The terms recasting, adjusting and normalizing are often used interchangeably and refer to adjusting items on a company’s financial statements that are unrelated or unnecessary to the ongoing operations of the business. Financial reports are generally composed to minimize business tax liability which in turn, results in an inaccurate presentation of a company’s true earnings and profitability. Because the objective of reporting to the IRS is generally in contrast to financial reports composed for company shareholders and perspective investors, financial adjustments made to expose the real performance of a company usually result in higher profits and an increase in the fair market value of the business.

Keep in mind that buyers are paying for the company’s future expected free cash flow, not the historical financial performance.  In fact, one can often hear LockeBridge bankers saying, “Learn from the past, value the future”.  In other words, past performance is only meaningful in so far as it provides insight into the future potential performance of the company.  Ultimately the prospective purchaser is attempting to estimate what the cash flow will be under its ownership.

There are numerous financial items that may need to be adjusted. The process is as much an art as a science. Understanding what the potential purchaser will accept as an adjustment, relevant to both the income statement and the balance sheet, requires significant experience and is a critical component in accurately estimating the value of the company.

There are a handful of categories which define the majority of adjustments. Below is a summary of these items.

INCOME STATEMENT ADJUSTMENTS

Owners Compensation
The objective is to account for the cost of all benefits received by Shareholders (passive and active) and their family members which have been expensed to the business.  After accounting for the foregoing, we adjust the total compensation to the fair market rate one would reasonably expect to pay for replacement personnel.

Owner Compensation may include, but is not limited to:

• Salary
• Bonus
• Profit Sharing
• Health Insurance
• Life Insurance
• Club Membership Fees
• Personal Travel, Meals & Entertainment
• Personal Vehicle Expenses

One-Time, Non-Recurring Adjustments
Expenses and Income which are not anticipated to reoccur under the new owner’s tenor are called One-Time or Non-Recurring and may include such items as:

• Legal Expenses (e.g. litigation expense)
• Broker Fees (e.g. M&A retainer)
• Consulting/IT Projects (e.g. new web-site development)
• Non-Performing Employee Expense
• One-Time Recruiting Expenses
• Start-Up Expenses (e.g. organizational documents, patent applications, moving costs, hiring costs, etc.)
• Insurance claim proceeds and lawsuit settlements.
• Gains or losses from the disposition of assets such as the sale of vehicles.

Note that there are plenty of potential “abnormal” income and expenses which may not be intuitively obvious to business owners. An example of such are:

• Business interruption costs.
• Gains or losses from discontinued operations.
• Abnormal high or low profits (e.g. large one-time orders, inventory clearance event)

Rent Expense
If the property upon which the business operates is owned by the Company or one or more of the company Shareholders often times the rent expense is not in line with the market.  If the Company owns the property only the costs associated with supporting the property such as insurance, property tax, maintenance and utilities, will be expensed without any consideration for arms-length rental rates.   If the purchaser is not acquiring the real estate the property expenses must be adjusted to fair market. Even if the property is being sold along with the operating entity, because the method used to value real property differs from the methods employed to value operating entities, the real property cost must be normalized to fair market so that each of the two assets can be valued independently.

BALANCE SHEET ADJUSTMENTS
The profit and loss statement is generally much better understood and garners more attention by business owners than the balance sheet. Consequently, balance sheet adjustments are often overlooked.

Regardless of the depreciation method used assets need to be “marked to market”. Mark-to-market accounting can change values on the balance sheet as market conditions change. For example, your 20 year-old desk may be fully depreciated and show no value on the balance sheet but it works just as good today as it did when it was new. In fact, it may even be valued higher today than the original purchase price. For profitable going concerns the value of the fixed assets generally does not impact the enterprise valuation, however what about the value of the inventory.

Depending on both the inventory accounting method utilized and the type of assets held in inventory, a mark-to-market adjustment can substantially impact the enterprise value.

LockeBridge does a significant amount of business in the metal industry.  Consider a metal processing company using LIFO.  In this case there should be a LIFO reserve footnoted on the financial statements. Depending upon the company’s inventory turn-over and the volatility of metal commodity prices adding back the LIFO reserve can substantially change the value of the current assets.  Even if FIFO is used consider a metal recycler, for example, which may need to accumulate enough inventory to fill a shipping container to be sent to a Chinese buyer. It may take a smaller recycler several months to accumulate this volume. During such accumulation period recent metal prices may differ significantly then the recorded cost of the inventory.

