Home  Sustainable Land Development Today April 2007
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Avoiding the Valuation Trap |
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Written by Stuart Phoenix
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Thursday, 04 January 2007 |
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Placing a realistic value on a business will help ensure a sustainable future.
Written By Stuart Phoenix and Tony Perrone
Beauty is in the eye of the beholder, and there is nothing quite as beautiful to a business owner as his own creation. Add to that the owner’s typical desire for maximum value and it is easy to understand how a business owner’s value expectation in a sale of their business is usually aggressive. The check on this is found in a third-party sale. A buyer brings his or her own notion of value to the table based on the marketplace. In a sale to management or employees, this reality is often not brought to the table, and the owner selling his business can fall into what we call the “Valuation Trap.”
The valuation trap occurs when the value placed on the company exceeds the acquiring employees’ ability to pay while sustaining a financially strong business. The eventual result is the failure of the company or a necessary sale to a third party. That is not to say there is anything wrong with a third-party sale. However, if a business owner wants his legacy company to continue as a strong independent business, the valuation trap has to be avoided. The typical valuation traps we see owners fall into, often with the help of professionals, are as follows:
Method Valuation Not Relevant
Valuation based on methods not relevant for builders: For financial professionals, discounted cash flow (DCF) is a predominant method for valuation. The difficulty in applying this method to building firms is that it relies on projections for a minimum of five years and up to 10 years or more. Anyone in the industry will attest that just forecasting what revenues and earnings will be in the next 12 months can be difficult. In addition, a terminal or sale value at the end of the projection period is estimated. This estimate is often more difficult to make than the projection. Lot inventory may also be difficult to value. How much will need to be invested to realize the value of the lot inventory? How rapidly will we build out the inventory, and what profit will we make on the inventory? Therefore, while the DCF valuation method is used widely for many manufacturing and distribution firms, it is not easy to apply to building businesses.
There are other exotic methods such as excess earnings or dividend capitalization, and many of these have a basis in financial theory, but in our experience, not in reality for the building industry. In FMI’s experience from numerous acquisition transactions with buyers and sellers, we find that the most relevant methods involve a capitalization of historical earnings, possibly using a one- to two-year forecast, and valuations simply based upon balance sheet assets and liabilities. Companies with large real estate inventory require special consideration of the projected cash flow of its development properties including a realistic development timeframe for the buyer and the seller (the two may be quite different). Capitalization methods typically will use a conservative multiple of earnings, which can be derived from a required pretax return on investment of 18 percent to 35 percent. Balance sheet methods rely on the historical accounting net worth (book value) and the book value adjusted for the market value of land and other assets.
Public Company Comparisons
Comparisons to public companies: A common method is to take valuation multiples for public companies, typically price-to-earnings ratios and price-to-book value multiples, and apply the multiple to a private company’s earnings or book value. It makes sense in that the multiples represent market values. Three issues, however, make this problematic. First, public companies typically are larger, are more geographically diverse, have deeper management teams, and have a very different mix of product. Second, public companies have different factors driving their valuation besides financial analysis. Third, there is no ready market for the stock of a privately held firm. Buy/sell agreements may be in place, but financing any internal stock transaction is always subject to the financial condition of the company at sale time.
Internal sales usually have to be done on a long-term note or share of earnings basis. In contrast, owners of stock in public companies can sell their shares quickly and for all cash. Unless the private firm is sold to a third party in an acquisition transaction, valuations for internal stock sales have to be financially feasible and not strip the firm of its means for continuing in business. An example of such a problem situation would be a company with two shareholders deciding to use a valuation of two times the book value of the company for one shareholder to buy out the other. In order to do this transaction, the buying owner would have to use all of the book value of the company for the value of the other shareholder’s 50 percent. Using the company to effect the transaction, this would only work if the stock can be bought over time and financed, with the company continuing to have strong and increasing earnings. This might be a gross assumption for a builder given the cyclicality of earnings in this industry. The valuation trap in this case is that paying for high initial value may not work over time, eventually forcing a third-party sale.
Business Sustainability
Use of formulas that are unrealistic to sustain a private company: To value stock in a privately held company for sale to employees or other internal transactions, a formal valuation done by a professional may be impractical or too expensive. Therefore, a formula may be written into a company’s buy/sell agreement. The simplest formula is to use book value, and many companies do exactly that. Book value has the advantage of being easily measured and usually conservative. However, it does ignore the market value of assets and the earnings value of the firm, so companies often seek other formulas to better represent market value. Formulas can be developed on multiples of historical earnings, multiples of book value, appraisals of real estate, or combinations of all of these. A formula, however, can create problems over time. First, the business may change in such a way that the formula no longer applies. The financial metrics can unusually increase or decrease in such a way that the results of the formula may not be representative. Arguably, the most serious problem is when the formula results in a value in such a way that the company or employees will strain to buy out exiting shareholders. If the employees cannot pay for a seemingly justifiable valuation over a reasonable period, the buyout will not work. The parties face another Valuation Trap.
One simple method to help an owner understand the maximum value that he or she can practically realize from an internal/employee sale is to take the firm’s current book value, add what the employees can initially invest and the estimated after-tax earnings over the years of the buyout, and subtract the book value needed to run the company at the end of the buyout period. Stated another way, the maximum value is what the company has now plus what it makes during the buyout less what you have to leave the employees to be independent of you. This maximum value is valid regardless of what other creative valuation techniques may tell you. Under this method, for example, if the buyout term is a 10-year period and ending net asset requirements are the same as in the beginning, the maximum price that can be paid will be the earnings over the 10-year period. The point is that employees of building businesses and the companies themselves typically can obtain very little, if any, outside financing for an internal buyout. Financing is typically tied up in real estate and projects. If they do obtain financing, it will need to be paid off directly from company cash flow or indirectly through payments in compensation or distribution to the employees. Therefore, the principal way such a transaction can occur is out of the earnings of the business over time.
Statistically, not many companies survive to the third generation of ownership. Many do not make it because the market changes and the company does not adapt. Sometimes, a third party makes an offer that cannot be refused. More likely, for most private firms, it is the inability to develop or attract successor management. However, many do not survive because of poor transition planning and unrealistic value expectations. Avoiding the various valuation traps already discussed gives the private company the opportunity to survive and prosper. LDT
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