Pro’s and Con’s of Price Formulas in Buy-Sell Agreements

/in , , /by Al Statz
Exit Strategies is regularly called upon to determine the value of closely-held company shares for buy-sell transactions. Common events that trigger a transfer of shares are when a shareholder retires or resigns from employment, is fired, dies, or becomes disabled, divorced or insolvent.
There are several facets to successful buy-sell transactions, but valuation is typically the most contested issue. The pricing method prescribed in your by-laws, shareholder, buy-sell or stock restriction agreement, as the case may be, is critical to the success of your next buy-sell transaction. Chances are your agreement (if you have one) stipulates one of these pricing approaches: a) a fixed price, b) book value, c) a formula, or d) an independent business valuation by one or more appraisers.
This article discusses the pro’s and con’s of formula pricing versus an independent valuation. Fixed price and book value are almost always bad ideas, so I won’t bother with them. Valuation formulas in the Buy-Sell agreements brought to us are usually pretty simple and look something like this:
Equity Value  =  Average EBITDA in the past two years  X  a fixed Multiple
Pro’s of a Pricing Formulapick_any_two
  1. Relatively quick and easy to calculate
  2. Inexpensive to apply
If your priority is to get to a price quickly with minimum effort and expense, congratulations, job done.
Con’s of a Pricing Formula
If however you and your partners’ want to see that all participants receive and pay a fair price, a set pricing formula misses the mark more often than not. One of the basic problems is that transactions occur sometime in the future, not when the formula is fixed, and formulas become stale as business and market conditions change over time.
Also, valuation itself is a forward-looking concept, and formulas generally use historical financial metrics. In other words, an investor ultimately cares only about what his or her return will be going forward, not what it was or would have been in the past. History is important in business valuation, but should never be entirely relied upon in determining the value of a company. As experienced business appraisers we see many companies whose future prospects are significantly better or worse than their recent past performance.
Let’s go into detail on some of the problems and solutions.
Businesses change.  A static formula can’t anticipate a change in business model.  One real-life example is a company that began life as a project-based, low margin contractor/installer of security systems, and evolved over time into a monitoring company with hundreds of annual customer contracts and high margins. Since monitoring companies trade for higher multiples than construction companies, the agreed-upon valuation formula undervalued the company when one of the owners died.  Solution: Rewrite the buy-sell agreement to require an independent valuation when a trigger event occurs.
Market conditions change.  Future market conditions are unknowable, and impossible to design into a formula. Consider the example of a real medium-size photographic processing company. With the advent of digital cameras and smart phone cameras, its film processing business was in steady decline when the founding partner wanted to retire. The pricing formula, which had been set 10 years earlier, overvalued the shares at the time of the trigger event. This led to a falling out and put a heavy burden on the remaining shareholders.  Solution: Require an independent valuation, or periodically update the formula at a minimum.
Stuff happens.  Major non-recurring events that substantially alter a company’s performance can happen at any time (think major lawsuit settlement, windfall sale, plant relocation or expansion, etc.). When such events occur during the formula’s measurement period, one side or the other gets penalized. Another issue we’ve seen many times, particularly as company owners age, is that they begin to rely on fewer and fewer major customers or suppliers for most of their business, which represents a major risk factor that won’t be accounted for in a pricing formula. For many reasons, pricing formulas can be rendered obsolete when things happen.  Solution: Have an expert evaluate the entire company at the time of the transaction.
Incomplete formula.  Most valuation formulas presented to us are too simplistic. What if, for example, the above formula was used to value an asset-intensive business — let’s say a heavy construction company. If the company had been deferring capital expenditures for several years, the formula would overvalue the company. Likewise, if it had recently replaced most of its equipment, possibly to take advantage of tax incentives, the formula would likely undervalue the company.  A formula can never be comprehensive and robust enough to capture all of the unique factors that can impact a company’s value.  I could list several dozen examples of this.  Solution: Have a seasoned appraiser thoroughly evaluate the company at the time of the transaction. If you must use a formula, have a qualified business appraiser design and update it periodically.
Formula is unclear or unfair.  Some of the pricing formulas presented to us are ambiguous in one or more significant ways; others are just plain unfair to one side or the other.  Usually the owners are completely unaware of this until a real trigger event occurs, at which point they are no longer objective. Sometimes the CPA or attorney who created the formula years ago is out of the picture or doesn’t remember what they intended.  Solution: Again, an independent valuation is the best option. Having a qualified business appraiser design and update the formula is second best. At a minimum, have your existing formula reviewed by a qualified business appraiser who can spot these types of problems and recommend improvements.
In summary, a pricing formula usually yields a share price that fails to reflect true economic value at the time of transfer; which leaves at least one party very unhappy. This is why most buy-sell agreements call for a business valuation. If you must use a formula, have it designed and reviewed periodically by a professional business appraiser for the reasons discussed here. If you have business partners and don’t have a buy-sell agreement in place, I urge you to create one now, before you are faced with a trigger event.
Business valuation plays a pivotal role in internal share transfers and all business succession plans. If I can provide additional information or advice on a current situation, please don’t hesitate to call me, Al Statz, 707-778-2040 or Email alstatz@exitstrategiesgroup.com. 

