Factors that Increase or Decrease Business Value By: George D. Abraham CEO & Chief Appraiser Business Evaluation Systems

24 02 2011

There’s a range of key factors that can affect the value of a business. While some of these factors are outside of the owner’s control, steps can be taken to make the business as valuable as possible. Start planning well in advance and consider inserting an exit strategy into your original business plan. Then start implementing the factors that increase value and eliminate the factors that decrease the value.

Financial Statements

Just how good are your financials. Are they minimal or do they show an in-depth look at your business. Can you easily track the flow of revenue and expenses flowing from the invoice to the financials to the tax returns? Can your track the sales of your top 5 customers? Can you easily prove all of the perks you receive from the company? Today’s accounting software easily lets you do all of this and much more. When a buyer is interested in a company, the ease at which the owner can prove the financial performance of his or her business has a direct impact on value. Incomplete or inaccurate financials tells the buyer that no one is watching and tracking the Company’s performance and therefore the future performance (of real importance to the buyer) is unpredictable. Value is created or destroyed by the ability to see the Company’s future. The longer the buyer can see that the Company will perform in the future as represented, the more secure they are and less risk is perceived. To the contrary, when the future is a guess, risk is increased and value is decreased.

Performance

Obviously, small increases in revenues over the year’s shows a different picture than equally decreasing sales and the same is true with large increases and decreases. The key to value is the owner’s ability to explain the precise reason. Many times declining sales, if explained does not affect value as negatively as one might expect. Retiring doctors decide to work less, firing unprofitable customers and price increases that result in increased earnings do not impact the value of the business as negatively as one may think. Again, the key is the explanation of why revenues and/or earnings have dropped.

Management

The big question is what would happen to the business if ownership changed. Obviously, if the Company’s management and sales department are you, the owner, expect a decrease. On the other hand, if the sales are made by the sales department and the Company has department managers that report to the owner, value increases. Another factor is the longevity of the management team and in general all of the employees. Have the managers and employees been with the Company for several years, or is constant turnover the norm? These people have key knowledge of the internal workings of the Company, products and services and relationships with suppliers and customers. A well trained (and cross trained) knowledgeable management team and employees with longevity greatly reduces risk to the hypothetical buyer and thus increases value.

Appearance

When you look at your operation, do you see a busy, organized facility with well maintained equipment? A facility that is busy, appears to be unorganized, with dirty equipment, reflects the same image for the management and employees. Well maintained, clean equipment and vehicles tells the buyer that regular service and good maintenance records are the norm and this increases value. The opposite portrays, short lived equipment and vehicles with higher amounts of capital expenditures in the future that reduce earnings and lowers value. One has to imagine that the kind of appearance the Company has, may represent the kind of customers it has.

In General

First impressions are important! A clean organized business with well maintained assets and good financials portrays a good well managed, solid business and reduces the risk level in buyers. It reduces the depth of the financial due diligence process, questioning asset and inventory values and creates a more secure atmosphere for the buyer.

Good financials, formalized business and marketing plans, well trained and knowledgeable management and employees with longevity add up to value.

Competition is always a risk to a buyer. The more you know about your competitors and why they will not affect you is extremely important to a buyer. If your company has intellectual property, valued or not, be able to explain (even better to calculate it) the advantages your company derives from it. Start an exit plan a couple of years in advance, to address any of these factors that may pertain to your business. A business owner that knows the strengths of his or her business and can reasonably prove it, has a large effect on the appraiser and the buyer.





EBITDA Pro’s and Con’s

1 02 2011

EBITDA Pro’s and Con’s

By: George D. Abraham

Business Evaluation Systems

 

EBITDA, an acronym for “earnings before interest, taxes, depreciation and amortization”, is an often-used measure of the value of a business.

EBITDA is calculated by taking operating income and adding depreciation and amortization expenses back to it. EBITDA is used to analyze a company’s operating profitability before non-operating expenses (such as interest and “other” non-core expenses) and non-cash charges (depreciation and amortization).

Critics of EBITDA claim that it is misleading due to the fact that it is often confused with cash flow and factoring out interest, taxes, depreciation and amortization can make even completely unprofitable firms appear to be fiscally healthy.  Looking back at the dotcom companies, there are countless examples of companies that had no hope, future or earnings and the use of EBITDA made them look attractive.

Also, EBITDA numbers are easy to manipulate.  If fraudulent accounting techniques are used to inflate revenues and interest, and taxes, depreciation and amortization are factored out of the equation, almost any company will look great. Of course, when the truth comes out about the sales figures, the house of cards will tumble and investors will be in trouble.  In the mid-nineties when Waste Management was struggling with earnings, they changed their depreciation schedule on their thousands of garbage trucks from 5 years to 8 years. This made profit jump in the current period because less depreciation was charged in the current period. Another example is the airline industry, where depreciation schedules were extended on the 737 to make profits appear better. When WorldCom started trending toward negative EBITDA, they began to change regular period expenses to assets so they could depreciate them. This removed the expense and increased depreciation, which inflated their EBITDA. This kept the bankers happy and protected WorldCom’s stock.

Another concern is that EBITDA does not take into account working capital. It could be helpful to also point out that EBITDA is not a generally accepted accounting principal.

