Know thy company's value

Chief Executive, The, March, 1997 by Fredric Roberts

In this age of IPOs, acquisitions, recapitalizations, LBOs and MBOs, private company chief executives would be remiss not to ask themselves what their companies are worth - and to whom. Sadly, the concept of founding a business, building it over a period of many years, and leaving it to children seems quaintly anachronistic. At some point, a successful business is going to be an acquisition target; you can be sure that either a supplier, competitor, customer, strategic partner or some behemoth that needs to add a specific capability is going to give you the once-over.

Someday, you may get an offer you can't refuse, so you should begin the evaluation and planning process as early as possible to enhance the value of the company - regardless of whether you intend to sell.

Because the increase is in the potential value of your company in some hypothetical future transaction, it's not that easy to calculate. But by focusing on core competencies and areas with distinct competitive advantages, the company can make itself more attractive to both strategic and financial buyers. Hence, subtle shifts in operating plans to reflect the focus on those areas can increase value tremendously. A good tactic is to link these elements to a compensation plan that reinforces both strategic and short-term operating goals so that employees have incentive to improve performance in the areas that enhance value.

Valuation is always a complex process. The CFO must calculate future operating results, such as sales, EBIT, net income, and cash flow. Other critical components are tangible assets, such as inventory and fixed assets, and intangible assets, such as brand name, reputation, customer base, and distribution network.

Look at your company as if you were a buyer. Analyze historical and projected financial results; compare the company's performance with its peer group; scrutinize the valuations of similar transactions within the industry; and perform both a premium and discounted cash flow analysis.

There are three distinct principles of valuation. First, your company is valued according to how it compares with others. Second, the valuation is of your company in the future, not the past. And third, your company has decidedly different value to different buyers.

Strategic buyers, for example, usually seek to increase market share, gain access to new types of customers, market areas, and products. They also may want to increase capacity, acquire management expertise (though they often bring in their own teams), and diversify sources of revenue. They often look for increased efficiencies, cost savings, and other synergies.

Financial buyers most often seek sustained growth from the acquired company. Cash flow is critical here, as financial buyers generally rely on new borrowings for their transactions. They also tend to require that current management stay on the job, rewarding managers with shares in the newly acquired company. It's a cliche that strategic buyers tend to pay more than financial buyers; and, of course, in periods of overheated stock markets, a public offering can, seemingly, dwarf both.

Here is where the three principles of valuation are applied: as a CEO, you need to identify a universe of comparable public companies and examine how they trade on value multiples. You also have to look at comparable companies that have sold recently and determine the acquisition multiples. Last but not least, you must arrive at discounted cash flow, which discounts the projected cash flow over an extended period, say five years. Factor in depreciation, changes in working capital, and other discounts to determine the company's "free cash flow" - how much cash the concern generates. Then discount back to determine a weighted average cost of capital to answer the critical question, "How much does it cost the company to generate its cash?"

Because many buyers believe that cash flow is more important than revenue, your company's projections have to be achievable. And it's crucial to find each buyer's hot buttons - whether they want you to stay, whether they want the entire company, whether your brand name will be enhanced by their distribution, and whether tax considerations help.

Naturally, you should avail yourself of outside expertise. It is the rare CEO who does not need sophisticated corporate finance counsel to get all of this straight. In the final analysis, a company is valued as a multiple of its sales, EBITDA, EBIT, net income, and operating cash flow. How high a multiple you get depends on how compelling your company can appear to each individual buyer or investor. The value of any private company can be maximized by determining the precise buyer to which it provides the most value - and then finding that buyer.

Fredric M. Roberts is president of F.M. Roberts & Co., a Los Angeles-based investment banking firm. He is also a former chairman of the National Association of Securities Dealers, parent of The Nasdaq Stock Market.