Why Should I Bother Valuing My Business?

/in , , /by Al Statz
ForbesA new article at Forbes.com addresses a question in the minds of many small business owners, “Why Should I Bother Valuing My Business?” 
The author explains several of the common reasons small business owners have their businesses appraised by an independent business valuation expert, as they prepare for a sale, buy-out, contingencies, retirement, or passing the business on to children.

Want a successful merger or acquisitions? Put an M&A advisor on your board.

/in , /by Al Statz

Companies planning a merger or acquisition would do well to have an investment banker (M&A advisor) on their board of directors.

A new study from the University of Iowa found that firms with an investment banker on their boards of directors pursue mergers and acquisitions more often. Moreover, those firms perform better after the acquisition has been completed than firms that don’t have investment bankers on their boards.

Read the full article.

Transaction brokers create competition. Why is this so important?

/in , /by Bob Altieri

The critical first step in selling a business is to properly analyze and value it to establish a price. In the case of an undervaluation, when the business is sold the result is obvious; the owner receives less. Conversely, businesses that are overvalued and overpriced usually do not sell. The reason for this is because of the principle of alternative investments, which states that rational buyers will act on some alternative business investment where they expect to earn a higher return on their invested capital. Setting a reasonable price is critical to a successful deal. Buyers won’t spend time pursuing overpriced opportunities.

All business valuations are based upon the expectation of future economic benefit. An investor, appraiser and transaction broker (investment banker, M&A advisors, et al) looks at historic earnings or cash flows (usually 5-years or more if available) along with other factors such as the current economic environment and outlook, industry trends and outlook, and internal business factors. From this analysis, when the earnings stream is expected to grow at a fairly constant rate over time, the valuator estimates the next year’s earnings stream, which is then converted into value using a risk-adjusted rate of return; as a devisor (capitalization rate) or multiple (1/capitalization rate) derived from market sources for similar investments. Note that the earnings stream is forecasted in harmony with the basic premise of value — the “future expectation of economic benefit.”

In addition to this critical valuation piece, the transaction broker creates competition in the market, or at least the perception thereof.

There are two categories of buyers: Financial Buyers, which include the typical individual owner-operator or investor group who usually pay fair market value (FMV); and Strategic Buyers, which is a company that has a specific business reason to purchase and has synergies with that business. Because strategic buyers get more earnings and therefore value out of an acquisition than the FMV of the target company, they may be willing to pay a premium price.

The existence of competition in the market, among financial or strategic buyers, usually results in the ultimate price paid being higher than if no competition exists.

In my 20 years of M&A experience, I have found that getting strategic buyers to pay more than FMV when there is no competition is difficult. When a business is marketed by a transaction broker, competition normally drives the purchase price upward, much like an auction environment.

Engineering the Future

/in , /by Al Statz

As a father of two budding technophiles, and having my first college degree in electrical and computer engineering, please allow me this opportunity to promote this important profession …

As the world’s population nears seven-billion people, mechanical engineers will play a major role in meeting global challenges says a research study conducted by ASME (American Society of Mechanical Engineers). The study, The State of Mechanical Engineering: Today and Beyond, was the result of a survey of over 1,200 engineers.

With the expanding global population comes the need to address challenges such as clean water, sanitation, food and energy. While the study shows optimism about the ability of engineers to meet global challenges, it points to the importance of working on interdisciplinary teams of professionals to address these issues.

The study also revealed that early career engineers and students will play a major role in meeting global challenges over the next 10-20 years, especially in the areas of sustainability or renewable energy, bioengineering and biomedical fields, nanotechnology, green building technology, energy storage, smart grids and greenhouse gas mitigation.