Various factors must be considered in valuing a company. One such factor is how much weight to be placed on a cost-based methodology such as the replacement cost method.  In any event, accurately adjusting the balance sheet may be essential in valuing the company.

ENTERPRISE VALUE
After accounting for all of the relevant adjustments, how does one then determine the value of the company? Thorough and credible adjustments are a critical factor in any valuation but even if the job is done perfectly there are many other factors to consider when valuing a company.

For example, most business owners are familiar with the concept of EBITDA “multiples”, and sometimes applying these multiples to a properly adjusted EBITDA can indeed approximate market value, however there are several other variables to consider.

Consider two shipping companies both with the same EBITDA, but one company leases their trucks and the other purchases their trucks. Because the leasing cost is already accounted for as an expense, most likely the company that leases has a higher value.  Even if both companies purchase their trucks the company with the lower capital expenditure, all else equal, will be valued higher. Capital expenditure doesn’t come into play when considering EBITDA. That’s why free cash flow (FCF) is really the relevant number. Most non-professionals, and many professional for that matter, do not fully understand FCF because it takes into account more complex issues such as capex, debt leverage, and tax rates.

As previously mentioned, purchasers value the future expected FCF. To do this they project the entity’s adjusted earnings into the future and then “discount” or “present-value” them back into today’s dollars using a discount rate which accounts for their cost of both debt and equity, the weighted average cost of capital (WACC). One critical job of the valuation professional is to estimate the prospective purchasers WACC.  The methodology used for such estimation varies widely and is often the determining factor in the valuation accuracy.  A discussion of the various methodologies used to determine WACC is beyond the scope of this paper but suffice it to say that the WACC is based on numerous factors including, but not limited to:

• The Risk Free Rate of Return
• Small Company Risk
• Industry Specific Risk
• Company Specific Risk
• Availability and Cost of Debt (i.e. leverage)
• Forecast Credibility

This article has mentioned only two valuation methodologies, the replacement cost method under the cost approach and the discounted cash flow method using the income approach,   however a number of methods should be considered to accurately value a company. Each method has its strengths and weaknesses.  Refer to below Appendix for LockeBridge Valuation Accuracy.

THE BOTTOM LINE
No owner one should enter into the merger and acquisition (M&A) process prior to obtaining a very credible estimate of value.  It is critical that selling Shareholders have reasonable and relatively accurate expectations, which reflect how the market perceives the value of the company. Additionally, if not credibly performed Shareholder’s can be subject to a material conflict of interest with their M&A Advisors, whose compensation is usually substantially based upon the value and structure achieved.  Refer to www.lockebridge.com/engaging-an-investment-banker  for a brief discussion of potentially advisor conflicts.

Both offer prices and valuations can range substantially. Refer to www.lockebridge.com/case-studies to see numerous sell-side transactions, bid prices and composition. Here you can see that it is not uncommon for offers to range +/-30% or even more.

The M&A process is not to be taken lightly.  It should be done effectively and optimally, the first time around. Obviously, unanticipated circumstances out of the control of both the Advisor and Owner can and do occur, however a failed process requiring the business to be placed back on the market a second or even third time is rarely a good thing.  An offensive position the first time around can easily morph into a defensive posture. An accurate estimate of value and an effective selling process should minimize the time, energy and potential defocus and exposure which can all result in substantial costs to both the Shareholders and the Advisor.

December 2018Dear Colleagues and Business Owners:

We are concerned that mid-market valuations may soon be compromised and many business owners do not have the time to ride out a potential downturn.

The purpose of this memo is to share LockeBridge’s current perspective on the potential shift in economic trends and the impact such may have on middle-market business valuations

LockeBridge Economic Forecasting – Highly Accurate Track Record
In 2006 and 2007 LockeBridge published numerous articles, sent thousands of emails  and advised dozens of business owners of the impending economic crisis and resulting business devaluation, which subsequently put thousands of companies out of business.

Refer to Appendix below for select articles.

While we do not believe that we are heading into a major down cycle, we do believe that volatility is the highest it has been since the 2008 downturn and such volatility can cause significant buyer hesitation.  Over the past couple of years we again authored many articles and have advised small business owners, who do not have at least 5 years to sustain a cyclical downturn, to consider the sale of their business sooner rather than later.  One such LockeBridge authored article, which has received material attention, is titled “Business Value Decreases With Fed Rate Increases” and can be viewed at:
https://www.lockebridge.com/bus-value-decreases-with-fed-rate-increases.

