Locking Up Good Value
You may use more gut feeling in valuing a service business, but the numbers get crunched just the same
If Bonnie Niten Baha, a valuation expert at Touche Ross & Co., ever doubted her ability to be useful to her new client, her fears were allayed when she asked him to send over a balance sheet. "He asked, 'Is that the one with the assets and liabilities or the one with the single column?' " she recalls.
You can excuse Art McDonald, Baha's client, for his lapse. His time's been better spent pioneering the private prison industry than studying financial statements. Ten years after McDonald, a onetime Seven-Up bottler who "got tired of counting money," began to house and feed prisoners in California, he found himself reckoning with dollar signs again -- with $10.5 million, to be exact. That's what a competitor, Corrections Corp. of America, offered for his Ventura-based Eclectic Communications Inc. And that's what brought McDonald to Baha.
What was his company worth? Most entrepreneurs want to know the value of their blood, sweat, and tears. Not because they're ready to sell. Just because, as with money in the bank, it's nice to know how much is there.
The question is even trickier for owners of service companies like Eclectic. Their assets aren't the kind you can see and touch. Eclectic, for example, doesn't own its prison facilities. Its earning power comes from its ability to care for parole violators, illegal immigrants, and other prisoners. So its value lies in murky intangibles: the talent of its managers, the quality of its service, and the desirability of its customers.
That means there's more gut feeling involved in putting a price on a service firm than on a manufacturer, though the process is the same. Like most valuation specialists, Baha relies primarily on three well-established number-crunching approaches: market, cost, and income. But because even these starchy methodologies use some mushy numbers, Baha has plenty of opportunity to factor in her subjective impressions.
She ponders the intangibles first, by probing the company and its industry. A typical weak spot for service companies, for example, is competition. Because it doesn't take much capital to start a private prison business -- and little time for established competitors to implement a new idea -- Baha wondered if Eclectic could suddenly face intensified competition. Unlikely. McDonald had been early in establishing relationships with key people in California's agencies. Moreover, he'd consciously decided to solidify those bonds a few years ago, when he sold Eclectic's out-of-state operations.
McDonald's tight customer relations helped answer another of Baha's questions: how durable is the company's cash flow? Service companies don't have assets to sell off during hard times, so having a dependable cash flow is especially important. Eclectic's looked strong. Its contracts weren't particularly long -- 3 to 5 years -- but in 12 years of operation, only one had ever gone unrenewed. A service business without repeat customers is much more likely to suffer from a drop in cash flow.
So far, so good. But what about hidden liabilities? Because there's no defined lifetime to a service, it's hard to know for what -- or when -- you could be blamed if something goes wrong. An insurance company, for example, may offer medical-malpractice coverage for 5 years but face a claim 25 years later. At Eclectic, the potential for such liabilities seemed great. Counting on 1,200 incarcerated people for good behavior is a risky proposition. What if one escapes and harms someone in the community? The short answer is that because Eclectic must take whomever the state sends it, the state would likely take responsibility.
That wouldn't necessarily solve Eclectic's problems, though. Such an event would undoubtedly stir public outrage that might force Eclectic to shut down its facility. "That's the biggest business risk they have had to date," says Baha. Still, she judged the risk to be low because Eclectic houses minimum-custody prisoners and has never experienced this kind of problem.
McDonald's humanistic orientation and innovative leadership presented Baha with the classic small-company conundrum: could the company retain its unique quality without McDonald? "Yes and no," says Baha. "Art is a visionary in the classic sense of the term. But by the same token, he has very carefully selected the people who work for him. So if he left, the company would lose some of his missionary zeal, but it would continue on successfully."
To turn these subjective factors into hard numbers, Baha began by considering the market approach to valuation. Think of it as a reality test. It involves using comparable public companies as models for valuing the company in question. In the simplest case, if Public Co.'s stock price trades at six times earnings, you multiply Value Unknown Co.'s earnings by six to get a rough estimate of its worth. Naturally, experts use several multiples and adjust them for quantitative differences such as divergent market shares as well as qualitative deviations such as quality of management.
