It’s a cliché that business valuation is both and art and a science. Or as it’s been more aptly put it is a craft. Either way it needs to be done thoughtfully. You don’t need to look hard online to find sites that invite you to put your data in and I’ll value your company for a low fixed fee. Trouble is that “under the bonnet” this is just some maths – this is a problem because you have no idea if the site is asking the right questions, and more importantly its only as good as the data input. As they say garbage in garbage out.
But if you do treat valuation as a craft, to be conducted thoughtfully, making insightful and supportable judgements about the business at each step you need to guard against bias – and this can arise accidentally.
Anchoring is a well documented phenomenon. There have been psychology experiments that have demonstrated this. Business students are asked if they’d pay the last two digits of their national insurance number for each of several items. Then they’re asked the maximum they’d be prepared to pay item by item. Despite it being random students with higher NI numbers consistently indicated higher maximum bids. The anchoring phenomenon can work to ones advantage – it’s a reason why it’s often helpful to go first in a negotiation – to try to anchor the debate at your end of the value range. But it has no place in valuation as the valuer should form an independent judgement.
So as a corporate finance adviser I’m keen to understand what my clients objectives are as input to negotiations. Conversely as a business valuer I need to be deaf to the client’s desired valuation. This might be a business valuation for divorce purposes, or to do with shareholder exit, or tax. But I need to avoid anchoring bias to make sure I arrive independently at my best judgement of valuation which is supported by the evidence and by my understanding of the business.
For more information on our Business Valuations service have a look at our website - based in Cambridge we provide valuation services to business owners around East Anglia, in London, nationally and internationally.
Asman Damodaran of the New York University Business School had a go at valuing the Star Wars franchise. Disney paid $4Bn for it – so did that turn out to be a good deal?
Damodaran reviews the franchise to see where the revenues have come from. Interestingly the original film is still the biggest grosser to date at nearly $4Bn. But the other revenue streams are even more important; VHS/DVD/Rentals, Toys, Gaming, Books, and TV series. These other revenues dilute Movie income to 20% of the whole alongside 23% for rentals, 15% for gaming and books, and a whopping 36% for toys and merchandise.
So how do you value it? Like any other business, one needs to take a stab at future earnings potential. In the absence of Disney’s, no doubt closely guarded, forecasts Damodaran makes educated guesses. Starting with Disney’s intent to make another two films he then assumes they’ll each gross something similar to “the Force Awakens”. I’d have assumed some slight decline each time around (as the history suggests) but you have to start somewhere. He judges that add-on revenues will continue be more important - streaming replaces rentals and he assumes $1.20/dollar v $1.14/dollar thus far, Toys continue to generate $1.80 for every dollar of movie income, Books drop 25% to $0.20/dollar, Gaming stays at $0.5/dollar, and he assumes that with the distribution power of Disney and Netflix (rumoured to be planning 3 live action series) TV rights will increase to $0.5/dollar.
One needs to keep making assumptions, when the films will be released, inflation, and of course the margin levels on the income streams – he uses sector averages here, for example toys/merchandise at 15%. Put it all together and you get an overall net income projection which he discounts at 7.61% being the average cost of capital for the entertainment sector. Net result a valuation of $10M. So Disney did a good deal. If you want the full calculation Google “Galactic Finance: Valuing the Star Wars Franchise” which will take you to his blog.
It shows you can build up a cogent case to value almost anything, although I’d have factored in some kind of discount just because of the existence of Jar Jar Binks.
Planning for exit and succession can be difficult in any business, but in family businesses there are additional factors to consider. One of the problems with family succession planning is that the two key objectives – liquidity and preservation of the business legacy appear to be in conflict – how can you get cash without selling up? A sale to a trade buyer may be unattractive if the plan is to keep things in the family, and this is where the idea of a sale to family comes in.
This is a form of management buyout – the family members buying the business are very often the team running the company. Often it goes beyond that to key managers – hence the occasionally used abbreviation the FAMBO. This is meant to mean Family and Management Buyout, or Family Buyout, although just to confuse things I’ve recently seen it used in East Anglia to refer to a Franchisee and Management Buyout. It can also be called a VIMBO or Vendor Initiated Management Buyout – because the its usually (though not always) the older generation which initiates the sale to the younger family members. At PEM we prefer to refer to such deals as Succession Buyouts – because that neatly encapsulates the overarching strategic intent of the deal.
Because family relationships are involved things can go wrong so as to delay the transaction or even kill it completely. So here are some key thoughts on how to preserve family harmony whilst successfully completing a buyout.
