What's Your Business Really Worth?
Before you try to sell, make sure you know what buyers want.
Published April 2005
EMAIL THIS ARTICLE
PRINTER FRIENDLY
COMMENT ON THIS ARTICLESome people are saying that 2005 will be a big year for acquisitions, and -- judging by the businesses I'm in -- I don't doubt it. Document destruction companies have been getting snapped up lately, and the market for records storage businesses has been hot as well. In an environment like this, it's only natural that many business owners would be looking for opportunities to cash out. Unfortunately, most of them have grossly inflated notions of what their companies are worth.
Inc. 500 companies are prime examples. I recently looked at Inc. 500 applications from about 20 of the companies on the current list. One had lost money on sales of about $60 million, and yet its owners thought it was worth between $50 million and $100 million. Evidently they hadn't heard what happened to all those profitless Internet companies of the 1990s. Another company had a net profit of less than $335,000 on sales of about $6.5 million -- and still the owners somehow came to believe it was worth between $100 million and $200 million. In fact, of the 20 companies, I'd say that about half reported absurdly high valuations. Most of the others were just extremely high.
It's easy to understand how Inc. 500 CEOs, and former Inc. 500 CEOs, get such ideas. As a group, after all, we tend to have fairly large egos, which isn't entirely bad. You need one to make a business grow fast enough to make the list. But our egos can get us in trouble when it comes to putting a dollar value on something we've created. We generally take the highest valuation we've heard for a company somewhat like ours -- and multiply it.
Most owners have inflated notions of what their companies are worth.
But it's not just the fast growers who think their companies are worth more than they really are. Consider a deal that was brought to my attention a few months ago by my partners in the document destruction business, Bob and Trace Feinstein. They'd heard about a smaller company that was looking to be acquired. The owner was asking for two times annual sales, or about $1.2 million. Since other document destruction companies had been selling for three times sales, Bob and Trace thought we ought to buy it. But they were making a common mistake.
You can't value a company simply by looking at its sales. Yes, every industry has a rule of thumb for doing valuations and usually it's expressed as a multiple of sales, but that's a matter of habit and convenience. What most buyers are interested in is something called free cash flow, and free cash flow is a function of profit, not sales.
As it turned out, the company Bob and Trace were talking about had very little profit at all. It consisted of a father and son who had a truck with a shredder on it. All they cared about was earning a living, which they could accomplish by doing massive amounts of shredding at an extremely low price -- six cents per pound. They probably did all right for themselves, but the business had no value to a company like ours.
To begin with, it would cost us more than six cents a pound just to collect the paper and make sure the shredding was done in a secure manner -- forget about any contribution to overhead. Of course, the father and son weren't worried about overhead: They didn't have any. They had no significant expenses above and beyond the cost of actually providing the service. As a result, they could get by without producing gross profit. But no business that does have overhead can survive without gross profit. It's the gross profit that covers the overhead expenses and provides the net profit you need to build the company and get a return on your investment. We would never consider buying a business without gross profit. We wouldn't even buy the father and son's customer list. Once we started charging realistic prices, the chances of our holding on to the customers would have been zero to none.
So how, you might ask, did the father and son get the notion that their business was worth $1.2 million? The same way most people do. When you hear that a company in your industry has sold for three times sales (or whatever), you naturally figure that your company must be worth something in that range, just as you're likely to think your house is worth approximately what the one down the street just sold for -- even though you know nothing about what's in that house or why the buyer wanted it.
I cured myself of this tendency by talking to people interested in buying my company, and I'd recommend that you do the same. You need to begin by understanding what buyers are looking for, which depends on who the buyers are. Some companies do acquisitions for strate- gic reasons, some because they want to gain market share, some because they see a potential for synergy, and some because they want to boost their bottom line. Whatever may be driving them, however, it's a safe bet that they will look first at your earnings before interest, taxes, depreciation, and amortization, or EBITDA. When you subtract from that number the minimum amount of new capital expenditures required each year (or CAPEX), you get a pretty good measure of free cash flow. That is, you see the amount of cash a company generates in a year after paying all of its operating costs and expenses and meeting its minimum new capital requirements but before covering what it owes in taxes and interest (which the acquirer might not have to pay) and before deducting depreciation and amortization (which are accounting mechanisms reflecting the cost and lifespan of certain assets).
