Pricing

Recently we have seen a significant increase in merger and acquisition interest in our client base. That activity prompted me to review business valuations for businesses sold several years ago. The first lesson from this review was the need to lose the emotional attachment to businesses and accept the agnostic reality of how businesses are valued. The second lesson from successfully closed deals was the need for clarity of objectives in buying or selling companies.

As background, we are talking about privately held companies with no empirical market value. That said, valuation is as much art as science. For private companies on both sides of the buy - sell transaction these are emotional events. Thus, knowing this and understanding in crystal clear detail the objectives of a deal allow shrewd buyers or sellers to effect trades that maximize the probability of realizing a successful deal beyond the transaction itself.

Published research suggests that 80% of all M&A transactions fail to meet their stated objectives. Consideration of any transaction, which also impacts valuation, must include post closing integration. To see our approach on maximizing probability of success, see our Basic M&A Checklist. (This MAP is read clockwise from 1 AM to Noon.)

Owners need to be aware there are many valuation models but all fall under broad families: a) Asset Driven b) Income Based and c) Market Comparison. Each model offers ranges of valuation metrics, which means company owners not experienced in corporate finance retain suitable counsel. Each merchant bank, PE capital or M&A specialist focuses on different industries, deal sizes even buy or sell side of transactions. (A short list of favorites follows.)

For example, a family valuing a company for an estate may want to obtain an independent valuation on a low end for estate tax purposes. Remember that a low base now may translate to significantly higher capital gains in a following sale transaction or may reduce the ability to collateralize future transactions. But we will settle on the low valuation objective for this discussion. A special note on this example: All states have different regulations that apply so local counsel is critical.

Here is an actual range of trading ratios for a consumer products company based on publicly traded like-company values several years ago:

Trading Ratios

Guideline Company Range

Selected Multiple

Bus. Enterprise / EBIT

5.7 - 11.5

5.7

Bus. Enterprise / EBIDA

5.1 - 10.0

5.5

Equity / EBT

5.5 - 13.2

9.0

Equity / Net Income

7.6 - 21.6

15.0

The various metrics relate to income statement entries; EBIT = earnings before income taxes, EBITDA = earnings before income taxes and depreciation, EBT = earnings before taxes and net income is revenue minus returns and product costs. The use of any of these ratios as benchmarks again depends upon the nature of the industry and objective of the business deal.

In fair value determination, premium or discount salaries to family members paid are normalized to industry standard, as are premium rent payments and other idiosyncratic expenses that benefit a family. This normalization may either inflate or deflate valuation depending upon the objectives of the parties to the transaction. Examples of other variables influencing valuation are:

  • Market or business category in terms of size, volatility, growth / decline
  • Competitive concentration and market share of target company
  • Nature and quality of inventory
  • Revenue composition i.e. few large customers with constant order streams or many small accounts with few repeat orders
  • Patents, trademarks or factors that give unique, sustainable competitive advantage.

Awareness of different fair market value methodologies is important for owners using their companies as a means of wealth creation versus current income production. All readers can understand that the range of ratios applied to whatever valuation metric is wide and the attending company value dramatically changes from the low to high end of the relevant range.

The key for me lies beyond the historic performance of a company. As a general rule, sellers are selling the past and buyers are buying the future. It is the potential a business has for future growth, a view I hold whether buying or selling companies. This gets back to the intangible but real value of brand strength and how to package a sale or conversely see extraordinary value in a purchase.

Regardless of turnaround or high growth going concern, I personally focus on the nature and strength of a company's perception in the collective minds of customers. Financial experts are essential in identifying and appraising fair monetary value and deal structure, yet real wealth is derived from grasping how to translate historic performance into ongoing profitable revenue while serving customers extraordinarily well.

Here are selected companies I know and their roles in ongoing transactions with us: AME Capital for client financing and acquisition of technology companies; Touchstone Capital for consumer product company acquisitions and business valuations; Millburn Capital for technology company acquisitions;Castle Island Partners for larger, consumer based business. By way of disclaimer, none of these company principals necessarily agree or disagree with views expressed here.

Small companies generally have a significant advantage over global ones in terms of flexibility, innovation and speed to market but suffer a big disadvantage in available capital. The capital I'm talking about is not so much financial variety but intellectual. Crowdsourcing can help in a variety of disciplines to offset lack of human capital, from product innovation to leadership skills to sales. When the subject turns to comprehensive approaches to optimizing profitability, the specific uniqueness of an individual company's internal structure makes the crowdsourcing option less viable.

Virtually every accountant and CPA I've met see profitability through standard cost accounting approaches. For small businesses especially those standards fall short.

In larger corporations there is a budgeting concept sometimes called "fully burdened". Simply, costs carry not only physical costs (direct product, labor and freight).but also fiscal ones (direct and indirect overhead, loads to offset underperforming brands or divisions, etc.). Margin (M) calculations are based on selling price (sp) minus cost (c) divided by selling price or M = sp-c/sp. Thus getting accurate cost information is key to margins and profitability management.

A former client developed a sophisticated yet simple program available online called "Your Cost Center" at www.yourcostcenter.com. I preferred 'your profit center" but that didn't fly.

It forces business owners, especially those driven by hourly productivity, as in service businesses such as health care, construction, accounting, legal and consulting, to build into costs paid vacations, sick days, owner income goals (for wealth creation), taxes, insurance and related intangibles not often included in costs. The program helps owners determine how many more jobs (units) the company needs to sell to meet profit goals, analyze pricing alternatives and helps guide other strategic decisions.

This is not a promotion for the service but a recommendation that business owners rethink how they envision product / service cost and pricing.

Last week an entrepreneur discussed pricing a new product to be sold initially on the Internet. We talked about product costs and his guess what he thought the retail price should be. My comment after listening was his estimate or retail was far below numbers that would support a 45% Gross Margin.

He was surprised by the answer, so decided to share my thoughts here. Take landed component costs and multiply by 6. This gives realistic expected retail during earliest stage development sessions.

Fifty percent 50% is the retailer margin, the balance manufacturer costs, overhead and available for spending and profit. Specifically, product cost is 33% of revenue, SG&A 67%. Further ball park figures I use are sales costs 12% net revenue, G&A 40% and Available for Profit 15%. Clearly the multiple can be changed to reflect competitive realities or a higher internal rate of return on cash that is in the detailed example.

The second recommendation is to price anticipating retail distribution down the road. Various Internet promotions such as free shipping and other option features could be bundled into the initial offering prices to lower the effective price during the test launch period. It is far easier to reduce prices once in the market than increase them.