Plan ahead and don’t rush each other. It is really important that harmony and trust is maintained. Nothing breeds suspicion more than the idea that one family member wants to take advantage of another, either by being pushy or appearing to scheme behind the scenes. This is true whether a family member is a buying or selling. An aggressive buyer almost ensures that the seller will react negatively; an aggressive seller communicates desperation and may undermine his or her own negotiating position. Actually this is also true of Succession Buyouts amongst long standing colleagues who are not related.
Take account of peoples personalities Families ought to know one another pretty well. They know about personality traits or past circumstances giving rise to unusual levels of loyalty, or even resentment, or jealousy. This might all come out in the run up to a transaction, sometimes they are deep-seated psychological feelings, and can be almost childlike—“Dad always preferred you.” Being alert to such attitudes and steering the transaction in a sensitive way that respects feelings will help ensure success. Often the most important thing is to make sure everyone is listened to.
Get the business professionally valued If your shareholder agreement doesn’t prescribe a valuation methodology, it will be helpful to everyone involved in negotiating a transaction that there should be an independent assessment of valuation. Fairness is the key to completing the transaction and maintaining positive family relationships, and possibly sanity. Neither buyer nor seller wants to looking back on the transaction with regret or suspicion.
Find some trusted advisors. Truly independent advisors who have the best interests of the family in mind can be hugely helpful in communications and facilitating agreement amongst the family. Each family member can get some independent advice, but its much better to select an adviser with a track record of brokering/facilitating such deals amongst close knit family or business groups to work for the company/family as a whole with the objective of reaching an agreement that works for all. A skilled adviser will listen to all the agenda’s and try to manage any emotional pressures that arise during negotiations.
Tax and estate planning My tax colleagues would point out that it’s really important to consider the tax and financial affairs of the whole family, up and down the generations. And a deal like this is an opportunity to consider these things holistically. Has the family provided for everyone as they intend and have they done inheritance tax planning? Again these are things that need to be done early. One of the consequences of some buyout structures is that IHT planning becomes more important – don’t leave it to the last.
Family businesses are important to us all – according to INSEAD they account for 57% of US GDP. There’s a general perception that many don’t make it beyond one or two generations. I’m not sure that’s true, INSEAD reckon there are 5,500 bicentenary family businesses around the world, and we’ve certainly worked with some family businesses which are now at fourth or fifth generation stage. Visit our website to read about some of the family buyouts we've worked on.
Bloopers are the mistakes made by cast or crew on a film that end on the DVD extras. Sometimes they can be better then the film. Business Valuation bloopers on the other hand are no laughing matter. You might need a business valuation for divorce purposes, a shareholder exit, or as part of some kind of tax planning. Whatever the reason, whether you’re valuing an early stage technology company in Cambridge, or a mature SME in London there are some common business valuation bloopers to avoid.
As valuation experts we are often get to look at and comment upon other advisers valuation reports. Often basic flaws in valuation methods, logic, or lack of decent data lead to challengeable advice being given.
Here are some valuation out-takes, make sure you avoid them.
"I believe you"
Believing everything you’re told isn’t a good idea. But I see lots of report where advisers have based all of their calculations on profit figures supplied by directors without having challenged them, or having reviewed the business. Sometimes its pretty clear that most of the text is templated and applied to any and every business.
Lies, d*mn lies and statistics
You can find statistics to prove anything – just ask any politician. When valuing a business there a range of indices available from which to source an earnings multiple. The lazy adviser might just reach to for one of these without either questioning it, or corroborating it with other data. This is a problem because these indices by their very nature are averages – and so they say nothing in particular about any one sector or company. It doesn’t matter whether they use, the BDO Private Company Price Index, FT All Share PE ratio, the Leading Edge Alliance’s PERDA, the Argos Soditic Mid Market Index, or the UK200 Group SME Valuation Index, a generic multiple will rarely give you the right answer in a business valuation.
Out of code information
As in any field business valuers need to keep up to date, and to use current data. I recently saw a valuation based solely on the Private Companies Price Index. Just relying on that would be bad enough, but the valuer then applied it to the wrong profit figure in the companies accounts. My guess is he has been using PCPI for years and has never noticed that it changed a few years ago from an EBIT multiple to an EBITDA multiple.
Apples and Pears
Don't mix apples and pears or you'll get a curious byproduct. Likewise there are a range of profit measures, EBITDA, EBIT, PBT, PAT, Operating Profit. And a range of multiples including EV:EBITDA and the price earnings ratio or PE ratio.If you apply a price earnings ratio to EBITDA you will significantly overstate the result.