Because EBITDA can be manipulated like this, some analysts argue that a it doesn’t truly reflect what is happening in companies. Most now realize that EBITDA must be compared to cash flow to ensure that EBITDA does actually convert to cash as expected.

To sum up the cons:

 

1. EBITDA ignores changes in working capital and overstates cash

flow.

 

2. EBITDA can be a misleading measure of liquidity.

 

3. EBITDA does not consider the amount of required investment.

 

4.  EBITDA ignores distinctions in the quality of cash flow resulting

from different accounting policies.

 

5. EBITDA deviates from the GAAP measure of cash flow because it

fails to adjust for changes in operations-related assets and

liabilities.

On the plus side, EBITDA makes it easier to calculate how much cash a company has to pay down debt on long term assets. This calculation is called a debt coverage ratio. It is calculated by taking EBITDA divided by the required debt payments. This makes EBITDA useful in determining how long a company can continue to pay its debt without additional financing.

Overall, EBITDA is a stripped down, uncomplicated look at a company’s profitability. It eliminates the subjectivity of calculating amortization and depreciation. Depreciation and amortization are unique expenses. First, they are non-cash expenses – they are expenses related to assets that have already been purchased, so no cash is changing hands. Second, they are expenses that are subject to judgment or estimates – the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud.

EBITDA takes out interest which is a result of management’s choices of financing. And, it removes taxes which can vary greatly depending on numerous situations

 





Business Value Drivers

1 02 2011

Business Value Drivers

By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

Today’s business environment is not just about survival, it’s about focusing on and creating sustainable value. But, which elements of a business are capable of creating value? Equally important which elements of a business are capable of destroying value? Proper business planning is the process of uncovering and identifying what creates and drives value.

Start by using the SWOT Analysis – Strengths, Weaknesses, Opportunities and Threats – this will help you identify the “value drivers” for your business. With this approach, you can focus on key value drivers.

There are many Value Drivers that have been identified in businesses. But, typically no more than 8-12 are critical in any given business; here are the most common 8.

Financial History:

Are your books accurate and up to date? Over the last few years are there patterns of growth or decline? If in decline, are there good reasons for the decline?  Accurate and current financials are important to determine how the company fares in its industry and amongst competitors.  A comparison to industry ratios can identify strengths and weaknesses in the business.

Management Depth:

Can the company operate without the owner, for more than a week or two? Is there any cross-trained management to fill in if you were gone?  What is the average age of management?  Will they retire soon? What levels of experience and education do they possess? Having a good management team can add value to the business.

Customer Diversity:

Do you have one or two major customers that account for more than 25% of your gross sales?  What would happen to the value of your company if you lost one? Are most of your customers considered “blue chip”? A good overview and a rating analysis of the customer base can be beneficial not only for added value but is crucial for where, how and when you advertise, not to mention a much better understanding of your accounts receivable and aging.

Owner Involvement:

Are you the ‘rainmaker’ in the business? Does everything from sales to

production revolve around you and your decisions? How difficult would you be to replace? The more the business depends on you, the owner, the more likely the value will be lowered.  One of the things I see the most is that over the years, the business owner and number one sales person, is now an office manager.  Maybe it’s time to get back out in the field with your sales people or provide on-going sales training.

Competition:

Does your company compete in a clearly defined market niche which is

defensible? Or, have your products or services become a commodity that is becoming more difficult to defend?

Customer Satisfaction:

Are your customer relationships based on great products and service, or lowest price? How long and what type of history have they had with you? Are they satisfied or loyal? Do you have systems in place to identify your customers and communicate.

Loyal Employees:

Outside of ownership, are there people in place who you can rely on and are

capable of doing their job day in and day out? Are they considered knowledgeable for your industry? Again, what levels of experience and education do they possess?

What is the average length of employment amongst your staff? A responsible business buyer will be looking for opportunities where the current staff, especially management, will remain in place, following the current owner’s exit from the business. Having key employee contracts, non-competes, but more importantly a loyal, dedicated staff that is committed to the company’s success regardless of ownership change will be highly valuable to a prospective buyer and thus reflected in a business valuation.

Proprietary Technology:

Has your company developed a unique application, tool or technology as part of its

Ongoing operations? Does it give you a competitive advantage? If so, this proprietary innovation or intellectual property can be positioned as a key value driver for your business. Technologies or processes do not have to be patented to carry value but privacy and confidentiality must be maintained. It is critical that non-compete and confidentiality agreements be strictly adhered to and enforced by the company, before and after a transfer of ownership. The benefits, application and purpose of your proprietary technology should be explained to a business valuation consultant.

Intangibles (intellectual property) and human resources (who go home at night) can be protected and leveraged through a combination of business strategies and legal protections. Business strategies include incentive compensation plans to recognize, reward and retain high performing employees. Legal protections include requiring key employees to sign non-compete agreements, registering Trademarks and Copyrights, and taking steps to protect proprietary information/trade secrets such as recipes and formulas. Contracts with key players, including partners, customers and suppliers, are also important.

In conclusion, it’s easy to be distracted by all the demands competing for the business owner’s time and attention. To maximize the value and profitability of your company, you need to focus on the key value drivers – which may be intangibles and employees – in addition to having up-to-date equipment and systems.