The ASME research study also revealed that over the next two decades:

  • The prestige of working as an engineer will increase
  • The financial rewards of working as an engineer will be greater
  • The number of engineers working in less-developed countries will be greater
  • The need for engineers to increase their ability to communicate more effectively, increase language skills and manage global teams will increase

When participants were asked how they would acquire additional knowledge or expertise needed to address future challenges, almost all engineers said they would employ self-study.  According to the survey, “early career engineers prefer traditional face-to-face instruction for acquiring knowledge such as in-house training, mentoring, and part-time graduate degree programs. More experienced engineers, on the other hand, are more comfortable relying on magazines, books and online courses.”

The study also indicated that “basic engineering disciplines will continue to be indispensable. Abilities such as multilingual and multicultural skills will be essential in the anticipated increasingly global work environment.”

Download the study results here: The State of Mechanical Engineering: Today and Beyond

Famed Investor: References to EBITDA make us shudder …

/in , , /by Al Statz

… does management think the tooth fairy pays for capital expenditures?

Article Published December 6, 2010 — North Bay Business Journal

This title is a quote from Warren Buffett’s letter to shareholders in Berkshire Hathaway’s 2000 annual report. EBITDA (earnings before interest, taxes, depreciation and amortization) is a good financial metric to use in analyzing, comparing and valuing companies, but, as business owners and investors, we need to understand its limitations.

EBITDA is one of several measures of economic benefit to which a multiple can be applied to estimate value for a company. A multiple is the inverse of a capitalization or ‘cap’ rate. When used properly, multiples are applied to an investor’s forward looking cash flows and adjusted for risk.

EBITDA is a popular proxy for Cash Flow because we can easily calculate it from the P&L — no balance sheet required. However, EBITDA ignores capital investment, working capital changes, taxes, borrowing, debt repayment and financing costs, which all affect a company’s cash flow and ability to pay dividends to its owners. The focus of this article is the “D” in EBITDA, or Depreciation, which results from owning capital assets.

Depreciation Matters

Don’t let anyone tell you depreciation doesn’t matter because it is a non-cash item. I have yet to sell or appraise a company that owns fixed assets that never need replacement. Not only do capital assets deteriorate, they are also subject to functional obsolescence caused by technology advancements (faster, cheaper, better) and sometimes new environmental regulations.

Here’s how Warren Buffet put it in his 2002 letter to shareholders, “Trumpeting EBITDA is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?”

Let’s imagine we’re in the drilling business, looking to grow through acquisition, and there are two companies in equally desirable markets available to us. Both companies operate the same number and type of drill rigs. Both generate $5 million in sales and $1 million EBITDA annually. Same EBITDA, same value, right? It’s a trick question. Company A’s rigs are 4 years old on average, while B’s rigs average 13 years old. We estimate that B will need $300,000 more in annual capital outlays to maintain its fleet and revenues going forward. Even though EBITDA is the same, Company A will generate substantially higher cash flows for us, and is more valuable to us.

Now say there’s a Company C available. It also shows $1 million EBITDA and is equivalent to A and B in all other respects except that it sub-contracts drilling to several independent operators. It owns no rigs and has no capital expenditures or depreciation. (Since there are no assets to depreciate or replace, EBITDA is a better approximation of free cash flow.) From a cash flow perspective, C tops A and B.

In general, projected cash flow should be our metric for evaluating companies. Cash flow assumes adequate reinvestment in the business, as opposed to the unsustainable reinvestment shortfall represented by EBITDA.

EBITDA is a good starting point for sale, merger and acquisition discussions. Just don’t rely on it for making a major decision; unless you would buy a car knowing only the model and year, or propose marriage on the first date. There are more EBITDA hazards to avoid, but the depreciation trap is a key one. When one of Warren Buffet protégés comes calling, we’ll be ready.

•    •    •

Al Statz is President of Exit Strategies Group, Inc., a business brokerage, mergers, acquisitions and valuation firm serving closely-held businesses in Northern California. He can be reached confidentially at 707-778-2040 or alstatz@exitstrategiesgroup.com.

The  North Bay Business Journal, a publication of the New York Times, is a weekly business newspaper which covers the North Bay area of San Francisco – from the Golden Gate bridge north, including Marin County and the wine country of Sonoma and Napa Counties.