Rules of Thumb
As a business valuer I wouldn’t disregard rules of thumb in a particular industry, so transactions involving shops, cleaning companies, and professional service firms are amongst those where one comes across them. But I’d only ever use them as corroboration of more rigorous methods. So shops are often sold for a number of weeks turnover plus the value of the stock – ultimately this must also equate to an earnings multiple, but where data might be patchy it’s probably a useful ready reckoner of valuation. The trouble is one often see’s quite inappropriate, and unquestioning, extension of these rules to other sectors. So for example I recently saw a service firm valued by a valuer who I suspect must specialise in valuing corner shops for after arriving at a (not entirely supportable) earnings valuation he then added the balance sheet value.
I could go on. There are lots of ways to go wrong, indeed a quick Google produces an academic paper entitled “110 Common Errors in Company Valuations”
The answer, and you’d expect me to say this, is to find a business valuation expert who knows what they’re doing, and produces a well reasoned valuation that would stand up in court if you ever found yourself there.
Valuations are quantitative and we rely heavily on financial and other numerical inputs. Not only that valuations get better the more financial information is available.
This is why start-ups and early stage businesses can be difficult to value. For a valuer there’s a death-zone somewhere between seed funding and the emergence of sustainable financial performance. As anyone doing business in and around Cambridge will tell you most start-ups have a spell when there’s few reliable numbers to work with. So how can we value businesses when they’re in the data death-zone?
Comparable Transactions: Of course no two companies are identical but acquisitions of “somewhat” comparable start-ups can provide useful reference points. Without usable financials we can compare based other metrics – for example IP portfolios, number of subscribers or drug pipelines. It may feel like horse trading and exact matches are rare, but a couple of close comparables can support a relatively accurate valuation.
Cost Approach: While some entrepreneurs might not agree, until a company passes a meaningful proof-of-concept milestone, a start-up is valued on a time and materials basis, if that. A potential purchaser might add a premium for timing and the cost of trial-and-error, but will mostly view early stage technology as something they could recreate internally.
Transactions in Start-up’s Own Shares: This is a bit like calculating the market cap of public companies; start-up valuation can be derived from the value of its individual shares. To use this approach one has to assume that the transaction was fairly negotiated at arm’s length and by a professional investor. Not all equity shares are equal and simple multiplication, while widely used, won’t often work. But a well-negotiated funding round can provide a usable value indicator.
Rules of Thumb can sometimes be used, but this is best left for corroboration of other methods. For example the Berkus Method (invented by US business Angel Dave Berkus) seeks to “price” different qualitative stages of a start up’s development such as having a sound idea, a prototype, or a decent team and ascribing a fixed $500k value to each step. One could defend this slightly arbitrary approach because if enough business angels use.
The Private Companies Price Index or PCPI is a widely reference index of private company exit multiples published by BDO. It is useful for establishing trends in the market. However from what I can see its often used in Business Valuations, call me a cynic but I suspect this may be partly because its widely available and free? I’ve always said it should be used with caution.
So I was interested to read of the recent case of Foulser and Foulser v HMRC, part of a long running serial litigation concerning a failed tax avoidance scheme, and the transfer of two food companies. The valuation of the companies was in dispute, and two valuers presented different methodologies. This roundly rejected one valuer’s use of the PCPI as the best indicator of price earnings multiple to be applied saying "There is no transparency of the PCPI. No information is available as to the number of private company acquisitions on which the average P/E ratio is based. Nor is anything known about the companies concerned, including their activity and size. It is thus impossible to take any view on comparability."
The problem in this case wasn’t that the PCPI is of no use, rather that it was a poor measure to focus exclusively on. When I’m doing a business valuation I’d typically look to use it as additional data to corroborate more specific and transparent data on comparable companies and comparable transactions.
To illustrate why this went to law you only have to look at the taxpayers valuation of £243,750 versus the HMRC valuation of £2.1M. The tribunal came out at £1.75M in the end.
With the Cambridge and the East of England economy continuing to perform strongly we're hosting a free educational morning seminar targeted at local small and medium size business owners (in the £1m-£100m turnover band).
Alongside our own corporate finance, and tax specialists we have speakers from our joint event hosts Barclays and Business Growth Fund who will give insights into raising debt and equity finance. The whole event is designed to give business owners practical ideas on developing a strategy for growth.
Any acquisition should have a sound strategy underpinning it. And it should look not only at the why and how, but also at the long term implications – when will you see benefits? Will it make your business more attractive to buyers?”
As well as giving advice on acquisition, we'll cover using strategic growth to maximise the value of a business. The event is going to be comprehensive, guiding attendees from growth right through to succession or trade sale.
A big thank you to the Institute of Chartered Accountants of Scotland ('ICAS') courtesy of which Mrs F and I enjoyed a cruise down the Thames last night on the PS Waverley (the last seagoing passenger-carrying paddle steamer in the world). Starting from Tower Pier and cruising down to the Thames Barrage, the opening of Tower Bridge make a spectacular start and finish to the trip.