Today’s highly variable and unpredictable economy creates a large discrepancy in opinions about the future. As a result, valuation ranges are much wider than normal. It is not unusual for a company to attract a range of bids of plus or minus fifty percent as compared to a more typical plus or minus thirty percent range experienced during a more stable economy. No matter how strong your company’s performance or outlook, no company is totally insulated from macro- economic forces. In fact, the performance of most companies is highly dependent on the state of the economy including external factors such as Gross Domestic Output, Interest Rates, Balance of Trade, Consumer Sentiment and Consumer and Government Spending. This uncertainty has a significant impact on the capital raise process. Whether the raise is in the form of equity or debt or to fund early stage or mature company growth; capital’s worst enemy is the fear of uncertainty. So what can you as a business owner do? Don’t add unnecessary risk on top of the inordinate risk already existing in the  economy and your industry. Focus on tactics which reduce risk such as substantial proof of efficacy, well defined business plans and milestones, and limit the amount of capital per raise while increasing the frequency.

Startup Equity Capital
For early stage companies seeking to raise equity capital, the principal variables are: Timing, Amount of the Raise and Credibility/Validity of the Business Plan. Each of these variables are highly inter-related. The primary objective of the early-stage entrepreneur/founder during the capital raise process is to manage these issues effectively, in order to retain as much equity as possible. This is especially critical during the early stages where risk is high, value is low and many entrepreneurs are scrambling to raise much needed capital,  and in many instances even “survival” funding.

Timing, Credibility, Amount of Capital
No doubt that that timing of the capital raise, the amount of the raise and the credibility of the business plan are critical variables for both mature and early stage companies alike, however; for early stage companies that properly manage these variables it can mean the difference between retaining a majority of ownership versus next to nothing. Too many startup entrepreneurs have failed to manage the capital raise process effectively, only to be left with a small fraction of ownership by the time the company actually turns cash flow positive.

For startups there are several value plateaus during the lifecycle of the company. Obviously, the value of the startup increases as risk decreases and the business starts to achieve its major milestones or “value plateaus”. During the early stages, it is critical to identify these value plateaus. Each value plateau represents an increase in efficacy; an achievement which enhances the company’s probability of success. Timing the capital raise to be in concert with the value time line (see diagram below) is essential. This requires an extremely well thought out plan with crisp execution. It is essential to understand when and how much to raise at each plateau, and factor time-to-market into the equation. Since most early stage entrepreneurs view the capital raise process as a total defocus and “necessary evil” they want capital on the balance sheet as soon as possible. Therefore, the decision of delaying a capital raise until the next value plateau is always a sensitive trade off.

Timing the Raise
The Value Plateau Model (VPM)©.  When speaking with early stage entrepreneurs, I often refer to the Value Plateau Model© (VPM), which LockeBridge created to better explain the importance of timing the capital raise and tranched financing. The word tranche is derived from the French, meaning slice or portion. In the world of investing, it is used to describe a security, either debt or equity, that can be divided into smaller pieces and subsequently sold to investors.

Tranched financings, historically used in life science companies, has expanded into other industries.  Simply stated, for the entreprenuer, the principal benefit of tranching is a reduction in dilution or preservation of equity. Tranching is not for everybody, however.  This type of financing requires careful structuring and is unique to every company. More conservative entreprenuers, or those that may not have the highest level of confidence in achieving their interim milestones may opt to take the full amount of required capital upfront.  Word of caution; be very careful that you dont get caught in a corner by presenting an adversion to tranching.  Experienced investors can easily interpret such an adversion as a material weakness in your confidence.

To best illustrate the stages of the Value Plateau Model © (“VPM”), we will use terminology which generally relates to the lifecycle of a technology-based product, however; the same concept can be applied to any product or service.

 The Value Plateaus

A.  Idea Inception (Seed Financing)

The first activity which generates value is the inception of an idea. Financing at this level is made to support the founder’s exploration of the idea and is referred to as seed financing. Value at this stage depends upon several factors which include the incremental benefit the idea provides to the consumer, the amount of required investment, time-to-market, barriers to entry, total available market size, etc.  At idea inception, there is little or no proof of efficacy, therefore value is very low.  As such, unless the idea is superior, you can count on funding coming from your own pocket or those of family and/or friends (thus the term “family & friends money”).   Typical seed capital ranges between $50,000 – $250,000

