnings? First, we take your financial statements (preferably at least three years worth) and we determine how “clean” they are. That is, we need to have financial statements that are at a minimum in standard GAAP format (Generally Accepted Accounting Principles) and not jotted down on the back of a napkin.

It is amazing how often we encounter sizable companies that are still using antiquated methods of tracking key financial information. When we are approached by companies like this, we often encourage them to take the time and make the investment necessary to come back to us with financials that are at least created by an accountant using GAAP. Although this may delay the start of your evaluation by a few months, it will ultimately help you find an optimal buyer.

How To Value A Company For Acquisition: The Key First Step

Assuming you have clean financial statements, once you engage us to conduct the evaluation, we send you a document full of questions that are designed to do two things:

• Help us learn more about your company
• Help you to start thinking about your business as a buyer would

The 20-30-page survey we send you can be daunting for some business owners. Not to worry, our evaluation pros are more than willing to walk you through the form and get you started on answering the questions. But make no mistake, the questions we ask are really just preparatory questions for the types of things that buyers will ask you later in due diligence. The time you spend up front with our analyst working diligently to cover these items will only help us when negotiating on your behalf later with buyers.

One of the key steps of our proven evaluation method is then to take the info you have provided us in your historical financials and our worksheet and then do what is commonly called “recasting.”

Most business owners have no concept of recasting, so don’t be embarrassed if you fall into this group. Recasting is the approved GAAP process when non-business related expenses are removed from your income statement and/or balance sheet to show the company’s true profitability.

Let’s be honest, you and your accountant have worked hard over the years in legitimate ways to understate your profitability. You may be unaware or even forgotten how the IRS has allowed you to legally suppress your profits. Many clients have lots of items that we can recast such as:

• Superfluous, excessive, or discretionary expenses
• Nonrecurring revenue and expenses
• Family vacations paid for through the company
• Vehicles leased or owned that are not critical to the business
• Family members on the payroll
• Excessive salaries paid to ownership

I could go on and on with this list. Essentially we want to show the true historic financials with all of these items removed. Why do we do this? Because if we don’t, the starting point of your five-year forecasted income statement and balance sheets would not be accurate, enabling buyers to legitimately underbid for your company.

How To Value A Company For Acquisition: Producing A Pro Forma

Once we have recast your historic financials (this process can take anywhere from 2-3 weeks to several months depending on your availability and how clean your financials are), we then work with you to develop a credible revenue and profitability forecast for your company. We call this a “five-year pro forma.”

As mentioned, buyers will review your historical growth and will want answers for any fluctuations in the trend (either up or down). But what any professional buyer is really buying is not what your company has done in the past or the strength of your balance sheet today. No, what a buyer is really buying is the opportunity to earn and retain the profits shown in your five-year pro forma.

Again, this sounds more daunting than it really is. Our professional evaluation team has decades of experience working with business owners just like you to develop a forecast that is achievable, and from there, to develop defendable profit and loss statements that form the core of your evaluation.

One Method Does Not Fit All

Once the recasting is completed and an agreed upon pro forma is finalized, our team then determines which of all the various valuation methods out there are most credible for your company and industry. This is where the real “art” of valuing a business comes in, because there are a number of methods that can be used such as:

• Precedent transactions – completed deals in your industry that are potential indicators of value for your company
• Public company comparables – this method uses publicly traded companies and their valuations to make a case for yours
• Industry-developed rules of thumb – history has proven that in some industries deals are “normally” closed based on standard norms like 2x annual earnings plus (or minus) “X,” with X being any financial item your industry typically uses for valuations
• Discounted cash flow (DCF) – this method takes your projected earnings after recasting and “discounts” them back to today’s dollars using a discount rate based on the relative “riskiness” of your opportunity

This is just a sample – there are a number of other methods used as well, many that can be unique to your industry and/or situation. The reality is, our team will typically look at 4-5 models in determining value and then use the one that is most defensible in the market. As you can imagine, developing the skillset to do this takes years. Fortunately our evaluation team is second to none in our industry in terms of experience and creativity in determining a company’s value.

Conclusion

That, in essence, is how to value a company for acquisition. In a thousand words or so I have covered what normally takes just part of a full day in a Generational Equity M&A seminar. If you are interested in learning more about our award-winning process, I encourage you to attend one of our complimentary, no-obligation M&A meetings entitled “How and When To Exit Your Company for the Most Profit – a Planned Exit Strategy.”

While at the seminar you will be able to visit one on one with our M&A professionals, who can discuss your specific situation and needs. But don’t expect them to tell you what your company is worth in that initial meeting. Remember, we need to do a full evaluation first.

To learn more please fill out a contact form or call us at 1-972-232-1121. If you decide not to work with us, please use a professional firm to represent you and avoid anyone who indicates that they can “value” your firm in any initial meeting.