Baha found three public companies in the private prison business, but they weren't comparable. Too much revenue came from nonprison operations. She did, however, have a real-life example of how the market valued Eclectic -- Corrections Corp. of America's $10.5-million offer, extended in 1987. That price tag was 1.37 times Eclectic's revenues and 61 times its net earnings. Applying the 1.37 multiple to Eclectic's 1989 revenues of $11 million, she arrived at a value of $15.1 million. Multiplying the company's 1989 income of $181,550 by 61, she came up with an $11.1-million valuation.
The cost approach assesses the cost of replacing existing operations, on the theory that a buyer won't pay more for a business than it would cost to duplicate it. Baha decided not to use this method in pricing Eclectic because it yields the lowest value. The approach makes more sense when a company has to be liquidated.
Baha's analysis rested most heavily on the third technique: the income approach. This method essentially says that Eclectic today is worth the stream of profits that it will produce in the future. Sounds simple, but it's not.
First, McDonald, his accountant, and Baha forecast Eclectic's income statement for the next five years. Simply assuming that all the numbers will grow by, say, 10% each year won't do. In Eclectic's case, Baha assumed greater economies of scale would gradually reduce overall expenses, relative to revenues. She also plugged in working capital additions, new debt, and capital expenditures. Most important, she added back the bonuses that McDonald and his wife had paid themselves, assuming that those expenses wouldn't be incurred by another owner. Since the McDonalds had taken out close to $500,000, this adjustment helped boost Eclectic's income significantly. Earnings of $181,550 in 1989 zoom to $701,361 in the forecast for 1990.
Next step: figuring out what those future earnings add up to in today's dollars -- or finding their present value. Calculator jockeys know this is simple enough to do. The trick is in picking the right number, known as the discount rate, to make that translation back to the present.
Baha decided to use comparable companies' rates of return on equity to determine the discount rate. Going forward, this is the rate at which Eclectic must earn in order to maintain its value. So the same rate is used to work backward from, or discount, future earnings.
Using a capital asset pricing model that looks a bit like alphabet soup, Baha calculated that the company's rate of return on equity was 17.41%. Then she took a hard look at the figure and thought about whether it reflected all the risks peculiar to Eclectic. Close, she decided. Her analysis showed Eclectic to be a superior company. To account for the risks that are there, she hiked the discount rate slightly, to 18%. For most small and privately owned companies, the rate goes much higher. "I've used discount rates that are as high as 40% or 50%," says Baha. Higher discount rates, of course, shrink the present-value figure more substantially.
With the discount rate punched into her calculator, Baha at last came up with a present value: $10,755,534. That, however, isn't Eclectic's true value. The pricing model she used implicitly values a minority position in the company; it doesn't include the value of control of the company. In the real world, it means a lot more to own the whole company than just a few shares. The difference is called a control premium. To find it, Baha consulted two studies of such premiums paid in actual company sales and pinned a 35% premium on Eclectic. Here again, subjective impressions came into play. One study showed the average premium to be 58.6%, the other 38.3%. Adding the 35% control premium to the previous value, Baha came up with her final value: $14,519,971.
What did she tell McDonald? That his company was worth between $11 million and $15 million. That, of course, encompasses both of the market values she came up with as well as the income valuation. For McDonald, that was as precise an estimate as he needed. "I looked at that and her models and decided that if I can continue to have fun and make the business grow rapidly, we can sell it for a tremendous amount in the future."
TURNING GOODWILL INTO GOOD MONEY
Grasping the value of intangibles
Unfortunately for service-company owners, buyers don't want to pay as much for intangibles as for hard assets. The simple fact is that a $1-million piece of equipment is amortizable and $1 million worth of good reputation isn't. That makes a very big difference in how fast a buyer can earn back its purchase price.
The answer is to "create" amortizable assets out of those slippery intangibles. Here's one that many company sellers should think about: the value of their noncompete agreement. Touche Ross & Co.'s Valuation Engineering Associates looks at what a company's revenues and cash flow would be if the former owner competed instead of going fishing. "Say Joe Blow is so critical to the company that if he were to compete, he could take away 50% of his former company's business," says senior project manager Bonnie Niten Baha. "We follow that logic through the term of the covenant."
Of course, keeping the former owner's hands tied isn't valuable in every case. Explains Baha, "If we were trying to substantiate the value of a noncompete covenant in an industry where relationships mean nothing, we would have a hard time."