B.  Alpha – Proof of Efficacy in the Lab

For newly developed products, the first test of efficacy is generally conducted in a laboratory setting and referred to as alpha testing.  Since there is a huge gap between lab testing and actual application of the idea in a real world environment, risk is still very high.  As with the prior step, unless the idea is a blockbuster, value will still be low.  The name of the game in this stage is to have highly documented, controlled testing.  At the end of this stage, a prototype may be developed.  The typical value for companies operating between the Proof of Efficacy and Beta stages,  which have product with attractive characteristics (i.e. relatively large total available market, defensible position, growing market, good projected ROI, etc.) falls in the $2 million range.  This $2M is just a general rule of thumb and can vary signficantly.   A  more accurate valuation methodology may be achieved by present valuing the expected free cash flow over the life of the company.  Of course, the forecast itself is generally the largest variable. So, to the extent the forecast lacks credibility the present value discounted cash flow method will not be favorable.  Typical discounts rates at this stage can be in excess of 70%. ¹

C.  Beta

Beta generally involves controlled use of the product in a third party, real-world environment.  At each plateau there are varying levels of efficacy.  At the Beta stage the highest level of efficacy typically occurs when an operator, working in a production environment, is operating the product without assistance from the product engineering team. When this occurs, the product is typically running effectively enough for the Company to enter into production,  producing and shipping multiple systemsor componets to be used in the customers production environment.  At this point, efficacy is very high. The investors’ focus now shifts more to operating and marketing issues such as customers’ perceived value and the costs of manufacturing and pricing.  Although still pre-revenue, if milestones are being achieved on-time and on-budget the company’s enterprise value will have increased significantly.  Typical discounts rates applied at this stage are between 50% and 70% ¹

D.  Production Stage (Series – A Financing)

At this stage, the company is filling orders for the product to be used in a production environment.   The company is not profitable but has an organization, a working product and some revenue.  At this stage, the investor is very focused on issues such as product reliability and perceived customer benefits.  Typical discounts rates applied at this stage range from 40% – 60%.¹

 E.  Repeat Orders (Series – B Financing)

One might argue that Repeat Orders really belongs in the Production Stage, however; I believe that when a customer, especially a well recognized and respected industry player, places a follow-on order it represents substantial validation of both the product benefits and the economics.  After receiving several repeat orders from well-respected customers, product/technology efficacy begins to fade into the background.  The focus changes from “Does the product work?” to “Does the company work?”   Can the management of the company scale its operations while retaining its competitive advantage, servicing the customer needs, retaining its employees and maintain the critical operations required to be successful in the long run? Discount rates for Series – B financings typically range between 30% – 50%.¹ 

In an effort to add some persective to the discount rate guidance, investors or buyers of mature “nano-cap” (<$50M revenue) privately held companies with solid historical performance typically seek a return on their equity in the range of 20% – 25%, depending upon such factors as the current risk-free rate of return (typically measured by the 20-year treasury bill), industry risk and perceived company specific risk.

A recapitalization is the process of exchanging one form of financing for another. For business owners wishing to take something off the table a recapitalization represents an alternative to the complete sale of a company. A recapitalization can provide the necessary capital for growth, achieve personal liquidity and diversify risk for owners wishing to sell less than 100% of their business.  It gives a business owner the opportunity to sell a portion of their company while still maintaining a significant, or even a majority, ownership stake. In essence the owner is able to create liquidity and diversify risk today, while setting the stage for a second “payday” down the road. These transactions enable our clients to partially cash out of their investment in the business and capitalize on the enormous amount of sweat equity they have put into their business over the years.

The original owner can continue as a partner and/or manager of the company, while the new partner and capital provider shares the business owner’s culture and vision for the future. Unlike some strategic acquirers who purchase with a view towards eliminating overhead redundancies, private equity firms prefer a more passive or board level involvement and a collaborative relationship with the existing owner and management. As partners, private equity firms are often able to introduce opportunities to the company that were not previously available and can provide significant experience in order to assist the company in growing to its next level.

For owners wishing to partially cash–out the actual mechanics could be that the company issues stock to buy back debt, which had previously been provided by the owner for funding. In its simplest form the company may merely sell stock to a third-party investor.

Less common and understood is a leveraged recapitalization. If the owner desires to pass the business on to his/her children a leveraged recapitalization can be a very effective strategy to enable the owner to both take cash out of the business while at the same time making it affordable for children to obtain ownership. With a leveraged recapitalization, instead of issuing stock, the company may take on additional debt. The amount of debt available to the company depends upon both the assets available to collateralize the loan as well as the cash flow available to service it.