This blog is compiled from the Ignite Your Business™ Podcast in which GREENCREST CEO and Chief Strategy Officer Kelly Borth interviewed Mike Ella, Director of Family Wealth Consulting at Key Private Bank. This blog is Part 2 and continues the conversation about understanding the value drivers of your business.
Kelly Borth: This week on the Ignite Your Business™ Podcast we’re talking about understanding the value drivers of your business. I’m Kelly Borth, Chief Strategy Officer and CEO of GREENCREST. With me today is Mike Ella, Director of Family Wealth Consulting at Key Private Bank.
Kelly Borth: There’s a difference between tangible and intangible assets. Where do they fit into the business value equation and what about sales and EBITDA as business value drivers? Can you also define EBITDA for our listeners?
Michael Ella: EBITDA is Earnings Before Interest Taxes and Depreciation and Amortization. EBITDA in the simplest terms is a vehicle to allow investors, buyers, to be able to analyze businesses on an even playing field. It’s comparing apples to apples. Therefore, interest is added back because generally what happens is the third-party debt in a company is paid off by the owner when they exit the business, and then the buyer will assume their own third-party debt.
Kelly Borth: So it’s the financial snapshot.
Michael Ella: This is the financial snapshot, and there are some businesses that don’t have interest. To compare apples to apples we add interest back, and the debt structure is going to change after the transaction. Then you talk about taxes. We add them back when we’re talking about federal taxes and state taxes because there’s so many different entities. There’s tax, there are entities that are taxed as an entity for a C Corp. Then, there are entities like an S Corp where the owners are taxed personally. There are differences in how that taxing entity is taxed, and how it shows up in the financial statements. When using book financial statements to come up with a value for the company, we add that back in. When the buyer is going to come in and buy the business, whatever entity they put for that company, we don’t know what’s going to happen: They might start a new one, they might integrate in into another one, or they might just keep it the same if they buy the stock. So, the taxes get added back to be on an even playing field. Depreciation and amortization are non-cash items, so we add those back because really EBITDA’s trying to get to a true cash flow of the business.
Kelly Borth: How much of the value of the business is relative to sales and EBITDA versus these intangibles?
Michael Ella: A multiple is applied to that EBITDA generally speaking to come up with a value. When we talk about service businesses, when we talk about technology businesses, that’s a little bit different. But, if you think of an average multiple of six, I look at the tangible asset value of being one to two of that six, so 30 percent on the high end, where the intangible assets is really making up that three to four. So, you’re talking 60, 70 percent of the value is coming from that. When you’re trying to get to a premium level of six as an average, the other one to two terms you’re potentially getting from a multiple is all coming from the intangible assets. What I’d recommend if someone’s going down this path, is to focus on the tangible side. That’s where you can really drive a significant amount of value.
Kelly Borth: When selling a business, how far in advance should business owners be aware of the gaps in its value drivers? What’s the first step in identifying those gaps, and how long does it take to close the gaps to grow the value of the business?
Michael Ella: Typically we like get the owners to start thinking about this at least 2-5 years in advance, the reason being it takes a lot of time to put in place strategies that are more complex. You need to have them in place in advance for them to be as effective. So, we generally say three to five years is when to get engaged. Our timeline, where we talk about doing 90-day sprints, we pick priority items that we work on for those 90 days. if we had another couple years, we’d be able to use that full time period to be able to drive that value. Where it changes as you talk about the value gap is the fact that an owner whose business is worth $15 million at once, needs $20 million to retire and go into the post-transition lifestyle. Having a year to be able to do that probably is not likely. Where that year should be focused on is protecting that $15 million value. If you have a wide value gap, what we’re probably going to recommend to is that you push out that time frame of when you’re looking to transition the business. Or we have to change how you’re going to live after the transaction. That second part typically doesn’t go over well with too many people. So we try and get the owners thinking about this three, four, five years in advance. If you go through this process for that period of time, then really the value should be optimized as much as possible. Knowing your value and recalculating every single year is helpful. If you talk to people back in 2007 or 2006 who had high valuation, come to 2008 or 2009 when nothing else has changed in their business, that value has dropped. The mergers and acquisitions market has been very, very strong so if someone’s looking to try and do a transaction, now is a great time to do it. Eventually it’s going to go down again. We don’t know when it’s going to happen, but that’s why planning and doing the analysis and knowing what value you need to potentially retire or knowing your value gap is half the battle.
Kelly Borth: Be prepared in order to sell your business at the optimum time.
Michael Ella: Absolutely, because you never know when that time is going to be. Trying to time the market is a bad, bad idea. No one can predict what’s going to happen on the market. Buyers doing their due diligence have certain goals they need to make, and they need to invest in some of these companies, especially private equity. When we talk about the assessments, and analyzing the business, the personal life, and the financial life there’s really two components to that. You have an attractiveness standpoint and you have a regular standpoint. The business can be attractive to an outsider, say a business in health care. Health care is extremely hot right now; investors really want to get into that space. So I can have an attractive company that someone comes and knocks on my door and says, “I want to buy your business.” But as they go through the diligence process, the merger and acquisition process, there are things that could come along from a readiness standpoint that might mean that business isn’t really ready to try and transition, so the buyer is going to back out from that offer that they gave. Where we can add additional value is making sure if you get a strong offer, that transaction actually closes. But if it doesn’t close, the process doesn’t change. Our value optimization process is still to continue to grow your business.
Kelly Borth: Somebody told me that the best strategy you can have is to be prepared. I think that’s great advice for our listeners. Thank you so much for sharing your insights, Mike, on understanding the value drivers of your business.
Interested in an analysis of your business’s value drivers? Contact GREENCREST to inquire about an assessment.
To listen to the whole conversation on value drivers, tune in to GREENCREST’s conversation with Mike Ella at the Ignite Your Business™ Podcast.