Every business owner, at one point or another, asks himself, “What is my business worth?” The answer to the question really depends on who is asking. From a purely financial perspective, the value of a business to a potential buyer depends on the type of buyer and the buyer’s standard of value applied to the […]
Every business owner, at one point or another, asks himself, “What is my business worth?” The answer to the question really depends on who is asking. From a purely financial perspective, the value of a business to a potential buyer depends on the type of buyer and the buyer’s standard of value applied to the business. Buyers are either financial buyers or synergistic buyers. The standard of value is either fair market value or investment value.
According to the International Glossary of Business Valuation Terms, fair market value is defined as: “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, where neither is under compulsion to buy or sell and both have reasonable knowledge and relevant facts.”
The buyer under the standard of fair market value evaluates the probability (risk) of realizing the company’s annual net cash flow into the future. The buyer may make adjustments to the net cash flow for such expenses as eliminating a non-working spouse’s salary and related benefits, or eliminating discretionary expenses (i.e., country club dues). These types of adjustments are made to determine the correct annual net cash flow generated by the company. Failure to adjust for non-business expenses will result in an incorrect value. The buyer is a financial buyer. This buyer is acquiring the company more or less as-is without major wholesale changes.
The financial buyer stands in contrast to a synergistic buyer. The synergistic buyer values a company under the standard of investment value, defined as, “The value to a particular investor based on individual investment requirements and expectations.” The synergistic buyer evaluates the realization of the company’s future net cash flow, the same as the financial buyer, but takes it to another level. The synergistic buyer recalculates the annual net cash flow based on the projected synergies and strategic advantages of combining the acquired company with the buyer’s own business. Possible synergies may include elimination of employee salaries, payroll costs, and benefits due to the duplication of positions; elimination/reduction of rent expense by locating to more functional premises; or the value of instant market share.
To highlight the differences between the financial and synergistic buyer, let’s look at a hypothetical company — ABC Corp., a wholesale distributor of various products, with office headquarters and a warehouse located in Syracuse. ABC Corp.’s customer base is principally in Syracuse and the immediate surrounding area, with a few deliveries to Rochester and Albany. The company has an annual net cash flow (after tax) of $100,000. Its net working capital and debt/equity ratios meet industry standards. It has no projected major capital expenditures. The transaction is a stock sale. What is the value of ABC Corp? It depends on whether the buyer is a financial or a synergistic buyer.
The financial buyer
Joe, a former executive, left his company with a sizable compensation package and is looking to buy a business. Mary, the owner of ABC Corp., wants to sell her business and move to Florida. Joe hears of her intention, meets with Mary, and proceeds to do his due diligence of valuing the company. When done, Joe is of the opinion that ABC Corp.’s value is 4 ½ times the annual net cash flow, or $450,000.
Annual net cash flow (after tax) $100,000
Valuation multiple X 4.5
Fair market value of ABC Corp. $450,000
The synergistic buyer
Sam owns a company based in Rochester, that is a competitor of ABC Corp. Sam’s company also has a warehouse location in Buffalo. With existing locations in Buffalo and Rochester, Sam’s future plans include entering the Syracuse and Albany markets.
Sam also hears of Mary’s intention to sell ABC Corp. He meets with her and performs his due diligence. Like Joe, Sam determines the annual net cash flow is projected to be $100,000. However, Sam takes it to the next level. He refigures the annual net cash flow based on the projected synergies of the acquisition. This includes elimination of two administrative employees at $30,000 each, plus 25 percent for payroll costs and employee benefits. This results in increased projected cash flow of $75,000. He also factors in reduced rent expense, since Sam only needs warehouse space in Syracuse, increasing the projected cash flow by another $25,000. Finally, Sam projects an increase in gross profit dollars by eliminating a competitor, increasing cash flow by $40,000. Based on these synergies, Sam recalculates the annual net cash flow:
Annual net cash flows (after tax) $100,000
Synergies:
Elimination of salaries & related
costs/benefits $75,000
Rent-expense reduction $25,000
Increase in gross profit by an
increased gross profit percentage $40,000
$140,000
Tax at 35 percent ($49,000)
Annual net cash flows (after tax)
due to synergies $91,000
Adjusted annual net cash flows $191,000
Like Joe, Sam measures the risk of realizing the annual net cash flows into the future. However, Sam knows the industry and he is willing to pay a premium to achieve his goal of expanding his geographic footprint. Therefore, he is willing to pay 5 times the annual net cash flows, or $955,000 for ABC Corp.
Annual net cash flow (after tax) $191,000
Valuation multiple X 5
Investment value of ABC Corp. $955,000
Unfortunately for Mary, Sam will not share his additional synergistic cash-flow information with Mary. Sam also can project the
approximate price Joe will offer Mary, based on Joe’s position as a financial buyer. Therefore, Sam will likely make Mary an offer slightly above Joe’s offer, but nowhere near the potential $955,000.
This illustration is an oversimplification of a transacted stock sale. But it does illustrate the difference between a financial and a synergistic buyer. Whether you are the buyer of a business, or the seller, it’s essential that you perform due diligence and recognize that the value of the business depends on who is asking. Professional advice and direction is imperative to get the most for your business, or to pay the least.
Edward F. Saroney, III is owner of New York Business Valuation Services and serves on the board of directors of the Estate Planning Council of Central New York. Contact him at esaroney@efs3cpa.com